::'PREFACE

I Audiên(e
'1hjs book
pÌoljder i wjctc audiencc with accesr ro Ìnodcrrì rnacro.ÈconoDrics. .fhc
.ore
au.licnce ìs undergrirduares who already have ÍÌìe brckgroun.Ì LÌ ma.roeconoDrjcs.
Ìr
i\ ako de\igned tar gr.ì.tuate stu.lcnts, âcadeìrìc cconoDriÍs, and economins woÌkììrc
irr policy nriking and the prjvate si.ctor irho rlarÌt an introduclion ro
Ìrìajor chanB€:
that h.1e rakcn pÌacc nÌ modem macroeconomics. ftrdvrc<lge orcconomics jras
L,eco;e
ilcÌcasnìi{Ìt .enh al to couls.s in politicat sc icnce and pubìic poÌjcl an.l lhi! book
wiÌl be
''. /.1 -
' \.11.
Tlìrlrughoutthcbook,rlcenrphasizethe role rìrat trp.,fe.tn rsÌrlayin ÌâLrour, pr)d!.t,
and lìnan.ial nraÌkct\ ìr short, mcdnüÌ, iÌÌ.1 Ìonlt."n m".","co.umi.,.
/,,ìrft,,ri,,r,
and pdlt.iri leatlnc heavily irÌ the boot. Bv instirulions Í,c mear
both Lhe trrcad nÌÌcs ot
thc ganÌe srlthiÌr I'lÌi.h the ptarcrs jn the c.ono.Ìy otcrate and rhe tcv
oÌginirations.
(i.nkrl brÌÌks tun.tion ac.ordiDg to the prc!ajling nnrcta^.
Ìroìic\, Íame;ork an.l ser
'|,d I,', |.t i.t,i i1 tL. ti.r , , U i , t i . \ r ; \^
r .
r,1,,r.,,.r.1 ,
'. ,

employeesoperar$!ithinasetoflabourmaÌketìnÍitutio.strÌivhi.hunjoiÌs;e\:L,arÍatrì
F L.r<..r.,1 \,. tr,i. ,- t.\!,\, ,.,r,.ri3o,,r,,3.,r.,;
,,, r^ -,i,:
io,. r".dr J. rlr-, \, ,r,,..-.,,tr,.
GovcrrÌDents ünplrnìen|ìscat poÌlcy wjthjn a nscal polil:y iìame ork.
t.1Ìevnlso.l.\j!ìì
., i ,.r''. .n .,t,^",r ,.-. .Lr.r,,, ir.r ,..ri,, J.r..ir..rr ..
large pÌr)eÌs in thc ccon.)ml'ÌÌÌav a.t
I,
fô,i..
ÍÌat.gicatÌÍ iÌì thcjr o$n ìnteÌest ân.Ì r,e aDaÌvse
r' mt '. .rr

2 What this book ofÍers

. to undergÌadrâtes studving ccono nÌ ics
lL i\ likcltÌ that vou were âLúiìcte.] lo econoÌnics becausi, it offe6
lhe prcspecr oi
ürder\tandiÌìij big questions about how ihe wond l,orks. $/hy has irÍtatio;
bc;n .,u.h
ü major trobleìÌ in sonrc colürlri€! at some ti nÌe\ but
Ììoir sceÌns,cry loí,ânil strbìc tf
'' ''r 'j< rr- m .F ,rur-nlr rII.IL\\|IIdi, n-\ iiN.
rl- l. rr.r ', , t, ., ,.. .ri.ti.rv
beftcr in Ìc.ent ycaisl wÌìy arc cermanv an.l Japrn peúòrmuÌlj $ po{;la? Wh.iarc t1ìe
l .l. r,1 r..r.rrn\,t,,...,,. Ii-r., . u,,o, ,, . tp, .
a consequence oÍ Chìna,s iapid SÍrlrh? How di.t ,oÌIe collnhies Aet lo be ri;h inì|e
''l- . ., .. \^ , r'.rr.i' .r,.....ri . r,t .t.\:rr .;-ro, l-LU,,.j,
Jusr as whcn srudÌiÌrg ìncluÍÌi.l econorÌrjcs lou cxpe.r ro be able to dÀclrss conìDe
:'rrui. d-l,.r'\ ..ri. _,,r;,il..,.. .-,t.,, ,,,--
:ì:,,il1ïïJi::111ïl;lliïi:::l':;:tl:,ìffi,f,ïï'iï1",1..11ïï.11ïìll.Jliiïïï;
 Lhe [U, the causcs ând conse!Ìucoces ot the US^t lridcnnÌS current a cco unt .lc tìcit_ th.
ìikcly cofsecÌu..ces foÌ uÌÌemploln1ent ot an acceleration oi pÌoduciility
Sroieth, tlÌc
ÌoÌc oleducatjon lÌÌ economjc gror\th, a.d $ on.
lhis book givcs rou a sl'sremaljc wav of thinkLìE about quc5tir)ns ljke Lh€re. you
wilÌ
cnd up with a modetrharyou carì use vouAeìt(o un.lclstarì.1nì.cmc.onomlcbchâviour
a.d policv issues LÌ the .e.ìl woÌld. ÌÌÌ wlÌateve,
iob vou get. wheihcr ìlorklrÌg in a stad-
up high li.ch compart or ir a tanìilv hUsiness, ììÌ a ,oÌuntaÌy
secLor organizaliorÌ, for
an nnestment bank, or for thc ÌÌÌinijúy ot íorciitn úade, \or1
$,ant the confidence !o
bc able ro ìÌìteÌprr,t nârion:!Ì and jniematÌonaì econonìic trends and
the policy debatc.
Such conÊdencc ìs buill in thjs boot bcciìuje jt nÌtegrates thc ditfcrenr.onnnnents
of

undebtand
' l ,Fr \', r'
a arhote range
ò ,.,. , r' ..i t. , 1,. -\. rô
ot l)cdormân.e and polìcr issues io turope, Japan, add ihc
USr\ nr Lhr laí rhirtyvears. you J]].) want to tat. a Ì.Fk attherc (hapter\
bclorestartnìg
on tire rcÍ oilh€ book.
Going ÌJ€yond colnscs nÌ nracrft,conomics. the book ha\ coÌe rÌa(erjaÌ tor
courses ir
(he ecolÌoÌnics of grorÌth, mofc\ aD.Ì bankìngl
lâbour e(onorÌÌics, the c.oÌìomj.\ .r
LrnemployÌnent, intenÌationaì nìoneiâÌ}, economicsj an.1 thc econoÌnì$
of moferrÌr

. to j{râduâte rruderte in economj.r

This book is based onthc ÌlajÌì 5trca m nr o netaÌy mn(rc modetusedjn.ün.entreJearch

in Lìriversitics ân.l centraÌbanks. N.Íodcm moneteÌ1l nìacÌoc.onolÌÌjcs
Ìrses rÌhat js ofren
calì.il tlÌe 3 cquation Nen Kcues ian mo.tcÌ, Ì!h e rc t1ìe th rcr equatj{ìr s
are

. thc Ì)hiìÌips cunc (IC) and

. in opLirÌÌizìng monclari poìcyruÌe(rírt].
Built arcund this corc.t1ìe book p()çid€\ vor wjttr a reteÌrnce bick to nÌtuitìve
and
less lonÌal cxpÌanati(nrs of the 3-equatjon moilel anil ot ea.h ot ìts coJÌrponlnt\..1.o
tâciljtate rhc fdiÌard lìnkage to more acLvanced treatmcnts, irc íroN
!r alìì;tcr 1S lìow
the modeì can be biìilt uÌr 1ìom mi.rotì)un.tatjolÌs i!ìLh iorwaÌd tdrkiÌÌg
opiimjziÌìg eco
nomi. agenLs who have Ìationaì cìpectarjoDs.
Thc book also provj.ies a rìgorous coi:ragc of grcÌrth tÌrcor\
bodr crogcdourj ancì
eÌì.togenous. The( i\ a comprchenljvc chapter on the SoloÌÌ Shan
nìo.Lcl wjth an
appendix thnt iÌrkoduces Ramscy savings. Wc enÌthisire the charactcristìcs
of íci.lv
,.....r .d\ Lr.n.i .. I I , {. rt- m .r I
.an bc iìse.l ro tertempjrlcaÌl)itd.rìÌethereconomies are convcrEiÌrÂ.
DìaAranrr! aDLtintrì
l .ll ,t",'.'i.r.,,nt.iI\d., ., ..r",t
'.',' pr,\íit,d .tti
rlrihed treatment oten.logcnous gror\th nÌodeÌs an.l cxplaì. hoÌÌ
lerjjon oti sjmpÌì1ìe.j
theSclrun\rclerirngroÌlrhrnodeÌr'CÌÌ\.Weiìtusriârctherich\.üÌÌct\otcuesrjctrÌsahoììi
.,F rr..,J, .J.t .'.F...rJ/ r\.-,. ..
spriÌrgbodrd Íor goin! on Lo nxÌc
"
lechn'cal anatlsjs aod prcvìde a stimuÌus íor thìnkng
abouL Ìì. r\.apptÌcd qu€rtìons.
 . togÍaduatest(dcntsinpoliticâl scicnccandp(bticpoticy
Tlììs book prcvidcs a \eÌl conraiDed úcarment ot moderrÌ nìacÌoc.onomjcs tÌìat i\
acccssibl€ to gradualc ÍudeÌÌts of poÌìtjcâl s.i..ÌÌce and public policv who hìve thc basj.
malhcmiìticaÌ compctcnces cle\cribed beloi\' the apprcaclÌ incoryoralcs the pÌcscÌìc€
oÍ mirrket lnpeÌtc.lions arÌd iÌrcÌuiÌcs corcriite ol a I'id€ range ot poltq, Ìbúum..nts.
Il is desisned to highliitlìt the roìc in macroecononri.s ot ditÌ€renc.s ncro\s coúntrie!
iÌì ÌrÌstituti()n5 lÌom th€ lâbour markct lo the nnancial syÍem and is rlell itcd for
Lhe stlrcly ol econonìic perf(ÌÌnancc and polic\ Irirhi. sp€ciÊc political contexts. tn the
chapiei on loÌiticaÌ lcoÌÌomvj rÌc cÌplain iÌì cìetail thc Ía dad n)oÌs ot dnaÌ).sis that
are u\ecl in political economv and thctr application Lo (,rtl known pÌobteÌns jncludiÌìg
th€ .redjbiÌitv oI.cntr.l Ì)anks, polilical busirÌess cycÌcs, the role ol union cooÌ.Lirallon
on wâile baÌgainiÌìg to solve colìeclirc aclion pÍDlems, ind loting mod€Ì\. Thn chip
tcr irchder a scÌt cont:ine.l ìÌrrroducLiorì lo nruch oI rhe ca € theoÌv lhat is needcd in
rì.rcÍi political c.onoÌ y.
. topÌofessional economists
'lhe applicd.hapteb on peÌlormance and poticv in
turop€,Japan, aÌrd th€ USA and on
unenrpìotmcnt provide oven icws ol rccent develot)Dìcnts Ì.tenÌpìÌ ical aÌÌah,ses wjlhin
the franrerÌork of coÌìtenporârÍ nÌacnreconolÌìics. With ìts cmphasir on hor\Ì
centraÌ barks bchave rn.l. morc 'ìonctirv
broadlt, on inrtirurions and polìcies. the book can be
usecl as a Ìelresher lor thoie pa4s ol macroeconomic lheorv that ak moÍ relevanl for
econonist' irorkjng o reaì woÌÌd problcms. Ahhoúgh we develop thc 3 €!Ìuarlon New
Keynelian modcl as the ne$' coÌ! ol lh. slÌort to mcdtum nln mo.ìel. Ì!e írorr how jr
lirkstothetradiriorÌalnÌacio{orkhorscs sucha\ I)_i/.Ìr and theMun.Ìcll IlemiÌrgnìod€I.

3 Approâch
1\'e bcgin tronì the âssumption thar our trBt task is to ltÌovtde a mo.ieÌ rhat c:ìn be uscd
t() undcrstaÌÌd macrocconomic behavjo(r afd poÌicv issucs. wel as beins phrgged
irto rhc rc.1 woÌÌd, ^s
rhc bool is tinnlv conneüed to corÌrcnìporaÌy dcvclopmenLs iÌÌ
macroecorÌoÌnics so it opcns up accesr t() morc advanced litcrature and couises.
3.1 Ìhe cuÍênt consênsus
(-onscnsus irr macrccco onÌìcs has oltcn been ehsilc but Ìe common g(NDd
is ÌÌÌuch
widff norL thrn hãs been the casc tn pÍcvlou\ .lecadcs. striking illrÍratior ot this can
^ in tìre ìarc 1990s, wlìich arguc
be iound irì the rillcs of two inilúcnrlaÌ articles pubÌished
for a simiÌaÌ nrai.Ír€aÌÌÌ nÌonetaÌ)' ÌÌri.ro iÌuÌ.ì: ,1he Nei! NeoclasslcaÌ Svnthesjs and
FP' '\l r.rr'll r).r'r. l ì. \, i. r ,, , r \'w r I t.,r. \\.rt,,I\dr
'.t,, i\"'\\ 't, ,rF\ ú .,,,.r , t...t." ,,,, ,..., .,.,,t\.,.,"1-.
ofthenrodelâ.estandardÌnethodologi.aÌfeiìtureso.ontemporaÌlc.onoÌnjcnÌocteÌÌing,
the te Ì 'Keyneslan' rcfers to the Íacl rhat sLìch nìodels âÌlo! ftÌ ,prolonged .lepaúuÌes
of e.onoÌrìic âctìvìtv tuom ìts optjmaì Ìcvel as a consequence of insrirLJilirÍ jn atsresarc

r Cn.dtÈndrÌrKii!iÌ99;l)fdCÌâÌida.cxh,r.dc.Íterllg!q)
 so \,voodnjd t2OO3).
I TheÌe i5 broacì dgrrenÌeÌlt lhat a fujì1 sâtistucún mr.rfç.nn!.ri! r:.ú: irrr ú n-
l)ased on opiirnjriÌÌg beha!ìouÌ b! micro agcnts, tÌrrt Ìndn ìduai ìreh:\ ìour rìrouÌd s j.n
ÌationaÌ e\pectâ tions, and thal the mo.lcl ìrouÌ.Ì alÌo$ toriraSÉ dn.lpìjce ÌigjditÌ€s. Thê
3 eluatioÌÌ (lJ lC ,VN) Dodcl is the baslc arâlyticaÌ Ín'ctitre in much oi contÈmtoÌar\
ÌÌa croe.ororìics. 1hc l h rcc c!Ìuatidrs are derlved tr om erpliclt optirììzllg treh a!n on
t1ìe p.rt ol the nìonclêry authoÌitv, ÌrÌice setters, an.l househokh ìn i.rpeÌfect pìoduct
anl:l1âbo!r arkctsnndII thepresenceof í)menomÌÌ41úgiditìe\.
ÌÌìthe nìainstre.nì macro model thât Ì{e pÌeseDt ìn thi! bool:

BusìÌìcss c!.lcsarcdÌiven b_v sÌiilt!in aggregate d€ÍìarÌd íirn.lwe contrrÍthi\ witlÌtlÌe

R€alLìusiÌìess Cyclc modelìn which nÌ{t,v íÌocl\ dril.c the c}cle).
Outputand e.ÌpÌoy Ìeni arc altcclcd b]'lÌrclrtalìons in aggÌcgatc dcma.d bccausc ot
nominrl iigìcìitìe! thât prevcrì1 *'â8cs and !riccs ÂdÈLtnrg Ìapidìt.
'11ìe central banli is rnod.ìÌed a\ a ctive\' a.lju stirE the üÌtcrest râte iÌì re\pon\e io

ílochs to the e.ononìt so at to r chieve jts infÌatloÌÌ tarllt.

Aggregate demand tÌrìct!ations shilt lhc cconomv awav fìonr the equiljbrium ratc of

'Ìhe eq!iiìbrÌuÌì rnlc ot unenTlo.,"nÌent llRtÌ) is the oul.ome ol impeÍèctly

coÌrpetitive la bou r and pmductrna.kets there i! irÌroluntar! uÌÌeÌnplovnÌent ât t1ìe
ERU.
Srfp\'shocks\hilttheequillbriumratcolLrncmd.)vment(lRU)a.djnsliLutionaì
andpoìic) .]iffeìence\ rcÌoss coltnlrìcs inpll dillcÌtntlRl\.

AlthouijhtheJ eqLialion \eirKevnejian nrodel is the LJ.si\ ld ou. nr)ú andnrednüÌ

ruì model, $re aim to araÌ_vr ÍeaÌ Ìile econonric Ì)enornânce $ ive ircÌu.le a Ìlcher
treatrÌeÌìt olÌÌtrcroeconomlc trccesses tban is often ihe case iÌr the nn nr al nr icÌoioun.led
Ne$ Ì(eyiÌe\i.rÌ ÌÌÌodcÌs. I xnnrltìer in.lude lhe ntÌ($üÌt:

. hoÍ'instlrurio.aldilleÌences üÌ wage settlng alf€ct macr.iecoÌìomic outcorÌÌer

. d n!nÌber ofÍÌechaninns through h'hich muìLipìe e!Ìu1ÌibÌ ia can.mc.gc a.d
h). Íeresi\ can operat€, irÌ.luding cooÌdiration tâiìurc5 and cepa.jLr uLÌlizalion cll.cls

. h oh th e fl ow app()ach to the la bour nÌ.ìrket c ün be iÌìtcg..ted rlith the rlrge and

trice setting Dn eì

' etpl.nâti,rÌÌslor..)'.ÌlcaÌorwcaklyprocrcìical rcalwager

. tr)biems irith usìng an interestrai€ bü\ec] ÌÌorÌeta ry ru le
' thc ro]lr ofthc crcdit.hanncÌlo monctarypolic!
. how ìmpeÌfect nrnÌmatl{ÌÌ prod u.es liquiclltv constraiÌìts irÌ ron5umptnnr and
elhaÌrces the imÌrortance ol r€ta ine.l ptuÊts lor iÌn,estnìent behaviouÌ
. slìort- a.d ong núr ciÍccG of hscaÌ pol j( and th. bglc of lÌscal polic,v r!les

'theÌúerrctjonolrrtioÌÌ!leÌprclationsiÌìhna ci.1rìirlet! $ith noir adjustm.nL jn

itood s nìdrketi to produce ex.ÌìangeratÈ overshootiÌìg
r catrscs afd .o.scqtrL:n.cs ot \egmentarion in ir te rnatir)n aì goods nÌirkets
 . short dnd m€dium mn nü1\sjs of inte ÌdcpendeÌìt economics, i.e. bc!ord rhe sÌrjlì
'1 , . " 1 -
. the shalcsic inlcractjorì berr\,cen ihc centralÌriìIk and laÌge
!!agc s€tter ân.Ì the
con!e.Ìucnce\ Ior €.ÌuiÌjtJrìum !nemployÌnen r.

LÌ thu .ase oÍ elch \.ariatÌon ni insiitLìinnri, poìi.), or b€havlour, r,c

shoto hoh, the
basicl.S lC l,í,( nÌoclelciìn be nìodincd to incÌúde ir.
3.2 How to Íudyãnd teach the 3 equation modet
Thìs book ìrÌtr)duces a rÌel{ graphical 'b.ìselin., version oI ttÌe 3
cquation í/.!-pC ì,1/ì)
ni \i .r-r.' , -,ur,rt'../\/,
'tl -! l,,tt. \//1r,dl n!/,
rt..t',...,.-..r.t, I\,,d...r ..tt.,,--r\,,.1,.
erìtecl in t1ìe larter alor! with the lrhlltip\ cur\es. Lhe aggr€grte
suppìy \Ìì. js;od
eììcd usi.B iÌÌpcrte( t .orÌ\rel irÌorì and the thjììips cÍÍles aÌc
deivrd úÌjcit\ r,om Ltìe
bchd\ iour ofwage and price sctte6. Thc 1,1ÌjÌtìps cuÌvcs are th€ conrúniÌú rhar rÌrc.efrnl
rr p. r'. '. .. t-., r . .-.. ,, .
I he centr,rl banl choose\ pretè cd combination ot oúLput and irúlalion aÌong r;c
1ts
lihiillfscu e Lhatir tices. tt lhen uscs the/Scurre Lo catcuÌate whaL iÌúeÌcÍ Ìalc rm,,sr
'.,,l r...:ir,-a..,,,n,4.,. .,,r,,...,t..1.
'Ihe /.!J,t--
I/( gÌaplìjcal anaivsìs js paújcularlv usctììt io. erpÌainiÌìi< rh€ opllmjzins
.1.,\,..r ,r ". ..,..\,i.r or rr
l..r ,, r,tr,,..,r..', ,.. irêiLL,- rh. .., ,, ,,
conìe Íonì and are thcrctoÌe able to vary the âssumption\ about
rhc pri\ aLc \ecror o. the
bcha\ n)ur oltbc policy nÌrker. tor exanple, wc cân sce lvhat
happefs if thc cenlrat bank
is nì'ì.ie independent and i! more âveÌs. r() ìnfl
more,espon\ivctouncrÌ,'u,,"*",n,,,,*i"ïi,ïllill,ï::ïil."ïl'ï:ïïi:.'"ï
$hl.h union\ arc impoúant a.ctir thc ortÌer thev arc not).
ln ol.lcÌ touse rheiiÌaphicaÌ oÌocteÌ, ir is ÌÌecessar\ ro thiÌìkabout rhe
economjcs behjncl
th. i1Ìree Ìcy re la( ionsh ips dn d l lÌ€ prc.cs\es o f ad jrìÍment. One ot rtr c reasonj
iS-tM got I
badname s rlÌar ir too frcquerll).be.al]le rn eÌcrcije in nrlcÌÌaÌrìcat
curye stÌiftifg. tÌ;the
fraDìewoÌk pre\ented hc.r, iD o.{:ler nr,!ork rhÌ
ensase jn oìcsamcroiwâ,. u-.uo,n,.o"."iiiï.j,jlìì:'""1ïiï:ì^ii:ïï:ì:ï,:::ïi:
sketching oltlÌe ti]lÌe paltÌs olkc)'vaÌjabIe\ as the econoDr mlr\ er lrorn
or€ eq,rili;Ìj,rm

3.2.1 why diagraÍns aÌe êsentiat

l)lspitc the.Ìclelqrlnent of the 3 equâlion (Ls-frj Ií/Ì) model, IÌicli\,s
tanì(Ìrs à /.À,í
molel oi 1937 nrÌrpìcrÌrenlc.1 l)) j riedmar's exl)ectation\ auÂnìertcd
thilliDs curve i\
.i, 'rl, L.\, , ,J ltl3.ì L L ., (.1,r ti\ ,tr ..t,,., .,,,. rr.f,,f,,,., L
l\rf ' L.r ^r- -. /,...ti ..,.. -rl.i,-r: ì n,,,.,.,J
rerlt\ lravc \idelined b! derclopnrenls iÌÌ economic ttrcorv anrl practice,
been
anct itrc
3_eqLhtrcn modd has nìt)eÌccde.i il iÌì graduate rcichìng
Urdoubtedh, thc tongc\jtv of
15 lM has beeD d!e ro the rì.t thâr its graÌrhìcat nlethod
pr^,des students witì;n j;Le
3Ìaled model tlrat they can dÌanìplllirte. AÌlhough rhe Lrse oÍ cqurtìons in iÌúermediat€
rna.roecor'rmics texts has increascd, dìagran\ Ìetai. a.entÌâl place.
tn our !ìenr. thjs ìr
lorgoodre.ìynr.Whcrdelclopìnganundcrsta.di gote(momìcs,itÍvcrl,impdlari
 not only to underlrand abour e!ÌuÌlibÌia ancl comparâtìvc Íatjcs but also to
di\cuss holf
tlÌe ecorÌomy mtght adjust irom one equitibrìum to another. I o do this math€maLi.âth
li.-,r-,^ r.-.t..J'i.,,,....dy. n\1tu,,,t.\,op
c.ononìic intlriLÌon, i.c. lhev help lou lo 8et a tect foi lÌow rhe ccononì! wjÌl
resDond r;
/ t. t,, ,r,r. I, i.." ,\.t'
', '
The bool is based on lhe asmnTtion ttÌat djffcrentÌeadcrs ga n cljftcrent
lnsiilhrs ftonì
mathcrnrtjcal, verbaì, and graphical reasorÌjng. So the book nrnkes use of them
aÌì. Our
liew is that tÌìcy reinforce each other, but jtí quite possjbte, f(tr eÌrnrDte. tl) use the bôÒk
with little emphasis on theequat oÌÌs.

3.3 Deãling with the opên economy

Ar iÌÌÌportant characterì\tic of the book is that it otïe* ir comprehensive and cohcrent
treâlmentolthe opcn ec(númr. \\,e !ìove fÌol]] t]re jrÍu odeìl_flenr i ng nodcl wjth txecl
priccs in thc smaìÌ open ecorom) to an integrar€d approach to neilium
tcrnì iDflation
adjustÌnents âncì thcn ro intcdcpendcnt econoÍÌjes. Agrin, s,e make use
ot a corc di.ì
granì to provlde a unltìerì organizi|g frimework for dcaling s,lth both thcoretical
inrl

3.4 How to use the modet Ìo answer new qu€stions

Once thc open c.onomy nÌodet has beer cov€re.], Íou Nììt be âbÌc to usc it to ansNeÌ
questidìs lile this onei nhat is the ìiketf cif€ci ot a countr\,,s inlolvenìent ìn â Ìlrr
.,^o.l. lpt r\'Ii ,.., \ rh, r, I r. , rt., I,,r..r d..-.rt,ú..o,rtc!.\
sholt run cquilibÌÌum.ìnd thc likelvpath of adiusrDrenfto it. How wlll thc Drivrtc se.roÌ
'\lori rd\r,la ,,, . .i ,.r . , ttpt,t ., | 1,,t., ttri | .r oÒòr-;.rt-
denìand shock: go!:rnnenL purchascs Íse and this I,iÌt push empÌovment anã ouiuut
.1. ilrê"'r\".ü, rr,''i i J i, | ,rìr.,o\I-r li,re,,:...
lêitü" 'ri.nr r4t .'ri,h,l.r"J . t.,.rk..r" I, r.rL,,.r *tr. nc
moncta.v policy shoutd be adjuste.l (thrprcr 5). Thc paraÌìct develoDmenr ottlì. sh.Í-
',ír,. ,,.,. I,,., o ,ò.t,.1
economy aspccts to be üÌcoÌporat€d I c.u. rlhat i! the tmport content ofgovenmcnt
war
related purchasesl The exchangc râre rcgime jn place wilj affc.fthc anah,sis
of th. shorr-
.u,r ,rd ,,ou \,tt,t, F\. LJ.,c. .o,-rFd ,,.ro- ,., uiê. . .,,úhFrt_.
.o.,,oe..,r ô,
or,-' ..ll..rNt-,. o \'-t.\dirr o, v r' Ír l. r .t. n |p.rlr .r,.r..,j
of fina ncing the waÈrcÌated cxp€ndjrlrr€ may atfècr rs impact ;n lhe economÍ an.l tlr.
i
/i\"..ior,tt\\.,\u,L,r-r.r.p,t4in,,,.p-,i..t\rrl-\err!,1
slÌouÌd considoÌ whe!lìer irvotvcrÌÌen I iÌì rhe n:Lr could havc med ium run
coD scquenccs,
i.e. tbr the supply jide otthe ccorÌom, (Chapter.l). One tìnc ofalgunrent
wouÌ; tuììô(,
'r'rr,l. r'\. ..-1t rl,r.trr, .r ,-,.lro,rd.,,n,oo,i. u .,\ r.B n)
inteÌ lÍiÌìi{ thc nrÌrpìy ot oil. hi\'.,r,dt,.,|.r
,ro o1.l pÌoduce a resati\.e extcrÌìal soppì}, sho:k a;
t

anirlysed iÌì Chapter I ì.

4 Prerequisites and te(hnical level

lve assumc re,r.ìeÌs have a tamitjarit! wilh InacÌoecononìic\ s0.h as provjded
by a priD-
cidcs couÌs€. we use aÌscbrâ and sonìe s iÌÌìpÌe calcutLs bu t ex pìajr
1Ìie mcthod;in; tlìc
re\uÌts veÌbaìÌy ând grephicalìr as Nclì. w'c ìntrodu.e tlÌe use of loiis ard cÌponerltial
hüÌctions atthebeginnìng oIChaptcr l3,bccausethe! âreusecliÌìthe thcoÌvoígrowth.
Chapteb 15 and 1{t aÌe dcslg.cd Ìrìorc Íor a gÌadLrate âudlence aìÌ.I more maths is u\e.l.
However, verbaÌ and graph ìcaÌ cxpla. ãlio ns arc siillprovided.

5 Chapter by chapter structure

(lrr\rrLrRIpr)vìdesmoLnâlionÍorthcoìainnrodcÌsprese jrÌ the book bl idcotiili
tecj il
a iet of key.Ìuettions in rìâcrccconomjcs. Since th€ booli aims to shorr how lhe model\
can hr bn)ught to bcnr oü .ontcmporary pcrtoíÌìance âncl policy isnìes, ffoss counúy
datr js Ìrresented bolh in rclation to thc shoú- irÌrd nÌe.lilìm nur ismes and in tcrns of
gÍnlrh ard the world dirilributtÌì of jncomc.
ìrART I consitls ol Lìvc .haptcrs, which prcs€nt tlÌe sÌrtrt and medìum-nrJÌ macro
Dodcl. C lr, s 2 and 3 scl oLrl thc boildlng blocks ofthe macro models beginning Ì\'ith
eggÌege1e d.nìa.d and sÌrpply and thcrÌ irÌcorporating iúÌatnÌÌ, the lhllìits cuNc, .nd
the monclary rulc. BÍ thc cn.l of CHÂlÌ 3, lh( l.\ lrc ,V,R nÌocleÌ i\ hÌ plâce. 'Ihc ÌÌìain
!tÌ.em nrodcì oI b('sirìcss .)'cles .s lluctúaliolìs iround tlÌe equilibrnüÌ ratc ot uÌìem
tlo!'rìcfl drllcn bv iggr€gat€ demrnd shocks Ìs conüastecì iïith the real búsincss cycle
modcì. ln (hc rcnl brsiness clcle nÌcÌiel, suppÌy ÍÌocls ptuduce business cyclcs and over
lhc coú6c ot lhc rycì€, the tÌuctÌìations in crÌÌployment re1Ìect the choiccs made b)
lio rkc rs rcspo. dliÌ8 to cha nginll o pportu nl I ics in the ÌaÌrour niarlet.
'lhc major iníilulional and polic) dctcrrniÌìants ol equilibriu Ì unempìo)'nrcnt ar€
ìnaÌ)5edi.C !,rr;1 lhcsc nr.Ìudc hosrwagcs and pilce\ are set under ìmteícct conì
petitnin, rhe jnflucncc oo cquiÌìbriunì uncnìpÌoym€ÌÌt ol sovertrnent poìicicri, the role
Lrl.lifferent ìnititutionalaÍangcmcÌÌts Iorwagc setting, etplaìratloÌì\ f(r hysrcrcsis, and
hoN the forv apprcã.h Lo lhc ÌaboLrr markcl .an be iÌúegrate.l ilith the modcÌ oi rage
aÌrcìpÌi.e setting lo enrich thc anaìysìs ofcq!'llibrnununenÌploynÌeDt. TheccnkaÌ bank's
nmretaÌv poì1cy ruìc ìs dffivcd as an optimal policy nüe in C ArìLl5 and thc problems
cìlinUatn[biasan.Ìtìmcinro.sislcnc]arccxpÌained.ÌÌÌ()rÂr,rü6,then]aclocconoDÌìc
role\ ot li\caÌ poÌicv arc pr$cnlcdr thc provisÌon ol.utomatjc stabiÌizeÉ, rhc usr ol di!
..€ti.nrürt policy to coÌnplerìenr nìonctary poli.! in \tabillzatidÌ, and rhc rcquüenÌent
''., idur,r.,ì ìr'r',,I.uh d.h
Ì)]\lÌ I 2 has t\!o ch apters th ât dcaì a'il h co n sú RÌption, nìvestment, mo nc)', and 1ìnânce.
lhe aiÌn is to lhorí how slandard ÌÌicrctoundcd nÌodeÌs inlÌLrence the intc.pretation ol
thc A, tlÌelÌ,Í, ancìtlÌe tÍn. Ìr arL!,r r 7,lhere iramlrredetailed anaÌysn ol consumption
and iÌN€stnÌent behavìour. ÌÌr cach casc lhc optimiznìg behrvìour oí lon\'aft ldrkìng
bouseholds or tìrms í uscd 1o dcriÍc rcspcctìvely.ì con mption and arì iÌì\e\hnenr
iLriìction, whiclÌare conrpaÌe.Ìwirh rhc sìrìplc nìacroeconomic hrnctìoni used iÌì fART L
ln CHrrÌn 8, there ii a moÌe deLaÌlcd analvlis ol tlÌe difle.ent knrds ol asset! in thc
r.onorÌr and the roÌe ol inf{nmation problcms in explâlrini{ the exiícn.e and lte ot
hnif cial institutioiÌ\.
ln lìAR l 3, an iÌúeijrated Drxieì lor lhe analvsis ol the open econonì1,. is devel(Ded.
(-[ r,+ ì 9 is corÌcerned wjth tÌÌe sho4 run anaìts]s ol:! sÍÌalÌ open econorÌrv. Ìt presents
theúadi!ionali!ftndelÌ Flemingmodeland in corporâtes finan cial open ncss b) ás\uming
pertccÌ capÌ1aÌ mobilltv and arset subslÌlurabililv in the tì)rm of the un.orerecl interesL
parllvcondirjon. PÌ1ce letting inihc open economy, exch.ìÌì8e r.te overshootiÌìg, and the
üÌìpìi.ationsotdrrtpirgtheassumttionsotasnralìecono y,pe ect capltal nìobilit-t,
and pcrlccL astet \ul)stitrìtability are examjned. Cr \rrR 10 eÌtends the model fronì thc
slÌorL !o thc medtum nuÌ by inlroducing the analv\is ol iniÌation. lve use i core open
economtdiagÌanr nr nu! the goods maÌliet equììibriruì (i.e. ilÌe operÌ economy 15), 1lÌc
sUppl,v s!.Ìc (i.e. the equilibium rate of uneÌìplovment irÌ the open economyl, ând thc
tradcbalancc. Thìs graplÌicr1 a pproach allows ut:

ltl to analyse the coÌÌtraíj.g sÌÌ)ú nìn respon\es of thc snraìì otcn economl undeÌ
nxed ar.l Ue\ible ex.hangc Ìate\ to a !i\en lìsciÌ or monetaÌv tolj.v chrnge oÌ
agjaÌe8aie .lenÌâ nd sÌrock;
(21 tosho lha!theme.lium n cquiÌibtiunr wlth constant iÌúlation lolÌo$,ing ll gir.cn
5ircck Ìs i]rdcpcndent olthe exchângr ratc Ìtgime.

Cr ì, rr I1 ÍrÌvs
the vcrsrtjììt) of t]Ìe itraphi.al aPfÌoach b-v ìooklng at agiiÌegate
dcmand, exteÌnal tradl:.ÌÌd cxleÌnaÌnìpd) slìocks iÌì thc opcn economv.Italso exten.ls
lhc MC Ií mocleL to thc opcn ecotronit sÌÌo\{iiÌg IoÍ'en inflalhn targeriDg ceniraÌ
bank reston.ls to arÌ aggregn lc .iema nd nro.k. CH^rrtr ì 2 goes beyon.l the q picaÌ 5coPe
ota nracr) couúe by lookiÌU at dre ânaly\is ol iúerdcpc nden t econonrle\.
Ìn |ART.1, there rrc ti\r.hapteÌs on itroÌltlì thnt prc\'i.]e a thoÌough treatment ot
hoth exogenous rxd eÌrdogcnour groL{th nÌodels. CH\r ÌI I:l concenhates or tìretheo}
en.l en]pìric\ oftlÌe Solo('-Swan nÌol e1 ol el.rg€rÌous groi{th and Lhe issues suNrn.ìint
con\ersence. cHÂlT L t.l provj.Ìe5 üÌÌ introductioÌÌ to a range olendogcnous and schunr
peterian nÌodeh of grorlh. \\ie cornp.re ciitìerent chnn.els thÌough tlhich endoge.ous
g(\ítlÌ rray operate kno lcdge spillover\ fronì thc accumtrlalion ot Ph)'sì.aì .apitaì,
úrvest!Ìe tirÌ hunÌiÌì cnpilaì, and nìveÍnÌerÌt iÌì RliD. lvc shott hos, Lhc SchunrPclcrìat
mocìeÌ can help us to undcrsiancl h.nÌ institutiorÌs alfccl gíNth, bolh in countÌjcs rt tÌrc
woild technoloS_ï fro n lìc Ì and 1n poor .ounüies.
|^Rl 5 consiís ot liso chapteL: the Ìni.rcfoundnl ons ol lh. NcÍ' Kcyncsìan Ììodel
irÌ cH^nflL 15 alìd a chapteÌ on political ecoÌÌoÌÌÌy. alrl rr l5 trcvjdcs a syslcmatic
ÌÌricrotòundcd trcalmcnt of tÌre ke) l€atures of the Ncw Kclncsiin modcì. r\ilhiJÌ lhc
\:ìnÌe lr.mci\'o.k, $rc inçettigate \€verìl ü,r.leis thit prcdtr.c nìullipìc mcdiunrrLrn
!neÌÌrplo,vmenl cqLriìiìriâ. These iÌìclude models of h)'ícÌesìs Proccsscs, and modcìs in
which workcrs valuc not onll corÌntrÌìption and leis!rc bu( aìso Iaüness, \!hi.Ìì r$uÌls
iÌì the cxistüÌcc of a range of ecÌullibrirìnÌ enìplo),rnent rilcs. CJllrrrìì Ì6 is on PolitÌcaÌ
lcononry. lhis locuscs on the use of 8anÌe theor) to n.âltsc sorcmJncnt and c€ntrnÌ
banÌi bchaviour. Borh chapteb aÌe self coÌÌtâiÌìed in tÌrc scnic lhat thcv do not isÍimc
prioÌ knorllcdgc oIsl)ecinc models or te.hniquesl othcr lhan s impÌc .al.u lus. ,\Ìl ol thc
gamc lhcory nccdcd Í.Ì CriÁ,rrR 16 is prolided iÌì thc chaplcr.
Ìhc book nnìshcs up 1n IART 6 with t\!o âpplied clìaptcrs Aìt h ough rcier€nce is made
throrghouL tÌrc book to eaanÌtes of paÍi.ular historicaÌ cp!sodes and to en4ìirical e\id
cncc. rhc ainr otI'ART 6 is n) \how howthe nÌoilels in thc booli cin bc uscd in a ìÍained
crpìo.ario. ol pcrlormance aDd polic),. CHìrÌrR 17 tatrics thc pcriod tÌom 1991ì and us."s
thc modcìs (o prorìdc an jDteÌnetlti.trr oluÌajor performancc and policy isnres iÌÌ a set
of OÌrClr ccofomici: lrcrÌ German ullitìcatlorÌ. through lhc rrcatiln of l\lLIl to lritish
.:.ononÌic performance, uÌe tÌS booDÌ, ancl tÌÌe Iapanese doìdÌumt. (]ts,lrrlR 18 locusei
ô. a kc! pi'rlornìance prolJlenÌ that ol ! ÌÌeÌrìplo) nr e nt an.Ì sho$ the usefulneis of
thc nìod(ls in hclpiÌìs to uDdeútarú the eiÌìpidcal patteÌns and njiÌcll cited empirical
slLrdics. lhc applicd châpters do iÌot reÌy on the ure ad!a.ced mâterìaìin |^RT 5.
ür a l(Ì\'occrsìctrÌs Ìrìore diflìcult nìai€rial is preseDte.l thât mav bc sk4ìped withoui
lf,s\ !i.ontinuitì. l1ìese section\ are Ìúiclted by an asteritk.
lr o klnd\ olexercises:Lre pro!nled at tlÌe end oleach chattcr a\etolso called clÌeck
li\t!lueÍiodsthãtteÍfüundebtancìürsoltheke)conccftsinrhcchapteÍb)focusìng
.n .onÌn1on .onhìsjd15 an.l mijundeiíandiniis and a sccond scl ol cÌ(rcises, sdne of
nhj(h.reopen eÌ ed questbns lìr dìscu $ion and o tìr cs a Ìc Ìt rcbìe nìs. li,rtlìer xrateÌìaì
i\ a\ ìì1.ìble oiÌ the bool\ webrite and we encouraiie ()theÌ instructors to prollde teachìn:l
nÌaierill rehted to tÌre Ìr(Írk tìrat caÌr be Ìade alaìlable to aìl on the rÌcbsìte. Ihis bool
.rÌÌ be u\ed âs a coÌe texi in a number ol dilieÌent courses aD.l some iìÌusLrat !r ÈìâÌhnle\

Chapters
I \Íoli\.arion IoÌ ìvÍacroc.ononìic \,Íodcls
I \gsrcgelc lrc'Ìand, AggrcgJte Supplt, a.d lìrsìÌÌ€ss C!cles
I nfâtlon, Ìrncnìplovnìcnt, and lVJodctaÌy RuÌcs
I I abour l\Íarkcls and Supplv Sidc |oll.ics
r \ ÍônclerÍ lìÌlcv

: ! onsr'Ììplion nnd lnvcÍment

I \Jôncvanrl Linarcc
t hr Opcn l.ronom)'irì thc short RLrn
la lfÍlilion ând LjncnrpÌovment üÌ thc Opcd lcoÌìoxrv
ll Shocks and lrolìcv Responses iÌÌ the llpen lclrnomv
ll l.tffdctcndcntLconomies
I3 r_\ogcnou! Gro$,th Ìheoq
l 1 Fndogcnoui ind s.hunìpetcrian Crorïth
I 5 \.\\ ì(cvncsìa. \4i.rofoundations
rar 1rÌlrical l.col)omy
- Itrlonìâncc and l,olìcy iÌì lurope, the L;5r\. andJapân
lS lnc Ìì plo! ÌÌlcnt: llÚtitutions, 5ho(ls, ând foÌici es
t

Possible course structuÍes

lnteÍÍnediate ma(roeconomics
( oÍ' nì.r.roe.orÌonÌic mo.leÌ: Crd|r.^ I .l
!on.tarl and Êscìl poììc.rt a.hdftcts 5,6
fonsun4ìtion, investnrent ând nroncv: J./..tí. l/re ol LhnpkL 7, tl
fìp.n ecoÌÌonry:CrrpnÌs 9 ka.ejtt \e.tìo, 6 ), 10, 11
Rrlcrrn.e to âpplicatnDs: a.haptus I 7, t t
ntrod!cti.D to groirth thcory ând fa.ts:rllì.rtt / l J4tkrt 2 nDd \t1(tht us( afChapto 1.1
Advanced macÍoeconomics
New Ke-vnesian ÌnicrofoutÌdations: C"Pler
l_\
stt,rtire usc ofChtptr\ 7' E
Microf;uncìatìdìs of coÌÌsüÌnPuor anclifveímenÍt
(Ìownscnd modcÌ):'-lìaPrer t sc( )':ì2
\licrofoündations olcrc.lit coníraiÌì15
F.\ogerous Sroi!th and convcÌgcnce:'-hdprcr l:l
l{
tìrdogenous an.l SchunrPeterian groiNtÌÌ:(-'l?dprer
use I I
lbpics iÌÌ politicaÌ €coÌro rÌ-Y: SeÌectivc o
'l/r'rPld 'j
tabouÌ economìcs:macro
labour maìke!s: ci?'prer2 n''rÍ'È -i' ó
-lnf",,,t" o*,and
,nr'"U"ctlv comPetitivc
Ì abouÌ nìaÌkels supPlysi'le Policies:C'dple' 4
rfÈ.ìenc,v irages: .4nddi, toClìnPtet Ì5
rvíicrof(rnn.latÌons: .t.l..rirt us' oí Chnpt(l t5
ÌlmpÌrlcâì and policl aiÌiìl)sisr c dPrtr 18

IVìoney ând banking

Money an.t inancc: CrdPleÍS ì
rún (-htltd 2 se.tioti 3;ChdjrtcÍ
l"r'*,i ,tr -.!,", it tlt"n and meditrnÌ acro rn'rdels:

Monetür!Poliry: Cl?drreri
Ìn EuroP€ LrS^ rnd Japa n r cirdtld l 7
i."JÌ1,r"t .r ln,,'* ta'r' p,)li.v making lro '
\,lodellin g tinr e i!ÌcoÌìsisteÌÌcy sa game: C/rdflír lÚ ÍÌn'] 1

'
lnternãtional monetary economìcs
Ììcyiet{ olthc opcn e.onomy nìodcl:C/ìdrlds
a r/
ìmperlect capilal nrobilit'v' and nnpcúecl a\sel
Lxlensìon to thc largc opcn econonÌ)"
ÍlbstilutabjlÌ$: a-'lÌdpr.Ì 9 srt rro't ó
ies: C/ìapra 12' C hllto I6 Ít:ti"t 5
M o.lelÌi ni{ int;rdcpen.lelÍ eco nonr
jcâuons: C/rífkÌ:r / 7
Ììc ference to appl

cÍowth
Intro.luclion to Srowth theory and liclslCltìllcr I sr'li',,]
2

Thr.orÌccpt ol the g(xÌ!h úte: Lhd$et 13 túiu l

Thesolowswannrocìelrndnea'ÌysLategroilth:ChòPtetl:liP'ÍjÒtÌs2'l(ìrÌ'lu'ìing
lechnical P()ilrc*)
GroNth a.counting: l--hdr,tu 13 st''Íit't 3
Theory âÌìd ernfüi.aì aÌìalvsis ol'onv€rgerÌcc: Cl'rlrld
Models of endogerÌout gr oNÍh: Chdpkt ì'1*ctit'1
l
jc'tions: C''?rer
SchumPeleÌian groNth Ìnocìrls dnd aPpl

Rcvlew ofcorc rnodeÌ: ClÌ |pter 2 5!tti'rn 5 6;

t'htLltlt !í-hnt)tu 1A

Mo.]els of h-vs reres !sr Cftdp tet 15 se'Líons 7 9

Applied analvsis.Í unemployment nì O!'(lD ccononÌics:
C/?dttd l8
Economi(s oÍ OECD
lntÌodu.tion: Cr.ìlrer I
Revieí, of core modcl: clldpr.,J .3 6
Revìcwolopen econom) rnacÌocconomici: alÌ.rpt.Ìr 9 IÌ
l.ürcpc:Choptü t7 se.tiont I 3;ClLaptú 18
USA: a-1,í/prrr 17 se(tíoì1! Cltdptet t8
.lãpatÌ:t:hdpttt t7 s Líu1 5

IMacroeconomics of EMU
IntÌodu.tion nr thc.nalysi\ of acurrencyunionr Craptü t t sectí., 6
IIistorical bâckgÌound: Crdpt.t 17 se.tìoì12
Mo.ctary poÌicv: Craprd s 3,5;C.hlptü 17 st.tia 3
Iis.al rule\: Craltü 6 Írit), .5
Dccper analvs ir: a- rrp1d 12 se.nor l

Politicaleconomy
SeÌí cont.ined ìnúoduction to garì€ rh€orv metÌìodsuse.L jn poÌjticaì econoÌn),:

Monctary poÌ1cy and tirDe inconsistency: Crdtrs i6 k ri.rr /

I iscaÌ and nÌnr cl ar)' polic y cot\lli.ts: Chu p1tì I 6 se( tídt 2
lìeÌr utatìon: l--rdrtfr I 6 rc.iio, .3
VotingganÌes and political busin.ss cycte modcls: Chaptct t6 sediüt I
(;anrcs between intlrdependc.t ccoìÌomies: Cl?.rprd l6
se.rror -j
 MACROECONOMICS

'At ldÍ, an âdvânccd und$gÌaduate bool i{hjch maps theoìy to factJ. The theoÌy, fÌom
üre new KeyrÌ€siin nÌodcl oi fluctuations to Schlrmpeterian modeÌs ofg(rlth, is sound.
Th e âpplications, fionì luropcrn un eìnpk)) men t to theJapanere sÌump, h ìgh Ìl Ìeveal j ng.
\ ou wili eÌÌjoy everl chaptcr, and becomc a good macÌoecononrist in thr prcccss.rr
Ah,io Bkntu hut J, altls s ol I 91 t la?fessot, ìídsarh u sett\ t ttltute af t ..1Ì oby

"lh€ best wa_v to lcanr cconomics is ni have a textbook wlÌich develops a tireoÌetical
lrìÌnework intcractivcly with practical cÌuertidÌs. Vl(ìretomt n\: IinPcrltt:tni1t, L1s!itu
rio,ú a,!l |o/i.ieJ docs iusr thú. The book it baled on thc mânìstreanÌ rnoneiâ+ nÌacro
nú€1 $hich is Ììos's'ldcly u5e.l by both acadeÍilc\ and policy makeL. 1ÌÌ a siÍâiiiht
f(Ìsard nÌânner, it shor,s how thí nodeì crn be us€d to.ddr€ss ìn eÌìonÌou\ variett
of tractical !ÌueÍions $,lthout heavy use of nathernatical technique. Thjs ir ntucienì
nacroecono Ìics for u ndcr8Ìiduates, post gra.luates ünd busÌÌe$ economists dlike."
Itefhen Ni.kctl, n haol Pt oÍa\sor oÍ E.onotnió, LSE;
Ìtlc t n bt t oí th c Ìío i.ta ry P o I i t), t:otn t n j tt!(, Bã n k aÍ F n il I d n.l

'1\ hcn tcachìng inteìme.lirte nì.clrecoÌìonÌi.sìn Hnlvadduringth( past) eirs,l deepl_v''

iflr lhil cxisriDg tcxtbooks w€re aÌÌ ÌacknìS: 1l propcr m lcroc.oÌìorÌÌi. lound ations lnìk
inS lDr!oÍânt noiìons mclÌ is the (eyÌìesiar consumpliorì f(inctlon, the inveÍnìent
a..clcraror, the lhilìipj curve, the possibility olpersistc.t (involuntaryl unemdot ent,
lo plccisc 5ources olnÌpeÍìctloÌÌs iriheproduct, Labo., or rlnancial marlet\;2) a mit.ìb]."
trcarnr.rr olgrowth theory tlÌât.an shed lisht on obscrvcd corÌvergerÌce and divergenc€
feÍerns acft)ss countÌìe\ anrl âlso on hoÌ! rrolvtlÌ poli.ìcs slÌorìld be designed or Ì!h,rt
the!can achiele 1n \alidrs.ou.üirs at ditìerentÍagcs ofdcvelopÍìent. BeinittÌÌe fiÌst
coÌnpÌehensìve attemtt at 1ìl1iiÌg these gaps, the Cadi. Soskice nì.croeconoxri(s te\t
book sìroul.l be uielì bv rny inÍru.tor who nrants to brlng h€r students tu the lrontier
oi nrodern macr)economi(s rlhilcatthe sâ ÌetìrÌìe ir.rrìa ìrÌjng 1ìr11] .cce\sibletu a brorcl
un.teÌgÌ a.luaie au.lience. "
PhittpP Athk,t.RobtttC. \ín&ano Pnlls\aÌ olEtunoni.s, Harwtd U
^,trsìq)

'lÌnperiect.o petitìon, knohì.dgc'bascd gl(Nth, innatÌon-tar!ctirÌB cenüal Lraú\ and

rì.n:" othercentral lcaturcs ot moder. ccononìlc sysL.nrs havc rc.€nth been irúegirted
i o the heaÍ of ma.roccofomic lhcory. alarlin and Soskicc do thc prolèssiorÌ a Sredt
\er!i.e b! I\Íiting i tcxlbook Lhat makcs lhcsc dcvclopmcnls a.cessibl€ to uncÌeÌiiÌaclu
airs. I hc boo,k prcsrrì ts nì a. rc.co no m ì.s at ll s bcs l
-as 'scÍLrl fia me$ork fòi analyzirrg
a (

il]ìponint qucÍi,rns."
rlLeÌ Ha1\:iú b) t:ínt Ptulessotoíso(tl sti! tcs, Bt.trÌ Unitús it.r
"Whât makes Carlin and Soskic€ lrÌvaluable n both rhcir clarity ar.l rhcir .onüÌjtment
to helpirgthe ÌeadcÌ undcrstJnd the iÌìtuitions tha! ÌÌcbchind the nlodcls. !uúheÌmoÌe,
ther€ is consiantlt an allcmpt to make the woÌk Ìcìcvanfto prâctical qucÍions of püb-
llc policy. . .They lacklc thc ìrÌìpa.t of ClerÌan Reuniricatìon, tMll, Britìsh economic
p€dormance, the 1990s LrS boonÌ, and the ÌoDg{Landtng.lapanese Ìeccssìon. TheÌe js a
nÌai.,r lìnal chaplcÌ addressir8 th€ isnÌes of uncmploynÌent, e*eciallv among the ìargcr
nations ofCoDtiDcnlal lurope. Ìhe authoh approach these questions lhro!gh the pen-
etrating anall lical lcns ol their ÈâmewoiÌ(, cÌÌticall,v address the eÌìpirjcaÌ evi.tence and
conÌe up r!ìlh somctiÌles nolel conclu ljdrs to thc conv€ntional wisdorn."
P.oltssar John vdn Ree e ,Dn tot, Cüilt(ít tÌonoj jt ptìíú kírc,
Lando S(h1ol of E.onoflics

"\,ÍacÌocconomics rÌeeds to be excitirg a nd .onterÌìporarl. Too oltcn it becomes an arca

of djtlcuÌty and coìÌflrsìon fi[ stu.lents. l his book is to be Ne]comcd for its veÌ] cìcar
vision ols'ÌÌat coìÌtempoÌary macroeconomics ìs about:ìnd its caÌetul exposition ìeailtnA
thcstúde.tt(ìÍhi! "
Dr vdry GrcBory, a\fuht Uniwsìty
 A€KNOWTEDGEMENTS

Thi!bo''Ì'hâ\beoramaj(nuncteÌtâkingan.1!!eha\ereliedonthc.ontibution\ofmanu'
fcoprc. our grcâtest.ìcbt ìs to Andrcw ctvn rorhì5 (lÌìwaleÌiÌìs supporl ròr the pioiecl
'^"'- urrrr
;,it"' Àil;i,;ì ,-,'.*r''
"" Hai.lìng is co âuthor oI rtrc
Ì!íaLrherÌ
.
i.ism iìnd nelr Jtrspectives on man\, otheÌ
,, ,P" ' tw
"
l:'"i:ì ";:,1, ,"Ì,i ii;.1l
r
. '.l ' '-,,, -: "-;,..: " ' :' "'r'r 'r1 'r''Ò\
""" ,, , ,ï:; :;ì l-lir":: .: ; j :
hê ,0 1
',Ill \ r;\,/hr \,,.,,.p ,l r,,r i.i , i
,."",,t. l;; l "l' il;;:.i1.,.;.l;,
Ìate nage Davjd Romcr
tìaye.l an jovaluab
''. \.ri ',,r'L-\-,., L,i ,r,?,\lúr, ,. ,;.;r;,,ì;-
.,, \.,..ii o,.r p"i.,n ,.\ "{1.,d .r.. ,ar,,,"u", i,,,i*
" rì,, \td\rn \o-,rr,,,t -r.,r.l..on r,r,1,,. tro-,r ,, i,.
''\/''dl']ìil"'''\l'''|l'úi''''^.1|l'll'''|'ll;'''
6attr, (;iaconro Dc ciorgi, ceorg von (Ìraev€nirz,
r.ian CLahrm, naclcl CrifrrLt. got,
,. -
I :,. , 'l,r .4,.,.Ja\.1J, .,._ .",-..r,.
,-,,o"-i.":
,r.prrv. È.. 1.t ] ,.,i .,,r I ,i,út,.,tn,..\..,
t rL, . De úrJlr IÍJL,Lrcft Grreth u.rcarrnp,' ,.,.4 .,.h
.,"."",",,
",-.,*,.;ìi"iïi";llïiiiïl;.'il,l,ijlïïÌü.1*,;jlffjïjl;jJll;l
E'
\ choli\
,,
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Oulton, Nicoìa favoDi, \IalcoÌlÌÌ pc

ìn.rrcÌt Ì irico prcvjde.r resca,ch *,,"""-

;ï"lll:, it..l Í,,":11::";
lil
d.d 8"t'-1,1. ",,;l,;,ì;";.';
and cìa.on,o Dc ciorsi ..Jmpìere.r aDd chc.(ed,"",,,,,,;;";;,;",,,";Ì,,:

AnclÌcÌ! clyn, Nick BÌoom, Ste'e DoNrick,

Darid Ho!rcÌ], and tu.a \un7ìata kiÌrdly
\\'iÌliaar WachtncisteÌ €dir€d moÍ of lhe
chapterj an.i Sreath impr^.ed theú Ìea.l
È\''|. ''.i';''ÒvF''l '| ,'" ',' "'. ','''
, 'ì]: ;i
ror drcirassi\rancc Ì!irhtechnic.l Drattcrs
in compütÌng and itraphics, we are indelrted
nr Gcorg yon craevcnjtT and.lohn ÌvÍcclvnn.
Tessa .r l.".r.r- ,rr..ruL"^,
s o Ìked oÌÌ ttÌe p repa ra tion of rÌre à"",C
tìnal manusc.ìpt. I he adrn j dslrative st!
non,ics Detartmcnr at uct have rjupportc.ìrhe tt in üÌe ìrco
p.oi"",
ar'olorhcwisleÌìscharÌszerìt,um j{rrsozjaÌfo'.c;uÌ,; "_"o"* *^5. "r"*, in-ìi.
.*tuobortLìr"trasi.ì.ìeas, and t. Haruìelore """r;;,;rì";";;:ilì'liï:ï:
N,t;,r,"rt"";r,"; *;;i";;;;'i;:l;
\Íany cohortt ot studcnts ar llCL halc sh.ì
ore,r rnsrrat ons ana tr,c;;;;,;:';,::::,::i:lï:ïïi:::.'.,:ïïli:ï:::
!..r..- .,."., \,,. i,., \. ;, -;; ï,,o.;L
iÌì uoircrsìtles ir scveral counlrics have been usinia the d.d1Ì chaplcrs avalìable on thc
iÌìteflì cl aÌ1cì ha te scntirÌ!ucrlcs ând nìSilestìons
a)(lr cdìt{)r lÍn l'jage at OUlj symlaüÌeticaÌÌy alÌ(Necl us the tiÌrc lo woÌk out our
approach to our saljsiaction. Nc recei\ed cxceÌÌent revi€lvers' rcports, irhich Ììavc
iinprovcd the text dìâÌliedÌ1. \\'c are !eì/ gratc uÌ to Nicola Llateman f(n ìrer elficiclÌ.y
and r$po.siveress duÍirrg thc pÌoductio proccss
Tess., andloÌÌathnn Gìyn ha\ e rem aì n ecì cheerlì llt' opljnrìstÌc that the book
^nilro!,
wo!ld gel finisÌìed and hâvi' donc a gÌeat Ìob al keepiÌÌs Ìlork in its pÌoleì pe.specliÍc
\iki La.cl pì ovided a deliillìtiul a n d inteÌlectuaìly stúnulatiÌìg enviro n ment ÌÌ Londo n .
h€lped ÍrcÌn time to lìne byJulicl, Dan, Wllliam, Lou, ancìCil1
 CONTENTS

.a(\ot\iLLllGE \l t Nr5

iii Òi rÀB LE5

:lBRrf Àii0x5

I Motivãtion íor tvtacroeconomic Modets

1
1 OlrÌpuÌ, únerpoymeni and fíaÌio
)
I Etonomr gro$ih
tl

PARÌ ONE The Mâcíoecohomic Model

25

Aggregate Demand, Aqgregate Suppty, and Business Cyctes

21
I Aqlrellatc Cemênd t8
2 lhe lloods marker rhe ó nÍve ts
I Ìhe money nôÍker rhe 1oÌve
4 Purt nq toqerhsrhe /t and rhe l/Í/
5 Agqrellate alpy
6 lupply rde n the imperfêd.omDerrton modeÌ 45
/ Aqqreqate dam.nd ênd rq!regar !rppy
59

lnflatìon, Unemploymen! and t\,ronetary Rutes

6l
I nÍàton ând Ph rps cuÌvÊr

2 Júofetõ yrulú dnd rhe I equêrion ó pa Í1Ê rnode 8l

I niaton aÌ tlìe mediuJr rLrn eqlrrrbr urìr
si
1 lJai on n ihe 15,/t,V modet

!l
Labouí [4arkets and Supply-Side poticies
103
I Suppy 5de jÍú.rües !ô.ú,;rdjtro.ts
2 t;.toÍ5 ihit ih'r rhê t1l5 and pJ.ulres 107
j lln on5, tra!le \êriino aÍanqeìenÌs. and rhe f8f
Itl
4 ntÍodúdon r. hfsÌeres5 adu:t l] ôiiê.i5 rhc fn0 111
5 Ìhe lereÍirl!le.uíre appro:.h Ìo un-ÂmptofmefÌ lzl
121
 5 1tl
I riaÌion, d s nílaton, and deÍaion
2 Ì!4onrtêry po ci parad qnì! D8
I ihe moneüry pa q rN e ln the I eqúalion m.de 140

4 AÌêyor Nule ntÌ/.tPa Á Íìode t5l

5 PÍob enì!wlÌh u5iq a ntêÍÊrt Í;tÊ ÍLre

6 Cred b ity, t nìe n.omisten.y, and ú e5 vüas di5íeton t60

169

FiscalPolìcy 173
I Ìh-o aúomatc Íâb ier5 114
2 lÈretiDnary IÈG pa i.y 176

t8l
4 []loÌìêrizinq Ìhe debt !êlqnorage,rnd hfperinfâÌ0f t9l
r9l

PARÌ Ìwo Consumption, lnvestment, and Money 203

Consumption and lnvestment 205

206

221

: [on.6 om on .omúmp1]on à.d inle5tment

249

Z n5truton5 2t4
I NíoÍ átion píobhítr 164
4 Ì,rlonef5úpp yãnd desand

5 M onel; ry trên5ÌÌrÈ5 or Íìechaii!rÌìs ând thr Íoe oÍinan.ê r propaqaÌinq !hork!

PARÌ ÌHREE The Open Economy 287

9 The Open Economy in the Short Run 249

1 Open nq the goods nìaÍtet 291

2 0pen ngfinan.. marlet5

I Êxed afijÍieribe errhinqê rate Íeq Íìe5
4 tÍôle bâ anrú dnc ba àme aí paimenis ]]5
 5 Ìhe [/]u.de F em nq m.de íor the short rún
l:8

10 lnflation and lJnemployment in the Open E(onomy 343

I níaton anc t]neÍìpoyÍìenÌ n the open e.onoÍìy 1.44

I Supp, jidê in the open ecofoìy

I Demard side ard Íade ba ân.e t58
,l Ìhe oprn ecafomy model l6l
5 ton_o Íuf equ brun

11 Shocks ând Policy Responses in the Open Economy 311

I FÍal, monetary, exrhanqe rirÉ,:nd apply s de p0 ire5
2 AqqíeqaÌe demand sho.tr 191
I Domeíi.5uppiy 5hoú5
I Exlciìa Íide and appy +0.k5 194
5 Rea r,aqe5 in open and co!Êd ec.nom e5

6 lnÍodu.tontothe:rn.or.soí.üÍei.y un.ns
7 lJ.ieiayruú n nìe opên c.!.omy 401

407

12 lnterdepend€nt Economies 415

4t6
2 nÌernaÌlonê 5p or!É in the med uÌ]l run 42Ì
I ÍrteÍdependene rì the lhoft and mediLrm rrrn aimpêÍìodel 414
.1 Er/lu a .omÍìorì .üÌenry àrea

PARÌ Foll R Grorl,th 459

13 Exogenous GÍowth Theory 461

I Crolith rnd the owth rate
!:t 464
2 Ìhe SooÍr 5Ìân Írodei
J 5olow oüth a(ount n!.:ÌrearúÍ nq the mpacr oÍ ledrno olll
_o

4 le.hrooaG prrqreÍ nihÊ5oo\t 5wrn mode 481

5 t.onoÍri..onvergen.e .190

6 I\h i;re ênd Ìha code. Rú e

8 Con.u5or! 5tl
 14 Endogenous and 5(humpeteriãn GÍowth 529

I Endoqenou5 !tÍ.!Ìh ll'eory

2 khúÌpeìÉÍ an qro!"tn nodr s

PART F vE Micro-foundations ând Politi(aì Economy 561

15 New Keynesìan Microfoundations 561

1 !umm.ry.íthe ar-quneÌ r6i_

2 Ìhe nê..,r55i.a berÍhfl.rk ìrode 1NtB11) 57.1

I m olrÌpú a.d n!0lntLrryuìenrp.ymÉnt

Equl bÌ
1 Drrqr crúì lll dên:nd +o.ls Jnd rú!ú r5p. Áe 594

t 0sequi brlun (2):arí3 i.atoÌ.andaamren 1q.íiemàrd 5ho.tr t91

6 DsequlbÍ! (li 5LrÍr ned crêqr lbrunãn,l ÍcfounilatonrdPi .s.ú ú 6!4

6l2
61i
9 F. rneÍ anC a Ía'qê ô'eiú hÍ:
6tl

16 Politiral Economy 637

I Ì(onêtirÍ po .r llre ìrr r í4_.\r: ra Íob em rf over:ìb t oú5 !o!êÍnÌent!

LI .Â1ú

Z t Ía and ronet.[ po .l .,r_i .ti

I Repú.i.i rÍoru.ton t!. laner !l _t0-rr3.e.íoÍn:ioÍ

t aàÌ5 ircr\ een inrrdeperd! t (On.tr ri

PARÌ 5 x Applicâtions 695

11 PedoÌmance and Poliry in Europe the USA, and Japan 697

I [ermài úr f .ât 0., tlp.. :pr.f ERil, anl t! aílermai]

2 lr'la(roe.oioÌ. po .\'(thn llliLl
I LlSA tlìe ne,! e..r.my bo0rì:nd t5 aíleinaÌl i1\
4 l;prn Ì!'ê LhaÌ ê o{ai3 o'sìqr;1orì
5 tonru5.r5

18 Unemployment: lnstitutiont Shocks, and Policies

I Labou n aket oútloÍìej
2 Ì_encs a:d úoÍ rlr rnÌ Ì/ jraÍ.ìi.n n EL opÈan ureiìlr.Íntnt
 I ÌEde, ?.hno o.ty, and unempo,/m..ni 7a:1

4 Llnemp.vment arC Êl\lu 769

r \r!hÌ 5 refornr 50 dÍfi.u t? 112
6 4... Lr5 on5 1Ìt

]E:EREI\'T'
'ti tl 789
2.13 Dcti\ilÌg the/lD (un'e -5:l

56
2.1.1 TtÌe,r D .rÌÌd l5 cuÌ!es
2.l5 lhe Rcal Busìness C\c1e model: cquiLibrjunì tÌuctuations 'ÌLte to 57

61
2.16
Z.1t-
pres5ure on 1níl.tion whcn empk))'mcnr is abovc equiÌjbrirün
71
3.ì L\Nard
c nrploymen l; .ìoNn$ard press!rc on irìLlation when emllo)mcnt 1\

belo| cquillblìun tìnPloYment

3.2 DcÌivi!18lhe Ì']hiUiPs cuDes
75
3.3 The oÌisilral lhillips.uNe
3.'1 Ì'hiìlips'oiigiiaÌ cuNe:UÌ( i861 1913
t7
3.5 DisinflationÍ.ostÌ\
7E
3.6 Ditnúlalìo!ÌandccntúLbankprcíeÌences
:1.,- Ìhc m,rnctar) rule:1he MltÌine
E5
3.8 ÌúÌalion sÌrockancìthc monelary nllc
ll.9 lenÌpoÌar! aggrcgate d€mand slìock andthe nronetary rule
J.t0 |crnancntaggìega1c denÌan'ì dÌockand the onctarv flrìe 87

3.11 DisinÍÌdtio. nrateSies and 5âcrìnce rnll()\:''okì tLtrkc-ï'rs'

'graduaLisrn'
90
-1.12 SacriÊ.eÌatios and convex PhiLlips curvct
-1.13 lggÌegatc.j€nìa d çrocli:ccntral bankholds monctgro*'th
rate 9,1

J.Ì'+ Compeulh e Ìnode1:the naturaìrate of unenìllo-vÌncnt atrcl thc

Ì)hiììips cr0ves
:1.15 Pernranenl L! slìock:ne$' mecliÌiÌì rìn cqüiÌibriunr atZ 100

3.16 Sketch oltlÌc âcliüínrent palh to tbc rÌeN mediLun-run equìlibÌirm at 101

Z folÌoNnrg n consu nÌÌion booÌÌ1

4.Ì DosrN\,n r.1 slìi ft of thc LlrJ cü lve: âd i ustnLen I Lo the IÌct! equilib riun\ 105

lolìosiÌil a !l'S curvc shift 106

LZ Skclch olthe timc path oI iDlÌatjon
.1.3 ì06
Atsrcgrtesúpplynrockandthen]onetaryrtle
:l..1 Zone otbargainitÌg dlscÌetion betwecn lvs
'cilìng
?nd L1'S tÌoor 712

1.5 DcÌningaage scttÌrg curles!I]deÌ (]iflcrcntiníì1uti(!ìâI 115

ârraÌÌgemcnt!
an'l Êrm ì ereÌ ì16
4. ii E!ÌulÌ ihiiuÌn cnrplovnÌent Í'ith cen I taÌircd, ì n
'lustr-Y-,
i{asc setting
4.7 lhc hump slìapcd rcìalio.ship betÌleeD unempìo_\'ìnent and the 117
ccntralizalion oi h'agc scúirg
.1.8 Ì IvÍeresis: the irìsld er outsid cr m odcl 11E
.+.9 UÌrenrtlo) nr ent teAisten ce: tlÌ€ role oflong texÌÌ ÌÌìerÌ\totnÌent 120

1.11ì LJnenìplolrÌÌcrt pcrsislcncc: lhe capacìty scratplnia eiïect Ì2ì

1.1I The Bevericlge cuNe 722
Lt2 lhc lr:'.iÌt cuNc andra.ancies 123
1.13 l he lÌevernlge.urvc and lhc I,VJ P.t equjìibÌìum Ì2u
5.ì CentÌaìBank 165 íìrìctions:uillily d.clirìcs r,llh dlsLan.c l!m thc 143

i.2 Loss circlcs and I']hillips ruÍve! 1i1.1

5.3 DelivirÌij tlÌe M,C lirÌe

j :l Ìr1ìatìon a\,ese SoveÌnnÌent: llal À,//i ìlnc
i.5 Hlgh rcs ponsivcn c5s otìnilâtir!Ìto outt^ú:1Ìat,V,( 1iÌìe 117
5.ó CoÌpaúÌgthe re\poní'oflh. centÌaÌhark in t]1Í) ca\e\:ÍeepeÌ l.lil
lhiÌliÌÁ curve\ and a ÌÌore Ìrì latn[ areÌse ccntÌalbanÌ(
tr; IÌrÌnanentLt sho.k Ì5i)
j.8 Lig slru.turc i. (hc /J la ìrn model require.lto deliver a Íand.rd 15,1
lallor rulc
.'i.9 l.ylorRulecriampLc
.'<.10 DerivingtheTa)loÌ Ìì!le 156
I I I lhczcn) loor to tìre n oÌnìnaÌ ir Ìterest râte iLnd the deflatì,rntrap 159

r.12 Ccntralbarìli annou.ccs â no! target:cÌecììbìÌitv ancìirÌefja l6l

5.1l Ìh€ i íl.tiLÌì bi.s 762
5 l 1 hÍìatidì bìas: .entral Ì)arìl rnd goçcnnÌìent
.r I DilI$cnr rn.thods otlnancìng rn iÌÌcÌease úr goveÍnnent 177

ó2 lhr govcr ncntdcbtratìo a.isc l.IlÉaÌi.LcrcsL râlccx.eeds thc 18,1

d..j lhe goveÍtrnent debtrâtlo. Casc 2. G írÌltlÌ r. te eacred s thc re.ìl 185

'i. 1 S$,itch tìom ih e sltuatìon $'here the gÍNth Ìate is greater tha. th e Ì râl 186
irÌtere\t rrte to the growth rate les\ thlx the rerl inteÌest rate
ra (aomparisonbchlcc. .oldluke)'and'gradúalisL'stÌalegÌcs1orcdrcr 189
govelrnrenr debt
1 Consl]mptioÌÌin a tt\'o pi'rìod nìodcl
 z\2
i ! irr'! i 'É 'r" 'rn 'd
_2 '" \ 'f
"rr
'''' pr' f zt3
_

Ì'Ll tu dtl d ro\c rr L

7.3 e' n\rtrnlìhÔn ur Ì tqu f€ data on

zzl
.'')ss sc'don a dti'"e sedes
7.1 ;;,";';,; '"."".'"''-
22.4
!" q'r'" \' "
..' 't " " ;u zllt
rrle
!ìse nì tLre renÌ inrerest
1.6 alr)limal crpiiaL stock: a 267
barÌk\
*"t contract for cunrPetìtire
ì'ïìt." ,." "ot*'t 275
lobi!1'5 mo'Ìcl of
portlolio aLlocalio!1 294
8.2 Ìeakatct'baraÌlced
9.1 ;:ïil il,;"',!ì€'ì irÌiecti'rú=pÌaÌrnc'ì
295
tÌìe lÍadc baLancc
z
t) Arise úì exÈÍtsìnlproves 305
""1 aÌrd tbe rraLrc baraÌìce
ï"^'ìlu"'*"- t rl)r ìnpact on ourpuÌ
r'|r"r i
310

";, , rro
".
'O -"
-' 'r 'j \L"r" 'l
110
",. "" par r conditiorl
9.5 thcüncolered üúerest ivoÌld intcrcn Ìate
311
* ta!it1 conditrorì1 raÌr ìn the
l.Ì t"ìì""'" '***t
3ì2
Th e forei gn crch
ange nÌarkel
9 .7 311
- ünder Ílciiible an.ì ftxed
derìrnd ìor m')rìevr coiseqrrcnces
9.8 faìÌ in the
exchangerates J20
poLic-v: ìlied e}.changr ratei
9 9 Lrl,r ns io DarÌ Íronctarv
lleÌÌbre excharÌge rates
; ;, ;'*'"'-"'1, "."nctar-v PoÌjcv: !ncÌer rÌct'bLe excha'Ìse 322
Poricv: a'rjttsrÍìent
; ,; ;..;;'"t "netâr'v
-123
aÌr eaatxple ot crclÌangerate
, ,, ,,ono*t'oÌìo" ntolletarv poiic!:
o!ershootìng 327
f1lcal poLic-v: fi\cd eÌ'hâns€ râre
9.1: f-'xtansìorÌaN 3213
flcìible erLlìânse ratt
n ì', l.-** '-L1, rates: aÌnon€tarv
132
".:aLpoÌic'v:
; ìt ;;:; :","'"'n;biìi.] in'r Íreaibrc ercÌÌnns€
expansì(nr 333
hr8e oPen c'onomr
9.16 IlcribÌe erchânge rate
rrxcd and fleaibLc
Nn in\rLrcntions uÌrdcr
;;; ;.'*u'"".'"' '""t
ratcs
exchange 3+5
iÌ1the economÌ
10 I Ììquilìbrilun empìoynìeni 'Ìo\Èd 317
ìn tì1e operecoÌrom-v
alÌox'rnd high
'iU., U*"'''*nÌ "nÌioymcÌÌ!
elnPLoYlneÌÌt 353
(Ln'esin cìosedandofcn ecorìolììes
lO.: lrice setLing
 xxÌiii

+
10. l.Ìújì ibrnnn rate o t u ocrìplolrÌre n I curre (Ën Lr) 35.1
10.5 OtltherÃLIcuNe 35t
l0.ar sho.t rür cquilibÌftm (g(Írdsiìn.l moncvnìarket): tD.urve; and trâcìe
equilibriúrn:AI cuive
1 0. I Use ot a delaÌuari on (or looser nr on ctarf poÌìc), a. d Êscaì polic), nr 360
achicvc target oulpul lcvel,IÌ, ard trade bâtaDcc
r0.ri Short run, nrcdiLrnÌ nür, andìong mn equjlibria iÌì the open econorÌì! 362
Ì0 t ÌÌrint Cal targetoutpuL and tra.lebaìan.c i\ rìota Ìncdirìrn run jii3
ecÌuilibÌium
10 L0 Ì.ong rur equilìbÌ iurÌÌ in the open cconomvi on thc 6r ând t/ìU curves 366
l (l.l I U€dnrm rlr cq uililJrirun at B (had e clehci t) jsdisrurbedbvan
c:change Ìa!cdepreciatjon
Ìll.t2 IrteÌacrìon ofloreìgn exch^nge maÌketand 1übour market:uiquc 3tt)
constant ìnfl!tidr equiÌìbÌiunÌ ile\changc râte expecratìoìÌs aÌe
orientcd to tracle baÌarcc
Ìil.l3 lrnlque (orsrant i.tlation equiÌ1bÌiunì itercìrangc rate expcctations 371
arcoriexted to kadchalin.e
lo.ll lheflÌU c(Ì!c
ìr) l5 mU cuÌvcslD open,le$ opcn, and ck)scd c.onomjes 375
1lì.16 E,(Ll.urves reUectthc scnsjtirity otrcal wages k).mltoymenl 376
lÌ I liscalpoÌjcv shiÍts th.È A, cuNe: ncÌ! nÌe.litrm-run ecÌujlibrir ârB 380
ãnd.o!ÌÌparison aìth Muncìelì Ilcming pÌedj.tÌon\
I L2 ,\djlúiìÌenl ofreal iïages rnd iúÌatìonr lìscale\pansion un.leÌ t\ed 382
ca.lÌange ralcs
I ÌI Adiustm cnt of reaÌ wagci ind iiúÌation:Êscal expansion undcrlteÌìble 383
eÌchangc Íatr,s
I: . 1 \Í()nchrl/exchangc rate policy js a sÌìitï al(rrg thc rur cu Nc: llJ4
nredium nrn e.ÌuìlibriunÌ remaìns unchanged atrl
1.5 \Íooetary poÌic)' elpanri(m und€r fÌexiblc cxctìânge Ìalcs:inflaIon 3E5
ftod€s lhoÌt nrrÌ efièct on emplolmenL
ll a, .\djustment ofrealrragci and iÌúìatio n: looser monctarv poli.t un.ler
lexible exchaÌÌge rates, or dcvallrarion
l:. suppÌt-side polìcy: lvJ slÌitìs cto{ n 389
: i6 AdjuÍÌÌeÌÌt of rcaÌ r,aites and 1n fl atioD: Irage acco J90
:1.9 SLrpply sl.lepoÌic\,. Tax cut mcans tt(,)slÌirrs up
, Ì0 \e:ative ag8rei<ate denìand s1ìock u92
:i 11 A.lonÌcÍic pph-side sln)ck 39.1
.ll A JÌ€ilative calerÌÌaltÌade rho.k 195
 Ì.l:l A ncgati!e cÌteNrl suÌlpl) \hock incÌeâ\€ l. the oil prÌcc shiftslÂLr 39t

shock ìqÂ
11.1.,1 hlcíraìnìppÌY
11.15 l )cvclical Ìeal wages irthcopen ecoÌÌoÌìy 1Lì0

11.16 5rppÌ-Ìsldepolìc!,.drealÌ!,gcs:coìnP.rhgthecLosi'ditdope 400

11.17 As\essjng the rolc oldevaluatìon '11)r

11.18 Ì,m adjun ment to ìn cÌea scd golemnenl sÌretrcliÌÌg' lvÌ Lh ln|aticÌr a'd '1i)5
clchân3c ÌeteirÌ€rtìa
Ì,hiìlip\ curvcs in tÌì€ oten economv: tenÌporary ri\e ir inflatidr .111

lolÌo$'ìr1g, ÌoosenitÌg of lìscal policy u dcr lhed e{cha.gt rates

.119
72.1 The 2 bloc nrodcl diagranr
,120
12 2 Loco!Ìotivc etìect oia lìscal cÌPansion ìn honÌc: fluxibìe exch.ÌÌgc

12.3 lleggar tll) nclghbour eife.t oin honre nÌoÌrctary enp.ns ion: 1ÌexibÌi' 423
edcha.Se rrtcs
12.1 lldnc iìscal erpansion: llxe.l exch.ngc Ìates '125

12.5 Home onetar)' exPansion:lÌ\c.l erchangeratrs '125

|2.6 Locomotiorì cftèct\: h ome Ês.aÌ cxpansion I lr xed €nchan ge ate ì 427

12.7 DerÌvìngtÌÌe troÌlLlËÂt, cun'e 129

12.8 Stable in ll rtidÌ Ìon g tlìc tlur

ir '1:J0

I2 9 SLabÌe worÌd in ilatio n, horne infla li on Ìising ancì loreìiln i n natlon 1l I

lelììng
Ì 2.10 lxccsi world aggresatc denÌand 132

12.11 trccss woÌld d€man.l: adjustnreni vìa risjng ilúcrcst rale\

12.Ì2 Deiving ÃnU\ tonì the lvjand 15 diâ8ram .1.10

12.13 l,ÌpansioÌì oIIMU s'ideÁD

ì2.1.1 Dillcmrce\ in rcal ercÌÌangerates arÌd rcaÌe\changc raLe a.ljustÌrìcrì1 412

i2.15 Difle.l:.ces iragi]lcgatedcmn.dsched!lcs

.1.13

12.tir Q)nstrnt ftrblìc sectoÌ.le1ìcit ratÌo stìâtegies

12.17 lrÌÌract oì1hc SlabiÌ1ty an.t G(rythÌiact, ec(tÌonr-t iis slL'ckatl'1/. 1+7

I a \ ò. i.m .. lrl, ,, .1.19

.15l
12.Ì9 \\'üge accod ÌlitlÌn stabÌe:1l1:ur!.
12.20 w'age accoíl coÌnbincdwlth a public sccnÌ delìril raliotolic\' .151

12.21 ldiLlstmentirÌthcÌnediunr rut:moÌìetaryexpalÌsionulìdcÌ nred

€xcbange rates
 12.2Ì Adjustme.L in rhe medjtrm run:monet,ìrv e-\pan\ioìr (ndffllexibl€ .155
e\chaDgc Ìilcs

Ì
l2 2.1 ldjuÍmcntinthe mcdiuiÌÌ nu: hscaÌ eÌpansl()n undcr a lìxed
cÌ.hnng. rat€
12.21 AdirLtment in th e mednrìn Ìu n : ll scal c.pa n rlon u Ilder fle\ìbÌc .157
eÌchante rates
Ì1.15 ìrlscal cÌpa n slon u n dc r I cxiblc erchalÌge raies: shoú end .158
nìcdtum ruÌÌ idiuslnìcnl
1 l. Ì there üoss countr)' corN eÌi{ence? scatteÌ tlot o I Sronth râ tes ot
ls .1aJ3

CDI per capit.ì bet$een 1960 an.l2000 âgainst Lhc initiil log olthe
t- le!el olCDlpercâpita
rl.2 Sìmulatl()n of exponentiaÌ gÌoi,llì on a normaÌ and logaÌlthmic scaÌc ltrl
!l
1 I :i s t andard soÌoÌ\' dlailram (Ì\'ithout teclÌÌÌololica pnrgÌ.ss)
Ì 17 s
Ê 1I 1 AltenÌâtne Solow dirgrâÌn (without tech noìogìcaì p rogressl: 176
.il :r(j(+'r,
l l5 Transilìonaì dvnamlcs ìn lh. Soloh' sr,in model
1 I6 Ìiolicy cliperlmcnt Ì: ên cxoilenous nìcreü\€ iÌÌ the ra'i n gs ra tcj r' > s lt8
1 ;.J foiicv expe.irÌÌent 2: .Ìì erosenous increase úr feÌtiÌl lv, ,/ > , 179
ll E lolicy expe ment 2: an exogenoús ìn.rcas. in Ic.tilitv, ,/ ., , .r80
ìmphcâtions lor output gurth
' ),.9 S tan dard Soìoi dÌ agra m . thc nìodel
i r ith te.hÌÌoÌogìcaì | Ìogrcss .186

I -l l) L |olic,v erperiment 3: an e\ogenou\ acceìeì rtir)n j n Lhc rate ol

t€chrlological progiess
1-1. i L Policy e\FÌinÌent 3: rn e\ogr r o us acccÌcral ion irÌ tlÌe Ìate ol
technolosical ptugress implicaljons Ior output gro$th
l: ll Unconditionalconvergcncc Ìnthe Solow IÌÌodel with tcchnoÌoilicaL ,:191

ll l3 DistÌibLrlion of rcaìGSli pcr rorler a cÌoss tìÌe linitcd Stnte\ 192

!3.1 I Gro\fth convergence irÌ the USA I gnrrth ÌaLc otCS|percapita il93
1986 201ì1vs.lerel ofCSl peÌ câpita 198ó
Il Ìj C in th e Ì lS^: groÌfth rat€ ol (ìSt Ì)cÌ .âpfta
ro$tlÌ convergen ce
1986 2001 vs.level oIGSI'pcr capÌ1a Ìtr86: exclu.ììng

1.J 16 CÍnvth conveÌg.nce lor lheOICD,1970 2002 .]!5

l.l l; Co. dil io n al .onvergcnce iÌÌ the SoÌow n odcl: diflerent grorlrh rates
düe ro dilÍcrenr savÌngs rate!
Ì3l8 lhe Colcien Rule ravirgs Ìare
 s07
13.Ì9 Policv eÍpeÌiÍìc nt ì: Ìisc inthcsavbgtrale
13.2t) Ì c úilit-\l, education, n ncì le tÌa1ia
male ìabou r forcc Participatio n: Aüs 5 15

d con cavitjcs 7
lro.Ìu ciì(nÌ furcljon cÌhibiti nii both conve: itie\ an
5 1
13.2r
518
r3.22 Isoquatrts ìlllslrating thc returnsto scaÌe tropcrt-v
n l5hirì g ret u ns to 19
typi.al co n cavc pro.lu.tìon lLÍr ction $ith
Ì 5
'ìirnì
^capitaÌ
oi the 5Zz
13.21 Numeri.aì ill$tralnm o f progtessjle l ayl or afptoxìmations
of Motio n
non Ìnìcar \atings Parl oi thc [undanÌent! i SoloÍÌ lÌÌuation
around the Ícadl'strìtc À'
aÌrd c ÌÌcìogerÌou5 growth 5lo
I
I .1. Gros,th patìrs s ith cxogcnou s

s32
)1.2 lÌreA,( model
1.1.3 Knos Ìe{ìge s pillovers lcacì to cnd ogetÌo us groirth
( Ìr : 1) oÌ exosenous 5 35

8Ìowth (! -- II CompaÌnon ilith Solow

,1.,1 ologi ca1 p(rilress 5 +3

I in.logenous I c lenn inâtion of }, t1ìc tate ot trchn
Ì'oìi c-v cap€r!ìn€n ts a n'l endogelì ous g(\
h:risc iìr savúii\j rìse in 5'1'1
1,1.5
produ.ll\'itY ol ÌÌ'\L)
!úration of the Aiihion Ìl owil t ìnodcì of Sch unìpeterian
545
1,1.6 Sch ema ( ic i1l

1.1.7 The rtiationsh\r bctwecn inrovation and coÌìPetition:

LrK linns 550

1,1.1J Average \ales grcwth bY !Ìumber ofcomprtìtions

(3'2881innrúÌ 55ì

25 transition econo'niet
,+.9 l,c r cenl aiae o I Primar-Y s.hool age chiklren
not attef schooì
'
b! 5 5 7
I 'Ììng
rcgion,2O0Ì
sfl(l
15.1 Labour s uPPIY and .lenr and
582
152 E.ÌuilibÍiünÌemplo-vnenturcicrtedcctcoìnpetitiuÌ
iR\
15.3 /.!, ìlN, and LÃf(l clrves in lheNCBM
lq tritibrì uÌn cnÌplol. ÌÌìc nt ivith 1Ìrì peÌtect competìiio n
588

wagc ÌiSidit\ 58E

15.5 Eqirjlibri!tnÌ enrployment: Ìea1Ìú3e pushÍuÌÌÌess and rcal
f_.!ÌuiÌjbÍnrm empl()yÌncnt: th e Calnlfors DrìIhll
Íeluìt 591
s9s
r 5.7 l,cfect coÌnpetitiorand inúputresfonsct
A.lrese.ÌenÌand sÌìockwìth imtedect (onÌretition and fixed PÌic€s
596
Ì 5.8
cìemand shock 600
15.9 The foNlad looking IS cune aÌÌd the danÌpc'ìng ota

t5.10 'lhe !licky ÌníoÍnrtion ?hilÌlfs cÜn e:'harÌilc ìn iÌÌílatioÌ taÌ8et 61tì

Slljc: in Ionnn llon .]ìttìsion ovcÌ sevcral pcrlods

612
15.11
MuÌl it le c nÌtorÌÌìc nt eqüìl ibria: 'lilfcrert lcveÌ\ oi ptrductilit'v
6 I 3
15.12
l,Íultiple eIÌ]pÌoynent c.Ìuilibria: eroBenous dìllerenc's 1Ìi aggreilate
615
15.Ì3
p(Íhrcti!itt at diftelent enìpìo)Ìnìcnt rale5
15.1iI MultipÌe enr ploym e nt equìlibriâ: elaíicity of demand vaÌieJ with 616
aggregitc acl iriÌ)'
15.15 lhjll4x cür!es: úìullifìe cqúìlibrium cnrplo_ÍÌnenl ratcs
i5.Ì6 lhc insider outsì.ìeimodel
15.17 $ork€r indiffcrcnce curvei irìth faÌnes! coÌÌ\id€rations 621
15.18 la1Ìness iD the utility tunclioorn rangc oleÌnplovmcn! cquiììbrla t22
15.19 lfÊcjcncywagesettinil 621
15.20'Merlu' costs andrlage sticline$ 615
I6.1 TìÌne inconsistency i nonctary polict: /' >/.
76.2 Lla.krlardìndudn)n 643
16.3 Tineinconslícncrir the one peÌiod iiaÍÌe 616
Ì6.1 Thebeer quiche ganrc 652
16.5 lhc bccÈquiche gam€:pooliiÌil on beer 655
ló.6 TlÌe beer qui.hc geÌne: a sepaÌatìD3 equiÌibrnrÍì?
Ì a, 7 PooÌnrg on í: â pervcrsc cqltiÌ ib rÌu nì at d the Intuitive CÌiternm 6.58

16.8 r\ simpìc cB slgnalllÌìs garÌÌ€

1ó.9 CLI signaììing ganre: pooÌirg orl 66I
16.10 CB snnpÌe signalling gâmeIa sepaÌatìng equilibrnun? 662
I Go'ernment corÌpetenrc in dlflcrcÌìt pffiods
1ai. Ì óó8
irj.12 ( t?.ìbcnent ÍÌom sinrÌing ând signaliingcoÍ 675
1tj.1.l C n1./ tu.clcclìon {ìnnìng benefit aÌr.l signallìng cott
ând 676
ió.1 1 ÌÌìbbs\ paÌtÍan\lÌip lnodcl
1t l5 lhc Alcsina modeÌÌlith tìLl inowÌedge ii81
16.16 lhe i\Ìcsina ÌnoiÌcl i{úh electoÌal uncertailtv
ró 1: Ioreigrr's beÍresponse i!úrcljon
ln ÌE H as Stackelberg le.ìder 689
1n.1t Nash cquiììbÌium with 5imuÌtaÌÌeous nroves
,ó:0 Optimlzing th(Ìrgh binding agrccmcnts ii91
ij.ll GanÌe iìr QueÍilrn 692
:,, 2l (lame toÌ Questl()n ^C
: 1 CrcdjbiÌìlyvs.disciflineefteclsrvÌlhamonetaÌrrúlc t00
: .2 'ConÌpetiti\ e d i\irÍlalio o' foÌlowiÌìg tÌìe shill I o LRM 742
' -.l WeíGermany:a.ljrìstiÌÌgtoCermanu lìcation
:1 'Rcst'-lRM .ounúics and thc Bundcsbank after Gll\iLl 708
-.j RetâiL ft1ce lrÍÌation Lrndcrdifie.ent monetaryregimes iÌì the UK
 711ì
1..(r lhe rcaL cr.hangcra!e in the lll( 19r5 2il0j 711
20lll
lÌ.7 !li:iÌìU.ì1i(!r an'ì Lrn( niÌri'rlnìcnt' Ì97r1 7lz
17 8 (lK lonr 1997r sq4rlv-side rcforlns hllrÍhêsi5
112
I 7.e LIK ÈoÌÌr Le97r
rggregalc {ìÊÌÌìand nììft h!pothesis

l7 1ll U( lÌonÌ M97: 5] nüúic lÌ-vtothesi\ 717

aÌrn infriìon l990 200+
17.11 Gerlì!n):g wtìì u!Ìcn\rlo-!Ì1ìcDt t15
17.12 UnìÊcl Gernar-v L990t il7
17.11 GcÌnÌiìtrï lìna'ciaì Lralancc!' 1990
20r)'1
719
e ECB erüBndìioiLntLnnd
Ìt.1.1 OiicìiÌl ìÌr Lerafuatr:5: US lr!ìeriÌl Ìlcse^ 72t)
IS sho'li
I7.15 htere\t Ìrtc dc'isnnìs ir)LloÌ\ing ao 12i
atr'ì outsi'te FìlLI
I1.16 AdluslnÌcìú to a positivc trade lhock inriclc tzE
S t'cÌÌn ol'Sl ÌrooÌrì
1l 17 lÌrs it1l'c süppl) sho'kr tlr e Lr
tll0
l990 200:!
1 7.18 USIìnancìalbnlìncrs
73Ì
l9q0 2l)0'}
1i.1'l LSA: groittlì ünenldol rncÌìt' an'1 i'Ílâlr'ìn
17.20 lhr l99r-\ 1Ìr thclrSi\ ?'1
i'íÌrlion l990 2110+ 7

Ì7.21 Jrpanr groltth uÌienldo!nÌcnt' rüd 735

1t 22 lhe Ì99ü inlapnn 736
1i.23 lapaÌr: zc(r nomì!ìaÌ ìntrÌest rale bound i37
17.2'1 nÌìancjaÌbJla'ces 1e90 200'r
.1âPan: i+2
jrlheUSA L'trrole â'(Ìthecur'zone r960 2003
18.1 UneÌnplo-vÌnrnt
i'ross 19 OÌr(lll
18.2 lrends and helcrogrneìt) ìn !neÌntlo\rneft
counlrics' 1960 2002
719
18.J (loÌnrÌof \h ock: irìtc raclnlr wìUÌ IeiiÌrlc af'ìin1Ìcaiblc rcrlwailc\
750
111.1 Oìì trice\' 1!50-2001 t56
19611 i'199
1E.5 Llt\cri.!ge cuNes ftÍ Ìiìc UK âncìStlede!ì 7i9
rüìerntlo\lnt!Ìl !nì ra'ìes'
ls t) lhe LiK, lhc \clhcrLantls' Jnd lreLnnd: 7í)
and tì nÌand
18.7 Ìvlacroeco tro Ìni' cìc\ eìop rìen t\ n SÌ{ede!]
j

riSid v5 iÌralLrlc r'ãiles

lE.8 Shií| 1Ìr relaÌile dÊnì af '1 1oÌ striil lcd ÌaboúÌ:
U
ìE.9 Di \pcrs ion '1 utrc nÌflo-vnìc nt raisc\ ih e lilÌ 172
18.10 Iqulllbrium enì|Lo) Ìnent in EÌÌ\4 and ìn ll\'1U
:: LI5T OF TABLES

1.i Ihe impoÍance of unbns ìn s'agc 5ctLlng: OE(.D counLrlcs

3. I Constant, riring. ancl f.ìlling iúlâtion 71

.i r.,d , .d , r'ì - r\' ì!rÒ.' r'\,! - .6 . ì28

Ì910 ztì00
+.2 Ìlleanúes of tlÌe centraÌlzalio n and .oordl n a lìon of *,agc scl I ilr g in '129
OL{ID couìtries, 1970s-r 990s
ó.I Gurtìr Ìates, reaÌ irÌterest ratesl irnd real rates of rcl urn 187
;.1 c.llrÌìpirisor bcti\'ccn PÌÌÌ and tnÌpÌe Ke_vnesian connrmptìon 211

S.l Maìn assetttpe\ 25ì

SI llaÌancc drcctofasaíehou\e 25,1

S. J Llalance sÌìeet o Iam o Ì r srphlsti câted ratèh olìse 255

S.1 AbankbaÌan(es1ìeet 255

\r A ban k balance sheet lvitÌì loan !! ithdra s n iÌÌ .ash 256

: ri .\ bank bala.cc sheetilith eÌtra loans 256
:.1 T)pes ol operì e.onoml 291)

:I DennìngtheÌe\ela d movcments ill tlÌe nonÌinal cxchang€ rrte 297

.l (lncolcrcd inrcÌest paÌity:rn eÌaìrpìe
3Ì5
Ii (lentral LrankbalarÌce slÌcct 336
: I Ijs.aÌexpansìon underlìred exchangeÌdtes l.llJ
: I isciÌ cxpansion undoflexiblec{chrngc Ìatcs .J5t)

\1onetâr) erpansion u!ìdcr ncxibÌc c:.han8c ratcs 385

:: sollw gr)wth a.couÌúing lìrtlÌe LÌnited 5tates,19.1ll 20Ol .r83

: I Growlh.on\ crycrcc Ìcgìesú.s il99

l ConÌpleted rdu.atio.alaltaindìcnt oi total popuìation oveÌ Z5 vears 502
.ii,ge irÌ per.l:ntiSes
= (iDI per crPitâ b\' re$icÌÌ ìn the Czech lìepublic.rÌd ]\urtria, I995and
:rI2
- I Ìiìi. potuìation gr)wth Ìr Chi.a
 in the 703
l l.l lrchange rate rerlignnrerts and ìntlalior 'lilfcrertìals:lÌancc
ER\{
70.1
1t-.2 SacrihccÌatio!foÌ IRM an'Ì on lRìvlcounrrìeslnthc i970saÍld191j0\
tìreexteíral balaÌÌ'cto GD! 7ì6
17.3 CorÌúibu!ions of doÌÌr cnic dem and and
gr{)wlh, euÌozonc 1995 2005
ì 99ih 726
71.+ US ec onom ic perfoÌnÌan ce bt decadc: 1950\
727
of lhe ()1eoinca tcchnologl in the post 1995
US
17.5 F.stiÌnatcs
produciivìtyÌevnÌaÌ: a nualpcÌcentageÌalesof 'hânge
erìrÔn)ne 2000 2003: 131
17.6 D itcretionarl' nscai policy ìnthe USA an'ìtbe
change in thc c-\'.licaÌly i djustc'Ì
(ÍÌu'lLÌr'Ì)dencit
gÌoÍlth ratts:JaPân' USA' Ì_'uropeaÌÌ UDion' 1960 20ol
733
7l.i ComParâuve
741
18. t StructuraÌ change 1950to 1973
7L)
Ì 8.2 IatteÌn\ of joblessrÌess' 1998
gÌouP' ÌlU 1998 7+6
1E.3 Diíference Ìn ioblcssÌÌess ÌrycducationâÌ
and the lls^ 717
18.,1 sumnàrl of elnlÌoymeÌrt and uncmploynrent in ìr(1lopc
oìicD I960 to 1999 719
Ì ll.5 NÍacroeconomic tÌends alrd ! n eÌnlrìoi'men!'
institütidÌs r'52
1IJ.6 1r.nr1s and conpaÌìsons inlabour nìarket
si)i Íudjes 754
18.7 !sinÌatecl cfte.ts oíinÍÌtutions on unemtlo'vmentr
755
18.8 shifìti!Ì the B€1'cÌidCe cur!e
758
'1hÌec uncmpb-Yment 'miracÌes'ìn f'urope: key macrocconomic data
18.9
717
18.10 Rcgional economic perf onnan'€: Ital,v
 ABBREV IAT IONS

',üR annualgÌoi!'thÌate
-l \Íl ìctile la bou. nìarlict poÌlcjes
'.fi a\ eÌage prccìuct of capitaÌ
r.rrL av.ragc producL ofìabouÌ
r I'Ii ar nNal per.entage ratc
::.' balânceolpavments
r.r bcn rcsponsc
ji cerltrrl bank
i .unrÌìon cuferc) area

..i constant rcturns lo rcale

-:ì .Ìe.Ìeasinii rehrnÉ to scalc
lriL L)\'.aÌnlc StocìrartìcGenerâl lquilÌbriunì
rr l ,l €ípc.ta tionri aúgmen te.] lhilllp\ cun,e
: : lu.op€anCentrall3ank
:'.l- IurÌrean Morletary Urion
i I.i r{.hange Rate Mechanivn
:. - eqrilìbrlunì ratc ol uncnrplolment
: luripeanu ion
.' gniss.lomestìcprcduct
_ ì\,Í. r r. ) Ur ,l
.\l SrossnationaÌprodLrcl
. gÍ)si íate pÍÍluct
jntorÌìaljon ar.Ì comìnLüÌìcations technology
r.
I. ÌÌìterrÌaticÌÌal Monctary lìund
.i nrcreariDg retlrns to scale
:: - 1o.g Nn e!Ìullibrìunr Ìate olunenÌplovment
: ìa*'otoncpri.c
long terrn unemploynìent
': \lasjachuset( ÌDstitute of Technology
-.:.ii nìarginalproduclotcapiLal
r.: l nÌargiÌìal product oflabour
':: Ìnonetarr;Nle
xlii

\ÍÌì\{ \Ía.kh!. RoxÌer, and \\c I

\1\t marlet vaÌue

NAÌRLJ non accclcÌaLirÌgÌrÌÍlatjdr Ìatcof uneniÌto)ìÌcni
Ììbtì n o. ìra nk tìnarÌcla I in sl iLutioÌÌ
\CBM ncoclâs\ical ber ch nr a rk üxleì
NHW ron human Ncalth
NIQ)C Nea' Kcynesiün lhilÌ4x cuÍe
NM\'Í nclv nÌi(Ír Ìno.Ìeì
()(lA optiÌÌalcurc.flar€a
OICD O rga n izi tioÌÌ for lcoÌronr ic ( .ioperati oÌr an d )er el(Ìm cnl
L

lDl lrcrfectìlaverianLqujÌibrìurì
f'(l lhjllìpt.u,vc
p... pftanounì
p.c. per capjtâ
PÌr iR prudeDt irscal poÌìcy nrle
lÌH p.mafcntirÌconìehvtothcsis
lfl pur.h.ìsirÌg poi{er paÌjtv
l'\ pdce settìng
PSD pubÌictc.Lordetì.it
llvl lenn\'!orl.llables
R&D res.È!Ìch and dcrcìotment
RBa reaÌhu\ircss .v.lc
RULC ÌeÌatircunitLìborìrcost
RWR rcil\!a!€ úgìdìtl
SAS sÌìoÌt mn aggFgnlc ÍrptiÌ)'
SB l l' \kiìÌ hiascd re(h jcaÌpÌogres\
SCÌ) SLibilit:" and crc 1h lì.t
SGPF. suLri{anì.fcrle.tequiljbrium
Sllr(l Stlck_Í I nforÌÌìatidr lh jìÌi ps .urve
'l lÌ) toral à.td tÌ)ducrn iry
UCI lrnivebjtv Coììcg( L.rndon
UÌl uncovcrcd iÌÍereÍ pariLv
VAI vaÌuc iddecltax
\{S srage setting

ZÌRP zen) jnlcÍcst râte poÌict

 Motivation for
Macroeconomic Models

::ì rool anìs to p rcvi.Ìe moclels that can b€ uscd lo undcrslarìd a idc rangc ot mrcro
:- r ,Ììi. b(hnriour ând polic) issues and to cxpìain hoir diÍtffcnl counlrics pcrlorm
:.-r :rr p.rtornìance cìrang€s ov..r tim€. lvc usc liro broad kinds ot rnodcls, one ls
:. :1i.!râted modcì Íiir anaL) sing Ìhe outpul, uncmtìo) nrcnl, inflalion, cxchange Ìate
:.r:i. ,Ji'problcrni ând the other is used for .Ììaltslng guflh. 'lhc cholcc oi modeÌs 1s

.: ::r rful b! thcir úscIuìnest in frânÌing k€y qucstlons lhar la.c Ììâcrocl:ononìisls. The

. -:i1 ar\: the ìeleh oloutput and cmpÌo-Íment detemìnìed ancìlvhv do they fÌuctuâte?
. 1 !loe5 iÌÌflition occaÌ and Ìlhel] sholld s'ervoÍy aboLú il?
. r: dne s govennnent poÌìcy affcct in natìon and rneÌÌlplo)'ÌÌìe t?
.1:r\i\uncmplotÌncnthish€rforleÌÌitthlpcrlodsoftimcitsoÌìccountÌics!hanin

. - ii.Ìi) trade, iÌÌternatio.al financìaÌmaÌkets, and erchaniie.ate\ afiect empÌovÌrent

. i.::\ :Lr. \omc counúies ich and others poor?

. ..r rre \onie.ounüics retchlng up with the lea.lers atr.l othelr not?

: ..:pliLn hon etisodes ol high unernpÌoyrÌìcnl or runawa_v lúlalion can occur

: : .s us to undeútrDcl how the \t-nge and prjrc sctt.6 in thc ccooomy bcharc as
.:iilì\.go\cÌnnrentaDClthecentralbank.CountrÌcs.Ì!tfffwìdcÌlinhowtheirlaboúr
:::..::i arc oÌganized ho\! importârt are thes€ diÍtffcn.cs for expi.irÌinil patterns of
: ..:.lnr mcnr? Goremments diftèr iÌÌ lÌo$, tlÌ€y rranagc ccononìic policy. Ìn manlr
: ::i,'5. Ììonetarv poÌicy iÌâs been leparâted from lbc govcr ncnt iìnd delegated to
. :r.,r(.. dc n t centÌaì bank. dozen l-uropein co(tn l rics ha! e di\pensed $ith nâtiorÌâ l
_i:r^ Ìroliq altogether b!-^ joiÌìiÌìit t1ìe luropean ÌUon€tary UnicÌl. In rÌiaÌÌy (ourÌ
.. riDns and emtbleÉ' oritadizâtions .r€ invoh.cd in sage s€tting. Horv would lve
. ::r rhÉse drftèÌences in iÌìstitutionrl.ìr.ÌÌgeÌncnts to iolÌuenceperioÌnÌancel
. :r- âni]!sìs of Siowth, somc nìodels emphasìzc (hc role ol the accunNlatiotr ol
r. :r both physlcaÌ caÌ)it.land hum.ìn capital. Oihcrs hi8lúiilht the nnpoúânce oi
: rtn e entìepÌeneuÌúl actn iti€s. To account for tlÌc vast difìerences in the succe$
: i irL.h courtúes have riised liÌ iÌìil stândards, thc rok ol econorÌ1c poÌjcy and iDÍi
' : .rÌ irangenÌents 1òr promotinit irlenrÌìent and cntrepren€uriâl âctlviiv need\ to
 above
lD thc Ìest of this chaplcÌ, ife put 1Ìeslr on thc b(Ìres of the qücstions Posed
to thc shoú to mediLrnr ÌuÌÌ nìacÌo
by lìrst setti.g out in a schcnatic a'â-v hoir nìodeÌ
cco orÌv. Wc motìvaiethc.ore componcnt\ ol the nÌodcìi{ith enìPiü'1data
sÌìotiÌÌil
wc do cxcÌcise
cr)\s co;ntr-ï tÌeÌÌds 1ÌÌthc key variabÌes tn the sccond scction' a pa ral Ìe1
ira] s
lor thc lonil run .ìÌÌa\'sls bl Pre\eÌìting some sllliTecìlacts ancì skel'hiÌiil
lhe nÌâitr
lhat ilrcwth has bel]n modclìecÌ

'I Output, unemployment, and inflation

rr', J Il 1.or 'iç l|i sl' r'i
ÌeâÍmabl'v
nÌodcìnrrshort an.lÌncdnún run rnâlysi!that is both teasonabì) limple rnd
realistic. lt has to be rcalìstic It it is lo P \'ìde â franrework f(t anâly\ing Ìeal horld
ar nÌo'leÌ
nÌ.ì.roecononÌic p(rblc m s Ìhc moclcÌ is a i nÌrle !e 6id1 of th e N es'
s Ke) resì

rtd. J,,f ih I ''Jr''lnJrr _r-d

This Ír c.ìlÌcd:l €quation moilcl corÌsirLs i5 curve that models aggÌega!c
ol the 'leÍìand'
rhe l)C_ or |hiììips cuÌvc that reprc\enls tÌie iÌnPerfeclì-v'' conìpctitive
supPl) side oí lhe
econon), an.] the tíÀ or monctar] rule tbat capturcs üìe bchavioúr of an intÌâtion
tarilclj ns .c ntÌ41 bank
ì1",".-,*" *"tt lo slÌo!\'hoi\ the cliflcrent elcÌnents oí short ancl nrcdntrÌì-{tn
ol inflation ÌtÌ
nÌa.rceconomic5lrt together to in1Ìucnce thc level of outpul nnd the rate
cconlrÌn,v Ne gjve
thc lhree rhâpte5 thal í(tlo$', r'e prcsent thc bare bones oÌ a 'l(aed
a baslc rationale irr thc mriÌì fcatures oI rÌacioecoÌìorìic be1Ìaviour
on the düÌând and
supplv sidct of th r eco. om-v. 1 h it pro!'ì.te! üs i{ith tlÌc t'Ít! for an alt siJìg
busi n cl'cl et
's5
and trends in uncnÌPlo-v''nrent
'lhe nÌodel tha!re scl otrt in thit secln)n ard iìr th€ ncxt th'e€ chapters $ìlÌ aÌlo us 1o

bcgin to anÍ!er queÍìons like lhese:

'HoÌ!do.sachaìrgelncorÌnrmtrcorl.Ìen.cduetoacollap\€jntìreÍockrì'rNd
iffe.t ihe econonÌr_?
. $hatìsthc inÌpact onorrÈrt.nd inflali()n olchanges Ìn goverÌÌn cnt PoÌlcy nrch as
cha nge\ il] tal.l ion or goveÍÌÌnc nt erpcnditu rc o r a ching'
in onetary poìicv or in
enrpl{)) cntÌegtrlatiolì?
. Ìf tÌÌe lntenìcL ând gÌobalizition rflccl product mirkel coiÌÌpeliLìon, what ilould
$e
exp€.t n) be the ÌÌìac()ecoÌÌomic nnpact?
'HowdoinstitutionslikcunionsoraÌÌitìdepeÌìdcftceÌltraibanÌaflc'tintÌationor
unemplo-vÌnent?

$rhat dotle nÌcan b-t'lmpact on the e.o nomt ' or 'nr acroecononÌic inplicatloníl Wc
n]can tÌìc iÌnPact on oütput, emplolnÌedt, the pricc ìcveÌ' and i'ÍlatioÌì
Our basicnìodcl
must tlÌ€rc tore provicl€ us\{itìr thc meads lo an\wer lbe lolloi'ing queíions:
jn
' Qtre\tion l. How i\ thed(trrl orc(rent ìeleÌolouLfutâIld c ÌnPlo-vÌnc nt thc
cconom-ï determined?
. QuestÌon 2. \\ihat deteÌmircs Lhe levcl ol enìpìovÌnert i' the econom,v at wtlich
ìnialion i\ slable? We call thìs the nrc.Ìiunì run level ol enÌplo-'''nÌent
'qìrili}/i"'
 :t

. -r.tLrLrn 3.Ilo!l rndivhv doetthe eco onìytcndloadl!'sL

Írom itt cun ent polition
::r:::dt the rÌednrm-run equiì1búum and what facrors iníluence Lhe tpeed and
::ì: Ììrne\! ol adiustnrent?

.:: ni ha!c a systenÌâti( iva,v of anss'$ing these thÌee questions, we caÌì tacklc n
: : :trnsr oi disturbânces to the e.onomy and ases the policy optiius !lailable to
'i.;.innì€ntorlhecerúrâlLra k. lherc js, howeleÌ, an ìmPoÌtaDt caveât.11Ì€ real'
:: : :inrotriies thallle are irtere\ted in arc open ones because they tÌa.le with othcr
.:;::::.sanddreconnecte.ltoirtemationallì.ancìaìmartets.ThisìÌeansth:ttiiisoften
::::: ri:i. to use a close.l economi ÍìodeÌ whcn dealing ttith an appÌied pÌoblem. ()lr
: :..r hend. l\re .an easiÌy k)se sight of thc wood f(Ì the tÌees if túr ma -v facets arc
: :-i-datoÌÌce. lhe ìnocleÌÍ extended to lhe oPen ecotomy ilr Chapters 9 tÌ.

' AssumptÌons and terminology

:.::.:.ibcgin,itisuselúltoclarifyÍ)meassumplìonsandteÌms.OnanÌstreâdiìg,thc
:::--rnrr ol aÌl the distinc!ìons that aÌe drâÌÌn lÌcrc tray.ot bc apllaÌent. Butrefer€n.e
:r:: : :ni5 s€.tion Ìnay provc ureful whenÌe.ding lhrough the oveÌvi ew of the model
-. r'rcciaÌ íeanre of rnacÌoeconomics is thal thc ì)chaviouÌ of a nunrber of dill€rcrl
. :i: r:É.o.omicactororagcnt such ashousehoìds, frms, gove tn m ents, unions, c€n
:: r:::rs-hes to be takcn into account simültnrìcoudv. lndividuaìs nrake de(isions to
:-::: :.. lahonÌ force, 1ll save, and to spend. lhct rcspond t.r job offers, to tÌìe iÌÍer
:,::.:i to .haDges 1Ìì thcir cu ent nrconÌe l€vcl, a.di. thc vaìue ot thelÌ acQrmuiated
.. ::ì I jnÌs aìter L€vcls of prcduc )n as dema.d tor thcìr oulput fluctlrates, thev set
r.-:! r.{Ì nrake inv€ímeDt dccitnÌrs.IiÌns ÌÌray also scl $agcs or do $ thrcuglÌ joiÌìt
i::::::r.nsllithnorkclrorr!Ìthunions.DotlÌhouschoÌdsandfirmrwillbesenritiveto
-.:::D.r1ttar,sperÌdlng,ardinterestratepoli.y.AndthclrbchaviourNiìlre|ectnot
i . : ::. .LÌrenr ltate o I econom ì. vaÍalrÌe\ bul also hoa' llì cv cÌPccl the lelel ol these
..:r,.s 5lrch asth€ inteÌestÌate, tìletaxrâte) or$Iag€s tomoÍcin thcfutlue.
:.rr.roe.oronììcs,rhed.{tr{di.srlPllri./ercfcrstotlìcsuppÌroígoodtan.ÌseNices.
: : .-iflt side.onsÌsts of:

::::r.rorsof p.oductlon, which are'1âbouf and'capilel'. Thc suppìy of and.lema ci

,. . .t 'r . .r P.' ,l-.,r 'r l\ .rd.
:-::i.hnologl tlrlrugh Í'hich lbc jnputs of labour an.l capitâl are trâÌì\formed inlo

:.:ild\inrrìichtheincomes(wailesaiÌdprol'1s)lhal o.kcrs and l_rnrs rccelve aÌe

st./. rclers to thc aggÌegate oÌ economy s1.Ìe .lemând tor

::t .ijiír,3Ìr. ./r,rdr,
-:i:rnd scrvices. The aggr€itate deÌÌÌand Íorgoods and seÌlicet con si sts of:

: : iumltti{)n .lerÌand
.::rinÌent dcma.d
m;o |i lì riIri
 conÍrnÌption dcnandrercÌstotÌìce\penditürebvtltll:tlr:l:::li:lT::11::i
iil;;io'"àïiì svsrem or asoia a.don non LrLuabrc
Ïl;
"'in " ""'.''c
"'.ïÏï,L:Ïffi
,-,,4..,ir.r. ". u."t*tt or a loat oílrrcâd'
on."n*,*t-.: ilïillTilì:,.i-ollp.ïlill:
"'ï*-i;";;;,.;:i"., to ".p""ain."
- o"'torherotaìam"'''!ï:TilÍ1"^:::l:jl:::i..ï
n' r"
[Lo, I\ tlt'f
r_c'L Jrorrrì,"',";
:.1'l: !is '
,
"*i"'ì,jiì"'r.""*.,*eaddir
I.r.i ,L.r..rô ;:"
I.i,ot^:::."" i,d..
,.J I lir4ru lrr ò ,o 'r
ìïì:ì:ïi:ì:i:ìï;il:;J;;,;;ì1,:,;"","""*,-,*.qlii"'r."qri1,111i1.1.f,.1,
*'' buiì'1ins\) nÌe a]so tr:ìrr or total
i:ïlt**l::ï::i.ï:ì.ì[:,.ï'* '""1 - '*ooL
 .: i:.úrpúlandcn4toy lnt$,jlliÌageandprìccscttebbeln.quiÌibrnünìnthescnsc
:.:: :,:.:c is .o LrD{nrd or doí'ÌnlaÌd pÌessurc on ÌÌag€s or pÌicesl
' . shaÌl sc. Lhal it Ìs rcasonably stÌajghtÍoúlad to irÌcoqnÌalc ìn the Dredium-run
r.: i tLs af LnrcsÌ gatìon of thr or!,ír.r..s ot.hangrs irr techroìogv !uch a\ changcs
- -r,ducrú.irÍ grorÌth. llut to inve\tigate the .dlier ol pÍxllìctivitt growth an.1 {h} iL
.::!:.hengc,lfc reed to extend the ârâltsis lo lhe lo,j rrr. 1\c turn orn atrenLjon
::rjijnthl:sccondsectionofthirchaptcr,r'hichiÌÍÍrducesgrctrtrhtheoÌy.ÌDthc
::. ru. enaÌvsls, i\Ìc allor! lor ilrxlth jn tbc populatio , iÌr the plÌvsi.al capltaÌ stock
::::in,.rÍ and cquipÌnerÌt), lÌü man cafitaì slo.k (skills olwoÌkcÌs), and im|Ìo'emcnls

-: 1ar ous points in th€ book, we mate rctcrcrìcc to the case o tefe.th, .a]4)ttitiv
::::k.Ls rlul Nc oitcrÌ r\,oiN rÌitlÌ a NoÌe gencrâl nrodcl wlth maÌtcL impeúedidrs. \\'c
::1.:rrct nìnrkct nrperlections \erv bÌ)âdìv ro incìude rot onlv tìrc .xercise ol market
: r.: búl aìso lhcconsequences olthe ìackof.omplclc inlormatn)n, su.h asrlÌeinabiÌìtf
tor Í)me qúcÍiüì\ ile shaÌl see
: . drfìorcrs to obsen e how h:rcl a woÌkcr ls nrorkiÌrg.
:'::rh.llìmodcìsÍ'orknìesscniiallythesaÌneÍ'av,ì)útlorotherquesrionsth€renücaÌe

.ì this intrcÌ1Ìrctort se(tion, lle providc a bird's l:,!c liew ol hoÍ' thc .litìerent blts oÍ
i::::.ndiÌÌediLüÌìÌruÌÌìa.Ìoeco.omìcsftL logclhÜ. We focus on macroecorÌomìc out
r,:rr\üìtiÌÌrsofoutp!t,uneiÌInoÌÌnenr,andjnnalirÌìjâncìonthcroleolgo!enrment
'i.rl :1rli.ies (i.€. spendiÌrg rnd taÌatior) and moncLnn policies. Thc aìm here 1s to con
r lÌrc g.,rcrai llea r.ther thnn to jet our clcrr stcp ol the aÌgumc.t. Ìhe details aÌe
_r r rdcd in rhc rcxt tlüc. .hapteú. Nhen iroÌki.g th.ough the derail,
lt m.r) be u\eiul
: rilu r lo lhc Òvcr!ie!! to see the biggertict(lrc.

-.2 Fluctuations in output and employment

,!r..n..r. ol nìn.roe.orÌ.!ni\ts js r!1th thc causcs ind conseiÌucnces of nuú r r fluc
::i:itn).s in c.onooìi. aclivltv. lìr shoÌt ror, rÌc ÌÌìcan verìr t.) v.:ar or quaúeÌ to qurlff
: ::itrìationt. lìig. ì, ì shorls th. quaúeÌÌ\ gíú'rh ratc ol.trÌtPrú tor rhc U]Ìited stares sinc(
:i. end ol lhe Sc.ond Wodd !V.r. Booms itlì súong gÌowth ol outÈrt anct Ìeccstjofs
:.iih \harp cortÌa.tions alc cvident: the swìng rom peâk to úough ancl t)ack agai. ls
..:lled the busin.ss cvclc. thc Êsure aÌso rlros,s a coÌÌÌpariton ol aonual tnrwth Ìalcs of
.itnìt t{)r the i;nilcd \tatcs ind lrance IÌonì l9ljl to 2ll0:ì. A sinììl.r pattern ot booüìs
i!d rece$n)ns is rclcaÌi.d forbothcounhi.s, bul Ì1 sirlsocleaÌtlrntthepeaksandlroughs
r: the bu\iress cÍcìc do not iìhrdys coin.ìdc lorthcsetllo economies.
h the sÌÌrÌ Ìun, rhc lcvcl of output in rhc cconom) depends on the Ìeveì ot aggrcgâte
,iiÌÌÌ,ìnd tur goodr and scnlccs. Ihe stardard ,/J.r,/-]V rìrcdet' ts a usehÌ sraíing poiú
rÌ undebtan.llng thc lâctors thatirúìuencr rhc Ì(vcl ol.ilgregaLc derÌÌâncÌ and hclìc. tlÌe
l!\ cloloutFú andemtlovmcnt inure nÌrt rlrn.,\sí'e íÌrtÌser, !l is re,rÍmablc lo assunÌe
ìhiÌt prices ünd wages arc gilcn in the thoÌr run. ìhis nÌ€als rhal 1\,c crr c(rrc..(rntc cÌÌ
r.\i q!antities (i.e. ouLÌl'L and cÌrìptovnrenr) adlust to changes irì the demând tor goodi
rrd scn ices. As we notcd aborc, it is co.vcnicnt i,ì a macnr nrod€lto l{x)li âL thc i.rtoú
ÌÌr itd€tennine aggÌegâ!c co.silmptjor exlt.ndlurc (bvthìnki.gaboutthe inllLrcn.es on
ihr. !pencljÌrgrnd sâ\,injjs dc.ÌsioÌÌ\ olco.sumcrt irnd.ggregarc in!e\tmentcÌDcÌìditüres
z:

1
r9.Ìs 1950 1955 ì960 Ì965 Ì!70
7.5

Ë s.,-)

; oo

1980 1985 Ì9!0

srâipq GnP rs4i di'i rnnua qÍowth

Figurê 1.1 QuaÍlerly qrôBth rãte oí GDP nn ì'ê un le'l
1Ô zOO:

ÍàÌes oi GDPÍor Fran.. ènd !5/\' r98l r.2!0r

^(oriElil:]!:l.lt]Ft]

(b-Í identil,viÌlil lhe dcLernrìnatÌ1s of the decision! of lmÌs to changc

lheir stock ol câpitnl
r:i." g-'","nr cnt is a direct 5ourc€ ol âggregate dc nr a dth(trìilh itsPLrrchascs
",1ulput"ni)
oig,,,,at o*r t"^i."t. rlc governÌnent autÌÌorities (jnclu'liug the ccntrtl bank) hale an
tàì*" t,,0"""*.t", utc ievel oI agilregate rÌcmarìdbv theÌr choicc ortìx rates and the

1.3 Unemployment: international (omparison5

emPlo-vmeÌìl
Lconomists nndpoììc-Ì makers areirÌteÍ\ted Ìn ríhal determìnesoü1putünd
í'cll' $e on 1i]úeÌ b! lürking
not onÌv in the !1ìoÍ NIr lÌrt o!.tldÌilcr [ocus
p€do']s âs Lhe

ât thi';eÌÌds tre\cntecl Ìn Fig ì2Is'oqucslitÌìsarìteiÌnÌnccliitcì):wh-vdodilIerent

counlrìer apPear lo havc.liffcrcnt uncìÌplo-vÌnent rate\ ind ilhy are therc p€rslstent
tÌerlds in uncmPlo-vmenl 1n sonìe counlries?
the LJSA tioÌ]] 1918
ttrc trp paneiot r'i3. r.Z stìos6 the ÌÌrontlÌl-v unempìo\ÌÌìen!rate for
toz0o:.ìlrcrotcrpanel sho(s theinnualunenÌplotnÌe irate tì)rtheUnitcdStatcsand
(GeÌnÌâ',v, Irân'c, the LJK' arÌd Ìtal))
th€ averagc lor thc i(nü larile litrop€an cc.'nomi€s
lroiì 196ó!.)2003 lhcte has been a lÌe d of rislng unenìplor'-nìenl lronì the 1970sto
r.,-r' ,'.r.t. rr...I1.. ,{r"dr'.
arÌd LIS urÌen\toyÌÌìcnt
TheÍ. ì\ a íriknìg diftèrcnce bc!aee lhe eloÌuiion o l Europca
'
Th€ j.Ìea ofa Í^ì;h\'constant c.Ìuilibrì unÌ t] n trÌPloYnent rare
looks more plausibÌc r(tr
ÌÌìc Ljnited States lhaÌì tor ìiurcpe lÌì lhe UnilecìStalcs, unenÌrk)]mcnt t1u'luates n ìot
 tÌ5 lÌÌrÍi flu_rme.l Râte

1950 Ì955 Ì!160 1965 r97r:r t975 Ì980 Ì985 Ì990 Ì995 2000

rrrl

:
a
: lj
r!rr5 rgio rq;i

:i:u.e1.2.iihvlrÊrìpôvrneririieÍortheLlS^1948to200:l.nd.omirnrsonoÍthe
. :: -.1: Íàiê5 íor the USAard Flrope, l960totuo:
o tfri d d l; BL,.À,.,t Lih.

r : :fìfi.rs to havc luctlÌate.l anlm.l a Ìate of âbout 60./. iince the 1960s. F.uÌopeaD
i.:::rli\ rìcrìr iças arcÌl beÌov that of the uSA until the i980\.
i - 1 -i ìü!s thc lrneÌnpÌo) ment rates fdlÌance, C eÍnanv. ltrl) , lapan, Swcdcn,lhc
,:::,lih.ìSÂorlhcsrmetiìneperio.Ì(usìngtheL5Aasaconrprri$nbcnchnraÌkin
::.:: r:.mrfl \lìoÍ lh.se countrie\ exhlbit sìgnìicant !ariabiìitv in lheìr uncrÌplovrÌcnl
: :: :::r.r olcr the past tÌrtr clecades. The UK tì)ÌloÌvecì the sanre úcnd Ìisc i. u.cm-
:ì:r.rr is Ììlrch of F.uÍ)t)e (IÌance, Gennanv, Ita\J iìom dre ea v ì9t0s lo lhc caÌì,\'
: i |tLri s n.c Lhen, there has been a.lorrn$aÌd trend thrt $'as inlcrmptcd but rol
.:::ìrrllrcre.e*ninoftheearlvl99ü.BycontrastinSNede., lhcrc Ìlas vcN loÍ'
: _ r.,rr mc.t ro rhe eÌ1cì olthe 1980s nnÌowed by a dramatic Ìunìp in uncn4tovrn.nl
': :runìpcan r!.râge in the earìy 1990s, which has \ubsequcn(ìvbccrÌ rcl.crsed.Japirn
_ :.11.\úcÌnelv Ìorr ÌeveÌs ot un eÌnpÌr)yÌnent conrprÌed lo lhc
otlìcr.ountries untìl
..r,rl991ls,whileÌecent)eabhaleseenalaj vitÌongasccndingüend.Ìhe\e.hdrt\
:.rng.5 in uneÌnpÌr)_vment that peÌsirt oleÌ tine and bì8 dlIIücnces â.ross coun
. ::.\ nr ot ivate the Ìroti(ÌÌ of a me.li uìì Ìununentlovmcnl rnt c, ln r1'hich chanles
: iìr e.d dilteÌe.ces acrcs\ colutties are assocìated rÌi1lì variations in mplÍ! side

. I À,'lodelling medium-run unemployment

: _:{i. b! conLÌaslìng h.r! the aggÌcgalc Í1pph sjdc is presented irì thÊ coìnÌretití e
:r rnd ln Lhc morc jjcrcÌaì Ììodcl wilh markcL lmpcrlcctions. Ì!.Ían) Ìeadeb rrjìÌ be
 it#qrorq^ r'r'lo l99s 2'00
-rl8o'_rií

llraìO Ì965 Ì970 197s

Fiqurel3 L-nemnÒ!íe'l ale5 tlr 5om"ÍÌlre í'ìi{Í o!'D e"NÔn ês r960to200l

,;:.'.",, .., .,"."..,.'.' ".,

ln iÌ coln
laìÌìÌlìar Kith conìI)clitjle mo'lels
ftonÌ lheir knowldge of nì(roeconomtct
narket cLeaÌs rhis nìeâns
thrt rhe rabour
ìLliìlìï" it" ,""our narket' i{e sa-ï
"ìi..ì "i
.i,"-:.-'r"\',J'r'r"r"
:: : "\t thr ,-1.1,, .'"1,-
\i ..":' .;',,:,:
mJrlct_LlcJrilrB Íc 't
I \ i.tl !rL1úal\ d'\
..,;'lï;.,.ì ,'," '' '-'
\u " ' iìkn tÌrcÌ cotrd iÌìdlas€ rhctr
Ï::.'ì^i'lìi;;".:",; jr thev eÌÌrPÌo-ved Ìess labNr' ìor'"r"
..- 1, ,,Â.n,.,^n,íi. 'r''lr' u ' ''
,',,',," ,,,:l'.;r,, ,.. \''r-' "r' ";"' 'b
oir ìt the-v
laboüÌ r{45 strpplied workc!s ÌÍ\Ll'ì bc bctfur
.r, ì," ,.,pu,'".i' io*ut 'Í
Ìess

-Ìi::ijlïl:,,.,,""-provnrerrthatcxisr,i,rthccompctìtiye€qu'iÌriiu rs'oir,,idry

-; 'l *'r'1-r '"

;,;:, \ 'r'lr''''l'ìiJ
t |" I'r"'
',," re'e11'ìns trÌe rrc\riìiÌìs
:ïl::ì;";;;; ";d;ith rìre art€ 'rrivcL'" or 'lorkúÌiift)r'Ììdâ job orrei'Iìs b'ttcr s'ates
:::ì i;i-" i;;;.;;;i;;iìl.n"-prn""a ''"-' '"arciÌiniì
,iI:I4".'-
."
t n) 1 qPti
",'t t tlrtli hn úü
t1 t
L t útc' 4 | üu tfl Õ\ n P nt
1
 - mperíect competìtion model
': :ii lo the competitile rnodel, we u\e a nÌore SeneÌal mo.lel ìn rìrich the equj
-. ì n rhr labouÌ ÌÌÌarlet does not nece5sâriÌ! coirÌcicìe with maÌket clearirg. ODe
: :::.: .o.iÊquence is tlÌ.ìt tlÌeÌe can be t?vdlrorrry unenÌnolmeni even at cquiÌ1b
: r,ì. conryetltive nÌotleL, ilages ancìprices enÌerge thrNgh the prcce* of market
:.-::- lrl c\emtle, in a peúectly competitlve pro.llÌct maÌket, each frrm faces the
;:ì:: rn.c a.d chooses its level of outÌrut ivher€ lts mâÌiiinal cort ir e.Ìual to the nraÌ
. :: r.:i: ll! .onlÌast, iìr the irÌpeúect competitjdì rnocLeì, $e caD tâlk oIllagc i.lt ,1
:- - r:::i r.tÍ.,5. II tlrere ìr impÊÍèct conrpeiìti(!Ì in the pro.llìct market, th is nreans Lhat
:i:::::silÌrtlìmsândfiÌÌnsearnrilìpemoÌnül'prolìt\becausethevhalesnÌeÌnaÌket
: -:.iÌisrÌìcnnithatiìrepriceìssetbythelìrnìab.J!etheÌevelolìtsmaÌginaìcost:the
: :::::r:..irctrlccn lhepÌiceanclthemargìnalcoÍi\theptuÍìtthenrm ìnakes.
::: ln+ìL ícc L .om petiiion 1n the labouirnarlet, xÌonet wagesr!11ìbeset b_ÍenrploÌ
:: : u nion s o r Ìry bodr thÍmgh negotiatidr. l he 1Ìnpoúance of uniiDs i n wage iettjns
: Drountricsjsdcnr)n\trâtedinTabìe1.1.Acro\sthe30colnrtÌiesthatbel()nijtothe
: Ìae r!cragc pcrcentaiie ofeÌnpkÌeeswith wagescoveredbl coìlective bargainiìrg
r::.--.!t\ it 60LrD. allearlv the lrSA is atlpicaÌ jrÌ uÌe linlted Íne played bv collec 'e
:::::.irs iÌì rï.g€ scrri.g. As thc tâble illlÌstrate\, tÌie iúlìence olcollectn e bârgailnrg
.:i:i:.rìtoit.nconsidrrabl)stÌongeÌthantherüte\oltÌacLeuDìornrembeÌsìrD.
.-::rln,rge ior an indn idualniìÌdepend both on theoutcone ofrÍage tettingaÌÌd or
i: :irLÌne oi prlcc tcttnrg ac(xs the economy. At anv gnen Ìe\ eì of eìnplo) ment, the
':: ::r!r consìstcnl withwage\ettingbehaviouÌirìanìmteúectì)competitnelabouì
-.:..:Ì\illirplcalivbehigheÌthanthatìnapefectlycompetitìvelabourmaÌÌet.Wh)ì\
:i::,ìneeìplannllonisthatiìraunn)nizedwoÌkpÌace,thecoÌÌectjvcbargaÌnìngpoicrr
: -r:rllrr€es i'ill .ormalìy resuìt 1n awagethatis higher than the Ìnjnjnrunr an cnrpìoÍ.c
r ,: bÈ prcparcd lolloÌkf(Ì.

Ìable 1.1 Ìhe nìporian.e of rn ôns nv\,:qesÊtinq OLaD.!riLÍÉi

ÌÍade union Membe6hip (%) colledive bãÍqãin n9 .ovêrà9ê cn)

rnij ÌÍda:.d úp;,!õa tshã?r,o:.D.jÍrioriì.'r.!rir.ir2oarl

iiirrr. ribr 3I, or D rrpnrn.,,r r,ii..i i700!l

t0

\!ha( is meart b) eqlilibriLriÌì iÌÌ thc laboúr nìa.kcl in thr inpcriccl .ompcLition
nÌodcÌ? Ír Ììeans that s'age and price n.tlcrs ìn lhc cconorìy arc in cquÌÌibrinm, ln the
sürsc that at the (urerÌt real r!â8e and lclcÌ ol cm!lot mcf t, thcy hivc Ììo ioccnlh c Lo
chengc Ìheiì behaviour. Ìher€ is onc Ìcrcì ol emplovmcnl and ratc ol rúrcnìplol Ììent
ar which botìr wase and pric€ setters acccp! thc ÌrÌcraiÌlng rcal wngc. ihj5 ii lhc inl.L
jn the
fectu confctit^,! tq íÌíbtiuÍltttt ofúre ìllof lcnt. \r c shnÌl scc lhat iÌÌrpcriccljo.s
laború or pnxÌuci !Ìirket hâle the cffc.1 ot raising uncdrplotnrcnt abovc lh. Ìele jn a
.ompclitlrc equiÌibiiunì. this is consistcÌrL iviLh lhc taÌl Ìr UK (úrcmpÌot Ìnent
^1thouslÌ
frorÌr thc 1980s a\ urÌion power de.lined and Lhc rìnÍkcls bccanÌc morc corÌpcljliv., it
docs nor square iïith th€ low une ìplormc.t ìn hlghly rnionizcd Swcdcn lhrcughout
moí ot the feú . We \hâ11ÌÌeed to cnrlch Lhe nìodcl 1o accoLlnl Íor s('ch iacls. Thìj í

1.5 lnflation
ÌÌnaginc an cconomv that lÌâs coÌÌstaÌÌt inflation. In 1cíÌs oI our discussìon so laÌ, mch
aIl economy is ìn a nednìnÌ rüÌ equilibrìunì, ìrich í'c slìaÌl .aìì lhc cquiìibrìuÌì Ìate of
unerÌìplo_v''rnc.t or ERU. W:ì8e and pricc srtlc6 arc conlc.tÍ'i!h lhc prcleìli.g reaÌnage
ârld therc Ìs lìo pÌesure lÍrn elther side lo adjusL s,agc or pricc lncrcascs: inflation 15
thereiorc .ons l ant. Ìl we rrow suppose that aggrcgalc dcÌìand riscs, oulput ind rmpÌr)]
ÌÌÌent i\'iÌl risc in tire shoÍ nìtr ìÌìd unctrplovmc.( s,ilì bc pLrshcd bcìor, the rlu. We
$rouÌd cxpcct lvage lnd price \etters to rcacl lo this. This is bc.ausc i\'ith tcwer unem
plorcd s'orkcrs alailâble, worler\ $,ill b€ Ìn a írongcr birgaining posilion ln lhc lahour
nÌarkcl and real wase\ will have to rìse to saLlsl,v thcÌr aspüatioÌìs. Hcn.c,lhc.rúrcnL Ìeâl
$ragc in rh. economt i\ n.rw loi!€r than thc rcal a'agc 1\ ith NlÌìch wagc scllffs h'iÌl bc
sntlsftcd. Âs a Ìcrlt. wâite setters râi\e Ìnonc_Í{'agcs in an atternpt to ichieve lhehighff
cxp.clcd rcaì wage. But 1l wâges ilo !p, thcn price seÌters will not be ln eqLrilibrjuÌn.
H ìghcl $'ages Ìaúe coÍs for tìnns. l o nì. irÍa I n thcir prolìts, hrms will teÌìd to raisc thclr

prlccs. An ircÌea5e in agilregdte demrÌÌd thnt ralÍ's output and e!ÌÌplo)'Ìüent abovc thc
cquilibriunr Ìevel ihereicÌ€ l€ads to i rise nì iÌrllntÌoÌÌ.
'lhLs jnrme.liateÌ) raises the qu€Íion oi r,ÌÌcthcr ther€ is a 1aÍinil tr.de ofi lì€t$'ccn
innarìon an.l unemployrìent: .ün the lo$rcr uncüploynìerlt rÌìd hiither irúÌation be sus
rair ed b) the go\ exnnent settirÌil its poli.t- to achir re this? I he cll\cusio oltlÌel:bour
maÌkct 5lr:!:tests that this is unÌikelt'. lhe facl that th€re is no hÍnÌg úade oll cioe\ not
dcfc.d o. s'hetherthe 1âbourÌrark€t i\ competitile. ÌÌì i coÌÌrt)etitìve Ìrbou. mrrliet, il
.nrltìo_Ínre.t 1s higher tha the level at whith labouÌ mpply and demand are equaÌ, the
rcal rlage r,ìll either be tCrc lowtonÌanÌtanì this lelel of empÌoyment fionr ihe ÌabouÌ nÌl
t\'sde oÌ trx) hislÌ lor ìrch empÌoynÌerÌt to be prolìtable iì)r nnns (i.e. nÌ)m the Ìrbou.
denrand sicle). UJitlÌ wag€ ânci price \€ttüìg agents. there ir a paraìlel Ìenììt. We can see
thì\ by extending our€Jrlìer exarÌ e.UnenìplovmentisbeÌo$theÃnLIandúúìatìonhaj
gone up. Aìe wase aÌìd price setteb irr equilibriunÌ? Ihev aÌe notr \ìnce ìnUâti()n hâ\ gone
up, the Ìning Íandards of !!orkeÌs (i.e. their reil Ìlrijet have been Ìeduced beÌoir the
Ìelel th ev $iÌÌ accept in the coÌìditlorÌ\ ofa tighi labou.rÌÌarket. Atthe next oppoÌtlür ìt_v,
rlage se tteÉ niìÌ therelore ralse nnrnev $:ì3es by more an.l lnilatlon $iìÌrise Iul1heÌ.
 19.10 1950

19841 199{) 2000 lq60 Ì9t0 t980 t990 20tì0

: :-Ì? 1 4 _:à rr !Í.!.nm.r p ..5 n Ìhe Ll5a m.ntht l9ll 200l ài.l âi.!â y í rónìê OÉaD
:: '!!:j ri l1l0l

: .1 \ho\!s the inlÌnrlon iate fd lrance, GeÍnâ y, Ìtaly, Japrll, the uK, rncl th€
. r. nLt pan€l shos's lhe monthly series of changes nì tÌìe conlumer pÌice incie\
r :.: - jA c o\ eriÌìg most o t the tiveDtìeth ceDturl A pa rticul.ìrh stÌilinii eÌement is the
: ::: : :ÌooÌhÌÌess ol th c scrìes alÌer I 950 comÌrare.l with the hr 8e epíodes ol iutÌatidr
: ::: r:ion iÌì thc prc war perìocì. As with the nenÌplo),rÌent data, theÌe aÌe rtiikjrg
: ::::-.r! bet\\'een thc .ountries an.l aìso jnteÌeiting pâttems over tnÌe. one featrne
:: :: .tr \ up.le.rÌy in thc post I960 conrpaÌíons is the generaÌll kN Ìeveì of (leìnran
:,:: :: r \ .omparcd Í'ilh both the Un ited States ancl Ìta Ly. l\teciaÌÌy úr ItaÌ_v, but alro
:..-ritrd5latcs,lrancc,â..ÌtheUK,therearetilolownúÌât]{)neraratthebeginnirg
: i::: r:.1oíthc fortt -l,ca r perio.1. Ìn between theÌe isÌno.ethan a.Ìecade ofhjgh aD.Ì
i.r : irtlitiof, r\'ith Itaìian üúÌatìr)n hltting Ìaies ot 20% p.a. in the mnì 1970s and
::-::::ri:ì.!earl,vÌ980s.Oneisledimnre.ÌiâtelytoasliwhythehighlnUallonerawarÍ)
-:::::-ÌÈprorìounccdinÌtaìytharinGcÌmanf,whyiúlatiorr)sesohjgh,and hât
::.irL,outthi.rcduclionìnìnflâthnlromrhemìdl980sandìLsconrclgcrìccs,ilh
-:.,:ìÌ:ìflationìr)'rhccndofthel990s.lapanpÌesentianeqüalÌytascìnatìngchaììc.gc
.:..:::derthc.conomicÌeasonsbehiìr.litsinflatìonexperience,whìchrcachcdlcvcls
-:: p.a. i. thc ì 97(\ and negatn e nguÌet in Ìeceni vears.

' a lnflation and monetary polÌcy

::::iil poliry is 5cr in mâny.ììiièÌeDt s'a) s. Iìr ÍnÌe countÌics and hiíorjcaÌ pcrlods,
::::::1 poÌjc\l h'as dircclcd to Ìeducìng unenrpìo_Íment; 1n orh.Ìs, it was orìcntcd to an
 D 'l'"
t'hichredrcesagsÌeirat€ d.nìand
t' "'t nn' l'l 'r
run equilìlÌiüm enÌtnÒytÌcnt {i1h ÌariitÌ

I
It
11 M.,r,J,",",,
,,,,çn,r Ì ''ret' Èti1"r,.Lr'-ú
a ínii'\ )
CentÌaì lianl, (drccs (he ìÌrteÌe\ÌraÌ.,
wlìirh derÌan.l.
ràÌsc\ aSgregate
1..( Ìurl u.ì \ n) nÌdnrnÌ
grâdu. Llt rel
nm cquilibinlD em!lovm erÌ Nith target

Figure 1.5 5.hÊnat. \'ew.l the slìort. àrn mèa t m run m.d.

ìnlÌation larget. Counújcs have âlso s ì1.he.l betwee Êaed and Uc{ible exchangc reLe
regirnesandwenÌallsccirrChapter9tlÌatthislsachanSei!ì onetary pol jcy ÌetiÌne Hcrc
we tâke lhc approa.Ìr to nronetarJ Èrli.v úse.l noi{ bv nÌâIÌ} central banks to ìLÌunratc
the üìterconnectionbcttrccn the aijtreg.tc dcnrand an.ì supply \ides ol lhc econonÌt iìnd
pollc_v.
supposc thatthe.cnlrelbank's folic\ ìs toscL thc inteÌe\tratesoâstostl:cr thceconor'Ììy
to a lor,larget úte ol innalìon. hr re\ponsc to a mÌge 1n nrflatiotÌ, $e wouìd c{pectto see
it plt i1p Lhe interest ralc. Thjs $ouÌ.| producc I faìl in aggiegtte de and as inlestment
spendìng rcsponclcd lo Lhe incÌea\€ 1n thc jnleÌc5t Ìate (ì.e. nÌ th€ coí oI boììorlnÌg)
lhe culìack iD irÌvcÍm..t oulcì l€âd in turn to loirer aggregate derÌìarÌd and a laU iÌì
output. LrncnTloymcfl a'ouìd go up arÌd innalìonary pÌesnue iloukldi ìrÌlsh
fig. I s pr)vid€s a schcmatic overlieÌ{ o lhc shoú ân.Ì mecliunÌ run nÌaffo nrxlel
LÌ tlÌe lclt han.l tidc, thc rolc of aggregat. dcmand' and 'rggÌeiitte srìppÌ-v' arc sum
nÌarized. The conÌponc.ls oI aggÌegate dcnrand dclcrminc the ìeveÌ ol oLrtpul at.Ì
erÌìplo)'nxÌrt ìn the slìorl ru.. The únrctural fcalúrcs ol the economv on the sulPly
sidc dclcÌmine tlÌe mcdiunì'run eLÌuilibdÌm rnlc of uncmPloyment (ÃÃU). ÌÌì th. thid
panrÌ, rhe Lmplicatio.s lor i.flation aÌe slìos'n: lf a.tual uncnrfìo-Íìnent is equil lo lhe
lÀir, lhcn intÌatior r'!ìÌ rcmain constant a.d thc ccnlral hank wilì do notlÌing. WiLh
uncmpìoyìnent belot! lhc i,/ìU, ìnUatiür isrìsingand !.i.crcrsa IoÌ unemPlorrÌert abotc
tlÌe lïU. An incÌe.ìse in ìnIalion above ihe ceÌÌtral bank\ tnrgcl wiìl tìi8geì a rise nr tÌlc
intercsr rare; a ta LÌ ìÌì i. fl atìon lÌill lÌigger aÌÌ er sinS ol iÌÌrncta[' pol !.v wi th a kNer intcr_
est ratc. In the riillÌt hand lancì, the reaction olthe centraÌ bnnk to lnflatnm üsins abovc
.,r fâlling bcl(N tlÌe irìlÌirtìorÌ taÌgct is shoÌln. lhe loopirÌg arroirs dcpjct the teedba.k
 r -::::il b.Ììk\ nronetaÌ! poÌicv rule to aggiegnte denì.n.1. .lhis illuÍrates hoiv
: . i:i uÍ,! ü Ìnonctary policy mle tu hoÌd inflaridr cÌose ro a l.)h, riìÌijeL vahìe.
: :.:.::.ì.thighÌighrs,hos,ever,thativeslÌallnccdtí)inlestigaterítìvepì$d€\ot
: .:: ! and oldeÍìaLion \uch as those cìepi.te(l rÌì.re o..u..

- 5.r mmary
:: -.rilze the kev r€mÌls that wc s1ìaÌìdcri!e i. detajÌtn thc next rhree chapt€A

: : r: rnrploynÌent an.l output ìn Lhe short run ar€ ctelcrÌnjrcd b! thc tÈvÊt ôi
.:!a.d in the econom).
'::::,truIiquenrediurìÌrúÌequiìibrnrmrarcotuncrnpìoymertat$,hi.hnúìaLjoo
,::: ì:. /_Âu). Ar Lhis rarc otuncnplovmcnt, thc e\pected real ÌlaJrc Lhat aÌiscs
r :. a,r.t ,
, " ,...t .\ -- l.r , \. r Ê
' I r'r r 14 I tr'. ,.., tr, ...,, m
i r, .r .r.,i I, li
i .::ifu1. ttcr( is jÌrolúntari rnemtìovnìent it thc equllibrirnn Ìate of unenÌ
:.: :r ilìr 5ersc rlÌât rh.í: aÌe workeÌs pÌcpaÌed to work at tlr1] existirìg reâl l,n!e
:-: : lri jobs. tn the sÌre(iaì cas€ of fcrtectÌy .onÌrditive mârkers. there is nr)
:::. uìempìo_rment tÌr borh.nse\, a fâltiÌì agg.csate dernand líiÌl Ìcad tohtrheÌ
I :r.nr:rhis i5 irvolurtar\.
::.: iì el ol aggreSate denrand pn)dures â iatc ot Lúìcmdoymenr beld! the IrU.
:.:.:ll!erisifg.liun.rrìpk)JÌÌÌentjsnboveth(eqüilibrnLmraie,iniÌationÌ\jlìbc

' :::r:Ìl\e.lhìtilpoli1:) nralierìarc tar8etìngiÌúlation, thl:ÌÌthc cco.oml Ì!ìlllcncl

,1, , It,r,'r,,t ,..r. l.r \.,t,,t,, ,t,r.^r A,
,. i ;,'.r\. rt,... .. \ I,t, ,,. * I rl-,; .,
: :lrlec nnt irstiLutlon! iÌì thc..ônonry ìvoÌk an.t od flre decìsions ot pollc\

: Economic growth

- The world income distribution

.::: : uìr tjro perlods in wortd hìslor!..turing Ì!hi.h thcre was a \uslaine.t gÍowth tÌÌ
.- i::ìJarcì!. he li A L o.curcd iI ChtrÌa be1r,!en rhe elg| riÌ an d ÚÌe ra,ellrh ;cnturj.s
r,,....,t .ot r-r.,4,J,.,t r.t ,t,r,ot- I i.
: : : r:iÈ!r| .cntuÌ).r ' he ahines. (rpeijcnce .lcÌÌÌonstrates tlìüt rlìe iÌìitintìon oi a
- :.:1r!€ídoesDor.rìr.ilìts.onrinu,rtioniÌxiennitet),:irìjÌriteotirs€irt).cìpetcn.e
rr I rúr 9!3).l1jni\i soaÌJjibÌrrtorS*r r rìijrl.th.rrc!ÌrL.ej...côn.rnlc!ÍndrDn af3r5
. rriÈfrg. (11rrÉúrug.rt/_ì,1an.li!.n/
14 ,' .

of gtrNth . China enterc.Ì the poí Second !\ orld War perìod as onc oÍ tìre $'oÌl'l\ poo ren

lhe n'concl phase ol sustai.cd iirowlh is n veÌ) re'ent Phenonìenod and b€gn' üÌ
fuÌope. A Í.lned irìcÌease in ln'Ìril Íendrrdr started in EuÌ'ìpc sonÌe tìmt
after 1500'
brúìiwasinitiallyverysl)i! DLrrjng thc iÌ bt two centrüies i t averagcd onÌt about 0 Ì1]1lper
ânnunÌ, lrhich ten!1a1cs into:r nÌ.rease ilr inclÌne pcÌ capita oler thc cntire pcliod
220lô

L.onomlc progrcss s1o1çlÌ tathcre.ì nìomerÌtuÌn, averagi'g 0 2'l0 pcÌ aÌìnum durifg the
1lUo 1820 period, wlÌjlc frcnì thc early núetcc'th ìt began to 3ro$I by about 10n
'entuÌy iIÌ scleDty vcab Groi{th
pÜ annunr, aìlct'irg lor a doublins úì the stat'Ìard ol Ìlrìnii
ratc, ttut .ut s,st".tty ,"uched abo\e Ì'l] per annunì
('erc only rcco ed aller 1E;0 Yet
thc century aÌìd a qun[er of nftalÌÌcd g(Í!th sìnce thcn has bad speclacular cltects'
growth eÌclator
transtÌ)mring lilc foÌ pcofle iÌÌ thc courrl!ies thal haie ÍcPfed on 1o the
aÌìdcÌeatlngayawninggapbet$'centhc'hare5'ã|{ìthÈ'halerots'Thedranraticlncrease
head ilr
irÌ $1)rÌd ìn;.Ìualìt) ts llìLbtrâtcd by thc fa.t that in 1t00, aleragÊ incomÊ Per
an.l lafan Ìlas aboLrl nre timcs higÌÌer than in IIÌicainow it is
Wcstem lu(;p€, the LJSA,
1ìltcentiÌncs higher'
t,tg.i.6usesthclennWoridlabìes6l':tolookaitlÌedìstributÌonofarffaiiePcrcapita
per h eacì ol ( he pop (
inco me rcro* countrics l n the \!oÌÌcl in 1 9 60 and 2000 GDl 'latioÌr
(l'jfPl adiuÍed exchangc
is nìeanìrü1 at conttanl lììces and at |urclÌasjng los'cr Paüt)'
r.tcs tu enable aÌerâgc lhìng slandards to bc comParcd across coutÌtrlcs Ìn Ìi3'
16'
tlÌc
coüntÌt avtìrges ol Gl)l Per capita arc me,ìv'Hr ÌP 'tlve tr) thc llÌrited States Ì'e
hacì an average pcr caple CDÌj
LJSA : 1. In 1960 ilÌe aoÌkl\ pooreÍ countlv. Tanzaniâ,
lcycl ol $382 PcÌ alnruÌì (i.€ lust above $1 per l\hjìe clÌha'! wa5 1i682 and thc
{''ì 'la!),
,.r'J,.ul l I "rr"tl'\'rl ''r-l
,u|tr'.r\'òll- ilòlri rrr'i ' \'r" \i ia{ur"' rr(ir'l
Olher examples ofcuÍc.t (lDl'!eÌ (apìla levcÌs ate:Unì1cd KingdoÌì S22,190
per capúâ'

Ììomania 5.1,285 Per capìta, Chiia 33,7'17 Per.apìla, aÌÌd Llganda st):11

Average iaÌosth in lhe LÌnitcd Stttes as aboul 1 8% pcr annunr luÌ 1870
to 20o(l
Ìl the a;cìage gn)wt| tete nì the USr\ ha.ì becn one perccntaile poìnt lo(Ier o\er lhat
pcrìod, an.l thus comparabÌe to those achievcd bv Irdiiì or lakiÍan
(r!er nro5t ol lhat

;eüodl, its per capita GDI iu Zrl0o woul.Ì have o'\'reâ'hcd abouÌ $9,000, Ì\'hjch 1\'o!Ìlcì

have ÌÌrcant a current lel ei of cconomlc perforÌìance rcúghll siÍìilar to tlÌal of \li'ìico
oÌ loland. Ìf on the olher hrìnd the USA Ìrad enio,vcd groslh Ìat€s onìv one
peìceÌÌtage
lhu! comÌraÌable to tìre groÌfth rate ol
Ìtoìnt hìgheÌ thau thc acnral one, ard
avcrage
lapan orTaiwan nrrnost oithat peÍiod, ìts CD| pcr capita lL'reÌs
wouÌd hale bcc' almoÍ
I(Drtin]cs ìrigherthan lhey arenow TlÌcse e\aÌÌÌplcsr illunrale how s'nall
(liifcrences i'
gu\thratespr{).luceìatgeelfeclsìnternìsofthcs(an'la olìì\'inia$'lÌcnüre!pcrsistior
ìont pcridì\ of lúne.
Fig. L6 shoss on thc ìett thc tÌequenc] clistribuli()n\ ol tht averagc GDP pcr capita
of countìies ot llÌe s,orld 1n 1960 and 2000, wh€rc averaile GDt per 'aPita is nrcantred
ìelrrilc k) the llSA í= ì ). lt i\ imme.liâtclv obvious Lhat the Yast bulk oi countrÌcs aÌe to
:lherrnrrorldlabÌ.irndiheíLpf.ningdo(nnr?nútior(ìeÍribnl8th(mtth'dorúrÌ!isindniiâ
1rro..$ (r. b. r..r$ed al lìrtprlúnLL
( 'upenf
BaúÌ.Íif!
't r,r r-itr..
r
'r 'dur
t('ner!ìs.rr'ìd ?rd l!\ènnrorÌsn iÈ NoÌld!ri'hÈ{"u riry Ìritìì sll
en9
L -L.r ltr..,
r
lì.ú.. ?lxl srl.r , IÍ.niÌì 12O01l.alhrltÉrl fror d.\rÌnolcdcirÌleddi!'usÍnì
 ÌÌì.,Ìì. Ì)in rihrLiôn I qaí) 225

:00

1t5

ti í) jÍJ íJ /5 Ì.00 1.25

LnL.rnc Dinrìbuti(ÌÌ 2000 I í)0

:r ìj0 075 I i)O 1.25 l.5l) 025 0.00 025 0.50 aJ.;5 ì (J1) 125 Ì 50
- 1ti
::-_:-i : : .ufÊanrbltônr i l96CâiClC00ibt..!rtt) K.rìÊ i.i5rycnmaic5oi
:: :: il)lì :i r,iLt.n nrga!ir.dzaoorinqrÊ:6liPrÊr.âptààrrlrn:ft!i..5ãìd
: : I thc

' .r cl\ .f aveÌag€ üìcome $,av beÌow tìrat of thc LJSÀ. 1he so caLled lerrÌel
It)00.
: :.r ÌjghÌ hrnclpaneliradifferentmethodolusingthcsamenúonndtion
:::::!út{)gìamsorÌtheÌeft.:l-ookingattheÌlghLhandp.nel,Ì!e.dÌÌseethe
: ::fí Lounú) i come dìrtibuti.m ha\ chaDgcd bclween 1960 and 2000.
:: i ÌrÌ nr odaÌ pattenì, meanìng that it no$'ÌooÌs is ii it has t\{o p.Èakr at the
-::'raltonl)lÌadone.\VeaìronoticethatthedìsrributioniÌÌ200Oisíiiihtlt
: :,. Ìn 19tj0. lhese are rigrs that over time as somc countries have beconre
::.::.r(r)reÌ,üie1íorldhasbecomeìncrea5iDglvürorcclLrÍereciìretweenÌìch

::: : ..ition 15 wlÌat har happened lo dre disLÌlbrúion ol üÌcome acrc* the
:.: ::.rrrd. rather tlÌan acÌoss countrjes. ÌÌì thc fast t$eÌÌtÌ \eaA, Í)me oÍ
: Ì'. lorntries n'clì as Chìnâ aD.Ì ÌÌr.Ìia havc gror\ÌÌ laster thar tìre Ì1ch
:: rrr har h!.lthe eltect ofpulìing Ìa€e nunìbcrs oipeople out of pove v.?
:: d f:.1Ìing ih. a ÍleÌenr rrÌL,er ótÉlatne ii..nÌ! i. th. nrrn oI.lìtrr.An.ì À nu!.
.:ìin!irdr.iiiigl.b.Ìhenrtì!ìd.IkeúÌ.Ìrn..ilÌnìgún..ii(l!i!!LigÈs..d..n.ers
r)1'f.rrnrrÌr*imrtrofthedtrlÌibrlrorÌLÌìr.hi\\rrxrhrr(lmrk.!rolerse.I(he
: : :JrJr d.r\rhnn)tsrtr.]
ir ii,l' \J,lJfrinrì or rìiÌleFnLmerÌìods.I.al.!Llnn3 ih. Ìy.rld !Ì.omè dtrribrrnÌr,
 ThishÌnts atpo$erìulchanitestlÌât occ!úed or.rtlÌe past lour.lecacles .ìs the world r!1t
ncsscd both gÌowth nÌiracles atrcl Sro$tlÌ dlsaÍcrs, coupled with a pÍÍìiund úânfdrÌÌa
ljon oI the poÌitìcaÌ landscape and t1Ìe .ollapse of nÌan:" :\trican economies ur eÌ the
buÌdcn ol the AÌDS epidemic. The ertent of ccononÌic inequâllt_v between today s $orÌci
cconomles becoìne! e\€rÌ moÌe niliÌU $,IÌcn wc are r€nÌirÌded thât iI tlìe deleÌopirÌs
wond olcr 790 m1ÌlnÌÌ peopLe clo not lÌa!e €nouglÌ food to eat ancl 1.:l billion people iio
noÌ harc e.cc$ t{) safe driÌìkiÌìi3 wâter. AlmoÍ hiÌI of the Noilci'\ population nìrvi\es on
lcss rhan Íj2 a da).In Asia the münber olpeolìe Ìlling 1Ìì poverq, on Ìe\s tlÌân S1a dâ!,
frll ilom.l2il nìiìÌn)n to aroun.t 28il millloìÌ errn wlÌen tâlii g irrio a ccount the lìna]Ìcial
ÌÌìclldonì ot tÌre ìate 1990s. Ìn Lanen lurop. on the other hanl the number of people
liïÌrÌg .)1ì ìcis rhân S1 r dü) has Ì(reised b-v a fa.tor oì twent).!
'1ìrda,v moí ot the OLCD .ounúies bgether \!ìtlÌ some ol tÌie Â\ian econoÌnies 1ìnd
thcrnschcs ãt the top ol the woÌÌ.I\ irÌconìc diÍrib!tion. ÌÌì 1960 however we Ìlitncss
LatnìtuÌìcrlcan countrje\ lile AÌgentiÌra, Unrgu.y, ind Venez!e1a irÌtlÌetop 25 countrics,
Ì\hereas nonc arc in the t(Ì) 25 iI 2000. SinÌilarl)_, soÌn€ Asia countries lil€ ChiÌì.,
lndia, Ìndoncsia, a n.l lakistân th at were iÌì thc bottoÌn 25 count.iesin 196r-) experil:nccd
suflìcient groÍ1h tr) mo\e weÌl outsnìe thls grÌp. DilÌereÌÌces nÌ econoÌÌri. growth ratrs
hü\e rrngcd lronr ai%) p a. tì)r Taiwrn to 1.8r/o p.r. for Z:ìnÌbia atrcl have di(tated tÌÌe
wiÌÌìers.nd loscÌs oíthe last ieir cÌecade\.
ÌÌìfìg.t.twcpÌottheÌeÌatnepercapitanì.omesotecotÌoÌrìieJjÌr1960ânci200llag.ifft
the.15 drgrcc linc. iÌrìnt\ thrt Ìie reÌativelt .los€ to the diasonrl Ìepresent counúies t]Ìat
hav€ s€en!crylilllechanse inr./.rlik,lirnÌg\t.ndard\ oÌ erthe pa\tfewdecadescorìp.red
to tlÌc USA. lÌrints that lie âbo!e tÌre clirSonal represent countÌies tÌÌat lÌa\e €rperi€nc€d
politlvc rcla tlvc rates ol econoDr 1c gÍDlth. Ì lÌe plot .ìÌso nÌo$s that rlithin the cÌu \tei ol
polnls in lhc loirer Ìetì coÌner, repÌeseDtiÌÌil tlÌe poor countúes ol ure rvoÌld, mrn) hìve
cnpcrlcnccd a deteÌl{)ration iI their reldtìve ÈrsitiorÌ. (ÌiL} \ erv tew countries that ha\ e
hird rclaLlrcÌ_v los'incorÌÌes per capita nÌ 19601Ìâ\e seen a tignihcaDt impn^enìeìrt ìn
ihclr rcìa(ilc liling standar.ts, an.l can thur be ideÌrtihed as gÌ^{th miÌacles. These ft)rm
thc ìoosc clrsr.r olpoiús nr the Ìeit ot the.15 degree lire ancì include ÌnoÍ of the Asian
ccononrjcshut aìí) Botsrdna, \{auritnó, ll)'Fu\, aÌ Romania.count!jesÌtpÌc\entedb)
loìnrsrorheextÌemeÌi$ÌÌtolthelSclei{ÌeeliÌìecorrespon.Ìtoeconomirsthathâvriee.
a deteriorallon oi thet reLatn e positlol over ilÌe Èast tei{ .lecades end are lhus ìabeìÌed
as gro$'th .lisaster s. \otable exaDÌples incÌudÈ ClÌa(ì, Ìraq, ând VcnrTú.ìa.
Gjvcn the vaÌiecì Jkúònnance oi countries as show. ìn ìrig. l.;. rlc nalLUaìÌv iacc lh.
qurstjon of what the Pro\fects are ín the evoLrìti{)n of the i.ct)nrc dislribulion in Ìhc
Íuturc. StecjncaÌÌy, is there an) hope that the woìÌd\ poorcsL cconomlcs \!Ìll.at.h up
i\'ilh rhe n.Ì1.Ì s Ììchest onesl We constmct Fjg. ] 8 hl fldli.g thl: gro\lth rat€ irÌ p.r
cepita GDP o\er the perjocl 1960 to 2000 âtaiút thc ìog valuc oI pcr caplti CDl, in
1960. Thls pìot is a súìple exaDpìe of an attenipt n) exflorc thc .on.cp1 of c.onomi.
corveÌge'rce end corÌesponds tu an oLìeconomjc hlpoLhesis lhat countrìcs $ìÌiclÌ niìÍ
otlpoor oui{ht tu groì! fâster and thus catch uÌ) with tìre ÌichcÌ oncs. lfthc.oLrntries that
are ìnìtlaÌ\ tooì aÍeto catch up, theìe \houklÌ)e a r..!rtna, ft:Ìi ionslÌip iÌì thci]r.ph, lf irh
, I

.f ((.f .nrí i|.qMLiiv\r.ih.Ìtlo rdnrrt\l\JorÌdDê!eÌot.renilúLnr!trt

tr'yrr rrrLdlirf r,rsidriai\\'d,2u,ì/ \trll\. rrr ur..rlrJnil úrnnÌm3o! 5l
 0..] l).5 0 6 1) 7 0.8 0.9
aD|per .apúâÌ€lx e 1o LJSirì 19aO

:çr- 1 7 ::: :. ! ot.1 Íê rt vê i.!rr.s p.r c-F ti rn 21100 õnd l!60

.:.-:'!rilìeleithJndside(pooÌatiheoutset) ha!Ìnglhchiglì gÍnvth rates (k)cated

: : r ind rice versa lor c,runtries that are ìnìtiâllv rich. We hirve aÌÍ) tìotted thr
- .:::::.orresporÌdingtothesampÌeÌegresi(Dandw.obscrveannalì1rrÍir.nopc.
::: i1i \lìould notc tlÌit the pointi are wi.leÌl.ljspclsed,.ÌÌd itulee.l ifae pcrlorm
::::::-iÌtentreobtâintlÌ€re\uÌtthattherlopepararìeterisÌìotsìijnilìcantlldtÍlcreÌìt
:::.lh!i,rrecarÌnotconhdentllconcìudethâLthcrclsdivergenceorthcbasisof
.:..:: L,! i thcre is clcêrly Ììo !i ol conveÌgeDce affos\ ccÌtrÌtÌie\.
I :LÈr iirLcr'.rcto pcrlorrÌÌ the same ana\ais o. subsiìmples olrhe daLa scl, sLrch
.::i.ountricstlÌatrrcinclud€arereìativeÌvsimìÌarìntcrmsoltheìÌeconomic,social,
:::::l.DÍhistori.aÌcapcricnceivei!ìÌÌobtainasúongnegative.eÌationshipbctwccn
:-:,ÌthrntcolìncorrcandtlÌeiritìalstaÌtirgposillonìthu!conn Ìing lhc conv€r
: :: :rr oolhcsi5. ln ahaplcr 13 ile \halÌ eIpìore thcsc Ìde:s lìútheÌ bv diílnguÌshiÌrg
: :.iin the1:onc€pts oiunconditidraÌ an.lcondìtionnl convergenc..

: ì The stylized facts of economic growth

r:: : in4ìirìc.l work o economic grorrtÌì bt a ÌìL Dber of econonÌlst\ such as NìchoÌar
: : .:.r sinÌon Krznets. and \{iìham Barrüol oncc)veÌecì a numhcr of ÍÒbr\i tâ.rvh.L,r
: : Lìro.r\s .il ec.,n.Ìnlc grollthj Íacts that \{crc deenre.l srabì. cnoush rcÍx\ coünlÌìcs
. ì.: iime tcì be used as the coÌnenronc of moderrÌ econoÌnjc gro!\rh theoÌy. Thcv havc
:,:rì used as a iluide to irÍìÌm modcl buildxìg but also as a Ìcst of con!íte.cv Íd an_Í
:::1Ì nìod.Èl t1ìat ha.lto jultiÍy 1ts cxiÍcnce bv how it\ theorctjcnl re\uLts wouÌd tr Lhcsc
18.

2.|

€ rs XX

! l i:)
X
X
^"* 4
x xX
XX x X
XX y xX
* Xxt
X xx
0.5
*tr
ó.00 ô25 6,50 6.75 7Oal 7.25 /.50 t.75 rJ.00 825 8.50 8.75 9.00 92s 950
GDIfercapìta:Ì960

Figure 1.8 5 therc.ro5i.o! ìÌt.orve qercel S.aitÊr F ot oï qrollh raLÈs ot GDP pcr.ap tà belween
1960.nd2000.qã.íÌr. n ià Ê!. oiGDPneÍ.aplt. n i.!t5

slyÌizcd fa.ts. Ove. tÌìc ycnrs, gro$th theoÌy has athacted a large number of taÌenred
cconomists and both our theoretical uncìeútan.ling oí thc .ngine of economic gr)wrh
and our collection of empiricâl tìcts has gìown sìgnificantÌy. Here we shaìì note the
.lassìc Íllized 1ìct\ ofecononÌic grcwtlÌ that have guidcd ccononÌists orer rhe pasr helt
ccntury, l\,hile .uilmenung the 11Í $ith íDe of the ncircr enÌpÌicrl 1ìn.Ìings. As we
lcarn the nÌ€chinics ofboth e\ogeÌìou\ and endoiienous grorlh t1Ìeory andthen explorc
thc rÌÌlcrofoundatìons ol grorvth by l(n)kìng âtmodels olinnovâtion in Chapre6 l3 a.d
ì.1, ic slÌill rcturn to this scction to \eiii ouì undenLandÌiÌg ol econorÌ1c gÌorlrh Ìrv
cÌplaj,ìirÌgÌo !ïh.t extent our nÌod els 1ìt these rtyÌized lacts:

(1) LaÌge discÌcpancics bcfirccD both lev..ls ânci gÌo$,th Ìatcs oi per capita income
persisr â.Ì(xs coun(rjcs and across time
(2) ln tlÌe 1oÌÌg Ì!n econ.,nÌies e-\hlbit a ldldn.€,l.9r"wtrpdrr, tìrat is oulput per capitâ
nnd capital p€rc:pitir ilro$ atr)ughlvcorìsLanÌ positive gu{rh Ìatcsoverti e.
(3) The reaÌÌate ot rcLunr to capltal is âppÌorimrtely conslart over the Ìong ru., rlhtlc
real wages g(r! Ìate cÌosc to that ofoutput peÌ ìread.l ronÌ (2) arcÌ (3) ii folìo s
al a
tlÌat the ratjo oícatital t.r oulput ÍÌo$s no trend o'cr 1im€ and the shaÌes oI capÌ1il
ancl Ìâbour in totâl jncomc stavroughly constart.
(4) H lgh ìrÌ\'estment rates ìrÌ both phvsicaì.apÌlaÌirnd ldmaìedtrcntion are cÌoset)
rclatcd ttr high li!injl ÍarÌdal.ls.
 .;rnpulation grcwth it asÍrcìated nith high livi.gsta.dards.
::r'rrrlogì.aÌ pÍogress . sír.ìa ted Í'illì product nìaÌket inÌovatìon is (hc ÌÌÌain
-::::ìg ior.c bchiod thc Ìong rLrn 8rowlh ol lvnìg lt:ìnda sintheÌcadcr.ountry

::!LaL. ÍcirÌ, ]nsiìtrúìonal and histoúcaÌfâcrors âItcc! lhc Ìong runeconoDrlc

-:: !m. nce ol an econom) and are alsociated isi rh di ltc rcnccs ln 8ro lvth rareJ
,

:::..úruntries.Suchfact(trshelptuPÌedìc lhl.hcou.lÌicshavo.onveÌijedt{)
: :. i eÌs.lGDP peÌ capltaa..Ìwhich countricshavc nol.

: Growth and diminishing returns to factor accumulation

' : :it oí tìre s\,ìized empirical tictr of econonrjc gÌorllh rlc cnn turn to the the
:: .r.d.Ìs. ()nc placc ro begln is to tbcus on rlhnl dclcínincs the ldd of outtut
:- _i.: InouÌdjscussioDotlhesìrortaDdmeditrmr!'n,irelocusedoÌÌil\inglefac
_ iJ.tnrn, ÌabouÌ. \'Ve essume.l tìrat dre anrounl oi capjLal cquip ent availabìe
:: .\.Ì r.es lÌxcd. Whcn rlc nn)\e to thc ÌoÌìg run, src would eÌpect dìlferences
. i ìi outÌrrú pcr iroÌt$ a.Ìo* counoics ltr dcpcnd on thc.nìoutrt of.apitaì
: _ ::r: r\ iiÌable. As c sìrelì see, human capilaì sìrouìd aìso be inclucled IÌLrmân
: .:.:i ro abiÌltics ard skills that peotìc can acq(irc. _lhc lcrrÌì hlnÌân 'capitaì'
:: : rilhìÌght thc anal()gy Nith physlcal caltilaì: invcslnìcnt onl! take\ pÌace if
:.: :ìlmnption is sacúhced an.l reÍiurces aÌe deÍotcd Lo acqúüìn8 (rpltaÌ goods
',:: ì:.rihrÌ\, ÌeÍtrtrces aìr.L tìÌne must be dcvolcd 1lr thc ac.umulâtion ol human
:: :r:r ,r8h educatìon, traìnìng, o. Ìeaming on lhc iob. ln addition to the quantiL)
.: :. :tÍ uction alailabÌe peÌ woÌker, both lcchnoìogl'and cfÊciencv líiìÌmatrcr
: .:..h$icdl theoÌÌ ol econonÌìc grcwth was dcv.ìop.d simultaneounv in l95a)
.-- júÌd\ íìn the USA at MIT) and TrevoÌ Sa'an (in and ìt n)cus.d of
: -::::r!B üre Íte ol factor accumulatj{D i n g rowtlì. l ^uírnlÌa)
h c cnp ital \tocl had grosll
: :::-i iÌ d!ÍDg the lìrst hall ol the twentlerh cc.tuff and provided the empiri.al
. . r: :.ì thi\ !ÌodelÌirÌ8. The eslence ol ihe Solon-Swan ÌìodcÌ is thàt a counLN's
:: ::i:!utperlÌea.l!!ouì.IbehigheriltheÌewasahighcrÌcvclofcapitaìequipmcnt
. :..:: lÌì iÌÌovnÌii lrorD a ld! le\eÌolcapitâl fftwo.kcr lon higherle\eìol.apital
': ::.:i output per ÌloÌkei ÌrouÌ.I be Ercwlng. Ho cvcr, aÌlhouilh ÌnoÌe ìnvcslm€nt
, :,::: ihe lr'.1 of outI{ú per irorkeÌ (and h encc ÌÌ!ÌrÌg starÌdardt, th e modcl predicts
: -::iÌÌ€\tnrentworìldon\Ìrireihe.iÍnrtftarteoflilingnandadstenìporarilv.
r:. ('er Ìies ivith tlÌe asnunption that tÌr erc arc diÌnin jshinil retu rn s to ph)'sical
:, n \

::::i: Hòi 8 one conrputeÌ iliÌl ir4noreÍour oulputj hiviÌìil two maÍ raisc)'our
.-:.,rputb!lacilitatnìgLJackupsandaÌl{nÌing_vouloconu re iïoÌkinsrìÌcÌì the
: ::riìÌ.t but it is unlik€ly tu clouLJLe your oulÌ1r11.
::::Ìrc.conorÌÌ) h,r\ hâd r paÌticuLar ìeveì olo((pr1t pcr hcid 1ìr ÍÌne !ìme.5ud
: r_:.{cr 5Ììar€ ol ircome is de\.úed to ìnlesLnìcrìt and thìs is ÍÌaìntaircd foreler.
:1: lrLan model predlcts that rnore capitaÌ,iÌìtcnsiv€ te.hnicÌLres oI produ.ti.Jn
::rptpd ()Lrtput per workeÌ wìlÌgo ut. Bur with caclì iÌìcrease iÌr capilalint€nsit!,
thc bonus jn lcrms ol higheÌ outÌ\ú per workeÌ dìÌnjDishcs. l3ul s'lÌ_v can thc hlÂhcr
inrcst cnl slìarc not pa) tar a conri.uouslv Ì]\ing cepìLâÌ Lntc.slll? lhcrcnsonisthat
part oi thc capitaÌíocl cìitappeab eveÌ,\'_vearthÍn'gh depÌcciation Ír lhal crcnlualìÍ (hc
Iccblc lmprovcÌìcnt nr output Ì!11ì Ìrot gereüte srúì.ìeDt extÌasarlngs lo kccp raislrg (hc
capÌlaÌ iÌìlcrìsi1y. AfteÌ Írne tìme, the economv wìÌÌtheÌenÌr t!mc to a lì$! cqullibriunl
and thc lcvcl oI oLúput per $orkeÌ wilì once nture remain consLa.l.
thisÌesuìtl
^nunìb.roIissucsaÌeraise.lb!
. Thc modeÌ irsell cannot accou nt iorüÌe persistent gÍrlth olln ìngstaD.ÌaÌds thathas
bccn c\pcÌic.ce.Ì úr tlÌe 1â!t two centuúe\. l he So1oìv Silan modeÌ can be amen ded bv
incÌudi.g â paìticuÌar küìd ol technlcâi prci]ress: il te(hrrolot:" is iÌnpr^nrg vear on ) ear
wllhoút usi.g up anv re\ource\, Ì!e can \av ihat there ir exoiieDou5 technìcai prctÌes.
lrÌ lhal .ase, the lnitìaÌ \itlìation.lescibed abole \louLd Lre oÌ]e in which outpxt per
hcnd ri5cs at this corsta t, erosenous rdte. Whcn in\eÍrÌÌent Soes up, there is a peúo.l
durìng nhlch orrLput ter hedcL ríet laÍer thrn tlÌe rate of erogenous technìcaì pr)gress
bc.ausc ol thc i.oease ÌÌ capital intensit) thrt i\ t.ìküÌit place. Eventrìau, the economv
iÌl rcturn 1o thc origìnal rate of iituwth, but wiih li\iìÌg Íandad\ at a hìiiher Ìevel tharÌ
would have bcc. lhc case ir the absence ol the íÌilÌ to higher invettnrent. ÌkNeveÌ, tlÌe
Íeâdl gÍNth ol ìh'i.g \tandad\ i\ not explain€.| bv any economìc nrechanìiÌ n^t/.
thc nrodrl add Lhis seems unsatì\lactoN.
. The nÌodeltÌi.lps lo cxplain rnìt lhcÌ. sh(Dìd b. a Ìrosiljlc rcÌalionshlp bctirtcn
output per head and.eltitaì tcr hcad. But doe5 it pre.lict corÌect\'bt how much a rise in
cipital per head ('ìlì riise ouq lpcÌhead?AsNejhaìÌseejnmorcdctaili.ahapleÌI3,

Thi\ questlon, nÌ t!nì, focusrs ltterÌtÌc!Ìon

(1) the need tu iÌ(hde hÌunarÌ as Ì\rell is p1Ì_v5lcal .a plt.l . \ iì lâctor olpr\hrtioÌì iÌÌ the

(2) whclhcr aìÌ.oo.ties have access n) the nmetechnoÌogl and

(:J ) whether everÌ il th.,v do, the ti'clÌnolog_Í can bc used eltìcientlv.

Ìi hunìan cnpitaì ls included alongsidc fhvsicaÌ capilal ln thc 5o1ow S$an nÌodel, tlÌc
predictions of lhc ,nodel bettft nìnl.h lhc stllized Iacts. üxloed the Solow Srv!D nÌoclel
.ugmeÌÌted b,! lhc i.cÌusion oi human cipital proridcs. poweúìl ÍaújrÌg poÌrt lor
lhinking about tlÌc dctcÌminanLs ot thc jtrosrlh o .ourÌtries that haie crusht uÌ) with
thc productivlt! lcadcr. Thc lrsÀ canÌc oul ol thc sccond Worlcì \'ïar as the undì\
puled worÌd Ìcadcr ìn ouQlrL p$ capita. Ìlut bv th€ mid 1980s, more tìÌan a .ì{)zen
co!nlrles nÌ luírÌrc plus AusÌralia, \cÌ\' l.Jland. Canada, .ìnd Japa. had lntântjaÌl\
narro$rcd tÌìc gap. l.cvcìs oÍ hunÌin arÌd phvsi.al .apital per hea.l had become sìm
ilar lo tlìosc in lhc IISA. But lhc Soìo\! Swan model is le$ mccesrfuÌ in prcvl.ljng
an cÌpìanalion ior lhe fâiìurc ol Ìols oi othcr countries to corveÌge n)war.l the li\
ìng slandards oi thc rich oncs. r\nd Ìl cinnol contribute í) the explânatior ot prÌ
sislcnt groNth oÍ ouLftrt pcÌ hcad in thc productivit\' Leacler siDce the onlv source in
Lhc Soloí'-S$rn. Ìrodel it ie{ogcnoús tc.hniral prc8ress, which bv delrDitbn is not
 21

I IGrowth and constant returns to factoÍ accumulation

i.:::::.r(tion nllh tÌre (te oI eriogenous tc.hnical progress Lh€ Solow S$an nÌodeÌ
_ _ : .: i Éd d neir ip proach to g.owth theoÌ y callecì endogenous ìngÌ oÌÌth. As Ì!€ |a\ e sccn jt
: : r i ii iÌ4rtn) n ol dinlnish in g retuÌns to rlì € acclrm rÌir tiorÌ ot câpitâl phrsicaìand/oÌ
I
_:::: that prclcnts pe^istcnt growth otÌirÌìg nanda(h ìn thc Sotow-srlan
Ììodel.
::::Jrnicso.ÍeatjÌrgendogenousgu{rhüÌesrÌâtghttonvard:dropthcasumprÌon
: ::: lriyrnrg Ìc lurff to rh c accuÌrìulati{) n ot capi taì and replacc t Ìljrh an as\umplion
. :::Ìrnt ìeturns. ll the bcncfrts tu grorlh üom htgh€r jnveíÌleÌÌt.Ìo not dìnrtlÌjsh
::::i4msjnlulti!€lypÌausibleihatìtrhcecononryde!otesâhighershnreotincome
:: -iment. rÌì]s râises thc gro$rh rate oi outÌÌrL pcr .rpita tcÌÌìane.rlr. Ihis trans
-::ì j.nr.ess ofe-\ogeno1l5 gro$th nr rhc Solow Sa,ann(xieìintooneotcnclogenors

:: r: r\rnrplc of rhe tifo.ompute6, thc ì.ler ot dimìÌÌjshìng Ìftuins to the accumu

::: ìi.apjrâl is attÌacti!c so one ctraÌlenijc torpÌoponerÌts otendoilenous groÌ!th is to
-: ::f ltirh cxphnations for Ìlhy Ìerurns ro factoÌ a.cu ruÌarnn nìight not.tjminislÌ.
-: :::
urnLjâl jdei locuÍ\ orÌ h!ÌÌran capil.t and aÌgues that acquiring Ììorc e.tucaIon
- :::t:rj.g allows ut n) ìcarÌì nx)re. Ìtthc llnt betÌccn ouÌ eÌiÍjnB human c:pital and
::.: !t\ to carn m oÌe is su flìcientÌy íro n 8, rhen c n do8eÌ()iìj gÌoúh ì\ possÌble: spc nd
-iì:.timcjneducationcaÌÌraÍethegroÌrthraLcpcrrDanentlr.Hoiïevcr,o enright
:,:riitinvcstiÌÌgincdu..tionwouìdclcntiìalì},corneupÂgainsr reliÌritsothuman
r:-:i l,cÌhaps rrÌe pomjsnrg ì\ th. notidr thal hisher inrcstnìenr jn iÌr)vative
::::{!le.g.rcseârchanddrlelq)ment).ouldaÌìoirtortlÌecont Drous tmpro\emcnt
r: Jlch\ itl.
. r r \hxÌl scc lrÌ Chaptc6 lJ and 1.+ aìlhough Lhcr€ is a sharÌr lr.?r.rid djfteÌcoce
. -:! the Soloir Swan nìodel ol exogenoirs groirlh .nd the úrore reccot tlÌe(r.ics ot
: ::nou\ grorlth, once 0ìc 5o1or Saar mocleÌ is c\te cted t() inclüle a broa.LcÌ con
r:-rpitaÌrhansimpÌÍb(lìldirrgsandnrachileÌÍ,l]ì.nyoírhcfrlpìri.dlpreciictioosot
' I ilrts oÍ nìodel are tjmiÌiìr. The so caÌted augrÌrrÌte.l Sotow S$an nrodeltÌcdicts
. : iurtries I'ith loiler lcrcls ol cDt pcr câpìla srjll grcr,fasler than rÌìe countrie,
- iirhnoìogi.iI1Ìontier and wilÌrherclore erenl(].11r co.vcrge tr) rhc richer ones
: :i. rergen.cislerv sìoÌ! becalìte rhe Ìetums to the a ccum uÌiì tnnr oÍplÌyslcaÌplus
_::r.apitaÌ.]iÌìirÌishmu.lrrnore!Ìd!ÌvLhândorhcr€turnrrophysìcaì.ipitalatone,
. r: r.er\ Ì!ìÌl ìook quite sinìtìar to encìogcnou\ gÌorrh.
: ìúelling hoí'techn(togv js traníèÌÌcd lÌom rc.hnoÌ{)$, ìcadeb to tag!aüÌs, both
:i -ìi qro$Ìh nìodel can bc brought cÌoscr ír explairÌing reaÌjloÌtd problems. LÌÌe
:ini ilea is that poor coLlntries can onh take adlaxtage oI the technologv used nr
r:rd\ancedcounúi€silthcyhâvesutÍcicnthumânc.pìtaÌ.Thshe\nloe\plainwhy
.'ri\r..,.r.., . Lt'rf.,roo.rr hr..r.

- r lnnovation and incentives: SchumpeteÍian growth

::urLhcrirÌundftsrdndiDggrol!11Ìjtlsncces\aÌ_ÍÌotoolimoÌcctoseìÍarttÌein.cntne,
:.Ìro\aLion.TheAustüane.orÌomiltJosedrSchLrnìpeteÌjirrjlingeadrjnthclÌlenti
::. :.r tuÌ\ , irrgued thatjrìnoraLlctrÌs coukl suÍ.ìjI Ìong run groiflh ând LlÌât ì.sLtrLrri|n\
22:
aÌe iÌnportant f,rr crcâtiÌìg lhe approprìite iÌicenLiles lor irms lo entagc iÌr innovauvc
actn iür!. I\ih), is invenÌÌÌcnt Ìr nÌìovati(Ìn diltcrert fìonÌ inlestment ln phy\i('ì1'ap
itaÌ? Ihc an$ler is that ideas are diffcÌent Èorn nxed crpitnìr once an idca has bccn
.Ìeveìopc(Ì, my usc ofit tlocs not prevcnl you 1Ìonì usirÌil ìt too Bv contr'n, !íÌ anÌirsing
nÌy computer, r-'ou canno! u5e ii simuìlaneousl,v Becâusc iders aÌe \Ìon-rilaÌ'in thjs
s,a), therc has to bc ÍnÌÌc method of cÌcatirÌg alì incentile Ior fiÌms to irrvest tine and
ÌeÍ^rrccs in froducinS thc inno!.iio.: il Dot theìr they wilÌ not be abÌc lo Ìecover the
cost\ ircurecÌ. latcnts are a f(rmâÌ n]cthod of cnnÚing â pcrio'ì of Íìonoto\ lor the
innovrti.g Iìüì bül other more iÌúormâl metlÌodt ol retilfing \ecrec]' about iÌÌìova
tìon5 are nlso coÌÌxnon. lIÌthe SchumpclcÌiarÌ nÌodeÌ, countrlcs can be trapped with loir
ÌeleÌs ol GI)P per .aÌrita be.aure tlÌe instituti.tral stÌLìctrrrcs nÌc ìrot conducjve to iaking
a.h antagc of 5t)illovcN ill I n n ovation fro n ú.h .oartries. I h s 1s ìrv€stigate'i fìrthc I in
ì

lhapter 1,1.Ixtensjons olthc SchurÌ4rclcÌian modeÌa1loÍ us lo e\plore the implicalions

kr iÌtriovalion and gfttlt| of pÍÍhrct marhet comÌretition' olhow Ènanciaì marNcls are
oÌganized, and of olheÌ structuúÌ âlld instltLìtictìaì charactffistics ol thc cconom-v'
jnts at thc içal tractâblc modelscan he\r
Thìs.hnpter is a taster lortthat is to.ome Ìt h
o rl_lril'l' \' ' I I "Ôr 'rr"

QUEsÌrON5

(1) E\plajn kr a in ecorìoÌnìsl the dillcrÊnce bctlleen'cüìsúúltnÌÌ'arìd'investnìrdt'

(2) Lxplaúì toanot cconoÍìiÍ t h c .ìifíer€ n cc betwccn 'aggreEate a'pplt'and aggreiiate

(3) (lonment Òn LhÌee asÌrtcts ot !jg. I Ì

(4) f(^,j.lc a concjscsuÌnÌnartotlhe €voLthon ollhe trnernfloy'ncnt Ìate irì thc United
Stat.sas conìlarcd wjlh thatiD oÌr( fìuopean cconomy trotr l9'r0to 20il{)'
(s) wih.t js mcrntbv the stntcúrcnl that ìn a competitit. ÊcononÌy' u'cÌnplo)Ìncnl is
vohnteN? lrplain hoü' thc labour !rark.t car bc in cquiÌibünì iLlhoush tlr'rc ú
nrvolu.ta{ lrìc Ìtoymcnl
(6) (:oÌnment on tÌÌÌee âspecrs olTabl.l t.
(7) C.mmeDt!ìn thke as fccls oi the loNc I pinels ol l:ig lI
(s) I Io$ s'ôrÌ.] lhe rate oj
l ou c{plaiÌÌ to a non eccÌÌr'n is t tlÌe re ntiÒ n shiP bet]vesì
u neÌÌto-vnÌeÌì t, lhe Lúc.1i.flation, and the tntral bank's rÌontlrlt
dccision aÌr'úl
wlì€thcr to (hangc the i.tocst ratel
{9) $ihai lhc coDncÍi.D beiNlcn lht concepl of dnniÌÌílling rcluDs to (alitel aÌÌd
is
the h)pôlhesis tlrat poctr (o!.úics.sÌoÌr lüstÚ than ljch oncs?
(10)'ArisehrsnljngsÌeduccs('DI'."]\ri5cìnsari.gsraìscslL\úr8\tandarLlsbutrotlhc
longÌ!nSroi{thrate.'AÌi5ejnirvingsranesthcgnr$'lhratepennâncntl! l\fÌaiÌr
i. sud5 tlll Logic ol ca.h ofthese natcÌÌeft\
 r: - .',h\ iÌÌightiheilord!olmac()econonricpoìi.t mâker\bearlmfoÌranl

'.i Iì rhe ear\' 1990s, c(nìmu.lst govenÌìeÌÌts feLÌacbs Ccn{raÌ alrd

i ._. rnd thr Sorict llìrioD.l'hc Íat€ control over the econonìv cnded and
' :':ì:rrìs rlcÌc intÌo.]uced. A \!ldch'held viesr it the tìÌne ias that the
: :..rÌr.icfct and Ìack oI dvnamìsm irÌ th€ pl.rÌnecì eco no Dr ics would be
: :rid.ilch-Lrp'growlh.ÌnslciìdaÌÌtlÌecountriesexperienccdacollap\eirÌ
' .':i ìnr grojçth ralcsorìvappcariÌìgnìth€mid l990sinCcntralandLrÍenÌ
r::.!.ii1.Ì990sinrhefrrÌìcrSovictUnion.LJsingthenÌeasjntrodu..diÌrthis
: i::,j! lhc poss blc role ol ioìpcrfectn!Ì\, irÌstitÌrtlorÁ, a.dfolici.s iÌì
- r;rr ihc rcaiiLv ol rÌa.sìLion dld Ììot match tÌìe.Èârly oÌrriÌnism.
 ::: PART ONE

The Macroeconomic Model

 Aggregate Demand,
Aggregate Supply, and
Business Cycles

:.: :.-lir\ the pr)crss ol sctling otrl the íÌoÌt to inedirnÌ 11rn nÌ.cro n]odcì,
. - ': tìre .haÌrtcÌ is to cìplaln how the leveÌ ol output ând cmployment is
-:. rhe Ìe\ eì ol aggrcgalc dcmind inthe thoÌt run i.e. i,hen Ìlages and
. .: :i. Th js pu id6 a Ìnodcl ol lhc bLrsine$ cvcÌe, ì.e. hoir thc level ol outpur
. -:rt flucrualr5 if rc5toÌìsc lo chanites in ailg.egate .lenr an d. We Lregì. ivith
:: : :--nrich ôIinlroduringlhc goodsnìailetequìÌlbrium a.d thenthemoret

.. .:iÌkÈr. Thcrc irc Lr!'o brondr,als oftlÌiÌÌlìng aÌur hoF monetürv policv
, ..:-i h\ govcÌnmcnls oÍ ccnLraÌ banks and heÌrce abou( Lhc useirlnesr ol
: : . .. r)Ìr the onc hand, lhc govcnÌnÌerÌt or .eÌr[al bank can b. nÌodeìÌed es
: : -: !_o.etnÌ) policv throLrgh its corÌtrol oler the leveÌ or rhc Brorvth Ìate o
.,:rrÌ\.1\:esìralìsrcrhartlìisatproachlsbesthardle.lusingthel]\1.Onthc
- :r:- !o\ ernment oÌ ccnrral bânkcanbeseen ai sertìng thc idterest Ìare so
i: :rr rcon(rÌv and íc$ l1 LoNard an iúÌati(D taÌget. This i\ the Í) caÌlcd
. l,Â)eptr)a.h devcÌofcdin (llìipter3.
. ::r.rldjjÌrs trevalen.c ot monctnq'rules jn nonerâÌÍ polic] makirg, lhc
::,.: r\ ú ÌrÌr\ thouìd wcbolhcr$'ilh pre\entiìrgthc tì.Í anilvsis ataÌl?
. : -.-!.torur.ìeÌrtândwhrgovcInmlntsandcentìalbenkshaveÌnoredtoNird
::<iirr Ìules, ìt 1s usrfuÌ1o havc i ÍÌnxì undeÌsLanding ol the lM âptroi.h
:-:.:. \1oreo\ eÌ, even it Lhc.c.tral ba l i\ usìng thc ìíl approrch, rhr M nill 1

- : ::fre\enti equjììbrìunr i. (hc drcrÌei maÌket.

. : : r. tì/ atproach is h€lp1ìl nì ânaÌvsing problenÌ\ of delìâLion i.e. ivhen
.:: rr: Ìn lhc c.onoml.lj etr il tlÌe cenkalbaok use\ a nÌonetârt rule to adÌLì11
- : :,:. n) rchicvc an inflatilrn taritet, we nccd ro understanct rhc .lrcumstances
: :.i\ ne) bc i.cllcctive. .\n i poÌtaDr cxnmplc is rlÌe situatiod NtÌere th.
:-:::.iiratejscloscLoz(roandtlÌeeconolrJjschafucterize.lbtalallnÌiipÌicc
., -:iiirterized thc.lapanes€ e.ononÌv lor ncarl,! a decide.
, : :. :\. nrall sccln Châpier9, much ofcn c.onolni anaÌyrjs is.onducted usÌnA

i: -::i.n5 Íritgcn th.ìt e\ e. if the lLr is lrss relevant ftÌ p recü..ìl po ììq, anah si\
::: LÌrousht. it renÌairs a useÍLrì ÌìodcÌliÌìil t(rt. Thc Il/LÀ,/ rìodeì can bc used
l8

ï:ïïi,'"'irnr, ï*ïïlïJfiiïÏiïiïï::v:ifi iïilï#ì";;

l: ì, ',i 'r;rit,,,1,,,,,r,i,",;";'.,i;r,,,;ì,
,t l'-''::";l
t,t,''.t.''' ,:',:".'''' ',."t t' t t'";'-

l{**+*s+r**t***r"rrtl'l:: ***

1 Aggregâte demand

. i ;r,:r-;;,,.i lii r, f
il1

ii i.'l:,':;";'
i|;i; "lit+

',
lu,ï''tt',' t;*';N,=t",*
r.rÊr\ rlìlr! ÀLlrr rhutrLd Ìr! I
 , ,!.Ìled lì,Í aÍrr t1ìr equalit! búweex Dn)nev dcnì.ü.I lljquidir\) rrd
:.!rÈnthem.nc_rm.rketisineqLLjlibriüÍr.ÌÌ1itlr!,/€qujÌÌÌrrjunÌ, relcvcl
.: :rÌ!Ìr)\.menLl ard the i!Íeresr Ìalc are con5tant.
: . traÌÌ btcrusc lt allo(\ !s ro arork olt \fhat hafpcÌÌs ro otrtput an.Ì ro
:: ì, hÈ! drcl! ls a chrnge jÌr agg..gite demand oÌ rlheD thc go!eÍnÌent
On thc A_ side, Ì!e crn anaÌ\,sc:

: ::riDtit)f or fvestntent
' i.,rÌ p!lir). i.e. ìn govcÌÌrnìcnt exÌreDdirLLrc or t,[atio..
:: \..,!Ì.lnalv\e.
_i! din Íì
- ::.: nctaÌ! pollctj e.il. iÌÌ the nroncv supplv

I -re goods market:the /5 curve

. .: ìr i lhc.onÌbirÌati{)n\ of the t'Ìrr,rest rate an.Ì oúlpur leveÌ ar l,tÌi.h theÌe
: -: Ì: tlr c gond \ InâÌliet. tortoods marletequiÌibriúnr, the rggrcgatr .tenìand
: :.:n .rsr nnrstequalthe 5uppÌ\.. \irì.È wea$urÌ. llrirt $ages and price\ are
: .: : Ì .i.!Lpl]fi\'illüclÌLìsttoan!clÌiìnge jÌr aggÌegarcdlnÌan.l.
: - i:: ::rrf d rcIc.s to the plarÌned Ìeaì cxpendinìÌe on good\ rnd scffic€s iÌÌ rhr
, . 1ÌroÌÈ. Ëqú librnìnÌ Ìe!üire\ tlrar plannecl Ìeal cxpcnditrne on Aoo.ts and
- .., t)rcrlorLLpirt:
rgoo.ls Ìnarkrt rquìlibriurì)
. _ ìriLdÍe.le\pendituÌcâ.d, i\reaÌoutp(it.
. -:.:.:.mrnd lsnìiìcleuÌr ofpìanncd crpe..ÌjruÌcorÌ.on\urìrttion arìctiÌrvcsiment
: :r,,.lor and planne.t gorcÌnÌìerÌt ïrendi.g. tt.rx be r!ÌttterÌ !t
Ìi) rir.i rrealrÌrr+ltr,1t ,{
r 'i.,m ìdì,l js lfrcnnìerÌ1. âÌìd,{ is go\ernment sl)cndiÌrg, rll io.erlreÌÌns.
:. ii .,n. is the Ìeal ralc !l nìteÌetr. and I reieÌs n) ôLller ln.n-iÌìtere\r Ìalcl
'
:: :i L:riiÌÌrestment. In gcrxÌ.rl, $euÍ: Ìnwer (ase ÌettcÌi Lo rerèÌ 1o rcai \aÌiabÌcs
:::,i!,rÌÌt\t.ÌefeÌ Lo nominrìt raÌÌabÌcs so t ì5Ìeal otrtÈú arrl I is outÌrut irl
::i::i i g. irÌ euros oÌ dol irsl. Ho$e!.r, rhis i\ n{)r âh1,ers posLÌtr: re ulc i or
: : .Lcrcnratean.l I torrc.lirÌveitmc.t.
. ::i ìrt.ì.t irrtrìÌes oi tlìc slìort Nn nracroe.onoÌnic modei can bc slÌo$.n nìon
. .i.un!. ÌinÈar nur.1io.s. \\e 51üll usc. 5iÌxfÌe ÌÌÌrcaÌ c.Dúunrttio! tun.IorÌ
!:ìtrnrflron j5 r tlÌnctt.n or .rrrentfoÍ t,ìr {j e..ÌjsÌlnrbtet in.ome an.Ì oÌher
-:.. \ Liltlì tlÌat aie {.rJÌarized iÌr a rcrln l.1beÌLd au orì.Ìno rs .onsrnìf I orÌ,
I (

,:'-trtd 1. hr {1ÌÌ\rrr :

(consLLÌÌ4ìtion l"..tion)
7-
30

rlheÌe r0 ìs üütononÌous c(tr$unÌptloÌÌ and .r js the coDstâ.t ÌrnrfortidÌ of cuÌre t

dìÌÌ)sable in.omc tha! is cotNuned: 0 < .r i I. The teÌìn., í calìed the ìÌarsinal
fr,t,Lri.or ., ir' iL,vdL ir ,rn 1 '
taxation lÌ, l l . I is lhc krtal taa reveÌìue, .Ììd ii c teke a lnreâr ta\ hruction, theÌÌ

ilhere0 r r) .- l. Thusif we sübslllutc the ta\írtrctioniÌìtotlìe.onsumption tunction

:ìnd rearrangc thcteÌms, the.onsuÌrPljon functìo is:

:
'! +.,(1
I 11,)1.

A notable tèatuie oithÌs consumptidr lunction ìs that consumttìon is atiècted by th€

.urcnt Ìevel olacti\ityjn lhe econonÌy. LÌ Chaptcr T, we ìookat the micrúoundations oí
cor su mpti()n beha\ icÌrr l o see $hy cuÌÌetrt d'ìd €Ìp..t .i lÌltrl" inconÌe are likely to be rcÌ'
clan! lor consumption crpendìture. The simpÌcn a) to jncoÌÌÌate the iDslsht\ ollhc
fo,aÌd-lookmgrn.Jd€lofconsumttnrìi\btincÌudinIin.fthe.ÌeteÌmiraníolerpectcd
futurc lncome. The.onsurnptio. íuncti(Ìi íÌitÌ\ whcn e\FÌed llttuÌe income changcs.
'lhe cnlpìÌical e\idence discusse.l ìn Chtpter T connrmt thal cuüent and eÌtected húlrc
irÌcomc i.nuence crìrrent.onntmftidr.
ln!.cslm.nt 1s assumed to depend neiiativel), on thc rcaì ÌaL. ofinteÌe1t and positíÌel-Í
oÌì cxpcc lcd frúure proitabiì i l-Í, the .teteÌmitÌâ nts oI tlh ìch aÌe PrrÌ ie.l hy the teÌm 'i. I hc
sinpÌc ìdea is that lìxns arc laced with an ar.y ol i.vestment frcjects, ilhich are raiÌked
bv thclÌ expectecl r€tLtrÌì. lt tÌre inteÌelt rdte falÌs, Lhcn this rcduces the con ol capit.l
and Ììaket some proie.ts pr)ntable that lvould rÌo1 othcÌtljsc have beeìr ur.lertiìled
SinìiìaÌlv, ìlttre erp€cted rcturn on pn)iect\ iises (bccause Lhere is a n'rge of optìmisnÌ in
rhc cconomy), theÌÌ at anvgiven ilterertÌate, morc Prolccts irillbe undeúalen.lle caÌÌ
writc dris iÌrve\tment funclionl

Ìtisrmctlmcshan.llt()useâlincariorm,/=Á r, , lílÌeÌe / is a consta t. Lap€ctational

or.onÊdc.(.c aclrÌ5 aÌe o1Ìen .onsidÜcd c rci aÌ determÌrant5 olinvestÌnent tr€hâvioLrr
lhis would lmÌrit' that shilts ol thc üÌ\.csúrcnt lunctidr aririÌrg trom clÌaniies irÌÁ could
bc oi grcalcr sigrincance tlÌan movcmcnL5 dlor,{ the irn estment nurtidÌ irÌ resPolxe nl
irÍcrcí raLc change\. A.leepcr cxanÌlnatÌon ol inle5tment ìrehavi{)Lú basecì on rnicro
e.ononÌlf Íou.daLÌons ir to be fcÌrnd iÌì chaptcr T.
thc /J_ cuFc ìs denre.ìbv the goods markcl cquìlibrìrnÌ coìr.litìo. (vD : l ). To.lern (
an c,Ìplicil lonÌ f.r the I5 cur!.., l\'€ use thc ljteaì veÌrnns of the conrmpti(tr ând
ln\.cstmcnr lunctidrs an.l subíitritc thcrn in to lhr planÌre.l eÌpen.Ìiture equation:

.r,'' ,,, i.,i1 4lt+1 dr.! (plân1ìed experÌditurr

TheplanÌìel erpcndjtu rc ..Ìuati(nr is tÌ1en tLìÌÁtitrìted into th€ itoods nÌârket€quilibriun

conditloÌÌ. ure reaÍangc, uslng the factthat iD ure iloods Inirk€tequilibriunÌ, / t.ana
ÌepÌacilg (1 .,ì bttlÌe nrâÌglnaì pnrtensìt) tosave, \'L, to lefine axeq!ilibúunlocus,r:
 31

I +l
)':1 Lrr.-,1 ri' 1rr'r rJ'
-r ,ilt ij l,r .1 drl+J
Ì
iì í,1 Jl

: : . \tute\ tlÌ!t i.tr a glven iÌìterest r.te Ììre ÌeveÌ oi i.rcstmcnt is firedj nr this
: ::::ÌÌÉntiJadded aütoÌxnnouscoDnnÌptìon ard g(^cÌnnrcntspüÌdini{i a..l
i::.: lil rl of outÌtrú ]s nmnd trr.' ÌnuÌtiÌt\ ing lhe mm bv lhi. .onstant, +;,
,::::rótÌÌemuhiplier.SaviÌÌil\aÌ ta\atioìr bo1Ìr Ìeprcs.nl l(ala8e\ tìom dre
:: .: inL.nÌe to expen.lituÌe. lhe reaí)n thrt tÌrc tex lcakage (l l ìs nÌLìltiltie.Ì
: i\ thatfaÌtoltarrevenuethatiloul.Ìhalcbc.nspcnl constitutesanertÌa
: :: :!rd :Jro\ e savings. The à ct^ e 1s.lo$nNaÌd !Ìoping b.causc. 11r$ jnteÌen
::::\.:rhin\estment,rrhichrliLÌbeasociarednirhhighoutput.IÌ\contrasr,
: i::rçtÌ !ate Ìs high, investment aÌrd he.c. cquiÌibrjtrm oLLlp|t is 1ow.
: . Ì\ derned graphicaÌÌ) irÌ Fig. 2.1. AL rr, jnlerrmrnt (1r A ot"t,
.. : )rn!ìptl)n and goveÌnrÌientspending are nroNn. l\ÍuÌtipltirs 1! + í +Al
: : r.r gÌr er outFìt equal to pLanne.t expen.lirue, /r, on lh€ l.! cur!e. Usinij
: :r. rt a Ios irÌteÌe\t rate, pLiìnne.l exÌrc..ÌjtuÌc wilì h.r high o!ÌiÌìit to hìijh
. : .. ì )ìi maÌliet equìÌiÌ).iunr clic tates a con.sto Ìr dir gh lr lgh o utput leveÌ.

_ Ì.reí'ìent flus
,/ L.n.nÌntr ...núnÌrti.n an{j q.Ì!n!rút rp(nltÌr

.il = i ir',,.rd1,=.Ì í ìL
 and thc.llagram, ('c caÌì scpaÌate thc
ô cuì!e cqurtion ol the
l\irÌg lhe 'teternìinaÌÌts
slope ând polllion oi the I-\.uÌ!€ irì lo thrcc gìoups

(Ì) AnycharÌgcinthcrizeolüÌe r,r,pildwlÌi chaniie thcsÌope oI the iS curve

Forc.aDrplc, a rìsc in thc tropc.ritv to conslrme Nill increasc the multipìier'
makitÌil
the verllcaÌ axìs
th€ lJ flatter: it rolate\ counter .ìock\\'isc fÌonì the iÌÍercept on
nti! i
(2) ,\ n) ch. n 3e in rh e ,r t lr,lt se nsiliti\' oÍ itÌrtst"tt'f (dl wiÌl lca'Ì t() â 1:o nsequc
chrnge in trre srope orthe lS curve: a le\s iÌìteresrclastic inlettmenl
írtrÌ'tion w1Ìl bt
relccte.l in a \tcefer /Jcun'c
(3) Anv chaoge jn ,nro, u lttous t otìsto PtìLnLat ì1\Sav"tn"tdPe din'' (.. {l ilill'ause
rh;lJ cuÌ;r lo shiltb)'. 1he changc iÌÌ.(rlononÌr\ spcnding times tlìe nìuÌtipÌ!tr'
A clÌange iÌÌ the variablc '1
iÌÌ t1ìc in\eslnreÌìt Íunction aì$ \lÌitLs IS

lÌtì.y can be u\ecl l o nÌan \Ìrlatc ann'ìs I aÌÌd 3 lor exaìnplc'

the lS cuÌv€ th tuuglÌ cb
oi th'
iì incornc tar is proportional, ì e lí t - f/' â lower iaì Ìat€ increases the sizc
Any iÌl
mrltiÌrlier and, a; 1n 1 abovc, swings the lJ t() tlx' Ìiiiht, nìakinil lt Llatter' 'hnnge
govcmment spenOmgrviÌl shift tlìc /J ln thc man neÌ des'ribel iIì í31abovc'
,r leatrrc oi thc ir nol€l of ttÌe goocls Ììark'l is tlÌal quântitjcs aliuí
through thc
Ìnultitlier tuess t{i take t|c econonry to a n:ìblc sholt run equiljbrnm lor exaìnplc'
oì oulPut and emplolnÌeÌrt
a faìl ;r pÌmned inlenÌnenl ltatls to a ÌnuÌliple
'onüìctjon
!nlil tÌì€ lcveÌ ot jDCome has faÌ1en to tÌìc cltenl Ìequircd t() nìake savirìg eq!al to thc
los,eÌ levcl ol n estnìent. ÍnitiaLll itlconre tâlls b! tlìc lall iÌÌ iÌrveÍIncnt'
ll' As thÉ
by l' = I ll
rcsrllt ol lhe falÌ rn ìIrconìc ancì assrminll l' = 0, coÌì$nìPtnn dccìnìes
''hls fall in consuìnptìon in tunÌ rc{ìuces Ìn'onÌc, and in the ÌÌexl tr)und
'onsüÌìPtion
1aìÌson.cmoft':1..,(r,'\ll=."':lITocalclìlalctlÌetolal'lropininconrc'rlesÌtmth'

l), : \l ., \l ;Àa+.,'lI
lr +., +,: ..1' )\r
: Ll
L \l nNÌuPlìer ! .\Ì

Th€ ch.ngc in oútput i5 ecÌual to the nNltipÌieÌ (i€ ì1s') tinìes dìc changc ú:

I lfdìe,\pÌÌrf,rnr Ìn.hxl)ier,rr.!rNhnrviÌÉia1'ncnsl l'Jtl):n"l'lÌrcúeriht'x5e'tLi't:'

nÌì.tnÌúb u.Ìkl ìgiLtr.úlh the a!3(lrrrrnf gc'rÌoú oinìê /l 'tn1'
';':n,,,rirr"".,"r.g".."Ínçí6rl.ÌlaÀLnrlìndaf(ÌtrÌeÍi'fr*drerir\Ì+1 r:+'i
(hi, r {ecxlLì liÍrfui

and rÌ!e nLÌnLr(i 2 2lrorì 2 Ì R rììe

-l Ì ;
 I r( $\ \uffl_r olsoods:

: : t:r.: -.rlieÌ..1 b !n .i..Í n.m:nn ar D. Ì\ ei.rt!a re MtpLr

' .rr:r i íii r .úirLt

: L-\j.g (D quantitt âdjLrÍnÌentto à IeÌ! Sood5 meÌÌier e.ÌLrìlihrium !s

.:i)ì. oti the I5 c!^ e (ti!. 2.2). At ponÌt I rjth outÌrlÌt fr. ro lhc lcÍL
::_: r r\.Èí cLenìlrÌd iÌì the ÊoodJnrarlei Ì)e.ürse atthe intrrsÌ Ìalr r ,
: .r. jì e!ÌraÌ ni lÌ. NitlÌ isgresate !lenaDd iÌì erce\t ol outÌrutj sto.ks
.:r ÌÌrire!rúit) rr oa the/5 curre.

- --: money mârket: the lMcurve

: _::..ntl the c.mbinütjoxs olthe Lnteresl rate ar(Ì orlpLn it \lhich the
: :: llluiÌibriuD, Íi the tocus heÌe j\ or the ire_\. Llìc lnoÌìer maÌlet
: ::: :Ìre.haÌ)teÌ, itìi rsnulìed tìretthc ccrLÌâÌ ba.k.onlrolstlÌe uÌe\
.. ..ìtrrÌ brnÌ(5 u\iÌÌg atÌiúeìest Ìatebased moncrrry r! c irÌ rilÌâptei:1.

l:-:-d íor money

::.. Ì: that aÌì5e\ ilhen 1lìst studling nra.Ìoccononìi.s i\ bet$.een rÌìc
.,::ì i.rLltci5ion nrholdmoner.Th.dr:cision losntrreferst()theLÌsc rhâL
. iÌn.oÌne. t)fthenrconre rc.cilcd in an! {l!,cn p€ri( íe.9.rnro.lh)
: 'r'ì itrhêr{ìrÌ.Ê\!ìì.h:\ f r.Ì.rL i..onìc,11ìcrci\aproÌroÌrLon thet
: : f.Ìh.n that is .on\ume.l. Ìl consLLmpliÒn cx.ccls iÌrcoìÌre. th.n th(.
:, :Ìrg i.e. tìre\.are lioro$nrg and âc.LrmuÌati. debts.
: : ì :r- !ìtrìdnd nÌ m(ne) l \'\iherca5 1lìr rnlifg dccisj(Ìr i\ ar ln.oÌr(
. !r ilìr !lÉma.d nÌ Ìnone\ i\ a dc.lsion aboul 1Ìrc lirrr in Ì!hich ro hold
. : :. !:r.uÌr.Ìclitr\none\ ora\anorb.ri55cll lìriÌnsnerthìrlrirncccssart
: ::::.Ìr(cÌ)rt\leenmole\ and.thcÌ iiscL5, \thclìsrrneorÌean h.Í,nr!.Ìì
: : r )r ÌniglrtanÍfer b\ counti.glhcnotcsor.oinsin \ouÌ wallct or\rnì
 ight incìude the balancc ìn ) oui cheque ac.ou.tÌ)ecause yolr halein\tarÌt a.crss lo lhis
Ìnoneybl ]itlng a chequc orurirg I debit.ard. You nrlght aho add nÌ the balan.cs oD
),our othffhigher Ìúercsl bânkaccounts tlÌc'tcnÌ'accolnrttlor$ÌÌiclÌtouhalcloghc
ì cenaìn notice peÌiod ÌItou want to withdrah Ììonel without a penaÌtv. thcsc ate
^11oionc (lc ì
onev and they raÌÌge lronr a narroiv d€fiIÌition (notes ând cointl to a broad
deposits). As we nÌo!e lrom nanor! to Ì)rcird nìonc), theìe í a gaÌÌ itÌ t1Ìe iÌìter€st rcturn
and a Ìoss ìn 1l.ÌLtÌlitv.
Notethnl lh(Ìrthoutthedícussìon of onc-tiÌemandancÌÌnonevmPPly,thcrcìcvant
irteresí .alc is tìre rrnildl lnteÌert rate. i. Orìc.hate.teÌistic coDÌmon t.r ali lornN of
morÌer is that it i\ a ve{'or Iâ ! ìnÌrìid asset .n d Lh eÌef(Ìe nrdispensa ble for cn.ryjng out
tÌansactions in the econom!. Secon.Ì, il ),ou havc c1.000 in vouÌ account, thcn ar long
astoudonolrlithcìr:wa.,votit,thevaÌuenÌmoneytermtdoesÌbtf!Ìl.1irismcansthât
money is 'capìtal saf€' irÌ ,orrn,r/ terms. Ìf thc moDey ìs úr an interest bearirìg accouni,
then the nominal anÌounl tliìl Ìise a5 itÌt€r€Í accÌues

3.1.1 Money ând bonds

Although somc ftrììs ol nr)ne-v do fay ilúrrcst, theÌe are otheÌ asset\ ivaiÌabìc in the
econonÌ) thal oíler a hiitlìcÌ ÌctuÌn than a terÌÌì dcporit as Ì{)nii as you .re p(parcd to
lakeotrson]c risÌ. ÌÌr aclditjon Lo s uPPl-ving Ìnoncl , rhe go\ eürnlert catÌ bor.ow jrom the
general pubÌÌc by selÌirÌg govenrÌnent bonds. lhc key difference benle€n gorcnrment
boncìs and nìonc-v is tÌÌat bonds aÌe not'capit.l saI.'i. nominai tenns:iftherc l5 a rise n]
therate of inl$est, then thc ma rket value ol thc bon.l fâlls
'Io undcrstand the iÌìvcÌse relatl()nnÌip bctirccn the marÌ(et prì.e ol a bord an.l the
iÌÌtereÍ ralc, consìder. bond that 1s is\ued by lhc govenrment at a face !.Lluc oÍ e100,
and thit pa_Ís.5 per anÌìnm i. teÌPetuitv. lfthc nrarket lnteÌert rate i\:l%, therÌ lhc frjce
üÌe bond wìlì seìÌ tur 1ÌÌ lhc maÌliet (the marNct prjccl irill he {ch a! to nÌake thc vicld
of reprcscnt a nÌarlet rctuÌn oI.10Á. Th€ ÌÌÌnrkcl \.alrte ol the hond wiÌl be €r-, $'lìcrc
=5
0 0.1Ì = 5j j.c., Ì : 5/0.01 : 4125. Aìr irtere\t ralc ìowcl lhan 5%) inrpììe\ a mailet laìuc
lÌighrr than the face !âI1c ofthcbond.IltheiÌÌt$cst rarc is elen ÌoneÌ at, !:r:-,21Ìlol lhc.
I 5/r:)02 = €250arÌd similaÌlv,1ftìÌe ÌúeieÍ ralc ishigh.tât, sa-v8%,the th€ rÌìarÌicl
valuc ìs €62.50. There is ân inveÌse Ìelatio íìiP bcli{'cen the maÌket vaÌue olthe borrd
(i.c. rhc price at i{hich Ì1 wilì seÌl in the nÌarke1) and rh. market jnterest rate. lt is clcar
that onÌ_Í iI the iÌrterest ritc is 5or,, í the nÌarkcl vaÌuc ot lhc bond exactlv equal to 11s
ia.c raìue. So unlike €l lì0 jn casÌr, the nomiÌì.] mirkcL taìúc ot a cl00 boncì will So up
('hcncvcÌ rhe n onÌnì.1 in te Ìest râte fâÌÌs an.lvi.c vcrsa.

3.1 2 Demând for money versus bonds

Considcr the choice betr,ce. holding one \ as\ets lr thl: ioín ot mo.cy oÌ in bon.ls, tor
cliampìc, ÍÌnÌ thepeispccLi!e oíabuilne$ clecidìng bowto nranagc ì!s cash. (As we rhall
scc in Lhapter 8, tlÌe discussn)n js not tundìnìerÌ1nlly dìficrcnt inÌcn addìLjonal asset\
súcb as e.Ìuitiet àre introduced.l lvl(Ìrev is rÌeedcd in odcr to.arrl oul lransaction5 iÌì
a nrârtet econoDÌy. Sincc desired tranractbn\ vary s'lth thc lclcÌ ol inrodìe, so $iìÌ thr
dcÌnând nÌ monet. lul lhc cost oí holding â\sets if the fortì of nìoncÍ is lhat intere!:
inúnrc 1s nregone.]\rlsc ìn tìrc i.ierest Ìate Ìlill slÌlít lhe bal.n.c ol advarlagc jn favour
oI intcresr beariÌ]g âls€ts ìncluding bo..Ìs.
 35

:. : :: Ìarize Lhc.lcmand forÌÌr.ÌÌe) ds fttìor,sl

I = I l),.i) ldFDand .r tì, Íre) r

:.: r'1rnL, inlcr€Í rate. \\le Ìeturn to thc qucÍion ofthe dillcrcnce tretiveen
::::.ii rilc, r) ilÌât feâtures Ìn the I5 eqGr on and t1Ìe norÌrìnaì int.rest, i, thâr
_ : :. uo..v miìrket. lve aÌe .lealirg herc (rlth the ,L' paÌt of rhc ,1v,,
wherc
:-.:.llr. drmand for licÌu itv. Aliseìn hc Ìevel of hÌcome. hoÌdingtheìntcÈ
t

::r.q!.d, Nill râi\€ the derÌrand for moncy (i.e. inl.ì, > 0) ãÌìd iì ÌAe iÌr rhc
r': :lldlngiheLe!elofln.omei rcìranscd ililllolrer the demarìd for moncv
\ote tlì.ìt the denrand nrÌ morcl is e\pressecl irr Ìeâl rcrms i.e. iitrrrrJ
:_r3lÌt ass!med that a Ìì5e ir dre pÌìcc Ìcl'el ìÌ1ll raise the .omìrÌâl denrand

:: :nahsi!oldÌe goodsnraÌÌet,ìtísomctìmeshellúìLniextrcssihedema.d
.. : tle.ìr huÌctidr ot the leveÌ of nrcolÌÌe aiÌd the iÌúere\t ìatc:

' I 1.,, .r-)

r: .: i arc positive.onÍints. lhe teìnr í7 l,l) rclÌc.ts the asset nìoüle foi
: : :.d rhr tcrnr (L.l .tl reíiects t1Ìe transâ. rio rì ! morìvc forhoÌ.ììng mcÌÌel.
r i :hÉor! .aìÌc.l thc Qlantitv lheoN ot l\Íoncv, the onlv .leteÌnìinant ol
r : : : rtrl moÌÌcv birlan.€s is the leveÌ ot oulput. lrÌ ot1ìer words, onl)' the
. .: ì:L1e is frcsi.rìt. 1he Q!.nt1t}'TheoN oI NJoncv crn be stared as: r# :
:r: :i th..ônslant rrlocit! of circuÌation. wc use tlìe noÌ! sLendard nrcre
:: :: :: :'rÌ nroncv tunctiorÌ in whi(h the lrensa.tion\ derÌÌand is o.lv one paÌt
: :-i: ì. monc!. Hence, ,lthorìglÌ the rÌansâ.riorÌslelocit), Ìr is corÌÍ.nt. the
::: .iripbcrlçccnÌroneyderÌÌa c:landotrLpLri isrÌot:itwilìraÌvifirhchaniies

--,:: .rd sp€rulative motives

: :::jrnirions giverÌ ld the lnvehe rclationlhiÌr betÌ{een the dema.d tor
::: nl.r!.51rnte:ìÌe lnonn as the assctnlotive an.l the spc.ulrtne molive.
: : : :!. .hoi.e betlleen hol.hng nroncv.nd bon.t\. Kq n$ argued ft)r rhc rel
:: ir,..uÌati!e mdiye as foÌl(n$r tI an irÌdnkiuaÌ hdkrlcs tlÌât thc cuÍ€rÌt
. :.r\!. thc lereL úre consì.teÉ nornìil, theD she Njìì expc.t the intercsr rjte
:.::,i düccouÉe. UDdeÌthesecircunìstiìnces. ihewiÌl chooseto hold lìnin
: :i :ni iholc tÌìe Ìrìonev requìÌed lor tranlaction\ jn thc lornì ofbonds. She
: rii-sh.r!Ìlc\pecttoÌeapacapitalgiiÌìorìthebordsrrhcntheintercsrrare
:r:iÌk\.1 hc.on\eúe wolrÌ.IÌre Lruc ior a curÌenr inLffcst rate beÌicved to
:.::ir Ì\.:r.rs belie\eclthat the sublcctire a$esrÌ.:Ir ot lhe noÌmâl iúereÍ
: :. r.rnss th. popuLation,pr Lrcingir ïnooth inlc6c rclatidrshit bctreen
: : :r:: rrd Lhc i g8Ìegâte .lema. d nÌ specuiatile baÌãnccs. Moreo'er a.€ntrat
: r:r ncs's arsuÌrent ìs that exfcftationr drlve lrnencinl nÌarkets and that
 luliìllinil characier' Ìl bon'ìhoÌrlers strd'lcnly beLieve
shìft5 in eÌpechliolrs hale â sell
in"iur"',**u.""utnehigh€rìnthcnrtLretharÌthevha'lPrcvi({slabclie!ed'thcv and i'tercst bond pric'"s down
ì',ìì"t0"., -tuu at*t "ntlw1Ìl
scll thcir bonds'
']rìvingr'l
.a ., -' " l

', ',r.1'l'
rr - 'nlr_\r'r"
, , t....r ', P r'l,
'- o *rrain abour w1Ìar dÌc e\pccts rhe nrrLrre rare ot Ìntercst of bonds
iiì"ì
"".n,,,u,"a,.
,.,r",-ntttU,.,*u".Uìenìflica!ionsotifvesloruncertaìntylntìlcsimpleÍveÌsiorl a rsklcss:s5't
,,ii.i,t.:'.,-", 'oa^*Ìse- iÌrdivi'1uaÌs aLlocatc their PonhÌio betwccn I lì
tt r-L "'. -rtnJr' "' '5
.,:i,. ';,,'r. r' ntsa'' d'rJ.J
'
. . Lr.. 'r" '''.r',' r' 'n I
r"Ll
., "
.t a 'r r'' lr'r''
rate wourd ìeàd her ro n'bstitute
ì;ì;;;'-' i;,,".
"ì;' rÌ€fcre ccs h1i{heÌ interesr
^ rhe hiiirÌcr expccted Ìehtm
;;;;;, ;ì;''er (*,ì"cc the 'ÌeÌnand íoÌ moncvl Lìccausc
Ìisk ircutred rhis fro'ìuccs dÌ inversc rclar ioÌÌsh4r btiwcoÌ
,,'..u, in"
,i"ì."t".,U- -.*t-tdtlÌe ìntercstrate '\ morc 'let aiìed discu5s n'Ì
",ì.,u,-'al
"rn"ì ol tÌìc specuÌâtÌ\'e

and assel mlrljves crn be íound

jtr Cha crE

3.2 Money market equilibrium

N,Íonc\ ÌIarkcl eQ{rilibrirün ÌequiÌe\ lhe dcm'ìncl
an'Ì $ppÌ} ol no'ey to be cquaÌ:

{nroney Ìnarkct equìÌibrjunìl

mon.v,:lemand = nìone! sLìPLrlY

jnterc5L ratc and the lev€l ot

sìlerc thc.lenr^nd f()r moncv dcPends 'ìn thc noÌninal
; , - ,'drr' l rr'"' ' "' t lr{rl ^r ' ' '\
';;;;.,,,
''""i1'n',, lhl\
.,'r t' u," ",,q ol nroncvi for ìroi!' \Ìc asume that thìs is po'sible
"ì,i'.,ii''
'
'"upl!
.r ' 1"'- "t 'rL ' rr'" '
'.";,"
;.1 .' r"
"..'r"'-t'
(Ìnoncy marke! equjlibriun

rn ut*'rrd dopnìg Ìocus ot nìoney süPpLv ecÌuaì to monc'v deÌnrn'

we can dchnc
. .r .r, or:.' r, i 'i rr'\' 'r r 'Ì J rr'

,.a'r,,r\r'r " '' t'r'r

ìor nntrÌcl is low bccru5c Ìe\s nronc'v has ro Ì)e heÌd !o
lìnan"
,n"ì*',!""tor,, a"-ín
",-''
(r ih' rtrú'oÌ"i trs ì Iif ro!ì iÌrc údn ür
=-,,,,';.;;.-,,,',,' ., ,,'.,"..!..r :2o1) /*' o' 'n 't
LÌìothtÌÌìoíl\ th'ÚidividuiÌÌìÌúeÚrlnìnrrtrLLLÈoÍ'ìmnranu'reÍr::
".tu,n,*,.."ú",.,.u,.'0(r
L$ÍnÍiih af o!..iiJ r.lur.I' Li)0
 :31
: ::. \:n.etlÌesupplt ol oncÍislìxcdlfors!ppittoequaldeman.lintheÌìo.ct
::::::-::ìu\ibe.ìcorrespondingìvhighasset(or\peculâtr.È)ri:lemandloÌnroncl.
i:::::: rri.! trill ensLrre tlÌls, sirÌ.c Llrc returiÌs tuonl bondhoÌciilg relâti!c Ìo thc
.-:i{!lLnL.ÌhrconvcrsearguÌrcftassocìâtesahiglÌirÌconÌelerelwithahigh

: :::-..rlenì.nd 1òrnÌoÌÌe\' lLuÌ.1lon, therei\i rÌeat rvd!of derjvingthealí cunc

:
: : :::\ tu \ee lÌo1r shijÌs iÌr thc dcmand lor morì€Ì or charÌgej ìn the inr$cst
: ::!i denr.rnd foi nìoÌìe! or chingrs in t]Ìe nÌorÌef ìppl) i!ìÌl allecr thc /.Àt
: .: .:.ihoil is íÌo$rÌ ix tiit. 2.J b ti\'o step\. \\oihrÌil tlÌror8h thì\ dlagÌarn is a

fìst, aÌ iF thc nìtcrLit scì\jÌive

d. dìand nÌ .!Ììcr i/ /, i)
GlôÌ{and is slÌoiLi b_! tlìc di\trrLr r.
\e, or,l ï=!
1,tr ì ,l

Ì|r'tÌr.\â(tirrìf ds.nnd i(Ì

lnrÉrdrmrfd nr ÌofetlutLÌon n:

,=; (' ï) i +,
 ol:
goocl nÌetìrod ol secudlÌg vouÌ ündenlaDdinil

. tht transactions denìandfor ÌnoÌìct ãndtberole of|1 '

. lh€ alset (or 5pcc!ìative) demaÌìd for Ìrone-v ânddìc roìe oí/j;
ÌeveÌ of tbe ÌnoIìe-v s[ÌrpÌ\ sct b!
tlÌe ccntra]b'nk or thc i'oleÍrnÌent'
. thr role oÍthc
'l .',1
. ürc DìoÌÌev mirhet: r = !Ê
the cqrrjlìbrlunr conclilion iÌì
nLpph liN
b Now' òtw in llÌe jntereí
dra\! in tlre vcÌucrl Ìeal nìoÌÌe-v
hr steD
,"ïi,ìï,i...u" ì*,
\rDUl\
l,
"',
li.e 's5lì'ì\'nÌnFiq l ì \'\\tÌrìr r'v
-,"-"
xllì',".iï^,ïllïi[,1]iÌì,ïillìì
a ' a \r'
; ì:;;aÌkct equiììbriúm coÌr'1itÌoÌÌ: I : I rr' + -! r roÌ mon.
" ",,t '
;:i:';'"i,;i;;
n,, 'Ì, 'J ' \'J rr' ' . l1.- -
;;;", , q ,, ,' .,,
.,1,,, r' I J_ 'r
,, ar', ce t' ilÌcn
sÌnc'
t',,,. in- o ,"*'ated $'itb tlÌc iÌìleÌest rate iH i e the 'lisra I
l
'-i"t' d ''l '
'
, t", ' l r'r"- r'i 1'rì I n^'
,"., r\ó '
"
..r\!".r"t
,,'" ," n ' q) J' )'.. '\I "'1
.l','
d'ïlì,ï,n" wa-v\ in i{bicrÌ rhe posÌlnrn andjcìr
o-,,'^,u,' ,'' tbc rM 'urvc' thcre are rour
tht dope otthelìÍ cuite 'an be 'lfeclccì'
(ÌlAchanireirtheÍd'lrdúit'bretatiryol'itdnaLÍ,t'ti""-':i":']:1"ÏIl.ll:::.::
.''-
l '
'... " "' i\nv ri:e iÌr ÌÌrc trnnsactions rcìocrt-v 's
tÌÌc ÌeÍúÌ
':
;ì;;"ìi",;',',"'r..""aÌÌ hÌÌarcc
il;:';;";;l;'ì"* intÌod.clionor'rarir'ârcìs 'ìeveÌopmentoínonÌranrirrna'l
makinil jt tÌatter
.'ìïi"'ii.,i,.ì" '',rL;,,i,tetber'NI1o thc 'isht (cro'Lwì5€)'
'r.l i''\r" ' "P--to " l'^-. .

n.Ìrer an'rbond5' Ì!ìl prdLlce a rÌâtÈ:

ij;;ì;;"ì',;"." ;" u*ootíoÌio mix beLrvecn
i'lliiìï,*y.1,,",,y1:lit:ï:::::^:*,ì::\:::i"1iïX'ii,Lïlïì:ï::;l:::ï:ìl'
(1.,\Ìtr, rn s hrrh L.i5c the 1ÀI.uÌ\. hrcl i!
tlÌat no olrcbeÌieles tÌÌat thc
ìïì'ì,ì'* " i".'*.t '""-Latl!'c cìemaÌÌ'll ii it is tlÌc crse
rate' t' tì]ejr thc specularive
,,ì,ì","i'.i*"" '"" '' than the actual inreÌest
"'!cr eÌa tic at i bccallre Ìrobod'! ii Prcparcd to use sÌrarc cnr:
ã"'."J t,ìl,".',"'ìs p"'fr''tlv s

'!ÍvÔrÌ!aninríenhrihalprnriÍttìen4rl')'oln'd')ÚiL\'s'rsi1i\eiotieitÌcieÍÌii'!ÕÚGdnxr:
ilìe rnÉtlÌal ? I iÌr 6 FonÍ
 .::irrirtrtheÌb1.ìupthebondpricc.LrndcrsuclÌ.ondilions,llìciÌìlcrcstrateis
:::r:. €Ìrone beÌieves it Ì!i1l rise to ils normal lcvcÌ (opinions s,lÌl dilfer on
.:':::rfrDnlìe\eÌis).hÌti8.2.3,ifi:ii,thcintcrcn-scnsllivcÌronctrduìaÌÌd
: :'.Í rune\Ìvouldtlrnhorizon!aì ali lhisls lhclamous'ììquiditylrap'casr,
: r r rÊtlün {tthe end oisectìon 1.2 Gcc lig.2.ó).

: : .. Ln Lhe rnr.r
sìpp4,. An incrcirsr iÌì th. moncv suppìv í'ill íÌift tlÌe l,\,í
::i :::Ìrr, rlnccât aìr) interestrate, ìr'ith r gn enasset d.mafd lornionev, â lÌigh€r
: . r \illì rcquirc hìgheì tÌarÌ\actions balânces to briÌìg money denÌand iÌÌto
: : :::: hiShff supplt. A hìi{heÍ output level ìtillgeneraÌc thc higher Ìransactions

- -::!r ìÌr tlÌe fri..lerel. tror e given inteÌert ìate, witlì a lÌi8lÌer price ÌeveÌ, the
::::irr(iioÌìs balanccs.a. onì-Í nnance a linïer aniornt oloutpui. TheliÍ cu^ e

::rinìalhcÌìatjcsan.lSeornetryolthclÌÍ.LrncrcquiÌcdtospcclt_ÍsLalcmcnls
. l \t f r'1 . ,i ..1
::::iu.hasìabovedrelitcur!€üÌlìig.2.,1,h'iththcouqrúLletcÌ,,t,oandintcrcst
-:::\baìen.csaÌct(x)hlghtòrmonelnÌ.rNeteq(ljlibriunr.Wcca.sccLhal(hc
: r:::::ì.ouÌdbeeliÌninatedeitlìerblariscinthcÌcrcÌofo!ÌlpÌllorbtalall ln
:::: rr. \\rhen tìreÌe is exces\ suppÌv ol nÌrnc,v (cìccss demând tor bondt, lhc
-:::ÌrrlancesaÌechanrÌelledintolhcbondmarkct,th.bondÌrÌic.isbidup,and
::.. ri. r.dlrced rrecall the earlier dÌsrusslon ot lhc jnlcÌsc Ìclalìofship bclí'ccn
: :.: rrf a.d tìre prìce of bondsl. Ìhi' coÌÌvcrsc situalion ol cx.css dc'rand for
. : . 1ìt e poìnt sìch as Z b€low lhc r.rV .urvc. l his s,iìì be.leaÌcd b_Í (hc saÌc of
' ::: Ì-ruiìresdowntheborxipri.candralsestlÌciJìlcrcsl Ìatc.

Lxccss n4Dlr ol nìoÌrev:

rv(T )

la.ess dcnand olmoncll

: - rÌ:r r tô môiêy nàrlet eqú br!ì er.eíslppfÒinìo.eyaÌpô.r.t e:dst{r.Íal n

::::: Èi: Ér.eí tleri:.llt.r ionÊy at co n1z êad5 t. ê rre n 1re n.í,nà rte.en ràt.
40

4 Putting together the ,5 and the ÍM

trnequilib
LìycoÌÌÌbinìngtheSoo{ÌsaìdnÌone}iÌìarket\'thÊiÌìt'restra(caÌ thcshoi
!n'ftìetlÌnL therejsonetrick\
riunÌerr:loiourputloragivcnPriceÌerclared'ÊÍÌìineí!
it i\ tlÌc r'dl iIÌ1cÌe\t
Dnbl eÌn hat ÌÌcc.Ìs to be a tldresscd ÌÌì thc 'lerilitlon olthc /\ clu!r'
t

r. thar ls rcÌÒ,ant sln.. invcshìeni speÌÌi:ling depe ds on tlÌr

'ratc, rcal Ì'1c ol iÌÌtcren

ÌrÌ the l€rivation ot tlÌc lI'Í curvc' it is thc "trn?'/ iÌrlcìe\t nte'
i' thât i5 rclcvarú since
the dcnÌandíor nì.ne!'depend5 olì thenomìtÌ,Ì ìntercstratc

4.1 Real and nominal interest rates

lo cìaüf)'Nh) it ttÌc Ìeal ratìrer rhan lhe nomln'l intercsl rate thnt atìecls Ìeal cxpen-
ì1
an in!'ÈnÌncnt proìec1
cìiturc d;cisj(tÌs ln thc cconoÌn-v, lbiÌìk about a hun conlidcring
i!ill not imposc gre'rtcr Ìerl búrden on thi
A Iigher rÌon€l oi trominal rate ol üìtcrcst
a
irÌÍÌatnnÌ ìrecausc lhe erpected p(rÈt!
ir.'lt it l, rr"Lun.".r Lr" .oÍcsÌJon'ìitÌgll'h13hct betlrccn th'
trom ü1e ifvettrÌrcnt project s'ilL bc hìilhct in nìonel l'ÌnÌs a'd thr baÌancc

real con ind the rcaÌre1oüÌ on tlÌc tìojecl l!1Ìl rot lÌâtc
change'l
'Ìhc real Ìntereí rrte js.ìefined jn teuns ofi'o'?r alÌd the nomirÌal interen rate' in leÌm:
of,rorir'!' lhinklfgofacoÌìsunergood'lhereaìÌateofirìtcrcst r'Ìshowrnuch€xtÌaill
,l. gooaì*t,,la h.\ e to he Ì)aid ìn thc iLrt!rc Ln ordcì to hale onc otthe
good:
t"r,"r
"i
toda-r: t goocl' = i1 rìtoo.]. , itÌrerc lhe \L!Ìrscripl t relcÁ
to toda-v and t'1 lo oni
p$io,r hì;Ì. lhc .onÌlnaÌ rare oi intercsl i\ hoN nN'h exÍâ in euo' ÌloÌrÌd hâvc n) Ìrr
llgoolsprice!rcm'ìÌ'
;aìd1rÌtlìcrLrturctrLodertohd!coneruft)toda!:1€i=í1+il'! Ì
the \:LÌÌrc: ìl loü ìen:
:onstaÌìt therÌ jl is ckar thit the real.ìnd nonÌjnaÌ intcreÍ rntes are

olrceu.o(o.ìrl,-rouübullbcablcn)bul'(l rì goods in tÌrc lutxre ln gencraì

l
1+,:lÌ+ tt-
"
rLhÜc ú is ilì c expc.tei pricelcvelif lhehìtLfcll'l r)tlÌât comesiÌrLopliysìnce't tinÌe i
irÈdonottrinon1\nratthcpri.cìerclÍ'iÌÌbealt lll\Lc(tsetheidìoÌliÌÌg']e1ìni!it!Ì'
erp(.teclinllatìdì:

f1
rl*, 1 rl
ÌJ) reaffanijiÌì8 lhe abole expression, ìt ìolÌot!\ thit

i' ' 'r: iFa;l

 41

,:l irl
J
- r::r:iir orÌj\loÍ',the.LnonìiÌranrrotrÌrisrrpresst.nirclosetol.ndrlc
:-::ì rfrôriDalion l(Ì rhc rclarìonslÌjl) hch\ een Lhc real and tht norni.ll

i::r+,_l
r--:il l:]Ìtr wilÌ dri\e thc di\'lrEencc betwccn rhe rcaÌ rn.ì foxri.aÌ iÌúeF
. -: |i nore.l rhai onlv onc ot th.ic threc rcnr5 is obse .âLrle: tìrc nomi-
. Ììc reilirrrrcst.ate.in be eniDìited tronl hì\toÌtcal.tala orÌ thc nomL
:: ::i lhe Llte oi irtlario.r thi\ givcs â rnr:as!re otthc so calÌct ralrv Ìeal
ri,rÌriiÌ elr. nn (Ì d,rr. nÌe.mre cin
Ìre dffi\ed ffonÌ â model theL ìs abÌc
: lìll),ll
bondr harc been jssued Ìn thÈ e.onom).thitirre prot.Ècted
.:.rurÉ thc i.ce \ rlüc is nìde\cd b\ rhc
raie oI i.llatìo., t]ìe. thc \ ieÌd
'||
:,.i:hrthrrcissue{Ìindo\ ljÌrkcdoÌ i.ilatiuì trooibo.{ls(UK jn 198ì,
_ :r(ei. l(.r')lll

-. -',Í model
':r rrxÌ Ll\ I the troblenÌ of thc 1l d.pcndiÌrg on the Ì.et dnd Lhe l17 on
::i r:it. rfr, conc.rntfute {)n hoÌ! th. ti,ZIí modei }L.rts irhrn th. rc.Ll
r::: .,rr rir.,ìtical. Thi! requir.s u! nr issunre Ìhat inflaülrÌ j, zeÍr afd js
. :: r, lo lünil.ì usrlÌatrwodiiiere.t iÌìteÌest Íiìiecon.cptrarr iÌrvolred,
' ,t!.rgÌirl nth hotlÌ,Ì,aÌrd ,r,on LÌìe veÌri.at di\. !!e sìraÌl rerLÍn io
' j:he lt/l.\:í iDodcl shen i.llation s d jtiocrt trom
zefu Ìf ClÌaÌr1cr.ì.
: r_,i 5 ìfd the li.:Í d.ìrnlrdrjps halc been dcrire!ì, rlìc \tro.t run cq!i
. : ::, rn.i Ì.!rl oi oLLlput wìÌl bc dercnììined Ìry ihe Lntebc.Ljon oi tlìe
.:: r,i rìrr/\.4MDodrl$orlis, theìnitiâLLt/L t equilibÍnnÌ isdistÌrrbect
- 'ilÌÉ €\ogtrÍÌ6 vi.irble!. ìrüst. s,c cln5j{]cr ihe.lrofuct!t ot thc nei!
, rÌrn.lis.r\econd, edì\cussrhelìkelvadjunmenL.)tthcc.onom\to
.i,lr,, r r

i::: e:t.h nÌail(et. t1Ìe most pt.ìü\jbìe simpk as{rmtriur js üÌrr moue}
Ìr
- i rre cÌ.rrcd veÌr rapi.tÌv in
relatjon n).Ìjscqujiììrr n jD th. an.l
Soods
.: rhr 1tI,t/ dirgÌrm, t1Ìjs mcans rhat the c.onoml retlrÌns to rhe ÌeÌ
- : ,: l.Ì tÌrc irlirútnìrnt (ìccurs ihroush chanire, i. LtÌe pÌice or borÌ.1\
:::. iiijrÌÌdLh.refoÌ. ÌÌnraÌÌi.t irÌrer.strât.s CoocÌs maÌtcLa.tjusldÌerr
:: !irrrin.c irirnol\csr(ljusrnrent5 to pr rcri(Ìì aÌÌd enrÌrto,,mcdt
.rìniplet. 8o\enmerÌrirt j.\ chiìnges. ln tlÌe nAt.ranrpte (lì g. 2.5t,
: .::-: ii ri\es lhe ne lS is 1Sií I ro thc ri3ht ot tlÌe oÌjÂin{Ì one Thr
new
:,.r isatrhc Brìnrt':.utput is hìghcrr.{tÍjisrhc inteÌestrdte. HiShÚ
.:: : -.: \ ilì grrÌeÌa1e lriglÌeÌ aggresrrr dernand ln.l a hishe. ourfut le\ eÌ.
 (b) ,

o o d

Figurê25
,.1!t Ê. .r :mDnèJnrdI-r
t,o. nln!
. Lro Ê .mÈ
n,,r.n""n P. q I d i 'h' er 5!lfi
'o

. :::':ì:''
-:"1 ;;,1 ll'.:' il :"" ^"-"r"'l'
.:'-
; "; I l,",:l "i:;':li::iì-ìo'Lq"'h"n'
;l;rl,ì :ìli: I,il, ,l:;.t ;'.,, - ï:":, : r'1,
.; jirïi':"1.'',ìfi ïiil ;ti:ì::i:Ì:':
ï
j:: ;ì: ; ï:ïi:1 ï.'ì:ïi"ï::
i'\ï'.". 1ïì1i.,ì"':;';i;;;" .''"'"'s
n:*:;:ll :.
ercrcss cÌemancr tur moncvbaìar =
Ïiïl i"Ï"1'.'lì
 43

i Ír: soÌ.i, causnÌil thr bond pÌìce to lall and uÌe iÌrtcrcÍ ritc to rlsc i/J to C).
r.!. i!icìest Ìrte.lrnìp€iìs th e exces .lemancl lor Êoodsb\'.cdu.ing lnçcslnìcnl
:.. !:ÌiÌreìei5, at C tlìcrc rcmâin\ exce$ denìand oí'inil Lo n.Ícascd consrÌÌp-
rt.aì lrith the nÌiìltiplicrcliects oltìre rise iÌÌ .iro! €nÌÌÌì cnl spcrrdlng. Oulput and
':riji€flÌrther(Ctoll. lheadjustmeltpro.ess.oÌìtlnucs Lrrì1il lhr nc cq('l
I
ettrnre.l lheiirÌlmuìllpÌiere\paDsnÌÌofoutpuI iì lo.4"ldocs nol occrd
s

. :N rlrcÌe it a frscal e:ipantjon without anv.haÌìgc i. 1ììr nonct sLtpfì-\', lhc

: .: _!, LnLeÌertratecâuscsa IalìiI ì.teìest sensitive spc nd lnij. lh. itrìplicâLlons
::- : -r. n.Ìeaseinto\erxìcnlerfenditueb\'(iltaìatio., ílìr bondnna.ccas
: : iìaÌntle, and (i1ìl Ìnonc! nnânce rÌe coÌnPa.ed usiÌrg thc lJ/r r!'/ modcÌ i.

: ,!:,Ìrd c\âmpÌe (lìil 2.5), the govemmerlt or.crlral bafk incrciscs lht
:: ìlL 1lìmugh the !!e oi olen ma!Ìet operltioÌÌs his nìcn.s that it enters
.
::: :ìr k\.t turchashÌs bonds Ìn exchalge tur neNl-v Ìrrinlcd Ìronc-\'. Thc I-Ií
.-d I I r i
_ .r hi\ehisherkvrl ol.ruit\ìtrÌÌd a lol.;crlnLcÌcstìete. \'\iith ahigÌreÌrìrrn€l
::::L!hercìenÌdÌìdloÍmontynÌtheneÌ!equilìbriLtmirìÌÌÌe!ÌulreaÌo$ernúerest
:.1!Ìcstratewillb.nsÍ)cìatecl$ith.rhighcrÌclcÌofirve\tmeÌrtandoutPrìt
' : r.lorLeÌ prnel oÍ (l ig. 2.5r.
',,r lo the rd j!nnìrnl IÌÌrÌ point ì to thc ncr, shoÌt run equìÌibrium at.l'.
: :: ri. rtJect ol the rnon.tâÌv iuthorit])s nction ls n) cÌeate e\ce$ mlÌrL) ol
: : mflÌ..d ex(ess dcÌnand ft)r borÌds râises bond pÌices and Ìo$es the jtúereÍ
:: .oD\ nÍr\es lronì I n) n, nÌÌ]ÌÌedi.Ìrl,! all.Ìitjng the neif iÌ(nev nÌârket
i: rL,rÌg i Ii+ì. The lall in thc i.rffcsr rrre cìeates.Èr(e$,i:leÌnând iÌì thr
:i.:: LJr stinrrlalìng nIe\tncnl. Hlghc. ìnlestment deÌìì.trÍl p!s1ìes up output
:rrÈnr ralsing outÌrut lrorn n Lo L r\L l_, thcÌe i\ on.€ âitaiÌÌ nÌone:" rÌÌarket
: :::rr r\ crccss !?.,rdrd tar moncl accompanic\ the ri\e in outlNt. The iÌìteren
. : l),\.ljrrslmentoto!ipLilindlhclnrcrestÌateÌlillcontiÌlreuntiÌtlÌeÌÌes
:: :.: I is rcache.ì.
. ìÌLs lLh_Í cxpan5nÌr.ìr! nìoncLary poÌicl nrav not raile outprú e\en irÌ
: :: ii tÌrc intcÌest rate is i. thc /.Ií .ltr\.c it llxt. \\ihen the central banh ente.s
: :: rrl!.1 lo focìrâre Ì,onds, thffc is no imÌta.toÌÌurepúceolÌroncìs:ile\erv
: : :: ::ri o.Ìl djrectnÌr lor thr j.l$cst ralc in rhc irúure i\ uÌr, thìi itÌplie\ the)
..:,nd !riccs iliÌl iaÌl DondhoÌdc15 lhrrcn)rc wilìüÌtÌ) \elÌ bonds at the erist
: ::
n(li ft:Ìentbet\leen monc_v and bonds as the Ì)rÁpectlve câpìtaìl(Á\ on
::i.Ì\ Lh. i.teÌesÌ recei\ed, n'itÌÌ tiìi'rfsull lhet LÌrere ìt .o Ìise in the bon.1
: rlr n thc i.teìe\t rate. lhc ccononì_v l! ln a Iiqtr ilv tÌap rLheÌe new monev
: Ìì,' L..onom\ iiiviÌlinglr''hcld asmonc!balâncet. The ceDhâl bankisthere
ii r. ús. nbnetaN poli.) to 5hiit thc cfonom) tr) a higheÌ Ìevel ol ouqral.
: .!..trsc oI the ÌicÌui.liiy trnp ras vicNcd as i lÌrroretical possjbiÌitl irilh ÌitlÌe
i. rn.c but tìre .e enl€rgencc ol ên Ün wilh vcÌf Ì{rf nomi.âl inlcÌ.st Ìatcs
. :ri r.r irt.l inteÌest irÌ it. sin.c tlìc norninal Lnlckst Ìxlc.ân.ol taìl bclolt
: ìn rhxreveÌ\one beli€vcs (hc intcrcst ralcr,ilÌ rise becomÈt pleusìb1.. The
: r Iìht s r r)le úr the rn.Ìt sis oI tlÌc Ìonglapancsc sÌump in thc 199ft end ls
. l..r i. (abaÌrte6 5 rnd 17.
fiqure2.6 ÌhÊ q!nrt lr.ìP

5 Aggregate supPlY
\\:e tu 5tenilti.allv the strrcturc oÍ lhe supplt \ide oI lhe ecoÌ:
!Ìctr\'Lo settiÌrgotú \\
rÌrât wiÌl be useLl to crcale an irÌtegralcd short and rncdiunr ìun rrìodcl \{e be!:
notins bricllr hoÌ! thc suppì\ ticLe looks Ln a (ompclilirc mo.ÌeÌ belorc nìovinir i :

rÌoÌe Sen.ral mocìe1oI imPeúect conrpclitl{ÌÌ ì!ìth(rìlch $'e mainÌ} úork

51 Equiìibrìum in the competitive labour market

In ttre conrpcllti\,e laÌrotrÌ maìket thc demand lor Lâbour end thÊ mpplv o 1..:
{Ìepeu.lon lhc rcalÌ!ag.. Tht.lowrNard sÌopìnt Labour denìand.a rennÌ!sthcl::
deÌnandedalâgne rcaì age.liithilìxcdcatitâÌstock,asi|caistrmeìsthecn5.:
nÌ)úaÌìdnrcdjumN.,oulputiiapo\itl!clunctilrnoftheÌcçclotcmPlovÌÌÌeÌÌl,1.

hcre/ i\uÌcshorÌ {andmcdiunr )ÌruÌProdLt.Liot Iunctìon l he nandiì nl aisurif:

that the Ì)írdu.Lion htrì.tÌon ls.haÌâcteÌlzed b! dìmininritrg retrrrÌÌs, rnìì.h meaÌ:l
a\ moÌe norlicrs rre enÌplo-!cd, lÌre ìncrerÌìclì1 ìn output declines hÌ íÌorL, the nr.:::
pÌocìuct oi l.Lr.uÌ, irlÌiclÌ can bc $.itten ns a4 oÌ lífl .ìecÌiÌres r\ enÌdovmeÌri
The laboür d.min.ì curve ls otLcn reíeÍed to as Lhc ì'Ílt cuN'e sirÌce undcr pcÌtec:
ferúion, hrmstaliethercal Nagcasgi\eÌra drrnpìol'labourupnrthepoilÍalilhÌ-
maìSìnal prodLr.l ()t hbo!Ìr ì! (qúal to the real Nagc
The nrppll ol labour is up\!ard sÌopìng aIÌd ls dc.h cd IÌom the oPtitnizilÌg b.Ìr:
ol houselÌolds ar they .llo.alc thciÌ tìme betl\'ccÌr rork
and ìeì\uÌe to nìaxidrjz-
ut1Ììt]. Ìhc rcal wage is 1akc. as gjven and thr Ì\'ortcr .hooser the rnìdrnt ol ÌiÌ'
supplv.
ln I con\rrrith e Ìrbour nìarkct, lhe mrrket.lcnrsÌ csleblishing dre maÌkel clraÌl::-
rlagearÌd lcçcì of eÌnÌ)lotmcnt. h js jsnuvnnìlìig.2 tirilh thtÌeâÌsaseÌt!nnd.r:::
ment,I,r ifor (lonÌretitilc lqullibtiunr). .\nv tcnÌporaÌt disÌtacement ol thc c.( .
 L,T L L

: ._ rúÈ.Òm.ett,r..tnr.rÍ n;i.r.f: Lr-Í[JÊicf :lìÊ Ê: Ìr.,]3rì.1

: .,'r i\ x$uìned to bc cÌl Ìni.alcdbv a mo\,ement in reâi i!rge\. Ior erâmpll,

. .::i , aÌrore tÌie Ìn.rrkcL'.lcaÌing lc\,eì kìue \al, to an urÌe\pe(ted fall iÌì
scs
- . . rÌrcr Ìabour nìpply c\.ccds ÌibotrÌ.Ìcmrnd at uÌìi redl Ìlag€ (rrr. 1lÌe
: : ,r lihour ríìll renrlt in elling mone! i{rge\ üÌÍiltlÌe urÌique corÌìpetiti\'.
: : r...sLrblúhed lrith thc rciÌ lligc at xr rnd err+rlo\nÌent at Ir. lrr tlÌìs
' r tcotlewluNili b.'úrcÌìflovcdi,ilìbethoser,r/ÌrÌrírill !nenÌpLolel nì
':: ìt rhe goúrg rerl ÌlaÂr. thcv trcii:r \eaì.hìIg ìor a job or leisrìre o!er the
_:1r1. Lhrlugh Ì!!rkiÌì8. lÌ1 !ig.2.7, Lh. Ìabour ntr(e. ìlhich (drÌ be tÌrorght oì
_r!Ìr xnnüÌt ol Labôur tÌrâl couìd bc nÌÌnied. Í shoÌÌn tiv the \ eúicrL LirÌe
:: r r, ratujÌibrilìnì tuteolu.tnrÌtÌo)rc.t ú Li,I '1. Ìlherel i\the laÌrourlorce,
. rlr, rnrtÌo) ed rÌÌd thc uncmtÌo_v.d. lt i5 Ìmtoúant to ÌemrÌnber that the
, rl i r'ÈÌ1.ìre optirÌÌum i. th. coürl)ctitn e equiÌibúrnÌ Ír the \duntaÌ) unem
' : .r .\j.tl lloes ÌÌot signit) e tdtcm. IìatheÌ, ìt reflects the choice Ìr) $orlieú
::::.: rni h(r! nÌuch to NoÌk rr ttìr: cxlsling ÌexÌiQ3e

: supply side in the impeÍÍect competition model

:
.,: ': ìa!rLtr..rìorn .s is lo aÌrâÌvse the calLe\ ancl cor trequence\ oltn?/r,úí,.r
.:.rri. r nLess thcrc nrc ìmperfectio.r iÌr the Ìrl)oüÌ Ìrìdrkei. it i\ not po$il)Ìe tar
: : ,lLiniiri uncÌìÌrlov.rent ÌrheÌr the Ìaborü miìlkeÌ i\ iÌÌ ecÌuilibìiunr. \nrce
:rll to clcn. lhc ÌìarÌiet. This i\ Ì1Ìerente(ìirÌ.ìn irìteúectlt competltìve
..: ir !rhìc]ì thc içage i\ \et ritheÌ bv emÌrloveb. b\'lxjrrr, or d\ a re{lt oi
- .i, irn cDrÌrlovcÌ a.cÌ union. Lrl)our i\ not Ì)o!glÍ.nl ÍrLd nr a !Il)t nraì ket
: :r!.rc.r!. rrag.:.r)nlÌrcts thdt ret the h age rbo!e the nÌaÌliet cÌeaìiÌrS ìe\ eÌ.
- r, rn :. ( hnllcr l, .olìecti\ e l)aÌgainnrg alielts i!rse settilg tÌ)r a rub\trnliaÌ
:: r,rrlrrs in Ìrost OICD countrie\ l\ee Appendi\'l!Ì)Le :l.i, ChaÌrteÌ + lor
. ::, ,Ìlìi.h rforkcÁ's,!g6 are c(^ered l)\, colÌectire brÌganììÌrS ìn tht flill Ìj\t
46

ot OLCD countÌìe\.1 lveÌÌ iÌì the:bsence ol unioÌÌs, problerÌÌs of motivating woÌkeb to

*ok effcìeDtì_v mean tlìât \\'.ge\ are \et b! enìpÌolcrs above the nìârliet cleaÌing ÌeveÌ.
ÌÌr lmpeÌfectì) competitive prod!ct nÌârliet\, 1ìrms sct price\ with a nÌark up ovei theÌ
costs. The Ìeal wage is therefore the outcoÌn€ of wagc and price settinii .lecisions acÍ^s
theeconomy.In an open €conornv modelì the pricc l€veÌoliinports wjll rl\o afiect líai{e
an.ÌfrjcesettingbrÌtthi\ issueìs not acidÌes\€d untiÌl.ter. Ihe tuÍ lectidr ofChapter i0
can be rea.Ì ìn paülÌeÌwitlÌ ihis section to see how thc openness of the ecoronÌy dltècts
irege scuing, pÌìce setting, ând equilibriu Ì uÌÌemphymeÌÌt. ÌÌì tlÌe impeÍect conpeti
rion modcl, th.lllll is the une ployÌÌÌentrate atwhi.h thereal wage is conristeDtwith
!hc rcalÍ'age expectatìons of both wager cipric€setters.

6.1 Wage setting

LJ I dcr i m pc rI.ct competitioll, there
upÌÌa.d sloping wage settiÌÌg ( WS) cu rre tha t is
is an
tììc.ou.lffpaÍ ot the Ìaborr nìppl) cuÌv€ in the con4Ì'titiye odel.llecause oflabou:
markcr iÌìpcrlcctions, the it.ite \ettiÌÌi3.!n,e lies alrove t1ìe labour nrppÌy.urve. lJì
lìig.2.lJ, il lhc Ìcal wage ìs eq!alto ÌrÌ, tÌìen tlÌe conÌpetìiive labour nrpp\'1s IÌ. ììut r,itÌ
laboLr.ÌÌrarkcl ìmpeíectiont. nr ÌliÌl be set at the lowerl€!el olenÌpÌoyment, ro despitr
tlÌe lact that an addirìonal number ol$orÌers (Ir lo)would be prepare.lto Ì!.,rkatthii
r,irge S1ÌÌriiarÌv, i I Ã = ro, therÌ thi\ ml4tt ol la bo ur is consìstent !!ith a rea L wage of 1,
but undcr inrpcrlc.r conÌpetitioÌÌ, .ì highe. waile, 1r,, Ìs s€t at that level oleÌÌìpioynìent.
lÌr n d irìon s i n th e ìabouÌ rÌÌa rliet are the key d eterninant ol t1ìe wage settiÌìit real s,ritr'
ln 1cíÌs ol mo.ev Nager, the i!ìSe setting €quation is

where ]r ]s the price leveÌ, I is the Ìevel of cn4tovmcnt and l, is. rìsiÌìg fÌÌìction i'
em]rÌr)vment. Nhen wâges arc sct by Lìnions, cmploycls, or through barilâirÌhÌs, it is thi

t!

E.

Figure 2.8 ÌlrÈ rr'à!ê rÈtt.q rÈa r.ì.ìe.: tue: lr,J.rrve à.1
 :41

:ìnÌrc!) iragc that i5 nred. Howclcr, h'orkcrs Í'iìÌ erahate n'age offers it
:
:i::rlrrigcoraLrhevaÌeexpectcdtndcllvcr-l.c.iljstheìnone,\'wageÌeÌatì\'e
: : :-::.i .onsunrcr pÌ1ce Ìevel t1ìat niÍc.t5 lhc stândald ol lìliÌrg and hence the
.-:r'ii thc n.lrrÌ ar.l expe.ted Ìrri.c lcvcl iÌc cquaÌ, ihe wage equatnü can
: :: ::nÌìj oi l.al ages to de1ìnc tbc upÌ\'ad-sÌoping irage jettnrg crNe in tÌre
:, . ,l:ig.iìÌr lscc ì:ig. 2.8):

L!1'! = úiEl (wage \ettingÌeaÌr.age)

-,, :: ihr..aÌ irage onuÌe LlJ cuNc abo'crhat on uÌel.ìbours!ppl)_ curve.ìt

: : : ìl.r mcnr i5 the ÍÌaÌl up ÌrcÌ irorkcÌ (i. ÌeaÌ teuntl.ssociated $ith l.bour

-:::: : r' lrll !. rp rctrtlon 5 ol this nì a Ì k trp, bo tÌr relvilS oÌÌ irrìp€rlect competitn!Ì,

- :: ::: Ìr\ unionsand

:. rs!.5cllLng Lrl hÌnls

.::: !.tting by unions

: :: ìrkpÌa(e5. !r.ì3cs arc Í:l through nesoiirtions bc(rccr lhc cÌìfloycÌ a.d
. . qniÊed modcl ol unìon Ìlage settnÌg ÌiNcs thr: .:ase ol lhe so calìed
:: ! lÌer€ the Lr!ìion can uniÌrterall! set tht h'agc. Thc ltnlon scrs tÌrc
: :::.rr\ij oì jts mcnìbcÌs, r'ho dre con.€nÌed Ì\'ith bolh thc Ì!aÌ ]!ig. ifd
: : dim\ nr strikc a baÌaDce l)et\reen (il tLìo hlgh a Ì!igc, Ì!hl.h Nllì Ìruslì
:. : :Ìt Ììnrì s producl âÌrd decrease dem!trd lor thc firtr s outÈ( end hcncc
::irr!ì jiìtooloÌLalÌagc,$'hlchlrilltailtousetheunion\rÌìonopolvpo(,crto
::r : :n! \tandards. lhis ÌcslÌlts iÌìtheruÌioÌ setilìga $ragc al i ilivcn cmplo,!
. : : ,: i: hi{lÌ.r thi. llìc coÌnpetitne rlate íthe diliiÌc.cc ls rclcrrcd to as tlc
r:: :::! \ up) iÌìd prodú.ct a potltirel) sLoped ì!r:e scllinS cLrrvc 1lì at llcs abovc
: : : rabour suppìr.un c. The cl€tâiÌs ol hoìr io deri'r lhc wiÌgc seLllnS.urrc
I \ ion nìodcl arc sct (trìt Siiphi(all.," irÌ Ch.ptcÍ.1nÌrd jn morc detaiÌ in

:- : :fìcy wag€ setting by firms

.-i !.l1i.g i!.Ìuite.htïereÌìt: her€ it i\ Êrnìs thiÌt scl Nig.s. lrst siqhl, ll ls
: r i that in cmpl{)!eÌ \lÌo!ld lolLuÌtârilv set a wagc ibovc ^1Llc ÌÌrinlm!m at
''tuiabourinrhemarket lhr argument ìs that b)'sctling a \!ag. abovc thc
....rh.,cÌnpli))eÌ1sabÌetoretaüÌawellq!.Ìificda.d.oopcraliv(NÌkforcc.
. 'i...r r{agei arise\ 1ìonÌ the notiüì tÌìai the Êrrr sc ts a wagc lh a I aÌloi\'s ì1 I o
i:..irsnrotivation,Íecruitnìent,aod,/orretentioÌìprobìclns. llÌcsc problems
. i: L is gÈ.ereÌlv not Ìrossiblc to specil! lrllt whal ã Norkcr docs, i.c. the
: ::i.: d\rÌ\,e e..uratelv the tolrrkrfs eilort. lhc cmÌrÌoÍcr mrsl thcrlfore
: .-: ::, nrDrilâtc the rloÌÌ(er to p€rfonn \!€11. tÌìc Ìabour nÌark€l tiithtens
^s
48

ÌÌÌore t! !n\'c thrse piiÌrlcn1s

dìlÍi'úìtliÌ tht 1ìrm
1.. ar unenr Ìrl,r) nÌc nt ieÌÌs it bccrrnÌrs
rhe Í\!r1 i' that
ì':.,.ì: ;;i.";':" ' """1-! Ìeave tÌÌ' íinì rÌìd 1ìn'1 \rorr eÌ\(!herc'
eilrclenc\'('ascrìscsas
i;"";;;;:;,";'"""t";Ìro1'etherorÌÌptÌltrrÉwrsratÌdthis Jlc.setLtrÌg
,,.""r"i.r',,*.,frf,t,ntsisthelciorca\ccofdr'evoíu'dÈrslaÌÌdtrÌglìre
(11!!e i,Ì.irLn'nc\ \'asc ÌÌÌorìeÌs
:i;::"';ì;:;i";:ì;.;;ì';;ro d..Ìirc r,1!ase !c,ti'g the
':a.
reÍ
i" tì,,.ii ììì" "u** 'to ( hdPteI Ìs an'ì'af bc Lìn'leÌstoorÌÍithoürreadnÌs

6.2 Píice setting

'I L' 4 '

set ll eqlrL 1o tlrcir rìargúÌiìl con:

I I/'-
l!
ú,r.
: I1
P
- v/'l'
\'r J DÌi'c to marl Ìirc prcíit\' Th' trark
lÌ! Lonlrait, !f.ìer inÌlcÌic't 'oÌììtellliur' fiInr\

.Ìrsti.it\' ol dcìÌÌancl ls iÌìLLÌÌi1e'

" iiii:'i;:ìì,":';ì;,";i.,,.f"1"'"'"p'r'' Lr'"' rÌo!ìts rI' nÌa\inr'cd lrhen Dì'rsiÌÌiìì
lI thc rabsL)Ìullj\ahrc ol lhel cÌanlcìtt ot dctrLìncl lr '
rc\ e!ìue is eqlrdl 1o Inarilinrl cosÌ ol I alì(Ì
(onsta!ìÌ marN up grellcr thaìÌ one
.rll.d eDsilo.I is corrstant. then tlÌcÌe Ìs a
.. rave Ltit sLa ,lartÌ nro'opoÌt Ìrli'úÌg l(trmula:

,1,-. Ì tt,t

arÌd tÌìc trire srltnrg Íriìl r'â3' !t:

\,fl

ri!2.9illLÌ\lÌ{tc5thcf5'ul!eiÌruÌ'lno'(Èn\case:becaoc.!'1'tÌrepÌi('leiliÌ19

erce\s ot tlì': Ìelr $ rse on thc rrtrour

n.l.'.' ìï.,,.""in,* lirant dcnaf'ì cLn \ e' t hc
cìenìrndc!r'e.b(\!.tÌÌal(ìnthc]lcu!vcai.n}lcreloìlDplo\rncntÚlÌ]esuternoln]al
iÌÌ the p(,o(Lcl
trrc iÌÌìrelreltconpcLition
;;; ï,ï;-;i"' ,; ,";i'e;nn i$o'Latcdi!nrr
lJ As rve
\\'e un'd horiT(!Ì1iÌl Ìi1heI Lhan d d!r'JìitrId tLopnÌg 'tr!!c
sÌrr!L nonìaLL!
conipctjÌion doe! nì 1r\'lt lce'l to J
hâçc rec.. :(it.hì!Ìg trlrtÌ pt cct t. ìnÌPcÌicct 'ìot
 -. :1.LrÊtf.rih. J/,1 :rÊirr.ÊÊÀt.trtil.l.n-nrl .nn tle l-\.1|re

'i.rL^ c ,\dditiorÌal d$ümirtion5 xÌe l!!(,ire.l. lhree alteÌìrattvcs âre:

_ ir! niì pírduct oi l!bouÌ 1s contta.t (fhi.h nnpliet thar ir is rqu.rl t() the
:-L.r i.d ihr nì.[l up is conrtaÌ]t, tÌr. tr.e settiìrs real Ìlagc is cqlaL to a
::.:i,-ì. nI Ìibour prod!cti!itv.
_i!r.ilprod!ctollabouÌd.clin.!hurthrÌrrlrkupì\.ou.r.r.1rLical(i.e.rhc
' : .i. is corplolnrent rlset then rhÊ lÌ\_.u^ e $ill tÌatte. Thc marli uÌ) would
:iiÌ.il lIlor er. ntÌe, nc$ entÌv rlrs cn.ouragecl bv a boon, heighteDinA
' i i!'Ìronìpctiti.Ìr.
, irt 1;ìejr plices u\jng â fulc oÍ 1lìu Lr,bi\i.gth.iÌtri.conrlÌeìÌaleÌâgc.osts
iir.5j.t.le i.É a\thcc.of orn! molestrom Ìe(\sioo toboorÌì an.tricc!ersa)
: :,,i!ll aho1ìat1en. Su.h. ÌÌoxì.lco(tÌj.jng rulcnìi8hrre5ulr ÍromÊnnt
- .ìÌ tlìe ertent nr rlhi.lì lhcv Dodif\ ureiÌpriccs | l.sponte nr.:Ìran!e\ iìr
rlid NitlÌ clÌrnse\ in dcmafd. lìrqrLent pict chânijcs in respon\c L. cha se\
ìri .oÍl! nì ttremseh c! lLhcsf arc the ni .aÌÌcd mc.u .Dst\ ol tÌic. .h Ìgejr
:
.':il ilsorriíÌn)aroi.ÌrhcDr ÍorsLrnlcgicrer!).!.
I
cÌpli.itl\ rt diiteÌc.t trtLcÌns ol lÌo$ thc ft:al Ìlagr nu,e! oçrr tìre
ng
: :::ç hurinr:s! .rcle oÌ rt the jmltÌi.atiors oi {ÌrpÌ) sidc !oli.ies nÌ ft:al ase\.
:.(Ìr\jtÌcÌ lhr more SeneÌaì dos,nwaft íopini{ /5.1i^c. 1n otheÌ .asi\, it ì\
: :rtnrÌrLaft1to !se i tht fi crLr.c.l hc llat 15 cur e oilcls i useiìt\inrplìtì.ainnl
: : rrrtìLrs thal firin\ do not changc llìcii prtces i. ÌcspoDse ro ilu.lrLition! ìn
:::!inerltho(Íass!rÌÌptì(ìnolstickrÌrrj.tsjI]the\hoÌLftrn)rrather.Lhc1,.lìtìnge
:..(!nrrvhcDÌh.ircostschangc,..g.isi.onie.Ìuen.colaclÌânsej.ÌliUes.(ìr
: r:.ìL.le a$umtrion thrt wage chrngcs o.cur retatúclv i.ÍrcquenrÌ\,(. g. irr the
.,!e (ür.t oÌ thc periodic rvrgc Ìclicl! tn the case ot iodlljdual conLradsl, it Ìs
:.!r!ri tÌrat fmlldc the rÌatrnalÍjggrÌ orthÈen.lolLlrcslÌortrur in LtìcnÌo.let.
: !rrreÌiÌìe ca!c, ilr !se \imtle ass(rÌrfLions to .ÌeÌjr.r a flat 1,.\ (ru c: n cüútânt
:
- rrocllÌct and a .onstant mnÌli uf. Gilcd the\e astunrplnÌÌs. it nÌDs set ttrìc6
:! r !|ÉcÌhc troht m:rroiÌr, rì1cn th. jlxed arroufr oI ortput ])eÌ i,ork€r j$pÌ 1
50

nrto tÌlo fiÍs, tr.lrÌs fìrr jrorkcr and real $ages peÌ woÌk.r. Lhr reiL llage Lmtìicd b!
pricnrgbdrr!ioLrr 5Lhcl.lorc.nfslantirrÌdthelScuÌrei\fa( lirìce Jrttilgcan rhcn br
5rnnmiÌ LTcd as Lh. markiÍìg út.t unit labour cost\ b! a hìed p( r.rrÌtaire, /ì iÌrÌo.orLn.c.l
!ì1ew)ìrar) or u. it laboLlr cosls,

f = l+, (ï) {naÌli up pri.irÌg nüel

(rÌcr. unitlabourc(Áts {retÌÌe c!\t ollaboüÌpc. !nit oIoutpLúi.e. Ìr' : I dtllded bÌ I

Wr d.tìne . loutÌrurltr s1ìrÌier d\ I (Ìanrbdi,labour pínlu.tì!itÌ).
It is lÌ.ìnl\.t() e\pre$ the maÌN xp 1ìr a nighLÌ_1.dlll( rcnt r!.Lv ÌÌheD 5erLj.g up rhe nÌacio
üìodel.llselet/, = iì I +i,l,thenthctÌl.i.gcqualloncnnbeÌ!Ìittc.âs

/, L. r\
lPr .(' s€ttjrr! equrtn!r)

wherellereleìtoIe\themaiÌ(utnoÌnf.r'o..ihsnrcan\thatr\thr.ìÌcotoi.orÌÌ
petitiuÌiìcedbvthenÌmjrcrea\es,thr!i7co thcm.rkupt.ìLl5 Di\ìdingc..Ìlsidebll'
dÌ!iÌeaÍrrgúg. gil r!

l:,, ,I .\ I l'1'
otrr|lrt f.r h.ad : ir.iÌ p.o1ìt\ per he!d +.e!L wrg6 tÜ |c.d.
l.ôLhcr Nods, iriÌ en the rnrrk up, the leveÌoiÌabour frodú.tir itv. !n.l thr Ìronc1.r'..{e
thctri.clrrcÌsctb!hnnsirnpli.s.spelincvahreoltÌrcÌ.rlNirge.lhiii5thcÌrrt..scitiÌì!
ÌeaÌNigc Gcc li3. 2.Ì01:

.'^:ï .\ r1 /rl 1tÌjcc srlting reaL $agel

rr ',r =rtrlprol L5ln,rÌr..d

Figure 2,10 e!..1_:Ìrn -;.,i:.Ê.Lrfe Arlrnl

 51

: -i .:rn::rr.rr liÊn !.!.ìÊ1- tlr i r.r r,. r

:'ium in the labour market under imperfect competition

:, :r .:Ìrì.. iDtrúe.l .onìlerjlion n .lrrÌacter zed h\ ar upr,.rÍì slop n{
:: ì .lnNn(r.ìÌd slopìn! 1\.!n.e 'lhc hl).ur nrarker is jÌr rquiÌjt)ij!r])
:.: r. s!.erig 2.1|l

, r =,\ Ì /rl
(Iìbour nraÍtie1 rquitjbriuDì, jrÌperÍcct.onrpctilio.)

: ::: !,Lr eqrLjlìbÌiiìÌ.lc!eÌôfemfloymerl Lr(.r, rfheÌ.! r sl.n.lstor.nnt.,r

:jL,itib.j!nì . 1.he as..j.re.] cqujÌibrjruì Ìite oI uenÌlroÌnrüÌt
: .rL.l tr LlÌe ìaÌrour icìrc. irhe
: : ilrirr pri.es ir!_ jeL stÌâ {lÌr rllcÌ hì8es (i.e. hjrhour a hg) meiìl\ lhàr
,..rrt.,

,, 'r i"
tr.n. r, :! ,r
,;.,, ,.-
:::,ì irlr Lhe r,.Se jncrease r.d rhc c(onom
:: ìi r,., rh.:,co,!nv,s.",,,,,'',,.
",";,ll;::jïïl:,j,l,"iiiJlfliïi
:: rlÌe,'!ujÌibrrÌÌr It lollo(s rjralj jnpr.c5elturÌgrlert üÌrÌoclu.e.t,
j rii ìi! in bchLecn thc ll;! and II (unalse\.
:. lÈLr\eÉn re.onrirerìrhìe and inrpeÌl!.ül! (on]perÌ1i!e.iluiljbrirm
r. ... ..,.i
rates

,r ,i-
"., .'''I n',
...r.,,. ,t
,. ., ,t ..,.
52

LI

Lrt

Figure 2.12 l.rieiÍ.ì LieÌ.r.f -":i

ìi lhcìt is imp.Ìltct.onr|etiliot iI t1Ìc pft).ìuct mrÌÌiet 1\'lth irÌm\ nuking 5upenÌornraÌ

profLs, workcrs ltiLÌ lìl: faìl kis thrn thL i. nrdrtifâl ÌrÍrlu.t.
lltheÌ!boLirÌìxrlrtlsitrpÜltctÌ)conrlctti\e.(tnernÌ)lol'nìLrnlatiheI,rllequiLibrl(tm
ri1\: ol uxenrflo\nì..t] 1\i1l ntceiilrill inchúe í!ìe iÌìtolunLu) unc'ì|lovnrrrrl In
.(hcÌ lroxl5. thrÌe r' ll be nìdn nìuaLs prcÌlred to lake a iob iìl the soiÌìg í'xl rldiie (nro
Tht hboLlr !utÌrL! j'di'âtcs Lhc
iì r. unrtik to lrnd.r !a.:ancr. How lo \tr k.o\! this?
'urrc
rcâl i{r!c ,rl (ìrì(h in in(iiliduaÌ ir lrrPired to it.rÌ SilÌcc th' Ìabo!r sÌrpll} cur c Ìlcs
ÌrcneatlÌ thc (agt n1ljnS .!r\ e, we lnl:Í! that tlcÌt dre peopÌc tLh(ì rcÌrld be ÌLillnrg t(r
iro ( dt Ìhc,crÌs iìgc, I I r, r'ììo are Ììot cnÌì(ìlrd rLhen emplolnreÌú is cqulÌibriunr
'1Ì1s

thffc i\ nxoÌuntrr! L1.etÌrlo) nr..t at Li' .. it ìi not iÌìc'iderÌ'r!t€ íom a Íeltilrc

Sinre
tlÌaL lje beiÌilrd
fc6Ìrectì\ c. latlÌer glten thc initit!tio.s en(ì pra.tice\ iÌì tlÌr r'ononÌ!
the Ìrag. n..l tri.c settì!Ì! .utre\, tlÌr / rìLI i! 1lìc unelrplo!nrcfr Ìate thnl
'on5titrrtes
anequiljbÌLuìnìÌrthLr\etÌs(that$agcn.dtü(.sctter\hl\cn'Ìtrí!ÌtÔclìa'getlìrir
behr!i,)11r. The Ìrlit het\\ec. invohtrÌtifl anclt oluntrrl urÌeÌÌrplol mentirÌtlì' iÌnperircl
corn!ÈtiLl.n modcl is 5hosrr in tÌrt diagraÌn
TtÌ€ cqLrjlLÌ)riunì rite ol uilcmÌ)lornr..l is tlÌc otrtconie cú 5ldtdltraÌ ü sufdl rldc
teat!Ìrs oi lhe e.onom\ thrt Ìie lelÌiÌrd the agt settiÌril .rnd frite tettiÌrg 'r'tre\' lt
cdrÌ tlì.rcIoÌe irÌ pri.citle bc chrn|ed lìl \uttÌr sidt Ìrolilie! or 5lntLtlrirÌ'lÌi'gt\ tor
cunrÌJ1c. dìrnires ln Ìcti\lalio. to ile.rkcn tradr Llfjoni coll.l Ìcnd tr) a redLrclion ot
uniLÌì bnÌgainitÌS !ìon eÌ .!Ìd LhÍ ito!ld ÌoNer tlÌe cxfc.ted rerl sligc that couLd bc ncgo
tiated bl lÌoÌliers nL anr lclcÌ ol urÌemPl,)lnren1, lolLtÌìnil l]11 iÌnd nrìftiÌÌ8 1lì' Ì1\
cu e doNn. Illlding aÌl rnhcr fedtur.s oÍ lììe t.orìonrl c(,Lt.ìnl, this tLouLl 1orço ürt
eq!ilìbÌiunr r:ìtc o unerìploltreDt. ,\ltcrnati\el), a. incÌedse irÌ thc {Ìegree ol pllnÌLÌct
nÌiLrNcl.onÌ)eÌition t\ar.sult,\al,oi.henge\iÌì1h.atPÌjcaiiono.oÌìfetitioÌrpoÌic\
or bccnLLsc the irÌtcrnet nÌnkc! it ta\iel to.onÌtre pÌi.c\ worLl lÌollu'È a Ì(\!rr prÔ rt

].lan.]i.\|].ít..ì.idj:IÈl.]t(l|Ì!Ì]|.Iltlrì.]l]\.]il]L.\llnl\ltr]]ll]],]
n,r.dlirì! \'r,nÌ 2r:l=ijj
 53

- <: reâl \!dge aiea.lÌlereÌoícmfÌoÍnrcnl (lhcl,J cune rlouÌd shilt

- Ênnnent Ì)olic\ ch.LrÌge thar atl..ls Nagc- aÌÌd price relling out
\
: lrrilurr ! rÌenrplo) Ìrìext. loÌ1cjcs Ìcìatcd kr uncüplo\ !rertbcrclltsj
: r rrod!.t Ìrr.rket re8!htidr an.l jrconrcs ãc.ods are aÌÌ ìeleçafl lt
- : : :hdt jrÌt€nÌatiur.l dillerencer in toìlcrand jn lìstitutìo.âl 5t.rrc
::::rci ìÌr equilibúÌ'ÌÌr !rÌeDrflovmrnl. Ì\c rcL!.n to ànaÌ)se sutplt

- : : ":3 ate demand and âggregate supply

:i. trorL- a.d nrcdiunri!n nì.croe(LÌnnnics, tÌre t(1).onponenrs

: : i.d.utplt'iìrcbrougÌrt loit.therusìrgi diagrarnÌ!1th rhcÌrrlcrl!\eL
. : .l .ulpul on thc hoÌlTontal ône. \!e ÍruLlrÌot rraÌc r:xlcnsi!r, rse
' i h..k bc.aLlsc il is not a pani.ulìrll Sood Ìra! ot enaìrsin{ iÌocks
j i Norrlr ff , il docs icÌ1 c i.oude ol !setul p!rposesr nÌ51, il pÍrlides
::ì. hür lhr pri.( Ìclcl ls dctennirìeli aÌ \econ.lit ÌrÌolidcs inôther
. Ìi. nrodcls.af bc.onìpired.
ln
.:::: demand: from the /s/lM diagram to the ÁD curve
_ ir nrerkcl cqullibÌiunr conditnÌrs ca Ì).. irrn\fercd 1o. diagiun
n. ÌÌr. \c.l .il alls rnd.)utprìt orÌ the ÌrìÌizoltaÌ aìis ln the top
I .,.ú..uJbcginsalto n1,l. (\olethattlÌelì1cur,cii nderedlrv
: : L'r. i1ììirh mc-rìs rÌriÌ1 rhe p!\itidr.lthe lìI cur. ts ÊlÈd bv the
:.hn€.]bl +.1 \e\t, we hol{l thr norÌÌirÌ.ìl nì.Ìre\ nÌÌt_ï.onÍant
. l r'| rl .rr''r'r ,l{J\
. r rl . ol th! re.l ÌÌrc!Ìel büÌances i.
rhc ha.ds of the publi. crcarcs
:_: nronrvmirletr \!ith tooÌnuch mone!'. hotrscholdsret)dlance rhci.
'.lì.,nd5. I his pushes !p tlÌe bond tÌice a.d lo*'crs the ilteresr ÌaÌc.
.: i f.clnrsrfilct'.1henü!eclLìiÌibÌiuìrisarfoi.rrlr!ìthlÌigheÌouqrrl.
r'r a ll irr nÌapped iúo the diaiiÌaD ben.elh \LiLlì /, !n the \ eÌtical end
r : :\ j hi..onìboìc.l glods and nro.e! ÌìrÌkcL cqrilibrid nr .itlicrcnr
: .i ìÌrc Ìl).!rreisslìôÌ\n.lttìÌlo\'slÌoÌì thisdclÌlatnÌìtharrfïLhtng
' r \ í.ul!es,i]p.ìÍt lronì. clrrniie Ìn th. ÌrÌicc lcrcÌ, íÌi1Ìs the 1l ) cun r.
. ri i ronrpLctcll,diileÍfni .hdracter Ínnr a dcnìand cu^e in a nìtclo
i: ;.Ìr.r. thc d('Ìrand .!rrc rehtes the quntitl dcm.trded ro rhc frì.e
.:ì.d L!.r B! contr.n, lÌrr.lt) (ur\ e repÌrsc.ts Lrro sets ol equjìibrÌunl
:.:i thc tÌicr lcçcl l, chanÂcs, it clisnnbs thi: .ÌlulljbÍiLìnì in the nìonc\
'Ì,.! : ::.:tÌi arhânilclnbch.riorrthütleadrthc inLf rcsl ratetuchangc. t hisiÌì
r: :il..lrrr 1,.n.:.lI:!d rlrrÈl.re !L\ ÌJ!fr)Ì\elillr.\ rr Ìi\
nìerr |Ì.tÌ,erÌ,1!ln
.: :.:riìlrn.. Ìr\ ldIr rìrÌr1 jn.oNrr nr rÌr rü)irffÌ \i]{ LÌrij?.:rtÉ trt
ÈLLrLtìlLò
r' pdrÊ Ì.!Ìrl..r r.t,Ìrfr1 a !ri.Ì r.r rÌr.rresn st.n. rA
54

Figure 2.13 u.'fr! rhe ÌDr!"'rÈ

clÌnngcs 'ìs equiliìrrium ii

goocl5 ÌÌÌnÌkct âncl
[ÌÌtr .reaÌes a .li\cc]uiÌiÌrÌiLun in the 'utl!t

;:::ï,ill j:lÏi:
,, ì:
ï:t I
jÌÌ,ï,i;:i;l::i::l:liï'.ï',il' j:
lïl jl* jt* ;:
I
ìì"""""'*'"'*"'p'-"'
:li::;ìïiÏ:::ìfi:li;:l::ìÏi:ÏJ,iï:ì,ï::::.ì'ì,,':
'"ì,liïïi::,ìÏi'l;,ïÏ"iÏÌ,1iil!,.111;; q1r;ll.ï111t,i,.,,.,,i",:,.i'ìï,,ii:ï:"ï'i
rhcjL
;, , ,
ïïìifJììJlì::::::"1',,:1.Ì:ìl::i::1,i"ï;'"i1,"ì"'"'"'''"''1'ì'in.n!
,
'..',ì' ^
1
 55

:!.iÌr rherr it is repoúed thal tâÌljDg trjct! lcad

:rrìi.t.r1ìdr thrt pri.cs $iLl t.rÌl ever lLúlher: .onsuÌÌÌptidr is

.: - c plyr ïrom the labour market diagram to the Á5 curve

: iiriuÌ maÌkcL cquiÌjbÌìum cin iiÍr br tr.n\lürecL nrn) thc so
r rÌr rhi()Ììpctjtireen(1 nrprrkcth'.oÌÌÌpetiti\eDodtlr, thc.c
.r.l ún\isLcntlrith laboLLr nliìrtrict rquilibrírnÌ. The nroÍ rL1.
. .i..Li t.J rc.vcrt rhar le\ eÌ ol..ìp o!nÌcnt nìto the me.Ìilrm ru.
.l 5jncc rhr ÌâbouÌ maÌkrl cq(r libriuln i\ dcÊned nÌ ÌerÌteÌÌns,
.ì.ì f .r ailc(Ì rhc c.ÌuiÌibÌirLm.
r i. r,i\rfcÌcioÌclrlÌjcxlrt,rr.orrri,whj.h isittlÌeoutl\úÌe!.1
: :: iìr .rn b. inrcrfÌete.l as Ìr:ÌrrrÍ.1i.9 r.lllìcr ihr .oÌnÌretitlrÈ
..r tilc.esc. A rìghrwâÌd !hilL iD lhc iì8gr(Âite denÌrnd curc
-,rnì.L6..fsrLnìtLio.. ioÌ crarn!ì(, lfould bc.ssociatÉd wirh
. - o.h eL thc rLnthrngc(l r'. oÍ r r-i ìl ihr pricr lereÌ ìrnÌÌr\ tr]r
_i - LÌr.
l.ofodr! stÌiieht ir.nl,1 io Z
'norcs
r nrÌrcdialr idiuslnrcnl oilregcs i,rd pÍi.es ls sÌlnÌnrrirecl Ì)\'thc
' ir.r1i.rl ì!r1r11,. A. c.on.,.ìyoIllÌisNLÌd i.l pr,riencet ÍÌuctu
:i ::..ns.qu.n.cot.hr.gesof (hrn,pp\ 5id!.s Ìì.elhrctLration\
: i: t tÌrc |D.(Ìrc it.c. hscxl tôli.!. .rin.tiìrr potic!, or trnrre
:,::t.ts lhc ÌrÌ icc lcl ÈÌ but not."lltLl ind lnrllo!rÌì.n1. \\'r retrnr
: ::.1. rr ÌooÌi moÌt cÌorelvxta nrodcL ol busi.rss.!cl!s $herethÈr

r:ches to business cycles

,: :Ê!s Cycle model: supply shocks
:.nitil]ns io.Ììrplo\nìrÌrt thrt se oÌrte^r in the c..noÌÌÌ\ rj it
i., rl]onì,r.d ba|.lafrlf ircdueprÌeh nrmptlv sid. iì.1lrsrìiher
. . i!g.rSrtc drnì.nd i\ .cntrirl tr) the !) .rlÌe.Ì ÌìcrÌ ìlrLsinrss (l\ cÌe
i t:,d!.. thr l.bolr miÍkri is r/Ìrnri nr ÊquiÌLìÌLuÌÌ 1\f ihrLl \ee
. I ilìr 5liuiìtiorlinn nìDirlirÌ lÌich thebu\1ne\5ú.lr is dri\erÌ Ìr\
-: ::L. tr..ì.ndrthrreirÌ.ì booor,exÌrÌorDent jr:nnnc lh!.cq!ilitrrilim
. ì ln\ nìLnL ls brliì! i1. 1lì the lìBa: nr( tl. Lt j\ sLLtÌì! side t.lctlB
LÌrn.l.g\ lhel drilr thr busirì.,$ crcle Tr) sre hoÌr lhi5 rorl\. Ì!e
i I Ì i. th!..on.nr1 i5 lnlliiÌlh it poirÌt.ì. A ÌroritÌr e tc.lr.ol.!! nrr.Ìi
r:Ì:,ìr xti.f. tÌrcn lìi115 (hl nìir3irÌaL Ì)r uctoiÌebou..!nrtorhÉ
: .: ri t.o.r)Df nr.rcs ro ÌroinL /r':tlÌi\ i\ a Ì)oorr. ThÉ ôffortlnit\ nÌ
::qr n:Ëri as i .ofs.rtu.n.r oi uÌr ne$ tÈch.olosr. Ì.ad\ uÌrÌn nr
ÌrL.ìrmrrlnìiLi:Llrh,ìr:rllìrL:illÌLUrlsrÌ.r
Ihi,LFr:i Ì.iLL:k. ìrL : .irÌ,?rr.rrd,L
56

L
 57

Lllzlr
\uÌ,

.-. . :r.i:ajr:! Ì.rÈ .r! ! L nttrtrit!údr:'t"rnrlqls_"1:

:\ úÌ.'{ lbe Lei(NaÍl slriìt in t't oì hbour (rìn r' $orkcÌt

tht nìârgnÌal lulÌ
: .\: liìhoxÌ. W()r|rr (lìoo\e nr sìrìtt 1lìc tìtning olthciÌ {l4rh of ÌlbotrÌ
'. .hiil; nr drÌnaÌìd h) ì!oÌÌ.nìg Ìì(re if g(xxl tine\ iìnd less i' baclÌi'ìc\'
: : rÌLt!'rtcnÌporal !uhstjtLttion oi laboul
: .ÌrÍcmainlceÌ)ticrl.rbouttlìci'ìeathit

: : :.!'r rr. tlre donrlnaf l ítrÌr.c ol bLrsiness lltrLtLìation\ aÌìd that

"cÌe
r :. irr tu.ely 'e! ullihúÌr rÌ PhLn.nenn

: ::: Ln ( hr|t(rs 1:l i.cÌ 1'1' technoÌotlc'Ì cha'lt pLals lhe l€ï rìe in
. : _Ìrr Ìong Ìun'rfin!th t)l Livlng nandaÌcìs Horeçcl iÌ teenrs Ìe$ pìeúsìLrL(
: i LÌr tl. tate oÍ tech.ic.l trosress lie b'hi'cì 1lìc |att'rn ol lroomt
and
.:.Ìrrr..t.Ìize cconoÌì!ei. \{herÌ.n ecoÌÌoÌn! ('overs iiom a l"'$n'r'
t,
: rÈr er. th1\ docs rÌol Ìnea. that it is teclìni'ai 1:lìa'gÈ tlÌiìl i5 causing the
:r:-::it!Ì isinÌplcreÌplanationconsistcÌrtwiLhth'agiareg'lcdcnÌ:ndìrated
\rorkcrs iÌì
: i !, .\ !l(s it tlÌnt 1!Ìrrn aglrcgate lrrnand lalÌi' firms hold on to
::. iÌrr Ìr'rc$nxì w1Ìl bc rhorL li\e':1. ll 'o:Llvr5 to hiÌe aÌÌd lte ilorkcrs to
:: r:: Lhis s'iìÌlrodÌirc tÌrr ortcomc that producti\il,! ÍaÌÌs
ijfÌibcerpccted.
:, .'rÌ,Ìo\ mentis Ìecìu.c.lb) lc*thar'trtPu1 iaÌÌ\l andÌi\e\iJrhoonÌs
- I :5 it is .Ìear lhat ilÌ the RBC ìechaÌììlnr lo bc ibÌe to cÌflanÌ thc strì)
: i:::,.i iì cÌìtÌo) Ìncnt thal takc ÌlÌa(e otü thc btr5ìnc5r c) cle, n smrÌ1 'hange
:!r ìnì51 lerd to a hrgc chinge irÌ thc tupph ol Labour, i e lhc lal)oÌir n'Ì)
,i\ i,) br \elv dani. Ìlorçcver, this.loes not hl the en4rìricâÌ e\ cnce'
i llrrt,'Òr lÌre nìâin e.r.ei in lhe hoLlÍrhold. the iIìlcrtemp'iril eld\ti'l1y ot
: r r ir!!!iL.Ì(tr\.riAlthoLtghthclBC.plÌo!ch lsuol
(hemdi!ÚtÌernr\i$roi

:ii rr:ei?.Ì, diÌÌ lÌi Ì rrrLÌ n.i lr 2002r r.d ur Fr.rì'li lÍìl)-
ìlt:liï::'llìlï:ìl;::i:,'"'"ii"lÏ;i:ilïÌ::lïi'J.'.'J:,::ìì:ï:ì:llìlÏii]Ïïi:'lli
*:l':::" '""": : ' --" 1
-:
'r1:'
i":"': ,
1
, :ïll:-
'l'' ,,' .,
,. ,

rïïïïrïiïrï$ïrl$ïtffi ìï.*ï'',*ï
::ìl'l',:ï::'i ll l':lÏH:lillì l"Ïl::llìïì

t*l*ffirffiffi'.,''i'ffi
'lffi*l-ïs$t$i*[ffi;; ' '.''
.,;
': '' tr . : ; ' ,"'
','

' ,,ì,. I i: ,'

...""''l'
ìrÍtt-*-*:* *'"iï'ïrïrrï:ïr'j'jl"-,'.ru,* ïÏi.1|
li:.,li'ïi;ffi r,,;';,:.,, ;,** **i:; ." -,,-..:ìnrh:
. ;
rïrÏiliiïii;iiït1ffi
j,ì*ï,ir:i;l: iìr:ilì:iiiiiiïÏ:

iiÌji:rïiï ìrÏiïÏÌ i riliïÏ: i'"''" .*'' "

:' :':" r :';rr'" "' ""n"
u'"''
 59

. :jhÚ !ricc ìcvcl it jnct)rporalcd inlo lhc .c:it period s tabour naket
.:1i. ..rll\. rhc prlcc ÌcrclÌises to /) ard rhcJ,l.\lP li: I .rosse\ th É,,15 cúr'c
r ,nì is rcsLorcd in the lâbo(lr markd
i :iÌr.. thc tvl.Ìí ÌnodeÌ Ls .onìbi.cd Ì! lh slúgg sh âdju\tneÈt on the
. : i!lL5 oí a lositjve aS nrock arc as loÌlojril

. : ::. tr) the Ìight rtrrl o!iput and eDtlovnient úse wiLh Lhc pricc nnd
:,r.t.ge.Ì in the \hort nuÌ. Thìr is a bü\nresr clcìe b(únr. i lo arÌalrse a
:: rhrrgh the ca5e ot a negatn e IS thock.)

: rr ith : :::.,irei. ther. is d scqúiÌib.iLun and.ventualÌ! r'iges ard price\ Nole jn

:. Èr ellerdr nr tltrn to.r reductnD ir aggÌegate deìÌard ria lhc'Kclncs

:-:liÌÌi{
:,:-:!repri.elelrlofllìchaslsoiÌ\ìÌìchlhcÍbcÌìnvc,wlÌiclÌnÌjft\the5,iS

: : .ttuLÌjbrlum ls ìedore.i 1íìth unempÌovment atthe llLi ahlglìcr Ícal

. : ri i.ha.ge i. the conrlr^itltm of outÌ\rt iuì ì.r'eslnìcnt lol io this
'. rÌr fl .nl, a..Ì a higher pÌìce Ìerel.
: .: ..ÌiÌe it i\ irÌiereÍing lo .ons er í!o poli.Í (rlìerijnent! | change 1n
:: .t\ i ppl), ìí'ind a ls.al cnpinsioÌÌ..\ monctirr! erpìrÌ\nÌì nrifts the
. :: :::- Ìlr(! r.tothcrighl. lhc ncr, Ììi.dium-ru. cqLrililrriLlnì is at dre tÃU,
, :. .rr!Ì! Ìted,.nd lhc pricc l(vcl lnd nominiÌ r'agc le\el ire higheÌ. Ìn the
- .:r: :1ìÈ l]etr .nd old .qLrilibria conìcide: the impact ol the Ì(reare on tÌre
:: -ìÌ: ihe l1!,1 cu ,e Ìs rcrÜscd by the srbslqu€rlt rise nÌ the pri.e Ìercì. Bv
ì1 at ::.: .. È5caL eripansnrn, oÌúput rctirrrÌs in the mcdium Nn to its lnltial ìelcl,
:r :riiuÌ ir dilÌereÌìt is lhc hlgher !o\ernnÌent spenlirrs cÍrwdr out soDrc
...:lt : .:: ' r :ri\.Lt€ cxprnditu.c.

: a:xclusions
:::.:.Ì\Êh.ìreconìeq!ite0liÌìit\!ìvüÌsetting(núanracÌoc.onomjrnìodel
::-: nre(Lnun NÌì tìrÌil)si\. We ran srurÌÌnaÌize the hn.lings ol thc .h.rpteÌ as

r:tr\
..i.,:: r'ÌÌ, the ÌeveÌot erììpl()vrne.t and outfút is dcLcrÌìinrd bvüÌe lelelof
:irlt . -.rrnl. slÌiclÌ i\ rnaÌ)sed usirrs the tJ,'lì:r modeÌ. Thl! IncaiÌ\ that l)Lìrnresr
- :ì5 aÌìd rece$ions, are due t() ihìctuâti{)ns j. the Ìcrclol.s!r€gate demxnd.
: : .:rÌ\.ìlle(t enDlovÌÌrent ând outplìt ÌrÊcaost olth.: .omìnirL rigjclitìet nr tìre
: . Ìlrr \ticliÌìes\ ol1írires and ÌìÌìcer.
: -:!LLn j. Ììre Ìrbour rìaÌl<et occurs hhcrc thc libouÍ nìpplv an.l Ìabourdcmind
: .. Ìn a c(rìpetìtjve cconom\ ând srrcrl thc pri.e settirg and r,aijc Ít
...: !si.animteÌlectì)conìpetitircc.orìoüì!.,\tthrconlredtneeL]liÌlbrjunì,
60

rnr ú.rDfÌt)\nr. nl j! r!lrtntaÌ\. \ hÉrfnr at tht j.rp.r i!.tÌv conÌP!Ì llr r' t!ÌaiÌìbÌnr ,
tlÌc( i\ a D]\írr !' o !oÌrÌrrlir and irÌ\ Òlu.lxÌl un.nì11.1 Ìnent
.1|r.lrìge\etti|!.aneL['siho\etÌrelrLroìtÌ{rPtLr.!n.in.litNiL]LÌ(iurLhdahi\r
jtilÌegreLcrrrellrr Ìì!túr'.Ll.f\j.tÌrelilìoLtrnÌarl(l \nriliÌÌr,theÌ)ri.csr:ttiisc!r\(
lie! Lìel,Ìr thr lrrrgi.âÌ tr.dú.1 ()l la!iüI cuÌ1t arÌd n ]LÌll bt' tuiher beLojt Lhc giertÜ
aietlÌ(fr.{ÌuctnLìÍkrtitLÌìrr(.lLonr.l\'iilìhlìf ÌlÌ r!r f ( Í1tr1t nLrrlÈi irì Pr: Ì iertioÌs
rberq!illbÌiunrunr'ÌìÌìÌ{)\ÌrrriLÌatri\ÌÌi!lì!'Ì lhìrÌtlÌ..onrlilitntoü. \LírcluraLtìnd
i.!tinrlii.âllÈaiurc\oilÌrelirb.rL rÌr(1ÌrÌodu.LmrrÌ(etsiLì|.Ludi.g!(^enÌÌrrÌìL(gtrÌatioÌì
iifr(ttlÌ. lnftìr Ìr.iituÌlrl lh.: Ì15aDdlrJ.uÌ\t\'
. The rFsrtetc deÌìr..d xr iìSgrlgrlt {ÌDLt rl.lct oi ut nìod.l c l)uìilh( Logtüer
ilr th..ìD.11 moltL. tlndÈÌ nolÌìnÌ .lÌ.rìnÌ\tnn.6 tht 11).rrÌr. jt cl.snriiÌÌd rÌ(Ìj
if! hccru\e i lo\vtr tli.c Ìtttlkidr tt) tht drel.ÌrciÌril olÌìrrlnìli(tr rnli iì ill ÌntlÌi
ìnlc c5l rai.. Ìrhr.h \timtrlrtes i.Ìnn{Ì lhÈ il) llÌre i\ t.rli.al il Ìhere is e Ìiquìdit\

.1h.Ìt'ir!\rItllrlì!!Ì!'grlemlÌrL].(tÌ1edt1lìcl'1cÌot'Lìtl)Lúnií)'iateclÌ!iihlib(Nl
rìurl.l .iÌuiLiL)rj!rn Iil)ri.!:satdür!r5a(ljuitjrfÌìfLÌirttL\toiÌì\eggÌegrtedLÌnìnr
\lÍÌ1, Lh. c(.!.nr1 Ìn!t(i reÌticrlL] rLl .Ì !loÌrn Lh. ÌJ (!rc lfd u.eDulormc'i
ÌeÌÌàiÌrs rt the lilr ll)rr\.Ì.ÍtnonniìÌÌ-!rrnrrrìrlhtÌei\rÌ()iìdju5Ìnrcntolriìircsa'l
frìces i. thr dìorl uì \\hr. adìu\tmfnt.ìot5 l1Ì. ÌrÌace.
tltr'c.on.)m! nÌlt(s rl'nr-
itre j,ì! .ur!r ü rl.h sh.tis iìlr sr8.s âdjuJt gì\Ìn Lhe lrt tÌi\li.! fÌi.t le\.1 trjct'
aÌrr55rmedto.diúlnnrn.dlrteh.Llt.rnage\ lh. ilJ\hitt\upÌLiìd!ìn!ÌtÌÌee.o'om'
e\ür1('rjÌ) Ìeiì|.h.\ lhe l!Ì.djutr ruÌ.!(ll,brirìnÌ.
. !\:ìc. Lhee(inôÌnyi\ n lâhouÌ nÌarliL'L cLluìLibrl!nì rlthelÀL'ì lh.trieliti
it tlÌe o(rLf.nìe ol (hc tr(tl]6 tlril .leterÌrìi.c rgstr!iì1. dL nrand rnd rSirrr!ate nìÌ)p 1
a \hilt of cllher siic mtÌìis e .01 fri.e L!'rfl rt Lr!ouÍ nri li.t e.ÌuilibriLrnr A l
'hantc
tÌÌe ÌÌÌ!n rt mÌÌ)L\ kid! nì a fcrr mc(lün run.quiÌibrturìì .lìirr.t€ri/eclÚ\ ,r ftlÌt ch!ni-:
iÌr tlÌ. prl.e Ìe\ rl \!lLIì n().hengr Ln eith.r I hL'lc\ tl or.orÌ11.trllloÌì .l o!tLìrL1
.llÌ(i..f!nì\flr.1tratesirÌo!ndlÌrelìlrõrrtnìLt!lslrlLslnrggÌesrtcd(Drn'
1Ì e. lu. LÒ lìltoL ìf.orÌr)ritcd lf llre Íl oI / 1t 'rrÌì Ê\ lrLr\i'r\i
'r'le\ rrc 1ÌrL:Ìci(rr'
!ìi\e!Lul ib,iunÌ Ì)hrn.ìerÌr l. Lh! ferte(tLt .ÒnrÌrttitì\Ê t.on.nr\, .Ìl!rnìtnìplo\Ddl
lÌeÌìtr.r.oÌrÌÌÌ\lratuÌ!'\riplli\jdee!!illbrjunri\\ol!.ÌiÌ!:Ln\o[uúrItLLf€r:ì
tÌ()\ nÌ..l iÌ6e\ ìr(trt Nn rih.n .ì t.lÌÌin iìlgÌelrtt delìiÌrd lcâd\ n) a relL.1i.. jr
nr 1lì.
enplo)m..1ÌreL!Í .quilihijLrì .. Íhjte fll..\ a.(ì\asti irrr l\(l ln Ìhe ìlnP.rIL.:
.olÌiliLi.n m({lel 1lìeÌe is r rììilLilrt .t roLuÌìlirl .ìnd ìÌr.luÌrtffl LLneDtÌo}nxfL .:
tÌÌetï1, i.{Ì thrre i\ i rlst iD iÌr\!ÌrLf LâÌr urÌempl.1 Ìnent I Ìr Ì ì i,rLl l. âggregaie dtrìra r.
p!nrs ÒrLtÌrtrt rn!:L cnìtÌ1)\ ÌÌrlnl lìclnÍ the tqÌ iÌ bÌilÌm
. \.orÌrplclehdillcr.ntitúeryretlliÒ..iÌÌì5irìr'5s.r.ltiislunledb!1h.1íìÌLlÌ'!
ner C\. c mo.1eL..\.|.!,(Ìjir! to tlÌe NIJ( xÌrÌ)Ìor.h ltt.trrh.rÌ\ !rÌ thr srLf|Ìl ticLÊ l
belÌirÌd .I.ks Shilts n lht ì/11 ctI\t.1tG nÌ tc.hf.l.gl n1.!Ì. ltnÈrilt.l.lt' ll\:
c! (le\i]rc rrluiLlbrìLuìr Phtnor!eirr \1..c tht t.ono.r\ ls rÌn e\ \ iÌì laÌ).!r ÌÌrirk.l e!ÌuiÌl
Ìiiì!ì, ilr{1n'cÌÌ\ e !l tihfther tn4rlo!nrr.l rt tiuotiÌnL .r d.lÌe$e!l lltrÌi ìs " inl ()l|l
tar\ xÌrfnrtlo\ ncni
 6t

.i. nl ÌrusirÌes\ cl (le\ .lostr ír tirat oÍ.onlt!ÌÌ)râN .(ononrics) Ì!e

r ì1i|Ìì and an ìÌÍÌatLon t.ìrsetlng.rnlral Lrank j.l.) rhe mo{ÌrÌ. 1trjs

' !.ir tl \\ b\.doc! il sLr)fe dorfnwatull !!lr\ does r. t.(rer5t i.

.t,. railg rhiil rt to lhc ri8htl \\|at hit)fertr ro rhc A (!Ne rlh.. rlrr
ì ÌrjliÌ tri.onsumc rií:s? 1h|kjn ús nB xo san.1.tìreÌdixg.a.ì5or
. , ,r.\L)pendiÌ nr thc.q!atnrn!.i
- !:it)
::iiÌ:rÚcitrinjs((rì5raÌrt.txftrtfiÌÌrordiwÌrrth.ìÌ)Ìrcn!r,hcrÌrhÊÌc
r. !r:i r rmÒ.nt jlr f(liÌ9.1. $ driiÌls. exlilain th. !dÌfept. he

: dfÌ( rr rhrdoesitsL|tìe!PÌrnrd?Ì1hrt ìrpl)ens t. ìetì.1.uôÌ:

l,l
:-i: !ln rì!rea!eirr rhe drnrrnd turrÌnrìcr lare !i\eÌ1lcÍc Òrin(Dlrcan.t
: fr : r. i.teÌen rÌ!sticrtr.lth. (ìerÌ nd ior.l|ìer !!Ls?
, ir rÌ ii ÌJ tìrc rcrl int.r.Í rlre thrt is r. r\ rnt for thc /! (!Ì\ e and the
:.:!;r rrtt i!Ì urelll cú^.
ühr thc /,! er e mI hc r rt.
.l iÌiÌrÌ11tÌtLanaljons n)r
Ìi1.ì
: 1 !.urlcuÌrNrrd\!!nÌ!rnrrnrfnÌ\dgr!aÌrscrb\ !nnusindirlÌL|cn
:'tll:
:::r;tr.ìLa aLÌrr rÌre riÒinE !lNa,qt sct:t.3 rnü lìrj.. nÌtiìrg r|er
'iil lhitthe efoÌ1orÌrr is aLÍi\ ! oÌ1thc |ì.u \ eÌr!t r)n \ (ÌÌrh. Li t
::1ìr!nr'Í1. cqnjljlrÌilrml \! hrt tjmÌÌrg rss'un|i lnj rr.u d rleÌn cr rlì(
: r. !....nì\ l\,rÌri.rri rD th. Ìr 5 crìr È búr.. \ üÌ rhc l,t (!. e ì. r

- ìLtrrs bi it\ of ther$uÌìÌÌir!rnrthctlnio!i!Lrrsr rtrÌ.DÌs.rsr re

!. ,ì i!:ÌLiate demÌr].
:.. i1ÌrÌiÌ!úties a.d.iitl.iL .esb.rlrccrÌtÌrÈrÌrari.r.riiiÌes o .ìbonÌ DraÌtLr
.i u.d(r LìeÌÌe.t as...rfir ed rvith j.ìfeÌte.r comf.rtii!D?
l:.: Ì elfr.t\ on Ii i(( nÌÍllr Í.i!( \ÌlÌng bchar irrrÌ ò Ìrtl!rte(ì in rh.
.!r,irÌr !itÌrc r.l I tr\ in!:
I rbout L.rjr)! iÌrrir iobs a{ iÌÌÌ gn cn ler el o

i - r rÌnm!.1 l.teNeÌrei ro f nÌLrt dolrcsr ( hr nL ironr i(! eiijl.o ltrÌrn).

: :r:.'nr.ii 5ef!rÌtf ..ntr'lburion5fai.L r\ emd.fc.\
62

fq)orLLoD or cJnf lovees .o!ere!Ì Ìr-1 Ín i'n u lst agrcenlef

ts
i.i) a Ìedu.lion n rthc

íe.8. ns thc renÌlt oI d rì..Ìine iÌÌ i.dúsujes irì the e(orì'nìv Lhat 'lr€ hca!ìll

(1r ) lithe (rrìtcÌt oltrif!úitl nc.i{otirtl.ns bcÌÌrer. trnúrìs cmÌllo\eL iì$o'ìrticÌÌ\,

an.l the S.vcurnìlnt, uÌri!. Ìr!$e\ \trikc a dealÍ'he!ebr thcl agrein) drekeÌcn!er
ilagelenra.dr. Slroi{ the.llcctjÌrth. 11J]I5lljagÌrnitthc,tdo 5oi' rcltLn ior:
i.i ) a ìedu.lloD irr thc lenilb.fthÊ rloÌking ü.ck sci tlrìlnorÌiers hrìjsh
at ÌuDchtidrt
on Frldevs úsnrÌÌe tÌÌdt jtaFe\ irÌìd f(Íìnctltllv olì thc 1cÌtjcaÌ r\ls aÌe rÌleJsurcLl

il,l nalftoÌ\ iJnf rn,erncnt! in i{oÌÌinr! c..dìtu!Ì)s lhatbo6i tr'rlle

í12) DoestÌrcaggÌesrle.lcm.Id.urteIoÌthetrh.tÈe(oiìodrlnoPeaotrnloÌtìiesa!ì'
r.iin.s do.r thc deF,urLl cun e 1..l)\'Uil
(1ì l.lflailüh!ih.longnrnagsÌe8ri!'nÌfl)Ltcurrrl'rÍìÌrrrllÌrïih1 \hIr rif'rreis

PÌoblems and questions ior dÈ.usion

QLrÌ STI(ì\ l5:lll nrodeÌ oI thc cc.noxr\, \!h) cloes ihc dott ol the 15 c!rc
{. Ìn an
nÌnltcÌ lor ÌrucrcccouotÌojni. poli.-v anaÌ-Ìtis? Choosc e poli.! i.sLrÌnent th.i rrill
chn.ge the \loPc ol the l-! an.l erlìlai. rrhr' \\lÌiìt(.en ) ou con.ludc iÌonÌ tlÌis eranÌte
about hoÌ! hs.ala.d nìonctaf, p!li.l mavirÌteracll
QUlSllO\8.5!pposcthatihcrcì\.ìLargtlcnrtorartÍalÌintri\ltesc.lorinrestnrerÌt.
1\lÌat ouÌd ro!..{trct th€ clÍcct (ììtlìis 1o bc? \\'h.rt N)trkÌ )ir eape.L Ln dcteÌrÌirÌ<
ho\r lo.g the elfe.l lasts:'

QLESÌÌON C.l\e the lJ/Í.Ì/ nÌodcl an.l conD.rc thr short ru. iÌì!licatntrs of ilìc úse
oItÌlodiifcrcrtm(Ìì€tarl tr)li(ies iÌtic\ Ì istoÌiccttheiÌÌtcl(n rilt col\tdrÌt ànil
loÌn) 2 is 1o ÌÈet uÌe nìone-Ì nìppl-t con\tant ChoorcdlÌi1itcsr.lor'l5 nN.lÌhnL
.ìet)ressrs lhc ìeleÌ ol rqoìljbÌnrin ouqrut (loÌnpnr. Lìreirnpii.alions l(Ì outP!toi1lìL:
u\e ol |ollcict 1 aÌì.1 2. \(nÌ (hoosc a pÌn dte srclo! 'l-IÍ' \lÌ!cÌi lhat ìo(eÌt e!uÌlibriunì
output and coÌnÌrLdc th. raìÌÌe r:ffcjte as abovc. I the nrthorj(ics irc ilrteretted in
5tdbiLizl.gLheeconom-,,,rÌo!ldJouìe.onnneÌìdlhattÌÌe!idopllÌnic\lorloLi.t2:
QIIISTIO\ D. Rcal ifd:es iÌrc mildl) Po.Icìi.al ür In!5t i.dudrì.rl e.ononìics. L\tlore
rrhi.h nÌlr!:Lcls otrlage lnd price ì()rnÌation an.ì ÌlhiclÌ s.uÌces oi 1Ìúír,ìtilÌìs in
c.onorÌi( âctiriL) âÌe coÌr:istcnt !!ith this obscÌ!ation.
QL.LS ION !. Kr)Ìì.\ cnrPhasiz$ tÌre realne\s ol the \elt equìlibriìli.g írÌcet iI.ì
c.ìpitaìislcconorrì) a.dhiShÌighl! lhe Ìole olSoçclnnentiIÌ Íibj l7âtion. \{iÌtoÌr
Ìrj(drnenaìSuest|al Ke)nessìnltrenceo!publlclohcv nsenornrout:
Kcines beliÈ\€dthit!.ofo.rbtl (.nd orher \).1)uld b.n.ontìilÌúr t(ì tÌi! nÌP1ole ìent.iíìri.tl
b-!inre\rigâtiÌi8h.ÌtLo.rìrìitulateÌnele\esrctu.ll-!o f.t!Ìiti.úl) úri!rconLrololtht I)olitì..1
a!Llroìiti€\ v) as 1o a(hiere dcsúib Ê !fds, lnd ther !ìer {rniìjn8 b.ncroleDl .1il \ci\ arrÌr .nn
cle.red.th.jilr ro ln lD( tÌicir airice TÌrr rnr .t vote s i\ Ì() !lc.t p.rÍ!n ' th rhe ri!lìÌ nrÒr.l
l'ahÌe\ t(i Òfhc..nd Lhrr l!tthcÌi run thr.ounti) r':
 63

:: . :x!unìcÌÌt ând consideÌ rÌhet it mggests js rhc pÍoper ÌnÌe

:::.::rs LÌr tou as.ee wiÚr ÌriìÌ?

'i AÍHS OF IS/LM

r: i.1.!, Ì(Di, a..l tal aÌtrrin!rs a( Ìnr!âr:

.:r .I /

::r nrtinn r1. ir th. rln\tanr t.!p.Ít.n .t.!rr.r dtjrüblê rome

{a\ iÌncrior

i !!li\tiiÌrt0 the tal nr.rnIn if n tlr.on\!m]rriúÌ tu..r on and rerrrdngr

r.Ì nÌntti.i nrÌrrtl..)

1: \ tt

:- : r,lj DiÌlrtcquilibÌiudÌ,

i r,il rrÌ .i íì /l

,.=,.-r,lr i, -.4
- :r:, ì \lr(r b] li6r ieft rnB, -t LÒBct the ìf LÈÌ.(tÌ ot rÌre /-\ lutr,e úÌ rh!l â\ir

.jrì+j
',, i ,,/
::: i:ritotthe/\.unronrhe/ar j:ìrhe.Ì :í)
rl
,=
,i.-l !{
.l
.:.' r rÌre rNltillier:ln t(Ìú5e i. rlÌr rìúLi tlicÌ has .. ritr.t .f _!l lrirhÌlrÊ
q
64

lrlÌii n

Fiqure 2.16 Ì Èl\. .!'

\lrr i iÌr\'nrr!'ìt \rrlltirr'urrr':!i:Lri; !'rriLntl

:..:i.:',:".,'.,,, .,,..,-r,. r,u.'r" iL!rf1r nrrtt'I r| tL 'rLt"'tr':\r;
,t. Le.rr...r t rs!l,,rr!' r I 2 lri =

tr LiLlÌrr lrÌr ì!
\$!f ì! tlrrt i]ì!' d!rìì1n!l .r rL!.f.l tìN.rrrr rlÌrì.irrrr'1\

--. r i,

I l.\i r!ÌrL'i

h!
r-!.ttÌìfLtln i\l rLrrr I I !|r!, I lì \r.rtlin!
r
i !.1 !h!rÌrLeÌ!!ltoi'hrlìÍüiìrrìr
. ari\iTjq I I \irrrì i= rl

niì,rl.ifr :,r: ürr it!Ì!rfi'ÌrL|r I1l iri\r

 65

tv

tLoritÌ .Í.iÌ.!l.Ltir)n

-rl
,l

ii.Lni;\rl!rÌir!t(iÌrülrtnÌr:.\rr\rnÌrh0rrrnia.i:.J!Ìrl.rr..(iÌ.!l.ti0l
: !r.!ìtlê.1 .rfri.l iÌnÌ!\ i til!r rÌif! rlÌ.rttrÉ irrercÈ|r!fthr lt/ Ìr iÌì rlÌr
.:.ni(lÌrhllethÈ nre^!lrronrith LhÈÌr1'i/orÌrlrrii nr.rr\r!:he riilrL tÌrr\
i . .,, \r. Lr(rÌiirg llattÈ,. ai iÌÌn\ni. rig 2l-

:-Ìrt\enjilirLl,,itlrrL(fÌiDrLÌ.rnì.n(\:1Ìi\riÌì/ rlreL.trÌ.i:\enr ri\itr.t:he

.! Lri\n.11Ì{r.n lreL.rlrr(l)iflrhelrÍrirlÌtlÌrr r\is ÌLnrüLÌhr fLe(.pt
ir ! ,r,r.rl lh!!the1.I/nrL,Ltr\inr.iü:kr.i\(rliÌr!r(!ralÌrriilrl r.Ìi7n.rrl

', f\ nrltlÌ: \rieif rÌì. 1ÌÌr1 \!|t r nrriì\thtll/ri8irLr.!ijrtúì...lrrÌgr

:. /:.iilÌ\hjlr\r|lheÌr 1rÍ\ 1,.
. ìr\rlrLcl ìriiÈi.LÌrrf r.l(Ìrl\hilLirÌr(lll[atÌriÌ,l!]rirÌìLú.ha.!r jrih0
::a lìrìritttrillbÊÌ, t/' ft
 ff.rJion, Unemployment,
ln
and Monetary R'ules

'-ffiil's#ffi
***l***ïíí*ffi
l, .,'
.', ,"t..,-,1^,1
"'l ",
'" ''tr '

I ' '
t'' ',',i,,,
. ;;l
'"
::
" ,1"'',r
,,

,",,
68

in\rstlgiìtc|IobÌemstlìalc.Ln!Iistr!i1hÌlÌr'rleoIrÌrint'rcstratcìrrscdnÌonÊtaryloli'l
_

*.,Ur. t thel'h1Ìlipt.utrei5cìelcÌ(4reL1^ndthe'onn'queÌÌ'c5oii'ÍÌrlionirÌcÌtiaare
'"
',''
:, , ;
,-*t-ina * tÌÌe rcÌ:1ì\rt "\ts ol ''!ltÌ trìr\e\' ând 'grad(iÌ1\t' di\nrflation nrnlei\
""' ,t tt" tt,,L al ho( th( iÌrflntlorì rrtc at 1Jìc ntcdrurÌr rtrn cquilibrnuì
t". ì,r t".,t"', rÌìo'etiÌr) tlÌc int€r$Ì Ialc Ììi5td Ìrìoncli!\
iieternlncrl rnoer Lro crÌrtr^\ting ÈrÌi'jcsr
ulr .cntrel blnli r.rrgrts the moncl. 5uppÌÌ sccrioÌr + rlÌo$ 5 hoi!
,ììnì",,,i" ou",,
"""*
lntÌarroLr crn l,: auaÌr rt'rl Lr\lnil lhe ita!rcìrrd
I\ \Í nìrÌlr I
I /
Ì'rb(trü iìnd
ì;ì,;t'.;:u,"' r: nìod.r rhr suPpÌ\ 'üc usi'3 !nÌ\'ricctLr 'omPctiljle nreles th'
siÌÌlìlìi('Lli(!Ì that lhe lt 'Lìnc i\ llit ìhir
-,,,t',., ln"rau ,uU ,a,Ìn rlÌ( anrl nreLr m!tri6l dillrrcn(e 1' thcba\ic nierh!nisnis
l-',,ì,ìì",.,,,.'"
,,r,,.'i,"r ".'-,"urtarLr
i* '",.t,, docs, thi\ foìrì1cllorú
ìs l' {PÌletrdi1nr thc chatÌrrtrescnts
','"" usjn! .ompcrirrr labotrr nìnÌket and
ì t,,,nors murct rÍ tntLarioÌì ân{l unenrtìolnre.r a

ì.",ìi,"i,'-'* .." rarqrt\ the 3r(Nth ol rhe mL!Ìc\ {Ìrfl! lbi\ is \lìlron
LrieclnreÌÌ's

;;;i"ì;';ì;: "",.'",;:,eorurr.n1'ro'mcnt an'.ìisÌ)Ìo!r'Ìedírthtreâdcrcanrecdtc

iÌÌ lhe
tarrllcÌ\ \tilh tÌre rfodel trescrn'd 'hapíL'r'

1 lnÍlation and PhilliPs curves

oi lrnr5' 11ìicÌr mturìs thr lrì'r le!el L{ relccÌs tht
l.urli.ÌÌ i5 ü. ,rt( .l.hrÌìgc 'r
;...,. , " '|ì
'''I
!rte ol iniaLtun (^ !'r tÌt. fisl I erÌ ls r:
1l'

rrt"
'
1{l nr(Ì 201í nÌ ihe le;0!'
i ;.,,,, .;,,"rÌ". it I'r\ nm.iì lrighcr olrcrÌ iL rrtcs Ì)ct\\'Éen
lÌi-qh iÌìfatiorr retÌd5 also ro bc \oÌariÌe
i",it.. .r1"" are roÌi(rned aborrL iÌüÌatì(xì
nn.t rt,,t .r""t", -t." t.i'rt\ 'Ì!1clun'ìeÌn]ines
lhe Na! in whi'h ÌìIi'Ò 'o'1et ilrlorma
n' mrreasc m lnorplo)
ìu,,'. tr,." rnr,, *" it is r;nÌ\ to rc'lu'c high itÌlletìon
I e
ì""'u *0,,''* to bnng jn ÍlatiÕÌr doÌüÌ lhe\'rtì$"lielrch1Ìldthe\o(ilìed
ot iÌÌlxtìctì atrd it\
,'ritl',.*ir*"''* t"t"""\ .I 'enlrul lra'lr' :rÌ i nìLl!'r 'ìì'tu*ioÌr
', '"""r"U.
iìnd
..'i,.*",r*p,",:. r1",ì)jr'ti\ ' ol this;e(ti'rn i! tt) tJtloÌt thc origin\ oi LntliìLion
jnlÌiÌlioÌìiÌÌ\ Prc5nrn'.

1 1 lnflation ìnertia
tn tlìis (hitter we úrtÌodtrlein nnfoúiìnt d\s(tnÌption usccì lor ÌnodL:llìÌrg ot ìÌrflatio'
inÜrj! lhii\riglrto erilÌcrÌce thathns r(cuÌnlì1ilcd on nüìil
".t,"i,*.ì'i'"Ì]n "r".,r irÌ
i,,i"a-'".",. ," -n". .otrÌì1rìc\ o1'c t]Ìr 1]rn 'ìe"dÊ\ nrggen5 rhrt changcs 'utlÌrr
 69

,Ì\rd l)1.cheng.r iÌr iÌrflalion, sìr L.lr is sunnìarized Ì)r, sariÌÌs

' : ( orsi\rc.1iìlhuÌi\c\.idencei5istandadnrodeLì.irhnh

::::: Ì u..DrtloÌ nÌeÌìt and the alL

.. :r..Ìr sú.{{cnecl ü) tlr..onrraÌr'lh.t irúÌe|on ierds outÌjut
:: : hrca(si. o!iÌ\ìt
ha\ gone up brLl tuuÌrÌ, Ìnniìti.r gocs rìÌ) Ìn
:: \.ÌriÍ irÌ outÌtú. Tlr s nÌea.t LÌÌiìt tlÌe in.Ìc.\e in tn l.tiim is
: ::-:..ìÍ: i. outt)ur trlÊ\ fl.ì(e. ().c nr(h mo.Ìrl i\ iÌìhoduced i.
:r. !.o nrlrÌ! emÌrjrl.nl e! i.ì.f.c to \rp|oÌt Ì. p]lcins the \trn
:i!ÌfÌcLJriors oithL lâ5t iniÌetnrf tcrll: one in (.nn5 ot{:\prcta
: ::r.r\oi ncrtir IÌrrhi\book,llenìâ ntÌ !seure{:.ond Ìloirr!eÌ,a
: rtrLr7i.g lhc irÌcllbion olpJstjlilari.n i\ ro r$umc that wagc s.Ètters
r r.rÌÌod ro.orÌtjrrLìe to br irhirt it tuDrü1out t(ì br lnn
tJeÌiod, 1.1Ìj\ i,
: irrÌrlto Llrcr,/.rpriLfÍnnÌBtion oÍd1t,'úatiuts. Stetpliedt. i.itati(!r.
: : ::!rú âdapli\elv rhen cìfc.red i.flition uri\ pe.iod j\ equal to Ì{d
: i:r t)a iflliiiür phtr a c.úr..tjoD trrì nr t!te a..(rrnt oi rh. rmolÌnt
.. \ ir tr..ist r.ìJ lÌ(^ e.t ( Ìongl

,lrttrL. ! !trLtJÌ ,[i]

: ...\lrnt le\\ thin or c!!rl t() onr. tl Ìra!t toÌc.irsting .ltstakes nrL.

i\ìÌxÌr Ìe rdâf tiÌ e e \tc.r:tir) n sl

_ i !. f\|ectatiôns rlìerenre
:. frnlnìet a. [terpreret oI ot thr: ln!i]e.ì
is ir netennjDânt ol núÌarìon. Horfer.r, lht\ is e. LLJlirÌrtllig.nr .rnd
: .:r nl ionnì.9 crfrct.tiüÌ\: 1Llì\, turi cnLtrcl\ tr) thr past s.hc. torm

rnd lL.lisric lnLcrprú.tjcÌr olrrh\ ]rast inf,rtiln n lfclurted is i deteÌ

ç
: r: ri i. t(ÌÍú ol thc ÌÌertia that .Ìì.racreriTcs ìlrse and price s.Ltins in
ìr. ì .o non \ i6! is tlÌirr 1ra{c sctter rn.oÍtì.ìr!tÉ tasr jrúìxLjon jrÌto
: ::qÍiigr.kiD rn oÍler trì nrali. !p nÌ ar\ cro\jdri. i!nrg !tandar.Ìs
.:ti'hiÌt lrrs teÌi.f pl.rce \iÌr.e thr preriorL5\r!e Ìo!fd \\ic nìiLl Sen
r:.it \.ìgc sftter\ arc .or rbLe n) f.lrlrÌrrc fuecte.t Íirnr. .hinte\ n)
. : !trnr.( ìrarsrnÌ. Thc rh!oreticrl a]rd emÌìtrì.irl (lebâ1. ib(üt jfitltit)!
riri{ion\ hrpothe{,s is rr\ie$e.t i. ChatLcr t5, rheÌ. a nrorr goÌrÌal
r .,.ì.l,rtlrfinirúlarjo. a.dcrpe.ft futuÌe jn l.ijonird$eÌrÌn:d
:. \e orÌi Íith tlìe srifdiÍ1 nÍÌìcÌ iìì shi.lr tlÌe ìÌriÌation ìnÚLia trnì
- r 51n.. irÌeÌtial'i.llari(trì Írrnd\ rrrhcr.tLrnÌ\i. I,r oit.f r.teÌ n)
..r siii rr *irrr . Lr|rrr r.L fì drilÌril,2t!: rr. r,rLriLÌ: ìrlL lhrrÌ 2l)nr i,i
70

Ìagge.ì núÌation dÌìd dc.olc jt bv;r to emphisi2c lhc (rle ol nreúìa 1rÌ it\ irúe+ret.ticrì

ì ij Lr Ì.)

íìneúid ausnÌexted |lÌillips.uÁa'l

ThisúttÌeiÌreili.rgmtrtecllhilllpscunr:.\\:he.theLìggcdinÍliti.trìtcínlslntcrlreted
I t..r ,, 1 ,..'
tÌre te r hpe.talio.s atrgnerÌtcd |hillits.!N e i5 u\ed:

Í = rr rit.r t,,.
ILir] I.r

re\tectatlons irLgrnc.tcd Philìip\ cu^ e

\\:eno!rhrrf Lo c\tendirÌgthc mac!r)model bl dcr'liing lhelhiÌÌif\.u es

1.2 Deriving Phillips curves

,\s Nc hilc h Chrptcr 2, lhere i\ a !nnluc uncnrfÌo) Ìnent rate,rt Ìlhich thc labotrl
\eÊn
rnarkcr ls €quilibrnìnÌ. ]\l lhì\ eq!iLibriLrnì, rhc rr'\ ancl-PJ .u es üon, 1ìhi.h nìca.\
Ln
lìo1h rlige ancl frice settcrs aÌc corúent ÌritlÌ tlìc Prcl ajlürg redl srire rnd h.! I no ìnccn I
ì!c 1o alter tìleir beh.!iour. (ìur t.ìsl here is 1o.ìanriÌie tlÌe LjrÌl t)€1,Ìeen uncnìpl.l
DrcnL rnd intÌationr ì!hI is iÌrllatì.Ìr .onstnnt e1 lhc equiLlbiLuì tute ol !n€nìplixnr..t
if(Ì \!hv. lttrerÌ unernplo-Ímcnt !le\ i,rtrs lrorÌr rquiÌib!junr. Ì!iÌÌthi\ lie ac.onÌp,ìnicd bl
.hanginF nÍl!tiiml
\\JÈ becnr $ith a nulncri.il e\ampl€ irÌ trhi.h lf lariol in ihe ecoDonÌ:' 1\ '1',i per )cnr
andnÌreDÌrlo!nÌentlselthraÃLj:enulolnÌc.l sr an.ltÌrtre!Ìüagei\xÌrseeti8.-l.lì
$rÊes.rÍrscL Ír thaÌ the 115 .ur!r .cpÌ.scnt\ Ìhe real $rire lìi ìieep t1ì. rlil
\Í!re\
'ase cortrt.rrÌt ât LrL Í'rgc 5etler\ rfquirc a mo.fr itete Ìì\e tÌÌat $jll nÌ!1.! up ior thr
rjtellÌ)Ìiceso\crthcfasLteaÌ.sirÌ.cpri.cshalrÌiscnbvl%ri.eìastsediÌúl'tionisl'r.
nr(ìne\ ÌÌltse rises o l'h lrjìl tlÌerciorr b. \Lt irnìs Lhen \et pÌict\ dclo niir to tlÌcir
pricirÌE rrle 5iÌì.( pri.cs aÌe \et âs a.r:Ds(aIL nìâÌk trÌr on tDit ì.rbour (ost5 rÌ1 '.\1, llij
deÌrer \ orÌ lÌo\r nìrL.h uÌrit ÌaÌr.!r.oÍs lÌa!c Íiscn.5jÌrce

l
r
lf rh. sLmtlc cr5t u lìere à\ eragc Ìrborr'fftÌlucti\ it) 1.\ ) is.on\tdú. tlÌe onL! leiÉrmiftiri
o .1ìa.g.sLn unjtlìbourconsl5mon.rNr{.chengÊt:
 11

':rr Ê.r 'f.r.r iinÊr ÊÌr ! !r-rÊn 5;b.,r. -"q. br Í .ìp cr .rr
_ rl r r iÊn Ènr!.tf!ì: j,i: !Ì1 .1 ;i
- -r. p rÌÍri: J

:: : I í _jr:ìi r r.i ar !r.r ni rr rtor

nl,,Lr 1r. rr; ,;i.lÊ1irlirr

!il!!r r::r ii_ oi! iJliaqÈ

.:9.3.1ì.

.t -1 ii

- . ì.,Ìrri\enb\ +./,andsourÌirÌaboLLr.ost\haveriscnb\ l'Ì,. hcreidehrnì5

::j b\ 1% in o]dcÌ Lo kc.p tÌÌeiÌ tÌoit ÌÌraritnÌ undranged. \\:c ha\ e cte.luccd
.,\ jrúÌdtio. rcrìr I rÌrcìÌa.g.d il1'r0 per r eaÌ aJrd the ecônonÌ! remains
ir!e
.:: iq .J 1).Thiti5iÌÌuslratcddsCasc Ì jrÌ 1<ìble.l.l.
Ì.1lìit exrtrlorDenr i! at rr. \vhidr i5 hilher th!. lhe equilibriLrnì a..Ì rhil
: r. s 1'./0 \\,ith cÌnÌrlo_ orerìt oi fr, thr re.rl $ag. on rhe ]1,J.!ne lies 2no
._ Irn br the igat Ìn ìilg .i.1 a.d labk :1.|. \Ío.c! Ìlages Ìlil lÌrre to bc
- ì,:, kr('p uÌe reaÌnagc ruìclÌangedj Llrc! $ilL t)e Ìriicd bv anoLher 2% r.) lakr
--
 13

rÌr

..1

fif !!ti.rll)lÌÌllÌtr!! L'

.t. ì.. r retc is caÌle.l OkLìn)t LaÌ!. The re5Ìutri!ene$ ol unemplolnr.n1

: : ir Ls ÌolleÌ iir.ountrie\ Ìllth titìrteÌ resuLrtion\ o. hiÌing and liÌ-
: Ìif\ conhneÌìÌüÌ Lurol)ean c(ìrurtúrtl rnd lrìth strongo rÌadirlons
irrnl. ru.h as i\ clìnircteristic ot JaÌrdrÌ. Ior e{5e r)f exÌro\ilion, iÌc
:ii .,ri r .ha.ges nr enuLo!Ìnent ancl unerì+tolnie.t nrn Lng o..-to,'

_. . r:ì rir ) 11s alrijmented lÌriÌliÌÍ cuN e is cleiìrÌrd at a Íeaslblc scL ol inÍlil
_i :. iìÌiCiren ìrteollxgi{ed inlìrti(rr. nr = r .\\'...nslr(r.ttrc
.L ::r rramtler úr'Irble :ì.1 l\:itìr i/ = i Ì = 11Ì.1,. .. halc id(ntjtìcd
: ì. tr.d outÌrt lairr:rt rÌ, -:,+%j at Ër. i - li,l1,j and rt /. f, 2/r.
.1 . -rLrl e ntr :r : ]li and se \ho\! ìt in FiS. .ì.2. To cnrthasiTc lhit tlÌc
: !ìrhÌìedntraSi\ennr,iti\].beÌleclf(ll-'= 10n,l.r l\Lng Lhc diti n
: i ihc otlÌe. flÌjllips crìDes drrlthev are nroÌln nr IÌg.3.2.

f' rrn.:Ìf itiifrrt tr r.'.t rgg.1lirtl.it fr if ir. rÌr Ìirps.Lre5, ÈÌtrúrd

74

LJ.h fbLllÌ\ (!n c is.ÌeiìrÌr'd b\ tÌ1o.h.rn.L.ri\tlr \

(Ìr theLà!3cil i.iaÌnxr.atc, Ìvhi.h i\cqurÌÌoihcllastirúlntl.n rileud hrr\thcheiglrt
ot ttÌ€ LrhllÌLltr c!Ì!c on a lt'rli.rl Iúe abovc lhc Ierel ol ortLjrut a!íicì.rted r'llh the
ÃÃU..ìnd
t2 thcnofeolthcl!l!Qrrc,llhnhfirr5iLsnope'hÈlhiLlìps.!r!.sn'jÌÌbe\t€rpcrji
1|c 115cu Èi!slceÌreÌindlice teÍsa
$ellis a djagra xìaLjc relÌrscnlrütr !l l'jhiÌlÌ\.urlcs il rs Lúe1ìl to rÌpÌcs! the!ÌÌ
A\
i. tquaticÌr loÌm ai iÌì Í'.Li(!r 1.1 1\:c ha\ t rr.{Llcdth!t nìon.Iwrge\ iÌÌcrcasc br lrgted
ifflrüÌr pltr5 en anÌounr to.losc lÌrc ter.erìleJre 3ap bcL ccn the erining rcaÌ $ailr
1i... ([ the l'5 .une] i|d the ftiìÌ wrge on thc 11t cunt 'tj.e\ iÌ(.e.ì!c by the \! ìr
amount ì5 tr'iÌg.s. The p$cerúâgc grt i\ a funrtion !l1lì. dilleren(e bctrl'" 'uÌrerÌt
and cquìLibri!m emPlcìJ mtirtiin nddjti(ÌÌ, sith .r)n\idÌìt pf.ductn itl, enìPl'l ment drd
ouLfut dre prcf.rtloÌal s. foi \irìlljcit\ Ì!e slalÌ utt drf 5iÌìllc lìÌìerr erprcnion:

i -Ìr',t r,r
I riL Ìrr

\rlìr:Ìe4i\rpotlli\econ5lrnt lhc.Ìe\latnrÌoi.(tlutlÍo.rthemedirìíÌr'rLnt!Ìuìlibriunì
sh.uÌd be th.trght !l in ttrlentagc tenìs íthis ìs rllÌo{inrxteÌv ttl!.rl to Lhc dititÌdrcc
bctÌree!Ì) iì.rÌ),, il ihr-t aÌe nÌcesuÌeli irÌ logsl tioutpÌillsrbolttlÌeÌÌrrdlúÌnrurequ_
lihÌilün. tlì(n L r,, is to\jinr iìfLÌ thi\ ÌÌill riìiÍ'núhjon ab(^e Ìrst pcÍiod \ Ìnihtilrr.
SimìÌarjriii,r,!i\ncgrtj\elnÌlrtionÌ!illInÌlbelo\rlasrttrjod\irúl.rtlon; onÌ) lrith
Ì : Ì, is lnlrtn!Ì .o.itiÌrt nt Ìxst feriú]'s rnlc tr!e .i| \cc fuÌn UÌi\ i'ìprcsiir!Ì tlì.i
the lhìllips.ur\ e 5lÌills trt or doÌ!. when.È\ cr Ìaggeclinlllli.f cha.ilts and Llr il it\ tÌupe
.ÌeÌrex.Ls o. ,ì, rÌhi(h j. Lurn Ì1'll.:clr the \loLrr ol lhe 11'\ .ÌÌrt.

1 I Phiìlips's original curve

\\. nos cons dcÌ lhe irÌlcrcsLjr! .a5i rrhcÌt aleirll i.ílatì(Ìì nÌ thl (.on.nr\ o!er nÌ.Jì-r
!!ir jt zeru.nd thr r.of.nr\ i\ bulicLcd atrout bt .tredictâbLc or rifdoD dìo.k5
1o âg!ÌesdÌe dcnra.d. llr rn..Ì{!rì, rrr mcan that !onrc ìr(trks dre po5it !. rnd tonre.rÍr
ncgatjreÍrÌhnlortplìti\sonìeti obot. a..1Íxnctlmtsbel(n\ tlÌel(1, llthe\enÌ!cN\
es

arc rhort li\r.1, it ir Ìe!vrÌr.hle to erpc.t Ìhrr rage tctL.Ì\ r'ìc\Ì d terlìp':rri( rLst in Iri(es
as â ieetìÌrg crPL:ÌLeÌ(e ard do not jÌì.o.l.fute Ì)rn i.natio. nÍ. tlÌcir wagc cÌaim\ 11
ír, the econoÌrl rÌoull bc obterrd al thc ÌronÌts \lìorì in Fig. 3:l llìì5 is o.t ÌLa\ to
freient Ìhr original |lÌilLlt5 curc publlnrecl ÌI .\' \\J. lhilliÌr !JirÌ8 daLi ftrÌ the L'li
betÍeeÌì1S6Ìend195l.r Lg.:ì.1rcpúd(t.c\ lììiLlitx ttlotnÌtlìe frriod bch!ce. 1861
aìrcl 1!r1J. \o1c that iirì.c PhiÌlÌx hiÌs rLncmPÌo!Ììì( nL .n the hoirontal nxis ÌìeatlÌÌel
nÌ!! ietl to right, tÌre |lìillits Qr'. is doNnllx d!p ng.

'\on ìniidr.i5.!rÌ.,.r\f.t$r.trlLnrÌrirr!thÈ\l!frNi.lr!lhiÌÌrl!.1f.Ìr.t(i r'Ì.qtÌ..èLlrrLrì3

Lì...Ìl,n l,.ilì rÌF Ì\'\ Nìd tl,È r5 ftrt \ llr\ u!Í.r Llr nr\'r$iin !ì cÌriFL0l, irtri tlL. n.fè r! Lr. \ L\
 t5

,f ,
- ra- Í
..1

:
aa

1l

.5 c,! 1; .rr,r: uK l86i l!ill

r:ìillÌps's original (urve may exist

but it cannot be exploited
i .:: ì I lhilì ps !urïc ol thc orj8irraÌttpr, $,e ist 0ìe lollcn!ìng queslioÌì:
:::(^cÌnnlentrsr,poti.Ì,tojhlltrheecono!Ì\'IÌ.onÌjtrcustomâl\posiLìoIal
. rì a hjgher Ìerct otacriritv at pojnt, (jn tig. 3..1)l The
Ìrolicy mateÌ Ìrì.ìv br
r,,; ,,,1 t ',,'r .r ., ,, I t.,,.

r:..rÌratthegolemmcrìtilcÌcasestìrenìone!suppìÌ(los1Ìiiirhelt./cun/clothc
!:r inrcr€st Ìalc l.ìlì\ aod output is raì\cd 1ia h jglÌer ìnr(Íment \pendiÌÌg. LrnlìÌÍ:
::roÌn shoclis rh.t !hifÌcd ure ccorÌorìr ). I .om .t lo, nr ,! to (_.r.r ,1 etc. iÌì thc r!orÌd
76

oi rhe oÌiglniÌ 'ììilÌil\ .!nr, re lÌrtr h(rÌc r !ujtr di I!Ìtnt !jirrnti.Ìì: 1lìr'{.!eÌ.ÌneÌÌ
ir \eeÌiirÌq ln i.qJ oxtÌ\ri iLjr be(âusc LL tÌete r:iluilLoÌr nith lLrfÜ L1..nflo\nÌtnt
cren jit|c( i\ lrre iulnLlt)n. l]lr.1ttaÌl\. the ilnd..c) n)r tlìr r..foÌì1 rr) be reàr
Ìtoint u is likcÌ) n) iE!rr lf tht.rl.rtlah.n\,)i' r.r k.r i e. llìr\
\ìl build lhe 2% Ìi ii
LnuatioÌÌ iÌr L. then I r!c .lâlnrtr erPc.lt{Ì iÌriìaiion 1\' ll ÌLre lrÌì rrÍr 1. 2'i) Ìr r' li tlrr\
ft)jÌrt, tltr. l.ng Nr tradL Òl betlrrc. i.llrtion rnd rr..mÌrLo]nÌent d!5iìtÌrcrr\ Ì)e(rt\r
thc lìÌjlLips .(n t tÌr1lts !p IItheSottmìentper\i:L\Ijthitsp.lj.ro lroltÌjn! outlÌil
at Ì:. tÌÌe |lrillit: ruÌ\ e ÌLìlÌ .r)ntiÌn(' 1. thitt uÌr 15 in axse 2 qr'1.ìbh I I lnd the ltn\ !
ú.tnÌ)lotnr..l hlÌlÌ)e iÌì.rersifgl.llrüÌr'
ài5|].Lated s ilh r\ cÌ
lhi\ rÌrnrpÌctu ,ì.
ldes Ìrtorta.! LÌltrslÌnti.d o15.mÈthiÌrg iÌì..oJroml.s crlled thi
lr.a\üit!u.'1\'hiÌrtlÌ!',!'lrtj(!ÌnìitoÌ gjirâlÌ\ e\tinìitdb\ l)hiLlips Í.n(Ì nr m3ts.il
thc Éri\ttn.i.ir1Ìxdt olib.lÍeenlnlrti(!r aÌ niDÌ:'Ìo\nÌeni,ihii'olhftedì\t!'f
is rhÊ S!!.rnú.fr lÌìel io cltÌoit it. '\ sLrblt lhjlLips rrr e onll r\i\i.d b.Lau\e Sor efl
.ìcnr\ !lillrriÌ strleÌnaticaLl\ lÌrt.,rfiLcuttoiit lhr.oÌi.L!riontril Lhrl.Ìj(l ÌrìiNcr
.in not (lÌo!Í nnr foúú lrlh.r tharÌ... (). a \ eltìri llfcr|!!etlÌ(k1L'loiotrt|utrttlìr
l/ìt.hr\L(tli.LhÈn(ìt1üÌn rrtrli.iÌll.nsruÌ|hillit!'urr''Lì5lrauseiuLreÌ!iÌÌ1(
rrhrn ìÌÌah \irlq ftilic\, .!ìd i\ \hoÌrrr i. 1ìrc lhiLLip5 rtrr e liiìlriìJìr is I lll lt Ì!l b'
rÌol.d.thatii!.Á1'Ì.mtntl..i:rtt)ir\L.u.t!eeri..m-ì.lt!nlrì\ìl:)1qrr.lÌreÌtn\tlìi
lr.lr, rÌre ori!ìÌr. LrhillitL.ur\'..trniÌrl.lirdcolinrarrreÌÌrerLit]trri.lh.drÌr

1.5 Disinflation is costìy

.\ninrÌroÌr.urtiÌÌÌpli.eLionoltlìi l'hiÌÌip\.un'f,r = - iìL l .jrthrtìithriuLhorLtie\
\Lìsh tr) Ìe.11ì(e Ìlìc retc.i iÌú1.ì L .n, uÌ(Ic I'i I b. e.ost irs thrrt ItiÌÌ ìrt ! frcri.d i. I h icll
!n..r|Ìr)l merú is ib.\ e thrlÁ(r. \!e r\srrÌì!'Ìh^t lhe e(oÌronr! L\ r. a \jtrrrtjüÌ nr ltlrl(n
iÌìialio.irhillÌârìd..nrtrÌÌtrÌfcÌnllo\nìüìlirrrrhêrÀrr ll nl. llif i'rrìll/11./Lrrr
ìtNeslertÌ)eriod,Lr..nrtÌotrÌÍ.1tru\tbiPÌi:hc(ìrÌ),rir!1.LhraIìL'TIiti\be.rusr i'
t h.l'hillit^.urfr slì.r\ irfilio.i.rq!.1lorlìrlìt\rrLõLfr'lt!ÌÌrÌurdÌdrìoúflLhrl

dcf!Ìrd!(Ìrho\rii,lhet(.Ì$nì-\Lrthnìihc//lLrReudÌìb,'ÌLh.ìlrn.ìrÌttÌllboulfìirkr:
1!thhi!ÌÌer!f!'nìfloYrlenim.rn\tlrrtthr'.lrrrcntrerl\i{.ce..t)lÌrcnÌriÌrtrjfLdi.Ll
Ìhi\ rill tri.ltr'r lortÌ üag. inLÌ Ìrri'r'idliìl on ArÌ(rth'r lrir lo Ìrtrt thìt ìt th'ìt lthcf
rúrrÌÌ)lLìr nìcnL lr rbo\ r tlx' / lLi. thur j\ i n{'grlL\ e i|p brLr c.n llre I1 t (ur.! ind 1lì.

ììr)nr uÌc |lì ll Ìr\.uÌ\eeqüiLiLrn,

; ir 'l l,

It- .: 0,
 17

Nr. 1l

6
j'ú

: i ì.nron\trate the foìnt u\iÌìg an €rln4Í€ ,nd n dlagraÌrì.' hÌ lìS. 3.5. the
i .Ìr toinr I l!1th high ÌúÌrti,Ìr ol 3'lô (oÌÌ lj( (;r iJr) 1t is ,rsslrÌìel that
r ìtr.k rÌisÌres nr Ìeduce irÌíl.,ti.!Ì tLì it\ target rntc, nhi.h is 2lô. 1he |lÌillip!
: . tirÊ ter5ibÌÉ ìÌÍÌatìon drÌd output p.irs, gìr,cn las( !criod s lnll.tion, ol iJ%.
!rt. on tìÌe clu\ e llith iÌÍÌati,rn bclol\, 8'lo irr 1o lhc lc I oÍ u, i.c. witlì hiShÈr
::!!t. \!ith lhillipt enes likc lhis, disiÌÍlation wiÌl ah{nls br coÍh.lt should
: : ,: ir tÌrÉ núliìence ol tlÌe pasl o. w.ge setteÍs .ould bc NiÈd a\\a), theÌì the
:i.h
::a.onÌe$di\iúÌatioÌìenÌ.rgcsrthÌsimountstr:)sa_fi.grhitthepoli.\nÌaliei
:: :!i f{-1rr : 8r doüÌÌ. e.g. to i,riÍr 2r. liÌ this casc, thc eclrÌìoÌÌÌv ilouÌcì

::::.ÌhellÌillilx(!n,el'C(;rEl,r,cassunÌcthilthcccntÍ.lLr.ìnllÌaschosen
,r,.t,r,'l.rr.l
: -.ÌrirL brnl.rn tlÌcn polrt on l,a-r.r al,foiúl.lhitLeacl5to
choosc a
:.r i|iit in tlìe |lÌillips .urvc, Ì!hich is not slìo1\l1. lrc.(uaÌll, the obiecti!e oi
I i\ ir.hiÈ!ed and the e.onon]Í rcl]]ains ar rhr LR{1

Ij rJlation and central bank preíerences

|r.' I r\
',iru.rlh Í'hich poÌnt aìong this .!rvc rhc ccntral barÌk Ìlould
ariscs as ro
: ÌÌrÌ.nìcntingaltoÌicvofdìrìÌÍÌrlion. \!c issÍrì. that LlìciiIì ofthecentÌal
rlrlr
:,i sl.ihrd i Ìi,.iLflrillrF\.u.Ì.,r hr.l,iirrll.rLed ú Llr.dr!
..fl,rri.nr. if., i\'.mfi'ilriir !.frrrrÌr lLF\( !(
'r,:rL,n!iSÌrbu15,rinr!l\(.jnahipt.r5.ÍtÌr.onúÌLr.r:li,!rli,Ír.,trrdfrl,,Ìn.nt
nr !.r iftlnifr dNì 1. r L3 srL fI - = 21i rhn ii Lrirlr r\ iir.
 r
1A

j
l

Figure 3.6 Ll. 1.t. i_...r': r:Ììi::i..ri:i

centr!L lìrfk..trlcl(h.n5. f.nrt ( 1sc. iS l6 lhisbr n!5lnllxti(!rd.ÌÌnl.i1hctrÌgtt

j. tlrr ürÌt pcljo.ìÌIú i1 thr.o.t oi a slrrf ÌLst ìÌì urrrnìfl.!nrtnt.ì\ n i(rirdbIlhcld\

aDdthi...tÌìlbaul(ifiiaeh.utthi nL.ÌcrtÌrttto5lrbiÌLTeouiÌ)LÌtitì, 1hl.lo.t!Ìr

rould nì.rc n or! lÌ to r- 10 1
,\ kss hernl rÌrÌ)ror.lr rrrÌcL li lo. Lhr .t.tÌrl bìfÌi lo .hoore toìÌrt t is iÌÌ llìL'.$e
lìs.usscd rh.r c lltr' iill in nÌ ,tì,:!r iÌnd Lhe Ììte ìÌr !n,'nrfÌ.1 ment iÌr the tun fcrlt).ì
üo!l(lbrlc$tìrdÌii( h.,trÌroscn \\..â.ltetÌÌrta5ric.hrfgtthttrtieren..so 1fL
.Èntrilbr.knonrlloÌr!'Ì t,)rlÌi!lc iriÌllfgnÉt\t!sacÌilL..i,Lstr.unenrÌrl())rrxÌì1 LÌl
ordcr L. g.l a gi\ rn (trL.lj(Ìr irÌ inllnÌiôn. r'É rìÌttr È il..g tlr. I'hilÌiÌn (ur\ e llorr A 1(l
(. 1\ r. summrrire thi\ b! sx\ iÌr! iJìiìL Ìh. nÌlatiüÌ r\ lÌ5 .n til lh. ct!rtral ÌrdÌl riles iÌ5 lÌ

Ìr!cr.trrl lrrotri's tÌ.ierencr ìrL'Lr..n i Llc\i.rtnrlì. L.tLilL.nÌr(nr.roï!f,'nì

plolnc.t tr !ÌÌÌ thr / /ìt,r .rÌr trr ,cÌrr.!cnl.LÌ sith ìndlI 0cn.. .ur ct. TÌrt iÌtrliiicÍr...
.rLr.\.1t1!odiltrrcnÌ.r.tÌdlbink:i,.;Ìro\.inlig.l.r, LhcindL lÉÌtn.ecune5nillì.
nr ôÌ. i.irri(Ìì $ rrÍ .rnlral t,,rÌrl ir. leLld. Thi\ ( rt ?i benli.lì..se\ t!irt D rnl i ìc
.(h.ro.c.hoose\Ìr.li.L/.nl:r 8, lhcÌn!ÉiÌú1,rtorri\.r...rntrrjbxnlcÌúo\15
r) hc.r!5È it i\ illlng10\rrrih.rib.'{t,Ìlf.rtì.eirÌ!r..rflLr\nì.ntn)lctiÌriÌaiiLrì
d.1rn br nrtre. \\hl'n th! lÌÌillifj.r,1.;ÌrL ô Li()rrÌ t rr ..nLÌil brÌrk cht!)'tt itt lre
ft,rÌcd t!!itnÌÌ slìc( th. iÌÌ!liii('. n.i .11,1c Ls trÌr!eÌrilil 1. 1lì. ..rr lrhiÌlif5 .un e rnl
ln rÌrÌr s:it tlrr..on.m\ r(ìi!\t\ Lo t.i.l lThtnÌtlnì.,f,r!.'sr.r,rtÌrlìl.liËuidt.thr
Èc(rìornrlo\nrh.frlÌri(!nI)11)il..1r.tl\tlÌÊ\.ìrlìrrriì1.Lh(.l.rntl^tio!a\trr
cdrÌÌ.il t.lrl tr LÌr it,,Èter n ril.,.f.. rrLn ri gunLri ilrc ..o.o.r1 dor. LÌrr ÌratÌr tÌoÌÌ

r =ì..drriÌriiil..!'n.,!r \i5\r, nkL.rft)iNtrt.j.. lh.dr r,rlorô Lht t!.1ÌxÌÌrìrÌl

r..ìiiterdrt r rlr'5 s.\ÌrÌaiÌrrdi.d.LiiÌlfaÌrrÌ)ttri:,ìlriìliìl.i llrL\Ì,rLl.fi\.ìlithati\
 19

.is disinflation and rational expectations

: ÌÌt ii thc jnflu.n.€ ol the Èr\t oÌì ltngc scllcÌs war ahsenr. il (ouì.1be
::.Lonoml tolrrmtloxrpoiÌÌtlJtopoìnl I i. ì:jg.3.5rÌLrhouta.!Ìi\ein
: :: \\ lÌât addllionâl a5sun4Íions abort lhc cconrD) .Lo ile nee.l t() maÌ(e
: -:irite tÌÌc.osL oI di\nÍl!tionl

: Iii\ab\ent. 1lÌis nìcins tÌìere aÌe nononÌjnrL I:lldllics nthccconoÌr!

. j.c lettlni{ Lreh.r!iour ol instltlÌtnìr\ thlt op.r.tc to produ.c inÍlat on
: .ifri|ee\fectatioÌls pÌa!n. rneln Ì!age settlng. lnstcid, 1lìcso.iìÌcd
:.ii4ri ,]?rrr.Ji\ hoÌds. lÌence, $e have

; íi+,,1f ll+.

.,:Èp\ilorìì is i rân.lonÌ íÌo.litcÍrì

::rilbrnÌtdrtriouncc5eÌrervl(NiúÌainnrtiritct,;r,thitlsbeìlere.lb-Ìall
: rrinr:. Anotherlfnf tosavtÌrisi\thatthe.crì1ÌaÌl)inÌ\fÔlic!
.1 is .ÌÈ.liÌrÌr. Ior thc 1rÌget n) be cÌedible. it musL bc coÌrsjslc.t rÌÌth

=l

: : rÌr rrmairjìrgcon\tarlt nl lhc taÌgct, apartiìoln uníoresecn sÌlo.ks.

...Ì.1tii!ÌsollnlrrjoÌrnÌeantlìi]1tlìeonÌtdi icreÌrcebet\veeÌrÌ!hataSerÌt\irÌ
:i lrr(Ì irülitio. L. be rnd ÌÌh.tit turns orLl 1o be L5 !rÌethini{ ÌrndoÌn:thev
:. .irnlìticrÍors.AnotherÌ!a\ toeÌpresstlìisitlhâttheagents\objectne
:r L. : !lil.rilon i5 cquÌ nr the obj€cti\e (rpc.teLit)n gne. âÌl the a\aiÌaÌ)Ìe
i !i trr' nrúcLuÌr ol the e.onolÌrl and aboul f oÌ1c\ thrt is nvaìÌabÌe xt the
.-:..tirn js ionn.d. Because.li oiihrjnloínal,on a\ aiìable i\ ure.l Ìn ft)rninij
: :r. itlirf is .o.oÌreÌatioÌì bltÌrcen th( cÌor teÌm an.l the 1nf(nnratìon
::: irì! crpcclì1io. it iorrlìed. \!hen ipll!(Ll Lo inilatn)n iÌ1 ouì mocìeÌ, the
:-:.-ii!n5 hrpothrtú mearÌ\ thiì1:

(Ìrtj(Ìu L r\pe( tr tions ol nÍÌa tionl

ìrjectì\e erperted \ iÌrLc aDrl Lhc I'hLlliÌr! cuÌ!e tr rx)1!:

(|hiÌl jt! cur ei rationrì ertectrtjor\)

: Ìrlrh Ìatio.el exÌrect.rtions, ÌllÌÉn outÌìn 5 it rÌlrjìibÌ (Ìì. i.nilion ls aL

:: ::rm i randoÌn \hocÌi \{e.an erprÉss ihis inoLhctl!it, Ìrt n:iÍn.gi.! iìi
80

r r,=,ri. .. l

.:i" .l
rr""*r-r.. I1- .'1 i3.2r

'i' I
il'u'.s {r+rrl\t n1ÌÌn\ LalLr'rlk!Ì

TlÌ i\ ülled the lrLca\:urÌ)rj:c mtth

lÌcÌe: Ìrrr.(ür.ea kri'ì lr a rani|ln 'ÌÌor s

*,,'^,l.,,,urt",l,to,lgr,",or.lÌolrtÌtlttcrsòO!tfulonlrde\iÍratronre!ÌLiÌibiiLuì\theÌl
(o, rÌ!:rrÌ:geÌrcrrLrr t. rhe p r'er.eÌì 5uÌÌrri;È oIuÌ*ntici
;;";ì,:'.;.';,';,,,,;'l,,,ion
.t.

''''
.eÌìrÌrd nìr 1ìrm s PÌod rtlt rcÌatit L ro oihcr hrÌìs it lvl1Íauú
; i,, Lhc
';:;ì,,i,;,'
','ll
','"

rppl' r.stonse 'rlÌÌofuLrI iLrÌlü\ nÌg in i'lhii'n 5LtÌ)Il\'' ìÌÌ'rcr!!'

ii" st,u,ra nut, Lr*' p,,ssilrilit\ tLÌ'ì s iìgc arÌd Ìrri'È \r1rcr\ Ììrr\ {L!Ìre!1 thtrl in
iÌriÌrÍÌrlionirtÌìr.c\!iL!ti(LrlibriiLcdlicr+rlfirÌìt(..tÌrlbrnloÌttìfgo\ernnrfittrl
;,,,;;,ì".;,,,,.,,atrirìcmfrornrerì1bero\!tÌtr'c!Ìuirjr)Inrmr.ld'!bL\nLr!s!Jacerbo!Ì
,ì,1..ìu'ut,,,' oi the i.tÌ.ìtLoÌì r'ìr!fL,'Ì1ìi; i\ iì'othtr
fr\ oÌ the dis'u5iiorÌ
'rlrrisjus tÍiÌ(Ìt oiI rr' br
ì,,''-i,"" t.i "0"* U," t(t'rs 'úÌi!lttc rlìctlrcr uÌc l'hiÌ1 l\
'ìrì(Ì 'uÌ\'e liÌrlet ot2ri Ì'
.'!pi,t-,U"Ut"g"'",-Ìctri jnsu'hI'r\È ne:r\ thirtltr'LÌrtÌiilLoÌ! aLrs'nr' ol irÌfiúrì iÌÌ'rlÌa'
Iri crrLÌit,rr Lrcn \iiLlÌ riÌti.inaL e{lr't'1i(Ìr: Ini Ln {hc NolLd hrt( t('
i',.,.-*U] -t n" ".,tlle\: (lÌt)L) i' iÌif itio' iLlheÌ lhc t'\!ünÌcÌrì
,,.ìr!]""r"" ntt.*t,t.t.. t!r'lor\cr LÌitÌ'rLLo clerÌitth'c(trf iI(rtdLììilit!
jÌr
risr unr!Ìpl)vÌìì'nt
ì rlì' i\\u' ol lh' rn |ronelrr\
',,,,,""t",g"pì,tnu,UìtlLÍt'tljL'Lj! ( '
FfÌir\ i\ t\l)L)r(d iÌì morc (ìepLh iÌÌ haplcr 5' i\ $ed b\
r'. .an s'tuÌaürc ìì\ 5r\ìJrg tlÌat uÌ n iror d \Ìlrcre 'r1ril1Lìl' uri!rnÌrtj'nI lÌ1rri thfrÉ
atio'xÌ e\fcctiìlions
all nìiÌrliet pâÌti.lÌraÌìlt tr) Írrrì thfii eÌpcct'nioÌì!
conÌnìjtÌÌÌr''t to lÌre bllrtioi
are no rtrces ol rntlatlon in. ia 'ìndrllde loitlnnle|\
i",r,', .,-,tr],,, u*" .ndom dro'k\ tl] in iLLon knotr'r r\ s(trÌ)!ìscs \ill lead 'utpLrt
"
LorlcilrteLurltstquiLibiLÌnìle\r'l'TlÌismt'n:if'orÌ1ritt1!Lhtnn"LrIdÌn!ddüiljl
lrttaLlrrrlnctiathaLttr,'rt\rLÌÌnoLe\'|bel'nÌporar\mo\'mÉntsil(Ìl!Lhel'hiLlj!\
1(Ì1bc
.1."'"'".'t-"*n,,.Ìrl, Ìr'cücrinltsiÌì{(ìrtrrmtÌìltolictrdìiiiLlatl!nrill
.,,t,,':ir,"i'1,-,",Sutt'jÌr.ìjoÌìLr.tÌ!ee!ìrlÌtLrro'ìtÌ)roirhe'5houl(]iÌlÍ)b'n.t':{Ì:
. Ìrhcnu\!Ììill.erljia!gDtntt!lÌrhllliÌJ5'uÌt!a'(ìtsìlitlgoei trìnri(ìc\iilio!Ìjn
o(rtÌtrrl i rìrn rq!illbÌnL ì lc ! bt'iu\e'ia'hang'iÌrrÊgÌtgrl'úenìi'drtor(lrinlr
 81

i nrh c ro lassed intlntir)n

\lfr lr Írlr .r ô I rE.,ti'rt.- l

:. i!Ììrise \uppÌ-v qlÌatnìn. .a u salit-\. {oc! arD r de\ irtit!Ì irÌ iÌúl.ltiolÌ
_:.Èd \ â LÌì( 1o e.hange in o!t$rt rclalilr 1o cquìlibrilÌn

\; r!'1.1ile to ir \r,relatitr 1.,r.

: .:irrfL\ cqLútion hislÌlighls th. tacl thai rü er tlÌc nssuÌnÌrtions oI rnLl.-

: : : poll.!.Ìr.ÌibìÌii), .nd thc ablctce oi ]rúhtì.!ì ineÍl;Ì, si.cc iL i5 onlJ
-t)l) : - r LÌÌgcs ln intlatn!Ì tha( .an allcct rtrìtÌrut. slst.rÌÌa1i. nÌo|ctirJ poÌ].-Ì
. :: .,LtriÌrij Lhc le\ el ol aclil iLr in rhÊ ec(rÍnnl'. Ihcrr is llso no .ccd loÌ
-Ì lìr.irLÍ: Lh.. ecorÌonì] ,.1trms diÌectlt to oqüllibriLrnr o..r a shô.:Ì lo
.:.iprearcd. Thete dre strong enunÌÌior$.,\\ itr 5haÌl 5rc in lh. Ìc\L of
r::-. nÌ ( lìitlo 5. l)e(rusr oI llìc fÌc\c.ce oï irúliliorÌ iIìÜ1ie, i 1âÌi.:l-ì ot
:.: Ì.rrÌ.(\slìlItLìreelorÌonìtshi lLh.Êc(DonÌtaltalftonìcq"Llibtjunra.d
: .:ì.,)dlessÌ! Lo cquitibriuü oÍ ll\ om accord. \\ a.lrns{q!cn.{:, ccnlrel
::. ÌÌr \\ ÍenÌali. Ìnoletary poÌlq Lo slabjlìze tlÌe e.on!nì!.

'.': letary rules and the 3-equation 15-PC-MR model

f \ìiion t. intÌoducelhcso .ilÌcd 3 e.Ìuatiuìnìodrl. Lhclhrr'ccqLâtlons

tj: . :!r\ e ecÌ!rtion, a.d

...:. rLl..lcÌirecltrorÌÌ thc gorcrnment oÌ centriìl bank's p!li.v tlidc-ol
:f! i ind inflatiorÌ.
r rlì. cmphr\is is on gr nlrg ianrjìÌaìit) sith thc 3 equaliür nodcl bl
: .. quatllr\ ue scl oul ioÌ thc ike .l.lirrity. hÌ ClÌ,ìÌìtrr 5. i nìorc
.: bl' ili.i nr.netaÌ\ polìc-! Lhat mikcs use olthe eq!.iion5 i\ !ud.Íilcrì ind
ilrr. (!Ìrheì \tefs d$riot the nÌore sophiÍ(irtrd \rr\nÌìs oI
necdcd 1o
lìJr!. bc..nre the ìloÍkhorsc oi nrodtrn nroneÌJr) nÌr(Í)e.orronìiÍs ar.
. ,\ r rnrtharizrthe de{c ôpdìrnLotagood nrtlìiti\eieel ír.the !!lirìstrrÌe!Ì1

..r,]l nro\vn the 1\ .ìnd (Ìrr 'jhiÌli!! .urcr iìr dirlranÌ! rnd trt uìeÌÌr out
: .n loÌm. The nronr1.ryfoÌi.t ruìc h15.oitet JÌ)perred tÌpliciu) iÌr il
ri r!Ìdrtion. ÌÌLn\erLr, is Nc slìiÌÌ lce in the next se(tiorÌ. the nÌorÌetnr)
: r,. ctÌtsented irr tlÌc l'hillips.uN! dirg!am bv ioinitrs theÌ)onÌt\ I. f',ì
' tr,h. j. fig. :ì.6, ilsc ioin lhcÌroi.ls/, f , 1. $elú!etherìoÌìetar!|oÌjc\
' lirLon a\eìse (erÌtriìLbinÌ iìn,l ot a moÌe ìÌúÌati(Ìì {!eÌre central Ììanl
2.1 The 3-equation model: lrPC'MR
Belore kic({si.g orÌ th. nronriil}'Ìrolic) Nl. rçe nurÌnÌarize thc lS eLÌoaüÌì i]nd
lhillips .rrrlr e!Ì!rtio. Ln th. ionÌ most us€lLrì .r lhe rndll\is oi nrockr aDd pdi'l

1 li tikc r nìi{htLl silrìflo nÌnÌ iÍim lhet jn 5eltnrÌ 2 of ( hilter 2

lhÈ IS rírririon rL1Ìl
lh.5inìpljhcationisloirritrllr\r = 1 !1r,nlhere lis liìcsLrnr oiex(ì3eÌìou\rnuilLÌìied
!pdcmen.ltithu5i.cÌuclitÌglÌtr,rterndpiibÌ1.\e(torrìogcfotrsdenìrÌìdl,afdrjsthe

\\cÌ!Llìmoreorclbepdnl.rnaÌL)irÌtercslcdintherciÌrateoiiÌÌterestthitcquâte\r'ioll
'Ìhi: ìs delined as /!. Ìhe Íahjlizúr| rntc oi lnteren:
(taÌriÌiriÌÌ3 ntcrctt ratei

Jr .an be -\eÉn lhât r\ (lÌ.!ìge\ u1ìrnr\ cÌ 1 or l c|i.ges AilrnÌing Lhrl.l and )', do noi
"
.hengÉ, ther, ütuatiorÌ.in be nÌb1rn.L.d iÌ(ÌÌÌih. 15 equdtidr io gcl

.l-\. oLltttrL gaÌ) t0rnì

The diil.rcn.cÌ)etl\Rrn.urenLa.d e!Ìuilìbrfun] outlut is ktìor'. a\the o!tLÌú giÌf. ('n eÌr
thrt thr c\ogcx.\rs coÌnÌrL{r.n1s of assre{alc .leri!Ìd arr ttn.hmrgtl this cquâtiinl
nÌalr\.ì.rar thal oulfrl \!il dL:tLate lÌonÌ cqrLiìLì)riunÌ t! thf cxtent tlÌat ÌlÌc ìnleÌert
rate di ft:Ìt fronÌ tlÌc sLebilizjng lnrereit rltc. lhi5r'iì!olrrPr.nnlinHthelJc{lLLeLioIii
e\pr,.irllIlrelL{riirdLouÌrLfrslendÌnttÌÌe\i.-tLhatanÌlncti.lrtÌcit(ìÌ$ 11Ìc.cnlÌaL
bantri l5 gojng to .lrooí: the iIìlcrcsl Ìâte Í) ns to LÌrtÌ!erl.e tlì!' o(rtttrL grt as it sc(ks lo
aclÌìrlc ìr\ ltrbililnLlon otilr.li!c. ft 1\ inrpodiì.1 to rbtt tlÌiìt 1Ìrc .c.haÌ Ì)arÌk.nnnot
bÌiÌìF ebotrt an instnntaneou5.hânge in o!ipuLb-Ì rÌteitÌl1lÌc ìn L.Ì.sr Ìate lt tak!'5IiÌne
tor ìnlcrcrtìrte.hange\ to ircd lhr[r3ìì to at]c{ t Ìn\estÌÌÌeÌìt i.(l otrLfut l\jeloolnL Lhi\
irì D.rc.ìetaiL ir ( lrafterì.
1.2) )'1i. ì otitnüJrttrt.ìlltlltiltrú^'.(ltLni.tt.l(:.tìeedsnonìodiiL.atìon

-:i r .l t.l
(3lThethiftrquati(!Ì.ihc,rd,Ì.1ínrÌ1.,I//ì,it.ìerircdiromlh.c.nLfaÌbanlso!lf'ú
ifllirirÌì Í.d.r)íL .Ìis(!ssfd i. tÌre ldst se.llon. Tìri5 r.n Lrc 1Lrll(cn õ

inrÒ..1er\ rLÌÌe. ì:ll

'ÌlÌis cqLletion rhoü\ thc .onrbìÌ1.1nÌì o outflÌt dÌìd n laLl!f that the (trÌÌr,rl bank n'jLÌ
(hoosc glr.. the Ì)hilli!s.urve tlÌât ii fi.ci.l\:heÌì iÌllliLlon ls hlgh, the celúral blnk jll
.hlosc 1o Ìcduce rggrcgaLe de!ì.iÌd (b-! raLsinS uÌ( i.tcl{\( rat!) Ìn or.l."Ì thlt iI]llnlLon
\!ill .omc {Ìoi!rÌ. Ïronì f-ig :1.É', \!e cn. lct thlt. hlglìc, I it r$ocirteri riih iì moÌi
irrf JtiÒ.-arcre central banl
 83

::.:::.i iìrÉ \ílì li.c lf i diigrarÌì, rle sìmpl,Í takc a 1,1ÌillìPj cuNc and find rhc
: -, i rrjt L urfrrinllalionconìb]ÌÌati{)n alongthePhillipscunc. lhisâmounÌs
: - : :: ::ingdrc\ hctlrccn th( .cniral ÌJanÌ\ i.dilfcrcn.. cu^ es and the reÌe\ art
: : . ì!r5hrinr rlrar iL laccs: by ioiÌÌilg t Lhrsc points oltangcn.f, tlÌe Ì.ín ìs
: ::!:r r.inr ol La.gcncll thc,V,C ecÌualio. I'iÌl hold. Note rìso rhirt ure ÌíIì
: :.:.ìLÌgh Ì = r,r and Í Ìr. lor eÌamÌrlc, in tig. 3 6 thc r\1Â tor the Ìnorc
::.- .rnrÌil banÌi Nould be lo!ircl bv joi. i.g up the point\ D, l)', lncl.1 and
: :.. rrfl ilion-avcrs. ceìÌtrâl baiÌl b) joìnlng rp poirÌt\4, l:', and,t.
: : ,:rd.6li.dìnA th.È role of the.V,! Ìinc n rì.croe( onom 1c anattsis js th at jt
:::::iÌ.nsilhjchtheeconoÌÌÌvwillbeguidcdbvrheâctn)ntoILhc.entraÌbank
::i:.i{Ìuillbrlunìoutputâttaritetì.Ílatio..\\lÌcnrleÌureec.nom}.i\nriíted
::: -i I cqu ÌibriunÌ bv.n aggregrtc dcmand or s!ppÌ\ slo.]i. the job oÍ
: i.rhor L! jstousc..hangeiÌÌtheinlcÌcsL rntei.)gettheeconomvodtothe
ì rlr.lin.) it musi contiÌì!e to adÌLsl tÌrl: lnterest irte unriì lììc economv
lr 5 risl to íror! ihis nÌ the I,hillips diagrrm (Iig. 3.7). lvr tun l{úk
': ,. i.tÌaiion hr\ ri\erÌ !bore target ro ô,r,0 slÌo\ln b) polnL Á. lÌriÌìt t n o.
r i l'( i;r 69iìl ar tlÌis lhoÍn Lhc lrade oil.ìldÌg anrtch rhe cenhaì
ii iti prele.red toìIt. To get lnllaLjon bacl to the iarget oi z'liì, outtut ts
r i,ll beld! equilìbÌiruÌÌ. The trr/? llf c slìoN\ thar the ccftril bant rljlÌ
, ii dor\ thiJ b\ rairirÌg the ìnteÌ.sL ratr so th.t airi{Ìegalc dcm.ì ct talìs,
: l-rÌi,. (Ìì(e the econonÌ\ it on thc.\,tt liÌre, adiustmenL ba.k to Z
Ì)oint
,rìth inÍlatiorÌol5%, tlìelei!Irhllìips.u /ethatureccnLral banlitaces
: ,.,ì rr( ir 5'lolrnd the c entÌaÌ ba. Ì I'iil .lÌoos! point l'. thcproce$oI
:: ritÌf, cnt t.les tlÌe ecorunv nrtoi.l Z.
:,'ill in inÍlrti.nr beLol! target, thr process ÌÌoÌlis i. Lhc sarììe sat. ìI
. r''r r' "r tr t1r :l
, : iirrrcd ponìt is C: Dote thal ri,ilh inÍl.ìtion ha!ìng lelì.n bel{^1, rrrgct,
r _ :r,. \illl ha\e to be míed l)l rhc ccnürl b.rrÌt so rhat ourput Soes abo\'.

|'

:
.Ìl Ì

rlì
 r
84

eqlillbrjunr ir ôÌder Ìo fr6h ìlrllaLioÌì Ì)r.N ut n) Z'li' A.Ìiun!ÌeLrt along the V/ì ÌinÉ
to Ìroi.l Z o..ÌLr rhrouilh !ra(tlt the !rnÌc ÍLÌuÈÌrcr oi tleÌlts irs irr Lhc ÌrÌe\iou5 ':att
hÌ ( haftÉr 5 nt c\thirr Nh) t|c govenlnc.l itould Lr! nr lieef
j'llarjon at a lo1! but
pls1lÍÈÌe\el.sL1.hd\2! ânl r'ouÌ.1beke{f toectti)gcttheerononr-1 tlrtothl \1/ìljre
lroÌÌÌ iì to5itidr 5tL.h as/J
Ulr. Lhe ì. li.c ii r(ll Ltn!lersLood, it i\ .L sÌìoÌt \t(Ìr to bÌiÌril togcLh$ the üoIì'rrÌ\
mÌe if LhÊ lhillip!.ìjdlriìnr rith Lhc IJ cur! n) ai to shoN e\pli.llll tht iÌrtelrsL Ìate
tÌìe (rrì LriÌ ÌrdrÌtri Ìntst \et iL ra(h slr{c iÌì oft(r to clelitrÌ Lh€ re!l!ir'rd ÌtleÌ ot aggr'gâtÉ
LlenÌ,ìnil Thi\ irÌtro.luce\ rÌo nÉs .on.€pt\' lt js ilnrÌ)Ì! i matteÌ ol !oi|'g IÌoÌn the 'ho!ÊÌl
outÌÌn lo tÌ on 1lì{ }LR Lirc lo tlìL ÍJ cur\ e io ('! ilrÊ i' 're\t Ìrrte t ril rìre celÌtiil brÌrl

\\lÌ! 5 th. I'hiÌÌiÌx dirgi!!r? \lthou8h il li t(\\ìÌ)Le to dctnt

lbe .\l ìine nlrNn nÌ
rher]ì.trìcrxÌ)nrlri.tÌÌel.!diaSrrnì.jtisrÌotottrÌrreirrrcdÌntthinloltÌe\erÌt'tlof The
ÌtrÍ!Ìislhatthe.s5en(eoILheÌÌronetar)nrlLislonLenLiI\the'eni'elbrnk\blsLfoÌn\
rc5ÌuÌ\r gnent1ì!'l'h jlÌiÌrs(.t eiliact\'Todi lrl\ n' nlcdtotr.Ìür:
.lht.entr,rlbìnksPÌrÈrÈn.{ibel!rc.fÜLìtÌ)!1n.dìÌúÌilio'de\iiìtionsithitcânbc
i,:tÌe\erÌiLdbl núìilcÌen.r.uì\ es ns wc harc nÌnr rf f
, th. ol/( liì. 1ri.]c oll b.1Í een ôutf ut rÌì.1 i.lldtìon nrd\ n b) lh' T'hiÌlifrs'uÌ1 t\
BotlÌo the\r.ìppca!ìtrilì.lhillitidiagtuÌrì Ì\Íoreot..b) rrüll'gj'the|1ìllliÌ}dir
grrrr.thc{ÌjrertnrftrtÌt)t|.nr.rÌrLiÌrnüeoilÌìcìr!!tLLreoluÌesLipll\\ide rhi'hdeltr
niÌÌe:lhctotitio. oltÌtr'tcrÌi(rl'hjlÌÌ)\rLL{crnd thcìoPeoilh' lnerti! r!gnr'ntei
lÌrillips cüive\ i\ k.tt to th. ntrrÍÌo.t. (Ìi.. thc cerÌ1riìì b{rÌk lÌ'ìs 'elctrlrttl iis dc\iÌel
r!!r€Êilc .ìelrird ÌesPoÌìs. b) u\ing the relr!i.t lhillit\ cuÌ\ e and lfLlifteren'c rtrr e'
Ne íriìÌl !Éc iÌ is 5( trigÌúlonúì.L to g. u| tu 1|c 15 diatsÍim ancl'lis(olclrrhnt irÌtclcsL Ìxtt
nnr\t b. n) r.l1i.1e tlÌc {]c!red levr'l .f (úpL1t'
ltt lÌ oÍl.r
ln practice, th( .ÈntÌrl bink Í.ts thÈ ,rìÌ,ifì/ inteÌÉsl rlc blìt:t do$ lhi5 irÌ cìrdcÌ tt)
(h.i,:isc rhÉ renl !.lrre\t r.rLc !n tlìr It cuÌ\ e ihnt ( iÌÌdcL \ cÌ iti clÌllsrrì lr\ tl ot !ASrciate
drÌììnnd. Tlìe ÍiÌl intel.sl rrte i\ thc rhort telnì ÌerÌìrnrtu1l rate r'']hc'cntraiLr'rìk'xn
\ei thr: .ouirÌnl i.lere\t r.Lc .ìì.r.1ll bLÌt \ìucc tht e\pr:'ted rate ni iÌr lâtiL)n i\ gj\tn rÌl
the shoÌt ÌruÌ. thc cerÌtr.l hrnl is eíuÌne!l to b. .ÌÌrlc io r.ftioÌ , iÌÌdircllÌ\ ' IÌì thl ncÌÌ
te.t.n,thr:lrquxtn!ÌnrodeÌitnìadem(ìreconfÌetebllxlinii(ìitielrflÌilndtolslÌrr'k\
rÌ]d s.ein: ho\! to anrl)s' rht i fÌc'rentrtion oi tÌÌe nro'eteÌ\ ÌìoLi'l rttlt nr nrbì i7r'
tlìc c.ononÌ] i. .ich.r\(

2.2 An inflation shock

nn !.llaÌidi \lì..1i it ltirightn)rltnrd thl -l_.1Ì{rrh(Ìr ÌllcÌ1ll in'l iudeed
tL) rnah s. Lrrlf!
1!.sLmfÌ\ s€t orú Ìnlre rìtlLcitlt rhtrneÌlri5ihitl\eha\c.ÌÌ.e{ì1 cl!ÌÌeinllg l'7 ÌhL
()t Ìh'
toÌr djrsrr Ì ìn ig :J lì is Lhc I: dliìgÌrD ìhe boLlom lnc is lÌrc T'ÌrìLlip\ dia.{rim'
L

thfu,i equati!ns lhe 15 tqLLatlorÌ is 5h.rÌr in the tol diaSÚnì. iì.{Ì LÌre nrÌìÉ1irt ÌuÌe {IÍ'l l
iìnLÌ lhiÌÌìfs .rLr c! ìr tlìc l-!ttonì o..: l\:e ttnlt âL foìrú I rrllh r = Ì' rnd ÌÌr larj(nr ât
thc raÌSÉt olz'Ilr. \\'e rssÌrmr thrt Lh.Ìc i\ an irìflilionrrl sh.lÌr 1o ìhe e(ononrl ÍIình
I !r'
pu5Ììcs jnJÌati! rLfnÌ 1Í. !hte.ononrvnro\esi'rf.nrtllo'rll =
 85

ta,
I

..t

l
.=,I \z
1

-.1 : :iil - dt:n.r:tì1r'rÈ

r 1! I L nttì!Ìlììif\tuÌ'Lrlí '1.
th( rrLl ìn ilìllaíioÌÌ: tbe nci! Phillilìs curlc i\
.,1 t, i-," -,',"t",
:i i.i it iÌìterst(ls thc"l ll']l at l' 1!ith Í = :J'!'r thtr\' the e'o'ornÌ ú
the InnÌclaÌ\
::. \i! lne 1r) Ìhr Í)Lúh cait ns rlÌe 'entrxl banÌ( iÌìf1rmetr1:
/! curle rlì' cerÌtriÌ Ì)inl Ìrdu(e: the
. . .I:,N' see thc paLrr drn\rr tlÌe ns
t! e'onojn\ retunìs
. ! Ì.i lhe \lebilizirlg úÌtcrcn ntt, Ìrtcntüell\ thc
: rÌiì rith t,rrcct intÌili(Ìr iìL PlirìtZ Notc lÌiil the ccntr'l bxnk behales
i . r. ,,,r" lnt" e\lÌlon: ftequcnt adiuslme|lt ol the itìltre\l Ìdtr rre
. -:. IlrL.o linlq L,Lle

-:: rarY demand shock

_ ...frrÌ\ \tìús otl j. e.LÌiihbrjtuD r'lth outlr(t at lhe equiìibriuLì
..,.,."1r"1.61 2'1, tsec ttil 3.9r' he.conoml jslhenLU\IÌL redb) 'ì
nrocl' ite Íìean
.-: . tl. ìrn.t droc!. B! . tenÌpÔrarl ailgregil' denìrnd (ÌÍ
' ,::r leris tht sho.Ì. is l.! anil renÌnin\ iÌt 15'It)rlnll teriod O(lprt
,,l, r tf,".o**t,ren.c oì otrtlJul abÒ\'e r, Ls tÌìaL iÌìlLiìtlon.1!ìLl
r ihi, r:a\e to 1ti. lhis.lehnes thÊ Ì'hnÌip!
curtc 1lL1rr rrl aÌong
.,rrk !ÌNstclìoosriÌsÌrÌeieÍrccl porni: poinL(l lì!!oifg\erlLcrll!up
 l

Figurê3,9 Èiì!:,r;r! i:. ".a:: nelix. iúit rì:r: Ê -.rii!ìr,;.f:

topoinrll inihe/J.ìjagnm thÈ centÌalÌrint (rn ÌL.rk Òur tÌrrL LlÌei|pr.trìitenrteÌtsL

ririrn)scr 5r'. IherlrÌríÌÌlrcnri](ljtrrrnr..rfrtirdonrtheI/,tlj..rop.i.llis{rftlvas

Iotunrnrarjze,theeco..nrri55hiiL.dtuoÌ!Inr,BesârrmlloiuÌreËsrcgirtedeDafd
slÌo.Ì(. This rise nÌ outÌÌrt ìnrild\ a Ì ir. in irúlrtn)n âholr taÌgrL LÌtorhe s!:trÌrr. Beca{15(
oi iÌúÌaiio. ìnr,rttu. thjr cen onh be .Ì nìlÌr.úe.t br tlshiÌrg orLrplr brl.r! .r tufcÌl
ph\ nefl rb!!el rlìe erÌLrilth.jurÌÌ Th{. .cnriìt l)aÌrk theren)Ìc ril\er r}rr iniere\i Ìr1r in
rrìio.\e L. thr .rSgÌegatc .ì..ì,ìDd nrô.k |ecxute jt .in 1ìÌk our th. ..rrsequ€nc.i fl:rr
.ll.ìtitD. lL nr!st irit tÌrc if Lrren rrtL, in or.Lrr n).ìi,p.cs\ i.t.(.Í ,rn, tj\ I !lema.il nnrl
rcdu.e(r1pIt llÌe..nLrilbiìn^i5n)n!i lr!)l.fs iÌÌt trÌf,.5,ìtL rrxjlatìle nrn)Ìnrarj.r

2.4 A permanent demand shock

lIthc(.i\eolr]r.:ÌnÌiìnerÌr.lemiD.t\lìockLlìcI-\crìÌ\enììiÌ\nrIJ,tr Íirs rhcìe

at2 rt,. hr ure 15 d i!r.rnr, rhÊ Ln iirl stJbiÌ zinir retÉ o irìrercsl i, r. Thc iJ cuÌrc
slì tt\
üghtrliíl\ n) t5 ..lrn at Ìrirh rÌrc irmpor.Í\ deÌna.d í|).1. .!\Ììt gor5 !| to Ì. : llÌr
eco.o'ÌÌÌ i\ rt foirÌt, nÌ the ,àitlilA diignìnr rnd iÌ | ir 0rr i.\ c|r!ri] iFig. Ll0l
 a7

Ì'/Ì-

t.

::-!rÈ!ìt:..'ìaÌr th..l ìff ll: rlr e:; ir ÌL Ê

: ,ih Ìn ür€ ÌrlÌilllpt diagrâm i5 e\dctl) as in thr pr!'tiot15 .asc: lht:

sLr
:J5 ..rÌ.t the 1l liagram. Becru\e thÊ 1r s1Ìo.k i5 a pclnìa.cnl onr:j lht
i: ite h.\ ris€n to,i. \\'ith hisher e\og€nous dL:nra.d, a hlgh.Ì Ìeel
: r rrd tu dampen lntcÌert 5e \ìtive cLenÌand 5o Llril .(rLpul is cqúal ro
-içÌ to tset thr cconoÌn\' onto the IIÀ liÌÌe .1 polnL (-. LlìL: c..ltãl ba.k
::.i:rrfu rtÌ,.o.siderabÌvhigheÌiirrnÌ!i]snc.$sirtin thc.âscoltht
: .: ir!(li. ()Ìr.. thc c.onomv ir at poiÌús C and r-_ , adjüslrn(n1 elong
..i ÌÌÌ thÈ usual ar. The leir equilibriu is al po 11t I in (hc I'h lìiÌr
rrZ ìÌr the l.\ diagrem. Ìn (lhaÌrter.1, Ì!e íÌiìLl clianÌtrìc lÌoil a j!ppÌv
..ì u\iÌril thr 3 rqLleLjon nrodel.

': nê and the real interest rate

::r:1.ìtiontarsetingccntÌilhinlisclslhe.onliÌÌalinteÌestrateìuorcler
. ì rrn/ infu rest rat!', i\'c rcl(ún Lo thr exanÌr[ in Fìg :] 10..{s Ì!e ha\ r
,lii(s . ì,'l.trionbrcktolhfÌnrgrl oÌlowi. g thc termanent.lema. d nn)ck.
i.- rlre nrtereÍ..ìtc nnd thc r.ononr-1 nr{et n) C ancl a'. This 15 x rise
].L1)1. :r! irL)n ,\ nr,'.
88

.orìlrâst thi5 \!lth Ìr'o .ì11!Ì.{tj\ es: Lü'Ìri.g tÌie r.dl inteÌest rate unclìi.ge.Ì I
\\(
keeping lhe rurtlrìl inteÌe\t ritc trnchinilcd Lt tÌre (enlr.l balÌ( lietps tlì. /.dl lntert\ì
Ìair rLn.hal8ed rt ri.lhtl o!ilLrt ÌemrirÌs nlI eb(\etlÌc{alujÌiÌ)rilì!r and i.lliLio. irìLl
(onri.Lrc to Ìi\e â5 Lhc lrìrjiLips crttr e dÌii15 rLlÌraÌd tarlÌ P$iod ilthe lerÌtralbanÌi ÌeeÌ)i
Ìhr r.rr,m/ irúercsl Ìrte urÌ.]Ìiìngtd, tlÌc r.on.nr\ nÌofcs üom ll to r poi'L on lhe neu
Lt.!r!.(lt'ìt.th€sorúhta\tolloiÌìtll 1hc tu:r!Ìì is thaL Lìre rise in lÌlliLlon sLjanaìltd
l)\tÌìrÌrcrsi\kn.ro.utÌtrú.ìboÍtl.redu.csLheÌe!LiÌìtcrcslÌate:ÌlitlÌaiil\'nnomìnrl
iÌúrÍiL ÌatcìrÌ.1high.Ìinflàtiof,LhererlifLcÌ6tÌdteiills.Ì.ouÌtrÌvoftsiÍi='-r''
therÌ i' - i .r ro. higher;r rrduce! LrÊlort ri. à trll in Lhc ÌcdÌ iÌttren riLr lrLll b.oit
outpur iúÌlber,trlj.{lÌret(oÌìonrl e\.ÌìilL'Lh.:r r$ar lrr.rthtnúÌationliì19.1
Ìhir.\inrÌrÌr ìlLLr:Lrilc! tÌÌat iL lttheÌii i.tocdkt(ihilthc(tnt Llìi'ki\Iocutel
on r|!'. srrÌiÌig tlÌ. nonrjrúlin.,lvhen ft:Po.din! t() tlì.lnrrta\e nÌ rrpc.L'd inilltnÌl
.:
oi !ÌishcÌ cÌrÉctell i.letjorÌ of Lhe ÌrnL i ìl...sl rait rrd futher uÌr rìonri'xl LÌte up
mliti ÌllI Lt) Ìrlc ihi\ lnlr) r(.oÌLnt

2 6 Sacrifice ratios and disinflation strategies

',\. hrle r*rÌ tlril thr ìmnrcdiett r$lnn\e ol I nr.,. inlÌ.rtì.n ir,'rc biÌfÌi lo
centr.ìL
rÌì i.lhlj(D \lr1r.k l: lo l.rÌìrln'n (úprrL h\ r1i\ürts thl lfleren r,rÌ( b! nr.!e tÌÌrn rÍrttl{Ì a
Lr.si lntlrtidÌ rrcÌst.nt l1 is h LÌÌìÌr! l. sr! e \ìü+ilr rlí'ÌÌÌ rrnrnrflormtÌrì t() 8.t n ester
iiì I j. lntÌation. \..ìthi\ m.enr thrL ú.enÌrlolnì!'.1 .aÌr iÌr.i.5.qttr'.(e Ìetl'rì nìorc
ritLrlÌ)nìeqLilbrjurn. llÌcL. Ìns.oldrLfÌe\"'.r'\h..1(th!rirN! in' íJnretìÌnts ipp lc'i
1.i thi\ rtirtr.l\ end rre rüì1ra\rc!l r Lh r Ìn(!e 3iftüeli\t aÌiproa.Ìr n rrhicìì unenÌ]rlol
nìcnt rirei b\ l.Í but i!r. Po.Èt\,ri dl: nllr !Ìtik.sloÌrsir.1nlnL.btiÌrg(luenjlr'L\
rfhrtÌtr .! Ì Llrr j\ e urkÌÌr pltil nrdÌl is higher urÌd.r..ld iurl.r or g idtrr!i!rÌr nÌ ntlì.r
rroÌ.ì.,ürcid{ÌuttÌÌeLLnL'nrtÌo\rìì.nt rte\iÌrr\c,!|tÌ({l rltrr lhL' LnÌletirD ilÌ!.k
trntiÌirúl.rt nf rclunL to tiìrgcl aÌx] rLn!nrflo\nrtnt lo rquìLilrriunì. r! Llr rìrich nirt({\
r iÌÌtÌÌere h iì( bcrn d lÌish.:Ì lotrl inìotrnt.t urÌtÌÌlPl.rnrerìt?
1\'r nÌ.rl 5c.lÌìrtiltlÌ. l'hLllitr.ÌLr!\artLnÌerr,ì.L1faÌrlLl ihr.unìrniltredrro!nl
ot urÌrÌÌrp o) Ììtnt t() r.hi.!c tÌre rfduclion ot irúlillof nr t!rB.t i\ tÌrc seme uldeÌ Lrlih
ttrateSi!'j . olher üoIdi Ln lÌrìj.i5c. tÌrr \r.rì1ì.e rìL .1.uÌÌruhti\c(tnrnÌìolnÌerÌtto
xrhie\ r ,ì gn cf rrduftion ln iniìrthnì i\ i.deÌrerú.nÌ ()i tht lÈlr.c 1ri lnlhLj(,r r\ er\iorl
.l tÌr..ci LÌrlhrlÌi
'Ì(ìiLlllsL it.lhì\.a.sunìriì1r(^eüì.rc.loÌrerrtes.ilirtleDrÌr.i.rrr nLl.

hìr.rc l re e!i: Ìhi tr)ughnrs\ Ò Ìei]l!Ì\e t. in lnthú!Ì lali nÌrol. i1! tdlet LÌtu
iLi\cl\. ihe tolirhr'Ì\ tlìr !!\r merÌt. thr b ggL'Ì riÌÌ b. thL'!..(âsc L. uÌìen4JLo!
nrcft ÌÌì resrroÌìsr' 1. xn e\pr.lfll nriÌ.úitÌr slìo.Ì ot thf DtlrÚ hen.l tht blsser llrr

r Ì ,ì r: ! ú.I i !. rr,lr,: !r rLq rari: I .rirji tr:L:. rúiLrJ ,,1 !.\:lrrÉ iLÌrl<
L
(l_ nrnr. 1 rL thr r ìf r.r.L lrirtr I ì Í:.rtÌtn r(1..\ ii' !rìÌL TÌrr .Ìrr.! Ìinr. rr: !r, ,!trì?sr
!. Lr.:
n Ì._!,Lii..nri.,r i,Ì.1. r a t dri., Ìr!! l).r: :Í.ì Ì:n Ìt ì
_.J'Í i L :
1 ll
[(l)s

l..d
iÌ,rl
Iíkr: l.=-r'(:r)l!L trirl.r'

: :111 l,r àt.r nrat-..rrÊs:nrli-r_irÊ rìLor .cdlJr<.r,rt !ànL.ir-

uneDi|)lo)nÌürt, thc quicl.ier Ìlill bc thr ll1r'r. oI tht economv to equiÌib

= -' ft is tÌìrrclorc unclear ho$ tlÌc tolal iìmôu.t ol unempLr))nÌent o\er
: -ìruÌatn e urÌeÌìplo-ÍÌncntì Ìe1rt€s to 1). Llut uÌìdcl a .Ìuite \inÌrle r$un4ÍnÌÌ
ìhat cunNLatir r uncnrtÌo) Ìnent is nìdepcndcnL ôl lJ Thìt a$uDttnÌì ìt that
:.rrnte!l llÌill4ìs.11Át ls ìLnear:

: ..iÌÌ bÈ \h.trr. gcomrhicaÌlt Lig. :1.11. tirsl ilr issrtmc me\jmoÌn toughìre$
:: ,: tlì(:!r!cíìrÌcnr to that l, \r its prcicrc.cc jt to
brjlg i.ílatio. brcÌ
:::::rliai{ lI. ir6ÌtrcLtr e ol the r sL jn unLrnplovmc.t lÌrat thLs cntaiÌs. Thjt
ìtÌr :rÌ! nìoncLaN Ìtrle i5 horirontil i5 slìo1ln bJ IÍl . sutto5e Lhal jnjtÌalÌ_v the
. .quìl brlünì iridr üìilrtioÌ1 cquiÌ to tlc largcL aÌrd tìrat theÌt it thÊ. an
-. nr lh!. inllarjor ìate i.e. ;r ;r > Ìr. \\iLh ìÍl outÌrrú taìÌs üom r,"
''Ii,rtl
, . intcl(iLritthacÌ Lo lhc sLnbillTinÍj
io 1lì!. c..rÌalbrnÌ( carÌsafcl!.uttlÌr.
: .::il,r!tprLl .iÍs hrck to t.. ll Ì\'e measure unemplorÌncnL Ìr! lh. dltlcrcn.c
::i: irlrnì cqrrilihÌLuÌn outp!t, therì tlÌere is uncúìPl.tnr.nLoIl r L,.toronc
.Ìr .Ìr !ncÌìpÌt)vment js rrro again: hür.c .LLmularilc trncDrplo!Drcnt ls

': 'he L 1fc gol ernnìent lÌas . nlorr lriÌiü1t nronctaÌ! rulc, r!//ìr. ,As n rc5LLlt
: iio.k. outlLÌt it rut trorÌÌ l, lo,rr so that in lhc lrÌtt fcÌiod itL.r Lhc sho.k
,: s L, t'j Inilrti(D is;:. and tÌris iÌnplìc\ nlhcnc\tfclj.LlÌhiÌ1,rtnì 5
: , -i = ;L l\in! vÃ, the |hill4x cun'e Nith nr = ; lmpl c5 lh.l output
: I I his nìcanr thatuÌeÌnploylnenl ìnthe seco.d pcÌ iod is l,,rrì. Hcnc.
i ntlo\ Drcnt alreÌtifo periodsìs ir. ],Ìr it, fr .
90

|i-'(;1=;rr rúì lincar

,\1Àr l,=-. arn.1 LurL.r'

IÍlÌ, L, lr io!L'(,údurÌGrn'

Figure 3.12 5à.rí.: ri:.5 i'_ ilì ir::!Í'r

'rirr:i
Tlìc.I..i(Íü]Èaslerln]!ìtharCün]LILalneLlÌ]em|lo\][..[!loc5lirt.ìepclrcloÌ]11ìc
trotiÌhediagnnì iriii':r rrì I r ìi\rìrcÌh I t! 'ntht
'"i";"1;.;. ".;;ì; '*',
n.,,tro*"fn-t,t r, lzrise\.r'tÌÌilr r''l ltcarben'Ènthaiillre'rddtÌÌcuÌrernpÌoInlenl
ro irrr I r+iÌ'r r'r)+ '11ì'
:'.,;ã;ìì".ì,,iì,'"t,".t prrlod nÌthesri'ruaìi\trlnr'ase
cuntrlar!\e ltn tnì lrlr) ) nìent in tbc
ì"ì"itt "."",, r, r; ilnorheri'o(\'itiieo
:."i,,,,,i""-,",",'nr,=1SiÌrcethi\d'moÌrstratì'rÌdiclr'tcìrpcndontbctanlcula
\:iì!r ol l, we rÌ5c.ì. lL i5 tr ue lÒÌ rn) po!tivr \ rluÊ oi l'
''': '' "" r 1 '
"
,' . t, .,, ..,.'Ì,
ür lbe rcgÚrl
,,. rssuJc lurr'rÌ |h1Ìlils cuÌ\'es aÌe íilL i g!o'l !Ììtìr)\imation
ttLar tÌrc
rhis Ìnr:lü Lhe\ ren bc used rs b'Íor'
ii ìr,,, ì*' *" -0""'" rrcre rÌúnetar! nrLc
u,.",-Lo" n,.,.,n,t"," e rtnenÌrlol nìenL r\ il ' rrllosrcÍhnth'PfensrlÌc'tÌì'
I a'd 11rL: ÌrLnck
;ì;ìi; ;ì:;;.;' .'" .,,"'".. 'u" us" tt,c '.'on"t.,r. .urc r!irh -
rr
Ì'jhìLlils cuIe r'fle(ts tÌÌe eÌr]piticdl ll!rclilìg tÌìiÌl
'ri'+ìi
úÌÍlâtiorl
..,r."'n" "' -,
iì.,*", *ss *,,t,,n"'Li. ro a Ì1sc 1Ìì (tneÌÌìllt)vrìerÌt th' hilh'r uncmpÌÔlnÌcnt is Jt i'
",rN'cx
gÌeatcÌ th'n tÌL. laÌ1ro r1
,.ì,'.À..t, ,. t* u*t,his ìmÌrÌ1$ r re'luctlon i' oltfutu!'Ìte InonetaÌ) flrìÉ \tiìÌ b'
llüìc.LmNlìtì!c üìcmPl')nìcnt wiuÌ iì nloÌt inflati'n
,,ì.i-0,.r,"*n"r*"a"ioÌre.theintLìftionisthat(tr€5trrtes,01a!er!i.rlationi\cÌsr than r
i"ìì,,,i o""i.i'"0'..t do1!n nr th( rrrs'r r ery trsl lrill br üÌorc cosrh
'ÌÌrration ,,t.itl
. , ': lo
whtre;ts etcct on trgc sÈltrngbehnl io!r itÌrìore lllìiti'd'
it higherturd
rnr nurr,{lrh Ln Lirìear|hilliltcuÌl esoItÌÌi5lilÌnl' tÌìe sicÌihcerttio
\\iithlineâÍlhllÌiÌr!'ttnes theÌc'ìuctionollnll'rlioÌr
pittenì r)l thc uncnl
i" .-a"t n.t U"'-.," "'tal uncÌìPl')D'nt 'on onll'Lhe llne
"r","ì"n"i,",','"""."'.trelbiÌnÌ(
vtlÍr Ìo(er '\ er iì lrnÌscr perrod \\ihen rht
ìi,r-"'i,, tt"",n'*,, "r a lhoÌt teìnÌl!.tn+ìo\
i,r,,iup, .,^., u,.,,"" n,tLcr il lÌigher mrÌìr. rìre (,cltarr crLcuÌition is rÌìorÉ
..,,-.",",, "."U,,,U,t-!nrate$lr)(1Lrcesanior'rafi'1ÌtlLún!ltheeconomltolar 5lÌrtcg\
l,lrlatrnlut aL greaLer.ruì!latirc trnemÌrÌo!menlc!5t rhaf doesngrad(taÌi\t
""r LÌlt rcÌates to 5a'rih'e ratio5
ì;" ;";,,,,.;;, ,,",,',i". t ,,ì.ri5cús\ tbc en+riÌical 'vidcn(r
 9l

. nÍlation at the medium-run equilibÌium

- .o monetary policies
::.:í Íate rule (MÂapproach)
:.::l]nDodcl,a\Ìdr3r\thcccnlrrìharli5objectireisir:inabilizethr!.ononìl
:. iìi .Ìr lnllerjor rt the nx'dlrrÌì run eqtrlÌibÌnrnÌ is cquil to tÌÌi'tiÍSct sct bI
,rl lhc charrcrerirtics of 1lìc.ìonctaN ÌroÌ1c\i le erÌnrre thi\.
: .r!!)n nn)Clel, in t|c nrdnnn nür equilibriunì. n = ;i il LÌre centÌalbanÌ
: . L7r trnenÌlnol miÌr ar.und ihe -L,l L
L .

::,1 r,.tÌÌk.hn.gcs it5 irúLtiof Lnrgcl, Lhc. the ÌreÌ! rrìediLlÌì ntrÌ rquilibrlum
.: r ro thr.ld oire. ercclrl lhal i.flation i5 dt the ÌÌ.\ tiìrget ritl'. ,\s Ì!c
:::.irrrtin ninllatl{lrcnnbcclinìi.âtcd.rìrentÌieÈ.onlnìt rÌlsdir(ciÌ-Í
. .:Ìil,rtunÌ. HoNÈ\'er, orÌ our nôrDrâl is mtti.nÌ tlÌat ih€ .elìtil ba.Ì ls
: -ir!iì\r a polnt on tlÌr ]rÌ!'rt a-augnìcnte.ì lhitLips cune. it (Illl h.!( (o
: :.: iìie to slt the elononÌt oÌr tlìc palh trrlartl tlÌe Ììe,! inÍlition 1iÍ3ct.
r.,rt oi|.osLlv.lÍiniÌ!ti,Ìr bciorc Lhc .eÍ'iniÌation trrset is ichic!.d

.. :- pply rule (lMaPProach)

:: il]i 1-\ / 1 nrodel to thL trcdlLLnr tur, ite a$!nÌe thrt tlÌc lroìlth ratf
: rrÌ ij undcr tìre corÌÌrol nI lhc.c.t!rÌbrnÌ(. Ììe!sorÌ\ $hI this mi! nol

l. J-ct
. -.:ì.1: irc cìtìoÌed nÌ ChaplcÍ S. Aistrmint tlÌ.ìt it is Possible, ììe sÌro\!
: ::li nro.rvnÌÌrÌ!dr1l:íì ncs1h. Ìareolirúl.rtionintlì."nì.diLrnì ruÌ
'' \l' ''ì

rjlljt\ iroi

: _:.,1nun ruÌ cq(rllibÌiurn. n = ;r io uÌat

Í=t
::iÌÌ be ^'

: ::: Ì:i1 nrirlict equilibrium conditi.!ì:

(IV]
I

ì. arâmednüÌì runcquilibriLrü. hcìcveloiotrllìuL itdclcrnr jr.d

:i:. l\Jar.l15.ur\rsatr.. /\ .ú.!e
l{ed br th. aggrcgale
hc is
ìir rr\. Ilence, thc r(il irÌlcrcsl reLc asrolieted ifith ) l! lxcd ât
tht Ìnednìnì run rquillbrium, ; ls..rn\trnl, lhr rrâl dcnìa.d lor

1ìtc:j_v. ' _ ìrf,t'rl,ÈdrenÀfèdüt!.r5Lh.dLlìr,if frliÌriìbi\i in5Ì.irin!

-..r r, È\fÌ.i.edtÌÌrIaÌr:]r1. 5
 Í

92

mo!Ì!'-\ li.e IìitaLsl:i.orÌnint ÌhcirnPÌi'atilrr olüÌr rcquÍrÌne tÌhâLthenÌone) nÌiìrke:

L5 irÌ.;Ìtr1ÌìbriuÌn i\ that tlrc tell strÌrlnt
oi nÌ'!r'\'DìLL!t JÌso be lonnent l! kcc|dÌc rcal
Donrt: \uppÌ) constaui. lhe prlre k\':l I Ì]](st 3lon'at th' 5rÌÌrr râte as 1lìc
ndìi''ì
morcl*rpplv.rrrlcnlrun.lerlhtcoJì1!olollhcduthoÌ1tir5\\ie!Í'1he\!jnbol_('alle(l
g-rrn,^l tu,lc*,t. g,,^thraÌe,\o_rri\thegroÌlthreteol thenücl \uÌìph
A\iJÌìtìÌ

.rrU

\!here the biI .rer _

f it Lr5c.Ì t.i cDÌplÌnsi7e t1ìar thr gÍ\!th Ìrte ol Lhc nÌ'n'r nìppl\ ii

. \\ hrÌr the l5 í.Il nro.lel is c\trnded 1' Lhe nìc'ÌtuÌì Nn,1he nìedl(tm
Nrì
'quiÌibrlu!Ì
is !ÌÌarncterilc(ì Ì)\ iÌ (ntslâÌ1t iJrnati!rf Ìaie i'qurL t')
lht ilÌlNth retc ol tht
'o'rtant

3.2 How the MR relates to the lM curve

/\ 'l'\l
llclore (LuIÌiniiÌo i tÌr!liÍi.ÌrdLiÌnallsi5 ofnÌ'iÌrctarr poÌirranLlirúlelioDrrsinguÌ'
rli^irranr, ür iì\l 1r|it 1\ th! releLìon b':tr\e(rì the '\//ì apfftúclÌ ind the / rll appr'ichl
'\irltrhrt ìolc.ioes rht r.V.u cfLr\inLhe_l'(ÌurtionrnÌrdrllIh'Jcrìet\!oke\p'inti
I i$t.1hc aplrr.ach 1. use ilcÌ)e!ìd5 !n lhc t] !r
ot nìo'etaIr loÌ1c! th' g(tr rrnmtnl ute\
1n i'rr/rr\r ld\ríl it t(i
Li tììe ilor ernnìent OÌ tht ccntrilha!Ìtril l! u\irÌ.{ 'itr 'ì!'Ìri'1 '!/r'!r
model ls lhe I !'quetllrr moclel \!itll
sLeer ihc e(.Ììom\ 1o its iÌrnation LarScl, tÌre
'oÌÌecÌ
u rll
ll!I it Nt her e i!sl e ìmeÌìt
noir{]. tÌÌc go\ rlLcrn!tj\ cÌ} ur( i Ììontl'srtÌÌrll'r trlt
'ould
ódidí!n.go\enrmtntsinìln'19;llsiìfcÌ1!rsl\r'lhcDÌos1'onnÌÜìnronets(Ìrpl\'iúÌc
i\nrsclrürgrttur1hctsÌo\fthrntÊotth'n Ìì'!{Ì+ìLl 'ÌÍ \'oth'rpo$ibilillittohoìo
tÌrr noniÌìil moni-Í mlÌÌ) constarÌt, il ìJj '\ 1"r'i) slflll rr"
(or nroÌìeÌiÍl largctln!
reSirìc Ìtq(ìrei 1lìil Ìve LúÈ thr LII cuÌtt apptrJ'( rì
\,..ôn(l rhclì/.o.dìtìr,nclocsnoidisrpÌ)erìr(henLheil-{ìiìtÌrr)'ì'hisbeìÌìgLsed l]crÊ
Ne rì.d nr dittúÌ!u nr brlweer (.rr th. / ìÍ
(oIìdltnÌì irhi'ir Ììcans 1lìil tÌìt dcÌìrnd Í'r
axd srrttlr ol nroÌìci arr cqual rnd 1l)1 Lhc o'tv \utth nil( r{hi'l
a$uÌÌÌ$ lhrt th'
js
nÌon.\'\upPll i\Í'Ì c\oAc.(rnI ThrIIÍcorÌdllirìì
ì/'
I
ihr morÌ.! sufflt' II , is i \c!l Ll \inÌt! slete\
Lr
This in ìtselí sa\ \ noLhirÌ! iÌbout horÌ
tÌÌ€cqtriÌìl)riumcoÌrdlliorÌlhattbrderÌÌardiorrÌ1'lmpPÌl ÜtnÜr'!drtrqLlrl TlÌisnrurt
.rs,r!\1,:Ì.!.iiÌ l:hiL)nÍs rilerÌfrnL:iNhr'!'tr:'i'iiL 'rrr"rtlr:iiLrr'\rf,rÈlrr'r!\JrL'l'r$
lr rr r( ftìr r ì i.< !. rLitnrr iÌ l\Í Ìr'!i?l' rrliLÌ ii Ì!\È'\id
L
 93

lìre go!ernnrent Ìs
, r,,1.ì.aDanftom1Ìì(he!eÌshort n úrclpc'tir'c olwhrlher
is bec'rLrse \!hen
, ,;;,;''.,.,;i';;,,, ì;ì(cresr rare based m('rrtr'l nrìc 1hú
"'r hrrc tlr crÌs(tre that tlìc nìrr'ev
,. .,ì;,,,'"i; rule, rh. 'en{ÌrÌ banÌi'' operatrorìs not Ìenrrì!Ì at ihc drsìred
.uÌctr\jse the tl]terrst ra Ê Ìrould
i,,.r , ,, .,t
"q"tf,n..-t
l, .,,',rnL,t"',",g",'"g'esimt, tht / \1'urve i\ prcsenr nì LlÌc ba'lign\rn'l in tÌk'
,,';;ìì,,,,';;,n",','erscctionoitl*rc"'"caÌrdÌrÌc'ÌÌtcÌeitratesctbvthe
rn i'Ín1\ orúflt'
-t" u11Ì1s thc Ìro5itiln ollhe c':oÌìonN 'i
',ioì,,ìin,,ii"" "
: r tÌrc iÌìtüest Ìaic'

-ilation in the,5/t M model

tjj nrdtriln!íÌoÌìì lht I eqüetìon A l'('
:rì,rlrl tÌrserÌ1s a dillercÌrt tì'lrreolÌroÌl'\
..'
,.,,t,"iuì"ìt^,','"ro""resiÌÌ1455e\sÌnentoitheitrÌdrcrtrorÉoirn!slìocl
:,: ,,,,,"".,",t o*t tt*t a'couÌì1 ol11ìe \trtrctirre ol thc irplÌ\ n'd donind
tu)rc'aninil
.. ..., rltrtL.,si"g tt '\'tÌ' the rcnÚiÌbank is nÍwrdlo!ÌiúÌg'
1,,:nilt,l"tlu.nl.n-ttlìíurìrrn'eiotlìreco'(ìnì)arì'ìselringlÌrelntercí
tÌrr ltc ot Ìnoncl
- ,'1. tfr" "cotor"" bark t'
equllil)IlanÌ Bl '
'orltrasl'
, l,\ I _ ,i \ tlìet ÜroÌÌrrart follc\ itfiÌstì\t'
,.,,1,,,i,t"'t,"t't't'tt"tt"'ntlìiÌLtlÌciÌ1cdìrrmrunÈiltriÌìbriuÌnoÌÌlI'lllics
Ìrtr' ot úrnationr thi\
. . Ìr\ ÌriÌi deltnrinei thr nRlilìnì üf eq(tiiibÌ rnì mlrt r mf Ìrl! trÌ
l: n. v,( nú'ìel and rhe gil^(ìl rnre oi the
=,,,'ìi "u n!r'L ihc rÌcr ÌÌrc'liuÌn
. 'i1,,t.", "f,tt "t-o -\'jt s(tÌrir'ted Lo iì
'rt"l)olh nrod'Ì5 i$umnÌgthcnrplÌ\'!l{Ìe\'ìrethc5'rÌÊ
rìlLh : i l,\ cnti'rÌin
I , - r .atr ol Lhe morrci n\+rtr 1\ Lhe nurìc as the inuntl'n larsel rn the

. r-.r.,{rì.:ni tdtlì Ìlilh nio'e\ Í1Ìrfh Nlc Ìrill bc !!nc$lìat di rer"t

n
iìL)ld ..,, r,i",,n" u r(. ìl/ì Ìúdel. hìsi\b.,.rrr(.i,ìrbelJ,li\1mod.l.
",,
. . .'rm<l Lo sticLto a crrìslrnt mo'cl s(tpPh Sronth
rrtÈ lhroughoül
l. ì,'",rn.-tt"' -,n"'cstrÌt 1ríthc iÌìLcri'rio' beíweetr rìre'cntral

, ì,
.l tlÌc
.irilL Lìt the tJ.trrrc to the rlght the r1n'iÌì otr4rut clri!'et ut
tÌÌc
:
:Ì lnt 5l1oÌ1 üf. iiultlt)n iin'ìthÈ nì' c\ {rPlL) gror'th rnLe Jn'

:.ì.Ìr otherì thc ÌeiÌlÌÌÌone) 5rtÌ+nr i\ 'ofstaDt

Hen'cthclV'trnc
1r) thc 5i]lc oi boÌìL1s a lall
in tÌÌr pÌi'c
-rrrr nrorÌ,:\' d,rÌiìn'l ['acì\ tÌÌt f\Í toit!
. :irtintercstrnte lhi\ is thr Ìrìrì\'€ÌlroÌ1âloÌÌg
'u!\'c
: r:ir\ lJ.ur\'t.
:i. .t+ìo\men( Ìe.tÌtr)n r1\r inintlrtiorÌnstlìoÌ\rÌbttiÌclhilÌif5
I ,,''.ìl .on"t *+'plr {slnce friccs rìsc irsLcr thiÌn loc\ drr nrone}
Figurê 3.13 q.r! .!:tÊ il:'r !lt'.tr ..Ì à

suptÌl I arìd cau\r Lhe lìr ctrrt r t(J llÌill t(J the lL Il' This danÌfrfs {Ìenrlnl â5 tÌÌe ìJrlcre\1

í.ir Since inflrtion h15 irorc up b(t nNsl cnd u!r beck n1 Lt\ oÌi8lnaì Ìetel ln the ncÌ1
nedi(Ìì Nn.quilibrìaÌn, ihc lrtidÌ inÌrÌirs Lhat oullut sill
iÌÌ'rlir ìÌì ln hale to elÌ

beLo(,Ì.. d!riJrg the ,ìL1iu \tÌÌì. nt froce\s lllllrtionlaiì5onl!rÌÌeni _)

(1)ì strÌal !]rafed alliu\tnìcntprth nr th. |h1Ì14ìscu r diagÌdn ltiÌÌbetraccLÌr\th'

.conomi Ìn!\ cs;Lt to tht Ìì.itÌlÌ ca!l and thr:' ür i íclockÌisr sÌri'aL bnck to thr
'trrt'
c!ÌuilibriunÌ i(c Iiil -l ÌJl
'1hL:adjustÌìentpnlh 1\nrore prÒtra(ted nrhÊ/\ / \I nÌodtÌtÌÌanÌ!lrìr the iJìltie\tratr
poìÌc) Nì'
ÌuscrÌ nonrlaÌ) Poli.:-Ì nr1. hec.usc $ÌÌtÌr the (err1fuÌ ti'ìIì\ u5e\ I mo'et'ìrl
ìt à.th eit iflcr,erÌcs lo S!iilc thr cc(trxn! rt) th. rrt( rÌìcdiun nul ctÌuiÌibrjLL'n oncÊ jL
jnlÌaiio' do(n' th'
i\ o. the disi.iatio. truÌ ic g Ìom íl to / iÌì Ïig I 10Ì '\s 'onre\
(rnLÌaLb.rnkstet)\inând.ülrthri.te.e!Úntr'llÌcdctailsoladiu\trÌrcntu\iÌrgLhtI\'l'\l
rJr.deÌrI. n:t ott i. lhe rìPPcndir

5 Conclusions
ln tÌrii .hatter. iramtÌlorÌi ì s heen !Êt oul llitlì n whi'h ìr(trt'i ard t(ticies n icctÌnr
n
thc e(oÌronr\.Qn bc 5) ncnrxti.nllv iD\tíiijrled lo LheelL'mtnti a\scmÌtedìIì
Chifter2
Lo rnallÍ: igtrr{atc (leÌrren.1 Ìthc l5 .!nt, rnd tlÌc / ìI (u(i and irlgrcgate $PtÌ) ithi
L15 rnd /'S crÌ\'!'s eÌ thclÀ1,).Iehi\.e.tdedthethilliticure\iì'tÌtheffonÉtar\

'llÌc l'hiÌÌìp\.rrÌ1e\ rrc t6ed to anal) sr pnr.e$es ol infliti'n Tìre origlnaìlhillips

'trn '
.ìepi.1(1a n.ìbl{: cmPúl.xl ìelrtl.ndrif bcllveerÌ unonÌJlo!mcnt aÌrd i'ÍlrÌnÌr' H'rvt\ er
jl a polrc\ Ìn,ìkrr trie\ to .rl)LolL ihis rc iìti.nnÌiP b\ chooslng a Ìoltff rr'erDlrrtmÉnt
rate nr cxLhaxlr Í.r t!t rg uf (lth d hilho Ìrt€ !l lnlhli.n the ltrbl' tuìrti(trì$if
q iÌÌ

.ììrapp!aÌ.lltlÌcrc are rro lâgt iÌì itege:nd pÌrcc \e11!'S arrd lrigt rnclpr l'c !Êtters an'elrÌi
1o nrirtri!' LhÉ Ì)en u\e oì Ìh. inl.ÌmatioÌÌ avnLlal)Lt trr LhenÌ. i loÌic\
r!ili' r
'rnÌr)t 'ho(ÁÉ
 95

_ i oÌ Ìrrnt belolr thc Ãlli lrithoul Lhc ..nsequence ot rver iÌì(rriìsirÌ!

. tìr,Ìi(] nÌâker, lh.trrf(te, the Ì']hiÌlÌps rLttr c it \ erftrl.
:.i Ìnll!tidr Ììlats i Ìole in s âg( sclli.! Lh.Ìt IilÌ Ìre a tri]de oil lìetl!een
: :ÌÌp!o)nÌcnt (1.liÌ rhe neÌt ,lìLnd o Íage 5eÌtiÌrg. lhis is ÍÌotr'n bl
. :::.ì: rie trúÉr.d bl Ìagged iÌÌfÌ,ìlioi ând thoenne íÌi1Ì up.ìs;r riscs afd
. Ìrr.Ì!fe oi Ìhrsc LrlrjÌÌi|\ cun'i\ rrllcr(s Lh. note ot tlÌe l11.un € r.nd
:;:rli.ur.,ii I s.olhorironlall islrctol15.urei pli(s a nronqcÍ
- oilhìllìps.urc:o the ntrnÌ:

: =: Ì iìil lrr

:ri5.oíÌ\' uncmpÌr))rììenlhxsnrriteaÌro\ethr1ll, or ÌnllahontotaÌÌ

: :,:.(rnlril birli'r moÌÌetrn Ìult, ILl. ìÌrtennsoíil5.hostn coÌnbnlti{lr
.ìi:.n gir r n th.I'hiÌÌiÌrJ.!rtc Ll laces:

1 L": /ri- ;rì lmonrtar\ rüe.,VÂr

: :,: r Ihillit! dirsrrÌÌr.

, . ..:n.d L. the ltrjiLips.u,re dntl the mcÌÌctiì.1 Ì ule to lonn uÌe to .â11!'d
.,'l nrodcÌ ThelJ.urlcfle)rt$orclesriL slìitL\ in Ìesfonse to \lÌ!c1i5
.-:f,';ilr dem!nd ind iÌ \hon'\ the ilnrrr's1 âlc thdt UÌe rentr.l biìnk
: .:., tr) iÌnÌ,ÌeÌÌrrrÌt iLs monet.rt poli.! .c. e5 rh(\uÌ b\ thr.h!sirì
r.r. The Ìnotl.l .ln he u\td to.ìn.h-r Lhc jÌnÌra.Ì orÌ iÌúl,ticÌÌ ard
llaltÌtnt liÌrLs oI sÌrock5 an.L to erplo( how the cerÌtral bink ltlll
'!.r..noÌÌ\. l\r can summilize ihr wrrki.g ofthe 1J l'jC llÁ nÌodÉl b!
i t!irt(!rÌ) po\it \ c eggregrte deÌÌÌind sÌro.ìi

.' L n.!Ìrnuner.orllLÌcnce ledds nr l risr ln outlut and r hll iÌl

. _ hÈ1.( tlre I Â1,.
'' nìrnL ìn t!Ì!r lÌpLie\ that Lnüxtn)n lriil ri\e rbot. thc.c.lÌal

:!:!Let tlÌe iÌì1. rfsL Ìrte.It s'i11!et in

iÌr LrÌcsr Ìate lÌish enoush to
jn
ìrrnt abore cqrLlìibrium oÍler to bring i.!lation ÌracÌ( d(nLn to the

. : :ìmt $ on tlrc IÍ^ lnÌe, Ìhc..:.trxlbenk iÌÌSral!iìlÌl Í.du.!' th(

: ::: t ì!. c.o.om_Ì rliÌl retuln lo lh. tIìU Hidr Ìhe irÌt!'rcsl rate onrl:
. lirl.a kveÌ.,s. anl il]1l;Ìlio. et raÌgrt.
:i irLtr. is r.Ì.led to thel.\.r/ Ií mo.lcÌ, we.an arÌaL) !c nr.icls !rdcr thc
'i.f.rrelbrnli\tailrllfgthcgro lb Lúe ol tlÌe morÌi'r supph. lh.
\1ri i.LÌ 15. lV Ì!orl iÌr Ìr!edÌ) rjmihÌ Ìra\ \ rnd in thc mrdìum rLrn

..i n lario. tâÌtet il it !:cs ir iftcrcsl rxte l)ased rÌìoÌìitir) r!le iìnd
. : tÌÌr ÌÌr.!Ìcrsuf |lrr,heÌr 1lÌe.entlirl lìink largcls mo.ev grnLth.
 t
96

trtlor]nÌlert!r.!()tih.tr!nÒÌn\ Ìll lÌe\tnÌ Lt$\lltll rctrrlìlngtr)i!l!iÌbri!:

l!ÌsL
toLLorrlr! r d !lurb,ìLrrc llÌf m({rrter) lr is aI ol ihe d'tilc Lnttr\rnLlt)j
'rinÌne
tÌrr..nt;aLbiì.ktun!1'rtÌtr'.(ÌÍ)n\Ìrr.lÌorrrL!'qüiLi!rlrtÌn lhr'ì'nttrr\ rLrÌc1':
Ì)i.oÌìtirÌeiI..t11eiiLbeÌ!rnìi.rLl.ttÌtitIiLcìÌÌ)foiÌdr.z'r'r ntÌÌerir'licrn!n ''rer!'

QUESÌ10N5

(11 Ìl.r I dirgrff r:LlÌr tlì.r L:ÌÌÌìi ürrlilltlheÌL'ttÌlrinrlrÌì!1n'iiÌlrllrr'rrrLtlnrt

!ìi.rsr.ì.r JeffithI \irnl : 1r |Êrr\ti' iÌrl]]ll.N rÌrd
ú!rrÌrÌ).1Dr(fl L\lrliin\lìithrÌrt(n!i:Ìlr( g'1tfìn!ìtrLr'id!\l()!ir(isralor'
!Ìrtrrl.1!riitirii,rrtì1t Ìrsrtlr11itL\Ì)rÌriÌedt.:r"rP1 LhigÌrtrriti'l

(2) (i r.tr,r,{tìnfl.\.Lú!lìML lÌratrrL..irj\n''t itì:ÌrÈhìÌrnn'tirotriLlonl-

!\t-r!.Lrti()nsl!i r.irltr thlÌ. rüÌrti\'r\Lt(latnÌ \'r"ritr \iN ilnr 'inrÌ
a..l'1r | Ì .h h\ Lr..h.i: aÌr! lt I ir. a lrrr Li'rl'i lf !trrr bthrÌ j(-\' )
"r
1l) l\t,Liin.rr(rLÌll r ltr.Ji{drl)li'ni lì1rt !r lìtirrr Ìarl( irr tirrirlrn t' ìl
,lii rllrrirj r . rr)\i r'
(4) L\Ìr iì. thr l tLrii nrÌrììi r( ratioÌriìrlLirg(l'irLl 1Ìr( 'ÌÉÌlrrlìitÌrÌ(rLL)1 LrìÌ)tÍi'
úÌ!r)rìati.Ìr (.( iiirl L !Q\'i rÌrÌi( lithlri'drlixr's m'lt i' tircrÌrÌ\'ndi\rlr! |
!rìr.r lr.t iÌ n-r 'm ti 1). rlro Ì) I \,r 'L'
I a r

j. in:Ìre ir uÌr uì
15) Lrr\.ri rL rhtr riil|ÊÌr' t|t i. )ì.nr\ :'Ll(n\lrrg ìÌr irìil1ÌL'r nì'r'(
.òei:L,,rtÌrr!!frÌrÌLrriitrrrirÌ1Ììirr!:rroirLirsÌrr!'isrJLrÌÌtrìtLolÌrt'Ìl
l, tlrt.rnlrr Ìì.1!.Lrij Ìr\r11Ì.tr11ìi.Llrtilirtrrirtr t ÌÌ1r !'ÌrtralÌraÌÌi 'rÚ
rirorl úìlÌr fr! catea i r!m:rllrrmtÌJ .rrd.ìÌ\rLLl 'r'hji\ nS Lli iúlJtj'-Jr ürË(t
(61 l.LÌ,Ì\lrì!rlexrft),rr\ rìi!ìÌi\. aSgre!rtL '1id|ÌrLÌsh'!r' ÌLnftl'ti!finrÌrÌ'lfì'nL
g,) lìr r,tr tÌrr IRlr brtuL lhc r!onL)m] r(1L Lr.t ÌLr rrìrdL!rf r tLi clr 'Lill f ltLÌ l
(7) \1ìii.r.r\i t)rtr.usrolnriÌrter!iiriteÌrrnil'uriiirl Ì!'l!\ t'lr1 e\'ÌtLrli!!
:rr ì!trr.d.rÌ\()l tl\.tthr:frlfritrL\ r:Ìli\:
1,r I:ijÌìtrl.Li! J !..ti.rÌrl ftÌljrìrLl.tcreJ ra ! rÌr'L
1l. f ìr niì!Ìirrsr L(!r)lai:,trlrrlh r11.,Í trìt nì1rf 'r nrlrrìLr'
(sì l\fìjirhrÌi\nr.rÌrtbr llrritr.irrrt,LiiiisirriÌrlrÌitlrinliÌÊirltlrnrttrÊ
l! !r iÌr I rr sti(úr 5 j I tlrÌri.i lhe ir.rirì'r rrÌirr ldr ! r ('l
Ìr!
(91 laÌÌi(r.tr':ll)rrrk!nf.ct:ir\l!)1i.1 ir.frirtirritr'L'Ìrarr(lri'ÌrÌlttl(tir'ri:rt\
ÌÉ rrr r.1 nr|li r: l\ trrl haÌrLrL fr ! iÌk !ntroml il thcri l\ r nüdrÌr:rl ln th'
LìrnrLiì(1 i ,r Ìr1,Ìr.r:'
(10) \\ hrt:i:(nr ! riit!t lht Ì\( d I
iÌlr r\ rj.h tÌrr ( rit'LIr 1t] rìriilu'r rÌrl
'nn'rÌrl
trr i i' thi /\ I \/ tr'rli l
iquLlLÌ)ÌllLn Ii)ÌÌir l.!.ì Ìrrg:ìtrÌ r ril! r'rnir Li( nl ilrr)'
 91

: r:Êí otrsÍord6.u$ion
',i lr(iors LntÌrÌc.ce tlìr'.büÌg{: Ìn tlrc urÌeÌÌlPl'l lnt ratr i\í)ciriid
riL
i Ì irì ntrtlül bclo l :.dl lI lbe rc.n(trìì) i\ tÌLìolcncin-{ rafid slÌu(tÌÌriLL
! ììrl!\ .rerÌl \ìrittiÌrg Lo.LiI .rerÌt 5'!t1ir5 1t g lrcnr '(nd ('oÌ!:!Ì] tt) neÌ!
:..iÌ.rrto!ldloxi\ltctiÌìltt!.ilcril'uÌdrÌs1\'t'!Ì(ilhcnrnqttÊ\inÌrl
-.rt .r tÌÌ( s. raLlcd 'joÌ)lcss Ìe(orcÌies dÌ\'!\s!41!Ìì tlì' l nit'd st:te5
..r:\ionriÌÌLhte!Iltl!rr)0sindriÌl) 200ülfL5rIuÌrr cìerÌ"r('Í)!LÌ"

.,:,,iÌú I orr attribrttc tl(. dl\ap]r.rr!.r' ol thc oiisnìel \trLr ' I'ÌìiLljf5
::-- ntÌÌ.bdlÌioLrÌ oithtilot'rnnref Ll
olÌrÔrÌ.er:ÒÌ
: :rÌtdLuÌn nLf ecl!iÌlbrntrrì. tire rceÌ rrlc'tirúrtu\tclcPrn!l\ oi hsrrl
:!Ì.,fclaÌ) l.lì.\. 1).lorLrtreclI)o's\'!riníter'ftÌ\ totht

:r:li.r(ÌÌ srÌ1rrts rÌ etrrvÌ!lìrre,r nrorÌttn(Ìrh'rì'tÌtn'n' Ìlrf itiorÌ

. . hthr!i.ur ' '\. e\pn.!i{xÌnÌ\ i!':al f')l '1 Ìtrd5 Lo iÌúliti(trì !iÌe
.. irrtel{indfIü j.ìe,r.cralÌLxtio| otit \\'uL!lt'tr(!n'Ìulr1Ìril
rÌ1.ìÌi(rì dr(rLd bt ìÌr 1Ììe haJìd5 cì1 a corìnìillee rfpÌeseÌìlLÌrg rr n LraÌ
i::.rL lrro (rts. n..ìl)rlcc teil(r dÌrd lhe !titÈünnc'll L\tLúÌ

:: -:.iiilvÈ model triedman's model

' i' lrirl flt
: i rn lfu rnìeLi!,I F..r!rìl.r .\\iì'l'rtr')f i' Ì116 \lrlrtr lrirü:
:: !r it rl ri,i. ..r!rr.nìn 'r\'ilh (.iì|?hti\r nLrL(t\ itiji ÌLiÌ"litlìrLrlr
'ieL
'r ':ìrr r..rL(l1ll:ÈriuììthrÌrL!Ì lÌitr tÌi(ÌÌiaL:!r\lrL:n'lirì'rìtÌr5'rrl
r !,,,. ih!.i,L.l tr,,:ter\ L:i n! tÌre üf,, !f rmfrÌt(L ntrrr rrtilrn Ir \i'
-. r,ì,,nìÌ r!!lnd.rrrieL.m!)!r a il\ i 'mÌlÌrnlnLrlÌrLÈ'Ìf ì:rìrfl lfr'nL ln
n ün!' hàtl!: ì' ! ii l
- r,l. r,rltr g;rLrrro r+Lrl: la rll.l :r th!! ltrrslntr1l
::: i.rt\l .r iÚ1.n.ìi:r,xìstrii thr rr:trtrrlÌttr'ÌL!ìrJrfLornrr'Liihrl'rr
lrúrjì I jjl Ìr. j|.rÈii r! iì,1 \ .elrrr Ìher. i.,'.n, 1 r! ir\' rÉÌ t|r
LL

'1Ìii.LiInlÌiÌf.Le'ÌlrrLt]rrri\..ìdÌ! úntr(l"l lrtr eÈr'ìf'ìirLoìnir'1

. r',n ;trt, s r Ìirrie.Lt rì \rhnlr ÌÚìemlll)\!I?ni lìl'r :lì"rtrirL Ìrn' n
: n i :tL.Ìi'r.
: ì,,1r h!,, rlrÈ Ìnr. Éiút\ 1rÉ tlrrref trÌ n h'r: tltr 1r! Ìrl ::'Énfu'
ÌI thr
.t:nrl|rÈdL]hilit|slnÌÌ6lL]Ìj33,i].tlre...n.lì\hl!i
: LL' ilrr r.f itrrr\ i' ri tÌ jr Ìrt!Ìì it' \ jrlr I :t'l rrlr f t L rnll r\(' níurr
..1:rniLrÌ ifÈd!(!n.ì!l!ì\nìen:l h?r I ì!'g!'urr rÈnr!Í1 Lsl-'nn\
. .'.1. :r,1.!S,Ég.t!dÈnÌr(jnigrf Lhrf t[r]rrLÌLrnlL\"1!!rtLLt Ltij!iir
r hÉlr iIi.úìtf:1,ü rÌr(l!irrrlúfÍrLÌr!t rne(Ì:tl"Li'lrnrrtu1srì tllì !
iLr't'ln'r!'r\
-., rr' (rf úr.ltlr.rhrÌ\l 1r:ÌrrilllrtrlrnLÈ ltrl'Í'Írl
!! ì::rLl.iÌxr re LrÍ,1\?dl LÌr. È\i\t( n'È Nl rlrrf r ú nj 1' L:f ti r ì L \'es f Ì
_ .r. Ì11 Ìi\(.. Èr,\ rakr5lne ln!rl'\'L rlr'r' rr'\lrr!Lell [ÌL] l'r iirìtr
-
98

.Ít ,l Lrll I !r,r-

I l
I
r.1/,1 i;r=ar,r

Figure l,l4 annri.r t,r: n rdÊ ilri':.iJ i ;-'. !.:ì!.rrrrr. td.:iir.Pì i túÍr!:

ìrlo rÍ' arrar! .t ilÌ. r a' i. th( fÌi!. .L lhriÌ rn\r .ulÈr. it nr.rni r Lrll iÌr thr Ìf.Ì n;gi tri n r rf'
lìiBh., d.nrinaf'rÌlrl,.u, lirtL'.rrÌrefÌtlÌrr ifah ttt.rrLìi0{ Lher!ttrlpÌrrifdr\ nrÌheLrntr'lr
rl, rJirrìtrd, iQdi Ìr.rlrLrÌ. iÍ!mra nrlraie tnÈir hbr!r !rtirLl !l(Ì\r! trr:ìì"\/\''irJ irilÌri !r
riÌtre Ì!r\ !\e fr cÉ\ !irr Ì,iÈr.!\ !)trirlj t. r(!m tlÌrrr r\fe.rtr.n !f lJ:ire! ii ! |?rnrL lÌÌ ttlr'
r(!ir,hli),.a-ttlt Ì\l l rLrr rrìlrerÌhtnl =F i ,lr|.r!!.1 tl]e inrnilitL !lr!rl.r L'
.birÌ\rrhe.!Lrentfi(.1.rÈl.ll].rrrf.tÉdÌ(rlr.lr.\rJ l1 ]]r.rhi.h.aÌrbÈÌrÌÌtÌ.!.i

.,i l' 1,

H(..e üìÊ lilrorir Ììtr elútio1 L

'ir Lì
'r.=/.t1! r'l
â.Lirnr rlrirrtiin t /'r nritbtl r Lâb.!i 'rpÌrl' .LLíÉ
lìL.lÌrnn.:\úriú\r\lLrreLhÉ1!tr |.j.. erÈir\.((lr iÌri ert!.tra l-ìirr l]r' ' lr.llreìllrr
ì.rLnÌrÌ\,lJiì!.!rr.nilllrrfìr.theri!lÌtÌr.rriÈitiilnrÌ!rL.Íl'elir.'l'.tr!r.!tÌ!r.\fe.hLnÈ\
i!,tiÌr.:Èaih,!.i\[i!]rrrhã.ir1(tri.nltir.rlnnrrrILrourÌrirLlrerÌf!lÌrl tr(ìrnr tÈ n iúì rhtrr.l

r!neiiljl ?; .rl lìr.1.Ì {ÌIrtli.a ti.uLrLLrt!'

 99

.I rrrÌ f\rnrtlÈ, fri.Èi arÉ trirc hÍrl !Ìl rhirh rhÊ lrhotrr nLIf r
rb.rr the erte.red
. :L l, t',, úren rhc Nr r L t rlr : li' iÌ | l.rl,!rÌ iÌprlird rlill be
lrl]orr luptlr
' '. ,rÉ ihâLLi$umr dli dlr rril Ìr.Ur iÌi\ ii ll.o L,Ì 2rí fr.nì rr io nr frr liS. J l.1l
': rh! iìir!Ìrm tl t nÌ.rr r\.irifle, rÌt rrf.!trd r.dl !âgÈ nru! lìarr Ìii(r LÌ Ì r! Ìor
r! rrtplr.a lr i\ {riÌ n, (1edLL.È thrt i r.rl{ÈÍ \rerÈ er|Ê.tlng 7ÈRr nrlai,xì iÌ,xlal
: .. tllrf i fro..\ rrgr in.rea\È .Ì L']] \r.! .1 rnr.lnt to rn extÉ.ted ÌragÈ in.í:is.
,ll,,,rl\ .rìlrl.\ F, \i.,le6 iLlrÌì.e! rl\e br J'f !).5 tLì l,r!cÌ dre a.tual rca ÌragÊ hr
rìÈe.nn.Dr.inshiLlLi.mÌhrnrnÌrrlÌrfut(ÌhÌ3hrÌrÌ4n!tmrntiliniaLir!rri\r\
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,rhÈ. if rà.t r!a, Ìrrr.sii lllrÌ 211,. OÌÌlÌ tlÌ!Ì,BlÌ iÌ rnr.ii.rÌrifulri\rnÌrhr|Ìirr
- i Lr .rn thr illÌrlor l)l , fi,aL.i .Ììdt tÌrr R.rÌ nìÊÈ Ìràs r se.. !hr. ii i.(t it lL\
i :ntnÌihri!ll!\ingfer.d.Ìr.{Èi5n.ulrlútdatthriÌiÌrlìatlLr.erpe.LâL..5
. rl iÌ iÌr..hâtLÈr. a.hàng. !Ìr tIt iÌrllrlirr l0d tu tr \lìiit iÌr ür Ì)lrill4rr.!rre
r. :r!, rh llits.r,re! ir. QLlrl È|c(trtirì\.uBÌÌ(rira l'ÌrÌllip: (N5 rnd \hiil
. ì.hrfg! i. rxte.t.rlÌúl,rÌjfr lÌir(lnrÌìrr!nrnÌ Lhâr.\fr.ti,ti!Ìtr iÌrionlrLl
:lrii ie rdrpti\! r\frrtatr,.\ | tlìr f!111,Ìi.f t..iLrd, I n.nrÈÍ !f,lÌrllr(iÌ
:i LÌ\cd.n tr\t rì9rn(t.r, r\f..i.d L.lllroi ÍtLLÌ har? châ.ged lÌ.nì 7Èír r.l',
:: :!! ( i\ìfÌÌ linuÌ.rr rhe irrÈ .: F , nro.er lrage! rrjll hrre !r rise hrÊrfe.Led
t! i,ll t]rr r(dlÌ!ìAe ,.m the a.tLLàLLerelin FrnrllÌf.1| !ttl)q'.Ile..e
1 rr f,ri ft,r rinìs rn...iin!? !) Érìrtlot I Ìr.Ìllr frnr\ rrLi rlso Ìi\r br arli
. .1,i.,!rìLiLsÈÌiitlnglrÌrl!Ìr l.r tlrni Ì r i.rnr,l (rÌr(titi,ìL JrlmrnÌr(l
:' s úìereL.rr rltv.rt !.rlÌnnÌr tlìr r\Ìr..Le.l i1r.!,1 ntJlnn(hút(\
:: iin.! oÌà ldr! nrn Í.n..íf rn lÌi(Ì, rr. i !LÌi].. oL Úre !:.tifeLiri\r ti.dl'l L;
:-: rlr rhrl!ÌÌ! nur L'hillifs(:u e i\ !e .al Ìt nrerti.aL at Ü lj ÚÈ nârrml

:' ::;-È9àte demand shock us nq the /tlMmodel

. :: ì.:.1ì \hf.llerl thÍrUl, t!nú,rÌnìÌ irtÌutr fl,,l nr(Ì i if tlìr r!
rll nu rll
: r.nuÌtnfn LloÍ inn rrn,rìr tÌrit rÌì. .ÈfLm rifli n .l\\ r!, .i (!Ì \rint
r.
::. {.u,!ì ì llÌ!in r ìleqLiilihrLnì.:rhÈe..nonrriçdlfla\ÈdL.rL! I l5lÌ
: .t:trfrr.ÌÌ,onr.trÌìi.hrre;ÍLLnìÈi5ãfenìaÌr?.l.hrng. fbÈhari.rÍ.sÌrúÌs
.: lh. .ir nrÈd !rì rrn erÌlilibriurì ji rl tonï 1.lI the ner! DÊd unr nnì
t 1: ti.l Ì:!!ilìbúrn rÌÌfloì ltrt .rl .r tfnt iÌr1,. rnl rnd úìt.Êrr
: ::ìr: iì highr il r. I lo( nÌ ÌlÌr l\ Lll rLrlrtr!. tlt I rr qrilÌL)rnLm ij il lhÈ
:ì :trn,rír\tÌìrl\ 1I/da!rânr r\Èll!..rrhÈA.u,re \anrn.ii,,.!ltlrrr(il
'.. r,,1 rÌì...nr nâL i.t?Ìesr,âLe Ìhii sú.nn\d.dgÈdi. ahatLer2Lr.,nrsr
irr,,.1\ t Luârn riÌìrrhi.hiÉalaf.ln.Dinalinrü0rt.aresa,Èllre\oÈ 1!irìr
': .:?rci1Ìale Ìrill br !.LroL0 thr rril iÌrfuÌr\trrtr Ìn boúr lhe neÌL and.Ld
: rÌrridrrloi\lÍn\nÌ1ÌhtrnnthrrLÌrrrÌDÌ\t!'fullrrrr.th?h.r Tontal
:htLL
_ r rnuÌ ot Ldp(!Ìrtl) n!flrn.n lÌr.JÌ5nÍtr\iÌhi\ Ìfith in i.1Làri..
i rr
- ì:arrn ifu rr iÌÌ' nredi!Ìì tr,Ì (!!rlrar rnì L\,, ,na tÌr r.rÌirtrl nï0Ìcn
. ,ìrl L,rn rt,\ì .nìr n nrrr. i. l ? ll5uii.!rhÈdanì.,]Jìr!Ì!r\rtlÌrr r

: :,núo:r andlìehr1.rnìtÌrernüL!?r

-r:.r ÌÌfuÌrr!ti,tlr(/l/!rÌÌ!nritiik,i.rri t /dÌhrli!rnrÌLhr.Ére.

i:,! r.Ì iffrtrn)nlâÌlsìiÌn)tÌLrÌiuÌrlrlr.J iflldtnnrnrr\ aÌÌrÌrrì to\ec
ÌrLÌ ,, 'riil;r i dìrlr\ LLIr h.f L.Uiinnr l.llr dnd d.n n rh.f nìfrinìr ri\.\
 100 ': : i:i r;:',.i:'.ii i 'i'

t,

Figure 3.t5 Permanent i5 ihocl n-"w ÍrediúÌn run equ ihrúm rÌ7

. He..ethclM.urvet vtJÍelativetoÌh(/.J.úíveiIìcjp.ns€toa.hângcúÌtÌrerealmondnÌÌÌti
"r, t{.-.. L "'l I,r \ ri\J r\r! r
"'
ln orrclanplc,lhegro\llhratr'orLhe monr,vnÌpflt is tn(tÌrnAed r h Í.ughout Íì tÌIr e.Ô"m\ n
Lìc !n nre P{li"r : Íjj at tonÌl Z in Lhe DeÌ{ rlliìihÍitrm*lÌrrt ì5 il I'as in thc oilliÌìal "e Ìht Ìi-'
er!ullibriunì ì!.tZ in th€ A,/1r!ÍdiaSrrnì: thir úea.s lhâttlÌc IlÍ cúÍre in thr ncìv (fuiÌib'irm is rÌni:::
to rììê l€tt ls it rìúsl go Ìhdtilh point I SÍì.e tlìe ìÌrtlali.n ral€ is nr rìl(Ìlv Ìhe same rs iÌ Ha! :
rÌìe inilirl cquÌlib.irm th.le tNrÌd lhifti. iÌreLIt inìpÌ ies lhât the Ira I Írtì ev sutPl-v is Ìover, ri:l
 t01

lv,

-. r,ri-èì: Êrtl r. tle neL! m-.d !ìr tur Êr! r rr:tzi. o(...:

. ..i .,r, (Ì nLlÌLt is Èd!.Èd dÌúin8 Llr. a.ll6trìrÊ.1 ne.i!n, iitlitr!r Ìi\(!
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: L fÌ.ì t!,1i\ tÌrnr(trl r.l rotìdnrÌcrLt(ì \h.rr lirl..uLtJ' 1..1
. ..L ir:rLrr ì.rÌc i\ p!\1tr! riÌ r\ ilr r.rntrÌ\ rÍnri.lor! thr r,11r.trÌr c tr,
: . : ilrr Ì,r\ \Ìr! t r,..(LÌ,ililÌnn H!ro(r,,.,(ri1r:.nlfrnr\brlinto
.r r.ri.irrfrri..g.esÌLrr .-ri\!.rì.rÈLL|Lh.lÌriÌl !\rlrr..fli =
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,\r'
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r

r L ìr\È r sr. rìr.h;tâ.Ledi)llâÍi\eifiillrri!, Gr.rihrrfn\trnr

.-:t-.1inìà.drò rlrDlre.Éd ai â..ÌriÉt!Én.!.1 LhÈ r r i,r tÌìr Ìril nLfuÌr\t
: .rnr.t !) t!.Ì1rÌrrq!iLiri!Ìn j\ ljlelì !)e.\!É ThÈ ì.: llr,N!l!nÌÌl
::. !r riliLiÌnir irÍlÌÌJìir.on.) liiÌr8 ir tolld\c,l1-.r r iÉ..nd tÌrâi'dL,r ìu
I n.,i (),r.!,,r,rtut i\ l,rld! r!Ì!ilÌ!rrrr. nÌlrnÌr L-rrglnì L. rll iÀl
:,,,ì Ìrìri..r.,ì\ i\l lrl\ t!i!ll!\ r \r,iril \lLLIldrdir)trÌÉf L tirll
. i ri,,f ,. Ì r :l.La lir l\ l,,.A it in lìL.n (, r,nÌ i rl,frr.hÉ gr.N til
.rr Lreü1!rlrll lì!t the hi!h !.Èr:f .Jdre.L \1 llrl.:írÌr.rÌÌúLi.d rr
I ' -1,1: beriÌr n) \hltl t,r rhÉ !ht r!ì1. r.r1..útJr \t,rrt! íi n\. lhr
L,!L.m it p!nÌr1.
 Labour Markets and
supp ly-Si de Policies

:'.r t(ì Lho\È that sÌÌilt tlÌe Íase oÌ p.ice Í'ttirÌ! c!Ì!e5 (lhange\
: it\. mÌninum llrites. uniuÌ at errtJlor"rrìent prcte.tìon Ìeiaisìa
i.dIarÌiciÌratìon br tlÌe gorenÌnrntiÌr nr{oiiati.trrtÌ!itÌÌ uniont
r ii ,,n\ ma\ shìrÌ tlÌe hJ (!Ne ClÌarge\ in .onrletitnÌr |oÌicy
_: /'\ .ur!!. TrìrtiorÌ lÌr\ eliects on botlÌ tlÌe agBresate !ìeÌnaÌrd
..l:).om) or Ìhe lrÌe hal.lit ìna\ tie used t! \tdbìlire rggregate
., tlìissútÌrli \icle jmplicettlr \. It hat!L\o been mgge\ted drat
.. i J-.o!.aÌÌm6 on tranrüÌg oÌ e.ircdüÌr rrir! be ible nr reduce
' 'i.r hr rrisj.g fr{h'ctìÌ ìt\ \!eÌ,la\ cLolrnuÌeÍ)leolrincie.cr
' r:Ì!.r .ot bccalbe 1!e d! not thúrÌ( it is jrìrportdú ijee (lhrpteÌ 2
':f :.Ì l5r.irutÌre(arsenlln) Ì.ìtrouÌnÌaÌlietfoLic! !ueÍirtrìrÌelate

.\thjr ho$ 5uÌrplt \idefoÌicietd la bo ur nÌiìrlet iI \titrìtion r

r: i.It ng.uneand,hence,equiiibríÌnuÌÌenÌpLo\ment.Thedrilr
- nrrntin tuinirÌlplie\dshittinthenuÌrtrr\ Nltnrthelhj]Ìifs
r ..rlÌrtrl rn.l iniÌrtiorÌ Lhanse iu reïutrr í) d nÌÌrÌv \idc drilL
':hr.t.1ÌalbanÌi. hÌ dÌe fìce of r tositi\.e mtÌn) tj.le sÌriil,lhr
: r.trÌe\t rate \iÌÌ(e irúÌ.rtnD ixÌÌ\ beÌd! taritetj iÌr ìhe lact oi i
. ,ll rj.1e. intÌation goetxp rn(l1,n)nÌ|t\ ihe.rntÌìÌbanÌi Lo rr s.
: :...t ìr ÌÌlt crn rhilt t1Ìe lfi .u e arÌd the 15 cur\e extc.di.g
_ ., ni ChrtÌer 2. lhe* iacnÌt i.(lúìe the trÌ Ìvedgc. trii.!.9
: .:!t :,)rìfetitl!Ì. ir !strjrlreÌrtir!rr irHi\htn!r, end rgrccnìrnLs
:_-lLìr rÌ! (thri nÌr! .ìls! !n(Lude ihe go\ ernnÌÉ.t) krdr. r5 r{nir.
' , r\. 5€.tj(rr .ì take\ r (lo\er l(!rÌi at ibe sa) in wh .lr lhr i[51i
: ..ìn :itiÊ.t ecÌuilibliLrD xnemtlo) e.t \\:r e\pÌiin llrL: loÃi. oi
. )rtnÌL nmìeÌ. ÌÌhi(h fropo-\ei rn 1I\ eÌie L nrrÌr.(1 Ìcìa1io.sÌÌip
. : ..jÌr:LlltìoÌr ot \irSe \eitinir rnd equilib!úìr un.nrtl.\ nìrrt.
. :: ,l:tll!Ì ÌÌi!ÌÌl\ .entrrLirecl Ìlage retting \tn'ctltr.s tn)d0.. l.)r
.:!r dre rrr
ÍiriclÌ ì prriod oinútxined unenÌìornìrnt dúe to
ìÌr
\utfÌr \ide ot the c((Ìr.rrr iì.d ll\ult irÌ
.::.. Lrìr terd be(l to the
::i.rrtl(^ nÌeÌri llÌi\ Ì)herÌ!Denon 1\ Ì$o\. ri hrrLcÌcsls. Ìr1ilÌr
: :-:.r the !r (dÌÌed iÌ!1\ rtÌrn)dch to the lallM mrÌkcl ln li]bdrr
 r

104

!...n(,nrjc\. j(ìt) 5e.ìr|.h Ìhci! ! hr\ rocusrd o. tb. tnrre\\ L)t I hi!h tlìe urìrfìPl.l (1 r:-
Ìret.hÈd niih \ à.if.lrs. \\'e *plirjÌr hori lhc mrtclìiÌìS puc\s ..ìn b. IrplcscnLrd I
d.rrÌrsaÌd d(ÌiÌìg (Ìilio.nÌit Lrct\1rc r th.1e.aÌrc\ r!te lrÌc tlÌr uni flo!.ì,:.t :,:-
k..h.ì\thellt\rÌldg.runeiìnd:lNr\r roÌ! thL\ carÌ Lre reLrtel nr tht Ì\J /\ nì.{Ìcl :
tu l{ÌÉ a ri(!rer irniìl!sl; oI ell!iLibri!m !fcnrfÌ.1merÌt.

1 Supply"side structures, policies, and shocks

lh..hi,l!Ìn(lhiptcrlsh(nrt[]tlrenÌllo!nr,'.tÌrtt\llilter\idtl\i,cro\s.oLrnlricsrÌl
llr,ri Ìhor aÌe Ìrrbiit.rlt LÌ,'.d\ iÌr !nrÌ]]plo!Ìr.n t in \Ì!e !lthtlÌÌ. 1hjs diÌln srt{gcsl: dr.
r..n..ot rLr (Ìr iì nìodLl r Ìth i (onii.r11,:,r tinrr úrr rriint lll' lìúl nlrrd 1o.rtÌÌ!Ìh')
tlìr / /ìt. sirjit\:Ì)o!l orfÌ liÌne. lÌl this .hijrL.Ì. re id(ntit) t.r.ilir5 lJìnl ren 5hlft eitIi:
thi 1Ì \ oÌ lhc l.\ (ur r i,r.1 therenrre nrift lÌr. cq(iliÌrriLrÌÌ irte.l !nf.ìpl.Inr.fL
lìrIofi.looij.S rt th. lÌcÌl !r!5esnt!| Ìs i. thc lr1 rxlL,r\.!fic5. r'c daÌjtr Ìl .
nÌerh.n .s .l lhelr nÌ+ìi.L en!l t!re ÌJ()Li.\ r!'5|.ist. l(,r t)ie\ it\. rii Icl!'r lo enl shitt Ì:
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tiLL.Ìrin! srL.h r \1rli1l lÌr i! 1.i. rc nÌoÌr Lh. l.jtiai eq!iLiL)iiLrü.1 Ptii.l I Ì.1Ìatì(rl
i\,ìt iÌs Lirgrl Ì€rrl Lri u. nÌÌt\t tlÌe l1-\.rLÌ1c rhitt\ llo ÌÌ Lri..!jc 'Ln.n t'rrer l
r'ci[L.n.d b\ e (luÌ,{!' n llii\ltnÌr l]Ì.ri li i fcr nrelìLrlrnrn.!lullib'tnìitZsii
lìiSh.r!nrÌrÌ.\!ÌdÌtind11itÌrì!úlirtioLì.1 lh.oÌLgnraL..rte uìe!Ì,prl5ld{'slrlltÌo Ér:
rlìi /rlt, IhÊ a$u!4rilorì tÌrdt tlrr 1\ r!i\ c l5 lar Dt.uÌ\ thrt the ÌeâL Ìrng. lf thc nÉ,
L!tLrillb,iumittheirÌììiisjlitd\lrjsjÌrJl]t lÌrLsiirLtlÌeÌ\iriliÌì!r.\ui:loir.Ì ttnÌL)::
biÌrgii.L.S Ì)(n\rr |rLins e io(er lllr L,!1 .n rtn.hrn!tll redÌ r!qt \\iih i d.1!.Ìúrd
s oÌr n! rr! curr e. tiìr rcll Í.Ì!É i\ i(Ì\er iÌ! tlìi nür equi:itrriLiÌn
lI Lhr.É.hdÌ t)rnl rid.orre(iLr arìtì.$i1!'d Lhr th(Ìrl. it r,rlcL ÌLr\Ê dropprd LÌr.
lfLcÌ!\rÌ.ìtero!itob.Dit:rlcresrirluìlifdi.ilÌÌúlcthetr.ÌÌ(ÌÌÌ\rL!nnthiil.tLr.
Ìij\lns lltttui I 1,1. Tire eroÌ!rnÌ\ ÌioÌrÌd iunÌr ltraiillìt tuI.1 tLì Z i:(t -iI i.l
ifrÌLntlr !Ìtroud lnri n (Ììt.rrlrl ,ìt.r Ì\llÌr l.ì!\i. Ìe\ÌrÌÌ.ed iÌrirdlu5lmr.t
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.ìnd rdlritrrgìi. isnl.rL lhrt ihr rentr.rl b,rfÌi is u:ing ! rÌÌ(!iet.rr\ t!ln\ l. tl:] l.rgr:
L.Ìlah.n ifit l lr h{'shilt in the lll r!r\. tr.if s lhat dre r trti.al |hillìp\ (!r f : ri L'
i

rhrou!h the poirl Èirli(lZ llÌeÌ)lÌilliÌ)r.!.\csi\nrcLalcdILththcÌreÍIliLjrrejlÌi:rÌr

x\ {re\ ÌìÌÌe\ l! iol! fg the dÌì:t irÌ thr l1\ r leÌr tÌ.Ên\ uf bttl\ctÌì the ÈÌl\tiÌìir ri,:
rr!r.r, iìndÌìr.L N.f tÌÌcÌÌer Ì15 r!Ì\c lh. llÌ!tthingn)hrÌrÌ)erÌ.ì\r(!Ì\e!l!ü1.:

I t.ì U. húLúi.. ell. hrc.Nte ri ilÌ(.!r(Ììt.rrLL nrt ltl Ê1. i. lhe iacc üt Ì!rc ÌrÈÌ! !itrirÌior
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tÌìrr.r!rrt1,.l\lôn.\\'rse\ri\rbrlifllÌ,ì.1h.Ìr.li.ittcLL ri.tÌati.Ìr FiÌrn\'((in'
tÌÌrrri![ ri\r b\ l.!\ tÌ]an i!Ì th. fir\t.ìÌìrl tlr.\ tttL lbtjì tÌi.t\ trÌr bi le$ Tht t.rÌt ìÌ'
núlúiur trlg!!.r i r.rrtj(Ìr rn ihr r.ninì bi.li r cul\ lhr lntcrr\r Ìxte. Tht llÌ1ÌLiÌ !
.!nelr.irì!lhr.!'nLÌrlh.ìnli\],(.r .l.t lnthrtr\{rlÌrI.jicht!)\r\jt\Ì,rcrentil
 i05

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: Ìl \ iL ,r? à.lrïnrnt .1i! r.r..! !rr-

::rrÌ\e.sel fo nt L. 1hjiclicralcsthe re.ÌrjrÌt.!t jI thr inlcre\t

I lrr elonônìv tlÌen lcljLÌst\ rürì ro Z Ì!iLlr the ce.tril traÌrk
at
,:. ir!ì the l,hil jps.!ne sìrilt l1B lrújÌ itscLs 1(]1,( ;/ =.1 I :]
: .,:nÌÌ is ìror!Ì1in fi!. .1.2. IÌrfJ(ion dÌ(Ìn o.rr I rS. ând pi.e5
: i.tÌih drjlL (lrcsuü.ìLrl_v ar thc nrÌt wrg. Ìoudd end thcn ìt
- 1 -l nrorLs tlrr s!pplr 5[)ck in,rlÌris ir thc same rì)Ìnrar as Íe
: Ìì irÌd ri.!r:galr drnìirr nro.ks, j.e. n,jrh Llrcl5diriÌÌirÌÌrLÌore
.i n.hdeÈtr1 iccn.aNlÌrl\ sho.l(Lilier tmrn rlÌeilllatjondld
i: :r \lÌiit\ ÌÌrc I1/ì s.lì.drLe Í) tÌriìl t Soe5 rÌrNrLith the toint u.lìerc
' tÌ ..- tt.
r iiÌÌrereÌfli.iLhtlÌecrìtiÌrt|c nteÌe5tiârctomitsi.il nlLe!el ô
nr jj orÌ Ìhe rc$ m.rìetlr! NÌ.ljne, rvn', edl slnìeDi tronÌ a nì tlr I
' rrri.\
fLce ir thc !sÌrrl Ì!.r\.. \.tt th.rr rÌrc sLibiljriÌÌi{ jflrre\t Ìr1c
: _ii,.r(diiìn ruf cqoilibriLun Sin|.re!uiÌjbIumoutÌmrishiirheÌes

:..i,,4ì1li:rÌ\jirrlrifirr r,ìrrrì\ÚLr.eLrrnÌr:.((Ì
:i.!rrrÌ](hiPti.l:r'rr]'Lirl]1tirÈltr(i\trr1tÌr!]r
.r ir trÍ: Ì)!ir.j d.Nrr 1,ÌÌr r
106 :::i:-jit:::i::::,:ì:i:::: r, . ::.:

1o lr t, Timt

Figure4,2 SlÈtch ôf the I me Fâtlr oÍ fi'ÌÔn Ío od rg à Ì4/S

'ur!€
thllL

l.

Figurê 4.3 Aqqregat€ 5!ppvshÔ.k and the monetary ÍrrLF

 101

Lh. !upÌrÌr side nrift, a oicÌ Ì.il inLcÌr!l Ìale i! requìÌed n)tro\dÊthÈ
. r igsÌegrte deDÌaÌÌd.

,: :: t.s that shiít the wS ând P5 curves

: rr! rre equìlibrlrnì rilt {)lurÌenÌ)Ìo)rììerÌtc.ìn Ìrc dlt dcd inúl
r-: Ìi thrt nÌift tlÌc Ll -l cúÌre and
- !iihil slrlft the15(r'r!É.
:: '. lredge: how are t'Ìland Pbeing measured?
: .\dD4tes oi Llìt rlage alÌd ÌìÌi(e s1ìiit tariablt!, ,)n. .ÌirilÌ.rtio. jt
.f.nrt, \e lÌarc rLíÌÌ h r\ the rÌÌ{Ìrrt rïagc and I e5 Lh.: fÌL.c l.tcÌ
: rllütdÌeir pr(.iscdennitì.Ìr. LìÌ(eirÌcüìi laì.s, ÌabotLr teì.s str.h at
i:nbrtions. and indlÌccttares s!clÌ rr \'^1 nrc i.lÌodu..Ì]. i'r halc ni bc
iÌ .ìndf nÌeasLìrlafdrrhichnÌermreÍeslìo]!onlhcallsin lhrìabortr
. lri\ it r Diatler oi.h.osing a.on\ entidÌ.nd $t ilnil il con\ cflcnl lo
_.uÌrÌrtiorÌ ü a!r ir Lhc ldbour mrÌliet rliâilri,Ìì. lhis .:.liils Dr.is{rring
:. ìrt)n--) Írte pàft 1o the enÌ)lo\ ee rnl to mrns11,. /', as thr..).túnn:Ì
:.l..ri\ e (ú ìÌr.lirrcl 1e\es.

t.onsunÌer pÌi.e ìft:Lerr

: : !ÌiÌÌ Ìrr sh.r'ì, = Ì'f l'. on th. úis !l lhc ÌibouÌ mxÌÌiet diagÌam. lhLs
::::.ii. r rragc lht c(Ì(ept reh\ ani fronì lh. tcÌsf ecti!e olthe Lúiliq of

: : :.r-lrisclhal isolÌeÌe\.rn.etotlÌeeÌnplolc.itthcr.al tfültr.Lirâgc,

!fÍ lll liboúÌ !t) n!nrt ìÌì(LLrsj\ e ol in.onÌc lax and noii!ag. labout
- J- ir..!rit_r conlributidrs pin:L b! enÌplolcrs rnd .nrtìorcc5 d tidcrl
. -:1ì !115 lor ir fn Rt li.e. erclLrtl!ì8xÌd rc.l Laxriì. Llìls l5.alìcil lhr
. rì! diilcr.n.c betÌveen the r..l c!nì!]]ptio. (asc a.d th. r,:al fú1rr.L
: . iiì jrrd-!Ì\:. (,j\.en lhe \Ìirt {e lÌare drinrd (hc ÌibotLr nr kcL diagranl
.: ,i l',. thc r,cdgr \ho$1 Lrp as â pÌi.e puslÌ iictor. Anf in.(asc in rithrr
:. : ìi\iìÌ ôn fdtr.e5 the Ìii.r srttiÌì8 rerl hagL and Lh.'rrlorc sllIl5 th( i).!
: r.n ric dcrn. thc 15 cu.ve ir(lucljtrs taÌe1. lh. iri.rc ellnìent ol.oÍs
. :ii .1rst ol Ìibotrr r.r hÌìÌ! i.e. the itÍ)ss $.ì!e palil tothc trorkrr t$lÌi.lÌ
. .nìi ìe\ândÍrcLrÌ se.uÌitl fÌìtnÌent\uÌath.r!.toÌr(. tradc b\ thr $.,rleÌl
: : 5 sorial sc.urit) contÌibrtiorÌ\. ALL dire.t tr\rs arr sunnn.rrized irÌ the
'i i 5..irn in the ÌrÌicint eqüaÌìon,,!here f is th. pnrdrLccr pri..:
,,:1
,, ,'
ì lliil ar.
108 :

.n.t"i'ii,ts'r !
,,,r,,,,I11\
11.;. ; ;, ;,
^ (r1 al
1.
wqÏ4
| )

cqüatÌn nrcLúlìng the ta{

cdge]sl
The l'J

W ì(1 f) (PJ eqlìatÌon in.ìudirÌg tax \'edgÉ

w'= f 11+ t,) 11' f )

A \ , ,r,,.,., 'i,' ttl ll -,;l "'f:flf ,.:l:l;"',

:;:ri"r,: ;ri i i,,l , , ,if ï,r;
1.,1".",r'",r,i ,
'.
.. ;'1,;,''.,l,ti'"'':til,t ;"rï ir;"1 ;'l;
t,., :'r 1;''"r'r'r'"
'1,,Ïli:t, '',lJti;':;iì':*
,2 Price'Push Íactors
r' r\''r'
r'\'J! r'ôn "
' ":"-"

ï.., ru, r,
(l'l cünc iÌìclü.]int price Push facttr!

u:
varialrles nìcÌu'lìng lhc tnr se+€ The l'5 rurte slilts
where ? is .ì set oI pricc push

. íatL úì thc taa wed8e, x'hiLìr is nchded nÌ ã

ì

ür colnpetihvc conditions
. r",, r', O* tlue foreÌarnPle l{) achrnge
^."'O',''
. Ìilc in Producllrlt-'"' r'
!Jh"r,.'r'",'iJ,,;'''""I,.,"'-"1 " " i. I"^"
J,.,.JLr..: ,. " "., ,....,..'.,.,,.,.,.,..'r,.
...". ^;
 109

: i::f i. .ìlrÌroLrStr reoLrÌ-rtnrì\ ..iorcing herlLh .ìrxt salct\ \rrfdaj.Ìs imÌrosr

::. :lì.\.rr\ h.!e a.onÌ)en\aÌiÌ1! portli!e e[c.t on froductil.itÌ
: .:iìrlrifter|ì, nDÌrnl cnÌpirj..t stu.ljcs otu.cÌr\tovÌrìe.r, {he Ìcit
: ..ljdrdasâ picc Jrushir.rôr. ìljosr c\|ÌrD.tj!ìrsccnrreof rhe inrpìcrot
: -L!.rerr Ìal( .rÌ rhc irlÌlt infcstÌnenL (lecj, ons.rThc ìdea js tlÌat i lÌjgh.r
::riarÌr!e!s$irÌ!estÌrrnrinfh!\icaÌ.ifitat!ÌDr!i.inlforteÌLraiÌìingreten
: . ìnrent. l hr tÌecisi. tra! tÌraL lhj, únnrlet.5 lnto a .lrarìge n equiÌ LrúLúì
r: i.luire.olr1pLicatcd be(ru\c l iepÊnds. ri)Ì c\aÌ|tlc jn the.ase
otfh\5i.iÌ
'r irL\rirt trtiÌe ÌiÌro!r and.ipiral âr jI th( p.o.ÌLrclit!Ì iunction.
hÌ our
:_ rÊ thesc.omincÌìtie\. Ìr is lhcreit)rr sjrÌtlcst to think oi a risr ìn Lhe rert
:i iÈ!Lucrfit p!{ìtr.ljrjt\, tlrrouBtr irs ciÌec1 iD ai\co(Ìa!iÌrg in!e\tnrcnt jf
: r nr rit(.tt otÌlorkeì ltnnlu(tn t! ln.l i. uÌe nÌor s cusLlrìi{ birsr. I.
,.:,
Èu\ìri.{ !p thr rìart ut.

:: È-p ush factors

.r Ìr J.qüatn!ì:

+
iit. Ìiaire tuslì r irie}lrs. i he z. \ jÌrclu{lc irÌnjtuliondl.
foLj.i. srNctu.il,
- :l:.rt thr.ll.t ctLn e ihÌ Ls donn rrhcn

: iÌr th.lr\el ol rLnerrtlolmüÌr bcnrjìtl iornxrÌ! f .!..i\el! jn thc rrpÌr.c

:.i,ìi(ìrj\Llìer!toort)er.rtrstothcnrerr!rtrrger.rtts.ìürirrìonbr.xujc
:. :ii iralar.r nìlrrd.rr(etLi.g a joL) aL ,ì Lofcr redl Ìregr .rt nf1
!n.. !nrnì
rir ef lcss legal !r!re.lion be.eurc thjs llrtucÈ\ llìe ctitlcrcn(e bitÌ\ Érn re
. .,rì!Ltlrr libour supl)l\ .u^ e
:,\.ileÌ, Ior cMmfk it nrLìsÌìrelthl.! Ìorfcr rhfrÍti(Ìì ot tÌad!. un.n
::. ììr..3Í em!10\ ees rÌrÌreÌ rÌade urÌr)n tersil\ )(! hÌÌn a lor rr fropoÍjon
.ri ire colr:red h) .olF.tilc birrserf rÌS rg cemenL5 U(nrc. ((nlrdj\€ har
- i !rig.l.IÌr thr rÌrtcndi\ to rhis chafL(r tìrcÌc is I tatrlc slxrlins tÌade urjrll
r:J .otrraEe lor ()lal).ourtric5 fúm l()t0 200t)
i: L.( n) e\cr.j\e biìrliirj5Ã rertÌaj.l jI tÌrr c.nrc\t, ioÌ c\.!rÌrk.
oí r n.acr

: .i, | lìiLrr\ qrlr

110

2l 1 Productivity increases
lìcÌc jj .orìs diÌrÌtr libiÌLr'xÌ!\it Ìrh.lher hborLr tÌ.dt(titll\ '\, n!Ìrld i]lpcrr i. tÌri
Ì1 i cqurti!f ir \'ÉÌÌ !s if 1Ììc I'.t equiìL ion :ìs lÒll'ìr \

t\

lo {pporl nrLludi.g.\ iÌ1 thr ll t e.i!.rtl.f in d \\mÌÌ.|Ìlcrl Iti! 1' it\ Ìole ìiÌth' /'i
.qutlon. .nr !üt irpt.Ìl t() tlÌ. s1!ljrei iicl that Ì)Io!lLt.Lil jt\ lÌi: hcr:' '(Ìrtirnrnu5lr
Ì1\inB r l r.cnÌ)lot Ìì..1 hr\ noì blerÌ .oftjnLÌmrn\ lilÌiÌrs. ll th. Ì1'j r'ÌQaÌi(Ìr takÚ
tÌri\ ì(Úr LhÈ. a riÍ'lf ttrìlhr.ii' it-\ hiì: f. cilc.i .n ihr allj: th.lragc rt|iraii'rnj oi
r rgr jrllf,s Ìrte ìÌr lìÌì1' lr Lth Prcdtt.lj\ ji! Wt Ìct!rÌ i. LhÌs debiL!'i' lÌrt atl)endi{ ':
LheÌ)ter Ì5 lf the.ont.ll ot tlÌi d !cu\ti!n ol tihrìtrìr\ Ìliger
{n ìÌrt$.stLng er+rlr .ri!urniof rri.ej llhen tÌrt rrÌrrdcl ji Ìiut 'LoxdlnaÌÌi'\111i'!
Ìrltìfr!rlÌLr1r\jt\ S!f\iLh oÌÌtfj.rLs!lnt\.lnaiioi\th.rtjriìgctetl.r5htrjldiheuÌÌdLrlrln!
!Ìo\th iÌr PÌo(Ìurtl\jil .LoihiiÌlrtrgt \.tÌ nft!Ì!riirÌr 50 thatur]dcrl!ln!l)Ì(\lu'1 \tl
Ânr,tlì\tisLh.narelinr loÌ r:3e5.1lcr\'I!'^lNrge(hjr|5 Th1\ronldthÉ'!tm1riillr1l
Lì\ LhÉ \tr .i 1ìrc l!b.u ' ÌìrÌÌ..-i. I i b\ Irlì(1h\ thcü.ì3( lu\h .Lii 7. Thtqu'slioÌl
srrlrrtlüfpr'ns\ìrenlrc.Lll]Ìorlu.Llrit\!n\Lhrirerol lll\''llr.g.sctttr\aÌeirbk Lti
(
5f()L rÌrrt thr LÌc11d h.i\ . rrnsel Ì1r.. tÌÌel \!lll :di!!t ih.lr aS. d': nrn'l\ a((oújf .-slr
i.d Lhe lÀlr s tr.chrnq.d. Ii it ük.. túri ft)r lbc cÌÌrngr ntrtÌrd1'ÌìxliÈit\rr\ i't('
n âjr \ctter: brhr\ i(rrr 1Ìr.. a nflrd(r\rÌ i!ì tn!ìLÌrti\ ilr Atr\ th \tlll reist thc l'llr iì'd it
sÌÌr(ì uf rrill l(rr rr tlÌc /.rìL'. lht.ls oi thì5 kL.(ìeÌrÌ)erI1r h.Ìr t Ì)iri 'h\ctr ed ìolllrrlf!
tht!crk'Iili7i.ì\L.sdorrÌrÌÌrÌrr.dl1cli\ittArr\rhiÌrthL'edlìr(.i.'LtnlÌÌÉ\rttrrl9tl
eÌrd lollo( ng tht $l!.d !l iÌr !ìÌ.IÌu(tit Ll gÌd\tÌriÌìllrcLrslif Lhr Ìrid ] lrlis l(l
ÌÊUe.t tlìL iÌ!ut ilrr pÌ.ci\i rol. ÌÌ(trlr.1lr
ti: llr iÌÌ i!ìr rtâgr tquatioÌl ÌÌr
".cert.Lirú\ i.frodÌr111itl j't!ÌcniLl'
Ìrut \lÌsfi.Lhel,iÌìn.Li(rÌr lhi\i.dlcrt.sLÌrilìÌ1\eorlill
c(ÌìÈÌ1 or e n\e .r l.rll i. tl !.1ilit\ Sr.n ih i. the l\ Ììinl. .rÌ. i(Ìs f'l nÊrtinrill
Ì.{ilr li i sÌrirtr)tth. Ì\ !.uÌ\ e.ri.lh iÌriln.(dhtÌÌrt.i LhL IJ r!r\.
\\:b).1:7

1l \ -\ .ur*, jn.lLrdlfg r'â!t tu5!Ì liclos

21.2 Training pÍogrammes

There lr. LÍo .hìr!ÌeL\ Lh,ou!ÌÌ rh!.h inrriisrd gorenrÌÌt|1 .lttnditu!. on Lrii'i'S
Dr\ loriÌ.rÌuLÌjbrnrrìÌ r.rDflotnÌc.l Iir\i. il Lh. tÌrjìrììS 5 .ile.ii\e. :, rr!ìt hi!hI
tiììÌrell s. Ìn)r!e riLL bc .hera(iirt.d b\ hithcr I ridu(iit itt and thit s jLL \iìi:1 th' 15
cu e!pjreÌd! 1\rliÍu:5.drbo,t.th.ÌìiÊirÌPro(ltL.rj\ú\rÌÌrlrÌ!)\ÌììhtlìeI\-\.r1tr'
'I lii1. r.nL ne(hin 5Ì, nrI.iÍd t,xlniÌq üiL\ n.rÌien ilìe brrqi i' !'!
lrrou.-rh r quiÌr
porcro cirtÌr)\ers iì.11 .ÌrtÌrt! io nriit 1lÌc 11\ rt e dorfjrâ(]t, helÌrirÌS i! Ì.Ìrcr
e!ujlibr unrnÌph!nì.nt.1\'lÌrrcis a rhorliiSc o nillÌc(ìüorkcArjÌÌter to iÌì.Í..s.
'rÌn
!rÌiüì ÌrergaÌ.inil po1!cr. lhtre!er:clrjll!e1|r.ií'iia\ÌÌoniScLsÌeLÌuccdLlhilhr'
Le\ els oi LÌri.inS. l)ro!r'rÌÌmtt tlÌiìt cnhìn(e thr 5lì llÌs ot tÌÌe !rrcnrÌrÌ.1cd it!(h .ìt thor'
intlÌe !\.Ì âÌrn)rorl |nrgÌaÌlrìx'in lÌrt Lil(l..Jr b. nttÌ)relilj.thL\aÌ!trr\ il.
 ílt
:rr!\rthr5rL]r!l).ltrorlicr\nbc1.i.lilrh.ôÌrf,.L!.i.1h!.ÌaborÍÍnarlrt.ihe
. : rlìiíld dürrìhard and cq!ll br onr r.enrtÌolorc.Ì iiìÌ15
:lê accords, in(omes policies, and industriâl Ìelãiions I€gislation
: !\!u a \ragc ar.! or'i.roúr.s tolLì 1. Ìcd('.c fqLLil brlrrÌr Lr.uÌÌìlo\
,: ,-i irlm 1lìc possilrilil) oÍ in(ru(]lL.lng m!Áu..5 1lìnÌ loÍ.., Lh. L\ ! cune. ,\s
.. Ììtlì. rìirt Í'.tion, diilcr.n.rs n 1Ìrc jf\LllLrLio.al aÌrlng.nì.nLslor(a!e
.::irrrnt c.ononÌir\ .c.t. thr d.!rlr lô Í hjdr wis! icLL n.'r s.ôôÌ.1 nilfd.ithrr
:. : ti\ er+Íolrr a.r$ tlÌ. rc.rìonìt l ik' ÌlÌr'lJ !. !c r rrL!' dlI.rlf S drlrre\
:.::.1irú. ÌÌl thi\ sertion. Ì\e pro\iiL iÌ Ìror. g(nrril;ÌrgunìcnL LlìiL lìnl\ \a8È
: !ir rnnnerÌtÌ)oli.\ anrL irÌd!Íriiìl rcliìlio.s lcglJiìtion
:, Él ot eÌÌrplolxruÌt, lrÌion nr!.r1iiL.r lrarr a .ho .c rs L. hoÌr hiìl|l 1lìc,-
i:r!oti.ìtiotr. I he liDit\ to ihis clìol.L' ir. \cL i( rh( uptìÜ cnd hr rnìpìo\ rrs
',!rrer b\ ìÌrtlì\iiualuÌrionÌIrDb.Ì!. lh..c lln{lorÌrarsrinin! nlrrsir!
'.d nr as thr Ìl.\r!eiÌìÌrsl: tlìis 1s ihr' '.el ÌriÃi th.l ìi.io.s .i. 1'.r rf ii 1lÌct
: :rj.iÌìS poÌÌer t! tire 1!lL. i.!. ii t r.! 16( ill thr'r'fnt..i at tlr. r dlsfo!,ì1,
:. liÊ\. ( lÌrauSe\ iÌr the enr lÍÌ!ÌÌent i. Ìihi.h rLÌìl.n5 opc,iÌ. !Ldr i5.lranir\
: ,lrti.n\ Ìesi\Ìâtion. tlrr dertritÌ !l u. on íÌcmbrrship. or Llr..olcra!r oì
: .jrLÌrinH âgÌeemeÌrô r!Ìa\ rlle.t t|f \!.apoÌr5 a{,ri,rb c l. Lh. Lr.i,rJri iÌ1d
i 'lhepoijiiLÌr!Ilh!'L1J(.cilin!irillrs.dcln'rll.nth!
: thc Ì11(ceiÌiÌrSr
'rì :r) tr! thc saire drÌd rÌr tlÌeil r'ì]l iq.css to rcsìst !. o. d.nr;Ìrì!i5. lhÉ
I .rcli a nìiÌÌnDunr rost tui.onÌc b! Lridin .fi thc iosLs .l i s.Llt .ni
-. \:! ol irtrhrnúrl rcinÌr. LÌ+ìLo!.r r.slsliì..( to 1!iÂ. .le nr\ nì.l riill b.
:. rÌ enrplo\eA a(tiÌÌir iÌr c!n.cr1 i. rfn.rc ffs.tìilìons, drrÍ.i.Â.n s!.h
.:iìftSir lo.l out\. ÌÌher( in4ìlorrs re.L lo !rion str kcs rL kc\ pl.ÌÌt\ bÌ
::i. Lì!t rt other ÌìLa1ìts
:. tÌÌr r.nL Ir* r.tualLr rÌrtlij.ir.d br thr lniiÌìj is sct bI lhc lrlrll(Ítr].
.- :.1 ri ihe hiÊhest re.ìL wirsr tlÌi i ìf d \ idriÌ11!!rli.r: il lo.i l(!düilLìÌr\i\t
:: ..ilìrttlÌe\ cànlrot Lrepre\ent.d b_! lììr !niiÌrk.dirship lírlì nriürsntr
:: lrìiüì k.rdÈrship dÉ.fte to i)ÌrünL( of. Ìl-\ cunr br o( ihr 11511lÍtr1.
: r:rit!dr\rrfcÌrìlo/7Ìì,rÍLlL...1l.fasrÌo'krrssür81ìit! r.ÂoriairlÌillÌrÌ
.r!\..lÌr.l\-rr1Ìoorl.anb.inlcrtntLalasi.r,ìot\idrd|.o.sLriintc!\erir3
-.. fii bk .ondiÌiiÌr: oi troÍk su.h l5 Lhc rtcnlit or sprcd oi NÒrl, ir Í rll
ri ,ri rlork, h.Llda!s, ri.. 5ho! d iì.r.I lhrsr .onnraiÌìts b. ridatr( . ihen
!ligoonjlriliciilhisr\rrrn.|..ssi,!LoÍc.tif\11Ì!.!lÌortiilÌiuuÌeirÌniI
: !l! ..!ìdllion\ oi cmpll]t mln1 Ìng.n!.nl ilÌcretriLlL,er!.pbetÌ\4Ììthe
r

- r. rì -\(lloor). nhi.h 1Lc d,:inr is Lhc Tonc ot b.rlaiÌriÌÌ! di\.retidr a\aiÌ

:,,ri brlr'(rn tlìc .onjtr ai rt\ Ít br thr ( Ìì\t.rtrr\ dÌJ b\ ihÈir Ndnber.
- ,:tu'L .n(ìsl5br.i!sci!ìdìrìduillr.rÌi.rornÌÌrlLSroupioirorleslrr)tr1.Ì
ìibl. to giin is lilourilìl( a scl Llr Ìrcn L iÌs.ouL.ltlÌe LìrnÌr ior the ìÌìdustÌ!

.::1irg.r.!r: ilofg \!h . r Ìì!..{otiiÌLl.ns irt!illr tale f|.e. i.c. uÌr Ì1't. sÈ.
i..7,).c ô bar.rai.i.Ãd 5.(liÒ.. hii.iìses tlìe oL,\iúus !!rÍnrr.i\ìrr
_i r\rÌ.isr iì.! ÌriÌrirai(]i(ìg dìs.( ( on. i.r lrlÌÌ noe\ Ì \ \ not clirÌcldc s itÌl
- . ì r!. riL onal( ior slclÌ bchiìliour ls u.irÌr.on.enÌ ìor thÈ 1(Ììp ru. iLúaÌc
 f

112

Figuíe4,4 i: .. .i ri: !r1e::iìn:lrl:_rl\\: nrr; _lrl_\ !'

"""tìr,,.,,,t"':,',',",,tupLl1!ììrÃbtlr!'LhoL1!hlllleht!ir!l'JrtÌircn\e5LÌÌrcnLfÌ'ì''

Ì)itrl1ôfrlrordr'
,..i,"i ,,",,",",".,,rt]lgrir]itrE11j'!rr.ri(!ì s,.i.h rÌì r(roÌ(ìrììiÌl
Jf!alrt\ sqÌ)oi1ed lìr
,"ìii","*, ," " nun ,u.. *u,..,n,.,,r "r... ro u,"tcri.Llir Ìi.ìLl
t(o'onìic
,iì-",,ì,",. .""," ,.,"" ihc Ìr!ìì1r'r rrì !ÌrlìiÌn.cd Ì! I nÌ so\ifrnrinr
Ìr'

and Ì'n' Ì(ìriìÌ nt\jhiÌiri

:;;',;,..sL,;.l,".t."g"'",,in3 I ninÌl o itÍ'd I iisc Ìr\rÌrìnL h'nJ\' lb' urÌlnn\
ì,._""". t"*ta enrfLolcÌi iìSÌ.rü t r rrdu'ti1r' in roiiúÌ{ 'gra(:
Lhe irrc'n1
.i,,;i ,,5 hìt r r rurrr .'rt rr' t'rs'
r Lrro!I ArtLr'tr!rÌ
,1'.;ì ''()n\
'.:":'ì,;ì: '''
ì,ì,,.u.ìi,..un._,.,,,n"u|1,{rsarì,ÌcrÌln.\.,,Ì1r,,Ëi,ltrÌÌnìtrúigie(drod.rrriLhil. l\ lrtliÌnl \rhtri
i'.",r,",,,ro,., '.,,,"t',.tÌiÌr! Lr'tìrLir \t!nrÌ l!llriti ' n '('ÌÌd t\rÌìrlÌÈ
l.

iLLt((!Ìt\' ÌÌr tìì'

, ,,, i.4,,r tU ,U".,, t.Ìati1rÌ} iÌnd ! r\ati\ia'toÌ\ ÌììirrrcioÌÌ''m1!
"t
ì,i,,,,.ì,",""u",,,-u",'.Ìr.Ln3Ìrp(lÌrrìu!1i!lÌ\{rìr'1hrÌr'lilrriì'coId\rtr'de\lg'er: ii!'lt n:
io.rlnLrthilrtrlnrqr!.!rr\11ìr'r\nlr'\rer5l\e lÌrr gi^ tr'irltiL "rìì$itll(ì
lbcÌrrlL'i \\!1rnüll \ti
,"r,r,r", u,,""." .trii,,t "ittr tar'!ó afü rìlroltt 5r{
," i:.ì,.,0,", ,., i,",n a.LhrrtrÌü! rÌú Ìc!. n,i {i..e..].,liJ ed!rin! !.cnrplo\rrr,:Ìrt
,""n..r,t t, ,n.","
_tiir,..l,
,_,.. j!!r0! hÌ ìhe lrige i'!!r ìlÌ|'rs io hr\ I LrÌa\ rd a |iÌt
'rL| 'rre 'ì
1,,,r,,t"'rl .ll .rnìrtÌjih.rLllÌoi([icrti]grt'|rr''tin(Ììg;truÌloir\t:ri1':(tr rn'h iÌrdÌ
,t"-"",:.*,tU,!*".tÌì:ì.rttnil:]'\nrÌher"Ì\inì\'lhtLrrohleüristhiL st'urt
rlrirl urLiL,r trr,c l.:, Lenflrtl'Ìr 1() 'ìei.._t ironì aÌìr r\ilc:t!'oÌd \iJr't it rnltlìL'n
l.]:.r:L].lrjLlÍ.\.l..L.l].rl.tr]l..tJ.L1.!:Iir irÌ:r
rriiLi'L
ar\,r\ir" hrrrÈr .ì1 ili '.! r:'rlìiì!r! 'rr''lììlrr':lì
_: ri- I ì l:ìrLLlf r"f i I rii'r l1 ìl
,,.',,-,.,,,'...,'r,:l' !r ìrrr ìrrrlr/rli '
 t1l

::hcrr'ãgcs. Ho erer unjons acl lhi5 w:r-, thc wage accord collapscs (the rVS curve
ilrll
::tts uparrds) an.l ma(roeconornic policv trÌ!st bc tightened to prctrnL inflation lronÌ
.rÌil. Lhìs pmbìem hâ\ the ÍrucLrrr. of the fâmoüs pìisoner!' dilemnìa game:í!o Èis
:.rs lmflicared in the siìÌne crlmc aÌe held iÌì separate celL\ aÌÌd carÌnot conìnÌ! c.te
:i\ irc loìd thal ìfboth coÌìii\s, lheywiÌleach sclvc ten,vears; ii onc confestes ând the
::rr docs noL, lhe one that confl:sscs goes tree lnd the other \erves tí'cntt-reaL NlÌerea\
. ritlÌer .onfcss, botìr get tÌlo veJ15 on a les\er chargc. Each PúsoderrcavÌrt asldllrNs:
rnÌless and m)'pa[ner cloes not, l8o tÌee; Ìlhereas ifhe, td). coÌÌlesscs, ] getten veìL
tÌre other hand, j l Ì .Ìen) tlÌe clÌargc bo l he c onlcsses, Ì go doÌln for l sQrty veab; if
: !r denies. thenac both set tìvo vcars. \'VìretlÌer nrl paúner co lesscs or not,I aÌ$ats
. r \ÌxÌt€r s€nti'rì.c hl c(trúessing: lcn Ìather tlÌar twent) lll he conlcsses) or zero
:.r thant$o (iihcdoern't confessl. lhe jnÌrÌicâtìon attributìng thc samereasonnìg
tÌr prisoners is that both coniess a.d get terÌ ycâis, $hereas th€ir ioint ut1Ììtv nìar
rrg strateg)_ 1{oLrld he f(tr both to dcn-Í, le.viÌìg cach with a t$o -vcar sentence llìe
-:uÌe ol this Sarnc ls one in utÌich thcic is a $ c.lìc.Ì drrrtTrtr stïri]9', nr tlÌe \eÌÌ\e
. rne nratety (r.orícs'ì ì\ pretèÍ€d ltrcspectlve ot lhe stÌatesv choscn bv the oth€r
::i pâ raìleÌ i{ìth tlÌe Lrnions n thtt jun liÌic lheprisoncs, thetemPtatnÌì lo.lelect {loÌ
: rrìsoner,b) coÌìlesslJì8 \!hìÌst the othcr one de ics' ht the uniuì, by btetkÌrs the
-i rrcoÌd whiÌ( tlÌ€ olhcÌs stlck to itl makcs agÌeeÌrìcnl to the accor.l probìenraiic Yet
::Ìr cases, the 1ìilurc lo coodiÌÌat€ leavcs the panics ttoÉe otl lcononìies chara(
: I b) hìghly centraiiTcd wage setting ot irhere therc n a single acknoü lc.lgecì lea d.'r
:: \iÌlÊtrcltlÌe achìcvenrent ol a \!agc accod €âsjcÌ tìran economics ìn whnh there
r urÌbeÌol.on]pcLingunlon\.\!etur.towtorÌnodeìthatconnfctsl\'âiaerestrâiÌìt
: Ln\titutlonal slrrctue ol wâBe sctlìng.

I Unions, wage-setting aÍÍangements, and ihe ERU

::ia ârgunìcnt ìs tìrat Sreater union ÍÌergth dìcasured b-v tlÌe proporli()n oí
.t\ that bclong n) a uni(nÌ lunion deDsitv) or bv Lhe pnrtoúion ol cmdolees
. r agetâre.orcrcdb) unidì r,iìgc agft:eìnent\ (.ovcragc) i\ airrgepusÌÌ r.ÌoÌthat
:. , h1il1Ìer i1J cuÌle and thereforc raires the l?Lr. Hoi'cver, an ìúlüerÌ1ial articìc
.- :ì\ lar\ CalmftÌt ancìJohn tÌìIlìll in the late Ì980í' atgued thrt lhcrc a'as a
.lped relationshD beti{eerÌ the dcgrcc ot centrnÌl7a1iot ol wase settìrÌg and thc
-. ajdhnfors DrìlÍlllmocleL slìowed lhãl r l{trv lïLrwa! consjstent \!ith elthcÌ!crt
:.]?rd Nagc s.ttìng oÌ with !er)'.c.|ÌaÌizecì wagc scttìng; the !!oÌÍ insljlutio.âl
:.::ìini\!rsarc calìecìnúenn€diaIcÌcvclolwagescltlng Thisisani!úereíingrcsúÌl
. :- hìghlighrs the po\sibility thit rrnÌ()n stÌength ls n.)1 ncccsraÍiÌl âsso.ialcdr!i1h
:,lfrt5hinthelVSc!rve.llunlonstrengthis.sso.ialedaithapaÌticularsLructurc
--.:tlì.grh.ritma.'-,o thecontrarl,beaslociatcds'ilhlowuneDÌto!_mcnl lììs
.::: Lìrolidcs a $'av olruÌr:lerstandi.g lhe veN loh'uncmpÌô-\'ment rates tl pi.nlol n
. : : \otuÌi. countrie\ and ,\!strÌn in tÌre I 97$ and I 98ü, Nhen it rxe €lsc\lhcrc
 ,

'114

Tlr trt jn\islÌs o the (l.rlÌìior\ DrlillÌÌ nÌodtl .en be erPÌii'ecl nrtlitl!(Ìr' Tht
Ìforltr\ arÌ: uÌìiont.(ì d .onìÌraÌe5 thr("lllterent 'o't'xt5
Ìn.!leL iìssünier t|,r1 tl)r
Nales.1ti.g!thnìì.eÌ,riiJrLltrdÌ\lr!.ÌdÌ!lrtthcl.\eÌ()ìthrtcononÌliLsiÌirhoÌe
. 'IinÌrt!L:l or de.fnLrrliztd'm.rn\r\itrrti{)rixtrJìl.hthtÍ'isatrn1'n\pr'lllrto
cach hnì Lhat tet\ th. n'egt iÌl thc hüÌÌ.
. lndústr\ Le\rl .Ì 5euni.ìÌ11ìntr€t\ihljtnsrn)r atl
nÌtenÌìlalLate' rÌÌcenr uÌcrc
üorkrÌ!iÌrinhduttr\ rtil. thÉdrsi.ccrnÌSirdLrtr'l urÌi!|r LhetlnkiJr!i'(ìu\i'\

. rcouonÌr r.i.]e !r'.c.lreÌired nrcen\tlrcÌtiratirÌllr!.i(Ìrthâtstt\the\iLgr orrÌÌ

rr.rlcÌr ir Lhr 5ec Ìfuge \ettiÌÌÂ dots n.t hrl e to be ÌitcÍiÌlh
t(otronrr. A\ \e slìiÌÌ
.cnt!rlir.il ftrÌ tlìe econom\ ì.lc out(1rJÌe r(ì Ìrre\nil: Ì!haÌ qÌ,r1tcr: Ì\ the trifnL t(i
fhich ÌÌrgr strÌers taLc lnn) r..otLnt UÌc.c(!r.nÌl ttidc jÌÌÌPli.âtl!n\ oiUÌclr
rriÌge tetti!Ìg .ì!ci\ion oÌ lhìtÍ'an)..tlÌcl.Ìm cooldi.xtÊll lo
'Ildr trtlercd
is

LÌ.i.h iÍunìe.L I hrl tie !.io!r lÌ.: Lhc \rrÌÌe uLllit-l tìn'(iÔ' i' lthì(h u lllit\
ci\e it is
jt
Ìn(Ìeisr5 n ith enÌltol ÌnerÌt.nrì Iith 1lìc Ìe,rl \riS. I(Ì \nì!lLcit\, is ÁsuDrel tlÌa( lht
Íì!e ls .h,)\cu Lrt a Ìnt!ropol! uni(rì rilher ihin b\ brrÊai'i'g Ìretlrü'' lht !ÌrìLÌr ifLÌ
rhr erirpÌo\er ior lh. cnrÌtot . Ì\' r\l!.lxtn!Ìì h. uÌrì(rÌ Ì ) n't\ the rr!r'iÌn'i
'iÌattrn
:

Ih.rcrretl\oditcrtntlL,I.(:fttrüagcm lrillon thllìrslcoÌl'rrns thculì\ irÌitlìi'h

ÌhrunloneÌÌ)r.1scnÌ)Lo\nrc.ttoÍ'sloÌrltoe.bxnHeijìlh'rr!'iì'dlhe\t'ond'nn
cenl:lhcertentloÍbi(lÌÌhclr.ì(Ìit,rkcsìÌltoi..otrnttlÌcinrf!(toiilsdr''i\i(ÌilorlLhr
erorrnrl \!id. prl.c Ìe\ rl l. reÌatiür Lo thf lìísL, as Itile n'LrjÌri bf.oÌrcs nnrre dc"'
tr r i7cd. Ììre !nio. bÉ(onÌr's moÌe (o..errÌ.d aÌrortr the (iJc.L on thr nrfÌo) Ì!tnt oi il\
(

nìe b.r it it nr.r.lse\ the trige IlisrloriellharrwasriJr.Ìtr\eiÌìthc iÌmsìLLnìaÌr

tlÌe rìrm Ìe\s conì|rL, tjLii e n\.omfìred lllth othrrs \\ac(Ìrscqu.n(ethclìrnrniÌlde(rtar'
enìpl.-\ÌnerÌt. rhich uillIiìlerntgiìlne lrrìpi.l .ntheutlit-\ ollrÌi.rn ÌrtnrÌreb i rii
i.ls to ÌnDit thc c\ercite.)i unnlr p rer Ì!h..lrager aÌl5!'1b\ tlÌcun onriJrnnLerLl
ll!..ntran. \rhrn rvases nrc stt b! .rn inchìnr! túrir)n, UÌt (nir)n I ill !icl! tht nnpr't oi
jlIrxgeiÌ(rrnscontÌre.l.rnancÌioriJìdunr\ oulf(rleÌúhrÌì.c.rÌiÌÌl!slrl cnÌrLo)nÌtrrl
ailinrjted.tlìisisbe(dusclhcLÌÉiireeo \uÌìnitLitlÌrjÌlt\bet\trrntlÌeplodrLrlrr)l'ìititrenl
lndr6tÌie\ (r.g. bctÌLeen crìgi.eerìtÌ: cLÌuiÌÌncÌr L end t€\tiL(sì l! tttriÌ i.* Lhif bet\Ìeen
ih. t(Íhr.Ìs o (ÌjltereÌÌt tlrm\ úÌ the 5âme l irsLÌ\r le.g brilr.tn tÌÌe ilrli llIL trÌ'clr pr!
dú.t{ì Ìr\ iìnì \ r.d hnÌr llì. Ìler.r, LhÊ nú!5Lrr Lr.i(ÌÌ üiÌl .xer(i\e 1et5 rcstraiÌrÌ drÌd
.hoore! hilh ll ltaHt tLÌr Ìì Lhc hn! lLtcÌuxion
lhÊ re(onil oice nrr ÌLiìlc nnxlerntion ìt of iì quilÈ cliltercnt Ìn . Ìt.rrjÍ: lroÌn coÌl
si{Ìerati.Ìì l:]l hat !re rcirrkl tr) rs thc gerÌeÍil cquiÌLì)riuÌÌr c IÈcti oi tlÌr ÌtiÌg': inLÌta\e
unnÌr tlìnL ls ofeütiru nt lhe lerr olthe turrì lrli$ x\ !ìtrn Lhe e(.IÌonÌç itidt trlce
It\rÌ arÌd nhcn tettìng Llì. m(trÌe! r'âge, .ss!Jn.s thdt uÌis sct\ tÌre reaL .o'iumftiorÌ
rragel(Ìtlclrt)rÌeriÌìtlr.rrrnrii.e.ï,íirÊÍiì1r'rrhi.his!rhrljttoÌtÌÌÌbrr5.i('eìroLrt'
rÌr,'eIornir..,rN(ÌÌ,\rètoL r I i ì.iÌn?L l:
'hrÌrih.rlú.1.Írrn.LrÌÌ ìÌ!Lq!.rtnn!úl.fri!'<rir:lii irl\
 tí5

: i 1lr union i\ \ettirÌg the Ìldse nÌ all ÌloÌlier5 iÌr lhc c.ononìr, lhr irnpdct ol
::.n tlìr e.ônorrÌÌ \!nìe Ìirice le!elcarìrÌotbe ignoÍÌ1.-lhc o. io. NìlltlÌereiare
- :lrat int iÌÌ.rers€ nÌ the Ì!aSe it \et\ sìLL ileDeratÊ aÌr in.r.:isc if lh( price leveÌ
:1. c.onon) rise irr LirÌe.lhe ouiconÌe $ilL theren)re b. rlral thc tu:iì .onnu!Ì)
-. :r.ìrs n!L Íise. ,\nother Ì!a\ nr fut thi! is to ia) thaÌ nircn nrxliing iL5 decisnÌr,
: :/rd rnion takes iirto account dre tìì(t thet dre rco.onrÍ 1riìÌ cnd up orÌ the
: ! !urr .fter üiiret rnd pii(er ha\e been set The centÌaìL7cd (nioÍì Rìlizr!
::::!Ì r(hie!e d redl rvdge hìgher than thdt oI the fJ cuN.. In Llrc slmtle.d\e (ú
:::.: tJ (!Ne, tlÌr ÌeaÌ sage i5 c(rrstaÌrt ! irhen thc.cnLÌiìi7cd rúr on pnb it5
:,ÌirìBtheticur\e.1twiìÌch(rren)nraÌimÌzern]Ì)Ìormc.L. lhis n4)lie\tlÌat
: ri! urÌjdr choo\e5 not to €\eìcjie jts mon.ÌroÌI p.Í'cr in nagc .rgoiiâtnÌb:
. :ìa\nnizell at the empÌr)) ment ievrl Íhere thc lâhour Í'ÌÌt!.r(n r c!t5 uÌe
rrÌ!te thi! orìtcome to thc tÌer it\L \ectnD i dis.ussion rbt)trr rhc prironers'
: Ìr. intheca\e ota.entÌaìize.Ìuri(lr. itsoÌrÊ\ lÌrr.oôrdLnrlio. problcnr L,!
.::le.ltci5ìo.makerrLh(risablelonraÌimizelhejoi.lut!ÌitÍolthrmenÌL,ers.
: :: :lu e argument .ÌiegÌaÌrrticall) . Ì!e Ìregin Í'jlh lhc urjor i.dlflcrence
.: : s. 1.5ì Thete aìe be5t thought ol ar co.rfÌjrlng tiro tomfo..nls oì the
: rÌkes a..Ì hen.r Lh. r (nL.ns iÌe jÌrleÌesld irr Ìrâxinìi7ing thc $dse bill
-ìtr.Êr r downwald notjrg LndLlteÌence cuÌr., in thc rral Ìragc c pl!)nrerÌt
! ic.(rr.Ì componc.t jr that thcÌe i\ r .Ìirlúilil) .I itoÌk n) rrcrluall! the
'I' l l 'r /
: :-ì nnilini{ the optimaì amount ot Ìaboui \uptlicd ro this gocs thlo!gh the
ÌrtioltheiÌ iÈeÌen.ecurv€\.
Ìriidrr the .r\e wherÉ rmioÌrs aìe organizÉd at jrdrtrlr lo rl. As cripl.ìnÌed
:.ÌriL!trÌ)elieÌethattheìÌríage.leci\idì$iÌÌhrltÌlr1Ìcimfâ.:L on cnÌpLor
. r &!ree ol nìÌ)\titrúabilitv betlleen the producG ol ditl.rcnl üÌdunrje\

- Ìr \ I\.1

...
....''

r,i!. 5.fi n!. rrr-.r ! r. e il f Í.,!ÌÌ ní tr I lrd àa. -q.Ì.rr

tt6

I l)ì

Figure4.5 -,,,. lì ,,,-'m!.1,'':ìi'rr :'Èr'ì:!d r' ' I rr f r 'r?

t'r'r?'r':tr:

i\ ltú. lììl\ i\ rcLlertt.l jn tlÌr'ÌrthcÌ \teep lndunrlc\tl Ìrbour dcmand 'uNt\'

h'
i!ìduttrrìcleÌuÌri.noÌìtiÌniresb\.bootiÌrslhchialìclLnÌdllleren"rtt\enrbjccttothi
(lcnÌ'ì'd cur\rs o!
.o.ltraxìL ot thr hbo!r denL.n.l c!itc TlÌrcc ÌrÌ)our
Ìer'cÌ5
'lilirn:'t
tn,,ìì,,gi:-'",,i,tt.."." ÌrÍ ìDdüsLrv Le\r! unnrÌs s de'ì'cd'
r,rr tlÌc .aie ol ÌLail. 5'ttnÌs
rlS"r'iscc rl3 1.5r. t\ lre rÌr.tÉ to r Ìnor. dccerÌt lLzerl 'onte\t i'r raile Ílling lh'
trnÌ(Ìì bcconÌes irore .o.(erfc.1rbotrt tÌÌe i'rÌrrct ol ú\ s'iÌrc dt(i!ì'n on üÌrllolnÌc't
o iÌs nìcmÌ)er\: I jt riìiscs iÌs Ì!ige rht hrnÌ rill rain' its ÌrIi" rnd !lenìa'd sill strit'h 1'
orher5(rftlier5 hegÍrterelntti(ìtrr)ldtlniìn'ÌÌrÍÌlrt'e\1ì'LterÌrl)oLirddndìdcuvesi\
$or I inìherllagròr.rritÌr th. coìs.(Ìutn.. Lhrtth'lrate s'llLnil!uIlc Ì{)rde'c'lÌdÌizcd
a,rSeÍllLnBLirsi'el(n!thatn:rrLnl!5tÌ) Ìtrc irage:cLLlI3 tt5"irr'
To d ralr (üt the jÌnpLl.rtlorrs ft)r rqúLÌiÌrrtu'r trnenìPlo) nx'nt, re Ììolc
lbrt onrc Ì{ats'\
iÌe\r1. llrnL:ct tri.rs RÉtuÍì!.S1othtl.\!'l ot tlÌc 'cor!rnì! r\ ! hoÌc sÉthcÌthìri
hr!rrhr15.!rcr\th.trÌifLLt la lq!lLibritrnr nlÌ()\m"l n)rtlìr
'i\e
oiirdustr\
ie\eliflgesrl1i.3issìì,r!Ììb]ÌlÌrlnter\e.1i'n()fthr'lrlri andthr15 lÌLi\isbeÌoL
thrlnrrür.i:..tirmÌe\el(age5.LÌjÌì3,\5itguedibo\elhcc€ntiìll7c'lctiebrj'Stìrl
tììr5(.onclclcnreÌrtìrìthcCalmtol! DriiÊ1l51'rlrtlrrÍrBtd"j!itrÌril"ltÌrÌi'c:iì'dr!
ih€.o\trag.oiIa3.irltirÌ.!ln.rei5c! ìmfor\ilrl!' or tht u!ìio' tt) iS'otc tÌÌi
ìt b..onrc\
rons!1tuerL.csolits\'iìgt!le.5roÌrlorlhet(onoml u ld' tricr lc\ tlrÌÌd hc'ce lol lhr rerl
consLLnÌrtio. Í.Ì!e. Ithj.lì elìlc!\ ils utìliÌ\ irt"tlrfr llen'c thc 'erúriìll7r'l urÌi!Ìì
u!É:

ÌiÌelabourn,ttl\(rrr\.atiÌsnaì!escLriÌ]Scu^'.lerdngn)rqriÌibrìLurr!'Ìrìrlt)\Ìrìr'lni
Iria- l
Wc cIr \rr llre únpÌL.ations írr tht Ã,lU irì L 1 ; ìr jt
Ìür in lhe (asc oi
iË
'erÌtrnÌl7ti'j'
or.lc.etrtral 7.1Ì üâÃ. 5tÌtiÌls rÌÌl hlgh 1!lÌtn trniÚÌÌ\ sct Ínr's il induslr! lc\eÌ lbis
ÍlìilÌ)Írlu..stheh(tÌìt\h.ÌrtdrclrtnnnìipbrtÌ\e.nthe!"treljzaiiononasesrllj'!
rnd the lÂt, ln th. itfendix tt)ihi!chdptcr' ddtr 'rn rÌe'ìsrrr'! oi 'È!ÌlrnÌl7rtiür n'i
.oorlúrrti,rn t)f Íng. 5eÌtiÌìir iÌt Ìrro\i.led lor ()!(lD "aÌrtlics L' l:haplrr ÌE Íe lÔ'r
rt how diif...nt rrlan{ernrrì1\ lor Nagt \et{i.S hr\ !'been rÌcastrÌed rnd lhtìì rolr iÌ:
a..o'r.tiÌiÊ i.r Lllllirc.ce\ iì.nr$ (ornL!Ìet irÌ üfc!ìplolDeÌú fiìttrÌnr
 117

Ì1,ìÌ.,rr i/, n I ìrt, .r{,n , ê ( êr1Ì1 7rl (.nL ó 7,ìr .f

.t r igr \Êttrr!

.ri:itrpEi'!.:rritpi:tf/!?ì..-._t.trn.nt;nrl:r..._ti:;:.n.if';!.r.:ii!

-oduction to hysteresis: actual Uaífects the EÂU

.i Ì LÌr..qrrllibÌ anr rar,,olrnÊmtÌ{r\ Ììrrnti\ \hiltÈ!LLit nrppl! s dc ir.tor.

' .i1io. i\ trrt)LLÌ:
:. ìrind sho.li\ hirc i ìroÌi rLLn etìe(1' orì lnenÌDL!rnÌÊnt but..ì rilr(tirÌ

-::.!..tt.llnÌandtoLicìr\h.!ri'ol.l.rtl.ì1 ÌnslrbllLTjfgtlrcr.(rrom\
: :.ill. t x't c,ì.,roi i.1lÌrLf .r' 1s 1.1.1.
: r.. ih.t iii.tr.Ì rLf.nrfl.rÌì.fL s1r\s ihorc cq!llihÌ .'nì
L,irn artu(.1
:: : :,,r dÌ .rtrnied !trn:d, il .o!ld hr\. r drnrrgifg .l ..1 o. lhc s('fltr
: !I \nhilÌÊre\uli thrt t|c lÏlr s Ìrl!cd. l his is i. c\rmti. oi!) riÌll.d
rirlÌ tlx'lll!ilibri!nì ol thr \!Íc.r d.frnds ôn lhr ÌrLs1o,1 .llrr'srslLD
r.:Ìhdrprndincr' srLsLdtodcs.rlbcth sthcn.nr{'n...l.lhj!\c.ti.rrr(
. i i,i rLncnìflornr. nl pi r'5is1( n.c itcÌnDLng lrônì ÌÌc.hr.i!Ìn\ lir.t rÌ,)rk

. i! nÚ cl i!..t. 1!hcr. n i.rcs n( scl Lô bc.rllL Lhos{. n 1!.rk i c thc

_ .Ì:iÌt ie!Dune.rflo!.rertettect.uherrthe|ìÌÌ! ÈÌrÌuÌrd!Ì)l.ycd

. I ì\rt{r.hü11htlrrÌaÌrorr DìrÌletrnd({\ett)iÌrtÌuerÌ.eraSe\cthn!.
. :i nÌe.ÌÌanifm iÌìet oÌrcÌrte\ rir (rÌ)r(it\ tcrattnrc a.d i! retrercnLLÌ]
.
.I! lune. ln (:hatter 18, ne Ìtrrl rt ihe ìtieDft n, nÌ(l eDljÌi.rl
:: ,!Ê .t lÌrrtereji\ dn!l Ì)e ìrtdÌ(e iÌÌ(rhlrÌi\m\ ìÌì e\tÌ.ìirÌlÌ! turÌ1rn

I Lhi rÌri.LÊlii ini Èd:rtrL.i LrrÈ,irL.,rrrÌrrL.,:r.r!1..i!ìLflr,Ì?tr \,! rl ,,l

118

ts

Figure 4.8 ,r.i:'!.: !ìÊ n5rr3_.Lr.il:rr..1.

4.1 The insideroutsider efÍectrr

\\ie d$rìÌne thdt tlÌr e.o..m_! is fiLiilÌr ât qtrllihÌiun rnÌnr)r Ìncnt, I. Ln ìilg. LE a.t:
tlìrttÌÌrre i\ r ì.ìLl in.r8.1rcset. (l!mâÌrd lhrt ri.]tr.cs e!Ì)ÌoyDe.t l(r L our usurÌrtstrnrÌl
ti(Ìì i\ thrt thr irlling lrlleLio. al /. Ì.r(Ìsrhr'..rrrrl hrnl ni.riÌ 1Ìr. ifl.r\l Ì,ri',.r
Lutrt iirirregrtt dinÌ,rfd 50 lhel th! c.or.Dr ÌetlrÌri nr I = f.. lf. holrcr.Ì. thÊ .eÌl
trrl LÌanl i\ iÌr.r.ti\ c i.d il lhe jnÌrrcl !I IalÌing iniÌatir!r (rr xggÌegxte demrn.t, r La Ìh.
rÈ.ìL biìÌiìn.e efi.|.( o. lhc.Lmrnd n)Ì mo.ti lthe le\ rÌrt etlÉctr .r .n co.!unrIll.n í thq
piso! etìr. . i\ $r.rk ihc,r Lh,,c..n.nr! mr! Ì.mriÌr n! \.mr tlnrc it / ì!o gr.rrÌ\ o,
ÌlorlrA rli,r ilìcÌr bL d..lilÌed Lhc rrn.mÌrÌo)t(ìout\i.ÌeÌ\ rfrl lh. L.sld.6l{hô rcÌìrl
enÌlÍo\rd.il, lhcr.rclnr\trÌrnghrrgaLnLnSf.sili.nbe.rL6L l.,.xinrplc,llìr.,lrnl
!pe(iÌì. slills nÌ..n tlìil Lhc lrÌì .i.f.l slmtÌr.sâ.Ìi rhcnr ifd ,!.f i.L rlx. rritlÌ ncr.
roÍlrr\ LÌ\ftrrs iìft pllsrLnr(ì l. hc ln L!.Ì.sLcd j. ÌÌaLntri.inS Lh!. r .trrn cmph\ mL n
ird in.rca!irÌ.( t hllÌ relrfrgei Lhci xLLâ.h no inrfoÌld.e lr) Llr..n al io. Òi cÌìrp .i\ rìL n
lor tho\r.Ì Ír.nll\ LLn!.nìfl,)rÊd I Thc..ní\tucfrcisrlralthcLÌ!.rLÍ!rbr.lnìr!rr,Li
.el ;Ì1 / , n: sh.rr. in ig. 1.E. 1n\ j..Ìcrn: in rtgÌrsrtc dcÌìrnd rrll simflÌ lìr rrlk.t.,:
n. risr n lhr (elrrer. trnhlthe irrr' = iri'i. rlti,Ì 11lrj.Ìr. hi!h.r iggrr!.ìt!. dlmüÌd ì11
!n:ü!..rì:f!.Ílil .n:..ÌuiÌibriümcmtìÒrrÌr..tha\hll.nL,,/. ll.lhiii\r Ì!!leL'ri
t(Lrc hlsLclls 5 i. s..\r lhrl o.cc rrn.nrtÌ01.rcÌrl hi! Ìis(.. i.d in\idÈr\ l!\ e enÌerge,
Lh(
Ì! th rragr 5r1li. p.inc,. .qu!Ì brirLn r.rÌrd.Úr..1 So.s ut rnd rrÌìÌriÌÌ\ rt tlìe rÌer
cli \ltho!grtrc.i5!.in.{Ìuillh,iunrrLn!.nìpl.!Ìr.fLo'ilin.ìfulrithrt.ìll ìÌì ei{tri
.-!il(dr andrthiÌLjres.oloilrctr,..ÌrasLLffh sldL..lran!c rlÌiclÌaLfuL\rse\eftnr!
iÌrângcnr!.,rLs riÌn rr.dur. (ÌuLljbÌLunr rr..drfLo\ nr.nL. hr. nÌi.rorr(!ì(Ìni. n1,rÌ.i.s r,:
thc nrod.l li.:''Ìrlii..d if ÌìoÌ. d!Liil | ( Ìritlrr l5

ir f,I r.f Ll 5,rrÌ,; l.rla i r: : ir,:rì, . d\tr ì ì.r r)s6

\i!tlrì:jljltr::t]\]j|Ì.ÍL'|:iljÚ.L.\rll|l:|]1!\
!Lij:Ìl!]i:.l]:i'rr:]'|È.Lrllì{l]]]l..lt:eì:gl.
 119

persistence
:2 Long-term unemployment and unemployment
dcm'ìrì'Ì rf'ì eqtriÌitrrltrnì rLneÌÌrPlt)\'
r cÌ!Ìrìfle oi tÌìr interìctjon bcll\ec' aggregitt
ì!Ì th" Ìrbdrr mârketÌr The
::ÌrL ni.trres on lhe Ìole cìi ltÌr LoÌrg t€Ìn Lr'en\ìolrd
lrom pnrrlcipirìon
.-,"ì", .,""-p,.1., aÌe lie\rccì i5 hiÌ\1Ììg rf 'Ilecl tithdÌa!'n(osion oi f\\choÌo
iro,,.,' -"-'*:, b.carrs' ol a Ììrcsrcs'i\'!' loss ot sÌiÌls;Ìnd ntr th'\e
'ì'.
.; ,. rvorkìng riit rro' nre thtrelort o'Ìr poor subnit!ìtes
",i,il";;rÌert littÌe .oÌÌr fttÌln e pÌessure i' ihchbour nrdrkct lht ìÌigher is the
:',rÌLnn.ì
urÌ.rmflo\ed Ì the o\crill Ì)ooÌ oi trÌÌcÌnflo-rÌntnt' uÌc
less
-",it,,",rl,-'* ('isr
"-,
.."_,_,\i,, .t,t-t g,t"t,. a,rl Jrrcmplor mctLt har e od setljf g li rhi\ is Ìhe'aie
pusÌr uP tlÌe
, ,.- " f"'tS pcìnì oi hìsh ulÌrDplo\nrorl Ì5 Ìilrh io e\tntrrllhIjll rr5È Ì' tÌì'
,l,,,li'.",,r,n"',ì,,", Lr!re|rtloled equrlilrrium u'trìrfÌolmtnt
':i ììr* ",,.
,," , i .,," 'hilL; upwarLÌ\' l rr r\ in tunì i{eiìkerÌ5 tÌìe scÌt e!ÌuiÌiLrratlÌìi
t
"'r " (lanutn\ i'd!' ürlation r1Ìc objccÌsL
-.t, ilt"-,9 Í'lìiclÌ hlEh urÌcÌnplo!nìcrú
-..,,,;; \!ork Ìrro
;;, *."'s J".u oI incn$o'rerLt rjei belìi'd \leLtatu'to
:,*'. iì" pÍrtrannn'\ is to r!'oÌ\nccÌ u'tnÌno-red u)rl'(6 llith tlÌc
",,. "t ".,,
,, ì'"rr", ot using crtrÌrlriÌrarrr)ns oí sticks
(r g' ÌoÍ ol b'nt1ìts il !'Lne scarrh
: LLnLl.'rtaNcnl anll caÌrol! fcg gr!'tt t'r Ì!n!cÌ to job irÌlcNiclfs' t úÌing lor

errÌ'ÌSÜr'e oi Ìo'3 rcrDr ÌÚreÌìrllorÌnenl

(in ìeJd lo 'r frìlonged
:\ÌrÌ,ìin hor urL:

-"'ittltl.un".tplulnt""r'Ì!rlek'a\aneÌ.ÌlÌÌ)lcthe''ìÍ'úinccon'ìrÌrinÌÌ'ìr1Ìr
,.ì'.',-'nn.",i",i,ìl ""ation rt flint"Ì in Iìg +9 teÌLr!n5sunÌ'Lhatinll'rtlo!rL5
i5he\ tr) kdre inthti'n to
,r,t 1 arÌd r rÌri'll cìe'recì 8ol'ernDent
. ',,ì-i
"t U"'", nÌfrtidr
rndrokcÉÌreltillt\ 1'Í!un1iÌ
'ì,",iti ".".."., *rt"SdlcdemaIìdtoli
rir'*'cr er' rilh hich LLnenÌplolmerÌt at I dÌc nr'rrc oi Ìonil
..'t_r""'..,," '
.':drìÌrÌo\Ìnertìr€Íilnsl!risc:itrú'snìl/_LirtltlìnhfoirrtitniÌbì1izc\'1\jth'r
, .'.1,.'ri"',s,",,,,,;"ÌÌtr''lor"lthe11:\rtrle\hiit\Ìit\!âr'Ìrs'\thlnedahorr:thi\
do$ ÌÌ bv llì! upn'e
' r .i',',,lii' o"rt i -,' tÌìr'Ìi'rgrarÌr' dìsjnÍìaiion is sÌorrcd
L1!|' to rr tÌÌen tÌìe go\
1, U,S .,r." lí lte arlnìc Ìlìat inUdÌion is bÍÌLghl
: r: I iLÌ r'rnt ro Ììor e rhe e'onom) bxck to I'
" ilo(el'r' L)c'ause olthc fres!''(t
equllbÌnrN!nc'+ìo\nrcnt js noltâlIr llt
-,.,tn"*"f 1""*,"*t'ÌrenÌ)lo\ed
. :lrt, úÌsider out\ìder modcl ìÌì tÌti5 rasc tht cconÔnrt \1ll c\enlLtaLLf retur'11111 to
or io'S 1c m u|cn4toled
ÌÌ rl.-m :,r I Lrre Lcrur ls tlìat àl pol't 1) rìre sììare
, ,l..rin"Lsin*un.nlru!menti\ÌoserLhaiÌâtlr)xÌìdllÌrlÌ\i-Lfli 'ttr\rn'jÌÌ
r'ill dÌrinli
: itli as emptormorr Ìe'oreÉ tLìc Ìrir' of lÔnil tcnn urÌeÌìÌìÌolc'lternr u!ÌrntlLrlnrenl s
,..'."t,r,"t tt,,t.'u"u u)'l Ìtihe s'rrrhg'eilcct 'rlÌoÌrg urÌìpLolc'l
tern biÌ':l(
., n* 1-til'. poti.ies ttlgcÌed at rtintlgratiÌrg th( Ì1rÌg
_,.,,.ir. l"ttdcÌ lor tÌÌc c!l!iÌlbrìLrnr at I to bt ntlâLneil oxccbdckrÌ
.
""."".t
ruill lt"' L e(l it\ objt'llve oI relLt'ìÌÌs rnlÌiìtLon lì(ú tlÌc Pro'cs
-i..r,,,."nL "clric\
:,)ili.tedili\orkersbeconìedi\conne'tc(]lrcmtlìclrb'uÌlorced!Ìingthephn\e
thr Í'ìgr:
r: ,Ln?rìtÌo!fienl Th': uatLcÌ I \'l 'u \ e i(hdÌüiì iÌÌ lhe diagriÌÌn \lìd\1
às1!Êhilese'n'
l. :"r. r nrLen trrr lorl-Lenì trncnÌ)lo\ nÌrnt nÌiìre is LLn'1ìaÌìgnìg
120

lleg Ii1 I (,rncìrì.ú!rtsIt.I irLiÌdci t.r.nr.!irìLl.ln,n

\Ìrr r rl ri\cin)l7L;;rr!q!ilibrirÌllljlr..iitcnrriúrl rr
Ìì j nrÌtu ul) rl t. (.i rn!i È5iÌìLliLion ir r'.a\cr.
\rr.rlniliÌ)rnu!!nìplor.rer i:Ì /r. Ìì \ tLÊr
lt Ir. llttt3ni t,r i.ll I I l,,r 1eq!i rÌluÌ / I r. ìs!)Lrìtirì
ritlrlrrdn ÌÌ J 5jill\ l.ÌìrÌ Ì \LIL.]
liilial eq!ìlib !Ì i1 Ir.rÌt.fÌrìblrJ.r lL'i\rrnrÌL.rÌ

Figure 4.9 Llr:.plriÊÌ:"siii .i úr !?r !r!t:Í - Ènprr Ê'i

hegi..j.g r ith dn nrltì.rlll l \5riR'.1ônSL.rÌrLf.nrfl.\nrenrxrÃ,Llrln\.\rahlliTlf!

ìrrhc\ÌreredrÌ!)tcdÌrlIlUí. lL ! thr i.t.6..tL(,Ìì nr lhedd\heLÌlr'J.uri!xn(lllrcI\
cur\et!ratilÌc!thr'lc!Ìt run cqrrllihÌLlrnr Ìir('r)I !|Lnrflo\ nent: lhr ìrLlli.g Ì1'i.uÌ\ r
tÌrr1rd.rniheret!rnto.Ì.nd Lhcc(rnonri \'llÌbcLÌ)!rÌ\eddt mtditrÌn Ìu. .1ìnsirnt
iniÌatnÌr e(luiliLri.r \r(lÌ as ,ìÌ Lr.i.l I).
It r als. Ì)oi\ibLe l!r fusi\ii f.. ro.Ìr.rirc Llr Ìough the fr j(r s.ltLnË.trÌr c lf i ri e\ th:ìt
ìt dÌal] ii(rll! \iÌÌÌiLrr to tirr l!rng tcN rLn..rPlor nr.nL m.dcÌ. Thr I LlrLLl.f isnsloll!Ì!\

rlaiÌr.lÌillÌ üte\ nl (rfr,ì.iit !1i lTrLiufer.rn.ou.l.rcdìrhlglr.rLLf!.Ììtl.\.ì(nl LìÌr\

thrnprerier\LÌ lti:plr!jib.llrilllÌm!if.n,i\.1lrcrltÌt)htmargi.\r11.Ìrhigh'nl(!n
(rt,rciit !iiLirirtilÌr \iÌr.r LlrcI b.Ì cr r tlrrt f.,Qsi!c:ÌroÌt.ì9. oi.rfâ. Lr i. Lh. !'.o.,r.ìr
ìÌÌ(in\:ti\itrioi!si) lig'inreti.rllrüri\lmlÌ .\lhxtthrlt.urr.LrLÌnsdolrnrii:is
rlÌ1r\niÌìL .'!. 1llÌllrrn\!rLnr.th:tlhtr.nnônr\slrlatsj.jlialÌ_1 :Ì.Dr.ilLLil ÌìrlrL.riL ìLrl
hillru !n.Ììrpl.\ lnt .s\.i.ii Ld r ith I |.drit!rstlrúÌcstrll.l1ììrdislnllili.npoli.l
!\ri irÌ tlÌc fir\ ior\.riìÌrìpk, Lh.f riLt i|.l.fqLÌltr'lt!Ì. hi!h !..nlpLorÌÌÌrntiìrìn
inn.i.rt(Ì] iâpit.l s.r,ìppìng. thr rxfLLil iLo.k d..lln.\ Ìrl1lì Lhi .oL15il!üÌ.( llLìt thi
iornrrnl rlopirÌSÌìrrtlritrc/5.1Ú!L.o..rLr5nL l.Ìr1., rirfl.!Ì.n1' \\lÌc! rBAresrtr
nüìriud is \LrLr\iq .n11) Ìr.ÍisrrÌ, r Ls.l.ir rhiL rqr llbrirLD u.rnÌplornÌexi i\ hilheÌ
rhü!. is a rc(!.q! bÌirLnr riLh .L)ns{rfL nlhL .n eL {.. HoÌrclrÌ. thr..oìonÌl nìLl
rrc rlui l! r.tu'. io ihL l]r lgi.âl .qüi1LÌrÌlrL.ì h(.rLLi. hiSh .el)i.itÌ !iiLiâtiorÌ rt (- Íìll
sLjnrrÌi1.i.r'r5t.ìr.nÌ.1.\..lrLillitlrec..nôÌì!rillr'!.LLLÌrtrjf.r.ìi'.,rlJ(ji\utjli^tlr)rÌ
r 1Ìr ril h l nr n.nrnl.r Ìì.n

' lh\i.Ll., i(i:i,rar:L\.ri[: ]ir.:r.., I:l

 121

I I, L,

: -'l _ !iin.rtpErijtÈ (, t .. ...;r 1r .. i.! r:t Èt .Li

- -: Beveridge curve approach to unemployment

: :-inL L,ldì1ion ot ÌrÌr(ü ÌnrÌk.t anrÌrils lronÌ the Írgc a.d prjce \efting
.:. .Ìr Lh. 1Ìllrr !t teoÌrÌc j.to anrl oul oi !rÌeÌnÌrlo\Ìncnt .r cmplu!.r.fL
: tu' .ncd lo.ìr the il(^\'tìtÌÌoach ând bclon8i nr Ì)eÌt oI Ìab.rLr economj.t
: rÈi.ch lhciÍt. \!e erplain tìre esrcn.c.Í thi\ aÌÌnÌ)a.h 1rilh.trú !etting
.-,. r.aÌ {ÌrLiils Jnd slxtr\'Ìroir it.xn bc (Ìited ro Ìhe ÌtJ l\ aorlel IÌ Ls a
ìfrÌ rt!t irìcn anrìlrsilg unenÌn.rnìcnl r\ deD(ÌrttÌared i. Chd|reÌ l8
. .Ì.h tÌadiL .n, un.nÌpLor ment i\ in e{luillbriLrni Í hen flora if lo aLCt our o
::ì!rrÊequal wlthncon\taÌrrÌrl)ouÌftÌ..,1,ìbou.ÌnxrtietcquilitrrjLuìi.tlrc
.-h Dcans llrat hires, r. rre.qual n) Í,Ìrarationi. .t, fìom cmplorDrr.r _ lìc
,.:hetnork.óindjoli\aìehertr)gen.o!sÌ.rtìctoÌthârhastr.ÈrÌÌreglc.tLd
:ih the c.nÍitu.nce üút aìr ìmtorti.t,ìsp."(t oi h.1r thc ,ìbouÌ nraÌkrl
arll iL x.hlc!(s tlÌe nirichi.g ol trnc.rplo\.ed Ì!oÌl(Ì! I'irh !nnÌled otr

: :\r(Ìì r)l thc nratchirì! hur.ti(n .an h crpLriÌre.l r\ rttÌorls. tr jr a$anìcd

:.:nÌnÌreì oi rrn.í4Íolrd rnd l: j\ rlrr nlnÌl)rÌ or la.an.tcs.rrd Ì i\lh€
:.,: (Le(ìjbr\ hon elìcierú rhe marching prott\ it Ln thc c.onomr. I is
. !! rd that rlìr nÌat.hirrs nnLtj(lr Ìs.Ìrar.úrÌized br'.o.stnÌlt returf5 to
: :rrrÌeioÍ,(,r Lc tlÌe nÌ:ìt(hing lürctL.n as

-:.::rÌDboofcílÌjre\ì\xro.:ât.dÍ.itlÌlÌiShcÌnraL.hirÌ!ellìcie..!ld.u
:::ijÌ!otÊlhi(11aìrcLJareflor{stcÌpcriodanLlLhallÌrcÌrrrnxtca.trcoiin\
-.1. hÌÌe\ end 5rparrtnlr5 tìrc m.esrLÌcd con\jtr!.llr Lhj\ dej.nbrs hoÌr rhr
i:r rr.ìlclìcd nitlÌ the r acan. {-. llol!]iÌrs th. mil.hiÌìg erh.icn.!.nt rhc
-.Ìr.Ìer .oi5{int. lÌiSireÌ uncÌìplorm.,1ú 1\ âío. aftd si0ì rìorl Ìì.úchÈ\
:. DiÌr rppll.int\ nì er.lr iob. \inìllan\, httLlin{ ÌrrÌdìpldD.nl .on\re.t.
'122

nrt)Ìc \rcâ.ciet aÌe r$o(iat.d rrith nÌlk mit.lrcs ll Ì!c a5ntrnÈ uÌrt tlÌe tl.a o:
lLorÌieÌi troD eDplo\ÌÌent tu lnc pll]\Ììrrnt is I ir. lrlÌcÍ'J i\ ihe Ì)Í4!únÌute
rxit rate fu Ìn eÌnÌrlot nÌeÌÌt thr.n lhL libour miukct nill Lìc n. Ílon eq!ìLitirnur nhen
thefloNnrr.unenÌrl(ìÌnÌent Vr is (lu.1i! thc fl!Ìt {rrrot Lrnrnìplornìelrt il]Ìo ìoÌ)\, ìl

iI= ì ,riLr l'l

L\ing the r!uÌnÌ)tion tlÌal mii.hi.g leÌics tlir. rrndeÌ..fslrnL r!.1!íì5 lo scilc aÌìd
a$uÌnjng n! tnÌtlicit\ th.rt thr sr:Ìrernl on rntc ls rn cx.gcn.us rofslirl (ì.c tlÌàt ii do.j
.ot depdrd on r((Ìuni. l.clorì, rt. ha\. I

I 1 ì'
|r \
/ I.
llllc dnÌ!,r dliìg,anr (iLh the 1lienryLllment l.ìtr'Ìr - U ll on tlie lÌlrironi.rl a\i!
.ndthc!.cin{riL.iì=!_EloÌrthereúì(dlr\ir,thcÌitrourm.rrkete!uilibrirìnÌ.rnbi
plott.d i5 shor!n nLi!.+.l1.TlÌe!rcdÌ\rrLìnrrÌUiorrÌrcJrt.!redÈpi.inìgLabo!rrìì.rrl(1
iquilibriÌrnì in lÌrc loN mo.teL ir (alLed uÌr lle\Èrid8c.une. 1he.! e is doÌ!n\!ri
slopirÌ! be.i,u\r al lr glì uncnÌrÌ,rynient. \iur a Siren nÌi'tchiÌrs tr(lndoi{t, jt ÍiLli,.
necÉss.r\ flr 1..af.ics lo be Ì(r1 tu ckli\.rÌ the conniìnt nuÌÌrbrr ol xútclÌe\ re!ujred
to b.ìlìn.r thc 1ir.d scfrrati(Ìr rate. \. (-(Ìnesel\ .t 1.rr unrr4JLolnÌent !!ith ier!l
!eopl!.ll].,\lng i.r rork. ÌÌ!rÊ \ acan(ìes a.e re!uired to.ns!re 1lÌàt tlÌe rÌumtrer ot tlìor.
tiNl.g lolrs 5 rqrel 1o ürt \etrtuti.trr rrte. Ant rLeclirÌc ln tlÌe el1ì(ieÌr.\ !l nútchiÌÌil, ,,
nill sh llt {hr.rLtr( l(J tÌrt Ììght $ith tÌÌe iìnttication lh.ìl iü\ eqrillbiLuD rt r Ni\eÌì
uncmplol,nìcnl ral. r'iÌl require â iÌitsher rale 01\ rcancies iÌì the elorÌ(Ìn\.
lJLLl h.n do.s this afÌtÌoalh tohLrouÌ mrÌlietecÌ!ilibrjLrrìÌ rehte í)the Ì1J f\ nrodeÌl I !

lhispolnl.lncen.icsha\ÈÌ)eeDilrúrrd.llow4er,orÌcclÌeteÍ)Beneji\bet\veeÌrÌloÌlieÌl
an.l lobs Ls nLrodurr(Ì. \.rcrncie\ reÌrÌeseÌrt a rìersure ol t).e\rlde iìr thc laÌroltr markrt
Holdi.! ilÌ Lhc oLh.r dtttÌmìÌr!nt\ ot ihe irage aucL ])rice tettilg.uNes co.\rrnl, ftr .i

I r\\ I ï:.ir ri rr, n rrir ì!

!1.1Ì..1li.icd1 rÌrtcìing

Figure 4,11 l: cê,rÊ'.qÈ r-r,.

124

cqoLljbÌLunr if
lhc libotrr DrrlÈt Ìs sÌroÍ n br'(h. i.lc4r,.L o. !ltlÌe ler eÌidBc cur\ e rÌrl
lhe lì'S = lt Ì nr Ìl Ls cleâÌ rn)m lhe dirgranr thal tÌrcr n ll b. lÌislÌer unÉmtÌ{)r ne!:
ÌI thc ahllll\ oa thc cco.t)n\ t. malch rloÌkcÌs lo jobr Ío15.n: i.]n outri \ÌriJt ot i|!
Ber eÌ .uÌro. ln thL5 .ase, tr.th ufcmflornrcfr artÌ râ.in.ir: rÌill tre hìther in t|.
jdlrr
.eÍcqrLjÌLÌìrlLrnrLalIiì.Thedctjudnrenl.lLh.(]rnonrrLoth.Ìx.rrqujlilrriLÌnr(dn1..
.xfÌrincd âs nnloÌr\: ii r deteri(rxtjo. i. nril.hing (rÌ:u6, ri.àn.jes ri\e ürrrebl Ìru\1.
ng lhc Í\'!.rrtrc ut(rrÌs aÌ Lìiting nÌlrlr.nrÌ!trc$uÌcíislotì!.1.121.|!luìlibrilÌÌr:
u..nrtlormc.lhâsgo..LrÌrrnltrggÌcgrL,d.nrr.dlrillhârriobcrtdu(."d.Iheeco!uÌÌ.
Ìr.r$ 1o ihc n.n .q(rllihÌLum nr.Í. br rri n i ig. +.ì}.
ìlL..i(il(h.lILlìrr.siÌ!\cj!Ì!iA.lôÌlri..fúslri.Lhit.oÌlün!b!ttÌrrDevrÌi!l!.
.u( c :.nìlÌrì5 u.rhiÌngrr]. thcn th(, 11-t = /'\ rutr. sÌri 15 l. LlÌ. rillÌt dÌd equìlibrúì:
o..ri.i .l h .{h.. !.rnrtÌ.,1rrÈ.1 lr{ rì ) bur iLh r loÌ!.Ì \ ir.in.Ì rate. llÌe iÌrtuìtir!Ì i!:
Llì. s{..nnd.i.c 51hiLlìlglreÌurcnrtloÚr..Li\as;ocLalcLlflhLì ú\rrrr(an(\ r!te1lL,:
ÌreL.lrlng llrsoi5i ind Lhis Í)De( hrl . IscL! tlrr'.IÌt.L oi hithÍ n ir!t presr!re, Frr iÌ!:
c!rLìi brium L ÌÌc.ìlrlo!nrcnl lo\.Ì LlrifÌroLLldhL,Lhc.rÍ. 1Ìr.!i.rn.\ r!tedidrÌotlall
i c!rLìl br lu.ì un.rnflol.nrr.l Sor\ uf rrilh litLl..hinsc Ln Lh( r i.af.\ r.ìte, thit nrSrer:l
lJì.rtIr.rrÌÌ.' bcc.isÌìiiLinbt)lhth.LÌ!i/lt.rrtr.!r.dinLlìcllirui.lAe(! e rjnÌUÌ.
nìl\ r irrn r; io ì,rì.
!tintúrLlriÌì!th.iÌ,rrritìDÌoirhlNihr.bo!,nri.li!.L,1rrlÌir\eüidenedthe\et,,:
1a.icì.5uÌat.arÌn..l,.!nl ior.lrafg.s . !.!rLiì brLLÌìrúr.nrfo\nìln1.Lrr!iditjtlrt.th.)j.
thrt slìiit 1lÌ. Ìl -\ or1hr. /ìt.uÌ!r\, Ì!. nojr n.lrrd..âL(l.isoilhrrrtthekir!!rnrr:
Ìi!.1 br!Ìgs NoÍkrrs i,rd jobs t,)g.rfcÌ. riÚi.r ro 1,.(:ufat .nil;ÌÌÌd reolr.rfhicaL nhbìlit
idrfl!rrrìkrr nriÌl.hifgrnrl Ì!Ìll\lìiiL (hc ll.trl{Ìg..r'Ìrc oul ift sirniLrÌl\ p.licie\ t
.i!.r.(-ì.ì!. I ìcs. bi(i.ri br Lúrtftn Ln,i Lh. .tlri...r . .Úp .\ müú r .L túnrnrs agerl
.i.s .r lhr .fcír1i,). . Lh. hou\Ln! DaÌÌ.t .i. he\. th. Òfposiit eifu!t. S(!ìÌe n)Iìt .:
cmllormc.l fol..l onlLsdrtionnìr_rnlc.LLÌr.rrllÌ iq.rs\oi.,n4rl()ter\n)hirert(Ì1.
.15, r'rik.njng lhr nlalrhlfgftrÌÌr5 5onì.1i.lorsrrll lnprirÌci|le\hiitbotrcrrrc\rni'
.raDrtic, i.rlhlng s!.h is af ln.ÌL.iic n !.rnìpÌo\rn..( beklìt lluì rtl)n. tharÌ!!rl1Ìr.
\!ir.lr nL..s Lr, ih Ls Lh.: Bcr.rldg{..u c l. lhr r lrÌrL aÌìd 15 ! Ìlrse Ìru\Ìì lactoÌ. rin
\h l\LlrrÌ1\rfriÌdsi.dhc..cLlrrrlJ /'-\LoLh. lÂh1. 1lle\e ettect\ rÌc Ìcif oÌ.i.!
\ oÌ\cn nr.\lrrllih, 1'.ì (l.cDtlofnr..l

6 Conclusions
IÌr thÌs .lrit1.r. h. lrir. cItìoÌct] LÌr. irfpli.,ìti!|\ i1Ì irìiÌ.rri(Ìr a.rÌ Lh. / ft, oi \Ìriiri
iIthtrrg. rndoÌ fl..\ctrj.girL^is ithcÌt-\.ulrii\tunrcr]rrt.rthL/,-\.!r.
it ttrrhe.l d.r f. tb. .qrLilLìrÌLrnr Ìiri oi uÌìinÌlrLo\ oÌ(nt útt. Thc n.6c ir.rl.rLLirl
equilibÌjüD u.cnrtlnriÌ..1 LstÌr..i:c1..id!rrìtr.rrlnriftÌ.Ì11Òrir!ps.r nÌiri
ìr fJ. h thr !r\c oi r n.gaLjre i'ÌÌt! slr Ir |Ìiirtiür !.r\ uÌr r.rÌ thc ..dtrirl Lìrnt nìll
Ìeï!!r.llothLsh\Ìii\lngth.i.to.5Lrit..LrÌünpLo\merÌtrÌllhrfLLnr.dibüruÌerÌÊÌr
lììgherflLiifoÌdcrt.,ÍlrtrrzrllrLhiirhrr Í1,rtiuÌo!totthcÉ..nonì\ lhi.eDtirlLÌar.
üiÌltlìenguLdrlhrc..nonrrrlo.!lhi.c]rìlÁ.ur\it.tlÌeÌrerhj!h /Âlriìndirì.d1(ì:
rill ÌerrÌr Ì. 1\ Ìr rq. riÌ.
 .125

lnstltutilnirlandpoln! reLatedüâge iÌìdpÌi(e pusÌr laclo6hivcbccnitÌcnt lcd.Th.

.ì.t,..,1t.'
. r Ìi\e i. Ìhc tax Í(d!:c

. 1fu1ì Ln tr.d".l \ 1\

. .L ri\e ìÌl the reil iÌúeÌe5t Lìte

. rrL)Ìc.mfÌoÌnrcnL rcgulallon.L.rth.r\Ì.,.Ì Lhallhj\i\nototi\etÌrtlÌlsher
ìrrÌucltrLLÌ orhra.oihcLLl.gmod.Ìati.n o agedemand\

l!e 1!age letting LuÌre nrift5 ut$a s Ì!hen

.:ì.ÌtÍ.ri\einthereplace erÌÌrntio,i.r.rllÌenurcnìflnvmentbcnehtsbec(rne
: ÌrlÌ. ' r'; \ 'c
. nl.f ! atu a..oÌdrd n]or. ì.!al Ìrnrte.Ln)n, c g. ln ÌelatnÌì to thr rillÌt io til.
,

.i]tr!rÌirì r.rior or Lrc.oÌrlr nroÌr poneúul as reilected irÌ !niür dc,)sll! or ln

..ril(1lvc hrrgâlf ln.{.oÍ$agc
'.ÌÌi.!LeÌe(iseLe$üagereni,irÌt,..!.i,stlÌ..o!ìs.qú..ceoldre.oÌlap\eoiallrse

' r rrl!. l5 e.hangc ln lliil. sclllng strLÌ.tltrett.ilxÌd rn iÌìteÍnRlial. lctcl ollúgc

i: Ì LlÌr g .l1lì r. r arr.\ irl]nì i nìur. dcctnlÌaÌi7r.l \Ìf i.tÌÌr e (Í tr rrì i nìorc.oordi.atcd

! co.LroleÌ\jalâ\ tr) ÍaretheÌ a chüÌ!e iÌi produ.t \ iLl Lorln theiÌen.lotlrodrr(ti\it\

: :\lhrrfí€cts tht cquiÌibrilurÌ tute ol lnexrplcì)nì.nt. A no$.loÍrÌ jrÌ pullciititt
r :\lh í(, r frll Ìn tuÌrctirit\'lÌ: nnti..orÌ1rìtl iÌl ìrìtÌ the l5 (!ne do\trl
,is Unler. a.d untjÌ, rLage \ettÈrs iìdj!Í theii b(hâtiouÌ trÌ ÌiÌìe \ith this, thr .on
. L.n.Êüill be a n5e ir rhe lÀ1.r. lt lÌas treeÌì rrgÌ(d thal a ÌrÍ)Lonilel perili oi hìgh
.nrflovmrnt.a. lcad to a deterjoiition irÌ tlì. r'lcr:tl\enesr $ìth Íhì(h tlÌe !nüì
.Ìl .,)ntcrc n)Ì job\. Ía1jch i. tlìnr nÌiÌ\ tlÌe ll J .uN c trÌ)ÌLrìc1\. lhis js lnoün .rs

., he\ c scen h.r't() uÌe l.rbour nrirÌ.:t l,itìr ìt5 eÌnÌ,hd\i\ on h.n\
thc low rttrìach
Ìflt)\ rf{Ì i rcrncle\ rre ÌÌütllÌrd a.Lds i dlm.:.!i.n tt) our LÌnder\tar irÌ!
c(l rroÌÌicÁ
_..iilLÌmina.Lroi,ÌltrjlihrhmunenrÌnornÌent. lhcB.\.:Ìi(]ge.uÌ\ei\clorrÌs! s
. Ìr! Ln lhc u.emtlormrÌrt,\'a(ìrÌcl djasraÌn drÌd :ho$ lhc nd, equiÌibriLuD i]Ì uÌe
.Ì nnrl,rt ì:or r gtrrn e\it Ìrte l(Ìn eÌnpLlrfì!'.t ând gne. the nr\titrìtiortr irÌ
. =.(rr(rÌ) that laciÌjratc tlie nüt(lÌnÌt oì uÌe uncnrplltcd i!ith \r.xncie!, d hillÌ
.:ìÌì.\ment Ìete NiÌl be ar!)(iatrcL uiuÌ d Lur !i.af.t ralc r..ì \'icc \eìsa. lÌÌe
]Ì .ÌLigectrtrtrriÌlh.!Ìriirt.inrÌheÌìthtìltheÌearein|.r(iÌsrdbarÌ crs Lr) occufational
:. ìgrrthj.eÌ mobllitl.oÌ Li emÌrÌ.\merÌt pr(ìte(tioÌ nrciÌ5(dc\ jml.ÌjÌ lhe matchinil
-.'s \\iL.a. conrbi.r rhc rnrl)5i\ oi thc nrÌ)â.t on.quillbriLrnr u..NtÌo\nrc.t
I :':. ircr(rÌ5 rhxt sÌìjiL thc Ì1't aÌrd or the fJ rith tho5r thnÌ slrllt thc Ìlr\cndNÈ
 : . !.drflovm.Dt trÌ unempÌ{Ì mentl rate, hiither vacan.ics in the ecoÌromv increase
: rq. sorkeÌs cân baÌgaiìr tar. or tlÌat enìplolers rÌeed t.i sct to atiract Bood woÌlie.s
''ilii

È \Í:
P,

::: r is tlÌc lacinü ritc. thc Wi cuNe \hins up irhen the !!cancv rate increa5es. As
: -iIíÌo \, a hiithcr ralc oIlecancies impÌies a Ìoi{er ecÌuilibrnun enÌtÌovnrent Ìate
:.-r.È lÌifher equilibrLurÌÌ uncmltìo_Ìment. Ìn otheÌ r!o(h, therels a tosìti\ e Ìelatjon
..t\!een ìac.n.ies and cqLriìibÌium unÊmpl{)vment (at \lhich 11.t and ]r5 are equrlì.
::: le\ erirlile c!rvc diagritrì. r'c.an noi{ inchìde the positi!elt sloped line rhowiìrg
: j::!r arÌd price setting cquiÌìbÌúm (Fig..:1.13).Ir the Beveridge cure cuagÌani, irÌÌ

Ì15wi(hhj.gh râcan.ie5
- Ì1,1_ lvìLlì Lolt ra.ai.i.s

t.,: L.

.:- :4.12 iê i'L/5 r'5 .! eardva..n..:

llerl!ction in Ììnt.lìifit efn{:iencr i c i.d

ÌÌicr!â\. úì 1Í.teor triL!l)rah faLnr\

= :- ê 4 13 ll,ê EÈ,r:r.1.È.-ÍNe ;.d lhe h5lJ lqr bÌ !Ì

 !

126
-
QUESÌtONS

11) !\'hrlisiri.rgcacrodrrì!l(lr\.ìithl l..LÌrtrol

(2) IIdì \rìo! .i thi.cntrdÌ ÌraÌrl rÊì,onl to t ì( .. litn ,:,1Lr I r3( n...rd_r sh.!r lhc
Ìrath ot rerlrig.s, iqnrtr.È anLì!Dtr]PÌoÌrr(nt.\(Itirìi.J\tìì.(((nìr,.ìrrdltrst\t

(r) lltliinrhrti\fi.intb_\ thcta\rcdgc Urie! J chaÌue !r thetü r'erlge rtir!r

(4) \i.Lk a rcatt!Ì pÌo1!!irr! tlre (lri.Ì (rì tddc tni.! iÌrcd]ÌìoihiÌr dtnsitl anLìrolÌe(Ìi\,
lÌar !,Ìj. nS r rsc lor er rEi lrr Ìhr rtt( nLliì lallc l l l! hr: do6lÌt Ìrlot rh.rll I!
t|er( inÌ .hangc ú tÌre reÌJti(Ìr\hlÌr rtr ir titrt:'( rn l ou !ic1c.t anr ÌÈsnlll fltterrri
(s) ll.( rÌÌìBÌri tÌì. .b!rNrlLrÌr th!t the Lì'orlLL.t !it\ 1(.d (i..c Liìli) has b.tn tÌrfarl:
in E!Ìofe rrì(lthat thc rÌrÌrd ol the !Deul Òl dri n1 it. hei n.t bccn Ll.rlntirdlt
rccol(ilea Ilth rhc ÌlJ l5n eÌl
16) Ìns..rioi2.thefrì\.n.r'dirnìnìrgiÌneDerpÌrjÌÌe!1.lo nnrúrrìr\a.ìlLcl.
\ ì.n h.Ìr lhú Silrr iif r ill icd Lo rrle dc(rÌ!1.
r uÌr:dr
(7) t\fLrliìh.r.thcLÌJr!re\rrrL rrìb,,ur{Ltìflt.urr.iÌedlrnednrlÌir. 15.
(B) \\'hr e!!illbr lÌfn !rntÌdrìeÌ1t lor er \ lr( n tre!.i ar. \r t it jrìdÌslir ialhrÌ lìraÈ F
ji
lìÌnÌe\eÌlllo1 1r.uÌrìr(iLclfcctthi\r(1,ú1,.\hIt.b.iiÌi.lcd iitalì iIlÌre
.oÌ!!n) ìrì q(Lrrt;.n 5.tc!r n) nÌteniatì1nr1l lridi l
(e) (:.drpaÌrrÌrrrìl(tetrLlb\ouL(ldc,sLnrhrjÌLiaer,Ììt\ileÌnro!lelriil,tlrritr\iL1
ì\ rhrÌtr1c teDr LUì.nìl.rcd . th!uìdÌfÌorrrÌúteri\tenreDÌ!).rl
(lOl l\hrl(1h.F.\cr ije.!redr rrLrrdiln|i.glf11Ìrr1 sth.ll\ l\.Lreuì)r'rÌi
511ìrì.! jrr thcracan!t !DrnrÌrÌ.,Ìrri(rìt d aqrinr:
11 1) llo\.itrr'ilr.úLdro!{tr.ilheLntenr(inrrttr(itlrrÌ1J./r-\.orth(ll(\.ridg.

PÌob êms ànd qtreíionsÍ!rdisc!$ion

(ìl-l\1lO\ \ ,a.rlbeÉtiert\onuÌreÌ4)L!\Jrì!'ìlifd Ìrfit.,rroli\uddr.i.(l
p(rn,ìnrnL' 5.i.hb(rrÌ)r!!Lu(ti\it\ l!tt!,ì t.rÌìÌro!i.. brr,ì[lhr!r!h
(.Ìt |STÌON !. TlììoutlÌ riÌriL nc.hin5Ì5rrnhrÍercsi\if!.rrìfÌo\nrc.t(Ìreratel
\thxtaÌrirrc(!bc!l!üÌ.ci.rÌhili.r.fiLÌroilh€ufcÌrfloÚr..1rtrtr (tÌdrirls irrra
Ì)!ÌLodot!li\lÌrilati!ÌL:'(i, en nr.iLnr(f LbnoÌ:'
QL.l\ ( )\ ( . rlo( Dr! LrÌÌ4ÌÌrÌt)\ rÌÌerú t,r.ìlir.ird lì\ iri birrrirr\ to rt!iinrl núbiliil
tl,rt1r.. i.l,r, nrrLlt)n aború joÌ\: r i \ÌorÌ!cr.nÌ|t.tnÌrÌÌ frtrtcii,Ìr irBi\l.rtiür'l
(lL 151ÌO\ D. L rì .,ns e.d leb.tr nr.ÌÌtt fug Laiio. Ìr1le.l lhr |(nrcÌ o r $l.ri
iÌtetnr dÌ!l .r{1f irci i( Lr.!r ' L n .ns r.d hir.rÌ maÌÌn,t r!uhLio. rÌr en .Ìlr.LrÌ:t
r15!.ntenìÌÌÌìr\iÌì!m,r.Ì:LL!.r!.sLi!rL.h1Ifr.oÌronri:hf.\ünb.rsf(]1.!LLÌlnrt
ra(h,)tthe.eiiÌÌe\.ii'gunr.nL lol.iLL lfd!LthrÌì !unrr'ÌrLt.\LLislr.? \u!!.!Lrd
r{.1iI!: li$adlÈr :r)l1l \S!'ll 1llr0l
 127

iLISllO\lÌÌì1998.Ì{(nrcÌlSoÌowÌetorrerlônastu.l_rb)\ÍcKúr\ev(lÌ(nrlÌÌrttiìute,
hiclÌ an.rLrsed tÌLe ec.nomic teú(rman.€.f lìÌrn.e dnd (ìerran\ irÌ ternL oi
:JrDhtmrntandtrrìu.tiyit\irÌ\ìrlÌdustrie5|!utr!ìrn)i]ts,Ibu\el)uilcLirÌ!.
ilc.onnnuni.rti.Ìrs, retaiÌtrade, c(ÌbunÌer l)r.kjn3. drrl conÌprter Í)ltÌ!are. SoÌ(^\'
i.qr15 lhnl thr \l(il repoÌt nìÌìpoú\ the l.nll\ ing (onclLr\i!n
(;!n!.nt hIt.r^cd t. hilir udcmplotmrnt rcSnìcs b!
rÊ ilieljho.d is Lhri lfridr!.Ldd
. il tscrúir1!..r. cs. rÌrd ioÌ ij \ rctjÌis ol.dr.6. nìilti nr úcÍ lcrcrnìgc
ng a ong theú
.:rc\ lhr iÌrlifui \r..kniss i4lob.icilion ir mri likcl_r' the reÍr L1 !l ex.eÍne ard
':irrnteÌj1ÌefÌÌi!.tmarli.Lreg!laLion Ì.stri.ln. dr.Ìoe.ono.r ( Ìro i.1. eïre( ! lr
ì Detr\ ÌrL) .r,iìdiiad.!raLeais.ifL nilro!ÌtlÌ!.aP La ÌìiÌtei! rr
rn rotr ln LcÌtrr1 ori\.o.rlLri oi us iij thc nÌo{tcÌs dsdotc.l in this chatt.r.'
Sn

-- 151ÌON f. DerÌìÌres ìr uniol densit\ dre oilt!r attribütel tu nnr(tLrr,ìl clÌ. Se.
-!bilizatnn,rnddemogrrthicchrnger.\\Jh)mÌghtthi\beso?\\lÌ;tÌrouLdtou
: .Ììrct tÌÌe nÌa(Í)ec(rr.DLc Ìmtect nÌ l)r? lsuggt\ted readiÌrg: C]Ìe..hi.n.l LucilLìr.
I 1)2 . I eich (200+l.l

. r!ìllc

:ÌÌ!L,lLii!i

ì
124

Table 4,1 ii,r L. r ! !lÊ.i ttr:nn .. .(r rÈ i. rì:. '! ri!. ..,. i9. l!tÚ 2lrlliì /:

Co e.1 ve bà,qà ìinq.oveÍrqê

oEcounweighÌedavÊrãqê
oEcD we thted aveÌaq€
 129

:: e 4.2 lll:ajr Êj !í thr.. J.i f,ìl!n iÌ n... a nit.r !ì i:q,' !:t:io r aFi D iu.r Í:j

.'
 Monetary PolicY

. .lÌìr .ltÌris.heÌrtcl oul iÌÌ nroÌe dctâÌl the 1!r\ thit rÌìo'et'ìI! tolicl hì\ bec'
l5 to \et
.t,l Ln rectnt.ears. rne tÌriin ftcì i! that cerÌ1rnÌ ti'r'k Ì)ehâ\'io!r cxn br lhouilht
.i in lcDns oi r 'rea.lio. 1ìn.rion' that thr brnk ute\ 1o rt\po'd io nrocls lo
':entral
. rÌìônr\ âni] stetr it lo( ard in eJ!licit or ìnrtli'll nú1iÌrjoÌl iarget

'::lr\ttaskolthcrea(tiontLìn.lirÌÌisrt)proridtr'ÍìonliJriìdn'hoÌlorthenìcdiunl
_ rhi.húllehnc.lirÌ1ÜDsotrnlrletn!ÌorÌlÌiccìelel lrrsel' Tììis pi'sdoi{n thc
rr!tr rLln irúlaLloir nrtc rnl 1o tht cxtent ihat torira looüìg e\pcrlrtions fÌal iì
r !tt!trlisher. .ommitfìcnt to a l(Í! intÌrtioiì entiror!ìcnt
:- jr..nd tast ol tlì1: Ìerctjon nrn.tnrÌ is lo lÌovjde guid'nce tìs lo hor' the clntral
:.:foÌic)'jnstÌrrIÌlc.t,tlÌcintercstiatc,nnnrlilbe'djrìnrdÌn(-PoÌìsctr)diiÍcÌerú
ls nÌel ilhile
s so ttiat rtre nLctlium run obicctlte ol \tablc nüliÌLntr
-t 'nininìjTinil
:firt Jluctrìitionr.
in.Í c\lÌnitÌl hor ìhit boacl slructlrÍ( n)r ÚonetiÌr) polic\ ciì' be l'rn1r1i7cd
t!l!.\ NÌt' D\ otÌnÌÌal ÌnorÌctarv Ìrolict NÌe is Ìne'rnr Ìhtt
ü1e
,rt'.u,r
",.",i"tt
.rr,nrccarbcrreLircLlrtthcí)lu1!oÌìtolhtl)IobÌeÌììottlÌcgo\a'rnÌrien('r'rntraL
l.:iÌÌll7ìng Ì\11ìì Ìeip..l t.i the constrrifts it ia'es ir'ni lhc Prilate sc'tor oÍ lhe

enl
;ìre..tr$e oi tht Lìast tìÌo.le.idÊt. 'c'lÌdl benks ln tlÌ!'(rìrcL) econorÌÌies
_r trinsrtiuÌ and d.lclopìng.oLtntrl$ ha!e !Ìrìf1r'i íürrcl i'ílaiion t'ìrgctúrg
:r'!itbisbroatlt}pe oÌ hnle tlo'e \o in{Ìirr'tl\ bl firing tlÌ(iÌ er'hrnil' fute
. .tÌL Í'here t rc cerúriÌlrurrÌi ute\ süch a iraÌneKrrk lJcíÌc
setÌiig o!t the d'(eils
'r irtìo. taÌil.ling Ìegime, i1 ls nec'star\ 1o sh! l'Í\' intÌ'ìtlrnr tiìrgets he\e
'hriI!

wrr.3l!it| lnurtion/
rrL i\
.úlstht id!'el'raG oIiÌrtlnti{!Ì ititrrn) ÌrosiLi\r 'r negalj\el \eSrtile
' rtì1r. jt a sit(tition i.lvhi.h ì1.rege prj'6 air l'ÌÌliJrgilhjs i5linoill ns dtlÌation
. rrr lcrl t(ì asÌ n\ well, ÌLlìiÌl jt $Iong Ì!ith LÌefÌiLi(!ì? \\ie slrall !€c lhaÌ the
:rtrÌst6 r ìe\! i5 that.o\t\ irc mi!Ìimired dìe intÌat Ôn i\ kcÌ)t LlN and s
taÌrle

rtrÌrters ? anil I lhe opelLuon ol monetary poìiì Ì!i! lisco5sed

ÍoÌ ür actitc'
,n ìrrg,t'ng ."nLr^t t,nnt that ases lhe ìÌÍÜe\t te as lLs poÌic) inslÌuÌìxnt aÌìd
suppl'! ln \eclion 2'
rr.sne L_cntial banl tlraL Ji\es the gÍotlth rite 01 the nìoner-
lìiÌnls 1!lLcail-!
'rtxre thc5e í!o teÌrdlgDls n.d irn'c\ti3dlr nlÌ1'rÌodcÌn ccntral

L
r32

lâÌ9.:l th. inÌlâlir)n ratc u\nÌ8 rn irliereÍ irte nìL!'Iathcr th Ì t.Lr!ctirÌH UÌr irrosUÌ !ltlÌi
mo.ct nÌÌt\. Secti.n :l \ets out nì detrìL ih! deriralion !l tlÌe.entral L,!nl s lrÌretu\
folj.vruÌcthatwa!nrtiocLrì.edinCh.pterJ:as1lÌcI/tcuÍ1rint1ìeÌ)hìLLjp\diagranÌ!n.
th c lll qúar io. n1 the :l equ.tiiÌr mo.Lel. Spr.itìciì l_1 , r!! 5Ìra1l src tlÌÉ role !,]l led b! tlÌi
I

ftnl.Í'i.g !l\ kel raÌiablei irÌ.cntÍirl brnkpoli.! maÌlng:

Ill thc.c.t.el br.k's Ìntlation tiìrSrt
ill tÌre centrdl1,.ìnl \ prckn'n.c\
(-ll tlc sloln'o (h. Ir|ilÌÌÁ crr!e
i+l the ilteÌert \erÌsìtilitt oinggÌcgrLrdcma.d(L.r.thenoÌr.ol1hc/J.rrÌr.'
(5) thc cq(LllibÌirm lc\ eÌot ortp!t
i.il thÊ \rrbiÌìzirÌ! jrÌleren rntc.

se.tio. + tr)cu!e\ on lÌol\'nn inÌ.ÌcsL raLL: ruÌc lucìr d5 the hmou\ TafìoÌ Tìtrle can Ì,-
ddjled ft(rn tìre :J e!uatioÌì nroLlcl. Sc.Ljo. 5 st.tr becl lÌom lht mÈcheni.! oI jnteÌr.
Ìarc barcd iÌrÍÌatjoÌr trritetúìit and ifrcsliileLc5 lhe frobltnrs lrjth u5jng str.h Ìulcs ir:
d.âllrg r irh macÌoecorr)rììi. proÌrÌcnú. ln p li.!ÌrÌ. the (Ìa.!.Á toicd b! dc lâll.n d r

bÌ rh. buÌt of the chapt€r,]!c dcscliÌrL nroncÌirt ÌroÌicv nriking rssumlng it i! in tÌr:
hendr oI thÊ ce.Ì!eÌl)ünk Honcrcr,irlsc.lio.aNrlookatlrhvilnrighrmittcÌrrhctÌr.:
môneraN tolicl, .ltci\ions all a.Lui]lll nriìdcbr Lhcgorernnrcnlrnd thcn LnrÌrl.nrc.ti
b| the central bdik or ülÌclhcr lh..cnLral bank ú iÌr.Ìependenl ot lhr g.rernDeÌ::
5e.tn!r 6 ìntroduce\ the idce Lhit lhc g.\.rfmc.t (oÌ ctflreÌbr.kl lÌi.s Lo achirr:
a trrget le\ Él oi oltÌnrt abo!( !qrLillLrrl!'Ìì ffflìât!ft)ÌpoÌLLlülhÌrolilaLrdrcason!
then the re5uÌt Ìlill Lre ilÌ.rt ln .qúiliÌrri!m Lh. lnlletjon râlc ls hlghcr Lhan lhc lerg!
ìrte Thì\ ì\ caÌled tlÌe irÌflition b iìs W( lhc. slì.ir hoN inllalio. bl.s i5 l.la{.d lo 1Ì .
trnteD ol centÌrl lúnl crcdibllitl and thr tlm( !..ofsis1rf.! ol polic\,. l o do this r:
ìreed nr nrtrochì(e l!r$nrd looki.g inlition crpcclrtio.r. hr d!.lcgir{ion oi nÌülctil
toÌìct t{) an iÌúepenlent .cnlrâl hn.k i5 s.rnctiÌì.s tÌotoscd;ìs iì .ìrtlìod oi Í.du.l: :
o. e]nÌÌìÌürjrÌS the ìlÍ1.ìtion blâs. nLlìlssrclio..Í..cxpÌri.LhalLh(d(b.tc.bour'ru1:
\ernìs discretjorÌ'in tlÌr. tlmc-i..ofs 5l(..J liLcÌetrrrc urcs r nì(r.h nirroÌlrr drfinitioÌl
'NLrs'uran the one rdopt.d in our arìilrsls ol Ìro..rrÌr poll.r. Lhis.ao be.ì s!ür|..
conirúi(!Ì |Ì li\cu$nÌS ho( .c.l.al biìüks bchalc
hr tlÌis (hrpteÌ. Ìr€.onsld!Ì o.l!i.los!.d cro.onrl. hc rcÌa(i,ÌìslÌip LJetÌ\een:l
eÌ(hanseirte.e!irneardnìorìcla^poli.ÌintlÌcopc.c.ofonniserp]ijrÌednr(]hrjrtÉ:
rnd Ì!re\ter uÌe rxrlrsis ol nìonrtin poli.! nrts to thc opcn c.onoDÌ\ nr ChrÌrteÌ

1 lnflation, disinflation, and deflation

hÌ (lhafter.ì, $e \et olÌt the,r.\ lic ìI-R model Niih ihe ìolLdLilg larrÌ.r:
.lnnxaliumÌunr(ÌuilibÌìrü!,irúìatio.jseLìuxltotÌre.c.trrlbn.k'5lrÌllillôntirgi
rh. (,ntrilbenk !c.ks to ltabìlire unenÌìo) mc.r
rrÌnr.Ì rhc I /it,. lr th.l5.I.\l \ rr\
 1tt

: ÌÈgrorÌ|oiiÌr. !Ìe!lirìnÌ r!n rqfi bri!.ì,Íìllilio.ire!ÌudÌtotlìeg(r\t1ìrilcoith.

::ÌÌo!LeL. iÌr the
h, nli i nr.neÌarr :Ì {fflt \ei L,t the tntr.rl Lrink.
: !: I Lr\di.rg..Ì. arrl . :-: rcofdthr\jfÌr'lLcrÌìdrl3r\ettjnts.núÌrtionjsp!:Ìsirt,'.1,ÍbL.hmcalr\dÌdi
: ì,,1c Ìrl.ìr.d L)r (ht i ftlrtio. rifecl! rrLrÌc.t irllrtit!Ì drÌ!ltlìere nill bc. (.iÌdc oI hctitcen inllìti(rì
::rìÌnot mÉnt Ìn th. nr(Ìt ruÌ. l lÌe flÌillil\ curr5 iÌ tu' Lh.,.IoÌt i.dt\ed bl Ìagged
ìj r=- ìrndnrllt\hrÌre\er; (hdÌ:rs:

.r r(! Rul. .ir h.
i,ì ÌÌr.s (Ì ]]ìrcl!\r
. 'r: \u(h Nlrs ir
. !: L,r (leJìârnr.,rrr
. .lrr Ì1! jl i\ jf rc
- : !nrttrr ri ÌreLlìrÌ
'rr r'tlrrncntc(ì
. ]! !o\ ir.nìtt1
rr È\ ÌÒ a.tìie\ I
::,rlrii rer!rnJ
. .1r tÌr. (.rg!.r
. i relite.ì lo tÌr.
l,) d(ì LÌri\ irr
- ir o rÌ.Ìletar\
:: lL) rcdu(ì.!
'Ì1r.ìÌr!L!L ,rr[:s
: r (ì.1ìÌlL 1fr.,
.- LrÉ i !)r(c oi
.: L,b.t\..n rÌrc
'lif:.(r^(:!l1Ììlslorm,thrimpli.ati.nirtlÌ!tdl5ffnLl.nit.!!tlt:uneDfÌ()\
-. L I -; '
. :Ìr lnrear lhiÌl4r (ur\ei tlÌc 5iÌ.'ll.i riiio ii col\trrÌt rnd iiìdr|c.d!'nl .I lhc
. rr.l-\ trileÌence\. \lihlrr!Ìr Llrc L ir. teth ot urÌeuiÌl!\LììrrL i: ii..lcd br
,r.r Ì)etr\*ìr r Ì)oLic\ ir rilìft dls rliìLion Lí) crlÌtd rold 1uÍk!'!'l i.L1 i nr.rc
j.t t.lic) . tÌre !umuÌ:tir ( rÌÌÌ!ru.l .l rLn!'nìflL)r nrerÌt rtquilci Lo irhl ,' r gjl cn
: Ì: iÌÌ iÌÌiÌltitlr !ì()ri Ìht l.Lrr.d .. 1\rd.SÌee.tiÌúÌ.ìti.Ìr.\.rsiof.l thecen
:.ll1rk\rr,rithÌuÌllnirrlihilllfs.LLr!\.thi\jinolor!..1h..aí',(hen.a!
- rtiri.rÌl\ Ìiltl\, the l)h llip5.(L 1c!h....rc uetttr r\ !n..ìPl.\ nr.n t Ìi\ti, r'(oL!l
ìi)lir\ ot (litnriÌrti(!Ì irÌorLr!al bi r.ì.rcL.tÌatioÌri]\cr:..rnLrrÌbrnÌ.tntaiL\r
\ìLrjiì.c rxtn) thaÌr loer.r 'lrid!ilisL toÌ .1 ia\.!rel b\ i .ss i.flrlio. iNer!e
::iiiÌ!or11lÌrnru!turi o Lhcbârj.rhoÌt u Ìx'(liLLtr Ì!nÌnocltL.\ÊrÒn.rnL it.(1
: ..r rerrLl\ ltisLì1ìriu|ftÌrÌj.ìtetoìÌre\tiaati m.rÌcdeeÌrÌ! tlÌeprlnrÌIlliÒ.lhrl
- .i ')r .r lo1\ \trbl!' lìrìLlo. Ìefu i\ arÌ rtJpr.,pr' nt. o.e n)r l)oLi.) nÌik!',s Lo hô c
rÈrx t. D. ob\ io!: b...jltr .t !:\iÌrts r lÌiq r.r ltr tÌ (ìt ortpr i 1,. rh.\ t tht
:!r:r L!\'L 5.r i\ Lr( i.:tr\e(ÌrÌrolthr l1-\endljclini\.)rÌl l'ì!'r..tr.1o\er
:-,rìfetiUl!'iulljÌrio,nrrtir)n!ürl'ti(LerrirÌill.\dlLitnlÌrtrr.1ì,'.ôsl't(ìtht
:,.,,t11ìrlisiÌr!irìlìall..tlrat\(rÌr1ÉÌArel\5rrhr\tilreiìi\sflrr'llinílali(ü
: ,lÌillÌ LrrirÌlirÌ! il d,rlin i\ Ì ltL) n) be ((trtlt . ÌrilÌl.rÌrril,tub[n]:. scrrhcÌr
: r, i ne!rij\ r. i.r. tr h!'. trjct\ irt t:lljÌrS'
ì sing inflation
..,,.omr Ìn rlrjch ntrirl!!rrps srL.lr is rrnL.nt irld 1...on.nrl. t.rc:, a \it!
ninì!t)n.ut|iìt p.'h.id nlhcc(oÌ!!I\
'l\Ln! j.ÍlatLoÌr Ìetle.t\ìÌÌ..!Ì51\lrfLr
; .ì e rble nì r.lju\t tri(e. iÌnÌÌrld it. 1 i
1r' r i!e\ ha\ ! br!'n 5c1, ÌLsi.g inU:til!Ì
.:rsituxtjori.\ÌrÌ.hülrlers Iiilrrigrrsllfuti(Ì\rres\nrnreLi.alll üu\trated:
ilrrgcLst\ÌrÌLrÌlto.tÌrr15(urri.nrtoJìlh!'Ì1iQÌ\e.lltlÌr'.i,.ligri.ÌrL.tttt
. r..ll a\ Ìn \ rgt \ettj.!, ihÈn thr ir:lilirl o.s oi.tithtr r!rl.fs f lrr lrir\ rrt iirLÌ\
.1 LthcÌr:Ìr\x!ÈÌjt5beiÌ\eeiÌilìrl'-\,rÌìd l\!.uÌYt\l. llÌi\ I.1Ìr.ls.llsLÌ ìì!lÌ.naL
. i dLileÌe.Ì !)!j.ìl gÌo!p\irrS(\r'lt.'j,c.rIloree\:n(l fri.r i!'Llr 5i'Ììfl,)rtÌtì
ìÌìtc.t tÌrcÌÌ iftcr.t5 50.irl 1frl\i1:rLì r Íi âr hLÌ\iÌitioÌ LÌr.!.ts \s rfr drìll
 f
1!4

s...inUatnnìrntÌrjroLì(5(ìitÌìì\Nirdhiletlpl'trLl\bce'toÌlo\tccLb)pìúlLrlÌìeliod\o
r' n)r di\iJrtÌ'ition r' r)' (o(tÌr!' ìf thc scÌric
ol not cnr'ìì1
'"ì]lïfi ,"., "' , ,,"Ìi\er
"

,: l ;

li :: i:ìil: ;:i:lì:""ìïi;iì,Ï:i: "-Ï

rir ï"ïìr
rr,-r .r",llLi-,t Ot ttt't 'ìÌiftar t' ÌÌìre bern
r lììilì:Í: :*ÌÍr:riil=n,
ilì::ìlliii::*;u :i:lllÏl:;::'ri :ïlì,ii:ï-';r::,':li,:?:":'ì".".

1.2 VeÍy high inflation and hypeÍinÍlation

(ìÌ,.. !.rÌnrion nb,\r loi i ì'i "u.1;:ì,,Ì:i'ìli:iìi,:::':l:i"iï:iiì:ilii:liJl
riÌÌ,s Ìi5,
,rlrr.r ÌiÊtlrtc. l'ró0 rnd lrl!6 tÌÍ Ìt Í eÌr'
Ììì

ï :l lï1.::i*ÌilÌlilil:ll,,l :*:1,::ì:iï:li:i:"i:i ;:'::""''ï::i:l''l:

ot ÌrÌi": Ìib'il
boLÌÌ oi rrish i'tÌitlrn r\ r
I
, ,'ïi ii;ì;,,ì:ì;:;,:',:.. "rr j!r ÌÌìt "nsequ'erì"
Ìtlr(rs H\ p'ÌuìnrlL'Ìì h- tÌilrl
ììl;::ì.; :ìl-;;';"g oi uìt tÌaÌÌjiti'iir
u 'aIÌ\ úÌ.ìiioü at(! Ììre abo\'É:(l
";;i ,,;1ì;":i"' i"i!'rrrnE Lo.
;ï:íijììl';:"ì, '5it'|Lr1r1ìn '$rri(rr r\\
rÌri irìaÌì tilrr!
:,ï;:;;,;ìi;,ì'.'"',,,;', (oÌnÌÌo' u trn' Èòt haL oi 'Ìrtittrr 'eJrrrrÌ1

ï,-Ï-:ï*i:rì:;NrxfNp;t1ç,iïïÍïidn:*ïïïìï
t
ilFrroNiJrs ortlìt\ iÌnd lherclÒÌe I
'liì"',",''",*"
'ìlionl b'(,r.ÌÌ r ÈÌi rìr!rÌ iÌìiatlrn iìnd soler'trrrìr:
:ïiil'ï:i:;: -,'"'''"i
ill'#ìi' li'
:lìï:;.ì*Ìffi :rl*llr;:l::';lll :llllì;.'iilii'ïi''ïïl
n\$ciârr':
" ìï;']iÌi';ì,'" ,, Ìrìat {Ìre rltÌcrìorrtrr!Ì LÌÌ 1ì1e
'L'n(rìir 'nriÌoÌìBle't
"' ""
'','
aÍ..id1f .l lrith \ r'\ poor e'(Ìlonìlclì'rnrtrÌ
:,".;iì";;,,.., r.er"',g,r,,,...,g",n,'1"''ïi::l:ìi:lì:1,ìll'llìJ:lìll'i::i;:':::iï::
ïïiìllï:i:,ì::;li::::ïi;Ï::Ìiì :l:;;";ì;;"'"ii, cisalpcrL 'rc':ri'liiLrg'lr'
l\ ÌÌr'rt chrsn c lt i\ i1i:
t'qrriÌed l()I lhi ret(rri tiÌrlige nLc(tcL
.,tdLl)ìlit\ Lhrl ìs iÌ\o
rt)
j'i'ic' t a s'rccc*r"r' r*Lnt'ls' di'úÌ rrljoD i! n't ü iÌÌ {trü'cÚr(tr1.
l;::li'ï;j, ,,'; i;";-,,,
ìi,ìlì,1 r., ìi; .;;.: *: i1ìu:1ïï:l;:i:;:1,ì;1;;,ï.::1.:1ì:::":'ll,li:iill:
.enlitrl hanli'i,ì,
bc pÌrr'ntl(l :"
ftom hnaÌìcmg l
J",,, ÌÌrìr i\ *\icr \iÌid thaÌì donc
::';,,;.'ì,,ì" ',"'Í)e'onoÌni's
I i:lll::,:,.,. ... .,,,i,., !. r i:i,ìiL,,Ì Í< Fì.Ì,(r !i'ìi ,. \.s, ,'íii)l
,.,,,,
 135

,'clatile inflation
'l1jo.itÌÌillÌltalsosrcm\toLJe!ÌÌorc!.lerjÌe\oliìtilcinilúicmi:.ôslÌ\be(!!Í'
i,Ln.ÈÌLìnrt\!nl!nd.mÌnettlÌeinlornrnlLonrl.onlcirtoiPÌi.cs trfc\Frtel
- i,rlnletn!rnnpL\clìingcsi.Ìer1viìriaÌrÌ.si.tlìer.onoD\:ilÌrì.trìrlitegtrrnl
::i ,rl ndexed b\ fr\t j.flrLion !Ììi thcr. is in !rÌ.ìÌrl .llated itÌn| n i.ílrii(Ìr,
-ii r.t]Ììcnsi(Ììr siLldroP. F.qudÌlt, thr rrnl rctruD on 5a!Lngi I iLl ii lbc.rtrse tlìe
.L.r.itÌaleonÌ\ irÌ. o rÌnr Ìrte\ e\pr.t'd nlrtlt!Ì.
..,:,.oml\!itÌrte(hni.alfÌrgrei\.jrxÌo!ilio.trÌ!eiPLn.ctrne\enLti.r.nreLtlrL
:i rrlrh reÌrid |Ìnorrtìon. ÌrÌices $iLÌ b( ÍiÌÌing rcliìl \e nr ouÌ.r s!'.1.r \lherf
:,rrLsnrt)Ìestagnrnt.\'oÌrhÌeüúÌatirtìÌÌalktthelcononricalLlrcl.tentchange:
.tÌi.r!â.dthrÌriorcdLsloÌtsÌe5o!rc!'alÌocati(xl lÌrrh(Ìt,t.ì1.1jÌci.llatìonlÌis
:.-ii nn lhte.onorr\ tlÌnl rrÊìlrl nri\old

:onstant inÍlation-what leve! is optimal?

: ihat conni]nL in lìri(tr i\ nLcdd Lt.'\|ectrr i.f \ iiÌe tÒ b. lltlnÌÌecL. rc 1(trn nl
, ìn ot !t r:lìnt !'tcÌ l hÌ Ìhc nìo{ÌeÌclÉ\ el()L)rd í) iar, tlÌìs qtrenion his ..1 bee!
..i i\ebesìnbInollfgthattlÌc..aÌth\Ìrotheti.il(ir(! 5lrnc*|nderi'lrl.htÌre
_: ::tte oi iÌìÍlil on il.È hislì .r 1.1!ì Ìrüid n.l ÌÌÌattcÍ nrtrlh. ÌÌÌÌngil]c that we
Ìr a \itlrlit!ì nrrhLchUi.csare !itlÌSui:i'rifeÌltirlÒerateol11r'"'Ìu)err
ìÈ rÌlt tlìis.hangc Lt innouf.cLl ueLl iÌÌ iÌdtn.t.rnLl thaÌ tlÌe iii slste!ÌÌ ìs
: i.) LntÌatiln so thil all tÌÌe t.\ thÌeih()llls at Ìditei bt lOn p â lr\: srme is
:,rrrt r ri pcJìsl.n5 drÌd l:)1h.Ì beueht\. lh.cortrrquc.ceoltlÌis.heni{ÉsilL
:lrrger,Ì)en.1ìt5.;Ìndtri.ÉsjtiÌÌnoitri\eill0%p.ìendtheÌìi)rìi'rl i'terr\t
':,rnìiìllt 1lì !.
r. -Lri toirú: lÌillìc,. 1ÌÌ reil nrrg.itr e\ ir the e(orroÌìr ÌeDuilr LLn'hrnse!l'
:-.nìim.\e\iroÌrìi..nnrntiÌrlâtlt)ntquìLilìrltrmÌ\illi=:l%pi toico!rttìnl
: ._.uLÌib.ìLutr rilh : = L0'ri p i The rtll i|1.Ìest riìtc i..ì thi 1.\'rl! 'l (ìrìtpul
: rr nrcnt ÌenÌàiÌì úi.hJÌtetl
:u,ceÌÌ1errnil\sj5,rrrknotrthrtatthene\r.(ÌuiÌjbriÌrm,therealnìonelnìpplt
,iÌ thrn irÌitialÌr \\'h\'l,\i hlgh ìÌìiÌatiln teolLr ltislr n) holi lowcr nrÌrrt
.: rh. Ìri\h íì rcofonrìze on thcir hoÌ.lirÌ{s .i Ìlonct í) n)r e!ullihÌün irl
:r Ì nì.ÌÌiet,tlÌrrÈllnrone $pplltru\tirtL!\trÌ lhdrÌiu llr! LnitirLl.rt nLlatioÌÌ
ì i5 L!!i|.allt
l/j
L 1 ll

::Ìi!nÌ ouÌftrl1tith l(n\ i|lletior, -r , r e 1ìit.:

{.!r'), ,=rrrr .'r I I

.-ÌliliL,rtunìorrLtul(ithhiSlÌ .lalion,nr, .hare:

lrll ì
136

llìis hiShllghtslht iì.| tlÌrl c\cn ilì our siJntlt c\ânÌrh th' driil t[ì in]lìÌì(Ìr
ol
3r'ô to lONi P;.1\ Ìì.1qlitc r\ \l[ighllo faÍ]ns!t\rrnr\rtir:L'AiÌcIlhcnÌo\ck)101]1
rnrÌâtion, niont\ r'igas, trj(es lhe nominal nì'Ìret strÌrPlv ând nomlrlal
ouLlui \!lll
Ìi\. b! l0%.âcÌr rrii llutaithctinre.Irhtshlft.thoch'ì!1f)hedrÌ'dLÌiÌì'Ìral uÌ \iìd
junÌp-in tlÌc fÌj.e Ìclel Ìo br1ÌÌg .ìoÌ!Ìì thc Ìeil nuÌcl \up \' ì/) !ìl to its rrlr Loía'f
cq!il brjuxì L.reÌ1i\l! |,,..l.onriitentrritÌrlhc'lenìindlollotrerreilnr(ÌÌerbaÌanccs
r]Ìen i.tlation i\ lÌl-{her
\\'hnL ue th. reil coni .l tr.ìrle e.onnnizifg (ÌÌ m'rÌe! baÌnIces Ì!herÌ nìflatioÌr
ls

rs lcather'"\ts Lrc'iu\e oi rca!

hL3lÌ? !h$r.orÌ\ c ÍrÌr.lirnr! ÌeierÍL1t{) sÌror LhÉ

rnd trnr atvr.ialecLttith rÌrore ìrcquÈtú trlLrr to thc ÌuìÌ or tlìr nìJ'hine Olheì cosl:
'ith
rt..alÌLalnìerìrt(on5rariscbe(.ìt6eolih'túìeifdeiloÌtìÌrolrcdìtÌ'heni{irÌ{trjcell:t5
\\ie
ileq!rntl\ìÌÌiÌÌrirÌÍliitjorÌnÌ1 entiÌonnÌc'L llÌcsc'onsrreestirìatedtobcquit'Ìos
llhr nÌouÌd
nu* r,,,.j.n t,.ti.ior:lI rìre r,rlr: r)lirÌfernÌì doe\ ÌÌot mrtter nìtrch
g- "r,tt"..,,
i'i.,' lr," .os1\ oi gctting iiflatio' do!" lÍÌn iì bigh nalìl!'lcr el (o I
"",..'tt 'nd
io.r ana star,Lc ode? lìne Lrsfonsc is thri it seenr! elrplricrÌl) lo ht th"ase thal
rntÌat on
ìs morc \1)ÌJtiìc lthfn it i5 hjSlÌc rncLa! iìhor r, t'lrtilc i'tlation bÌings iìdditio'!Ì
'oted policie! ircqttentLt begirÌs not \nìpll
(.ott\. .\nother is üìiL lÌre iJrúi.ì1lnn .t di:iniÌ'ìtl'n
n'ith high Ìr!t llitÌÌ lìlgh.ì..Ì lis ng nú1ilioÌr' r' Ìhi\ sirÌ" !o\ts ItiÌl be i'ctrrrcd i'
c 'i\e
nìcIt1o go nrr i1)\! intÌ'ìtlon at ÌrerÌ
sLahlÌizinq núliÌLiorÌ, iL Ìrut be \r nsLÌrÌe lor lÌre go\
.Ia|a.kegttlrrt\Èllisn)rstablislì itiÍibiìitl' tnÌLd'rel lllxlr
(ìrÌcr Íe reln drÌ sirmÌrtion that indt\rtion t! i'llatiiiì ls ridcslredd in thÈ "'
eÉ
noDìl i.d thaL adiu!tnÌent ír hlgjrer iJìflatiLr' it iÌìsLiÌrt'trÌco6 Ì)e'lúte aLl PirÌies
that
luÌl! i.lr)nn(d aÌìd crn.hdtgc lheir ÌìricÈi â!ì{Ì n'gÚ rt low con' l1 15 clÈir
lhe

coti\olÍ\ìt.hiÌrStoihi8húrÍ1ntl!necononr\nÌcÌilcÌ)n)bÈlnoÌcnìbs1ent1'ìl lhe'on
túNons rerl('tn!Ì in indh id!'l\' Ìi\ irÌg ttan'lnÌdt b' tl\ tetÌ ÌrigÈ rli!sLÌìerús
gn e\ rlse

nr arìrÊt). L)i\triLrrttj(Ìr.l cti..Ls âre rl$ Ìiltl! to Lr"uì:!tÌnntiL4riìt'L1j!r1Ìiìtio' rhilt\

Nerllh fr(ÌÌÌ . Éditor t() dcÌ)toÍ lt ìt .Lír lilrll to Ììrike tlÌe r'ldtÌl\ por)Ìcr \iJì(t tlÌc!
reL] o. nnÌ\ít(tLflnlLerr:dtrn!L.n\iLnd!rr lht int(cst irÌ"nrc tronr sliÌÂ5 Re(og

uìrion ol \u.h (osli i\.o.tinc.t $ith:uÌ\el cliclen'È thri shoÌ\\ tlìc ge!reriìÌ Ìlubli'
ji moÌr dlcÁe t. inUrtiin tlìiÌn \1üL(l be eìfccttd I tht 'osLs rterc 'crÌÌ\ is lo\! ii
th.I seerÌì i. thi .\rnÌp . (ìì luìÌ lIl()rtnili(trì' "nulclc jÌr'Lt{aLlon rnd r'ttJnLrÌreoui
cr tÌì nrgeti\ !'l
ztÍ)
i.rn r eln ltr ìron thls aoal\ \i! Lìrrtthc ofiiÌnnÌ!rte ollniltrticì' is
'r
hÌthjllirÌgxÌ!Ntthei+r1imr1ìnllrtì(Ìrrerc.Ír1cÌedllÌtt'irllLoc'rÌ\ft(IlhcìolLoNnÌ!:
ÌhcrctlÌrÌì;nh!ldliuhifh f!1rcrc!ìLìo'cl 1Ìrot6rnd'oin\ii5z'ÌoÍ)Ì!ì11ìrlrposjti!e
irÌlliÌtn!Ìrnt.:.ther.elÌtÌrLr.trrrf\.eSrtì\! TÌt''cgrti\ c rtâÌretur' ler!ls pcoÌrÌe torrant
rl oÍ e(!nomìring oÌì ilìtir ÌÌl.nÊl !rolilin!\ r5iìt)e Lt'lhcÌ ìSri|ì i'd tlÌjs i\ lneilì'LÊÌìt
gi!or tÌLrl Lt ji tirLurÌll ro!tLr5i LL) trodL(e lÌigiì Ìr(nr!''c(Ì m(trÌcI IireírlloÌ!tlÌclog1(
o rÌri!rlgrtnrerÌithc!Ìrl1hafi!Ltj\eÌfiÌlÌate'ìiiniêr\l nÌth' n'nriÌrLllftcÌe\triÌLcn)
b.7er!.lnlati.!ìlrluLdhra'ÌolÈneliLncli.c frl(t5lilÌÌnS ühi'hìi'àlrddelÌ'lio'l'
!hÌr si5 \ÍiltoLì lìÌiel in 5 \ lclr ol th. .ptirìel rtt€ oi ÌntÌlti!n: lhe r'1r 'l lelleLil)rÌ
slrouLlcqttaÌuÌ!'Ìirlri1.oli|terenli.lLnSth''iÌÌìlfaÌútrr'slrxtÉtqunl n) reÍo'l!
dcÍlrtinÌì nÌrtirnill
 1]1

)eflation
oi dctÌ'úlon oL l'
::'iir..grtrc1.-(I. 2L,ipr'r'oÌ tqrtji rl!''tL) lhcrc i\ â ìr1' rl( no\i hÌ i \ !rl'1 !l
. i. aÌid l r.rÒ \
jll ht 2)i Loner ln ! tcrr'\ ìLnÌr lhr' thrl
nr!'
,,1 .,ì,t,,"t,,,,,.t",""-,,uonÌ\Lìcl)enrntií1)nÌìhiriì;rrharrrÌr'iÌ'ì)n'cn
I n..rlr..',rt".r.,rAtr'c ÌeÌili\ef nrrhuÌg'tiÍo'lrtedlt!tr tech'ic'rÌfrogrer5
. .letrrL! rt\.rltd
l,,t,f t*. tllo mriÌr r{$ìs I h! delrtiLxr i5 Ìì't \ icNed
therc rr!'
"'s,ÌÌì""".
r ilrscLìr! ..ntrilbanÌ. OntÍìdir5nìho1!"'rl'Ììics\oÌÌiiÌr'ìrorNalLìDÉs
. ,,,..ì U."g"*., tht e"!lonr\ ScLtúÌg stü'ìi iÌr a d':rÌrtidr l t 'iu\rd
',,,1" to the illarcÌ]t dirh'rtlt\ i'
: r; ii aglrcSrit rìelrentl Thc hr\l rer\!r' Í'ìrtr5
jit'nÌ to rììo'e' r!!Ac LLìt5 rrrrÌr
,,,;,"i ;ì;s;," r rof'ers !L' Ì.'rni'uÌ'Lrrr r's
r

Lo r'hirr' (lÌnn3': iÌÌ rrlrIliLr

.*.. ot Utn",.,n cÌi.ltl tbe lle\ibLhÌr 'tedrl
.ììn,ri".,; ,1"" u, o "rl 'ü dcnr "ì lor !rì ' Lurd oi ltrLÌouÌ iì rerl nrlr '!t
i\
.!Ìlr(:arlriÈ\edriilìdÌjirlÌ'nionrnlcoirar'l],1ìfr'ni1|lhinronc!siì!el(ll
!c.tr)r Ìrhtrr lh trl Ir!r'c!t 5 trt't!\ar) llri\
rÌ3!Denì rt rclerr'd
-..: n the
,,Ìr':,oLeln oillngthtlLheel:otilìcLLb'Lìr mrrÌief'
to ÌüriÌri'rin d il'le!ìce
. rri r.õon \te.ìs llonr the tlced IoÌ tlìr clntr'l Ìriì'ÌirlgÌegiÌte
::irÌjonlrat \ delÌ.ÌroÌr lÌrp crn cntr3e llheÌì ileiÌ d'nlrnLl Lt'iÌLl\
: I rll üü erenLLrrlll b.'orlc Ìì(g{tit'' L.lÌ thLt
t' Ìútttn tÌ{' tlìintsr erÊ
dr'mLr(l uìtrÌ
Ìrì,'dn.mrti. \tli n:rhili/L'b Ìlìit op'üir t'i boost trEgreilate
Ìììrlr6 trjl lo stoÌ)
, .,,lu,g Ìril t,' op",ar" tulnci'rtl\ rtr!ngÌ\'ernl iiir f!li'\ res!jt úÌ Ljlt
,, .. i,;ì',',,,' ,,' ,,', m'ìctrr! r'lic\ tÒ
\;innì ite the
"oìrnry ì\
, , *tr ,"t.' t.,ttu,S ,\ nomúÌnl úúrÌe\t rrtr !Ìo\e t' 7tÌ' 1r\ los iL gor
'rÌ]
, :lilr delÌiìLiorÌ lÌÌÌ)llc\ n ÌrosilÌr' É41 lnì'rc\i at!' lllis Ìrir bc nr'' hi!h nr

,1.,. u".."u t 'i'11 1!ed 1!iiÌÌ drmLnd Ìlill irrcl dciÌJ1ioDrilÌiÌ'dtri']1r' fuslì
'-:,.,
::e.t rrt,: qr' rrhicÌr ls r'\r'tl\ lbe ÌrrtrÌg loll(! impuÌ\r' This
I
. ..'i t.,tni, tlì' u'li*ft tÌií!lr orÌ tÌrr rÊri i'terclt rirt onr'
'^t"'n
:...f,.,.,,,,..,"".,-tún'll rn(]!rlrltiìpÌ'!es'(ìirisugtrÌlrti'rn it d()'r
""u
' r\ i:i'j\ , ,.. ".,tt" .,,,.''"t.tL"" ')i ìhe "ntlrl brnl ioÌ tlì' |Írcels to 'oìrinur'' lh'
. i' ,.r1.,,o lì, Aüril iir s!''tì'ì' r eÌ11 tht tcentJrrìrÌ'sc trterirnrc
r

'*t*
:r ij iÌrü!secLln ChrÌì1'r It

, - ning uP

rì 1iìl! disrtr\i'n is rÌÌirL c\tihli\lì r r!r ìiÌrel rÌr'hol

toliq nÌiìker\ nìouÌd
LL)
\!lÌt
:r,t lrr:,r l<ep; llation r"1i rÌrd\tabÌÊ:ItÌjsraL5'\'rnsihtrqrenl'n
. crtnmie:rtitlrÌrlgh,LLsinS'ìndtoÌaÌlÌÊnìflatl'nl\\:elrer"lrtadlnnred

:"'t' L" i a(t ÌnìÌt 1 ÌrLrl'Ì Lr' ir Ìn liti'i r ÈtL irL'i Ìiir!Ìl l
' ".,...r,.' _Ún\t'i
_r.,1 t:dr.!i.rI Ìr.Ì ìì\\i:rr!ì iÌì LÌrrlnr!rúr 'trtL1i" rr:Ìl
ìd L 3 r:i' Ì' ìÍl
, . U'""'' r r:: rì Lrt'rL [!!r!ì{.]ifìrllLri
"...,,','ttt'" t:i'ìÉ rnÌÌ(1 ÌÌ(ÌÈ 'rLrtriì)LÌrrlrn 'rlrÌ'r"
...r',,.,,,'."'"t''"r''"l'ì!
 F

138

tlìrt !!\crnnlc.(\ mrr be teÌnpLcd 1. tatc adQÌrlrge ol the iÌroú ruÌ trrde ofl bctitcn
itúLrtiür.ìndu..mtÌo)meÌrt.Sin.crlsingi.nilion.eflectscììitributiimâLc.ìntlicÌlrrLhr
e(ononÌt, onc lnrcÌrÌetrtì.rÌ is LhiL thc tolilifrÌ t)ltenr 1\ n(aPrblÈ ol resohìnil thrÍ
contlicts, irjìl.lr theÌett)re c.!nc lo Ìr. l.flccte.Ì ìn ri\itÌS intÌâtiln.,\ \ari.iion o. LhLs
tlÌenÌÊ is thil Llr c oÌigln (úiitualio.s olhiilh rndl(t risiÌìir iÌúÌ!tlonlies ì!i1lÌ th€ lì Ìr iìn.ifg
olso\rnnÌìc.lst..djng. \ Ìrc:Ìrill5!'c lf thc.elt chrÌ)teÌ r'herÌ se di\.!\s is.alloli.)
there iì.e sitÌr.llons j. rìrnh iìrc LLsuil ÌrclholÌs .f ÌìrÌaucilr: solennnenl 5Ìì.nd n{ 1i.ì
tardtnÌr !r borrorçi.g âÌe Ììrnit!d. Raisillg leì.s na\'Ìre ÌroLjti(dlh !n!!p!l.r and iu.lh.:
b(ÌìoÌlnÌir nÌ.rl bc|Ìrhibitirel!rÌprnsncbc.auseoldreÌe\eLolpubli.debtthiÌL lra\
rÌreadv been bu l1 rLf. I nder nrclÌ .iÍ.unrsla..t!, it the 8or er!!erÌt is iÌÍ.nt orì rlisìn:
it\ ï)erÌ!lúÌg ir1 rcsÌn).re to press!lL lronì foÌlLicall) ilnPoÌtüÌt Sroups irl thc (con.Ììl
itmathdenrir.thoÌdoithenc.cssanÌcÍuÌctsb)iÌ(rea\ìÌrgt1ìenÌ,Ìn.Isufplt,.rht
u\eolnrÌr to rì.ân.c g(n enìrrrn1 :fcndlnc js.alled s€jsnorâ!e. rv.tÌarn f c Lh.\!o]É
n, rnd Lnrìits io s.ignoÌrge iÌÌ thc lìs.al poli.!.hatter. Chrpter íj.
1\'e ÌlishLilhl llrc eÍrìmetr! in thr Í,lc .I lht .eÌrtrrl bdÌl iÌÌ sjiLlìtlons .I high âÌr!.
Ìi5i.g ìrihtion as.oÌìÌìaÌeclsith sltúitÌon5 oldeuation. LÌtlìe ionl(r. thc 4.1n. in\ oh É
nrcnt oi the (enü.1 bifk i\ Ìeq!ir.d to kccp Lhc j.ÍÌatnÌurl pro(ess goirÌgr in lhc laltÊr
d.fl11jo. .aD tre.orììr scll nútiiÌÌirÌs. Il.nr ohscr eÌs lú\ e rrsuea uÌat unlilic i.llalioÌ:
aÌl troblentr. 1rlìich.Ilrn reflect unr.sol\.d !)!irl aD(L PoLjti(iìl .onlli.t i.iÌ ÌlujÌ.
taLntlÌÌ aÌ tlìerrfor. |oÌitì(rllt urìpoprl Ínutionr. deUaticÌÌ..n bc sol\cd ìrl lÌrr
gorenlme t irenrriting (ìerlìnd tlÌIiìrgh ln.:rtr\ed so\tnnÌÌent sp.ndirìg oÌ tix cur
n.dnced Lr\ l]rs'nro.ct .reati,ÌÌ rhi.h i.c totuÌrÌ Ìhis nìirqtns lhit il is hid ÌloÌn'
(rnd Ì)al lLrcNl riìLhrÌ theÌì Ii!litl.aÌlt cxpcLljtnt toÌict tlÌrt lerd\ to drfli1ìo. lrats.

2 Monetary policy paradigms

The fnÌÌxÁe ol tlìis sf.Lion i! to Ì)Ítride.n o\lrlith of lht sìrjít i. monetar\ polìrt
txÌrdjgÌn uÌrt b..n dÌscurel iÌì r pan!il ttat a..Ì fÌom dLfteÌÊ.t teAtecti\ es r'
h.r5
errlier.hrpters.' llollì frrrdis!ú trlie r\.!i\ c. lhc ineÌtiâ jD Lnilxti{)n that pÌo.11ì(es tlll
-lhe íi6l
I'hilÌìÌ)\ (!r es ard b.1h in.o+Ìtr.rtr tlÌe 1-!.uNc. Ìrarx.1LgD.I hlch we nr!Llc.rl
the monet mpplv jnodcÌ.)r lV pâraclitsrÌ. is.hiÍa.lrrl7dh) lhr ntìolLing tÌoPo5ìtiorÌi
(lì theultim.t.dcLrrÌìiÌrxntoìthrpricelclLlafdÌere.Ii.nal(trLsthcnro.erNÌÌ)lÌ
'21 (hri.!lÌumÈÌrÌoinrnclnrrl.licrisllrtmone\ nrPPLI;
(.lr ihe rìÌe.h.ìnisD lh()Lrgh $ hicÌÌ uÌe econonì! idiu!Ls lo x nclt (lrtllibÌiunr ltjlh
ccnr\tìniirialio. lolloÌ!nÌ8l rlrtrl is tlÌ.Li rmhodLcd j. th. /J I rlr Ììodclflu\ the
ineni.L auSnr. n t.d n)r e\pe(tatilrtr r!SrÌÌüìt(L]l lhiÌlifs.rLr.
Lrt us c)iiìm f!. horr xn IS nÌocl is lÌandkd nì ìhis txradigm. \\'.: rssumc lh. cco.oÌn'
tJelrúat.qulliÌrrium.enÌno)ment$ith.onstifli.llaÌLon.qrLaÌLolhrgroiçthrrte1ì:
tlÌe ÌÌr.nrr! \uptìr i:t b\ the ceÌrúrl bdÌl lor a los Ll!r: /J slìo.k, thc inrparl Õi lhe Ìj':
irÌ aggrrgiLc dcÌìrnd or r\ìtÌ)!t irÌ tlÌe slÌort nln l5 damtcn!:d bc.e('sc Lhc rlsc i. jf.!m:

5(:r\r \r !ÌÌ.ìrmÌ,'Ls 2lrlLl

 .:,i :.:,.t::. :...:..: 139

pushcs up thc demand toÌ Ìnoncy. Aspoìtf(tnx areÌebaìanced, the intercst ralc riscs.This
i5 a movement alrrg lhc LM ro thc noÌth ea1t. The change in output and cmploymcnt
iÌìcn leeds rh Ìough to a rise Ìn ìnflalion, which gìven the hxecl mon€}, supply growth rale
Íiggers a leltward shiÍt Ìn thc /.M curle. Thí irduces a flìúher dâmpening of lhc ìnìl ial
jrinìulus. In thìs paÌadìgnr, nroncrary foìì.y is pasrive (i! the foÍÌì oi a Êxcd gror,lh ralc
r:l cI, ,ri thc Ìnoney soppìv) and Lhc cconomv adjlbts t{) the new equilibrium by IolÌoi!'ing a
:a lir 1ìrotracledspiral-rhapedtathaslagsininflationìDteractwithashitÌingtl,lculvc.lhcso-
.alìcd'Keynes eftecl'ìs doìng (hc work ofraìtirg the interest râte: risirÌ8 inflation reìatiÍe
io a lxcd moncy suppìt growlh rcduces reâl money baÌa ces and leads Lo a Porlfolìo
.: \n]8 trdjustmcnlrlilh bondsbcÌ'ìgsold. Êxcess supplvof bondspuslìes bondpri(csdown and
ÌÌì€ intffcsL Étc up. Thchighcl rcal ìnteÌestÌate dampens iÌÌterest scrìsilìte spending.
lhc sccond paÉdlgm, rlhich a'c shall cau the interest rate reaclion functlor or MÃ
Daradigm, is clÌara.tcrÌzcd as lollos,s:

1r the uÌtiÌÌÌatc dclcrrrìiÌÌant olthcprìcelevel and ìnUationis poÌic-ti

lr lh e ì!Ìstrlrment ol poÌicy í the shoft teÍn nominal irìtc r.st Ìate;
lr t1ìe Ìne.hanÌsm through lelÌich rhc ecoì1orÌÌv adjlrltstonewcquiìibÌìLrm wìth
a
.onstant inflation íolìos'ìnga shocl isencapsuÌatecl iÌÌ anìÌìtcrcsl rate ÌLrÌe.
\V.. tâk€ the samc cxarnplc as abovc. ììoÌ a positive 15 shocli, thc ccnlÌal bank responds
ri tÌre ris€ ì1Ì inflal ion duc tolhcincrearein output:a\ a cods€qücnce it raises the iÌÌterest
:aie Output falÌs below thc equiÌìbrium an.l brinS! iníÌation dos'n: the centrtl ba k
rdjun\ t1ì€ iúereÍ iã ie to gu id e thc cco nomv .lown the À,ÍÀ curtc o ach ieve the infÌâtion
I

:a!3et at equilibriuÌrì output.

As lar as nìoÌÌetar_v poÌicy is conccrncd, the plradigrn stÌift ccnLrcs on t!!o isnì.ês: the
:Ìrorce ol mo etar), polÌcy iÌìstrumcnl and ilÌe choice of an actìvc or a Passiv€ Policy.
irom a strbllizatioÌì p€ispeciive, it Í'as clear a long time ago thaL to operate monetart
-ìolÌc) Ìì â pâssiv€ faíÌion be it l!'iLh a nxed Íionev Npplt or a nxecl iÌÌterest .atc
ìas not necessarily optimai. Willlanr IÌÌte prcvicles a clâssic ca ytÌeannent (1970) ol
;: Ìct
:.e i$ue by looking first at how thc Eìaiìle impofta ce of /.Àí veÌsus lJ sÌìocks allccls
:.e opti il choice ol a rnoney sLrppìy leÌsus an inierelt ratc ìnstìument.' By draNing
:Lnrple ls/rnt diagranÌs, it is apparenl that if the econonÌv is .h aracteÌìze.l by LM slÌocks
E- :aÌl
..g. ir the demand for mone_r), a lìxed inteÌen Ìate is betteÍ ÍoÌ output ltàbility t1Ìan a
:r\ed nÌor€y s!ppÌy' the.onveis€ hoìds [.Ì /.! \hocl\. The second contributidÌ ofl]oole\
Ë:ll j .iter is to íìo1Ì that an d.âr€ monelary poÌicy is noÌnÌalÌtr sltpernÌ to a prrr,vc one
:rhen ihe ecor,rmy is cha r.cterized by sh ocks ar.l bv lags iÌÌ â d ius lm cnt. loole \ ânalysis
t coDlìned to tlÌe short run $'ith prÌces nxe.Ì. The tenor of his arguÌnents is eve Ìnoie
t
icrruasl\'e wherÌ rle nÌove to th€ mcdiúm Ìun and aÌÌiN prices to adjust.
FroÌn th€ perspective ol the s€cond paÌa.Ìi8m, it is not sensjblc f.n poÌicv nÌâkers to
.a\e the adjrÍment ÌÌÌ€chanism to iqoÌk aut{)maticaÌly via thc Kcynes effect âi nì th€
i. -r' r\Í paradigm. Í,e havc se€n iÌì !.hapteÌ 3 when leitiÌÌg o!t thc anãlysis uncìer â lìxed
F"l ronetarv gro$th ^s ratc, tÌìe adiuÍnìcnl pâth t() the new equilibrlurÌ ldÌrtÍirg a dilntr
rdn.e to the economy Ìs protractcd and coìnpÌicated t() elpÌaìrÌ. This it because ol the
nteraction between iÌÌflatiorl in€rtia and the portntú a.liuÍrn€nt proccss (the Keynes

t"

I
I l!0 -r'i . '.:'1 :.::, :

etfect) through wlÌich chtnges irì lhe Ìeal orÌc)'supplv affect lhc ìnteÌe\t rate (c''
thilt\ left as Ì'sirg ilúaúnÌrelativc lo a hred nìonqÌ supprygrorllh cutsthe r€al F:
sìpply). ilehave scen, a lufthcr conÌíication aÌises becâuse otlhe nÌpaciol1:Ìr-
iD the ^s
hflatior iate on lhe deÌÌÌand lor NoIÌe-ï (rI'Í shilts right as the demârÌd for E:
faÌls x'ith rislnii iÌìflation).
Thecomplexities olexplaininglhe dvnâmÌcpailÌ otrdjunÌnerl ìs notsimplyapÌ.l
í()r thosc lcachirg macr)economic! oÌ tÌyi gtoìeamabouiitbutâlsoreíÌectsaprII
faciÌÌij policy ìÌ akeis. [he spiraÌ sÌìaped adiu sim eìrt Path couldbcshoú cir.uitcdr-
the lM paradism: having âchìcvcd a íalÌ in injla D to ihe Ìcvcì desìÌecì (equal ::
gr)wth ralc ol the money slppÌy) $itlÌ LuÌeinpìoyme t abovc the ÌlÃU' tÌÌe Ìnor:
authoÌity corrl.Ì iÌÌiect a one oflboost t() the nìoney lupplv to takc lhe ecolÌonÌy sr:
tothene$,cquiìibiüÌn.Hos'Iever,lhisisanuncasymi\hrreolapasslvemon€ta11f
a'ith occasionaÌactivism ând could í'ell be ÌnisinteÌpreted bv thc pubÌic as tlÌc ìnc r_

lcnt iÌÌÌplemc ntation o í polict .

By contran, in the sccon(l pâradignr in üÌe IS-PC MÀ model,lhc monetâry poli'\
'
tÌon tunction ba\e.l on the use oI lhe itÌtereí rate as 1ÌìÍrurncnt is t activist r'
ftanrework tÌrat is consiÍent s'ith slceúng tlì€ ccoìnÌny tohrard cquilìbrium uner:
rncnt ancl provi.Ììng â nomiÌìal .ÌìchoÌ lieqücnt a.Lju\tnÌents have io be made :
ìireÌertrate i. or.ieÌ to achieve theccntÌaÌbaÌìk\ obìectlve lhÌshighlightsthcfai-
it Ìs qlìite consittent to thirìli ol thc centrâi bank as fdÌo*'ing a 'rule bas€d' alfl
to Ììonetâry pohcy, yel havlÌÌil tu bc veÌ) dctivc li8 1 7 1 1 in ChaPter 17 iliuslrai-'
írc.Ìuent inlcrestÌate adjlìstÌnents made br.eI]Úal banks nì thc tlSA' the eurozon!

It cN.ial k) Jee that ìt is the implenrentation of the policv rulc ìKeìlthât eslah '
1s

rhe nominnÌ anchor and thu\ ültimatelv cìetenìiDes the piice lcvcl oÌ the ratc oi:::
tion irÌ this paÌa.ligm (depending on irhetlÌer tlìe taÌiaer is the prjcc Ìelel oÌ thc Ì::i
intlatioÌÌ). lhe adtusimcnt path is casy to eÌplain and stÌaithtfor('ad as Ìre ha\ ' i
ìn Chapter 3, sürce thc central b.nk rcsF)nds dircctì-v to n cks blr changing th. r::
rst rate. Ìhc question of ho1! to bring about tlÌc ÌequìÌe.l change in lhe inteien i::r
ihen :ì te.hnical pioblcm toi ihe ccnlral banki wheteas in the frrst paradigm' ageÌr::
facecìwith an eco omì.trcblelnoflryingtoÈgurcouttheitnpactofchangetiÌÌiÌìi:
on portlolìo choices and hence orÌ (he irtereÍ rate. These àrguÌncnls IoÌm the ..'
case for uslng the s€con.l paradigÌÌ l! is a better descrìption ofhor! monetarl Poì -
conductcd and it comcs closer to how 1t drouÌd bc con.Lucted, givcn Lhe obiectì::
thecentraìbank.Milio. IriedrÌìan, thc mostlaÌÌro!$Pn)ponetÌtoltheuscof then: :i
nìfp1y.s policy target b-v'' the centraì bank, has .on.cdcd that'The use ol Lhe qü:.::
of moÌì€y as a target has ìnÍ been a success 'Ile addcd: 'Ì'm not suÌe I woüld at ol::
pusÌìitashaÌd as l oÌÌ.c dìd'(Fird,1.i,Ì/ n,ra, TJunc 2003)

3 The monetary policy rule in the 3-equation model

ln Chapler 3, we devcloped a graphìcal nrethod to Prcdict how an 1ÌìÍlntion tar:.-
central bank tìrat iims to üÌ1ÌÌiÌÌìizc lhe íìuchratìons oÍ output and nìflatlon fÌo.
trrgets rlo uld Ìesplrnd kr a vâriety of shocks ln this scclÌon, we piÌÌ doilrthc role pÌ:
 '141

!r lhr h)llol!ìnS \ìÌ kc\'l ari!trlcs ìÌr.L ntral bank poLic-t mìkingl

llthe.rnlraÌ banN\ jnlhtiorì target ir

2) tlìr.entr.l Lrank s prcIcrcIc.s, J
ji the slopc ottlÌe l']hilliÌn cüne, o
Ìr tÌìr interen scnsiti\it-ï oI{Sgrcgate dcmand (i.c the slote ol the A cLNel rr

ìr the eqúìlibrnrnì ÌÕ,el ot oultut, r,

. thc stabilizil]S ìDtercsL rate,,'.i

lÌìoÌ.]ertunìiketlÌcdlscu$i.inolÌÌronetar)lrolic\r(le5(on'rete(a:5h'ìllL6esfrcinc
l.t .\!rÌrpìtsolllccentrrLbenÌi5uLilit) lLLn.tnnÌ folr$ insÌ'unìtnt nndconslraLnts HorÌ
ir diiícrtnt
:r er. thc basi. nrÊthod Iot .lerilltg a nìonet.ìIr foÌ1c\' ruÌe will b€ lhe raIÌ]c
.ìÌitì.ls are clìoÍìr. lt in!(n\ es thc iolkÍlin8 nL Ps:

Dtli.e iiÌe..r.hd1bn.k s rrtiÌitv ìun.:ln!Ì ìf lrrns ol both outpLrL rnd irflation lhis
lict pÍduces tlÌc folic] nr iker's n.lilir rc nce cur!'s iÌì o utPU L in IÌi lon \pi''c
I t

'lol
I Dehn.lhe corÌnrajDÌi li.L:.1b) lht tolicrnakÜr thesc are ilìclÌÌillitt(unlrs' Ìlhjcb
rÌe also sÌror1l i. outP!t-rÌrÍÌation tlìac''
tÚk'
ì L)crneuÌeottinnrlnronerrryNLr n outlruL inI].r1](D spa'er Ìtì i! Ì\ thc Dotttdt)'
ìJr line. f.r: gj\ erÌ I'hiÌliÌìs rt\ e Lhrt ìt in'È\, this \Ì]Cnç\ tlÌe 'cntr'ìl banl'\ rhosef
!ürìbjlrltion ot o!tpül dÌd ind!tion. Ro!ghì\ ' t1Ìc highcr is innation as detÜmiÌrrd
ìr!thcI'hiLlipscuNcrheecononr\ìsont|cl(ÁerirìlLlhccerlraÌlrnlrkset''sgÌeilatc
ÌeÌatÌonship is
.lÈman.l andhÊn(e oüqÌìt iÌr oLl.r Lo ledLlct lnflatioÌÌ Hnìderì iÌì thjs
thepoljc\ilrsLÌuÌÌenl,;th.LlìreccntÌalba'k1!illtr\enrrec!rctÌreiptìoprlateLelcl
.l rggregatr rtcmruLl anctlÌcncc cÌLLirut \!craÌ!lhirSrithì'iÌlhirÌChapter3rtÌÌe
..,rìr"l r,auf cr,,.,s,:s Ll LcsL toifl eÌrlu Lhe lhilliÌ)s (.trr\ e that it íi'es rrd in odcr
"
t! dcÌiver tlìc tjSlìt lelcl ol aggregilc denìiÌn'1, it nìoÍ s'Ì th' i'terr5l ÌrÌe nt lhe lcleÌ
.ÌÌoi'n b) th.It c!i\ c
tìdl(tsÌ dì'
! - \\:c (drÌ nÌí) cleri!c the i,rr./.!lrurr rrie, r\ hi'lÌ lclls ihe lentral binl lÌorl'Lo
! inteÌest Íalt ìrÌ r!\f.n\e 1. frìÍci1t e.ononri"on'lì1ioÌrs'

Ìnv is
h
, The central bank's utility Íunction
lìJplel3,1!cnÌ1ioduceC1iiaunrnJInr.rliÌa\thcceÌ]LlalL]n.k.\iÌr.1ltie
. ir5i;tiÌìS tht: tr!de oll in j(s tref.rcnces bch\ecn úÌÍlation and uÌìcnÌrLotnìent \Ve
. crpraiìr bo{ tlresi'crn b. (leri\'!a] nÌolc l(ÌnÌ'ìlll \\'c atnuìt th't rhe ctntÌal banl
. Ìro con.rrn\: tlÌc Ìate .il iniÌntl.n. ;. ircÌ thc ler'l ot cÌttLrut Ì' I ooNlng Iìr5( 'Ìt
.rtion and loÌlornlg lhe !llscu5sion ìÌÌ (rLLon l,lLe a5rnnÌr that it
hrs r 1ârget riÌre
Ir: :]l]ilion .r r.d tlìaL it lrnnLr io miúrn 7c ílu(tLLations rrou'd ;r ' A snnplc wr! ol
r :!ì! thì! i\ lÒ a$um!' that it llants to nÌìnj'ìi7e ihc Ìols lunclion:
fg.Lirlg

t
142 ::::: ir:i::1!r:ii::r,::,1;:r.'ri,'!i:1:ì
wc have jt minjmlz'
Rathcr than hâvjng thc cen!ìaÌ bank naximjTe a utility fuÌÌclion'
a toss tunrlkÌì. A ;ss function is jiìsi ìike a utiÌity
fun'rÌon cxcept that tlÌc higheÌ th:
use ii rather tharì r utilily tunl:t()n ptrreh
,,^r, ,n" *..* n O f.t ,ne central bank (!ve
expression above' the ccntra
trx conveniencc-try puttiÌìg a Ìn inus siiaÌì in fÌon! of t1ìe
r'ttl --*,o.*.,-ize Ìt) lhis particuÌaÌ loss lltÌctn)n hastwo implications
liÚl
*t
tl.ecc^trafrrrntis^sco"ceriecltoavoi'linllationbelowitstargetâsilisinflatjonaboç:
ír. Ìf ÍÌ : 2Eo rhe loss from r 4olo is the same as the Ìoss from Í - oEo ln both casis
-
nrflation back io i:
i- "tlt + s".,,"a, , âtlaches ircrcased inrpoÌtance !o bringiniliurnn r'dr' h''ô r
LaL€t.1. ..le.rr \dh"1 r.m-' h" u\"r'rtì- oh'|r'lu
. " *". t",c"' t "'," \ mcròrn dr''r''lr'\ i' r r' r"r'rnç J\' rPtdr L'e *^'
"ì.,
ìnliation and ihe larget grows.
__
"
and cmploym€'l
W" *In ..* - ,rt" ." tral bank\ second conccÌn aboür outPu!
ìs thc ecÌüiÌÌbÌiunÌlevel/r arÌd iL seil:
We âssuÌÌe lhe ccntrâ1bank\ târget level ofolrtput
it is Lrlefuìto dras aticntion to i':
to miÌrìmizc th€ gaP bctween f an'Ì/. At thjs point
lact that we have arsumecl that the equiìibium
ouiplìtleve1/' is knotln' that the cúì:r
taÍget w€ shalÌ
lu"i, t-g", -npu, r"""1 is )'", an'l that it is abÌe to stick to lhis higher ^s of outlj_
levcl
=
may largel a
uì ,".,a.u, *"" Ìf y" u kno n' the 'entral bank
1e irìteÌPlay of iúeÌest gÌo!'-!
Outprú Or emPloymenl) targets are likcly to arise Í()Íì
and central banks mav be unablÊ -
tË"
".,-ol"y -"uo"u bv tolllcal ìnstituiì{Ììs' g juí be fore an eÌecijon
rr nwitti ng to go against l lese PÌessures
at paÍ iolar Llmes (e

rrre centrailant's tos as a resült ol o utput beiÌìg dilfe Ìeri from its target of i," ìs

lr v")'

Note lhatthis Ìoss fun.ln)nagain suggcsts svnÌmeúicalattitnde tu positive and nqa:

a
:
;viatìdÌs-in thÁ case, ftom thc eqüÌlibÌium leveì ()l output The most ÍraightfoF rcaij
m(xlel
way ot tninting arnut trris ìs tlÌat thc central banN uÌdcìnânds
t1Ìe ancl
< thcn this unrecesi-
rÌr;t ÌÌÌflâtÌon is onlv coÌìstant at I = )'" |
Ìf f" ÍePresents

.,n"-ploy-"n, tr.* rf,."1d be eÌjminaie'l lf)' ' /'' thÌs s uÌÌsustainable tü1]ll::. l
ãilIr-**',.*".Uovmenrtobrjnsthc!\\Ô'Ìat€dintlationbâck'Ìo!vn wher'-- ba'i
the;ononrv is dishrrbe(l, the ceniralbank sces its Lask as íeeringthc economy
this conÍant ìnnation outputlevel
iitr." t'uu rur, r,'t.tiu"t iÌe addeci together' w€ have the cenlÌaìbânk's obiccrn'e
i

r:lr r-l-+ rlr r I. (central bank ìoss func:

jnÍìâtion- This h a crilìcâl F
r{here il ìs the relativc weight âtLachcd to thc l(xs Ircnì
less seight on devÌatio=
mcter: a i:l > I wiÌ1 characlerize a centÌal bank tha! places
vcÌsa An iúÌar
;;ìpÌoyment from its target thân on de\dations nì inflátion- ândvice
o""Lr" ."",.ur n^"t .naracterized bv a hi8her if the central bânk cares onl) al
'' 'i
inflation deviatidÌs and not at all about oütput d evirtions' ll = -
Ì-etus nÌst lookat thegeometryolthe Ìo!slunction iÌÌthethiÌljpscurvedúgram'o:
a$uÌÌÌplion tÌrat iJ - I With , : 1' lhe weights on output ând
ìntÌation deviatlo's
aln)ut ÌntÌâtìon and outFrt dcvia:l
rhe sanÌc. i.€. the c€ntÌaÌ banliis eqrìaÌì,vconccmed
 143

,1,
Ì
r. I l. ' l. l
llrllrr..ri: rl=l lÌìllihrÌÌ r'Êrr: Íi: Ì UÌicnln(ìt!rertìrÊ \È: iri i

Fiqure 5,1 af.1Íà .iii.x:iJ'Í.ì! Ú rrd.. rsjirr i:ar.Êtr.-: È br i:/Ê

IhÊÌoni{r.ctioÌrLs\inÌp.nìd r:Ì!l1h i Ì ea(hindjl crtn'c'urtcl\r'úclcüì1h

: :rì at ts cerÌin'1lee Ìiii. a 1(.ìil Ìhc ll)\r dcdnÌcs rt tht cir'Ìc gets smalLcr' \riÌrn
:r iìÌld I - ),. the cir.le \lÌÌlnÌ(\ to x tirÌglc foiÌrl l('lÌ'd thr' bÌis\ lolÌt'ì iÌrd thc
rrsisetiìmL.iÌÌÌuÌìi!lÌiclìi\rercÌh({ÌieilrlJÌLser5)torrmenÌberilJÔtrthinkoiitis
jth tÌrr .cntrll barÌl 5 lbjt'l^ e to get 'r5 clotc Lo tlÌe buÌÌ s cÌ c
-rget 1i5 n)Ì aÌ.1ìcrl I I
! . |.$itrj..l\iith I = f. iÌì. ceflÌxÌ b..Ì i\ ifiiiiêÌ'nr )'tllten lnilrtì'n 1'! iìb(trr lr)l
I .irrr)r'in(].ulLrìrtIli,b.lor!l. aboloIr' Iht\ ârc 'ÌÌ thc riìmc Lo\s cir'le'
L)nhuhrfi=i.{Ì,iÌ!ehiÌle!Ìdifterc..e(i(/'s'lt1;Ì1|ecrntÌalbn'ÌiisiJrdìilercnt
.t,Í':Iis.!lrÌúÌâtl.n1%nhor.roÌb.Lorl-riìdd!trlÌrú2'ri'aboae(orÌreÌ'Nl) Ìhtl
,. Lrr","-" L"tt-".". hì!nrrÌtsthtìÌrdiilcÌen'cclne\elÌlf5ojile5iÌÌLig 5l(lÌì
.r.tÌaì ba.kritlì jc$.\.Ìsiorìlohlrtiorìlj - ll üìlÌ hrrc eÌlipí)icì iÌrditier(n'e
""
:!' $ 1ritlÌ iÌ reúi.nì !etÌÌcr tìrrr r hLÍi7'rÌtàl oÌÌtnretì'xì lhs 5 ll' )'
JÌr tllaL üe
'asl'ott I
tradr
:.li;ft:rerÌcc.trr r: erú ne.f Ìei1c.túÌ! lhrt th"cntral li'r'k 1\ !nlv Ì\illints 1o

:..14Ìi1ÌÌin1ÌaÌio.ft)rJsnrrÌlLriaLÌiioutNllbdÌlintlìcoth$lÌ!o'âre\llthttt'tÌai
''k.r,e\.nl\abirújiúìilioÌrtlìcÌri-rlrìdlheÌo$ellitteslìolnrc'rÌtdiÌneÌìsional
rus lhe liJrc et r i1 '

, I The Phillips curve constraint

r: r'l 5haLL tlrartlÌc Lerúrnìbank
asstrnre the l(!cÌoi outpul \'ia iis xÌrilitl
'an "introl af'l lr)
-.ir nronetirl ÌloLic! b-\ ÍltúÌg lhe iÌÌtcÌett ralcl to coÌìtd
rggrÊ3iìi(
(ilre'tll rì'r üc
'le
hrt' alÌeadl
.."r, n..,inu,.ott"utirÌlxtìon onll nnlirÈctl! 1' A\
.--Ì5:cd, .utprú rtle.t5 jníÌalion ria the Ì'hiÌliti
'LLive:

i:r, i, ir r.

:l!.ÌÌÌaÌlri.[')1rlÈl.r.|!rl!ij]:l)eplÍnt?dirrtlr,!!Ìr],rel
, Ì.úrtrlfìfrt:.Ììi\rÈiirr útri'rLÌrì!irLÚt'r'|?LqlaiiiiÌrtNh(ÌrÌúlftitnni\rú:n
rrhtrr rr!
i .Ì i Nia ÍLs.i | .rrÌlÌ1 i.< rlr Ì: tn. rrÌúúÌ tìrÌL!'it'rrÌ rrtP 'n tLìr "rtËL'rl
.{r!rli.Ìri,j, .rÌr.ì tjri.uì..r
Íigurê 5 2 LoçcÍder rn'lPhll p5
'!toet

r : ,,. ..nrr,.
',r^r2 ,'? ''! r1"'ì'1,,,; ." :,;ïr' l;;." -
. ,. r, Ì -J rh ,,. ..
n,,..",.
r . ;,",,,._ ,.,",.
.f:rs". ìiach lhillips.un'e is labelled by laggen ri r''''-
.,;,, ,ü,e. rr- usr'r^''8 'o' ' 8o'
í ' -
"1.:,.." r-,1;;,., ri. "o, n- s r" 'ô''''r'FL'ur "\
,,.,.:;.,,,
"i;1,"""ì:ì.'' '|'L"nor . " n"
:J, ;,",,, ,",," .,. :tr ,;:ì;ll;j.:-,; "::
:

.ì,,,,,, '' 'J.d

",'"1
Ì,'i;;l;
1 tl."
"'' "
LILÀ i. D't\!een P irìl\ rlLdìii
,ntl Lrn ',nl\
rl ..,,,,,,,Ë,,,,,,.,.
\o"' -"ov"r'r rr
;.J., ur"r"1 "r' 'horr
';'ï;': ' " ','' rlr^r r\ iËr c
' "'nr"'r"
'l :ll"l ;,';: '.,''';":,, " ;"". -"," '
l';:i#";.;ji.;,";;;".t.ona'iril*ist'estonttt':l::i'ïl:::'ï:ïïi,'Jli;'::,;
'' \"r-''-'ìd
": '''";'.''''
r
'i'
.." "::",,1s ".-, ,,',, '"r.'
l.::ïïÏ:ï:ïi:l:ï.,ïii"ì',.,
ill" - PoÌicv'
L*"*"'"""n acconÌmodatins l^:^ïin \i'" 1
tìÌe inflation tarsctlJ:
p.*,y,.
ìi*.
"oi".,n "o
nÌt
iflhecr ì]"r * r"."a r,y ", : +, ,r,"" s
Ìn lrct. nswillbecvldenl lrorÌìlig
5 2'

,J."*;;:,'"ì. ;ì;;"ir", 1"i i"* r's o"rc.::::l ::,:l ili: ;iïi :ïïi,-
a

;:iii ï'.,''''ì'*"o"n.'"""':,::ï.?l:i;ï :ii:

" "":':Ï;i
'1":"ll*:;:il,1;"':ï::iijl*-iil'li,.,l;;;;iurnirnp,vrninna'lionra'leor: ".,Í "J'ï:
MR
3.3 DeÍiving the monetary rule'
ol Ìe lo\s tunctior in whìch - l so tlÌat r'e haii :
FoÌ simpli(ily, se use the fonÌÌ
'J

circLcs às inIi3.5.2 abovc

Ìhis üÌìPÌies:

L: tl l")t + (n "-t ))
 igure 5,3 Der! ng ihe I'm lne

$'hich - so lhat cach l''- has a

.J LrllÌìg lhe silìpÌeí version oflhe !hiÌÌ4rs curle 1Ìì
'r
1

-:'ilop€nsüÌtig.5l:
- 2't1t
r-r rtf h.

- n-"1.d|i\''r ul'{\"rr Ir'':rr'êp'r r\^ rdc' \L' r$ê r''u. i\P

| . '."."'; t.'^. - '""' ' rr'\'J iJl'rrlnr' r-' ' rr'd'lt Il I 'd
r=3'itsloss
,,.f.,',or"*ro,,"n,"n",7eitslossatanÍgivcnlevcÌofí r''lhussÌìenr
'J rr I'Ir|rlr ' urrl\ ' IoJ 'F l-r'14
r' tr L
',."-L,rInP
{\\ '{ 1"'r"ìlrr'-i' Pri
from'l%to 4% nnpììesa taì1in/ from
.-ir",t,,ulÌ,'1,r.,"t"nÌtcaniÌ]creaseinn Ì

.iÉ C.n.ieri\É tlÌc monctary rule cxplicitly as lolìows B)'choosing/tonrinimìzeltle

,.,, a*t.j",tt" .p,^" *lue oI )' lor each vaìue ot Í r' substitutiÌÌg
the Phillìps
'üNe
.: r I ând nÌinnÌizing *'jlh respect lo l' we hale:

'!i)1,=21y y,)+z1r - (r /") "') = o

' '
:0' vJ+(" r+lY r") nr)-o
i-!': ÍÌF.r lr,
::rr j,l+1. ì:rr
'- \t lt)- \"- Í )

lhe ccntral baiÌt: it

.- nronetaty nrìc 1Ìì the lhiììÌrs diagram shoils lhe equìlibÌiul]Ì for lhe
-l *,"tionthip between the innation rale chosen indÌectly and
', ,'." l f'"utntn""
..t"i.tç'.,.f-*"U'.ectìybylhe'cntralbanktonìarimizeitsüìilìt)'(mnÌjmiz€iK
,or,ê 'rr'r I r'íi
 v

lll:""'.",'
liïtli.i"l., iÏlij.lliiÏ"'ï:::Ïi:'1:l :Yjl

*:,'il,:,,i1,; :','-:Ï:li'
i;jt.
:f :,,'",:1i;,, 1',"::",,. :'' .
,, lr:;Ì, 1",:l;':r;:;'
;,;:.':;"";1", iìï ",,ì;, l.:1.
, lì;
:,,11 l;;i: i:

i,;,iiÏ iÌ,rlï'iì,,'l'
1;:,;,ï" r:; i: ;,: I ,;

""1-', ,,n,o'\'i'" I ';' ,;', i.'

11'1,;,;1,t ;,.; '1,ï,"
,.1 ;,,'tf, '=,',,,
:l111;;,; " t:,,,,,," .,r",
,;.","i:i,'''.l'.,i,r ^,

;";;,;"'1',
"':,,,'lr1':l.;i, j,,, i,'
,ìr"
 :.. ....:.i:. :..:. . 147

!"

Fiqure5,5 llqlr reipo.!vefe$oi nÍatorro.Ltpúl ÍàllÍÀ ne

rì É.15" .rheca\einwhichn = l: IrÍlo !s the okl and ÀíÃr dr e n ew monet.ry nrle linc o btained
.:ioúrirgupthe points D, c-, and B.
E\ aÌteÌingthe nopeofthe ?hiìlips cuN e, Ì!e also leam moreâboutihcmonclary nrlc
rdrriÌìg ,.:.etei rhill{Á curves Drake the MR ìine ÍlatÍer: Ìet us now conÌpare the rcsponsc oI a
:..tÌaìbank to a given Ìise in Ìnlarìon ìn the case wheÌe the lhillips.urvcs arc íccpwilh
\!hlch ::. casewheÌe dreyhave a slol)c olone. OuÌirtuition ieìÌs usth.ìtÍe€per PhÌllipscuNcs
llake things easieÌ ftÌ the cenlral bank slnce a eÌaller Ìi\e in unemploytrcnL (Ialì in
::riput) is Ìequn cd t{r achievc afy dcsire.Ì fall ir jnÍlation. Let u\ slÌow lhis in a diagranr.
:: thc ìeft hard panel ot lig. 5.6 sc compaÌe tllo economles, onc wilh flalLcr !hiìljPs
:., cs (drshed) an.ì oìre aith stccper ones. As ive have aÌreâdy sÌÌoM, lhc Mn ììne is
::l!cr f(n the econonry wìth rtccpcr PhilliÌr1 curve!: thÍ i\,Vltr. SupPosc there is a úe ìn
:ìÌlãrjon1neacheconomythalshiftsthelhill4xclÌrlesup:€.chcronom)natpoìntB.
.ì (. can see that a r,rdl1.r cut ìn aggregate demand is optimal in t|c cconomv eith the
i:,.cpcr Phìllips curvet (poirt,D). This ÌeÍle.ts ouÌ lntuitjve argumeÌÌt abovc.e
Ìn lhe rÌght hand pancl, s'c compaÌe t'lo economies with identicaÌ Í1ppl). tidcs but
::ì Ìthjch one has an jnJlation-avcrse centìaÌ bank (the olaÌ íÌaped lndìIlcÌcnce eÌìipte)
rnd sho$ the ceDÚal hank's Ìca.Llon to inllatidr at polnt n. lhe morc llìta(ion-averse
:inÚel bank aìways responds ro Lhir shock bv clìtting aggregat€ demand (and ouQu0
.roÌc (pointD).
drkrlilÌ Having seen the de ofthe dopc ofihe lhiiliÌrs curve and olthe centraÌbafli\ pÌcfcÈ
i.es ln the.liagÌaDrt, Ne noÍ'dcrive the more geneÌaì f(nm ol the .ent ral bant\ mon-
i:lÌl ruie as f(tkNs. lve elso makc explicit the timjng structure in aÌÌ of thc cqualions.
-:1 .h oosúrg th e i nteÌest rate n pffiod zeÌo, the cenh al brn k àilècts outpu t and Ìúlaiion
ì

:ìfeÌnd1.WeasÌnneirjsonìyconcenredsithwhathappensinperiodÌ. lhisÌsthc
::aÍìr that its loJs function ìs dcine.Ì in ternÌs oí ), and Íì. If we let i:, and d taNc anY

,iih,r. l,tlìroüttui.ütiÌrÌt\IÌ)rÍn)rBnênnìIa!ônsÌro.llsalÌ{i!sÌÈÍ
:r:r a : Ì â5.ompare'r Í1üÌ1! = l. rÌ' ir 1 l, rlìe ourprr.rr islês 6Ìors ii  . 11rril
148 .:

,ìììi,,,,,

),, ), f,.f
i. Stccpei |hilÌip5 oües b. Crealerir ition i!€rsio!

Figure5.5 Compr i,j lhe ierpon5e oitrê.eiü. bãnk n lwô.asÈs llèÊpei Ph pr.útuesàndamo.
nírn.n à!.tre rÊflÍâ b:.1

t^, .\J,r \r',. -. lL .r,oo\ lir''r 'r'lF

L = ly ),.)1 + )(i nt)'1 lsl

ÍL : Ío + d{IÌ ,'") (s .l

By subltit!tiÌìg (5.3) ìnro (5.2) and dìfferentiating r{ith r€spect to lÌ (sin.€ this is th:
!ìiab1e t1Ìe.cnúaÌbank can contrt via its choice ofthe iÌìt€r€st rate), we lÌâve:

fr : tr
at.
r.) + "r,r{",r L'(f, rìl "rl - 0 (s ;

5u bstiiÌrting €q uatìo n (5.3) back ìnn) e.Ìuatìon (5..1) itlves:

(r r.) : n,r(Í, Ír ).
NoN it .an bc sccn diÌectly that the laÌger 1s . (i.e. the nxÌe Ìesponslve aÌe wages t
cmploydrcnl) or lhc ìaÌger is al (i.e. the more infÌâtion averse it the centraì bank), th.
natLcra'jÌÌbc thc sìope olthe monetaÌy rule. Ìn the 1ìrst case thìs is becalrse any Ìeducti{).
ìn aggrcgalc demand achieves a biggeÌ cut ir i!flation, i.e. wìrateleÌ its tÌeleÌences, tlr.
cenLÌal bank gels a'bigger bânij (i.e. ÍaìÌ in in|atlon) ld ìts buck (i.e. Iaìl ìn aggregaÌ.
dcnrand)'.ÌnLhcsecondca\e,thíisbecause,Ìvhat€vertheìabournrarkctjttaccs,amo!:
ìnlalion-avcric cenlÌal bank lviÌÌ wìth t{) recìuce inlÌrtìon bv nroÌ. than a lcss'haÍc
 :. :.'.. ......, 149

3.4 Using the IS-PC-MR gÍaphical model

B! nÌakirÌg cxphcit tÌìe detcrmjnantt ol thc sìote ol the rvr line, thc roìe ol €ach ot the
sjx key inpulr k) the eliberalions oftllecentraìh,Ììk is nÔÍ'cltaÌ

1ll irÍÌation targcl, Ír:this nllccts tlÌe posilion ofthe líIì Ì1ne;
rhe ceÌìtral bank's
(2) the ccntÌalbark\ prcÍ€rcnces, ri:r:this deteÌmines thc shape ofthc ìo$ ellipscs and
aftècrs the nopeof lhc Líl ìine;
(3) rhe nope ol lhe lhillips curvc, ôr lhis àÌso atlects the slope oíthe M/ì line;
l+) the interest sensitivili'of aggregate dcman.l, d:this deternìincs ihe sÌope oíthe Ã

(5) theequilibrìum level olorltpul,/,.:thls dclcÌminesthe positidÌ ot lhe vertical

T,hlllips cü.vc and alïects thc position ofthc M,Ìì l1Ìì€;
(ô) tÌìe st abÌhzin3 1Ììteres L rate, /\:the cenlral birnkadiutrsthe inlcreÍ rrtercìatìveto (
í) it mus t alway\ iÌÌallsc whether this hat sÌÌifted, c.g â5 a .es últ of a slÌi ft in the 15 or
due to a.hange in thc cquiììbÌnìnÌ levcì oloutpü(, /.

On the Lìasis ot the moÌe dclaìlcd dì\cussìon providcd in this chaPter, thc Is r(- lvlì
graphical nÌodcl can be used to analvse a !Ìide variety ot problenìs. tD ClÌâplcF 3 and '1,
thc graphical annhis of inflallon nroclis, lcmpoÌâry afd PeÌmancnt aggiegnte 'lern'nd
íÌocks, and $ppÌy si.le \hocks ls p(^' ed. Ìt each casc, therolcofthe slx inprús to
t1ìe ccnlÌal bank's decisi{)n (.!Ì bc analvsed and exPerimcnls underlaken to cvaìuate thc
üÌÌpal:L oíva.iatiofs in thenì.
Wr take one of thosc eÌamp1€s irÌ o deÌ io .Ìa rify in the dlag ranÌ each ìnput to the ceÌÌtraÌ
,.1) bank\ decnnÌì and tohiiahÌlilht thc depl.-vcdbvtlÌe lag in the elfccl ofnÌon'taÌ-vpoli"
on aggÌcgate demaniÌ ancì outpÌrt lhe erample nÌo{'s lhat th€ ccntral bank í e gagcd
in a lorccastÌÌg exeÌcise: it ÌÌÌuÍ iorecast n€xl peüod\ l'hìllips cun e and ncxt period\ iJ
cur!€ We assunÌc !hat the economl sttrts olfrliilÌ oulput at equÌlibrnrm and núatlon
at tlÌc target rate ot 291, a\ \lÌoa'n ìn liil 5.7. ure taNc â Ìlennancnt poslthe ailgrcgale
denìard sÌtuck Írch as inÌproled buo)an.v ol consum$ cxÌrectalntrs: tÌrc 15 rto\'es to
1)
IS'. lhc consequencc of (miput nbove l'. i\ that intlatÌon i{ìÌÌ iisc above target in this
ca se to .191,. This dclì nes next pcÍiod 's lhlllips cuN e (l'ClÍr = rl ) al ong wlÌjch
the cent raì
baÌÌknìustchoost ì1s PÌelere.l poìnl: PoirÌt a- lhe ceÌÌüaÌ bank forccast! tha I lhe IS cur!'c

is A', i.c. ìt juclges thaL tìris is a pcrrnanent slÌo.k aDCi by going lertÌcaUv up to polnt C'l'
ÍÂ) tlÌe lSdirgÌam,it.an worko!ttlìa( lhe aPprop tiate ilÍcrcs I rate to set ls r' lhe thillipt
^s
curvc shift\ downf ilh faÌhì8 inflalion, tÌìe.cniraÌ bink (duces the ìnteren rate and thc
econom-v movesdotln the M,rÌ ììnc Lo poilÍ.2 ând doÌ\'n lhc Ll/ curte to Z'
'1hìs exanÌpÌe highliiihts thc rolc of tlÌe stabllizlÌìg rcaì interesl rate' IolìowiÌÌs tbc
''j:
sÌìilt ìn the1.!cullc, theÌe is a ÌÌc\!sLabiìlzingintereÍ r.tcand' itÌordeÌ tor€ducc lnUâtion,
t1Ìe jnteÌe\t rntc must be râiscd abole the nc r\, i e lo
y' To sunrÌnarizc' Lhe Ìi\e in
oulput builds a rhÊ ir nú'ìtion above targcl into tlÌe c(.ononìl' Bectuse oI inllâtion
inenja, this cân onlybe etnÌÌiütedbvpuslìingoutlÌìt b€lo$'aìr.j luncnÌrlotmc't abov€)
th€ cquihbúrnì. lhc gÌattÌ1caÌ prcscntation cnÌrhasizes tlÌal the ccnrral bank raises the
intcrcst rate in rc!Ìronse to thc aggregat€ dcman.l s1ìocN bccausc ìt can {'ork out thc
150-:::r':li

Figure 5,7 Pêrmafent 15

,,K
sho.l
l.

'r', 'or 'Ir' roqJ-rrr;'l'Ê"'- I 'rJ

"n.,''. rr'r' I d'u, u'
i rp g''Pr'''
iÌìlo acc':-r:
irt".".n"r t.tr i5 r"""ârd looking and take{:l 'âvrìlab1i' inloÌìnation ì e la:-':
ir. , .;..t.o, is li;ited bv the prcsence oí !ntratÌon irìeÌtla
"ì,ìt;i
,"n"ì,,",t,n" "" ".onomv
nnU,U".url'c and by lhe time lag lor a charÌilc in thc ìúcrest
rate tr::'__
hÌ the l't ecluatìon it i\ the intere\i :ra
lii".lt.". ,n" r"gçO on-eÍ tatc nì the 15 ctrrvc' :: j
attjme zcrr thaì allects outpat altiÌnc oncr/Ì Ì" =
d(fo al lhis is because lì
cofsumpl(Ìì ancì irìveir''
iU." t.. nÌa.ç U* tnlcrest ratc tu Íced tÌrÍnigh 1o
u".*-tt. t " it't a.t'" ut lts optiiìaÌ ponú c_ dÌ !ìÌ lhiìÌips orv! ln' = -.
-cler to choose
ÌcrenìratbanktnunsettheinleÌes!rateno$,4r,'AsiscleârlÌornlhediagranì'ü'::'!
U""r tt"U,Utt *nn Ut,t throughout Howc\€r' jl is inl esiÌn8 to see: 'j
"\sunìption

."," ,,, ,l. tn" *t-" *en gocs clircctl!_ ftonÌ I' to Zr in the lS dìagranL
'n
d it rcìna
'
"-"0".'-,, i c;oints'a
ììì ìn"'unt,it' arcl z coincìdc sincethcassrcsatedemandi'
 l5l

, l!llÌ ,r.d Dorcdi,rt.h oïit(t b! Lh( rhâ.gc i. rÌr. i.Leren Ì.te. thrre i\ no (hrn(. íor
ìlnri.nLorls(. lhsundrrlilì(sLhcc,rr.irl nn.oIlâgrandhenceollde.r\tiÌì!tririhc
:.. Lral ÌInk: thr morc tinÌcl! and ac.ural.: aí, iofr{ast5 oi nÌifts ìrr r!!rÊ!ate denÌand
L.d o olhrr kìnd5 ,:,I slìockr, 1lìc g.câ1.Ì is thc .lrn..e that tÌre (erúrrl bdÌl c.rn otÌset
rnr end li.rll Llìr r nìpa|.r.!ì n lâLlon. On..: i.nilion har Ì)een allectelI. ihe pre\encc
. lal io. i.rrLli rìcins llÌ,ìr tbc rcn LrrÌhrfÌ mrL!Ì drani{e tÌÌe inte.eÌ r.Lte.ìnd !!11h,r
Lr.oJnr.ftr:r thc IIÀ liDr in !rd. r 1o st.Ú il becÌ L. thÈ i.Uatil!Ì tarset.
iiddllio.lo]r(\'idinBairnnrcnr.rÌ..er_rst.meLi.rnalrli\olnÌo(l\tuiÌriÌÌ(]i\iduà
:,.nÌnr an(l lìorr i5pr.ts.)f lhc aggÌcgilc d.rÌrnd.ìn.l nrÌ)plt \ìle \tnr.turc\.rilc.l
::tnl banN poli.!. thr l-\ l'l ì//ì g.afhi.rl Drodcl fÌoricle\ r u\elLrl 11.r\ i.ì i .nignl!'

..rncrndrtlc1r..i..rlrìpi(trr.c..nomj61rjürdresl!Ìesulìply!dcli.cL,i..Ì,ì

:rìi irìirrcii icnsìti!it] ol c]ip..(liÌrLrc in j\ {ÌiÍIcÌcnO drÌd rhi.h arf boÌh lflLialh Ln
iib.iLrnÌ sith.onnrnt lÌilili.i. lirilh r = /!1. I1 both eronoir r's in'nrbi(ld l(r
: rtrrìe slÌoil to a!tc!Ì!rnou\ d(mand rlc.i. rnrhle thr.ousrqu(.r(s LLs Ìrg th!
: ÌÌnrl3 eq!.1i.Ìr nÌolÈl lsee liir Ì:.1''il
... iÈ.ond.Ìirn4ìL( rr.!uLd look el Lh. LÌìfli.rLioÌìs lortÍo r.oronìic
: Ì!tlLrtift ileiìti(alirÌrLl resÌrL.ls rì..ft Í.r tÌr. rcstr!tri\ ÈrÌc\snlìflletio. tochange\
: .ie\eloio!ip!t.e.S.oiÌrr.onoÌr!ha\eslccf Ì11(un! andlh{',.Ltr'!lÈetI'hiLÌil^
.\ ,hilh ,,r trhrreas tlìe othc. hr! llat I']hÌllipt.u ts ll i .onrÌìot Lntlrti{lr rho(l
',t
:: rÌrat úlr (uúr!L bdnlthrt:.15 i..mm.n jnloest Ìdte lor blth l..nonrjtt? I\aÌn|Lt\
::r: ln dre dìr(n$ed 1rrrthcl n(hiÌrterll

r A Taylor Rule in the I5-PC-MR model

'rerest rate rules
: ìr.i(trtr \ectidr, re l(Ìrlrd iL hnÍ tht lt !trne is uscd hr lhr.entraÌ tìnl ti)
rt ÍÌrat iÌrterert ratr to \it o... ll lri\ ro!Ìell (trri jt\ .1)tlmrl r)trtfrìt iÌúÌalion
Irii(Ìr jÌr tÌÌr lhilÌìÌ).lir!riür l..of!cLthr\lo..rirdlh(bcsla\x1ldl)ÌelttritiLÌì
. \Il Lnrr 1\'e r!)tr .lrtr\ h.rÌ lo doltr rn i/ìl.r.ii irrr'rr/1. rrhi.h LÌiÌc.tl! trÌ)Ìene5
.Ìrrr iÌr ihe !rtereit rrÈ irÌtrr.ìs.i Lh!.trrtr'.1\tate rilth. l..noÌìi. \te then dÌoÍ
: rilrfu\ n) tlÌr lJ!ÍN\ L.ìtlor RrLlc.
. r'riÌÌr to{rther ihe tlÌreÈ rq uiÌ Lio. !

'I'hillìÌ\ cur rl

1.\lÂ

:!r\erqurti!rÌ\.renaÌlttodc'\.1.mLLIil(ÌtireirÌtlreslrnl..rìlnt!rmsol
:iro ot)sen !tiors ol ìÌúLiio ì ind.úLfrLl . Lhe ecor!r!Ì\.1t ( r sìrr5lLLun' Lr)Ì i

l'
152 : : 'r',
using the ÌrhjìliÌn cürtc iìr tlÌe r!ÍR, we gel

l
ni .tl!r r.) ;l JIJ'L )'".1

(,' r atr) 0'' r,l

an.l ìlÌ!€ now nìÌxtitrúc tor (l'r lrìuslngthell,l\cgetthcÌnteÌestÌaterulcl

ì

,,t,,+ |l
a a:os(", "')

Twothlngsar€ imrn t.liâtel-r apparcn l: Rbt. onÌy Lhe inflathn andnol lhe output i:
nrìon is prcscnt nì thc ruìe and tecond, aìl the parameters oI lhe 3 equation moclelÌr:-:
lo r the cenúaì bark's rcsPoÌÌsc !o i ris€ i n ìnflatiolì. I f each parameter is cq uaì tt) on'
l
.o.fncierÌtontheirlaliondeviationisonehtllÌlìnflatio,ìis191'poiúaboletheta:::
thcn theinlcÌe5tr.tc ruÌesays Lhattiìc rcal irtereí râte ecdstobeO 5 pcrccntag€ p :
hìgheÌ. Sincc úfÌauon is lÌighcÌ Lrt ÌirÌ È)irt, thc Ìromiinl inteÌe\t ratc Ìn$t Lre r:
jecurc a úse in tlÌc lnteres::
b-v 1 + 0 5, i.e. b) Ì 5 pe(eÌìlage poirrLs in {)rd.r lr) 'tdl 1n ea'h ::
oí0.5 p€rcentrSe poìnt5. for a iaivelr deviatntÌ oÍ inÍlatioÌÌ trom tarilet, a'd
conÌparingthe situation Ì!Íh that in wìrich d ^ = l:]- I ecanleetÌì41

. a nìore ln|ation-aveÌse cc n trâ1 ba nk (.1> 1l Ì!'iU rai\e1hc ìnterestralcby morei

. It is 1Ìatt$ (d > 1), the central banli will raìse tlÌe ìntcrcst rate by Ìes5;
rÍhen thc
.ÌÌbcnthePhìlÌips.urveÌssteeper(n_'1),the.cntralba.krtilÌÌaisetlìcintereJt::
b,vless.

l.ct u\ (oÌÌrpire the ht.rest ralc NÌe tlÌât slc have derh ed lronÌ thc l:l_cquation r::
wirh the liÌrous Ta!lor Rule,ro

fr r\ :0 s.iÍo írl o.s.(ro I.)

wheÌe -r is nÌi's inllatioìr tarilet, /r itthe equ il ibrìunÌ Ìevel oI outtut :i:
thc centrâi ba
ìs tìre'stâbìli7ìnij'iÌÌtercst Ìate, i.c. lì1e real iú.rcst rate on Lhe IS curle wÌÌcn outlL:
.!ÌuiÌibrìLrnl. TheTâyloÌ RLrÌe \tales that iloulfut it 11/o ahove equilibrirnì an'l inil:_
it at the targct, the .c.tÌal banL sìniuld rais. lhe üÌtercst Ìate bl O S pcr.cntage '
reÌrt1\r to stabìlizing irteìest rate. As abovc Í'e úrterprct the cìitìerencc bct$een
r.,. rs thc pcÌcent.ìile gap;thi\ is lhe equivalcnl
of delìdingl as the iog ot output. -:
inilàtion is ì7ô poiÌn abole the !arget a doúlputì\tìtcquiljbrium,th€nthcTa\I:
sa)s that thc Ìeal inlücst ìate nccd\ to be r-) 5 lcÌceDtaile fointt hlslÌer.
 r53

4.2 Interest rate ruìes and lags

h.ifLc -l rrLrr(lcdcÍi!rdlroÌì lhc3 cqtrilion modeÌi\iirniÌarto lrllorlnrLe,Ìllìich
Ìr !. (lc\ cÌoÌrcd as i. r1ÌÌpiri.ildcs$itrio.ôlhoir.c.treÌbdnÌ(\ l)eh$ ed. Hoü e!er. it o1Ìl)
tuIúircs 1lìr .c.Ìral banL io (\tond i.tLatl.n. qt nbt rislrt, uÌis seenìs par.ìdoxicil,
1o
r \ rn Lhal thr..(.rril bnn(.n(s eboút bôth n lâtion rl.lorìtÌmt at lerÌìoÌÌnrrted b) iis
l. Í lun.(ioD icquition 5.21.
iì L(] úìs o!t t hal ti) g.t an ifl( rc5( relc ru1. Llìil is ÌLlie the Tr!l(tr nüe in Ì!hi.h both 1|c
llLr(ion ind o!tpul dr\ i.rtiürs n.l Ììrcs.nL. \!c n.(Ì nr mo.litt tlÌe 3 eqrili.!Ì nÌodc to
', n thc lig sLm.l!rr .1.)s.r 1. that .i a ÌceÌ c.on(Ìn) ÌÌr thi\ \r.iiiÌì, rr crp iin ho1!
r 5lj don(. Horrclrr, ior nÌosl purlnrscs. tÌrc anrìr\i\ ol sho(ks ind p.:,Ìi.r (sfo.sct.ân
r. .ondu.t!'d rrit Ì thr sirnpLc. singÌc lag nr.dcl. rÌhì(h 1rÈ kerp is oLrr corc 3 cqúrlion
r i'a- ÌlÁ nÌodrl iÌì tlìe rnr.riÌìd...I Lhc book.
\sb.firc\!cas5u.ìrtìa11h.i,:LsnoobseIaliondÌtiÌÌÌ(hSiorlhcn].ncLirliudroÌ
rii. c.lhl ccntriìÌ b..k cn. sr:t rhe inteÌert rele ai)l as soon i5 iL obs.rtr:s.rtrÌutt.ìxta
(rnd i,i i. W( c.n 1i. uc tÒ iÌssunrc lÌrrtthÉ i.teÌe5t Ìrte onlfhns nn riÍ.cl o. (rúÌrut ne\t
:.'iod,i.c./iriÍ..tsrI.LÌìc,rfrdslr,,plidrabouttiÌÌrlfÂ(heL iskÌLÌned15thdtittalies
: .ir IoÌ oLúfut t(J it c.{ i.nrtio.. i.e the outprú lÈ\ cl l, a lc.ts iDir Ìì r peiix1l.ìter
: Lhl! rìQ.\ that Lt jt,r 0 rnd notl,r uÌat js iÌr tÌie PlÌlllits.tr^,e tr)r -,.Lr Ìhe Uo!bk l.ì!'
riLn! rs5lunÌrti(ìr! mar.h the vier olthe Lì.nl oi I .gìrn.l (Ì9991:

iIrt (!i i! !ri8. it Lr <5 uÌr t. rl].uÌ orì0 t..r nì thii and oLhiÌ ìndu\Ìrrrl
i !rrÌt)jiÌrrÌ r\ nÌriì!! j\
'r.iin!\nirÌlirrf\]lìrrnì.modcLarrÌro].r.h!ngÊn)'ufjts]rca(elLe.Ì.n(ierìanrì!f!Ì
J-Ìrtjor. inrlÌlrìi it t.Lks !p to a urLhÊi \râi lL, dÌ!\r r.tnitI.hanSe\ Ì.lrnr. th!ii iulLn
: rt r! dic úr1l.ri.n rrtc.
i:È double LaS nN(trìÌe is sholln ln lig. 5.8 and emphasiTcs ürat a deci\irÌi talrrÌ
-.:Ìt^thecdÌtraLb!nltoruiìclloanrocÌJt!ÌÌ(nì).rlii'.lLhcinlleliL)nrrtttÌloperiods
::r i.e ;r. \!lÌen the e.onomf is djstuÌbed in tÌÌe.ÌLrcnL ltÌiod ptÌn{l zero), th!'
::ilìr ÌruÌk looks iìlÌead t! thc imltÌicrtion\ nÌ irrlÌ.lion en.1 \ett the ì!úeren rat. s,r
:., lletenÌÌiÌÌe r,,, Ì!hi.h jÌì lrrrn dcteÌminer the drsi(Ll trltrc ot -r. À:i tlÌe dìigÍanl
:.iratet. rcti.Ìr bl ttÌe.rÌìtrilbenÌi in the currtnt p$lrll lrr! no eítect on outpul ,rÍ
: rtj.Ìr ìD UÌe errrerÌt peri.ì.1,:tr on inÌlilir)n irl a veaf\ ti.ìl Si.cc LhÊ ctntralLrrnlc.rn
: .[Í)re ] Ì .ìnd ;r Lr\ its inlcr!-1 ratc.Ìccjtion. it\ l{rss I!..(io. i\

.,ì.1,
i.n llrL: doubìc ìag. lhc three e!uaiions aft:

ir i +41)'r ,r,l It,rtjl \' ,r

.L l- = dil] ,rl (l5l
,l
t\fi1

:.i :qritrÌ, ,!.d:l\ rL'!i! Llisr I i, i ,Ír1 a.r, N|.1llr\ \\dÌnin l9niiifrllìi

t
t54 ::: : : r: ,i :::.::.r': :t.:.:i.

lo 'il

I ./ ./

I
Figure 5.8 Lã! nÍ!.trÍ. . the IS PC,\Ul mod.
r€qu rcd 1o dÉ ver à sGnCèrd Ìryor R!€

By Ìepeatnìgthc sarìe steps âs above, i{e can cleri\''e thc interestrate ruÌe, whlch tâkes lhe
torm ofa TaylorÍ1Ìc:

dL,r+ ..1- t.,-l

ÀÌÌd /o rj:0.;(-o .i)+osú r.r
(Taylor Nle ìn 3-cqoation (.I{)LÌbÌe lâg) modcÌ

lve crn also show how a lavìoÌRuÌe is d€riledgcorÌetÌicâlly from the lS l'(-'_MR nrodeÌ
Thish€\xbring outtherolc clilferen.es in ccononric strücture (d€mand and suppÌ1
th at
ridet and iÌr ccntÌal bdnk prclerences can havc on Lhe coetÊcients of laylor Rules l.
Flg. 5.r, lhc iDitlaì observation of o!tput and lnflation in period z€ro is shown b) th.
laige cross, !. To work olt what iÌÌter€st rate to sct, ihe cerÌtral bâÌÌk nolcs llìaL ìn th.
iolÌowiig pern , inÍÌation $'ill Ì1setoÌrandoutputaìllstiÌ1beat/osi1Ìccachangei.
the intcrcsr rate can onlyilfccttL. The central baok lheÌeiore inot!\ thât the conírair:
itlaccsìsthePC(nÌlanditchoosesitsb€stposiljononiitoclellverÍr.ÌhebestpositLor
on Pa(Í ) is slÌoivn by whcrc the ÌtrÌ line crosscs il. Thn rtìeans thât output muí bc l
ard thÊrenÌe that the ccnlral bark sets ro in rcsponse tu the iÌìltial i ormatìon sholr.
bt pojnt x. This erÌÌphasizcs that the central banÌi mun lorec:ìÍ:ì luther period aheâi
iÌr the double ìag ÌnodcÌ iÌì oÌder to locate thc apprcpÌiate rhillips cur\'e, iìnd Ììencc Ì:
dcreÌmine its optnnaL intcrest Ìate choice ior today: ìt choose\ Ìo . lÌ ni. Oncc lÌ:
cconomv is on the,VlÀ lÌ1rc, lhe cerÌtial bank conlinltes to tcìjuÍ the iÌÌterest râte to guii:
ll_ . . ' . n ) o J r s , l a \ r Ld l ru FqL, Lri.rn
,
'
l r

The Ìemainirg t.ì\k ls to gire a geometric preselìlation otthe cLouble lâ3 Ìnodei and lÌ::
a*ocìate.l Taylor RuÌc:''1 /j:o.s (Í, nr)r05 (/. !). Flg. s.10nÌo$stheexanìf:
jnlig.5.9ri{ai.^ssiÌownjntheÌefthandpancÌoIììig.5.10,thetiïocompone ts oftÌ::
Tayl()rRule are íìo$Ìì by [he vefticâl distanccs cquaìto.]í],o /JandÍo
"r,where.':
the slope olthe PhiÌÌips crrve.IltlÌese arc addcd logether, we hâvetlÌe iorecâÍ ol;Ì -
luí ore more step is necded io erprcss this forccasl in terms olúo clther€lorc:
^lavertical distilì:.
Lieliver a Taylor RuÌc. As shown irÌ tlÌe ri8Ìú lÌand Ìranel ol Fig. 5.10, the
ÍL Írcrìralsobecxprcsse.lask, -,) d0i, /'\),'!heÌedâncì-i = * reíÌecttiÌe íof:
olthelhillipscurvcandthemorÌetaryrLrlecurvc,ÌcstcctiveÌyàn.tdreflect\tlÌeíope:
 :::, ' .': :.:::j. 155

:idcl)

:rttly

rgc iÌì

Figure 5,9 ÌãyloÍ Rue exampe

:re 15 curve.'r Thus, w€ hâve

gúidc új + i) dl,n r) = iÍo ,-t) ) ,l.ro r")

,:rd by rcarrarìgÌrÌg toq'rÌIl: tlÌisin tcrms ofdre ìÌÌterest Ìate, w€ haÍe aTayÌor Ruìe:

t
(ú I l)' t'')
:os (Ío 'r) , os (1,0 f.)

:\,t.il,rtúrih.diagrrf,,,,,),andìÌci.rn) iünglc\nÌ)*r,ndinúeaÌgebratorhcA,rdirntrjcn)
:.rtrr3ersÒti1,c relevr.trrgler
 r
156

..'l

Figure 5,10 !!r r rj :lìÊ Ì: : Pr.

1\rc jl,iking iì5fc.r oi thÌ\ di.(!r\ìrÌr ìi tlÌrt it hrlps io dìsJì. i,..Ìrxnon conïÌìji!n
ab!uL liìllorRúl.s LrlsolteÌrrr!(]tlriìitlÌerrlirtì\r\Ì.iihr5orÌcì!lput.n.LiÌÌÌàtionirÌ
i lill.r rÌuÌ. indi.ire rhe (erÌtrrl bânl'\ fr!i.ruÌ..\ lo' r.du. f! inl.ii,Ìr i,\.oÌìrpiìrrd
to orLlpuL dclieLlon! Ìld\e\er üe hire rlrrl(l\ \eeÌÌ t ìil ìn the \iÌrsle irS rulel, tlrt
i.L.r.!Ì rrL. ftrÌ! o.l\ lrxr thr iÌú1.ìtiüÌ dr\ì.rti,Ìr iÌr it ln spit€ ol tlìÈ l.rci tlÌrt tlìe lo\j
i(l..rion tle.c\ r cighl o. lr)tÌÌ irúlúìiÌÌ rnl !!tÌÌrt d.!i,rii,Ììr: thr .Lrrrer !l nÌiÌrtil!Ì
e\.rs ôn il c.Li th. \l7t ol the rsirelrte dinrtrú tiìÌld lì.n.r UÌe irúerrn ratcj trÌrtrbt

OnÍ 1t nrrd Iv the m({ìel t() r!llc(t tlÌe t.LCt t[]t l .h.LrÌ!e irÌ .u\Ììt t.rlc!.ì \eaì nÌ
rlic.t nÌlâti)f rrlrcd(rÌ)le Ìr{ ÌorieL . tlÌen tr!tlÌ uÌ. jnflirtnÌr rÌú .LÌtÌ)rú ller iaiì(rìl
xlttâÌ i. lÌre jnrerrtt raÈ !uL( aud ii re\elrbLei lrtl.r \ Rule. lhe rerÍ)n i\ thdt tlrr
.urre.i fcrjocì orìtfut !le\ iaiirÌl Í.r\r\ r\ r !rerLìr ot /rr.( í.5/riri hrture iÌrrÌati(ÌÌ nì n Ìri!ÌÌ
lhr .c.lÌrl brnli r ÌÌl r rnt t! rerci n!Í. lhe(eÌÌirrlt!ìÌll\rÌr!ìir!Ìnìintllti.n,alfucÌf
itr !caclL.n tL) i.ílaLio. rn.ltr) tlÌ( idr(r\t ()l ìÌriÌrti(!Ì !ont.riÌre!inr Ìhe !tr1Ìrul (L\ lrtkìn
lerNr il.ìL)es rrr.ìlleft dre Ìclúi\ r I eisht orÌ ihe ìÌrihtioü rrd ou\)LÌt ÌerD\ j. lhr T Ì.r
Ituie ThÊ !clxtn L Í'cjghì! (!r iÌúÌrtioÌÌ rDd (ì|tÌÌrt iÌÌ !rr I r\ l1)r luLr .lit.nd .fl! of , .
tht n(Ìrc oi lht I']hiÌlit\ .LÌn e, \irÌ(e the ieÌrti\ e Íeìillrtr dre utÉd to o...esl n.\L
')nlr
It i\ tÌrr tÌ{Ìre oitÌÌe llììllif\.ur$ '.1 tÌüt rlÈ(t thr rrlatilc rejghl rn flâLl.f
d rlìttü nÌtÌk Ia\ Ìu. ]ÌrìÌe. Ìor .. -. Ì. the lhiLlì!\ (!ne\ tne rtLlf. rn.] Lhc //ì
(!r!e i\ il.1tier. lhere rre ts! irrìpll.irtion\. rÌÌi!lÌ ir! irÌ L)fpo\ifu diÌr.tL.n\ ì:lÁ1,eÌìo!Ì,

rìi:n rlrri dànúLri.FLr.ì iL,l., .. ninr..anrn:

l.ììk\ I r, ,.r.\,.r.únr r.\.ìrúi,:1..:rìtru!l!\r,: rì ìiÈr(
.frl,rr- rr' ..q1'!:,ì,r1,úr.1r.i:1,ìil,r'rrn:ÈÌr.rrÈi.:lÌ!rt;ri,:
^i'.ÍrÌr
rri:,I:i.r.nl .f.,rLr!ÌfÌì...L!ì rrr.L\(rLÌ\frrrr ..\iìI.ìrlrri 1r,iinLlnl.nt)kL?r?|r5
 151

rrttricÌìre lÌterett iLte r{cti(rÌ i\ lrPt nìel Lo d.rl (lth dÌ} Si\eÌÌ i'ì.r!'i:c i. ô!tÌrtrL
rÉcau\e uÌ1\ triLl hr\ e r Ì)i!rrÌ etir.t on ln ìLlof Llrin lrilìr,, litlÌr,\1ÂcuíÍl5llel1.ri.
rlutontireothrrhul,r!jì'rnri\.intlì(.1.ÌcsLrelcrllllha\erÌ)i!!crncgi(!.cIc.Lon
ÌÌÌiÌrtldr. Ihe\etÌ\!elir(tsn!pltthrln'iLh'ì ' l,Lh.ìralrncttirttrtcntlÌc.odl,.c.ts
rÌrdÌ!e\: tlÌe (!rllìrient !ÌÌ ; -' gor5 (]oN. n) lÌrt (erÌtr!L L,nnl rr,ì.1\ l.is l. if
niÌrtidì nÌocl rlrereriihe (oelì.ir'rl on rL, ) go.su| Ìhe (enk.lbirnNrci.Ls Ììorc
. dn oxtÌtrú rh{li rs (oDÌürel nitlÌ thr rqueljt,: ighls n tìie lr!ld nIlc.
1\'e !!Ì! ser tlÌat i r\ lor'\ \1rìilht: oi 1r 5 ifd 0.: o. Lhc intÌatiorÌ rnd !ul PrLl dÒ iil i().i
.!Ì5e sÌÌtÌÌ tlÌe 1J (ur\e, the |lÌillips .rLr cs, a.d Lh,: lI clr e r1l hatc a t.f,: ol)nc
(ÌrÌrorepricj\el\ìÌrtlrecare.ltlÌc/-\andLhc\r/ioÍmirN\!rÌ(1. lhls nìplicitÌrrrthÉ
,{ÌÌofr te coethcient\ on ure I ì)loÍrLl. i.m .I llrc.entrrl lirnk s nronctaÌt Ìule wiÌl
rt ditlererú lun ríl 5.ll.5 r il e.onomics di Ìi:Ì L.
. thc i.lliLL.n i\.Ìtlof.ltbc.cntraÌÌr Ìk
' the nrppl\ sile nn,clure rs rrll!'.1.d ln lht noÌre (Í Ìhe |lÌ llits.!Ì!e, (ì
. !ìthci.(crcst Í,.; Ijl jtl oIrgglÉ!atedenl ìd.

5 Problems with using an interest rate rule

rrr(oúrrLbdÌlr]ìl\:lrLìlfliJÌr.shr1ìrr!ItrdlÌit\ittcnìltlou\errÌiÌÌ.rL:t.iÌ1.tuÌc
ì.taÌ)iÌìre tlrt r.oniÌÌr\ 1)rÌc rfan)n s1{ìkl Ì)rìlirÌ\.:LDrtntorotherc!mf..cntst)l
:lrcgrtr lÈnì.rnd lajl nr rcspo rd oÌ Lr) Ìeìrni enouSlÌ 1r the chanle in tlÍ n LcÌc\t Ìate.
.rÉ\1ülÌ \eriÌr(lrrÌÌu; rnrtiÌical eriltD(tiorth. im}ì(t ol (lÌirrr.{!'s !. lh..ô\t
.rtit.ìiiuirhìrh tlx'irÌt.I.il ritr j. a Ì\c\ .onÌPorclìl trìatilet!ihir!p..Lc.iralÈot
:!rn iìÌÌrinrrc!l ior.riuÌÌÌ1c br r!hrISt iÌÌ lotriÌr'5 t L\ úÌlìtr rrik \.otho ÌcrÍtr
ÌrÌ tÌre ìÌrirre\i irtl Lìì.rÌ iiì toa ie.t (utprìt iÌÌ tlÌc d.sl cdnürtrìerarl:c5lftinrthetrd
rÌ tÌÌr ìÌúrr4t rà1. th,rt j: rrlr\ rnl nr iÌr e\nn(ÌÌt d!'.lsLont ir UÌc lo'i r.rrr I.d/ nrterett
i!Tlrt.entralbanli.iniIr.Lllrc,/r.irr('rrt,rr,lri,r'rinlÈÌe\trrt..\irlli.or'.theÌtrL
ìtÌÌerÌ(ÌÌììÌr.rLjrÌir[5lIilr5ii ft'Ìh) thtÈÌÌ)r.tliIrt.o L.tÌati!n ]l.lnrrlf\t(ìc\lL'nÌ
ÌriLlÌ :\tìre\hortinrlLonst!'iúlnLr'Ìe\tÌrtt\.Ir(Liìt(i lhtÌt]itaÌlJlf !rricrÌcdn)a.
!irìrì\rìÌr'lìri)r/irnr.irr.Jr.\ ìrc LonS ÈIlj irÌtrk\( rile Ìeteb to lllc if Lc Ìsi rate Ìì.r
. attirììell!Ìrrnrr \(,i]rbond,l\'r.xÌrerpÌistlÌeLongltìrìÌirÌteri:L ral.isloÌlrrrtl
;i' i i' i; i, ,+il ,,- il , ,.,
',
\ ir., tbir mcan.tlrr 11!Ì! t('.r nLr'Ìc\l Ìiitt \.ì\,tlÌ.i.liri.slratcorÌtÌ\cÌÌt!r!'ir
iì.) rr cqruÌn) tlÌr i\ eÌr!r oi'iiì. (\fr.ltLÌ i.ttÌe\t r:te. r.f. ) err b(!rls ior tlr. n.1t
..t\ \eaÌtÌrLu\thctÈìu,.,,rlÌl.h s.rlL.Ìthr'uI.rrt.iIìl!tÌrmilün.
r t r.!Ìuil tiDe\. \ r tr(rÌlcLdpr.l Lh. Ì().9 iern inttren riLr'1o rrctcd tlìt rlÌort t.r'.1
. Ì-.\ thrLÌÌì.ertrirÌt\ ÌrEÌÌÌìLurì,ìJìdrr.ro!ldrrÌrtct.l(.i ifdÌ(!rg renrrìrriuc\i ,rl(i
Ìt\ É jr ihc iure dire(ii(Ìr ll...LrÌ\ t,tLc\ (jlLtÌÌeÌr h.rr thc de\ired erlÈ.i..\s il
..trÌ eranf!c. .olii!leÌ tlÌe sjtÌ ill.n i. r'hLLh lhe ient ni blÌrÌi cuìt tht !lÌolt tir'rrl
: r\i ratc t! rtìÌÌlLrte tlÌr eco rrnì\ bc.:ure it lt.ìr\ iì rc.(islo. Ì\ n!ÌnÌìÌrent. li t r.
,t58

1ìnanciaÌ Ìnarke8 belicre thet thc ( rdeilylnii carse ol the recessìonaN

thkat is liteL!
a hlgher lofg Nn
to pu1lrct hiilbcr üfÌal1(Ìì ìn the Ìong nrrì, then markcls i!ììÌ beÌicre
rcaì trÌtercst liÌtc will bc ne.csliry. HiglÌer long lcrm ijÌ1cren ratcs rÌe likcìr to danrperr
irìtereÍ scnsitile \pen.ÌìrÌg at a tiÌìc wlÌcn the arühorllìer rr' lNúg to stlD\uÌate thc

thú; cxaÌnple ol tbc Ìnrr its to lhc use of mo '1aÌypoììc-v as a íaÌriÌìzalion toolconÌes
A
this
lron tlìc lact that thc n(tnintl iÌllcÌest rale carrnot bc neiaatÌl'c The Ìcas'rn lor
(hoice to hol'ì casÌr with â Tero noìnirÌal
as we hrve seerì-i\ that thcre is alaavs the
retum. Zc(r ÌJlaces a lloor on the.utt in the nonriÌì'l intertst rate that aÌe aviìilâblc
tlcnce a pnÌr1em cau aris€ il tlÌe rcal üúÜest rJlc Ìequire'Ì to nìnrul'rtc acti\ity in thc
lhereforc lìnÌitcd tclrpc
economfrvere rcgativc. LÌ a veÌy Loir 1nt1aLì{)n €conoÌÌr,v, there is
dcrÌand !i the rrquìÌed rcal iÌúcrcst ratc
to use Jonetar-v poLic,v to slimxlatc agsregate
*iuÌ an iÌìílatioÌÌ (erget oI2%, lhe zrio 1Ìo'Jr 10 the ÌromiÌÌ'l inter(rr
is nr,g"ti\'c,
".g ironic'ìÌ-
ratc nears trrat reaÌ inteÌest ca!Ìnor be rc'Ìuce'l beloN l9'o lhis is rather
thr ccess[uL imÌ]ìeÌncntatjon ol a stabilit-v oricnted modet'ry poÌ1'y akÌÌg lhe lin'
(ìlh los' !nÍÌatior
outllne.lh tìris chapter mal ha!€ th' etì€cl otpro'ìuciÌìg an e'ononÌt
trìnblchÌhctcopc;lnìonetaÌpoli'-vtoslimuLalethrcconomvifitishitb\anegatni
slú.k ìs Limited. we iÌìvcstigate tlÌe pÌobLenì ol r detÌâtion tÌap bclíN
lo slurrmaljre. the rcnsoÌìs lhaÌ Ìnoneta pollq cìÌÌ iail to have its dcsiÌed cLiect oÌ:
output nì.Ìude tht tolLrrwi il:
. jnvestlnc.ti!lnse siljve to the rcal lntercst ratc;
the s1ÌoÌt ternl
. the ìong run real lntercst ratc doe\ noi Ìnovc in line irith chrniles in
noÌrìina1 intcreÍ rate:
. rhe cerìlÌaÌ banl \!ishes to sti ulale deman'l but thr' nomìni]l intereÍ rate i\ cÌose t'

5.1 Íhe deflation traP

nra} opcrate 1s to
'lhe siÌìtleÍ s,a-Ì to see lÌoi{ a dcnatidÌ ltep the lacl thil
'ombinc ot iÌìtcÌen ì:
the nomiÌul nrleren tate cannol bc negatnre with tÌÌe lact tìÌat thc real ralc
âpproxìmatel-v, r i -! i : 0, tbc ìnininunÌ rcnì Ìate oI ìnteÌest js ìiÌìrLr =
SirÌcc
*;en inilation ì\ positì\e i e Í > 0' thls 'loes not ÌnirtLcÌ \ery muclÌ in Seneral sin'i
rhe ÌÌììninÌrun , i\ fcgativc Bul lçìren Ì < 0 the nÌúìinrtrnÌ rraÌ rate is
potitilc' TÌli
stablìi7c deÌrìand atlr i5le$ thi' tÌL
frrbli'm thri cin arlsc ú t| al tlÌe rcal rate nctcì€d lo lig 5'l:
ÌnÌrimum leaslbÌe leal Ìatc, i e ri < .n r iíl = i' This co"ìit1oÌ1 !! shoü'n in
whe( thenabilizirìg rtaÌilìtereÍralt itbelo uÌeminiÌnudì teasiblc râteo1191' Giv€nÌÌ_'
.tepr€ssed stal. ol.ìgilretrlc derÌìar d .lepicl c'l Lì! the tositìon oì thc
lt curl'c' if ÌúÌatL(rr:
hâ\ fallcn to l0/0, thtn its'ill bc inrpossiblcto a cÌr ìeve thc cquilibrlum levcloioutpr'i
The apprcrch n) ÌÌÌonctrry poLicy dercúbcd in this chapirr ofusiÌÌg the
nolnìnal nìtcÌe::
rat€!.;) er tosetthe.eaÌinteresl Ìatea\soclat€d Ìh aggregate dcm an d irt cquillbriu r:
orúpü t then .cates tu l!.ìrk
Io 5re whv, ire ass ume th e ceÌÌüal bânk scls the lo en reaÌ rate Possjble' nâ nìcl-v
r-
so thar ), - l,o aücl the econoÍÌy is at at point !. since ':
f0 l!, the conseqücnce is th:::
ìnt1atÌon hlÌs. That inÌrlìcs üÌat the nÌinimu[\ rca] Ìate rises hrrthct Ìeduclng oLl(tL::
 159

Fiqure5ll r"?''
I , t Ê dÊ'it. rirì
"., 'o:e,,.
..rincrersiÌrgllrÈsteed itirhiclÌi.lhlLonìillsiÌnLi3 s'll ihrÌlrrr llÌe5JìlíL\
:i her(ononrt isihus.iugÌrtiÌrnli.Lour!irclcorrdrlleti'rÌlrit
i !t!ìÌ Ïig. 5. l Ì lhìt !rll j.g out o thc.Ìell.rll.Ìr túÌ:i ir''luirr\ rilhci
(l l\.rle\PìÌìsio. or Íro!€r) ot.!lo.(rnort jìn e\lnrcnt oÌ
..!Ê\s
'on!urìÌìtion
,: ilÌiits llrc A cun r l. Lhe ri!hL oÌ
. crti.rÌ oi moÌc to\iti\. Lntlation c\Ìrcctrtio.: Ìlrtttcted ii leti'I tr('oÌre\
irr'gatirr.lhrr:irrÌìrÌr'shjtt\lcnt.anLlth.(..rltlrLbn'ìicrnrLsctìleilliLrtstrrte
r.nr1!ÌrtrÍ!r\11!inthf(Útralüâvlonro\ei1ìL:e(onom\totlìií tlì eì:1iÌ(tril

.,rr. tÌr. 1.Ìea oli\.elLnS iroÌì the dcf.tiorÌ triÌÌr Ì^ .Í(rrj ! !o5l1i1e iÌúlntL'Ìr
.i:LÌrs nrrl not r.rk iÌr prr.1lct l\'ilLoì Ìiritel e sucl ihil thi\ is !ÌìjitiÌr! l' lÌre
.Lr!:. n\ the a!!Ì.ir..enÌeJìt hrs rÌ. inrtlicaijo.: i.r inl 'uÌrdr L 'Ì lLúurc Ìn('r
_ Ìi.\irì5lruìerú\ilÍiÌÌÌÌolillecte.ononri.brhlnÌrrr_'lDoth'r1ü)1'iPuLthú
.rrrrt lhrltÌrtonjl Íx) to.(eteerpl.Lili(Ìrio jÌúÌ.ìtoninthrlulurei\toÜeate
: .i:,Ìri.I luture lÌighcr atlr.lxte (LtÌìì1nd it th. alÌuÌ.rltie! cLo Ìr'l talie
:: tl]i d{:mrn!i, ìt i5 fo trÌod h(Ì)irÌ! lhiit fe.p]!'nilL rJP'ct hilh$
j'iÌrÌii)''rn're\
.: .!!(\ hÕÌre\ er, tlìal it\iil!.r61\ Ìì!rs!ing I target !l lor' Ìr!t p'!Ltn't iÌìfihorÌ
:.reÌlt Lhc econonìl irlln Sctting jrÌii e.Ìell.1lon trip in tlÌe llÌit Ìrla'r' lJujtrr
:Ìril ,ì Ìr.Ìi..tter dÌ.f oi Ììì.nÊ) !i ih. Ìinl ilìrt \lil1'n lriednrâ' !115'Ússcd
i ìr!( pÌi.iical lorrÌ ot. lor !:\rmpl!.
j:srtins.r .htq!t lÒÌ t\ rrt hrÌnfLccl
'l1j7eÌì
.:.nrr.i nelt hiSLÌ p.Íered nro.e\ roui.l reniÌl11Ì\ irisc agsrelnLL' LÌemr'd ir ìt
.Lì!\(.o.nüÌÌpti!n !ÌrerÌding lihe 15.!(l rould nrift to the Ìì3ht) FleÌroi Lsout
. -! tLril i.(ÌeÌreÌr.LeLrt.tÌrtÌrlLìâ.Ìis nÌ.]rÌr. reÌu.tirri t(ì lo Ìhj\ \jn'r it Ls iì c(ÌÌrbi'td
i:r. Ììì..c1âr) Ìioli.-t mtr\!rf (L e a Ès.11 tÌrn\ler il.dn.td b\ ÌreÍ rrrone\ cr('iionì
!rú5 Lo rÌre iÌnPoltnft iol. Òi .oo irì.1.r1 h\.il r ll nìl:)'ctul pnli'\ nÌ rh i'g
::r!ÌÌ lriÌì r.d nr i ÌiÌgeh unintirìp.rt.d .lxnBer t)í.reirii'g iÌrdepc'rÌent '!rì1Ìxl

.r: i5 iÌr id.Ìitionrl .hâ.nel thn)trth rlÌì.1ì a dtlìaljo. ttu]r.in be nr:Lir'ed lu5ì r\
: -Ì),rt.(l intlrtidÌ :lr tt lterlih irÌìn (rtitoÌr t() d.hn)L iÌl llrc econonì! er thr Íel
160

\.r !. .1d.b!' rn{lel.Ls Ìrìiì.rLcLtrtc.Ì LlctÌati(Ìr h.\ Llr..!to5iL. cI r.1. II r$et ÌrÌicer irÌ
thrr.o.om\ic.g.tr)peri!trict!ìrÌtteÌljÌrSrrü.lisg.ndsPr..s.th.ndrbLor\jÌrthe
rrlrronrr r iÌl n.t orn) iÌÌ1tlìrl rlre ÌÊalburcLrn oi thrl. dcbL is ls ng1Lh.LLebrjtiixediÌl
nl]nìi.rl LcrÌ\ butÌ)ri(rs.rc iiÌljrgrbat aÌÍ) tlÌatllÌc iss.Ls Lhel th.l hI r u:Èd n\ te.rüìtl
!r.olÌaÌclrl IoÌ thr !,ebt rr. shÌLnÌiLÌrg in \ ahre. llÌis 5o .iìiÌcd IiÌifú nìrcL chennel !Ìrl
nlil. .r.itnr.nt le$ rens Ll\rtr)thr.gesirÌtÌÌer.i i.l.('sl ril( th.Fh-] \LctÌrÈ.jngthe
l-\ .u'!. ind n rìkning th( i.!e\tmc.t Ì$|oÌl\e.1!'n f.s Lilc ln lrllon e\fectatid\
io!id b. !.fcÌrrtd.l lrr sitÌ eLi)f j\ IuÌthÉr (onÌpli..L(1lrh.. d!'lâLl.n gcr\ cìrtrerÌ(htrl
berr!ì\rbinÌrult.ie'Íe.rlrnth.lraÌrf!crheet|ol)iÌ.ks,1h ciÌcflngthcsl]bjlit\ottlÌe
brnlin(5\sL.nr.ìÌieÌrÌ!titrlf.hrtÌsnì1 .o tìÌnr!L,ri\L(.dlianstotiLÌitgnrnLiotìr
t()ÌJr.rrntihrhrúloarÌ\l(!ìnì. n9trÌ)úrÌtiÌeirbalin..dìrcL5 thLs nrarlottÌr(Ì!e LÌ!t
rÌot Lrr(ri n L ihanÌiing rrisi:.

6 Credibility, time inconsistency, and rules versus

discretion
6.i Backward-looking Phillips curves and credibìlity
ln thelS l']( IÍrì n( e!, i!rr'I'hilliÌr\.uÌrc i\ Ìr1(ls.ìÍ(l l..ki.a:

rlÌich .ìri.; rÌrxt c!ÌrdÌt i.Lraliorl Ls LÌrÈÌllirÌe(l b! lng8.d if laLio. iend lhe outÌÌú
lirpt lrisl\io.\i\iÈÌÌtrrthlÌrr.irlcf!ÊtÌÌrtlLj.iLìfiìto. 5.,1sLl-\ i.r'. lhrtjno ert!
r.d!...fiLLo..üLi1j,!trnÌ:Lb.Ì.dr(úl.Altlì( !lÌ th. r\ ftür.( o| .o51ì1 tlijntletlt!Ì
ii\.ÌrsÍ(1 ir sr.i:(!ì 1 irÌrl .irc\ thrr ,rLÌuciÌìS iÌúl.rtirÌ Ì !:,nì ,rì.dcri1!' ft(Ìs.tfcrÌ. nì
rLqÌri'. i iÌ.rjjicc iÌ! tenÌrs,) lrigh.r r.cmÌrl()\ÌÌent. iL n,ì\.r,1(d n th. dlntL$it)11ol
h\t.rl.iLiro.tÌrrt.iÌ.úi\cl\frlflr$(Ìi!ÌÌtÌatiuÌlÌ.r:bÍ'nob\r1id!.d.r!.,nr..ün
lllr.rÍ 5 i r.( I \ lÌ\ o.c LÌl
diriÒ.s lht .ìcbatc rbi!i h.r hisÌ lo D({ìeÌ the iÌlÌ1,ìtior.
iÌr.ri...nonrirr\rrr.hiLtÌe!ÈÌ:trnüÌstlìjüj\rdjfdctii rì( ì,rp1rr l5 lh.k.l t.j.r
rolrlglìlL!hthereìrtlÌìtilLlroushthcinrÌtialort).1(ltriid.!liÌÌ!l'rllliP:.rdcnril.hct
rh. rmtÌri.rl e\nrÌÌ.c i.f.cÌ.j.9 j.ÍÌaii(!ì l,eriistcn.r, it hi\. nÌ,rjir sh.,.1rom n:.
llcrtrse it Ìett\ on.ìd ho. r$unrttj(!r\ j. Ìrdrti.!lLI.lro!t ihr irltl.ìtiln pÍi.rs: riLlrrÌ
the. bejn! (ìeri\ el irÌÌr i. .tlLnLTj.g Ìnj.ì. Ìnodtl nt ü ir:e or pric. \ttt..i brlÌ,rrìorL
jrd.t\.otrÌlo\rroleior'.r.dLhilLLr'!.ÌÌrena)nÌonetrr]Ìroli(]rhe(ts.[t..!rì.!.
1te crÌì dilrn\tri:i llrc foiÌrt u\jr1s aÌr eulrpk. ln li! 5 12, re irrsur]re thnt t r.
(entraL Ì,arÌl r jrúLriion leÌgrl ir +li, a.d the e(oÌL!n\ jr irÌiiiìlLl rt poirú Ì rith hjth
Ììrr !râl) Ê irrtlJti(). ,r lrl oÌrtl:-r= 1r. lhr((Ììi..rl Lr.!Ìl rúÌL le(i( e\ t! r!!l!(r it\
jiúliti.nt.ìr!rlnrlr,,ir.ri = 2.1,, 1\'ithl)r.l\.ìd l..lirÌqÌrhìLLip\r!rer.iii5!leirrllrì
lig -i.lltlÌrini\jÌrll.rr o. rrilÌ Ì)e (rÁtl\ ìndn)ÌL!riÌr!tlÌ.irnnn!Ìr.ÈcL(lÌ:ÌÌSeiÌÌiìflirlion
t!r3ei, nlt l,lirfri.1 lrl goe\ ìÌr thorrÌ b\ Ì).nÌ lr. llÌ. e(!tronÌ\ iherÌ nÌittr onl)
! lurLl\ tr tlìi r.jr LÌlüjlLÌ,ri|Ìr rt Z r\ ilrr !dÌr.Ll rLLrl rÌìpLrnrerÌt\ thr uxrti.ìI\
[ìLr \\ÌÌetlÌer,]rroL Lhr.cntrrL Ìrinl\ (ìr.iri(!Ì ji.uÌnolrrtll r!(L it Ír rÌÌrther il i\
 161

, . - :5.12 a:1t: :.ìrl r r r! .:5; r!.,1 lì !Êr .r-.d lì tr r rl i. t -

..ì ir\ thr |ri\rte se.t.)r Ìrìnk.1 no cllttererÌce rt nlÌ ti) the prUÌ.1 nlleLlof The
ìn tb.Ìt it built úÌto thÈ itsLlnr takc\ tnnt i| itlÌ hightr unexrpl.it.r(.11 t. r1Ì li
i ut. Thc ìnrbìlit\ ol tlÌc .ì.tÌd n) take x.\ r.|.orúrr .f the re..tio. oi l{ase or
.!tlrr io í,rrìrr.J (l[n!(s ]n D(Ìretrr) ÌÌrLict l5 lLn5etitt!ctorÌ \\. .oui(1 malie
: rrlr\ cÌiltetnt i$u!Ìptj.!Ì Llril r.c(!foratei iriio.el c\fertrtions or Lhc faÌt r)i
rrtìÌrn.É\ette .credlÌ)ilitl,iì.dthrìl)\eÌ(e.lÌrorÌinrlÌigi!litlt\.lnlhir.rì: Lhe
. r.€nent oi a ÌoÌrr iÌúÌriio. LiÌlrct fr..irìc* rn lrìncdirte (lì:ngr ln 1!i3c .üd
.!Ì:i.g nr ó nì Ì)Í{11Ìt ü ìgL ind triLc in.rtr\ej ba:cd.. e\terted iÌÍÌiìt on oi 2 rô
rìrrÌr on tâ\t ìÌúlatiur rnd Llr. ..onom\ Ìn.r er d r..tÌt tìlDr ,.{ t! I I lhÒrl an)
ìr. rn u.enÌ)lot nÌrnt lÌLnlctÜ.Lhl5nÚi.Lnrtatin.rlorrasdreeril.n.r:rr!!.;ts
:r\Lnuet11n ìi iÌÌdeed (onl\ r!L'n rìr€n e (r\Ér ìrÌli.Lio. trÌset 1\.ìnnourr.cd ls
..rd in (lÌraptrr 15. retni dr\.Ì.tmdrt\ i. Ìnld.lllng lht lhilLiÌr\.!r\..im Lo
r iÌh lr giì ..i r nÌicr) opiiÌnìrirÌË birs.d nôrlcl thet caÌr Ìrn{l!.!'both corth !li\iÌìiÌ.ìt on rid a
'r thrcÌedibilit\ !l núÌÌet.I! Ìr(ìL.l

ntroducing inflation bias

. l-\ 1'a, r/À .r.{l.l l. th s fôlft, nre.LluÌìr b! itllx
n Èqu libÌjurì i5 (hrrir.lLÌì7.d
.!!r 1!lhc...lrelhe.k'sLnílxtir!ÌtrrSet.lnd.Ìrifútrte!ÌuihLtrìLrnÌij.!'.d.Lcrnrj.e.i

À
 rF

162

br Lhc intcúe.tn!Ì ot thr ri:J a.d I'S.trn e\1. Ilore\ cÍ, sjJr.c ltL hiÌ!( scc. lhiìl iÌrfcÌiect
.ÒnrtcrlrjoÌr Ìn trodrìct nnd ÌahouÌ maÌÌieL nllÌlies thit,r, ìs l.ss Lharr tÌÌc .oÌìÌrdjrilt
i(ll-cÌntlonent lerel. itìr golenrÌnent Dd\ hòe.ì lr glcr tirÂ11. wc assuÌrc thet LÌre
lofcnrÌnent (rn i posr (his o. the fentirl brnk H.1! do lhinils chengL: iÍ lÌre cen
lar get
rÌrlhrfk5taÌgeiislLrllenìpl.tmentouqrú.ornìorr:gcncrall-!al.ÍrloioutÌrtttabolct'l
A staÌrLng Ìroint i\ to lcìok ât rhe.entÌal balÌr s rÌelt oÌrjcrtjl r I(].rlio., lL n.r'n xnts nl

/ =rrr Lri1r I- ir'l

rhere)r ), lhislsstrbjeltasbeiür1.)lhcLrhilÌLÌn.u^e.

ln llg.5.ì3therÌe\ i lillcÌtncecune\rrenro{n lht.etlÌalbxnÌirideaÌÌrointi\rÌ!s

ll rc assumÈ that r, i I (l(, tinÌrllcit\ l, thln li.h indiilcÌcfcc circle hn5 it\ centre
i1.1. lhc ntroÌe \et !l L!\s .lr.les hrl e \hittel to tlìr riAht. S n.. nolhing hes chrniled on
thr sutpl_1. tltÌc ot the r.onoml , tìrc lhiiÌiÌÁ !!res rcÌnein u..hengd.
lo lrork otrr the (eDtr.rl bnfÌ s mo.etrrt NLe. .oIìs d.r th. l.td oi oülput it chooses
-rll
ol /'r 2 i{ilh the inlil 'Í(n.c.ircie thos\ Ìrhtrr thc.cnt,al hink's lo\s is mllirnized
(poi.r l)1. Since the central brnkt monrtrrt ruk mutt rìí) ]rris rhn)ugh l, it is tlÌe
dor,nrLâÌd \LoÌrniil Linc r//l Ln ì:jS. 5.1:J.
l\c .ân see nnxredirtcl] that the govrnnÌÌent's leÌ9.1, toinl 1. d.cs .ol lie (D the
r,. rt
i. "equiLitrriLrnì r! Lh co.ttrnt iÌÌtÌltiln ât poifl a llrl! is lrtrr:Ìc tht nr(netrr)
l
onÌ1 be
rtrl. ítríl) lntebect\ tlÌrrcrLlcaÌlhilliÌL cur\e rt! I '\lpolnLr.i.fiÌ onLsrbovcthe
tirgcr: rhe lrÌget rate i\ 2'ri,buL inildlnm ìr.1*:this !np brln'(cn lhc 1ârg.l râtc ol inllxrn)n
and Ìntlrtl(lr 1rÌtlÌe rqu IibÌium i\ (rÌÌecl tÌÌe iÌú1.rtn,n blâs

-"'-'*J:

Figure 5,13 Ìr! r'.tiì i..

 .:i :.... -. ri 16:l

ol its
no$ p1Ìì doivn thc $urct of the intÌalion bias ând the deterlninants
I < shaÌl
:: \\:el)€gin bliíÌo(ing rÌìy the cquilibrtunÌ is ai point B iIinÍÌatiotl.isinúiailyatit\
'.ri rate of 2%. tlÌc ceütraì bank.hooses ìt! prclerred poiÌìì on thc Ír - 2olo Ì'hìllips
:i ancìthc eco omy i5 atr. But s'ith output above €qoilibrium' inflation goes up to
continues
,nd the irhillips cuNe shitls up (see Iig. 5 13). The Èocess of adjunÌncnt
the PhÌllips
polltlJ: outpü1 ìs atthc cquilibürÍì ancl inÍlation does not chanS€ so

: renÌains hx;d. N ejther .cntraÌ bark n oÌ Ìlagc tetters hatc anyincentiveto change
nor outpul aÌe at
:rr rÈhaviour. Thc economy is in cquilibriunÌ But nejther ìnilaiion
|. -:ntraL bnnk's targetÌel'els (see |ìg 5 r-l)
ol thc
: can dern e the;aìne result nìatìleÍìaticâÌly anLì pin 'lown the detexninaÌìts
equation (5 6)-
:::lheiiiationbias.ÌvliÌìÌmiziogtÌÌecentralbank\lossfunction
(s.7) .-_i n) the Phi11i$ curve-equatjoìr (5.7) implìes

I yt+at1\; i+a()' I.) nr)=/ lÍ +"-l('- "t)

i.. poìnt Cl. 0.

_i ]€N' moneì aty nrlc is:

: (s 8)
' ),' "i(. "')
' ::!iìtion iÌìdccd goes through (Ír' /r l Slnce cquilibrìuÌn Ìequjres that r I
: Í

' -. ilriüm, intlation !!ilÌ ex.eed lhe target by 1..Ê lhls is catled the Ìnflation
Thc steeper is the
', he sjgniiìcance ol lhls resuÌt is llÌat í :' -r wtrencveryr > l"
I -, ."nti -o,t",,.y (i c the ie$ inflation averse it it' thc greateÌ wilì be {he
"'ìe raiscs thc inÍÌation bias A Ìoser o iÌnplies that inflation Ìs
::- l bias. A loweì ; âìso
É :...n!ive to changes in output lìeieloÌe, ânygiveo recluctioÌÌ Ìn i pa-v\ ation isnÌore
to allos'a
foÌ the ceÌÌúal bânk' it
:..;r.r in lon oütPut; so, ìn cost beneÊt te rm\
thc
_ -.tuinflationdcìaÌiltlelessoutputloss A\ $'c shall see ìn the n ext subsection'
discussed in corÌlunctì{Ìì Úith the probleÌÌì of tinc
' : .-. ot liflation biâs ìs usualìt
ceüüal bank or the govcÌnmcnt announce! one poììc-v büt
i:.nc-v úÌ whìch thc
_ :r.elrlive to .Ìo otheNisc. Ior lhi! kind ol behaviour 1o arisc' it is necessaÌy to
-
: :,-. foA!ardìooking iÌúÌâiÌon expectaljo

.: -lme inconsistency and inflation bias

the problem ol intÌalirÌi bÌat to !íiblems of cÌedibiÌity and
time iÌìcoÌ1
: i.l
. .- .\ adoÈing a forwaÌcì looking thillips clrve lìe snnpÌeÍ r5slnutiolÌ to

r..:rnnÌxìelorifÍlàiionhir\,{ithba'karrdÌookniSmflaintÌ'iÌrè'htntrúsccrheÌp!1196/)'
164

iniil!o. .1fc.t.ìúÌls iìrr t.ìrrncd r.tlr)naÌl\ a.d lheL th.Ìr: ii nô i.natioÌl

Ìnrlie it th.rt
iÌrrú :ir..' : ::, llhet :, is à nr!lün djjLLrrbif.c. Th. i.1ttilio. is ther rrigt
tlÌ!Ü I . .\s r,c serr iÌr (.hatter l, this is thr $ .ilÌrd l.ucrs \LtÌtri\c strffÌ) cqtrilLon
riri(h trr rcprodu.c hcrÊ:

1r il.ucrs {ÌtÌit {'Ìrtlv ÈquâtiL!r

:]. '
\\'r corÌtirNe to nssrLÌÌr Lhai the (cÌrtirl birnl.hoos.! Ì Lx.d h.nlc rl.r/id lÌnge tÊtter
h[r ch(trerÌ -r. ]his dciln6 Ìhe (ÈrÌt.rL blnN.s ar(i.g ltitÌr dinriilrrr. \oÌ!, it o er
'''l
tr)ttherentirlbìn,lLorh.o'e.Ì r.. 11ÌìtnnstÌr(rrlrcÌethccttrraLbìÌ1Ì!tmlrttar\
Ìrrlcclit\ther I lrniúl ÌÌne.ìr.rtÌ)oiÌÌ/JiJrllg.5.l3 \otc that tÌre fotlti\el\
n.|ÈdÌinrtrÌe oriÌÌ.rfiÌLcdì\Ln(arn4DltrqÌ,alio.\rrlìrcrtlra.xsI'hjÌÌjf5curltr
1nÌlariünmrstbe5!ïlì.irrìlìrhishnrrelrrethrtc.ìftilL.nolüre.cnlÌalba.LitoirìtÉ
otrtÌrutnn\a iÈtàrg(l wLth- 1|rtrrÌdI I,(hctcnrfrrtt)nha\bterrerìo\e!
bcúuscrntin.rersrirloLrLftrtlÌonÌlì\o!llputthc(nLÌrÌbrri.nal(\sciÌ.ÌeÌnorÊ
distalttronÌìt\bLi:sÌroinL lwagrrÌldfri(.\ritrÌ5riLl.naìÌ-\c\Ìrc.rìnLnÌlahon\rtfri\t
.t lNn o\ er !Dl .rbl]tr th. LaÌget ìÌüÌ.ìtiou i,tc oi 2r,il
The úúÌ.riion bns p,cs.nts r tr!t,FnÌ.1\ i\.lclÌ f.Ìr ììjg. 5 Ìl,rlrcl.\\totheLcntÌìl
l)aDli !t l] i5 gl.i1rr 1]ri. lhr L(tr\ to tlìe .enllìL biì.k rL (l si... orlÌìol i\ thr sxnre bui
nriÌrtioÌ ii highrr iìl l, 5o üre.erÌtrrl b.rnl rolli.lfil!br b.lL.Ì o l il (_. \1oÌto\ÉÌ
$ aile \etteb \ro!ld Lìc iúsL i\ haÌrÌì\ lt l, d\ rt ll. 5iÌÌ.c trtlolnr( rl a.d Llr. n'iÌrfii. aÌÊ
(

tÌÌe rriÌÌe iÌÌ ei.h.isc. \\Ìrrt i\ l() stop tlÌe (erÌ1râl biili h.Lng r1 a :' \lh.f lLi!c and tri.r
\etters arr l,rrtraÌd ooking,lhet trlÈrÌì is.rLLed thrl o inr.nì,c/!ç1sr;1ì(r. \lLlroü.-{Ìh lhr
re ÌfuI brnl .l.lnr5 10 h e aÌr irú1.ìti.!Ì t.rrs(t .)1 ir lrag. s!'Licr irl ôn Lh. besi\ o
this t.ìrgr1 (2,1i,r. Ì!hcf r..ne\ to ì.t) tlÌe.entral bnik do!\ .ot .h..sc Llrc oúLlút lcrel
.onsistrnlnilh lsLrrgcr.lÌrsho.t.ntfoirÌtllthfrcis.oi...fLlrr: o.lhf.cnLraìbifÌitLì
(hriìtlrhrrrn5 it f.ifl a-, lherÊ i\ iìn iÌÌrerlii!r.

6.4 Solutions to the time-inconsistency problem

\\ie hr\ e rerÌr th.1t tlÌr tinx' i...r5isLcf.\ tÌobÌem eÌìte\ undcÌ the nnl.r'i.g .iÌ.um

Lh.cc.Lralhâ.k.rgo\cÌrÌìerúlÌasrno\eÌrÌÌrlìti!usnuLpLti.r!(tiìc.)r I )
rrire d pü(r seit.Ìs furnr lhrjr jnllalion clfcltilj(!r\ u\iÌìg !âtj.frÌ .xlcclrlio.t
Lhc.crLÌâlha.Ìir\csarulebr\rrlrel(tidri!ìÌciiüìbrLl.Pcrit\ÌritlÌdi\(retidr,i.e.
.h.Í)sò iLs dlsifcd Ìc\ eloi aBBre!.ìte lu4drÌd ir1Ìer inllnL o..rpe.t.tìons hr!e beuÌ
orm.(l i. lhr fÌi1xLc s.!t(!.
 -,165

h.rÊ aÌe thrcc brcad aPpro.chcs n) sohitrg oÌ Ìnltigatifg die tiJìe lnconsistencï
: r,rkn rnaniÍcstcd ir irúìation biâs, i{lÌi.h arc Ìelèned to as rerìla.i.g dis.retÌon bv
. I l.i.leÌegation; ând reput.tion.

,- i Replacing discretion by a rüle: commitment

:ì!' lLmÌÌg of thc ganre betileeÌì lhc cenúal bank and Pivatc secto. ìs chansed srr lhat
:: ._.ntraÌ LJank .annot choose thc rate ol inlatìon a1ÌeÌ ltage alÌd price setters have
::-ì.d their €xpcclatl()ns, tlÌ€n thc inil:ìtion bias disâppears This c'talh a Ír(tctoe
i::\Ìgh rlhich tlÌc cc.tìaÌbdrÌkis prcveDted froÌn optimizing afteÌ thc prn'ate seclothas
::,agrsandprÌccsan.li!ÌeferredtoasapoÌjryoíconÌnìitm.ntÌ.t|üthaÌÌdisffction
'Ìì1ract that .os(s the chaimÌ.n ot the cenlral bank his or her iob il ìnilation dctiates
::r lhc target is onc posible !ÌÌetlìod of enforclng this

ir I Delegation
. ììÍlation birs is cqlraì to lirì, . sìLuaiion ìn whiclì thc Íor
ancl tÌris mav reUect
i,ìrr ratheÌ than lhc ceìrtraÌ bank controls nronetary poÌlcy llìc govenüì€nl couÌd
n k i{ith
. : i.e th c i nllatior blas b) tÌanúer.ing control ol nr onetary Policv nr a centr'l ba
iitpüt laÌiiet closcl 1o)'. arú with moÌe iÌìÍ1alì()n aversioÌr (hitlr€r Jl than thc govenr
..: i. Sìnce output Ìn equiÌìÌrrnrnì is at) - l'., ìnUation $'oukl be bl( iiht closcÌ to the
..i nÌÌd Lhe governmctt woulci be unanÌbig(tou\lv bettcr oíf if ìt deleiaates monetarv
ii to an ircLeperdcnl centÌaÌ bank
. 5.11 ilÌLbtrâtes thc re.ÌuctioÌÌ in iÌúlatìon bìas through deÌcgatntì ol monetJlv
- to thc centÌal bank. The flâtter lloped nìonetar! nrlc ìs that oI the centÌaì bank'
:..andthcmoresteepì-tskÌrecìt1ìalofthegolcrnment'ì'rR(r''\'1Â.t!ìclenlllimpÌiesa
the oth'r h!rd ìmtlies t| aL
- r.r üú1atìon bia! $'ith lhee.tuitibriuÌn atpoi.t B IIÀ.r on
..:libÌiun]irâtpoinil,withÍ:3rh\{ageandlricesettcrsntìonaÌlye{pcclaÍnalìct
: r:rorÌ ÍrrÌr te when lÂ.ed with an in.lePende nt central banlithan illÌen taceclby thc
-.fìnÌenl.Thereductjonìnth€llÌlaünìbiaslscìuetolhetÌattcrnopcolthe'enlral
. i s .V,,Ì ìinr and to thc f^ct that ccnlÌal bank's outPut laÌiiet is closei nr eqüiLibrium
: rtrt tlÌan is the golernmentìs.
::.ìeÌegnlìontoproductaroilllssnn)veftonrhliahtolo$'intlâtion,thercntÚtbelìo
ÌatidÌilll' ln this 'ase' if I'age settcrs
. : r: ion iÌìÜl ia ancl erpc'lati oÌrs ÍÌu sl be fòrÌÌrcd
- nÊ that the polict nrateÌ s pÌefcrcnces halc chang€d it the alPrclÌialc wav, drc
.onÌv$'tìÌnrjtìclir€.tlldosnt1ìe!cÌtlc:l|hìllipsc rvc aL1,. fìorì toilÌió lothe reÍ'
:libriunì t'ith; 3'lo ât PoirúÁ.
:re p
blem irith thìs p()posed soÌuti(Ìì is that ifthe SovtulÌÌrcnl carÌ dclcgate po$L
, : , tlÌc ccntÌal b.rnk, tthy can t it take thenì bacÌ( when it wants to? It *'orl'Ì pal thc
- :rxrìcnt to take ba.k those ÌroÌ!c6 at ihe moment thal irage sclteÌ! choÍr â Ìo$'nr
-.\FÌrdingto ihe loss irnctioÌÌ parameters ol tìÌe cedúalbank lroÌ then thc iiovern
::Ì rouldbe temptcd to (ÌÌ for a 1c!cl oloulput greaterthan )i LhjskitÌdotrcaíÌìing
, Ìetin]ct used to cxplain i!h,v ilot.ìnnents have ofìeÌì ftrurÌd il necessary to nÌake
:::rÌ banksconltitutio.alì) it ependentanda'Ìrydelegalionissometünes'ombiÌìed
r. ionnìitìnent de!Ìccs ìile the oÌìc dnculs€d in 6 '1 1
 t
166

l.r

FiguÍe 5,14 ríi r l 15 .. Jtrì rini; d i.'r-'r_mrni

6 4I Reputation
.\ lbiÌd solLrl .n to thr'lÌoì)Ìexr ol núkjolì birs Ìie\ Ìllrh the Rot.dìnrcnt or c€nlriÌ
bi.k ÌruiLdiJrg r Ìetxt.lio. nrr brlng t(uBh on i.ilatnìr SulÌro\e thil Lhc q!\enünc'l
jult ho$ iÌìd.ttndeÌrt thr ce tlr banl ìr' LlìcI onÌl lnoN drdt tlielr is i lrn)aÌ)iLìt\ 1r
that the .c.LÌal brnl l5 irr.ìe|efdr.t d r probâl)iÌit\ L I /ì tlÌrt il l5 i Ìruttet ol i|!
gor etrrrìr n L. The onll llrv thrt Lhc\ (in lìnd.út it b\ !bstilirÌS thr dr rislon\ talelr Lr\
lhc cerÌtrnlbrnÌ! Ìtilìlsi\tÌrt.ií'.boÌ!íÌo11ldthecentrrlÌ)ânlLrelÌ,nt? lbr\ |Í)bLrìì
c.uÌbÉ.r.all\eüìÌrd.leiìtsiÌìSgamethrorl.lhLsÌ\donclnChapterÌó H$c Ì!e \i|ìpll
.(!ret 1lìL Ìlô our oi lh. ín!ti.n
The silrLitLon i\ on( ln Ìlhi(lÌ the (erúfuÌ bifli iÌrterr.ls Í
jth 1!r8t s(tt'6 m'Ìt th'ur
once. WiÌl ì r,\'erl .c.lÌxl b.ìnk 1!itlì.ìÌÌ o!1F1ú t.rrlrt ab(re tlÌe eq!ilìLrrlúnr hnl it
Ìrtìt)l].rllobchr\ensilitl\rÌeto,..:h i.e ÌÌi1lÌ.n ouÌÌ\Ìt targ.L.Ìt)\eÌ nrtlÌcrq(lilibÌirünl
lli!.tlÌ..ÍrcdÌs.r]lhxriti\Lro$iÌrletobuldaÌeFìtatio.ir!t!LÌtÌnr:\.5eÌìttÌro'
,)i\olvlngLhrnúÌ,ìtjonhiatPloltcm.Letuslìrgln1\ithtÌr!'.r!ÉiÌì\hiclÌthrin1.Ìaction
t)et\lLcn thr ceDtÌrl benl dÌrd sng. \etter\ 1r..rLÁ lrLile:lÌ pcrjod (tre. sage \fLLcrs ch(!!t
rl \! th no Irrcsird{c t)lithttiì{', Lht !tDtnìlÌri.k it I eil.r L(rgh (Ìr!t 1lÌc-t k.tú thtre
i5,r pr.beì)iÌi$ oi I Lhrl jt i\ Ìolghr;the.L nlriÌbrÌrÌ( tl\'..hoo\e\ o!tput n f.rl.tÌ orÌe
rL kron lng rj llrpÜl({ìtÌlo.th.üage\.1t.,:thoo\ei:Ìi.o\1ni{lÌ:thr.c.lt^Ìbanl
Ìlrrn.hoor€\ i I kn.:trri.g ;..
lhr Ì\trÌt ii tlÌìt iÌ reeÌ! (enlrrl brnl üill .hoolt t(, iì|.| Ìll( a r(rsh onc in Lhr hr\t
ÌreÌiod. rlhÌ.h Ì!ill rslrblish a lor c\tecled nr liìlL(!r ktc
i. thc \c..n!l pcriod Llr.Ìeb)
 161

r i biSS,', griÌ1r h.rn bi.ili.g o|tÌNt irÌ t r. se.orÌd prrlnLÌ. The .Ènlril be.Ìi
!i.ün: n Lhc nst perjod Lhr outionÌe i\ lnfitLoÌ1.r1it\ Ìergtl iB) irlilaiio. hLr:l
r'Ì r ir lht e.ÌniÌiÌnirun rirìsLcad .l the tirÌÌl n(Ìr-iin..r! !utromr oi ln leLi.n
: : i Li,lcl afLì (uÌ)Lìt rt rqrr lihÌÌu!ÌÌÌ rlÌiln . Lht \e.ond tcÌj(i. ìt crn gi n bi
- : rLlp(1t iho\ e the eq!iL|ìr irLD I j.É Ìrl eÌpL.i1i.g üre slÌo'l dúr tradr llt Lrrlrr..n
::i.rlLtncnÌ)1.\mtntbt.rs(rÌtrireiÌrrÈr\. . nrlsiirfìl ria {Ìi\!Êillrì d.(ell Ln
: lri Ì!h.. thr samr ir r'rl.i{Ìcd t|!n 1r Ò 1o maÌr\ plr orls. ÌÌre L)txeits t. tht
.iLnÌi r. ì brhl iÌrg i\ ii ll rrcÌe tl\ÌËh iÌÌ.Íesr. Tlìi! is bc.âutÉ thÈ liluition i.
rr!'i5,.frr1tdr!:iÌÌ.uúiSìi.untiLilrr,r5ltrri{!1. llì 5 L\ te ot rÌr.trt I Pu'ltÌer
: rriLl.f it)rtÌreÌrÌo.t\ btIhichrÌtprt,ìllon loÌ tou.lh.c$ carÌ Lìr lìu l1 ln lhe
:r!-r.ncÌrticrjl

t yr '-. ye a good rnodel of central bank behaviour?

r:rrerÌuÌatth.i.llilLonÌ,iì5P'.hlcmiieÌnnirrilcdìi1ìÌr'ohlc.ti\toltlìigorcÌ.
..rÌtriìL bifk s 1. \1.ìÌ)iLi^ lhL ccr!uìrl rI|rr n.l tlìt tqLLiÌlbÌiLÌnr lr\. o ntrlÌÌú.
'ltÌr' I ÌaLheÌtl Ìr1r r.. lhìr is Lhc lare bl]Llr whtD ilriliÌiÔn e\ti(
:. ,Ì1 Lri.kllrÌÌ l..]üÌ!.nd Íh.rÌ iÌrlÌ.ìlio. .\te.t.t o.s aÌe irlio.el lhe (erÌtr,rl
r'l!.tlr.. Ì Ì =, ir.u' |cnclìnLìrl m.dd I(Ì ÌÌìnn,taÌ\ p!ll|.I. i.L!()(1Lìced l.
::rl.\\.rrÉtherÌÌrdnrn\krlrttlÌ!rth(r\strnttj1ì.thaiÌrì 1 i'âg..d1Ìal 1o
'nrL.r.rÌrll)rnl t)rlÌir!lt)trr.lt oi:cÍ5 nsighltrltr'.the.tntIilba.ÌijtnÌs.rPthlr
:....r. nììrg(^trÌnnrÌrL hhirhirÌl r. Ls ltnÌ)tld 1o ÌurÌ tlÌ. c.o.(,n\ at!nL:Ìn
:ìibrl.r th€equillbriÌrm.lÌtn\r\( i.nrrnl rrl( l)Éc(Ì1rÌrìlc!,thi\ìjÌìotlhrÌit1
: r: o rÌ:. rl titrDli I hi.Ìr jD !ro51 .ater erc rndL Ìreì trÌl riD go\ elLnnr'nl rnll
| \ o fL.LrL\ lrÌir rlrd bi .orÌ(cr I iboul their p o c\tnÌril (lut.ìÌìrÌr!. !hL\ toúri
Ìirl7c.Ì nedUt bt L'r'L!'r IÌ(n1itt

:utiLiinlirìi\!th!L:rtLÍr.rnr!|l(iaÌrr:iÌNilh!fIr\!+ìr\rrrÌUrtntì!rl!ht!\Ì\t
:. .r.ri fntr!Ì I'rl!n ilrLi r\f!!lillnni rr rràlÌt\ r,!\!\rr. lie lriÌÌ)Ìiii'n u\Ì ri)rtr i
.!ri:.ìitrIrrì.t.cÌ]1úl NrILLÌ!t.lrl.rriÌtijrrìin.n (loL a l-'r:Ì;.rrs:r. ierfll trrrr'
. !qrÌÌrlir.tln.SJrnrrrnLrli11!ì,)rtÌl!dnr.ÌÌrÌ.ì(!L irulnifuÌ!n) r'nLLinrg
.ie e\el .1...n.rì].iLtr'itt.tfr..f.rr.l"lsrL àlÌ !rtÌ1eerr lr jLlF!lÌÌì rird thr
irl,Ldatn,r.nn.rf ÌrÌ 13hL L:iLr rrLl rì.rrr Ir niÌr r r\ rrk'l b\ irrÌ!\rÌi'!
i tutr:r ÌiiiLi'i$ |:|!.rtrÌir!) Ìi!..!sirrtrr\.tì!(lin('rrinÌrLo )eÌ:!rir!Lhii
nrrr L!Ì11r:lrrrni\ ìifcÌli!inl|L.,frn] Lìi.riil,ilLhr!r.r Lhr.irri. t!Ìe,rrL.Ìi\iit.n.\j

. -]uiÌiÌÌiLrnÌl
:iÌ i..nLr. LÌi l:r t\Ì,ii:l r Ìr.h\.i.iil b1 :ìe (Ì!súr Lf l)e r!!n i! ira\irr! d'nr i s"r
r.,Ì.i.qu 1eitlr|Ìì!l\.srr.ll ir!rptr!.riLhr\rnri..LnÈ1r\rìriilìg.Èrri|iri!lrr!5lber)
:!rrlnr ìlrtrr:Ìì h'rLúilrllrnr...!ìnNL1r.ÌrtÌr.'.rrriÌrr rLlriL! rar rrf!.rttheld n)
Ììnrtj'n r:
.L !r1.if! r\ rÌl.LÌ)L! :Ìì.l'iNt rir.dil trrÊrled n! tÌì! 11Ìrirrrìl \\ 5tenr L'

trllL.lrì1 lrl \1!rrÌ 1Ú1 iì,r LrrlLr ('ì!rri'Í'I Ìlllir''Ì

. :n1rrìrjriÌ.r.l.lì,r,L,.,:Jgii úrirr.l!r'f!!'úrinì!Ìri.
, Lr fi l)\ llnLrLlr '! l,(tiL,r ri Ìr,nf n,n!d.tiLi. r r.\..d1: rrlìrì lr r | ì Li.tr rrì Ìtlrr

À
168
r
6 6 Rules and expe€lations versus discÍetion and learning
1\f .n1r rrLuÌ. t. tlle (rsc iJì Ítlìl.h tlltrt i\ rÌo núrti!rr hie!.,nd L. ôur hÌôitlcÌ u!igi
o Lh. dL\L!..ti.n l)etrrin üon.t.t\ lt\ arÌ!l (Lj\!rii!.Lr lì. hrol(rr'Ì Í\iS. ! nr(ltLl
b.rir\c LlrÊ reaÌ 1Ìrl!l!\.ìrÌìpr5olÌniÌ:til!ÌtaÌSÈtiÌr!.cìl lhrnl]rmn.d\ Ìulcbestl
h, hIi,r ',\ {inÌr1Ìl/ÊLl r a nrn.et!r Ìerrti.rÌ hrn.ti.n.lrh Jr n.11 Lhrì.s tflxrl!
!li:.rLonntiretiÌnriÌrron:isl...t\tn\c\\'er.lrlÌetriJlhrÌ'i,.rn)gii.:Ìom.t
Jrarr.Ìr,rÌk t)i r cÌÉìrÌ\ !leÌìn.i ttthli. Ìn.rÌttaÌ\ ÌJoLi.\ 'rL Ì! Llr i. clfÌ1. r i.1ÌrlLoÌÌ
1.Lrq.r n; lr Llr..ere nrr ur LÌafk.l F.nl]rnd (,r uÌe Llrof.ln ( rnL iÌ Brnli r( rt)n
prrrdfiLÌri rrnrrr(!lol!.ilì.L] con\trajÌrecL(j\r.tor'ii.lri.a.L.Ì 7r!Lhrf.LÌcal
lÌr5rn c ,) 1nr'Ì'51 lÌr Ì)rr(ti.f. Ì!! ol\e| t ì rÌìlt \ft.i.rLnì .l ili.!crìr.l\ .Ì n.ni
tiìr\ p.l .r inrnfg\t ceÌrtirl Lr.Lìk\ Ihe Ll:.r Ì(Ler \hrr G ('.:Ìln Ls Lh! ì(rL taÌn(rÌ\
!ri(l:] i..nLÌrÌbxÌrLint)er.rlirìi.1r.rtltLÌti(rr.Llh \i1lÌ!l:5..1 .n. \r'L nra.\'xÌtj.le.hrÌr
be.n rÍltL.f süggc\tiÌr3 il i t r. c.ìhd..o\ertl\ t.r.l,rlltú:.9ânL.Ìlah.Ìrt.tgltirÌ:
Ì!k.Ì Ìr \ \rrgg.\t\ tlìrt iÌì pra.Ìi.r tlrtrt ir rÌ!t r slÌrr'l di\ti.rlio. anr.11!Í iniLú)ÌÌ
LrrletiÌì! 'is:nì.! btrt ÌìtÌÉr í:,rìì. tlLtitÌdr(t nÌ trìUhi5i... ÌrÌr\ rr conrÌ)rrcd \itrÌ

\e ll:. rir Llrrr thrÌe rre !ri rs iÌotrr thc (Ìrerati!ÌÌ ol ,ì ÌrltÌr'11 .1.d.Ál(uìrnd treÌr\
It
taÌdú fr..r5s. ì..rtrrt l)olì.1 nrxÌiLÌrg T|i\ !ttt\ii LhlL tnriLìi.g ln oÌmrtiLìÌÌ
aÌ)LÌ!ttlìi or.Lrr toii.r Ì{.1irn !n.ti(Ìr i\ lilel\ 1. ri trr tLl.'lhrnrrL.sdin:ri\e.
tÉ(r!\r c.1:)...rl.rgcÌrt\rreJilci!t lnfeúi.r aÌ(lLoolrsrnì(llLhcrÌt)rcii.ti.jÌr:tÉ
tlÌe.i,ì.Ì on oi thr LcntüÌ truÌk L. r \h..L. Jt the r..r.Li.. trn.ti)f \ relL trndeirt.!r
.ìnii. fiLio. I lht Ì)Ìì\rtr jc.LoÌ Dr\ lrtlÌ) n) n.ìbiliir' iÌr. !.o.omr ! ì.ï!!r\t n) ..

Ìo'r\anìfL.LrethiÌrl!i,r..gittrca3!rrsrttljìr.Lrìdrh,rli.tÌrt'.Llr,Ìr..clìÌltr)l
_lrfÌifLr\lcdgct)Ì lhi\
i.! cr.Lio.iLLnrtn!rinlìriLlrsLlrrlIrtertnüte\rliLlL,ilnr.Ìa]
:r..1 .n rrlll lfÍlueÌÌ.e the r\tr.Lcd tlÌtiìrc f:itlÌ (rt iÌrli\:\r rrLÍ. r:lìlth rrll lrrlÌr s.jii
rhi !().! 1rrÌ 11ÈÌcst rrt. dLrrrnNaÌd\ t:rÉ rrtc rtl.\rllL (ii L.L.r.;L sL nsllLlc ill'.tì
ì.i. \\srl frj.e\ {LÌÌ rr \lì,r c t,icer !r ÌÌ!i\e l,ri(!\ rìÌi\ Lirt rIrÌli Ln Lh. r\fr.ltri
.iLh Lìl iìt.rc\r raÈi rrlrl i n t)r!c tlre tti(]rt\ oi tlÌ. ..nLÌ.ìl br.k Ltì h(Írs1 duÌra.tl
n ()uÌ e1.ìrrtlÈ. tlÌÊ !r|c.lnÌ ôÌr ot r lerÌ!UÌ\ ÌJÈri,:tr] .i l.r LnLrÌ.'L il|1 rt)trlLÌ lc]11.
tt) Ìr(!Át !\ret trri!.s iìnì.dleLrì1 1r.q nÌrÌr Ìrri.r5 iìc hou\ tri.r\ Ìr LuÌt rs ri
ìrrll \ee iÌr (llìrj)ter ,. tlìi\ ,ii.!\ T,)L)ir', rì rÌ( fìrrÌììiL rL'.r li.fnr. r.d 1r.1rld th.r.
loÌr tÊ.(ìt. Ìrirr iÌ\(n|xii i.tì .(ÌÚ!!Ìtrtlr!Ì. tirÌlir-ri.! LlrL raì\.rr () iggfg]tl

o. thr ()thÈÌ ÌLrr(. n:rl] sr.iìt i11 eÌ!tìlÌrri\ r!Ì li\ fiìf L.li( rLLr'.1o. úi\ .ìl
rhL ÌrÈItiiÌ! thri !:!.ìri\r -.ÌrrrÌrtr.Ll[iÌ]l!tÌÌrlreriiL5il iiiiLi\ilrl.i.rlr!iÌnrL
thr r((ÌrÌn\ rÌ](].n!iq r( 1. rÌÌ)criÌ!rÌÌt\ nrrÈrlrìT..L,rLr L.dsinr. Lhi r.L
ljÌn:!nÌ li\eI .,ï nnirNpL,Ifr.nL jn:Ì! er!ÌÌ(!ÌÌ\ t\prIi!'r.,r! ii rLÍjL . Li.rrongi.ii
 169

Conclusions
..Ìrr!1rr, ( e lr!r r put rhc sÌnnlighr o. nro.rtirr polir! hcsliÌi|.1fìoiÌituasdn
' .iÌLôn.lihcpheroÌnenaotinllxrjon.dislnlilj.f.â.ddcfil .n,rthi.h\rsnhti
: \ Ìhr!!rnnÌrolrh\ lo( xnd strbl. nllition is.o.: dr.r.d a drsiiìbLe obje(rì\e
.1 ]ì,1Lers. \re e\âÌnj..d lhr Ì.ríifs Ìrchird ctjsodcs ol risifg iiÌlÌiriìon d the
.ri.rbilit\ olLrtteDtl:rt)boÌd.utlturiborrtlì( cq(' liÌrr u.r i.!!. t l.llirÌ!SerÌerrl
irfl drlÌirii(Ìr)i5LilÊÌ) robÌintdâ.S.5Lorì..írcro.om.sribìì Lì:.
Ìr {Ìr ìghted lle .iÌftcÌú.cc brxlcrf lrlo nìofcLi.! ir.l!.r fi.id {rìs the L\]
: !nì i]nd tlìe ìü tàÌarÌjgm lÌr thr Ltrr trridignì. nro.clrrl folir! is passì\c.nd
nir nrppl! SÌo\th rrtr d.ldnri.r! rhc râl..rI i.llrtio. ln thc mcdiunÚrLn rqui
ì Ll\ .o!hrn, in thc lfi târr.Ìigm, th..cnÌ'alìrifli is e.Li!r..lL idlr6l5lhr i.turrÍ
.r\nr5teertÌree(o.om1 bâ.lilotrrjÌ.1 inl.tlr!Ì.1fquiÌ briLrÌroeLftLt lhtLrtlol
Ìì .ìt rÌednur ÌLúr .LÌúillbliunr ii {h.rc orc driÜnìi,r.,l br'f,n .\ \ i.c lhc nonìi
:, iÈit irte .aÌrror b. ncgrLir'.. nr.n.lir\ tolici (. ll h..nm. i..I t.Li\t nt !r. \' lor
- i.rrraterotnrtlalLon
i:ÈnÌati( rtÌnor.h 10 ÌìofcrxÌrfoÌ . Í Lhlf th.I/lì txf,(Ìignr {rn br nì.d!,llcd
..it\ nrg urr oÌrìrcln c\ (, thÊcenúrÌbankiorrb.golrnnrrnrìendiLÌ.ntllri.gllìc
:. !ìtr it ta(e-r lhe.bjrclire or lÌrc rcnlÌrl bânk l! lo minLÌnize thc t\l!.l rt) rrhl.h
!Ì!r!r dì\erFÉ\trÌrnrilìrgerrrl!.f LnLlâLl..end x)DatargetÌÊreloloulÌrrt. \\'c

i5 tÌÌc.qrL librirnr l!.!rl oioulpLLl,r,.. i môn.lirt toÌ .t ,c1.Ll.f

.:: drt o!1tuL ti,g( I
:t)nwll..rbl.L1r.en{riìbrnkLojll.cr1]Ìe(..ono.r_\loitsinLlâl.frnd()ulÌrut
:.r itÌrcr.,)f.mrrrpcr'c...siflfrliÌLilln,,ìggrcgâLrdcmrf{l,oÌ {Ìrdi slr..li
..ÌÌtlìl brrÌl ill (ìo ihir Ìrt dlljxstiirs the nonÌjrÌlL irÌtcr.n rai. í irs to riic.t
.,ri irnrren iì1r dn!ì the Ìe\ el oi illti<dte deÌÌÌarÌrl ,rÌi o!tpüt lh.,ìfìp!:ììriiir
{r ìr ilÌere.l qrteìe\t Ìrte rìLl!leÌier o. Ì!hcthertlÌe nibillz|Ìg rc.l iLìt.rrÍ riir
. -lr.rn!Èd aÌrd orÌ Ìhe irteren tntitì\ it\ oi eËHÌcsdte denÌ.ìni .tlÌe il.pe !l tlÌ./Jì.
niÌàtion r\tr\e the centÌiìl Ì)anl ir. rni the rrtÍÌLe !l irúlition nr rhrn8eJ irÌ
ìpL.r nÌent rthe \l(Ì)e !l tlìe lhjlLiÌ^ (ur cl.
:x c nrôrrf lìorr to !l.ri!r an inlffcsl Íilr nrk lro.r th. .l cq{rrlio. nìorld ihi\
.. lie i(Ìnr ol e LirlDr lulc in Ìrhi.h th. ccntLal bifli edilrts th. LnLr.ftrL .alr. ln
nsrtoob\cÌ\cddc!iiLii,r.sol nfiL .n ro i.rrt((endôl.uqrut rom.qtriÌibÌl(nl
:.!: :he eco.oml ls.hiri.Lcr 7.d br i lnir ìn tlÌc rl[..1 oi Lhc ]ntcÌ6t ÌrL. .. .utÌrLrt
i Lag ir the rlft,fl ol . .hi.Âr iorLlpuL on inllnli.rn .01ÌrrL1 aiI..LslnìLion
: r. irìc teÌiriÌ. thc. rhi int.n5l reL!. ru c oLr rhas th. i.flrLi.. ltrm lf l{. lhi\
- lgÌrt\thLiâ.:L Llrnrrlìr..,i.11ì.ìLÌrL5ürirÌiÌatiorìi.doürf(L n Lhc LiìrÌo, nLl( ill
: :rÉ r'cjglrr\ oD i.iliiiLrLr ird or lpuL ir tlÌe rerÌtriìl bi.k s ìoss IL1.rllon
' r pur.lr ba(lÌlr LooÌiinglhilLiÌrcure,dLsinlÌatì(Ììi\alsa\.cortl\andthdt
!entriÌhrnÌi innou..eDent\ ire heÌier ed.
\ not rlte(ted Ì)r ihe LìÈgÌee to ithjch
::l thc olúful trÌ!( { l: iblrc th!. cq!ilibriLrnÌ le\el oi ori t!! L, thr |.( | lr.Ì banli r.ill
:.'!aÌrÌrnrâ.hL,rcilsiÌllitonla'gcrlnl.q!iljbriLrrì hcrcr,llÌLì!.i. nllitioÌÌbias

A,
110 :.:: ::. .:::,.::.. : .. :.:

We cÌarily the dcbate about rLlles vernrs dis.rclion by expÌaining thal lhe supeÌior
jLr of a nìle that prelents the ccntÌal bank lrom optimizüìg reís on the specilìcation
oI rhe cenüal banÌi\ loss tunctiof. If the central banÌ Ìargets a lcvcl ofcmPlo,vmentabore
lhc equiÌibrium, ar inflation blas aÍise\. When cÌPectatlons arc ralional, this cÌeatesthe
tìm e ìrcoìsisten.y pnnteÌn. Lly contiâstì iÌì our baseli ne case, whÌch i I ir argue.Ì matche\
thar of central bants in nÌaÌÌy countries, the obicclivc it tu stabiÌlz. lhc cconomv aÍrÌd
€quÌlibrnuÌì oltpL1l, i{hich €linÌjnates the ilÍlation bias A fulÌer undcrstanding by th€
public of the monclaN Ìeaction íunction can hclp Lo Íalrilize fü$'a.d'looking expet
tations and l.ìcilìtatc lhe molemcnt of a\set priccs consnt€ÌÌt witÌì lhc centÌal bank's
ÍabiìÌzati()n objectivcs.

,:i QUEsTTONS

(1)'lltheecononryhashjghbulstrbieinfÌatjon, lhe gover.rìcnthasÌnuchtoÌosea.d

ÌirüetogaiÌì bv rcducing iníliliontoiì low ralc'LxpÌailì and asscss this staternent.
(2) Whal ârc the ad\üntagcs ând disadÍantailes old. inflation r.te of:lrlo as compaÌed
Ìrith onc of oqo per anntm? WoúlL1)'ou rdvocate thc replaceìnent olthc jn0atnÌÌ
targct by a price levcl larget?
(3) lxpÌairr Nhat hmeant bt lhe cenúnl hânk's l6s ftrnction Hoi! !Ìe the ( entral ban k\
prelèrcnccs relÌectedin thc Ìoss hrnction? usea trulìr e rìcal e\ampÌe and dirSranrs L.
expliìj. hoa the .elìiral bank\ Prclìrc n.cs affect it\ rcacúD to a negatiye aggÍcgatc
deÍìan.lshock.
(4) llos'canthc ccntral brnk djagnose i!lÌ.ìt kif.lolsho(khas distúficd the econoÌnv?
(5) (.o nìpare th€ resironsc oí an iÌìi atbn targetiÌÌs cen t raÌ baDk to a pernnne. t ncga lil e

âggÌegate slpp Ly sììock wltÌì th at to apermaneft ncgative aggregated€ma.d shock

(6) Súpposcthere âre tÌvo rcgions olthc courÌtrv, in one olrìÌìch lhe Ì'1/5c!NeÍquit(
Íccpand intheúhÚ, tì1e I4rS is q(ìtc Iat. \'!hy mislri lhisbcso? Comparethe
implÌcations íori.flâtion and uncnì o)'ment ola c'rmnìon posjtive tetnPorarl
aggrcsate deman d s h ock I ktr! shoúÌd Lhe central bnn k r.sPnd-l

(i) ll a .cntrâÌ banl adopts an irterest rate bascd nìonetary policy m Lc lì kc a l avloÌ Rule
rrthcr rhan a moretary groÍ'th rate rulr, hlh ar ttoukl )Ìou expectto happcn Lo dre
nÌonc_ví'pplf?
(8) Ìn jmplerìcnting a TryloÌ ryfc intelest rate NÌ€, docs lhe cen al bankneed to boi{
anythiJìg.rorc thrn the coÈlficierts ir the Nle, its iÌriÌatjontarget, aDd cuÌrent
outputa.d inilationl
(9) lvÌ1te doÌrn thc lâyloÌRuÌe nì tc ns olLhe re!ÌintereÍ ratc Holding the outputgap
cotuÌlnt, dors e risc ìn inflation byxpcrccntrse poilìts caÌìlor a risc ìn therrDi,rdl
inteÌeí rat€ Ìry Jnorc lhaD,le\s than, or b,v lurtx peÌcentagc foì.c? Ìlxplai'Ì
(10) t-Ì nder what circum stan.cs rliÌl a c€. t l bàn k útìlizÌng an Íúerest rJte bdsed
monctall Ìrìle to \tabi izc rhe econon)' lail in ils obiectlle ofral5jrt8 output?
 171

'1) lh...n1..Llir.LrìL tr(e! r sh.Ìt ND trade oiíhtrweelr inlÌation xnd !Derìtilo\ ÌÌdrt
riìiii.lletl.n.\f((l.rtnrn\rÌebrcliÌr! ÌooliiÌrg!r llji!úÌltjonexpectrtnlr5!re
[liotell]rLt ârr irrnÌed lielorr the (en d l lirDk .hoose! iti optjmd l úúlrtÌoÌr outfut
flir l.rflain (n.h oftÌrele cases.l\'hrt dilfÈÌcrcc.ìLre! it rnllie ühether ldl or llr
'21 l:\p riÌì nÌrit jr ncarl br rìrc llrtclrcnl úril a B.r.nrdrcnt ürat is dctcÌnrincd to
rea!re ìÌúl.rti,)n ma\ ha\.rtnrblcnirr.hj.rlJrglhisoÍt..mcbc.r(sc.lala.k.l

: r.lens and queíionsíord Íusion

. L5l lON.\. \fhat rìe thr, in.cftircs l(Ì a foli.r milicÌ k) erÌrÌoit the rhoÌt Ìrnr
:i li rúì Ì)eôÌeeir unemlÌ.)1nrL:.1rnd Lnllal ôn? \tÌrel are the .onrequencerl l5 thjr a
- rL!Le\(4)tnm ol c(Dl.nrtÒ,erv ccnllaÌhi.k.15? (rsc olllcial reÌroÌt\ oI a.cnlÌrlbxnÌi
: :{'rclÌoicen)ÌrÌ(^i(1.srrlÌ)oún)Ì\1)uÌargtrnrc.1.
l\ l(r\lÌ.(ürsidrrd(lentralllanliuÌatnÌariiÌize\thel.ìLlotrnìgulilit!iL!Ì.ti!n:
t=k,) ))ta "- ')2

'-rrÌisapo\itive(onttantÌtipolì(\jrLtÌuDreÌrtìitlÌegr.lltlìÌatr'oithrnro.r!
.1.t,
::rtJr.r it sith the lot\ 1úrcrio. u\ecìúr tÌÌr chr|tÉÌ (llirÌt:io.us onhol! thc.cnl.il
:\ r rtilìtt úsei sìth olrtfut ÌrthircentÌrlbanÌi Ì)\'eiübitious ?) \or'.5:!l]rc lhil
:. !ÊÌÌtrrl banl iet\ the Do.e\ {ÌÌÌn) SrrÍth reÈ dtteÌ rcr!Ì.nìi. agcnLs lìar'(
:- {)or!tediheirr\fe.tahonraÌ!ìutiÌúÌati(Ììintotheirdrcitiornìiking.andlh(rs
.ì ì fhìLlit)\ cur e:

- -' nir ,,.,

-ìnrÌinij thrt agr.rt hr!È Ìeti(lreÌr\Ì)e(tationt. í)l\ ( al!.bral.illJ .rlhcotl Ììel

LiÍÌaiion Ìxte un.ÌeÌ di\.rtl.n. i.e. hI.l thÈ intlati.n irte tlÌ.ìt tlì|'ccntral brnk 1! ll
.h.o\e u5i.g itr Do..râÌ1 f.lic) iÌr\tÌruÌreÌri, _..r illiÌÌtrnÌ.ìril]ìlrr'ulillllirilh
rrÌ)ect to -ir. hr\ jng u\rÌl rht lbilÌ1Ìú cu^ e n) mÌIritLúe l,rrl iÌì rh. !'LÌÌilJ
rrurcÌìo.i a..Ì ure.ì ì, = r l.r ttrhdìtute loÌ i.)
\rLfpnÍ thit brí.reprirrte:c.t.r nfnt.ncrpc.taljo.!rrcrÈti)rnre.l.thecentral
:ìiìnk.ouLd .onnÌlj1to r prìrti.ular Íalr oI hliìti!n. whil Íl)ul.ìdrat Ì.Ìte bcl I)i\cu\t
\oÌ! Ìeturn nr the cas. oI di\.reti{)n. ìnd mpto\e tìrat re e\tüÌd tlìr nìod.l to.o!cr
t\l.perjocl\. hì oÌheÌ rL.Ì.1r. thr (entral ÌraIÌ( noü .are\ rbout 1lÌc srJÌl oI it5 lo55
nutrii(ÌL nÌ ca.h ÌreÌi(xì. i.c

LoLiÌlL1l lit! l)r :.ì i.,, ,,j'l r;1, ,.r i". .'.)']
rrnffc th. sub!.ript\ iÌ ndte tlÌe periúl.
 t
112

Sutp!!c:Ì\o thdl jn tÌÌ( rlAt p.rlod agenl5 t\Ììr't Ì1o lniutj'n i;r
0) hilc trlì'n
tl,. recona perl,l rnlr es iscnts crpc't that i'tÌrti'r' llj Ìre rquxÌ nr rht
útl lhrt
r._ruaLLr' occrr Ln tnc irt liÌlod
(i c c\tecliliorì5 arÈ idrftìr!' !o r: ='Ì ì \\'hrt \iÌÌ
!c the:q(iÌibriurÌÌ Iate\ oi rrtPuÌ dnd intÌ'ìlion irr cr!lÌ ternÌ11
Di{!is -\ (ür ll'dnìi!'
(.iUL5llO\ (1. ls thÊÌt r tÌalrlni brÌsÉr'' \ttbiljTnÌ! lnil'rllnn alrd !labiliT!'S lÌrr Ìeal
sLdr !I rh. (.r!Ì!m\ I lxflrirr
QL_F.SÌl(ìND.L_rìÌÌgì85.8asiìguidcdirlrtht"ÌÌe:ÌÌÌrljrìg'tirgraNtolllu\trirtctlrr
Lìgstru.LrÌeì.the\úndiìÌd\rÌ\i(Ììoitht:jlquiiliotrÌììnclelNor'r\sumetlìrttlÌt'rci\
n;legLrr'LrretlacÌürgelIìrhtntel$trat"'(ììtscltt'LoÌ!l)LLlÌrutl)aürdligrrrnl()
,il,^,",r, UtU fng t,.,.u"r UteiÌlltlrrcrhg!r$toP(ridcr''rn'r\isrrÌÌÌÌâr!'ttLr!r)l'
(Ìì'oitht'c'tÌrlÌrenl\
,,i,"*, u,. o'."*,",," t morÌ.1.ìr\ ldi(\ ' Got| the ltrb\itr'o
",
iirt,iin,l "..l't,1u,.,i,"ìi(Ìi'otLr'r(lrro \!!rcÌul'clrnd rnrLoúttheìr1ier iÌbollt
lrtì1r' t)'i
thi legs bcLtret n â theü3c i. th' nú È5t Ì'1r'arú il\ etl"Ìr 'r' out!ut
anlLln

tlx't jde|Lif tlrc sdrr. ir.toò ii! Ìe:|ontìblc Ì'rthc ìrSi:'

EdrÌl ollÌrgland' ÌÌctcrr
QI.LS ION L.seL!'.t tÌ\o L)LÌt ÔlÌlre tt)LLür LÌrB ..r1tr'lbarÌks:
ir r oi \err lerhnd.lanL ot (:a,ìr!ìr. i'(Ì th' Sr'Èdi\h RlÌinrLnl furlr ol tlìrsc l 'erÌúiÌ
benÌrs hri ld.fted c\Pìl.ll ì!ìlldij" i'rr{'tnÌ{'
f-orie'ho io!"htÁe' bâ'l: rld orLl
r,u*il".pr:,1,*"l,^ttrrlsnìran!tothepLrbÌ1( H's d'. jl '(Ìnmunn'rl!' rnd c\ìrÌ:irr Lt\
ntcrr5Ì Ìrledr(isj.n\nrthefubliil(:'rìrtrrerrhrlrich"ntrrlbinldidìrúho\il
c\ÌrÌiìlnc.ìit5 acti.ns loll(r\ iÌrg thi cr dìrs 't 1l \cÌnr ml\'r
l0!1
ì rìll
Fiscal Policy

IheSo\erìÌnÉ.tÌsrrsÌÌ)rìsbhloÍ1ìsrilpolil!. Ihr nÌa.roc.ononìic (ìcs o 115.alloli.!

. drlorrrir ir,/l,i/iz./r rÌrxt jnsulìte thÊ rco.om) to sone eìtent hon \hocÌ(r
to pr!\ ide
to.strr!ate derrrnd The trabLljT.úio. fu Ìded b! 1fc autonrati( rtaÌ)iÌirer\ i\.
hor e\ er. hrteh a b! Ì)ÌodrrL .I lhe \lÌuc1trÌe oi th. Lix aÌrcl í)cial teerii) \) ltems
1lÌese \tstenÌ\ are t) ticallr.lsigncLl lo meel rhÈ gor.mÌnent \ ìÌr.onÌe djttúbuúü
lnd nÌi.íre(orÌ!lrn gorlr Ìrth.Ì thal jì! macn)cco.omic otrjeLtì\ e\.
.lo\1âhllL7{:Lh.ì.\'cloJ,ÌìtÌÌúrroundthrrll!ililrriLurìr.tr.b!rLsnSdij.rÌnn),
drxng.\ if gn\ cdìnr(.( r\puditur. iÌìd,!r ti]ri.ìtion.
. tr, pluÌ UÌe ÌìrÌancins oisor rm m.n1e\pen.ìiture !r r\ n) uÌaiÌrtanr ! nrnrirÌablr
ÌücLer (Í tuÌrLlc.trl)t if th! cr.n.nr\.
\\ctrall bct n Ìriih thr rDrl\\is otilì. shoú nlolcÒ il\.el Ìì.ljcr r.d examinr
r' rrt lhc nri.mr.!nomi. elle(t\.i:.lÌirnlf in Bo\lrÌÌrÌrrnLL'Ìf!ndilure.Ìjlfer x!L. inil
:,:, hü! llrr crp.ndituk is ÌìrÌaìtrerl \\r nÌall |.omparr th. lnr.cL.g ol gorenìmrÌìt
.rt:rd rirlhír!81ìr}i.ìtion,borÍn\irÌ!ironrthcpubl . rjc isiui.sbo.d\re.(ìÌroÌÌ.riÌril
: .,nì dr( .rnt al brnl .i.( rÌeü nÌ!rÌ.t crc.lio.r. rlÌìs dìi.!rsio. iÌrlroc[ìcei tl]c ron.rÌ)t
'i ih( bnln.r(d b!dgr1 nnrLtipLjrr .
Onrr i,r h.\c inirolluc!rl the id.r oI lhr SolirÌÌrìrnLs búdgÉt Ìdeltit), se (arÌ ure
i ì prolldc iì ir.ìnÌ.Ì1.irl t! tlirÌl nìorr stncLììili.i l! aboul tÌre Ìoie ot llìe !o1
.rfur..l i. t ì. .rononÌ\. h ilrr Bo\enÌLÌìr Ì1 boÍotr\ i. ôÌdri t(J li.rÌ1cÊ it\ (urtÌìt
iir's cxtcndlt!rr, it ij irnporirÌ! irn obligalioÌr on lÌ,trLrr LaxÌrareú t{) Ìra\ the irÌter
iÌ !r lh!'irbt.nd r\cnturlÌ\ to kÌr.r thr prirÌ.ipal lhis i! \h\ Íe e\teÌrcl thc
. !r..pi oi ilì. bulStt ronitraürt t! irÌcluar iÌfLi.iiL\ its i.1.11.nrf.ÌâÌ !o.rf.lrent.
ìjj lrnds nalrLr,ìllt to r (o si!]eiìtür !l \h.i driexnirìrs th. Í)Ì\rjrcr'ot Lhe so\
.inrc.l Nb.l iors lt LÌreriÌ ilthe !!\.nÌnìrnt s drlìt rn(io is lf.Ìcr\LnË:'\!hrt rac
:,5 dclcrì.c hi'1h.r lirir ìi rln.rirlabL. ic ..nsin!'.1 Í!Lh thc !ol1É..r ot thc

i.rhsis oi (hr j!n.rirÌrt)iLji\ oi publl. drbt brirÌ!s r s L. lhc íur r)Ì hs.al tolÌc)
ÌrL
, .i.
Ì\ r slriìl .rrstisrtÊtÌ\!!,It\ÒiÈ!.àlfoli.!nrle.()nLlrL.nclrr.{Ìlllra\bei.
. ..ir.s1.d LheL lls.a p. .\ rlìdrli b. i|o!tht l]i iìr ir siÌr ler rrl 1o nÌrn.trÌ! tttL.\
rl., theL Lh. .nnL lbutioÌ oi hnrl foli.\ io jr./ilirrrnri dìorrld b. g.\ c, fc.] br r flcal
. .1 í'Ì..().LrotlÌrrlL! ,concenÌ\rbolt\rÀ.rrr hi\.1.(11.Ìh.i.L,o, L.tio.hr
: i(mÌr(nli.i.lirift\ rtÊ(al Les.torllinìp]t.t]Ìe\o.ill.d(;.ldr'nRrLl.s[sLhrl
't74

onÌt tubÌn iÌD r\trÌrrf L i.LÌ not t!LìLi..lrnsrLtrfli.. nroull bt nnrnced b! borrosiÌì!
Tht Bìiti\h:.lerrnrìcrl hit intul!crd a lls.nl rLLl.likc th1\ OtlÌeÌ.Lefrcit lr iebl úlc\
hNr l)ern centr.l nr lh. \Íre5iÌiht Rulc5 tur.flrt lr) F\ÍL. llor rax nì.h Nles 1,. hi
rc.ììÌìio the lriìnì!'rtrk Ior rnelrsirÌg ls.i foll.t:'A!etjrt] ((Ìr\i\text ritlÌ..oIÌüÌÌ.

Thejìrtera(ti!ÌÌbrtrrccnLricrÌrnlnìo.LlirtPolic!Ls.\d!ìÌrt(Ldt\e\eralpoirÌ1\iÌìilìr
rhrtreì.\\'rIìole\ÌrÌi.LlrrllÌre(onn!'.tionbrLÍ..níi5cdlÌJoLi.!nÌonet.rtpolj.t.afd
l.flrtio. At we hr\ e sr.n ln ahaÌ)teÌ:.. Ììrc.r:5 oi risinq intÌaiitÌr Ìe(Ìuirt\ thrtrÌÌon.tarl
poli.!e!..nÌÌÌo!laiÈ thls 5ln.c !jtnÌtinlÌirtion p. rscd.cs notfrn ide e(ononÌi( beneits.
1lì{ nrJts ot it uurt li. risüi'hcÌc lÌi uÌi\ .lÌap1l'r rr. .Ìtlore Ìhe r!Ìe oi r.UI'rrr{r' trì tlrc
li.k betil'een g(r rrnmr. L sfcndi.il rnd núlit !n

1 The automatic stabilizers

n thÈ rnÌÌrLe nNliipÌicl modeL, it i\.lcar tirr.j llit d. pcnd o. lhr lc\'ÉÌ
thilL lnrrÌ)LlucìÌrt
.i i..oiÌr reduce\ tlÌ. \i7. .l \inìiÌirl!. be(.ì!( !nrnìplolnr..l b.n.!it
Lht Lnrllipl cr.
pnrm..tt \ eÌ\ rrìth tlÌc n(rÌìbtr \ unÉnÌplo-r.d. LÌansltó iÌtrÈr\e .ri thr lrlrì oI.rL1ftrl
IiÌls a.(Ì thi\. tr!), ÌrdÌi.c: the \ize oi tl!'nìÌ,lLlfljtÌ. TÌrc i plì.ililÌr i: thaL 5!... Llre
liÌì en.l bcÌrelit \\\tcír 15 s.L u| í thal bolh Li16 a.d tÌrns1.Ij dclì.rìd ol1 LÌ]c l.\,ì
.I ich\ itt . ihe\ red!.c LlìL !7e ol tlÌc nìrLltitÌ L:Ì rn.Ì thereio[ di]rnP.. Ìh( i.rli.l on
.úrÌÌú(ÍìrÌrerogrÌroLls.hr.SeirÌpr!rL.sln'.djng.ÌÌrtenn\.11l.l-\ / /modcl Ì.crll
Lhrt r !naÌler nnrltipllrr Ls rtllecie.L in i sLcctr' I' Lun e uÌiri lìiiij 1.5: i.' hnriTo.lrlh
Ln ÌeïuLr to a .lì,ì.{c iÌr crogenou5 .xIL'.diturc l\ee lllÌrlirr 2ì. 1hjs l\ Ìrhii ii nìci.:
lr tÌrr 'autonìirti. s(ebiÌi7cÌ roÌe of th. li\ i.L] í!jrÌ ttüritt s\ nfnÌ. r\ .onslq(c... o
tÌrÌs teature ol tlìi hs|.ll sltu.tue i\ tlil llìr'ÌrrLdg,'l LÌÉn(ìt ri\er rhen r.ii\it! fills i.d
declìnerühe!rr.tj\ ll,ií's
TonÌte+irlii]ìc5lÂfllLcrnceotilìrbrdÂ(li1L'l.jlrecorllelrtlrÌ\Ì).új.ulìItiLlr.
ir ne(ess.ìrt t. k.oÌr Íh.t|cr o!tpuL !s lr!'1.r. il. oÌ lln)\e t!l!iLitrliLr!r lo.ìssisi lol
ic) rLìlcrs, t Ìc.I.li.rll\ edìrútetl brLdg!'L d.l.i{ !\ .rÌ.uLated. 1lÌi\ i\ ihr Lrud!Ét.ki|. L

thrt trou d prriil gilcn r\i!tirÌ.! lilLr rnd st!.rÌjn! (orìÌìrìtÌnÊÌrt\ ii the ..oLÌorrìr
rr\ ofri.tln! iL rquiÌlbÌiun .!tf!1 ìisrrdri.i lrc lnron iq!iLitìrjLru ortNrt. tlÌ! .!n
rept oiihr. ct.lirelh rdlLLtecL(LÊh.jl fdl.:ìLcs rrhclncr ni!rLN!li(\ i\ eÌÌ)JrtrìdrLr] r,r
rorúnì.tioÌla .().rtÌìrrjcrlfrotrllnrrfLhu5!.!thr..li.!lÌ\idiu\ttddeÊ.itrrrÌÌtiìi
ure ú hs.il ilr.r. ir Ln r\tinÌrtiÌrt Ìhr l.!!' n cqt'LlilÌatÌÌ (tr'iÌ\ú. \i\i.1 tr!rÌ)Ìt.
ol thii pÍúlcnì 5Ìì.Ìr rrf \hrÌr er,rnìi.i.3 (h( or glfs .rÌ thr ldrgÉ ÌrúìSet cltÌ]!i. tÌrrl
dnrrgl(l rs!r.lellt nrìrÌ.teaDe.o.onrl(si,rllr{ lt;üaÌ(1 l!]l(\.uÌ!liÌìJr|arÌnÌtÌÌÉ

lr.L (LsLl{.1f. llìc fuÌatioÌrnrip |rtjr..n LhL'd i.Ì..1 .oÌr(eft\ ()t ihe n\cxl l)elaÌrer\

Lr Ì.r \r-.!Ll!:Ìrir.rii r\. rii hü:A.LdrlìtlÌ Ò|1!t r..[.t Ì-ÌÌ]:ljrrii

= risir'L.rrnìrl nr|! !' lÌfr(:.Ìì.Ì1 \11r rtr \
 115

,heÌeíi\iì..nsLantdndthrLcÌmrr,. r, crfnrres lhcnrpi.L .. uÌt bLLdgct den(it

,: tire à!iomilL. \tìtrìiirrr5.r !I orrtnt oullut, l ', is b(lou equllibriiun !ulfuL, )'. uÌc
.L!Ì(!ìr) ìs i. r Ìecesion.lhc eunÌ!'rtìc \labilizer\ !iill ruturÌalL.rlLl lÌtlp Lo \teÌriÌìre
Ììr e(on!Ìn!bv Ìri!iÌS 8lrÌ rrn Ìrcr1t e\pcrìLlilure on tÌrÌrslerr rnd d.fÌe$iÌrg 1.\ o erNe
, , ì, r ' lrr theìeb\ p!slìi.g trÌr tlÌe i.L(1rl dehcit.
EÌlehnìli..,lheinrpr.t.iflhtbullridrlicitoitlìeartL,!!rli.5tìbilizer\ls7'nr\1ìerÌ
LtlÌrt i\ rt 1i cLÌúiÌjbÌnrnÌ l(\(1. A rero.\.ÌicaÌÌv a(ljusld tiudg.l (ìcfi(it irì!lic\ zero
\.rr/i,rríÌr lì5(rl jmttLse: i r!.lj.rlll .diulLed leiì!j1 inÌrLie\ in eÌÌrrÌÌ\ionir hsral
. ìn.r üÌd a..t.li.xÌl\ adj!5tcd iurìrÌu\ j fÌlc5 r .oÌÌtrarli(Ìrrrf Ìls.eÌ \trn.c
Ì\ ne hr\ c jrL!t !ÈcÌr. rrÌ (ro.odr) ìÌr rc..\sioÌì nitlÌ lrrLlput b.ioN lhe e!uiÌìbriun Íil
. rLÌn) ÌÌ.!cahlgh rctLriLl!.1ì.ll berarrs.lhc se.orrLt(I.ì ln tlÌ. riÌuatnÌl 16 lì i5Ìr(trìti\L
hr.\cli.illlidjtr\teldeh.l1ortrüplusl!7tÌotlÌenthrrctLral{lclicittirrìpl!Ìrtlect\th!
..1.ìmatir \tibiÌ7.\ rÌ Ì\ill disatte,ìI o..c tire econoÌn\ I.trLtl\ t() tlÌr c(ÌtriÌìÌtriLr '
Lni. ra\e. Ê!.il tolict i\ L,!:tr LdLng no id{Ìitìonll dis.rÊtion,rry \tnlul(5 lo Ìrunr th'
: :rLiD) br.kt.1ú!.lilìetq!illbijuDi(ir lnA lìltcrmnÌollr$,theÌri5nr)ÌithtÌlanÌ
i: ôl the I5 c!Í!cì. r-qurlÌ\. ilriJ.r./nrrr'l l scrÌpoLic\ li uted t' sLjmrìLatL lht rcturn oí
:i.o.(Ì!rtorqÌlLljbÌirüÌÌirÍigh$\ar.L5Ììittot/J,ì.!!ÌnllltedÌrLtcdLlclrcit 'ud
. ,:b\.rkd. ln srL.h a (d\t, 1lÌc !(^exüì{'nl Ìrd\ to (.r)SrÌiz. thrt t\rÌrL{1rÌÌ-r it rÌìnt
. i ro take ÌllrnsriÌcr n) rt(l!cr Lht in(rLní Ln deÌ)t t ìeL itiLl i.(Ìnlanl Lhc e(orÌoÌnI

rir Ll retunì! 1. (ltrllil)rirìnÌ otrtÌrrìt \((Jr an opforltrnitt itouÌd rI5' Lt' \h'n lht
!onr) iirtr.t( cLÌaiÌìÌrÌi!Ìì oúltut. ilì!'g.\ enxnc.r tislÌtc'cd hsci loÌi(\ Ìsi! bv
:iirìggo\entrÌrrnLr'\ten(ìit!rL í)r\totu:Lnn).cithrm(Ììr1iÌrlÌr(ni'\ÌuleirÌluldinË
:::i:.f,)m)br.kl.nrr.1\tÌÌe.quLÌiÌrÌirrm.Wtdr!llrcLtlÌnt.lhsjt{elihtn$ei]rrnÌ\':t
:: ur!'dLtrÌn ì pntrlcD o:1ì...1 f!lir\ ..d tuÌ)Lj( n'.t(Ì lrhL
-:.Ìr LúnìÌril djrc.tl\ t! !ii\.rti(ÌrLrl'll\!aL|oLi.l Íe Lrri.fl) rld(s the qucsti(Ìr
! ,r rÌuch st:biliTrÌLon ir !L!n. b\ thf i{ltomrti. \1ebiÌizcrs. lìor lhc 1r\ ÍlÌtdrLlc nl
: ri i. auttlnaii.5ìrbjÌÌrer. ii is neces5irl thattlÌ..hdrÌ!clnxs{Í'iercoulputlead\
in(.Ììì!'aÌìd ilrnL thl\ iÌÌ luJ' LeJds ro a (1ri'ge ìÌr 'o'iunÌl
'IiÌngc in di\Ìì.srbÌr
: \5r'c sir!LL\rr n nn)rtleÌill in Ch.ìtltr /. ho!ichoLli.l LÌjrttr"tt(Áitiüìi L' thr
!ì. LlL\triÌrutiirì Lrnd io rt\ltìnri liil.r.ntÌ\ t. \rt.h tiÌìloÌìri 'hi'Se\ iÌr (Ìj!Ìrtr
: r:Lì,Ììt. hÌ tlÌ. p(tÌr tcrÌÌirn.ft in..rtr. h\Ì)otlÌ.rls terììfLirxn nr i"(!ÌÌe
'Ìringe\
:ÌÌl]L'ircton(.rsrtnrftnÌr:blrn!rrPÌio.itroLrllÌrtn|i'eltirl"nretlÌiìtaicct\
.!r.Ìrti!n. li1lìlsi\thtc!ri.ilrcntlìrnttt(!ìÌrti.:Lll)iÌirlÍìrt!rrll'ialt HojrcleÌ
Ìi lr.u\€h(nl\ i r moÌe hLrh Lo tre liqttliÌji\ coDsL rLÌìed lhrn ri'lìrÌ r!re\ ìnd lhe\
: ìiÌ.IoÌerer.i nìnr. n)terlln rr\ rlrins6 irrihlji Lnc.rìL'' lÌr ord'r L' tstj ntc lhe
::-::,ri lìrc dÌit!rììaLl.5trl)ìLirlr5. dct.ljlid nfoÌuiìtioÌr it xl!'drd rÌot o'Ì\ 'rÌtlÌl 'fd
'Ì!'tì1etaÌ5\\l( butaLr!.rnthtirlìllic.tri(ÌL.l .hrÌr3.: ln r3!I(gxtc a(tit L\ n)r
.. rokÌ\ ritlÌ !li L'Ìc.ÌÌt\ÊL\otLn.!r]iL
i,lüe\tiLühr5b(ìriÌrtniliÌtc.Ìrt.r.tli n)rtlÌtl \{: lh'auth!r5ft)cuioni;ìL \te
: . r Ìole !l:.d(Jll la\Ò .rrrd tntnÌp or nrtrú rfrìPtÌLirli1rn lÌr 1|c I 5l '\!r hich
lir.berg Êlrd LÌrI the trÌ:1!rer! !l Í'l\ rL).!i EÌr rÌri LtntÌntlotmÉnt b'Jì' rtt

!Lr.nÌr rrt ':hil'!r af L!!rì.it!

'dLLirtir r. ,1. . rLl\:iÌri!ifi'\
r. ri, rlr. tt|1,ì. .rrdL:ÈnrrrlllLrrrLl
 r
176

aÌroui2,l,iiol,ìn!irìiL iÌnÌ)!Ìitu Cl)lr lhisisÌathc.modeitrnrlthtellt(ÌrÍilLl].lrl.ìt.r

iI nì!nt l!m|cin .oLr.lÌieiriih I glrr, Li\r1io. r..ìÌÌr)re Senero!s !IÌenrplo\nìtnl

2 Discretionary Íiscal policy

1ÌÌ lhc /!'1,\I.r( eÌÌrre\rnirdi.(hatter2.!o\ennrìrrìl5fcn(11.gi!nfÌnrxll!irume!l
t.l b! r:Ì,)gcnou\ rnd trÌiriion li u\trdlLl !rxlellrd rjt hL I rs exose.oui .r er d tinìction
otlhcl.\.Ì ofi.c.ìne.\clìi.!.jI!!\enrnent\N.dln!oÌ i.Ì\xtj(Ìr tee.l\ Ìlrrou3h
to.ggn.silr deman!i1iâ tlÌc .ìLrllitlitÌ Ìr(trt\. loth sfoLntthcÌthx5ìreenÌÍ)erlìlicìt
..Ìr5id.ratLon or hor tlÌe in.r(âsc Ln go\ ennnerÌt \pc ì(li.! i! Ìina.ceLÌ oÌ, nr.tÌrtÌ r1, i
oi thr .onscqutn!€\ ol rhiÌrq.s ln the Bor entrnürt d( a.lr l(Ì the aict sto.l! iÌnorÌe\
tìì.1 bo.dsl i. lhe Éc(ÌrÌnl. \\r'r1etd i() ÌtrÌel\ th.n: omjsio.\ herc. \\'t ÌresiÌÌ L)l
irÌtrodrLri.g lbr c(lrceÌ)t oi tlìr lorenìÌ!tnt trlilgrl |...:Lr.ìj.i rnd thÉÌì fr!!etd iÌr t$.ì

firn. Ìtr. ass(LÌìc rlrat l!)u\elÌ.ld! ilrr Lhar go\ cÌ.m€Ìrl Ì)(tì.ì5 the\
âÌrd nÌm\ t.ìle the \
tr.!l .orÌìfrií' tirt ilìit
oi tÌrrir rriìlLh. lìr)m
\ itr toirll, bo.(ì\ rrc r .om|.neÌri ot tlÌe
lìÌÌrrÌcjiliÍ.1s. lÌreterÍrÌrLÍ'.1.ÌottÌret((!r!n].,\ssrnrnËtlralbt)11L\ìrtreaLtÌÌ.se
rrÌnp.r. thtu1.tÌlllerr.t ur1ìods .l hnrÌrcinF !n in.rr.s. Ln golcÌ.me.t clfen(1ìt!Ìe:
t.r\i1ìof. ìr.nd\. and nÍÌr . h. !!ntÌ)t ot thr bilin.r1l bu.Ì{cl rìultiÌ)Licr i\ nÌtI!
!lu.cd lrls.tirrtrriÍrÌ slÌ.r': lhrt iÌìe nÌeuÌ!d oi lìn.f.lfg rn Ì.cÌtr\e iÌÌ !.rtnnrent
(\prnditurr jflÌuenti iti iÌìp..1 o. (uttlÌt.
!(rofrL,rrei.\e\ii3ltÈtlìi ogl. oitht.LaiÌ! thrl bo.ds iÌt.ot rrcaÌth nÌ tht ÌreÌ !ÌÌaÌ
s(rlor tÌrÌsi\tÌredo(tfìÌlrol Rl.rÌdìarÌe!u1\aLenre'nì|hl.ìrth.l.ìrsighlrdhou\ehold
r.ilir.s Lhrt rnr lr)n!li thri rIr lssae(ì to iiI:Ìì(e e\trn S1:Á r'ÌnnrfnL iÌ1.{Ìlng r'llÌ hr\ t
l.b.rltaidbihlghrrtrÌrÌinrlilcfon. lhìt mSSe\t\ 11ìrt 1Ìr.r. rr.. .11.rstrf.rs trndtr
ÌLlrl.h lr\ aÌìd l](!Ìd ÊirrLì..i1 n.Ìer\e\ nì !.\ eÌr!!ürt spL'.di.! i,. lfdLsli.guinrrbÌt
l!lrar aÌe tbe irìÌ)Ìi(rtìon: lor Llr. Ín) nÌ\lìnhÊ\rirlpo.1 âift1Ls,)tL(ftrL r'.. irirürt
fÍrlLrâ.rììt:i.rÌnÌc(lÌ.nlsnì L b(!rcL\ !rt Ìr)t ((Ìr\idrr'rd L. bc nc( rrrrllh '
2.11 The gov€rnmeÍìt budget identity
Ia.h p(r ü1, thL {or. rÌner11 nu\t hfi.ir i1j c\P..dlltrÌe Ìrhn\ rnd ìl!r fx\ Ì.ttÌert
on thr 8o\rrÌrìirnL(l!ìrL (iorcürÌÌÌentiebtjiih!sto.k.llorcrrlnr.flho.d!thalhrre
h*rÌ \)Ld 1o thr pr ì\ itc sr.trìÌ iÌr dre Uìn. llÌe SoÌ r r r.r.n t.xn u\! L1\âtlt)n, thr sll. r)l
rÌeÍLì.!Ìd\.ortìctrinLi.g,)aÌn.nertotìÌÌan.rii:.rp..iÌ11trtr'lh.\.('Ì.6otu'rLÌ\rÌc
oìtlìrrì{hlhandsiL1tLìIthÈÌLltÌìti i]ndihru\r\1]ilr.dsrrcr)nLlìrlcltlrrfLÌsLdrln
ìtrr!nrr lÜnr\j Lhc g.\ !ÌÌrmÉ.t ! Ì)!d!r1j(]ürtiit fci.iìt.Ìiodi\:

(i ill I : \,rl \II |lo\ ÉnÌr]ìert b!dqet idenrit\

jrhr1.(; l! .-g.\.Ìfrr..t e\Ì)eÌ 1 r. on,t!.d\ ind 5. r .$ Ln nonrl.âl Ì. ì\. i L\ Lh.

rìl].ìi.al nL.'.iL ri1.. B L\ LhÉ (rú\tirrdirÌ! no.l oi bond\ ri(i hL i.. Ìh. r ilL L. oi LÌrc
 177

Ìrìti(!ìdÌdeÌrtatthrbrgi..j.gl)ltheteri.!l,Titterre\enu.:rÌÌr'iì5!rr{1[cto lrn.s$!
\/r ir the yalue ol the nÊ\'ho.dt i$ued nr the curerú pcriod, iìnd lH s lhc n.Ìt hilh
r. eÌed nìone\ ÌrÌintedÌ\ theg(trenÌÌnent.
I il 2 The fiscal policy transmission mechãnism
lìr nindird pLrscÌìtiìtnÌì ôt lìs.il Ìrol .r ir uÌ. /J /.II nrô(lÈÌ Ìs rÌr(trLn ì)\, | sÌritt iÌì
:[r ]\ cunr: tlÌ. .rpeÌ jture ÌÌÌuliipli...orÌÌ(s
irlo plâ_r lo nrrfnLli.the iDtâcl ot the
:r\.il inrpulÍ-..\! tlÌe le\ eloì jrì.oüÍ rìÍ5 (hr.i.rìiì.rl n)r mo.el ìr dÌì\ en ut. ind, ai a
::nsrq!rrÌ.e thr irÌtÈren rn te Ìisr's n lrd .rolfdsoul nrmc!.leÌe\ttÉ.tltj\eï)erÌdintÌ)!
:Ì:iprnat'sc.nrrLÌuÌenÍrnnrn,ltj(hno.tÌanlcjni.ÍlaLLonorirúlìúrìerÌre(t.1tjiÌÌr.
::ii ris. irì th. Ììirnin.rL iÌiterr\t r.tc i: ilsrr n risc irì th.: rÈal i.leren raÌe. lhi5ìtthe h\.rl
'. iict tranvni\iion nìechâninrÌ

,l
ìc /-\.u.rc5lr lls t!tlÌcrjghÌi llr.c..foml no|e\nortlÌ er\til.!r.{ l ìc !]riì(l doÌl
'qrt/l:(L^r lhsiithrslnìfl.st orÌ oln)riÌÌe.ì iìrÌaD.ial .r!rti.il oL1Ì lL...trr
ì.n pÍi.!'s iìr.111ú i.c. Í1ìrf Lh$. rrc no \rptl\ \ìle (!n\lr.irL5 on Llrr c\trn\j(Ìl
l.tn ilt ( )!tpulcrp.ìnns büLhcce6! rìrc i.cÌ.ese iÌr lor eÌrìrnr.l spc.di.g ls lr.r.ccd
LirihÌrvnc(ìr.nd \s!is,lh.ifl.rú5lrrtÈLsalÌeLtedl\ertl.1.(ì ldl. l h. ri* Ln tÌre i.trÌ
:,: irir mriÌìs th.{ thr iLrll nÌuÌLlplirr.ilÈcr oi Lhc Ìì\e iÌÌ goÌ rur nìrn L s1rL ndi.g.Ìoe5 n.t

/i

::ri1l )

'!:rÈrr:niÊ1rÊ_illrl
í
174

!c.rd,aitLìr.ehslìoÌnrn.{ÌtrÌliÌrÌìLrmou\\rLithislÌer,r'dLlsconÌpositi'njsdlierÊÌÌ
slirc therr is a hiSho conÌP,rÌrÈ.1ol xorcrrnn.nl cxPerÌditrtc ând a l'jtct conÌpo'cnt !i
ilìl.stmeÌÌt Lhan iÌÌ the irÌlllrlequìLibrlrtÌn lhis ÌiiÌnlol.rort'Ìjns out llìoÌr\io!n] Ioi
oc.rtr 1t t1Í i.teÌe( Ìrte i: hcÌd conna.L, i e il the D(Ìtl 5LLfln) i\ 'ìLloÌld to rrprnd tr
ÌÌrirt rire rddltioÌìil dtrÌiìfd I(Ì rÌoÌÌcl

2.1 Tax fìnance and the balanced budget multiplier

BeloÍ. (e eriÌìLne thc nìÌfli.iLLon\ !1 rL!Lng t.\ntLo. t(ì tuin'e sot'ÍìDe!ú erpcn'i
itrìÌ..\!iiho(tbrtiolÌo\\irÌ.1nrlseúÌlorcDnnrnL\ÌrtÌìdiÌrg.illhouslÌta\rerelÌucsrL\t
be(rus! olthr i.crensr' LÌì ou1f11l, Ìhe iÌr.Ìc!\t if Lixrti(ÌÌ nrdtr'ed b\ tlìc hjgher l'1cì ot
acti\'1-\LsiÌrluilcitntLocl!\rth.gepLr.ntdr ilcnditrìreindlr\aÌìür'5(rtto\rlhcreil
xtr!poÌliorirl Lir: I r,l'.,\ithc.eit.qtrniÌrriLrrìI(nÌ(r1iÌì3Lh'increrÍingor'rfÌìeui
ratt ì5 thcÌc Iill onÌv bt
ïretÌdlng lit ü c a\\rulc ft)r \nìplicÌt) tlì,ì( Ürt irì1.Ìett 'on\tantì'

ls: lt
tfl
_\ l

\r I
i.r ìnlltlflier .tft'.t ol lhc chrnS( ln.!
1l thc is :' But rlr k'o\! uÌat thc erÌ)rfditur(
ÌNLljplicÌ ìs eqtrÌto
lÌl

which i\ sÌìaÌlrr lhen I lhj! irnpli.\ llul 1r\ rerenu!'at tht D'Ì! Ìc\el o
'qujlitrriuÌì
otrtÌIrtÌLllìbeÌrsslÌlntÌrcLncrer\iing(r.írnrerÌtip.'dinS lhe rcnín ir slreighitor
Ìra : thr bo(trt to iÌrcom! IÌom high.Ì SrrrrnÌnerlt \ÌÌ'dinS le'rds orÌ1\ lo hi:her
llÌi\ 'ot uÌiìl LhiÌe i\
nì'4"
tar re\rnuc\ lor tht S.i!!:Ì.Ìnent lrut alio to hii{ÌLer:aring\
â Í.ì?rìrrrìl l,Ì(lí.1 ,/rri,lr et the ÌÌ.1r eLluilibtjuni: the ìn'rÉase irÌ i"oÌne to {c'eÌrte
sr\nÌ!5tlu5tarnLlotr.l . lÌrÈ !r.illc.l ÌeJliage\l eq!.1 1o lhe in(ÍriÌí'Ln ro\'r'mtnl
\Ìrrn.lifg 1i e. thr Í) riLlÌr{] iniedionl nu\t bc Inler thaf the Ìt\el ol ifco ' nÌ rhì'h
c\trr ti\âti{!Ì nlonc $ oÌild hc tqu.ìl L. the ìn.ttrst nr Sot'írDelt iprrìdlng 5iÌì'c lhtrc
j\ r dclì.1t, tlìe !lr1tntrììcnt jr ÌroÌrowL.g nr inrÌrlenìerú i15 sfc'dìI! Lrlafs \\ircLuÌÌrtt)
lhe.onscqutnrrs ot nr.h b. ìsìÌrgbcl(\\
\or'5LLìrp()\r lhrt tb( gorerurLnt r.(Ìinsc5 taÌatillÌr b! tlllh Lt) nrLân'c üre
jn(rr.ìscd go\emÌìcnt spr.dÌ.ts to thiL tlìtrr' s no clelì(it.1 lÌìc íìort nuÌ (qrLiÌib
'er
rilu!.úhetìithr cÍfeclo. thcecoÌrom\ otrrllr lrr ÊrÌrn.rdc\ltnlitu"tr)trrnrnrtl
To\erthca $\cr1t)thi\qttcstiorÌ.iÌ s siÌnfÌe( liNe atnun.lÌrnl the ìÌrterr!t Ìate 15 i\c(1
Suppoic ürrt 1|!' g(^ em,Ìcnt nÌcrei5c! got rr nnrcnt \|eÌìdi.i xnd Ìr\rljon ÌÉ\ en!c b!
e\rcili the ir!Ììr'aNrnL. The ar!unrcnt i\ lrrn\ÌrarerÌt rlì.. le\xtidÌ ì5 '1ogetÌ'ius
(
i.e. dü.s not &pcn(ì orì lhc lelel oi irì..ne onsi.ìer iìr\t thc lnfect oÌÌ otrtf|t oi Lh'

h \,j+r \.t+r,Lr \ji

 119

rÌi \..ond, th. inÌpa.1 on !utpLrt oa Lh..hr.Sr j. rl

lr . -\l ., .,ll 16.lr

\ .cc Ì)\ thÈ e$unÌÍÌ.n oí tr\ nÌìint, l! \r, 1i is .l.er Lhìt thú nct etlect .f the
_r if!e.lìr get e\tendLtuÌc IfogdìÌnÌe i\

\r \Í \t
ibiì1.ìn.(d budtcl nrúÌtlfl jrÌ)

,ÌrÌ)ì1.Ln.edb!d:€1m!lti)tierrrsuìtisiì!cÌ\jnÌoÌlrntorÌeitdors.old.Ìr.fdônlhe
..uÌ!tìtiinlthrttnres àrr er!!eÌìo!j. t hingcs.n Lhc h.tdÌatUÌe8o\tír.r!'nLsÌrc.dirg
i goodt !nd sen jce\ i-\:t ) i{rnerrtr'i rrtriÌ.\rLÌrul and inlonìt r6.l) 11'lÌcÍ(a5 Lhc in.Ìcrsc
i t.ìÌatidÌ ì.,/iirilirrA \prndiÌrB porcr iroÌr Li\Ìral.Ì\ t{) tlrbe rh! protid. Lh. good\
ì *n icer íli :lì. IitÌÌe\e t!1o B(rps hiìtr Llrr nrr. Ììarsnral pírpeÌìsill lo..f!umc La\
. rnnne.ìhrÌe, i e. { i\thriuneiÌÌú.2ìi.dió.ll.lh.nthrbrhn.rdbrLdg.LmuìlÌrÌitr
i .qtral tr) one. \\Ih\ I l}cau\e rSS|Lgit. ...sLLmttl.n ÌeDuins urr.hingcd rs r con
.ÌxeÌrce ot üÌe tdiltiiÌ)uiion ol spcnili.g tôNrÌ Hcnce the onl! ltrte.t ôn oulÌrtrt
.rc: l(rì the liót rolÌnd eltect !l th. g.Á cr. mcn l s furchasei ol Soods ind str L.Êr.
.e bxlanced buclgÊtn ltiplierresuliisinrpoÌLi.ln)ÌÌrractì(iìlpol.rÌrLLrtosts ago\'
iÌ!.1rhat Ì5 unabÌeorLürÌÌiÌlinil to u\rdcbLor moncrnnürirÌ!,..f sLllì Ìai\c the Ìe\ el
'irtiliq jr thr cco.(rn_r Ì)r eniragiÌìS iÌì . Ìrahn..d hudset erp.ndllrtrc lÌogrrnrÌne.
'r.:l7c.l th. nrLÌlhÌrÌier rtiÌÌbÊ pulLed dol!n Lìrlo\! onc olce tlÌe nìPirr ôI Lhc jncreated

ì:
'llò
.!(us.. t. thc c\trnl lhxr lìre ircreasc if !utfrLl lrshes it abor. th..qrLÌibÌium Ìe! el,
rìi ÌÌonrtirr ltoÌL!ì Ìult ( LÌl c(rne irÌto Pliìf lo .ilscL thr erpa.siÔ.arl infect ot the
r!hr. . lin..dbLtrÌgct.:xÌrarnon

.2 Bond finance
r .!\'eÌrÌrnrts tlre nÌoú NrÌ Ìrú]c1, lhc tossibÌe rtirct\ !rÌ igg f,'gatt .ltm! nd olthr jllo1!
_{ rtocÌ(olli!r j irÌihÈ rcon!nì!iÌ,lsing noN a Ìr.n(ìlìrLìr.cd dÈÌl.it hd\ e b.en iSrro(d.
.ì r\ e hdvr nu\ n lÌrtr r, ! riie irÌ !nt.rnÌnent tÌrt.dnrs \!ilì n.t Lnduce nriì(ient crLri
r\ Ìer enue io r'4t outuÌr (]t1ì(it.l. oLh.Ì 1!(r.Ì\, there ü ill bc ii.onhnuìÌìB req!ilerÌÌcJr(
r stlÌ bln.ì\ tu co\er the 3!p bet,rcc. .\ten.litxÌe rnll lrrc.Lr. The \tocl (ú gorrnì
Ì llÌl
_rrìrtÌrÌ s,i.e tÌÌe\ireoltlìen.lio.eldcblintheccorÌonll Nill nrt)tr.te!chverr.lor
:ìi(Ìrgr\thee(ononÌr rexúirÌ\itthcnctrle\tÌotouqnúâfdÌìrlntrÌn\anun(hrnired
::i nrtaì\ \tdÌce. uÌe So\ exnÌÌeÌìtr'llÌhal r n) selì i.lditi{rÌ,ì I bond! lo hnalcethe dehcit.
ihc ir!Ì)l]c!til!tr ol tlÌis lLefend o. inrtlÌrer g.1eÌrDìrÌì1 bonds xre con\idered Lì!
'late\rctorilent\toÉÌ)rese tncl1\\'nì0rj.tìrccco.oÌÌÌ.loilhfnr)De!rt,$ea\$ÌÌlf
lÌ.t: tÉ :lLi :t tlr: ddìr,al r,Í :u.,r. 5i !ì, i.r,Í,,,iìrrÌÌnxì.!dtrr!|. rrr.ìr! Ì-tlrt:t.an,rl
:nr:.ürÈ r.riraiÌÌ, isL.n:ilrÌiLt_ i r rriLnÌ! t,drrúLrÈ..r rrrlfìin(1(:frn!Li.:dìinú
::: !i ir rtr.h i.iÍ rÌI rJür.iI lìra!. Ìri iiI i,r ÍdJìr:,,\ Èlurlrì.tr
iì. i.a i.f \rÌ1Ì,n.r irÈ L,1hr.Âii
 ta0

thatitovrrnÌnentbo ds are üerved by housch okls a s .ì lorln ol s'caìLh Ì lhonds are Ì{'eail l
then changcs 1n tlÌe Íock ol Ìlealth $'lll influeDce LJoth consl!Ìption and the d€mani
tbr Ìnoncl. This nÌeans that the 8ov€rrÌÌìcnt has to tak€ ÌDLo accolürt the iÌnpa.t.:
jÌ:
these.hanges ilhen scltinia both ÌÌÌonctaN and lìscal poiicy.]\ bond lìnanced iÌÌcreasc
e\penditurc i!ìÌÌnotonlybringalro!t i shitt in the 15 curte to thc righL (dìÌect elìect otlhÊ
Ìise nì spcndjngì blt \!ìlì also Ìead to a íurthcr riillÌtward slÌìfl ìn the i.5 as coun'Ìnplior

ln additi,rn, lhe new bond\ lsnìeci bv thc govenÌÌì€rÌt ÍÌìÌl prodrt.c a PoÌtlolio €Ilcct
in tìre ciemind I(Ì nuÌcy. fte .lemand for money contains lìnan.ìaÌaealth as an argo
nrent. Àt a gircn interest rate, hìiiher slcaìth ìaÍes the denÌaod Ior mone) ! d bond'
jn pìoportion so âs to Nccp ihe poútìlio bnÌatced The conscqucÌrcc olaboÌìd lìÌÌalìcci
cxpanslon nr golennncn t spending i!il1 bc to Ìaise tÌìe proporl ion o f bond! to moncl nl
rhe eco onìy-si nce, by assunrptnD, thc nì o ne) nì pply relna i. s co n Íant. This !\'jÌl lcrd
ro âìr increasc ìn the demin.l f(Ì moret lo r6tore portfoli,r biììance. The IÀÍ cúÍtc i{11Ì
thcref(ne slÌift lo the 1eft {scc Iig. 6.L l.l

2.2.1 Are bonds net weâlth?The Ricardian equivalence debate

lrn.ìer spccjel assuÌnp1!ons, a bond lìnanced increasc lf
governmetrt expcndiLure will
have eractìy the sanìe cllect on outpul as a tax inanccd onc. Ìfboncìs are nol conii.ìered
âs net wcal!h bv housch{ìcìs, then tiso iÌnPÌications Iolìor' ìrn:t, the cons.quences oi
changes in ircalrh !s thc goverÌnLent\ dcbt üses disappcar and secoD.l, the cxpansi()nar\
impact oI the ï)endil]g pr)sraÌnne slìrinki ba.k to that ol a balarced budgct ThesÈ
tNo eflccls are irÌtimnl.ì) conÌÌectedr households do nol tìee boncls a\ nct ttcaÌth ii
they takc irkr accoufl lhe tact th.Ì ta{cs !n the luturc i!'iÌl hale to be raised lC) ÍÌ\'ìct
-.<
,-!f,|

tÌìe debt and t{) repa}'tìre priÌìcip.1on lhe debt. r\s notcd carljeÌ, dììi argunÌcf( ha\ r rfil 'dilü
pediiTcc sLÌctchÌrg back to the nirÌetcctrLh century clas\i.aì cconoìnít Da\id Ri.aÌdo_
and s,as rcvne.ìi th c l 9 705 lrt lìobert lJaro and is known as 'Rì.akÌi an EcÌui\'.le r cc
lhe Ri.ar{Ìjrn equivaÌcnce ÌesuLt d€pclrds on the lolloÌÌirÌil ass!tmPtioni:

. th. abscn ce of liq u idit! coÌÌÍraints o f h.u\ehoLd s, i. e. housch olds aÌe able to borroq
I .gajnÍ expected futúre inconÌe nt t|c cuirent iÌìterest ratej
I
t,
. tìre iÌÌterest ralc and tinÌc horìzon faced LrI holrschokls ând the Soverlnncnl ere the

. houschoìds ha!€.hiìdren or heirs and lncoÌntrat€ uÌe xtility ol thc!Ì hejN ÌÌ their
: lrdl
corìsun\Ìi(!Ì behavìdu, i.e. househcnds behave 'a! ii' they ÌaÍ forcvcr.

AIr$ a clear \tat.m.nt olthe naturc oI lhe a$unìpti.Jns requircd lo deììver Ricardian
cq r rivaìence, lohn ScâteÌ, in a nr el ÌrÌ Ìh c /oì rr"dl .)Il.ototll.1lreírrrl", con cll es:6

tinite horizoff, non rÌtrrútic oÌ hop€rative l)equ(Í motires, .hìldles roüÌrÌe\, ìiqnìdit:" cor
stnnú\, .nd unceÍaiÌìÌ] c.n all lead Lo iailrtre of Ricardian eqlilalen.e and it rcerì\ vútralh

Ìhr.l.hrn.rb.ut nì.hÌr{lth ( in Ìr irÍlrÌafds.nh (19731, i corr.tnìn n)

rÌìaLpâf.rif | Írdú ind soÌo\'(1976). Jrd in Râr r19351
 181

thrl I re
.eÌi.!ir tlr!t r,Lìc ,r tÌr!!. !r.trr!\ .l ÌrÌÌ rllrtr\rLin(i ff tprrrtL\e lt rfPerr\ Llliel\
r,.:lnii r ÌRl.allrrrl
Lh, coÌìn'.\u\\i(rfrtlt.rr5iobrlhrt(!ìr'gt\itrtì5LxÌÈìl!\ iìll oÌrLl piÌtL) oi srlLrt
-lÌingci iÌì trlrate \i.r.Ì \l\ iÌìgs: lhi 5()!r.t5 o ÌÌ(!Ì'qtri\rl'n'ti'LhtrriìÌu'rldnrÉarÌ
ÌrÌ,rL lli.!ftliìn €!l!ì1ilcÌr(e l! n(,1 a !.od rtP(\ext' ii" ol mr(rn'oiuìri'
lrthi'\ Lìur
:,r rlu ì 1. LÌrir i]lÌ]rle nÌ r'hrtiÜ t Ì)t.ir\c tlÌ' Rl!:Ílirn ÊqrLllaleÌrll rtnrll i\ aÌl
:!tr.;LorÌiiLheiÌtt'Lrml(ìrrllne(rIt.l .!rr5'tiÌri1'ì L't Ìht|!rìâÌìtrì1 In'orìÍ'Lite

I I lVìoney financed Íiscal expansion

-r nnil ìctlÌ.ü .r hrÌrn.i.g .LÌr i..rr,ìsr' ÌÌì rJp'n!ìit!rt 1\ 1lìrtu! r rÌì ì!ì'rcait i' Lhe
Lrri : . netiìr'r illt ii r \/l irr Lht!.\cÌìrìr..Ì iridgrÌ i!1('lrtt L' rntrÌÊtrrnì:' tlÌ( .-sfljtr
I Ìerú idÌ\ Ìr1rnL]\ nr 1lì! .drÌr.l brÌrl rÌkl jÌr"d\ trc rÌrlfl\ prlntÉd nr'11t] o'
:,:LÌrdltÌ,rclnlili,lilc.ÌrÌ., ìtDÌ\'Ì.1(o!ntrie\'lhL\Ì!i1Ìr'!LoiÌ)!bL 'hrÌirf'chr\ÌÌeÌr
liì 1\ú b! Ìlrt ..nslitntilrn .t tlr. ccrtrl Ì):Ìll Lhcrllí!ìi(r'tlÌish'ì\to(ìorlilhlÌrt
hotlÌ tnir t
..i',,r, ,"',.u,"i{l',",..t c): nr.rÌctrÌ\ ifrn'Ìì! \Íi!Ìr'LrÌ\ ÌroÌir\ 'anÌLìt
(lL\ru\i] l'hrPt'r 5 rrìd Ì)e u\r{ì at tiLll Ír
. rlnifiÌ rÌrhn, Ìor tlì. rLononr\ iì5 iÌr
r r.r !o!,rrrnrr I L c\Ì)rndLtLni
.ì!ú1!ìl: t.iì.!.ìiiL\jiìrSiÌri1'1tu,rLLonirrÍhrclìthtr'!ÌdenbllÌìeS'(eDtìcntlo'
'rlrì\ 1ìnrl!lÌg.tdrÌirÌlÌr\i.f uÌ5ttndnrgr\iÌr'1:)'ri\Ì'nÌrjÌh th"rÌìttulbaÌl's
rrILr poÌ1. mlc. su!prs. rÌÌiìÌ lÌrt i.tinL!r]! l' at eq'oÌìLrrruÌÌ cnrÌrÌo\ nrcrÌt 'ì'rìtiÌ'ìL
:.,1 LiIi5nL rlrtrrg.Lrrti llnrt!o\enÌnì'Ìúnr'Ìr'1\r:il\iPr'diÌì!
thi\ÌrilLtliggdr'
lirt.rnt bxnl iÌÌ nrrrì'et 5ìle\ bt!Ìll5
-: irc ir lÌrr iltrr.sl rati .s L
"!ì!f5 'rÌr'n 'l
: . ,iLthdr.rr\ li!l!i(1llÌ tf.!ì lhc r.L)ÌÌ!rììl 'unl li ihe olÌ1(ì\jLt'Dr|n1 rÌÌ Ìrìt)ntrìrl toli'1
:rìLhati\5o.iaÌrdhLtirrrf.Ìre! rÌ Ìl'dtÌt11\i!ì 1\(sÌrrÌlrrtulrLotÌÌi(Ì!t!1j'n
ì ìrfr.Lr\iìÌrir.úÌ!o g(^!''Ì!tLrL !|erìtÌl'! ìiì tht 5lcti'in altt 'e\t riheÍÌ!t

l! ó.1 tht \rnrÌ Ìì.iltii: L)itll!' üiltr L'.1Lriìhod5 r)t h.rr(irìg.uÌ l"reri' ln
n ÌeÌÌ1.ÌÌrcrdll!re rr. llÌurtnler.

Deficits and debt

.-: r. l. r( jÌnr!!]'t.ttl i.c (o.ceÌri ' tlrr gt\tlrìtreì1 \ brdget CcÌrti1\ rhj'h
. r r írrr..\ .i tlì L urÌd\i'rÌr!Ì:'tri'tÌÍ)fi\
r
ortht S'tr !ü|'Ìrt ! r'\fÊLrdLluir.rl
:_|lÌ,ÌÌ l .il.:ien!liÌìrcnlrr.t.iirtLliLilì\ingtlìilÌrtrr'rtliü"ÌÌlL!\to'kt)l
lt
: " rr rcbL lllìt rh:tllcLtÌ nÉt i]ìL Ì[ih'i ÌlÌr g'\'r]1r "Ì \ "bl Lr'r ilnì!'?
. : \'iiiÌrs.rilLjL.rÌrlrrLcri\i.SÌrdchÌÌit'h'
...: tl,r..ctrcsLl.Is.r.ern'Lìto nr'\t h'rLìÌLd rÌÌ. gr)r!'nÌeÌrL'\!rrrlc prrlt)!L
_, rrlr\ Ì\ t 1,rk. llìt inal\ s \ ÌÌr tli) rr'Pì 1ìr51 tr1 r\'Lu']t t1ìi l(ì\:lbjÌit! Lhai

i]1.]LìI1..1]l
 F

182

th( gtIrn]mr'.i !rÌì borr!1r r)nthr...iÌrlbiìnlirit.lllnlitcuÌu\rlh"Ìcationilìrisll

poÍded nìo.tv detì(iii \\:e \h:rlÌ ÉtlnÌ to nro'e\ lìnincing ìÌl Lh' ne!
Ìo rlnaÌì.r its
\rrtion Ì,rr f,rt. th!'hul!rL jd€rÌtii) ls r\ n)lloÌ!s:

t;
<z ìtÌ = I lli - ,rlrrìr r lü !, Èrrj '

\\'r trgif b\ .ll5lL.g!ijrLng triil\1'cn tlìr i.lLrrL {'Ácr'ÌneÌÌt d!'l'it rlÌi'lì Lr th' d
.!.ÌcrGb.Ì(retÌtoLaÌeaf.ndrt!ri indÌe!in'teiii i'L{'Ìl'LtÌì'ìì = G+il rr'uÌd1hi'
pÌimìrt d. ì.it. ÌLhl.h tÌ.Ìude\ tlìr inttrtn fll Ìtrrìls Ô' thi ü b1 1Lt trìnìir!deÈ'iL=
t; t trlrln},LtanitorotcuÌiìtthcsÌo.i\o bornl\ nlhee(oÌroml lhtilbtthe])!bli'
isc.ÌLÌal1t,Lhc\nr.kotsoltrrnl.rìl.]tÌrtItrer.rngngÌlrib!(lgctidtrÌiittntrtns't
that the i.L(rÌi! r.it i\ i!lrrÌnr thi .hanll lf tjt 5ln'Ì ot So\ lrnnrcnt l'bL

-\t: ú Ir '/l
.hdÌgc n (ìilìL = tÌÌÌÌi,l .ltÊcl1 + uÌtcÍsL oÌr (r!tr1i'diD! !L(b1

.|i.gc iÌì dci)t = â.tlÌal.lr icLt

li 5lhe !,:Ár'ÌÌnnc.l delìl r.lrtì\( 1o nalioiil f(1i'ìL'that i5 oi 'r''tÌdl |.o"tIÌ Ì\'

tltr'Í( iore lrlì fc tÌrt (lcbt frlln ar
d
r].'DL raro = I'

Ì!h.reIi\thctri.cÌÒelindÌ i\rril natioÌìiìl in.oÌììr',]rhi(1Ì rrx'iÌns lhdtl)l l: rrÌìl

ifnl .rtìlnìiÌl inconìr TÌÌ.nc\t\tel]l5lr)re\!'1cthÈbudlctnltntllrcqltratioriSo\enì
ÌÌrrnrlrrdgcL L!ìetrtiL!lÌr\.lnjdi.31lÌrorglìl)tr':.lhisgl\r\urtlÌei'LtLÌì!LthclrtL)(iDÌi

lll GT1l)
(,Dl 1\ f, t',

ÌrlrcÌ.1Ìre r.lio ot thl lÌiÌnrrl LÌc r.ìt to netj(! l ln.fDe ii:

Ì!ì!Ìli!i deh(il IJT

,i

lnnrrlcrn)pindo(niJìL'.ìetenrìirrents.lilr.gÌo(tlÌiflhcdebttoOL)l)Ìrtlo ic \/''
e Ì)egi. (lth thc dchrÌiti.n oi ]]:

ll ì)t\

us!. Lhi d|fro\imdtìolì that

,\d ì lÌ \| l] \l' l)r'\l

 183

rnd diÍlL1c.:i.lì sid. b! /) Lô S \ c:

rr tfll !f{ tla

't
i f) Ij |'t
lÌÌ /,-. \JJ.

. h!'Íc ns rLsu.l. Í.c rLrll. Lhc {,oNti Ìrte oi Ìrrice\ ii.e. thr Íalc oi LnÌlaliünr, +. r! - dr
:Ìr. gír1r1ìì rnLc o orút(LL ns i . tÀinH r - i .. !!e iret tbc .lÌortjng e\tre$jorÌ lor tlÌ.
.i,iÌì.{r'ln Lhc (lrbl 1o ('l) I riL ô:

-, ì)

i s tquali.n ÌrÌo\ides a toNeú!l ,rr! ol und.r!Lin.Ìlng tlÌt lLÌrÌ trilr dclcrÌLnrnt\ or

6.+l ' . gnn!rh otthe.ìebÌk)GDlrario:

rh. ÌrrlnraÌ) dtlicit Ìaho, d

I :lrr r(al iÌìt.rrst raii. r
rhe gnrilh !I ÌeâÌ (lll, .
- tiÌe e\istiiÌ! rìtio ol g.)rr'rlr.rr.t debt t() cDf. 1r.

.i Ne núLl see iÌì tlÌe hnat sf.Lio. oltÌre chatter. i1 irl$ ÌrÌ(\' t\ d kinÍno,k t(Ì
'kjn! dtthe iìÍ!LNle\ tlLrt !ofrrnnrcnt5 hx\ e iÌrtro!i!.r.l.r rÌrv(on\ilÈrnìtl|nltt.ing
ÌrtcÌfret tÌÌr e!uaiiorÌ, lei !s ron!1.ÌtÌ Ì\!o cd\ei:

' i iìsr ì. ihc rcaÌ rlteÌÈ\t rate i\ ibolc th. gt\tlÌr Ì!t( 11.r. I' ì I. Tht rrillÌnìLli.
trLeli.. ia,.a,l sar\ lÌret iÌr thi\ ..5r, lhc tÌcbl rt) GDI rilio ltlll be risirÌ! !n]rss d is
:-.:L \., i.c. trnÌ6stìrerÉì\ rpÌnnàr!bLrdA.l strÌtor. TlÌerÌplenalLonij nriìi8lÌtioú enll
::r thc r!.aì ifl.rcsr Ìate ab(^e tlìe grorllr Ìrtc. the iÌiterrst !â1meÌìti on 1lÌ( rrisli.g
::Jrirlsinsh!leÌtha.j\GDl.Ìl.iÌ.r'i.Ìlici.SlhcdebtirLr'r!sLL5punÌiÌìguplhcLlcbl
::r!.n Lh.:o.h1râ1 tÌrrt thi\ .aÌr b. oI s.:t \. lhalthed.bt ralio d1)e\ rìot ri5. L.. br
1r s IoÌ thc gt)renrme.t t(ì nrn iì prlnrar\ hudgel nrrplus

r r rie: ÌhrrLi intc(iL.alr'i\Ìrelor tlìrÂro Ìh riÌlc i.e I _, l. lrl!.r\eÌefresents

.rritn \.enârio i.onr lhc pfrspictí e !ltlÌe !.! clnÌÌrc.1 \ hndÌ.es. \ n.. the gr.itih.ú
: :!drÌÌÌ) is suilì.Ìrnl to (dace th€ nÌrpà.t of int.rctt trt nÌents on th. dtbt burllen.
::.li\eLoiprimiNdrrl(.iL s úinrìtterÌt üith,ì..trrstnfLratio oidcbL Lo('DI'ÌÌrcletdii
: i ,\ rrnnÌcÌlt sr!'rc Lo rLlrì a ÌrÌiÌneÌt nr$lus iÌr th s Í:enaÌio, it rbüld clttluaÌÌ! eÌrd
th n.!ili!!' !(rlti. dLìL lhÈ t!Ì)Lj. secioÌlL.uld olÌn 1ìnrn.iil e5tL:ts j$trtd bv thr

-:rrgram helttr nr (Laritv tlìe Irle(io.ìriÌr betiteen tlìr p.inrirr detìcit, thr I.al lf LcÌctt
. :je gÌollth rate. lrrithe drtrl râtl. and í) hìghlislìt thc ditlÉÌenft Lr€tlrrcn ( in: I
.ìje 2. \\r u\e d diairr.Lnì ÌfÌl)ì thc cÌelrt to (ìDl ratir, il) !n the horiz!rrtil nlls in.Ì
: r\tholthe!leÌ)tt()(lDl)râtiÒr'\rloÌ1the\erti(dlrris lhcÌrÌìmaÌ!leÈcit,rl,lsLhc
-rÌ)t tenr and UÌe reLationslì | bclween th€ real jrÌtr'rcsL retc, an!l UÌe 3r.jt1h rât.
::ìÌre\thenopeolthelirÌesh.jri.gthÊgÍnltÌrottlÌcLlcbtÌatio.Ior.rn1 rconoÌì1,

4.
184

lÌr 1r.dL Ì (lL\ th. rttn+rriiLt lhr't lirÌÊ' i1lìr frÌÌÌÉ l()r tlÌ. llrc slr'itini \l' rs i
tr)
t!rÌ.1 nf.l/r rrr]c.dlo].Ìon Llr.:.uDeÌrt ÌrriÌÌar! deh.it. thc reiìL|Ìtc1:L Ìitc:NÌdtììt
irÌflh {tc. TIrr Èri\Li.g Ì. rl o d.bl. /r. rt tiÌnt l LÌr.. teil\ u\ Ílrt[ nl ir. on Llre lhr\l
liÌ i ol..Ltrte.rn iss thtnÌitjil fti\tjoÌoiihtLiof.tì\ i\.rtlÌ.Iorir.ntrÌerirsìth
ll) 0. thc LlcÌ)t irii.i h Lll h!\ r.hifgrLÌ Ìl \!e look rl tht c.oÌÍÌnt iL i lnl('r LjmÊ
l ig. a I jÌÌ!rtr:tej.iÍ' I: tÌr rr'iilflocn iúe tr...LÌs tht !r.ntlr irir. ig a 2iiltÌror\
r!.fof. Ì\ r'itÌÌ ir prl t!\!1.Ìì.L.On.tIelnoliLhceri\tiÌrtsle\Iioi(lLìrt.ÍeQnÌì\
tÌÌt !.o..nrr \ |!\itioi tin th. phiÌ!r' llfe. But n.lr lÌret tlrt Ê(!rÌoLÌll I !Ìl t.t ÌeDLriÌl
\i.rtiüriìn t \ilÌ tr rrror LÌrg nlr'L I .rs( rÌoÌÌ3 tlìr fÌrr;t li.e ar rlÌiì\rì bt lhc rrr!Í'
\\'Ien n.1L .Ì)\er \ el. LÌ]r'deÌri rll . r ill b. hi!lÌ.r
lìB ar.l(Ì) nr(rrstìnr.on(Ì!\ (iilh r'\tr.t11 tht \irrÌ. i.iereri r!tt rnlli-lr.{rLh Ìetca'iÌr
Ii!6.lr,rrhrrtrithrL|i.rtrÌ\nrr'f!5rÌr.ncttlìeìLìt.(.Ìrtitbel.rtlÌeho.i7.ntaÌaÌi\).
Ìlere rr ÌìoL. thr \ìt!.,1i.,,ì r itlÌ ilìr i'dll r'È.t 1rÌitii ld.bl Ìatio\ lt rn..ofo Ì1 hìÌrl)trÌ5
n) !r!\ e l lf lt Lrl drt)t r.ilo \h!tr n Ì-rI tni.Ì.Ì it\ d.bt rrlio riLlL)t tàLliÌì{ iir tr(\\n Ìr\
thcarr!ri i. LhcÍrÌtlÌ 1!r'sltrl\ dir..Ll.. 1tÌÌr isihl!:'ThL\i\t)t.a!\iii 5eilltr.tiorÌiÌl
\ìrirh tlÌr trlrìrr\ nLrÌrlÌr. l\ nrti.icrìt I laÌgt t,) oÌis.L Lht I _ tr'fu.1 srr Lhrt tÌre.Ltlrt
irhrdÈLrtriLioi\!\iìtÌrlrrrLN.thtntlìidL:htÌairorillrcnÌ.ìirì.on\ra.t:uÌt
ìâti{) !Lrrlirìr5.
tLDrrlnrÌrLLslrc!ì!riLlSLie.kLrliìtioìn.LÌtÌrtii ,rtlLtltn!1\iÌr3i .\a.tÌ-\ottret
r'ach.ilrrr. LiLL i1.tr tr.rt 1)oLnt li i\ Ì1.Ì çiil1. rdi!hLi.crca\Êúrilrrd.bL riL .lrisser\
rncrrÌiÌ(i.nslfgdrl)lr]Ll.:!rllJillìliiÌl.rt:llnrg(1.h1Ìrljo.ìÌìrlÌÌopr.Lr'Ìrnnürl
\ütlu\ rrn r.ld lÌre !l(bl rrljo ir!Ì!ti fl bttt ll raDnoi r\ tigxtc tht ur i.hi.{ill.rtìi(s
oithr !i.bt Ì!hL.h i\ lrirliri.tt Lr\ liìr' ,.lrlLoÌìtÌÌ1f bL'Lícct I aÌrd _ ,\n r...om\ ÌliuÌ
x deL)t frijo e\ âl Ìri)int a l: .hrrtì.iiÌizcd b! rÌì e\.I i.. cr\lns rtÌìt irtii

Figure6.2 ìÊ.rir. rÌi i!-irt it. ai:. r!- lr'È:t rt::r.:.r,i iii !.r't iÊ
 145

(,'l

Di-"!d"fift d1

. tÌiggc.5
Figure6,3 Ìre golernm€nt debt rato aas.z Go{dr rate er.eed! Lhe rÊal nteÍe5t àt.

ijg. 6.3 illusüates the case in whlch tlÌe growth rat€ excccds the inierest r.rte:th. phasc
::i has a ncgrtive slope. Attoi.tl nÌ Fig.6.3íd), the debl ratio ìs risnÌg ìs s1ìo$'Ìì b-t lhc
;.1nrs to lhc sotrrh easr. But'lhat happens when we obscne thìs econonìy somc tinÌc
,:(r and lhc dcbt Ìatio has rìsrn t() the level sh,rwrÌ by point B? As lodg as thc prjmary
r.ìcit and inLcrcsL an.t grú'Lh Ìâtes remaiIl urÌchanged, lhe econor\'will rcmaìn al
- rìt li. Morcolcr, unìLke poÌnl B 1n lig. ii.2(l1), this debl ratio is slrrld:â sllght inffcasc
::lìc dcbl úlio will put the economy on to the segÌÌì."rÌt i{iLh the noúh wcstcrÌ-! arons
..ingil back !o lhc equllibÌium (and \ ice !ersal. Ho$,can tleexPÌahÌthis? lct uscomÌrare
-:rtljinlig.ó.2(r)withpojntËìnFii{.6.3(a).1nIii1.6.21}l,thetìctthat,':--,,nÌcans
: ..i Nhc. lhcrc is a sÌÌalì incÌeaJe in the debt ratio, thc itterest burden of thc dcbl
::::ìior.cs Lhc incrcase in lhe dcbi Ìatio- lly ..mtÌnst in lìig. {1.3(d), the lact that I < ìr
-:rú tlÌJt lhc incrcasc in lhc dcbt 1s danÌpeÌÌed bec:use ouqÌú gtNs iâster than thc
.::r€\t.osl oí thc dcbt.
iì. los'cr pâncì ot ììig. 6.ll shows the crse where â primary {uphú chaÌacterizes an
:- rìoÌìv ìn íaììch Oìc grorlth the real iÌúerest rate. As the .liagr:!ÌÌÌ slìows,
raLe exceeds
--:ì nn ccononry 1!ìlì convcrgc Lowarcì a negative (lebt ratlo. Ïre goveúrÍient ÌliÌl bc a
.::roldcr ol pÌìvate sec oI lÌnanciaì assets.
-..a. usc lhe dcbl diagranì lo erpìoÌe Ínne iúerestnìg cxamfìes. ÌD the lìÌltexaÌnple
i: ó.](d)), Lhc initìal sìtrlaLion is one ir rvhich theÌe is a primary dencìt, the iturth rate
. -:ÉdslhcrcaìinlcÌcslra(c,and!hedebt.atiolscìechÌiÌìg(allim.t,theeconom\'isat
:,:ìi.lljrlcassumclhcccooomystrddenì)experiencesariselnlhcinteÌeúÌateanci/or
, :..Lin lhc groúh .â!c so tlìal r > :.f. \'VÌÌat happeDs? Ìhe tcw Phase lìne í shown
: ::ìe utward-slopìng Ìì,ìc aÌìd the economy jrüÌÌps lìonÌ poiol ,1 to toìnt B. The debt
186

lrt )intn,Ljlri Lor 5r t

Ì)

Figure6.4!r!t.liiÌr'r:tritr'rr.r.Ì'.!r.!:lìtrriÊ:!.ï.rtlrìrÚ:rÈ4.1.!5:rii.t.rirÈ
ir.,i : ;:Ê :jj iÌ:n rl. .r :e .:i àt.

riti.:i lìcgins t{) ri\e rnd r,ill Iiie r!itlouL Ìimit urÌÌess lÌr( nL\'trrr Ìrte. groÌvtlÌ rntc, or lh.
priÌÌary dehcit clÌangrs
l.(hcst.ondeÌaínpÌtlFiir.6l(l,ll,]!clitÌoÌruksi.r!'c.ononr-tbuttÌri\iiÌne.Lsso.n
nslh.lllitcìriÌr' -r ô.rub. th! Ro!(nÌìent lnrÌxtinl(h lighLcns lit.alpoli(l solhât
tlÌc prÌmar) .Ìeiìcit js r.pl:ìced bl i primal] suìrÌLÌ\ iJÌ ). I his Ì!ot1Ìd fültrjre a.ìÌdnkti..uL
irÌ golcmment \pendi.3 endl{Ì rise in 1iÌÌrLlon. ll this .ould bc donc Ì.sLrntaneorsll.
thrn Lhc e.ononÌ\ rouìdn \ttronìPoint 1 ) Ì)oiÌìt Crnd 1ÌrcdLìt Ìrrio iloul.L bc
|.o.sLi.t (aÌtho!gh u.trablel.

3.1 The costs of high and rising government debt

h cìanrtÌe\ r. hiìlc dircrL\ed, it is .lc Lhat tÌre cott oì lÌillì pubÌi. dcbl .Ìjíteìr
LÌrc
a..o.difg to Ìrhether lhc iltereÍ iúe is higÌrcÌ (Ì Ìo$eÌ than the lrortÌì raLc. ìI the
Bl|n!Lh rrte is hiilhor thi. lhe ilterrn rnt., 1lìcn lhe econon\ Í
(olr\ erlirÌil Lo a !hbìe
dcblrilio therei5no pnn)Ìeni l!ith íl\rrr.1'. lhetÍ)bÌerìatic\itrìrti.Ìri\.nclnnhich
lhc ft:al interett irtr .{..tds ure tÍxlth rntc. ,\llhough the latte! hìs l)een tlpÌcaÌ ol tbt
ed\ en.ed ecotrclnic\ i. tÌre lasttÌletrÌ\ !(irs.1hc lonner $ at (haircteisticoltlÌc p.l\ nius
trrc.t1. Table íj.1 pírçidts datü lor tlÌe L 5^ ênd Genn!Ìrv. It i5 iÌÌteÌestirÌg to .ot. thâl it
thcl.er s hen uÌ€ groÌ!Lh rate e\(eecLed ilÌc Í.al intcÌett Ìrte, it Ìlas ne\ e.thtless thc casc
thar the ÌeaÌ rate ol rclúÌÌr on caÌ)ìtal renÌ.ìnìcd ib(\'e the gÌ(^Ìth rate. For the etolut oi
.I rlìc .Ìebt irti(). il i\ Lhc rÊlatnÌÁhi| bènr.L n Lh. ÌeaÌ guLth ì{tt and Ìerl irÌtcÍr:l raLr
on golcDÌnentcLebt that Ìnxtter\. LÌ the.d!arì.dl !ou.tÌier. itìtt\licrlÌ\ th!.asc llrnL
 147

Ìablê6.Í li.r.: àìil :i it:s. r:trr.

rj r rlt rii r'

;r realìÌrtere\t r,rt. on gol cmÌnent b..tÌs À úsllÌee. I hls merÌÌs thll Lt Ì5 $ell bll.:trr Lhc
_l rrÊrìlretrr..rf ì(1i.\.c5Ì Ìenl.r
ì\ Íe lìsre sccn. ltiLh r - _ . a subslrntiaÌ lrir!.rr\ suÌÌlhr |ìi\r hc required to stÕt
... debt iio ri\iÌìg tLl1hcr a.d rÌÌ r\ c. Ìrrger Ì)ri ary !uÌnu\ i\ ÍclloLÌed to.!durc lhe
: ,tbu en. lhisisllkcl!Lr)lrertrfroìrleDtntrtlÌ.r..nonr\ nrr a nuÌnber ol rfnírns
.:..riììS uÌe pri \ suÌtlu\ eìihrÌ r(Ìuirti Ìì.riÌriÌrl .tr1\ ìÌr eipcnditue or poliLl.rÌl\
.iLìÌrLaÌìrr.rca:cslilaxalL.nLle.iüíotthelrsuppl!\Lüeelircl:i.createsilìlnxalLon
:- il$ Ìil(eL\ t! Lìi5i' rqriÌlbrjunr !nrmÌrlovnÌetÌt rlrJ sÌrrtÌs loírrì and to |ì.tri! nrâ.nr
: :,rifiic DrarÌailenrc.t Ììorc Lì1iÌìcu I A high le\el oi debt uÌ,rt ls ÌLsi.S Ì!iihoüL limit
L lljgËeÌ (oÌ(exl\ lhaL lh. goreÍnnc.l Ìna) letau]l .. it\ &bÌ 1 Í). the 3'r!.írme t
I ri., a hither iÌÌtcr'csl ,41. oÌì itr bo,,osint í) in..[rrate t]ìr trtmjLrnì IoÌ dcix!Lt
.. \ highrÌ ìÌrtellr\( riÌ1. rlllÌ iÌr turn ir'ed back to 1lotren th( drht l)x .r a! (eLÌ as
:rlrnjng ìÌr enrÌx'rìL lni.Ì.Ìiti(Ìl,iÌ1soÌneIoirÌi,.r..lLttoihLgo!ennncÌìlÌrx-lrlrec!i
:: l..o.hnuet()hrÌJ..ciLscxÌ)trìdjlrtr!thtS!!enlüc.lnrì\ r.soÌttonÌon'Ll7i'Sth'
..Ì ìs.\fl!iÌrd iÌì th( fL'Ìl!rctioÌÌ.
rL(1fÌriniÌÌtsuÌcnrc.hâÌrL.soltlì.d.,bl.1)DrÌÌìi.s.rÌcìrd!.nsstrDedthilLh'inttrest
:- J riÌ LhÈ grrrtiÌ lilr air c\oËexN5. H.rer er, ü e lìntc Ìu\ jìighlrËhted tÌrc lotcnti!L
..,Lr,r.k rt!ÌthrdcblraLloLotheiÌl((i$lÌaÌt lostcjfh)tlÌismrLteA.Lctu5'o"lcltr
: .i5c oia i{(tr ennnrÌì1nP.ÌrLinS iÌì thcbenisn rtliinc in \ hi.I llrc gnn\tlÌ Íalc clceed\
:riilLnleÌe\ttute.15r'clrileretnjlìllrlsÌe!ìÌ!e.rprimaÌ)Lrudg.tdeli(iti5.o'!Ldent
: i slrìte clebt rntio ind a Ìrrger pr nrrr den(it is i5írciated \! Lh a Ìrrg.r dcbl Ìatio
r ghcÌ ir tlÌr drlìi ril o, the rÌrorr tul.crabLe i\ th. g(^ernnìcnt 1Ì1 tlÌe r!c'l rìrat
. (ÌilLonthiP tietrlr(n thc gulih rilL: r.d tlìe Ìe.rli.ttreÍ ral. bcc(rne\ idlcrsc: it
i i. u..ìeúale r br8$ ls.il rjglÌterììfg Ln orcltr t() \tcdr tÌre ri\i n lÌre debt Ìit n Thi\
:j hLljt\ mr) irÌ tLrnì Ìcad ro a ri\e irÌ th. rLsli tieunrlrì end tiSSÚ súch aD rdrcrs{'shitt
itro\ide\anrr:u.rcnliorlhetsoffÌnnìentn)be(olr.cÌnedaborLLlhe\ìreolllì\:dcht
:,.iÈn$ÌrentlÌ.rr 5.o Ìnmedirt. th..atoian eter jn.:reì\iÌÌÂdcbl Ìati! be.iLrsL: Lì1e
- :.1ir rate i\ !borr thc r.el i.Lere\t ritr'.
.,ìiniÌln. ìi rrttr ll.ú \tn. \ i-i.rr\ rit, trÌi.rLÌ, rrrlrr.rrLlr .Í.rrrdtlr?litrl d' 'ir'trtrll
..1i !nrì,fi:rìtr\ihÈr.fui.iiÌ irnr rr ir!.rrr.:.nt!r..:lr.d dìr.ffn ir!.iir.ìil
í

The goverrnnc.fs úrteictrPoral budget idcnlitv can aÌÍr be iÌÍerprctcd as !ts ítverr.
corstÌaüú ând as the ÌequÌrcÌìcnt tor tìre âbsencc {)fa.lelault risk oÌì its dcbt $e bes :
Ìth equation (ó.6), i{e assuÌìc that tìrere is posìtive iiole.nÌrletÌt debt (Ì c. l, ' 0) a: :
ÍocuroÌÌthe conditioDs llcccssary nÌ thedebt ralio nottu i!Ìcrease, i.c lo.ar:0:

sii.e^, d 1,' _,' .|.

Lhis nrpÌics thaL lor ll' :: 0.

ba '1

\rl
ln order to irÌterplcl tìre budgcl constÌaitÌt irÌ thìs wav, ive haw to thìnk ol each \.:
iblc il] leììÌ\ of its 'long Ì!n'or 'fcrmanent'valrte. The equâtion says lhât nÌ ÌoÌÌg I
sLìnniJrabiÌitv. $/itÌÌ a lrìlen lo.A-ru real itÌtercst rate in excels olihc cxlecte.l ldìg rj
Sror\'th rate, ther€ must b! a lo.g{uÌr pÌtrÌÌ.ry suìÌtu\ il dte debt ralio
is to be c._
stìnt. \'Vhrn lnterprcled in tlÌis s'iv, âs ire \haÌl scc ìn the section oÌì lìscel polic-v n; -
l)eLo$,, this e.Ìurtion prolides a nlclhod fi)r evâlLrating tìre núttnìabilityol a nscaÌ pol -

3.2 The costs of Íiscal consolidation: cold turkey versus gradualism

lnthc previous chaplcr on nìonclaryfolìc|, we discu*edthe choice fâ.ing agoveìnÌÌì.:
thal (,ishes tu reducc the intlation rate. Ììr the prcscnce oflaia\ iÌi the,rdjuslmctt otra!:
.nd prices andLÌ ot lniiatiorÌ cxpcclaLir)nj, the govcnrment face! â tr.dc olt betw€€r:
rapid lãllin inUâtion a.conÌpiniedbtaPeÌìo.lolhjgh unemtìolnÌentdÌÌd â moft:grad:.
lall j,ì i.flatìon accomtanied b)'a longcr PeÌ1od oI adlustmcnt but with a lorÌct teak r:
u.cmÌtÌo-vment. lhffe 1s â siÌrìiÌnr lradt oli wheÌì lhc govcrnnrent seels to rcduce i.
dcbl rallo. The terrn Í'rL?/ rotsrlirtrto, is fÌequentìv uscd to Ìefer to th€ implcmcntah.:
oi lscaì poÌic). so as t{) achi€ve a sustaÌnable debt ratìo The ha.le olf LJet$ccn a 'cL :
turkc)'and a'g..dualirt' \trateg-v oi lìscaìconsrlidnllon ìs illustÌâte.lüÌ fig 65
lhc econoÌÌÌy bcglns atpoirt.l úì a siluatnm lvith an unsuslaiDâble debtproblcm (nt::
lhaL rhe losi ol lbc arguxÌent appÌlcs e.ÌuaÌÌv to a sll(1ation in irhich the elistilìg d..
rario, aìiìÌouslÌ .onstânt, is vìeNi'd as'l(Ì) hiSh'). Lct us slLppote that the governnrÉ.
('islìcs n) re.luce thc dclrt to th€ levcl showD bv poilÍ 1). lhis ill be consiÍent 1\'ill i
/oL1,er ìong mn primary slüplus Lrecausc otce we achieve thc lowcr dtbt ìatio it l) 1..
primaÌr su4Íus necdcdto ollset tÌìe i.terest bu en of thc dcb! ìs lorvet lÌò!e\er,t.-
goÍcrnment cannol rcìa\ 1ìscâì poli.y immc.ÌiateL) to the lüìg'núr !rjnrary ntrplus. l:
.Ìi.Ì $, the debt í'orrld iiro forel'cr as showl by the arrorvs to lhc noÌth ea\t.lo.:
the oúgiraÌ phasc Ìlne. Ìnnead, thc golc rmentnì!sttiShtcn lìscaÌpoìicy. One Íratca
wouìdbe to rìise lhc frimary ntrplus 1.) sL, lhe ecoÌÌoÌÌÌy $tÌrÌd go lrom Ìroint,l to poi: '
/:ran.t nrove louth \!cstt(níard point C Onccthe desir€d debt ralio is Ìcãched, the Ê5.:
.t .-.l,\r rorl, ^'- rlo\'riôr"l lnr. J{rJ.! 'r.
dcbt redu.tidÌ thccostìstlÌe\lÌarptighlcnjngolpolic! nìitiaÌÌy.
 149

iigure6.5a!''p.:Í:|.:tLrr,r:r...lrri.r;rl!;ir!à,iirir!,..itJr:1..:!r!ì,r-.ìÌÊ.i er:

lÌ\)li.!
\lirnri(l!rlr. rlìÈ 8.r erxnerú (!!Ld opi ior. Ììorr lradLial foli.\'. Ìaisi.g the nnth'\
lrt c.olgh L. let tlÌe È(orÌ!Ìr\ nrÌ tlr i 5oüllÌ Ì!!(.rh ÌìLlì ilo ! ì liter a |eÌn{l
: ..bt rrdu.ti.n tlÌc :ôennrrÌìt .ould o..r' .qiì!Ì riirLsL Lhc \RÌtlu\ í to r" rnd Í)
tLn\.ri ilÌt Lonil nui r dlLìel. lÌÌeproce\süo!ld.otÌiiirLcrúrtlÌfojltllÍ!\rea(hed.
im
ri ii r Sful!rlist plln\ drÌ!l tqujre\ lre!frrÌt rr.ìli!ÍÌììrnL oI lhc Jircrl ìanre t() el\e
r! i.!ÌÌoÌrr\ t{n\rf.Ltlìr l1!Ì3 nuÌ nrnrirÌirbk posilioÌì lu51 i\ j. thÉ.ti(u$ir!Ì ot (r)ll
.:ie\ \ rnu\ '!iúrìrÌi\nÌ) iI thc di\irú1.ìtion nrat.!r .hoi.r'. lhe e\scr!ìÌeÌri.t the\e
:rÌÌr!ti\ e\ det)ercl\ on the tÌelcÌerÌce htr(ti.n oi Ìhe !!\..rnrerl.

: I Can fiscal consolidation be expansionaÍy?

' LÌridl!.u\!ion .I1h. ..!ls o ll.rl c(Ìr\oLi!lati(ÌÌ. it h!r b.rJì nss(rÌìcd !) fxÌ thdt aÌr
:.(r5. i thc fÌ Drrrrhü.lfi( s(LÌtlu: iL.t. e Lutir 3(^errnnrnt rÌprndLLLrÌr o. tÌrr1\
\. ..nsrLrÍfti.. or if!.51Jnc.Ì endior a Ìi\e Ìn laxalL.nl ÍilL lÌ,rr!' Lh( nrol'l ür (Ìl
r(.f.L o {lrrlngLhrlr!!.lo o(lttulr.drri\|r!uÌrerìtlt)tnìrnl1b.ri1trrlh.ll.trtre
:iil5tolhcl.ILr. \rg!.rrÌrL5lÌiìrr b,:.n dc\ cl(Ìrc.Ì tâÌtÌt inre\püú. lolhc.rp!Ì1..c.
rìn_nì .nnnrlldilion l. thc Ì(rii{\ o r numlrcÌ oi IuÌoprrn.o!nlrics LlriL r.o.
,iliÒ.eÌ\ slr.rL-rLLn . l..L .ìi! ..1 .c.cs\aÌjlr occtr . Thr nrndrnl lr!.d .11.. Ír)tr1{Ì
: .r. !mrd lI Llr. ls.iÌ.rn5d dit (,. hr\ ÉÌtrr.i.nrr\ elle!1\ \!11ì.lrnLl\ sLÌo.g trl
. Ìi.i:h thc !trf{Ìird..f L

L' tt ir .\ Ìrr nri:hl lrscxl .oÌìítr.leLlo. slrnrtrlâlr rggrrgnÌe ddnaÌ(L? Ìithr'.|.oroÌr! li rliÌ'rdi
i slrtc.l \. .allcd l{:iÌ sL(-5 r'if r.nLtainible lisceÌ Ìr.ritiürì. tlìrn bc.e(r5r ô Lhr'
.ri lÌ.mltrnr lhc i.l.(!t ÌiÌ( ÌÌ ll b. hLlhcr ihxn tr ÌlouÌd Ì)e otheÍ\i\r. lf idd Lln i, i
. L\tc.txlÌtìnoi$nr, liiÌr(lo r.itl!,lr.u\eh(nd\rrxlhrrrltirelrdth.iÍr5trìlLr5nI
: lr h1.alth. A t s.el ..fml d,ìr o ì Lhil ris l ith d l-.r lÌrt ÌruL)Li! r\ .rrdilrk nÌa! blosL
ÌrL.r'.!tnr.nti.d..nsrLnrfLionbItrllu.i.gth.ri;litrcmìLuDdrrLrenlriü.1lr]rtlnr\nl
ì.it fÌf..r(1Í câltlr.
190 :i.: :::. i. : .

govenìnìcnt announces a I'scal

Less.liânìatic aÌg!ments nÌay also hold weishL llthe
(e il the pubÌi' .! V onetiziÍ
.,r*;i.r"tin. plo. tt,ot is baled on cutting SovcrÌìnreri conÍmPtion or raisìÌÌg taÌation' thi
sectff wagc biil) Ìathcr than cutting SovcrnÌÌìcnt iÌÌ\'estmeÌÌt
signals a conrnritÚrcnt to nscaìÌeform lhis nÌa)'lltì
hou\e
Oì,Ui'. "'t ntt"* n]a,,hjs
tÌÌa1 taxes ìn tlÌc ruturc u iiÌ
i ,,iar' *p"ct"a.' .t,tretime weaÌlh because the! believe
not llqui'li1-ï connraìned anc
n" -""'.ii'""rt,n ,""' ,rP, itÌcn ior houscholds thaL rre
luturc income' their conlunrptioÌl
aie therelore .bìe t; horrolv àgaillst th€jr erpccted
..!,.l.np\' i,lil' \ ,J.r''8ì pr'rnórrr '\'ii'!l ü \r f'Lr i r/"Jlr-''rr' ur
..,,\. rê ,,n ,, \ 'r' 'rr Inì'r"
"..;,: ",,.,"..\.,Jn.,r,{ expecle'l luture inleresr
in" tn*,,," p.og.ÌÌne isb€lìeved 1o b€ ân €ndtrrilrgoÌìe'
"*r"rt,
râtesiriÌ1belowctas s'ell A5 r rcnrlì, ürvcstmenÌ will
rì!e'
than slnrplv lhe sìze ol lhe lìscal consolidation
if," Ul"o ,nn, lhe rorqosiln'r râther
imPacti\ úÌtereíingonc SoÌncerÌÌpiricalsufpoÍl
pr.St"*"*U".-U,*tis shoniun 'n lìscaÌ consoÌidati'ìn in t1ìc 1980s and
'u,.ì1,, o p""'**a Ìn thc stu'lies ol ìiüqrean
of !he DrogÌânìnres: cuttins
rlV0s.t rlc -gu-urL, centÌe on the eripectariôn.l cílects
bcìlevc'ì to bc nÌore costÌ! in polilicaÌ tcrms than is elthri
g.t".t ... js
"t".,
i*,t,tg g"*-.-, "t-ptì(,n
it*slnrent or raising ta)ics Hence n govÜnnlerìt embaÍldÌg on a
p-"".-e ìraled on Ìecìu'rn)Ìrs in consunÌnion nÌ'v morc etïecrlveÌl
.;;J;,.'
nscâlrelo n and hen ce Ììave a str)nsc t ellect on cxpe't atioÌr '
'ü""iti,l,'..i',,*'
irr th€ PÌi\,att serLd
-'
"n,,.t
cct comPelìtidÌ mâcro modeÌ highlighL the need
lo takÉ
ìit"ì'rrtgn" r.."' r,," tnrte
ì;"" o.u-".,.g,he imlact of a 6scaÌ conloli'lation ProgÌaNne ol
"..ou*
. the nrpfll sì.le iÌìPacl (úthe con$lidatìon poLicy'
. rhc stance ol nrÌìe arv policy, lnd
I

. oth€r ÍìpPlY sidcPoLicies

uneÌnplovÌÌÌcrlt
Iorc{aÌÌ4ìe (onÍnidation via hiShcrtaxes iiÌikclyto rdis'cquilibÌiurÌì
i{iÌl lead rr) nuìclaÍv poìic-v tight€ning undeÌ
f,r." ili..,t'1" i, tr,it"a o.wntards)
and a
conúatt' n coÌìÍtidâliitÌ basecì orì cuts Ìn püblic
an inlatiof targctiÌÌg ceÌÌtral LJank Lly
ent 11ht
;".;;,;"; ", ó.r;*t o, i lreneF ts 15 lik'ì)' to lox'v equilibÌiu nì uneln trovm
I1.J cu;e shìlìs {Ìoilrwards) and permits aD
castng of mori.laÌt Polic}

Ì 9130s-and 1'l9O\ s!ÌiailesLt that thc inpact

oì the Progrimme! on output irÌ the nÌort
^n,.""1,"r'roi,,*4",^tfsoflìs';lcotsoÌidatioiÌpìogramÌncsthata'ererÌìpÌeÌÌrcntedin
the
nur was 1nÍluercerl by iÌìc balance betwecn expcn'lit\rÌe
cutt and ta\ incÌedscs ìrÌ the
d\ l|pdí ui
'.-,'l - 'r"rJ\uol d 'lr''\''E '
.",,'., , .,:.. 'r . .ì .-lrr'
". l ' 1 ,

. exPcn.Ìittrc bascd co.Í)Ìidatlons'

. in\tenr c ntatjo n .Jl a .levallration of lhe exchange Ìdtc' arÌd
. a ÌLage a(cor.ìat the sarÌe tÌm€ as the 'on!ìlidation rr)

! íc, nrexrnde,1!\nìr. PcrDüi, and l! er(le93l

; adrsni (r e!8r' For r rc'eni \uüÌxrr orr Ì'c e!i{ì'nL'! see ÌÌÌr! t2or,l
' ' ;""1;;; :-;","i
"..'',, "",ì
 191

- Monetizìng the debt: seignorage and hyperinflation

. S(n enxnlnl h.5 high d.ht aÌrd i\hr5Lor.fli.treÌonÌiì.ÌiL.ore\ParÌdit5(\f.fLl
. lL!r (.n ]t d.1lìli i L.irlnotborl.ìrtrÒ,cbc.rurcuÌchlghÌÌ5liotthegor.r.mc.Ì
. ÌliiÌÌ{ rni]lei ihr t(rÌt lr ufltiLlirS tr lfnd ind il is !usi ling oÌ un:bLt ttr rils. Lilctl
.Ìr rurto.oLìsldÜLhcLúcolruÌttiìr\ lrâncLnËol!.\(,.meÌrte\Lr!ÌÌd Lurc
:iri\ \e.ti0n r'i shrlÌ c\tÌoÌe:

:-inidtunì,ufimdjcxtl{!r\oltlìcmonel.ìrÌìn!n.i.g.lËo\errìfr(nL!Ìfcndit!rÈl
.r..eúnrÌtirtr.fnLìì.)nLtaÌ\ lirnÌì.ing,i.llilLon,tlÌr' nlrtjolt!r.ifd
!il\LÌÌÌ!r r
. lj!Ììt\ 1! lorr Ìì!.lr \cjgÌÍ)ü3e.iÌn hr.oLÌe.te!l lrÌd Ì!hìt nÌal ..r.túrl l(,
,:rÌriÌiìtiorì rÌh.Ì. ifllxti(!r tor5 iÌb.1c iÌìe rate tlìil rr.LÌÌd xürinrlTc lire
.Ì ÌÌent j \rlÂf.rag. rc\ rÌN..
r,..r\u!'Lh.\r (Ìtr!nr(Ìì! \el,:,hr.Ìin)the!tÌÌ(Iil l(,ÌnÌoiilì(gÔlernnrtrÌ15brLdgct
. ! ai li\Ì i .:r..irÌ1j.Ìihi.hlheLÌ\eolhis]lto(tÌed!]o!rr\lsrnaltemiLi!r'í)LÌr(eoiì.an.rl(l

liiti-1

.r.Hiihght(rrtÌtdmonil rnd broiìrl nr.fr'\'ìI. i5 \í=iH lÌhcrt{ ÌilPpal

:. Lr,Ììll.g ioÌ niÌìrtrrt bis.r multiPLirr. sL'c tht \Plcn.Ìi\ to LhrttcÌ E h'r th.
r:i.l] oi thchaÌr,iìÌrS orÌÌìonttaÌ\brriim!ÌtiÌìÌìcr'rll l! straìBhiilr raÌd tr) nÌ.!l i
- r,i.r'.faÌ) ! \ n) iÌÌr[ì& nro.tI hrÌ,ìn.r:

\ LÌr fub .
ll- (; r úr \II
r ft ng LhÌotrgh 1r\ L)elLìrr i h\ .oìÌirÌ.ri Gl )'. r'e ÌÌa\ !'l

V]GTiT]-\H
'I
\r1 "
nt
_ ql,
.ì ll 16 iir

:,rj\thegrorihririroirlghltn\'cÍ.dnr,)tc)rndlri'theLìtiooihighlor.Ì!'d
Lo .ominaL CDI'li'). L.llorirÌ: ihr !rm. rtuÌr\ i! Ln \e(tioÌ1 l. 1!c deri\e thc
rlon Ì!rthe(hrÌÌ8ciÌì lh.dÈlrtrrtjÒ

\l] J i r _l1r :irll

tl t'.b'rlt

À
192

lvc caÌÌ scc fÌom cquatio. (6 9l ìhatthc iiu\'th oftlìe dÊbt to GDI ratio tliìl be rcdtrced

to lhe edlcnt that the dellcit is bcin3lìnanced b,! ne$r ÌÌì'nley cr'atidÌ
l.et !s Ìook Ìnorc cÌoscìv at thc termirr /r. lve knoi{ that herÌ thc ccononÌ} i\ iiì
l.,1',r I lr' u^.r. i { t|río i 'r 'i uJl
innation, ancì assunriÌÌs lhe LJantlng muÌtipli$ í is we lÌâvc: :'! - .'r : ;'
'onttanl, /?reÌÌ irìs
Hlgher innationwill Ìedüce the gtrNth ofthe dcbtÌ'tio assLtmlntihal 'on
st;r.1his has led 1o the use ol the term tíl,riflÌ tdÌ to reÍèÌ to tìrìs elho'l of lìÌancüìS
ìelatcd ternì 5rr.('oÌ!r-g€ shich
solcünnc.t expendjtüe. ltttkes us to lhe closcì-v'' '"r!'t'L€s'
able to nnanc€
ìs ,rs"O to ,"r"t to lhe ânìount ol Ìeal exteÌÌdÌLuÌe ihc iao!'írment is
seignoÌage rclerue is lheÌeforc
through its rhilit-v lo cÌealchiSh toÌ!$e'lmonc-v

HP

Ìn medium run e.Ìuilibrlún, 5 "i, (ô.r 1

A\ a prDonion olrcal CI)|'j, telilnoÌtìgc ú

'ri=t'"
the finâl term ln tlÌe cquation lor thc changc in t1ìc debt ratìo ir eqüati()n í6
91
which ìs
The dehnitio. oi scìgnoragc nrggeús tÌrat the goYerÌÌtìent can Lììrance moÍe of il5

crpendilure tlìrough Í:ìiinorage by raisúÌg lhe i+owth rale ol thr money ÍtPpÌI an'Ì
beìÌce ìr) Ìaisl.g intÌalionrÌ \\ie have alread) teen in ChaPier 5 that high and
Ìi\ing
jìrÍÌatioÌr irÌìpos6costs oÌrthc ccononr) \\csìraÌlnowseethatthereìsalnnittotheertuL
k) $,1ìì.h reiltnoÌage can l)e uicd as a Í^rrcc of rêYF'rrÊ 1'nd as a Ìnethod oì redltcilA
thc : Fiscal polic
(leht ratú). l:he ìiÌnit arites bccausc at üÍLnlìon Socs up, thc putrli' Lrcco!ìes Ìcss i{iLlirì8
n) hol(ÌnÌ(Ìrcï. Recalì Lhe con.lition ntr equìliÌrÌi!n] ìn t1Ìc nnÌÌey mad(et:

6.Ì2ì
(ï)'
= Ltì. y) (6.i3)
t lt + r. ),t. í6.1.1)

Whcn the groirtlÌ ralc ol tlÌc moÌÌcy suPply an'l lÌcnce ìIúlation aÌe low' the dc'nancl
ìor rcaì nÌoncy balaÌìccs is high aÌì.1whe innatìoÌì is high' thc denìand l'n real nìonel

rrllìeLcl1ii,'ÁhipLrcnrecna'f13ênìl.nnin.tlì.3r*rdrLalrIldr?nÌìnliLtlnvrciSfotugeÌ'(nuea!a
FrÌLrnksr.t(nrl'ifrl reaferiS.l)ufS.rden.ilIoritslÌ:f'llrÌruinitnnr"rntie5ìijlunntedifliguÌel'
I i\.hÈr, 5ihrt, ard \;.Hh 12002: 8ii]
 t9l

ìilii.csi5L!s:ie.ìnif.rcis!i. nlaLl.f /e!/ÌllÌ\ tlÌcdcrììiìÌìd nÌr.r1nÌorÌer balances

\.: n.\! subnit!te dre LÌ!ÌÌa..ìI(JÌ nr.ncl j. (o the sr iÂn orltc .ÌÌìrr\sior], re hd\ e:
! -{
Ilt
=r,,,
,lrilst hiqh.r nìlner grrrth (and inÍlrtion) t(15hr5 u| \.igno,iìA( rja th. tuÍ ternÌ ü!
:-lürtionia l5ii;1.ìt|ushe\1t.|rr.rjârfcscrondLrrÌìlil rrlo!Í.Lhct.ìr.ìn.rlos\.
L.hnsufLhcr.teott{\etjr)11{r.Ìhj:c.$.,: has(hccift,rro rcdLL.lfglhctaÌLì.\e1irÌ
' i.esr, rcilrÌroner tralarces.ìemar.Ìed. +, issrLnri.g 1, ls..nslenLr L.ìprì..r1Írlir.!
..rgciL 1lìnt tlÌe sec!rÌd cifect Ìrcginr to ouLrll,igh Lhc l rst .tft:.r r{h.:. i.llnl oÌ1râtrs 8t)
.rlrÜ Llìin nbo!t 200rr,i Ìr.e.i tìri\ 5lÌggcsLr Lhiìt lh. mr\iÌìunr rnrotLnLol rcvtn!t th!
-rr.rnnÌcÌ1tcorìLdrairetìriii[\11ìuÌdbcibo!tÌO,,iroGl))]lrcsc15li.ìitcsiÌì.1i..1€
'rÌ qtì cr nerit trÌricrlÌ\ c!Íail theiÌ us. ô sfìgf.rig. n.L b..eusc tÌr.v.r. .t,r. tht
(ú.r01
r\ ÌììÌr nnÌlunt tÌrat.aÌr hc colL.lt{Ì btrL .iÌlhcr lìc.iLú. th..osLsoIh gh!rjnllition
ìnrigh tlìe tierÌeÌìti.
rar 11r l':r.!rì4)letr tlìe dit.u\si.). ol r:L!noÌagL:, rfc LurJr lo Lhc thcnonìcnon o h!pcri,rlla
r, HtpcrirúÌati(lriru!uelh{ltrnedasasitrleliÒ.i.lihichthei.fliLio.raLr: si.(r.css
)itÌ ltì tnúülh (rur .Ìj\.ursjon í) iaÌ doA fol anÍ!cÌ lhc qucstLon .I r'Ììr ifllaLio.
\ihìslÌilhnÌ(üldoccru.IicÌrhiglrLnlâLio.lsdrivcnblrhegolcrrÌìcnr'sn(dLo
: . Ììrrlti erten.litlÌr, r'Ììr sho'rÌd i. nil iôn risr iÌrov. lh. rat. et NhL.h th.: mi\iÌìrrDl
- -Ì!oraile can Ìre..lkcl.d? ( ).c anÍ!., is thaÌ thc s.ig.o[gc cqurtion hoìds i. .qúilib
rr I leDCe it it takcs ljnr. i.Ì t.otl. t(i rdltrsl (h( j. dcrÌi.d ftrÌ Do.t\ lo inÌlatl.n ii.c. I
: !t\ n) Í rÌ(rrì\ l, th. lorffnnì.nL.a. ahrars !ush rLt LLs Ìtrenue b! ÌrLsj.g thr gÌoÍ lh
:: nt the Do.e\ n'Ìrd\ ÍiìsL cnorrsh lhir nrc.hanlsm ÌLcs behÌnd r fanrou! rhe.t .l
.L'rfl! iìnd : r'!rin iÌrtl) n .lerelotcd br 'hiÌliÌr ( rgrf rl

,i!. .q
. r.!s
thÈ
Ìr lliÌU
; Fiscal policy rules

inkinir.ìboltÈrcrLpoÌì(\nrles.rltrtul|lacetobr:ini\lrithllÌcS!\crrÌrÌ.nis
, L.nì!o,al budilet .orÌ\tiljrú al]d thÈ iì\oriatecL tol!en.) .ondi(lon thit 1r. ha!c sct
r lhc.irlier s€ctiinÌ. To :o lÍ!! tlìjr to r rule toÌ sorennnent poLi.), thetustnepis
iô.121
:rng. 7c thii,ì pnr!lent 1i!crL poLn! i\ orÌr in ü hiclÌ tlìr !o\crÌnncnt is \o11l:rÌi Lr.ìscd
l..gn,.oI p.rrÌÌrnent ralLres!luÌerrLe\dÌ]t\!Ìirb1es. \\r 5lÌ.ll ilìen be rble n)
. ì i.r hon d r viiii.ìrs lÌ oÌn nr(h pennrnent \ rÌur\ (lue to llrr .Ì.ÌitâI llLr.iLr.ìtilns lnd
l úrlural rhinScs í) So\ err!ÌÌeni erÌìenditrne l\u!lÌ rs lLrture !!\ orrnnent pension
: _ I Li.s or Ìo.g tLnÌÌ $rtili( iÌrre\tÌtrerÌt Ì)ÌoSL ìÌnr! (rn br hrndLú Lr\ ,r h\(rl ruLc.
'r.(Llìc.lÌa.,r.teri\tic\(útlÌi\])rtrLrnt1ìt!rÌtolic)rüeil)l|Ììrrrecleir,iti\Ì)os\iÌ)Le
r.rpirc it \!i1lÌ alÌ{!ì\ e\ìttnrs Êscal toliì ìuÌe\. lljdel) di\.u$el e\i!tìÌrS f(ìl
.tLlr5 irc lhc \ô c.lled (ìolderÌ lìrle nrtnÍìu.e(Ì b\ thr LÌ( gorenÌnrnt arÌ!l tÌre lrlei

inrf.\rrìt.rh,:,ìiÌrnri.Itri\rL!iÌr:r.rr\r*lr,la(r: i(:i!.r!Ì!r5a
ì.,.i.t!\rff rl!irlnrl r!lr;hr.riLÌ.rrlr!nr.rÌ1.,i rJ:LNricÍ \er:r)ir\ru,tnÈBrIÉ.rr(rrrr ri(

A
 Ìf

r94

n.orl)orit!'dlntÌìe5Ìibllit)andGÌoÌrtlÌrâctoitìrel!r.lerÌrLrrÌì!Ìr'ÀrltethalLÍ'r's11ch
rR Thi\ lÌìs p(rt"
.ristnìg i5.âl Ìrolic\ ÍrLl.s rre noÌ necessariÌr.or\incnL 1riÌh tlÌ!' l'jl
lirÌÌ\, \erious c(ÌLequc.ct\ n)rtlì..o!ntirs in ( hichthc ruÌerlÌ.!rLrr'n iqÌuhì"d lre
s.L ort erinrÌrÌe\ oi .lÌ.umn.rr..5 in Íìrl.n lhe iPpl .iti.n !l r'\iiLlfg t'lic] Nl(s rÌt
llkchtcìhar.danÌiìgirrgctit.ts.lnlheinil!ubse(tioJlr'etrrrnloLh'LÌuertloÌ:iJc\Lsl
inghrQLpolicrÌule!.r.not(.xìsislerúNlÌhÌlÌulltntgo\cnnÌÌenlbLJrrvnrÌr,lrhtlìile
llìr) ì)ren imLrlemerÌtr'dl A c.Ìnnron !nsif.r rt) Ìlìi! !LLlsli.rÌ l.fr'rs 1o tÌre ÌerÌdenl] r):
30\ !ÌìruerÌii Lo Ìrür 'eri.!'ni\ e' brLdi.et &1i.lls

5.1 From budget constíaint to prudent fiscal poli(y rule (PFPR)

It i\ u\etu loÌÉrirtlhcg(^errÌìerÌt'sbLldgtt!!n\lraintiÌri!'rnì;oldrechinii'itthÉ
.l.bt t(ì CDI' Ìatio lc,cusing firn on the Idc ol the r€.1inlÈÌest Lilc ('' 1ll and1lìcn o' tÌIe
r!ìi oltlÌe .omnraL hL.Ìt\t ntr a..1tlÌr' relt ol núÌrtlnn ili 1(ìr

Jt'rll r rlJ

\, .l ii -, /l 6.16
: rl il rr rlJ

(,1\ rD t|c trÈ e\iÍiJrt lel eL oI tht dtb( rrlL.. r. ÌlÌr:.:co.l ioíÌ ('r' 191highlishl\ the liL'l
thrt ÌlÌr.lrbt r!ti. is raÌ5ell rrl rìre à|.turl .ìe1l(it 1'l ill rrd ÌcducecL Li\ llìc gnn\th oi
norlinilGDl . _.rll. 1hriÌnlornì1ôl7rlÌighlighttthrlu.daÌlent.ìÌd.tc!nrnÌalrli
ol tÌie |.hâ.ge nÌ t|c dcbt iriio rt tltr' lÌinrxr\ lei.iL ú11 rnd lb' rÌjlfeÌerÌ'c bcLlrccn thc
rerÌ irt!'tu:st úte afd the Ìrnl gxrlth ralr 11r
_ ò) lt i\ ,r 5o lsefiìl ni \lril' .ô l9l ìÌl
Ìernis ol üre rctrìll dcLrcìt
drri'! .+_,ir
= ,t it',=ll,
L).rjrìrrS.ìnLlcI(ÌtnidrÌrLnicalf,nictL)eSilì5 r)D tlÌÉ..n.1Ìtn!r ll):_ ilÍÔrlheclebl
rn Llo nott!in.rlrsÈ lhis impÌ1e5:

t'. i .i LLi 11

rrhrÌ€ the supc,ÍÌiÌrt 1' rr .Ìt n) thc Ìonii nuÌ oÍ pctÌa!ÌrÌrL'\'aÌut l-et rrs r\sumc Lhrt
1lìcÌc 1\ a t\pc.djlurepoghmnìe tlìit rnlaÌl\ a Long Ìttn Ìatit) otgcì!eÍìnrcnt
iriÌ tf ptrbÌic
cÌtÊÌrdìt!Ìr lo (iDl, lj l ll TÌre qu6tnlr i\ lÌoÌL nrould th 5 h.sl b. hÌru(e.ll or tht
' '' ':
rt I '': * r'' i" ll t'

A Ìrru!lent ls.iÌ 5tÌ the 5hrÌe ot t!r iÌì GL)I'et n cof5Ìrn1 ÌÊ\el e!u.ìl1o
rLìle i! 1o Lhc
'ttrnruÌ.JìÌ'or l(trS nrlì l.1el re!lüirc.lnr !tisì\ thc ú.ttriìirìl

t,r= r,r' l!l -l,r' _!,1, rl, Ld..l lìi\(ìÌloli.r NuÌ.r

 t95

Substii(Li.g tire Pl iR Lntl) i{r Ì 7l iÌnPlifs lhrt tlÌc dcbt tutlo m^ as t{Jllinfs
's
\/r: i,: Ll,r't' +ir y' _, .l't, 1.6.22'j

lÊnirc golnqba(lici thc raÌìoni c nÌ picklnil a.o,rrlrrra t.rr share rslht br\is ol tbe [rl''
k r userpliin hoÌ!iÌ ìrorks. stickiÌrg lr)ttÌerulc eìr\urrs ín\en.] atthotrghitrrìic\ontlÌc
go\ cÌìnnent nìaLìÌrg public its lorr.ins abouL the Ìr.rl i.tercsl Ìate 'rnd gÌoÌvth Ìrte and
i,botrt e\pudLtue pro.-ilrimme\ ì!cÌÌiìrto thc luÌurt. 1lìc mk inÌrÌirs thxtilgo!'crnnÌen1
:rtcnditL,Icisl.rrpdìíll/)'eboreitslÈünarrntÌetel,borio$j'g\houl'ÌlrDan'((hjt thjs
(nLiiÌ\ a risr in tÌrt dtbl reri{) arÌd i\ consisltnt Ì!iÌh tbe ruÌc TÌÌi\ w)uÌ'l Lrc Lbe cas' ìI
tlÌc,c i5 a Ì1'|.cssj(tr so thal go\ erÌÌtìcnttÌr sícÌtarelÌìgheÌtlÌi"onÌÌiìl(Ì'e thraút(Dìiti'
R)

n,rbLljrersirc\rorliÌìg)iÌÌr(1Ìfth.iro\ernnrrntu\e\dl5cretionrrlhs'eltoli'!toÌrÍnno1c
tlÌi'Ì.tuuÌollhc ecorÌlmt lo e!ÌuiliÌrÌuÌÌ cnìlk)vmrnl' It {onìd dtohe the 'iÌs' ita ÌÌÌ'r ior
thrt Ì!ouìd
lÌoÂrânnneo.\cettiolìiÌlg.\e ìment inirõtrLì(trìrr inveslnreÌú is llantÌed
iìlc go\ÉnÌnc.l st)endbg rt r \lìa e oi Gl)l aÌur rls Long ìurÌ lcleÌ lol manl )lnÌ\
.Ì dacadetl.,\. clinifLc,r lÌrit nìight be thc nr\eslmcìri rrquìÌenÌr'nt\ asso'lated \rilh
i6.l iì Lìrnìan unìlì.atiÕn.llthr i,:iì intr.st ratr i5 ()nÌìcleÌìLll llÌoi!n to bc Lenp()rêril! ÌÌi3h':Ì
tó.1S)
:hrÌÌl(!lrerna.cntrllurorilsroltthi\d(lÌc$edrrlrti!elojt\longiLìntiÌltre'thefltle
.r\ s thafthe dcf.jÌ crn siÍ,ìl Ì)e iÌl{rled 1o w tÌÌ (iì'd tlìc 'ÌebÌ riìlio t{) rjsc) LquiÌlh"
( 6.19 r
:ìre rLrìr \a\s thât rn Êrpc.Lc.] risr i. p.,rrrrrÌrl SorcürnÌcnl Vrrìding, k)r 'xanÌLìlc'
r\
. !onÍaÌuen.. Õl Ìon3 Mr govtnìment pcf!on obligrtions
n st bt htrìdrd b\ r rist nr

r 2 How the PFPR deals with stabiìization and structural problems

. r nLrll lool ìn 1ür. nÌ . liLLlc nroíc .ìetriÌ at tìre 5tabrÌLrlion and
stru'1rtraÌ asp"ls oì
rr x!\,cÌ.ment\ l scdl Poli.I.
l6 2i))
: I Stabilization
'ÌiÌl.lorstlÌ.I'lìlltiIÌìPÌ-râboütlhebrln.celretit'cnth(a\eoiautdnntLcttnirlìi7eÁard
.rrrLiondr\ lrscaÌ poli.!? The lne nnplLet tlìi1 rìriln the SolennÌìc't\ erPcncliil'rc
rrf.rìr be.rfcctecLt! risc aÌÌrtc it\ iinrg run lilcl in "cli(rl doit!Ì1!rn\' this Ììu\t bc
iaì ll )
.rirs(ìnÌuPsirinsi,\cÌagedo\cÌtlÌc.lcLe,thcrti\no'aieIoratli!$gerLccbctiteen
, rna Li. r lr . tsrrmi|g Lhere js no othtr rtaslrn l\uch rr tlr(''trìirÌ PoÌi'\ dìscu\ted
.l'nr] nrr.r dilcri{en.c bctllecn rarl arìd ii'lir. Lhe imtlication ìs that uÌe fr erÌl
.L .rll) a.ljustc.Ì trimiìl:i lm.l.tlrt de1ìcil lliÌldcpcfLl on Lhe prc cli\tifg 'lebt
rnti{) arÌd
:ì tÌr..Ìiitercn.c hetÌtrc. the real i!rteresl Ìrte rnd the:rÔi!tir IiÌ1e
(i 2 Ì )' IoÌ criìnÌrLe'
::1r..\1(nìg dLìt iúio is 0 6 a!Ìd llre r€al jÌrtereí râtt errcell\ ilìc g(Nlh ratt bI2 1%'
:.rLhel!Ì']Hiv\tlÌatrhcc)cli.ilÌl!dirltedprìmaÌlb(dgetsüÌtlLr\\hotrÌclbcâlÌei\t
. .i ail)l) isi..e 0 li \ 0 021 - 0 {)lllr This cou.ttLs eganÌsl lhe !Í of
'/is'rlÍÌ'rtr
. rlloÌì(\ 1o the eÌtÌ1t Lhnt tlÌctu'i\ rÌ! LruÌÌÌ ìIÌrÌrcchrnisnr lor iser\iÌì3 it'
,! r'lrn Link thÌ5 discus5i(Ìr silh tÌüt in sectì.Ìì I abo\'!'' hÌ iÌrtnlhì(irrg the 'o'ctpt\
one oi dc'onl
: :lr. actu.rlan.l tÌre c!.ll.aÌÌv.ìdiurtetj b(dget Lr.ìla'ce. 1lìc €\er'l\e lris
,i.S the obÍ:rvÉd budgct delì. t into th. Ìran drr Lo tlrc opernLlorÌ o1 Lhc arrn]nratic

:ìlÌLzes nrlt'f l.l)af{ì Lhe delì.it tÌn1rÍrÌc1.1ìiÌrtìcteriTÈ the c'oìrorrìt n'heÌì 'i(úÌrut

t
 f
196

\.is iqtrjÌLìrntrÌn. It, !\ hrs 1r iìditL.iiÌll hccf rhL cr\e. tÌÌr aLÌtoDrtj( rtabiÌizcÌt aìr
aL Lhc
.o.sLdc,e.l íi\eLl b\ otheÌ ìÍrlnnliÌi7d.i,),ì tnli.\ ohjelti\e\. then dlth(tr'gh the\ tla\ i
Ìre.ÌgÌounLÌ ìrbiÌia Ìr roLe. ilìc.cÌrlÌc.I att!.lLo. j\.n the !\e.t d1\cÌetjonrr) ÌroÌi(\
iosLahLljTcoutÌrrtiltÌÌelìì(eoiíì..Ìs.Bulaf.tlrcÌÌ\r\otthiÌìlìrsrboutrquationilill

!11, ' r, = lírL. i L1 +nir. r',1

ìjiìsiÌuÌcn)ÌlÌíâlfoli(\.jfíÌnLÌr!tc.iÌ-.ctlnr.iItfc!.\eÌtnìreltsaiÌnìttottrbiÌire
riutfrLl it rl íilÌr the bu.ii{rt iÌ! blL,r.r.. iL shôrÌd.iÌ bÌrlÊ the oferati.n oithe auto\rati!
\tiLbjÌ 7rr br .hoosj.g i1 t. a(lÌirrc lh s .bj(.1h.. lì.r rraÌnÌ)le, jt tire ËolernÌnent ii
lÌarlng to rL5. dlÍ Ìrlio.rr) t!Ìn) ÍorL1i.(Ìt ln r.1cÌi.aÌc(rút\t ior ttrÌriÌìratìo.. it.oLìl!i
consldc'n.Ì.isinsrhereïr!Ì\i\rncs5o Lh!'nrLLnnrarjcttaÌ)iÌi/eÌ.1)! Ìrisiniari
lÌìt! 1ì\ cl! thchulÌÌe. oÌr ÊÍal poli{ 1. .ônLÌLÌìatc n) .taÌriÌizìÌi(rì nr(rÌd dcterÌ!.
ont|.rcÌcLlril m)nelrìvtolnrj5Pliti.g nLlr!.r\ÈrhtÌctlìeÌìr !r:l!o1eÌnÌ!ent
doe:Ìlothi\cn.rc!ttriD(rìeirrrpoli.t.lls.ilpoll.\r\artaÌ)iÌiraÌionn!ìli\Ì)oteuliall\
nlcìrr imPorliì.t lìl;.otrÌcl Ìre UÌc.is!'
!rrleÌrnr.nrÌ.hangr:ÌxLerrtsiÌ|r..nhr.nr...LeÌ\t!ljc)jtlDÌrotcnt(cg.l)era!\r
tÌir rÌonrjÌr.rl jÌrlL rr's1 rit. j\ 7errr. r\ r \h.rl rrL br'l.r'lr.r theintÌoducÌio..ih\cdlrÌle\
nì.Iìr.tlÌo\rirÌ1hr ( sStrbiÌjtrrÌìiLrosihl'acl.aninlerltÌewilirthertfÌotrirteu\r
(ú Iìrcrl poli.r ir,r 5lihllLTili,)n.

5 2 2 StructuÍal fiscal polì(y

LnLile lukÌrr] po .t, lÍrl Ìr(ni(\ rtlìte\ nú oÌr \ 1. lbc .1.1. b(11 1. S.1cÌnDr.fl
e\Ì)eÌ itlre prolr.nrnr!'s r.ith etiect\ lbtirÌ! ior d...dcs lr. lorff.nìriL nìit lti\ll
ioiÌrtr.üucr1oÍfÌnli.h.ir)\hucturiìltroLicìisnlÌ.\r.I.{1iÌìi\noL bf pcrnrn..fL'
ck\pite eÌtrÌrdnì! o\ ( Ìrrn) bu\nre\r (t (lej. l)tlÌ(I po i.i.s .riì! b!' ol .irrì.iLc du, r
ti(Ìr.inldÌ,\rtdtlìirro..bc.o.rideÌed!rn!:nerú.Lrtlìilrsl.ilrir.r\ onr c!uld think
olrfngr.rmnÌctor!.nlr{LlrcLnrait[ì(trìÌr!lthÈe.onorrì\rrq.irÌr]r'otinrlhrÍi]il\tili
alter lrc.ìdrs .)f n(gli.1 li Lh.l K (tr (!rÌ!uricatioÌìs irÌirislrlL.l!I. irÌ Liìn (jclmrnr if
tlÌtÌrl(oifrilì.,ìrio.) .1..odÌnSnìuÌel)I|Ì1.\iÌr(tth..(L'r..i r\.Loi\ir(niiÌr3Ì.sil
,t
c.ìLlcd tììiìn.. Lh s. q dLltÉÌerú eriìnìtle i\ tlÌe.iìr! n) rtìlrh tlÌr g.rcÍ nentjj.orÌì
I,Í lo
rìittcd lo p,rt p..5ons nLn LhÉ i.deiìrÌiie tuture lorit\rScirrjl populìtiln llÌi\rntaiL\,1

.ì|.|.ordlng lo Lh!. ) lìti,

Lh! râ\ thrt \llNÌd Ì)e hirea Doü lo it\ hi!]ÌeÌ LdÌB ruÌÌ Ìr\ el.
.\lftnÌiìti!(lt, ii th. gorcln mc11t.ìr)e\ not | ì\h 1t) riire tlÌr tiu nÌ.ìri, t!Ìe lìlIlì i.di(rtr.
ih,ìl 1;hoL,ld flrôdr...hrngr\jÌrpoli.Ì ! ait{) ÌelLr.e i-i I rrìch!rÌri\ingthrretire
nrinLrlcÒrtudrL.i.glhctutuÌeretjrelrrulÌrenefrtiteS.rlìlntlÌepenjl(lrentitÈmrÌìt
dr ì.rd ii i fÌoÌr.,lion o lL.aÌiìÌrrtr.
ls

5 2 I Why a constani share of taxation?

\\ J'll,N rLLll i. Lcnn\ L)l r .ofslant tiìr nrrÌc:' 1s rr. hâ!. sc!.i Llrc
h\ rÍiLrlish thr
N. hr\ dcsìribr pú|rrLlis i. ltrnri oI xlloÌrLng iL)r sl.ìbiLiziìri,)f .\., 1iìc.!.Ì. ind
 197

in\ eslnrcÌrt or
!ì tro\ lLìúÌ! e cÌerr metlÌod ot rJreh \i'g tlìc hÌÌ'n'iÌ18 'l Sü Ènxnent
c{pìi'it
,,"i.u", f'.St"..*t U,., hile r slN(türxÌrnLher Ìtìrn a '!cÌì'al tnìì' trolìlc '\f jo8i'
j'ìed hl rfPl\ uÌg Lo !o\ c'nnrcnt e \uÌìiÌi!
rrLio atc tLrL a crrxtant tar nlaÌe i\ Ìr(n
,! rtplic\ to lì.u\!lìoÌ.lt in sn()othÌn thtir "Ìtru'rtÌtun li
a\ ìs (6uiìl it ìt nsnun'd
rn"iil" a^nr,,u"tt uÌr rel!LnB te1e5 i'cÌtnsc Ì!iÌlì tht iÌìounl fuii"ì c tlÌcrc it in
,,,,*.,t,"g *",*""f U".rLlon (rst thcir. Lr-r IÌaiog\ ltilÌì thc diinLnishlns nìiÌgnìiÌl
e is 1o \nì'!)tlÌ j1i
,L lLt' oi coÌÌs,,mItlon. tlÌc oftìÌÌìiìÌ ü.! nÌ the 8ot'Ì!rnr'!rt t' Ì)eIn\
,.r,t""..1f..,",," o\c' Llnle .ltrn ns thr rrtioÌìÂl lN(ÚelÌolLl 'onnrm'l d "'!tàfL
,,.
ntrÌÌìt.r.h PeÌiod, lnrct)thjDS.on\ÌlnÌrtion l)l borhÌ!úÌ8 rnll sr\irÌg' tÌri rc\ÌÌ'ìst
retiofiÌ
aÌì11 ir\a's irÌ
- .tnrmcnt tares :, Lo 'tanL r!ÌoLuÌÌ 'r'ÌÌ peÌ1od rnd bnrot{s 1' Ìhe butirìÚ! clclt'
: ttDìporrr\ i..ìror unlolctccn lucÌunlion5 ln erP"litrre rdut
rì\ ÌÌnturl dltast(rs, ei( j

: I comparing existing Íiscal rules with the PtPR

or the í'/n''1)
- r. !rll\ iii.g lìsral tulcs tefd Ìo b( t\frc$ed in tr'ÌÌn\ ol the drrÌlrl r/riirit js hel!tu'l to cxÌ)rr$
.,r.',i,tei.;l rt u,.Ler L,,.unr1rrrr tht liirllì tr'ilh eì sliÌrg !ulla it
: {nr enìmerú ìrn.ìSrl .(!r\tÍrl!rÌ in thl l(ÌnÌ (j 20 I

rllrl. tlclJ| - J i/r L/J r l _' l)

ror Lhe d'íìci1 lo (il)l'Ìrtior br
: .in th.n r!\r'iÌe Íhc llIR (iÌÌ tr'ÌÌÌÌ\ Òtits imÌ)Li'nli{!Ì5
: rúiig ttris lnto la l2l .nLl reiriurgin::

nitlì
. . !r ol thr 'llÌÌ bÌÌnils ntrt thÉ la'l tlriìt ! Lr ghtr
_
dt1ì'il riiLl) ìr
"Drl^liÌ)Lc
...\ iilhe!ínrtlÌriteoi.onÌlnaLGL)lll r - lìshilher'
.N:r|.ÍirÌrto\tLtoÌrto.(!nlertìhjrtrithrìisÌiÌii[rl.!\lcrlÌnÌlÌì''Ì ]r\estjSrl'
i!!ìs nrr tbc xdotlÌ.Ìì oi lìÌ( rule: rÌ Ìllir Ìro nt'
Stability and GÍowth PacÌ (EuÍopeân union)
u.l ('r!\tlb fu|.l,'lÌlìt hnÌ'erf Urìì'n (i' irìstÍ'ÌullirtÌLìtdrebüdgct
. r :ìÌrìllll
rrtio Jro!lL]
Í) ri;r rntiü nm\Ì b( l.$ thrÌ! J r rn(] lÌle ' cÌi'rlÌ\ 'dirrjlcü dL'ncìt
..ìn!ì.c or in {ìIllus \\ccdrIdn'rhtÍ ar:

,lrri. Lr(,Dl 1ú.1:lì

ü!Ìtr.ìllì rd ,trli r. ir.i ,1,i)f t6l1l

'.i rrLlt PÌr.e\ r :iSitl liÌnìt.n tlrc il'l]'it rlÌio Lnrl lÌ'nct 'n tlìc t'o|e ior Íi\'nÌ
r:.r Hone\rr'ÌÌìil'll'RìrìtÌi.rlcsUÌnlìlrrr{'L\ÌÌrrtc!n(!nicrr(ìs'nio tÌ\'dttìciì
!i tr hÌ.d nlnìher li LhtrìÍ:iÌr q r rb'i t rr I m r d'cpI('e\tl'n is strlh'irntto
::.,lrl.it,rttoconsisiintÍjthtlÌrI'lÌ'Nrlrot.l?i Lht.l1i hÍììÌn1ÌcotLhtsinblÌitf
l_,,r,rlr.tttLLp,..,,'r1erlÌrÌopiirt'strÌ)ili7rÌnr' \ptrofrirt' strLrillT'úiüì rìlL
.rìLrü(rrniltlrcritei.lhr.ìeh.ilii('lLreL\dueLotLÌc\LÍkrÌìS'itÌLc]trtorììati'
i lÊ .\ cn ii th€ L\ lli.aLL! ìdlusle!Ldcncii i\ /rr Òr'

&
 f
198

'1Jì1. sc..nd rul!'tìnce\.r ÍigL.ì liÌnit o. lhc t\tentLô n hi(lÌ lìs.i Polic\ cdnbcÌLs'dlor
jÌl
ntu.Lr1ÌxÌ tu+Ìì:cs. A\ Long i\ a 8ot.íìnrcnt ìÌnc5lmÉnt ÌJr.igriJÌìm. i5 ÌlorthÌLhilc
tlìe s.n\e tlüt ilìc {Ìj\(orrn1.{Ì Ìrresc| I \ ilut .i Ìlrr .\te!ted 5o.liìL bcÌrÈht\ er.Nds ÍÌrq
e\p!..1c.1 t.ci.ìl .osl:, ÌlìerÌ .o.ri\t!'nl 1t th tìre l'Ì1'jR. currtnt !.!frnnrent tl)eÌldjIìg nrìr
tie.ìbolr it\ penìiÌ.tnt Lt'tcl ,!l >.i ri.a!úlNc!\cLicrll\idiu\teddeirntrill Ìitt
'lhìs s t(JrÌridcleÌì b! the \econd Ìulr l]l lh. 5taÌrilìtl an.l cíu th |nrl

51.2 Golden Rule (e.9. UK)

lhcí)(rlledúrl.ìerÌlÌiil.otÊs.alf,tic\ \ta1rsthrtuÌc|.lrli..ìÌ-r r!li!nr'd d'lÌcit iúti
rìrrsl be rú larg.ÌthrrÌis rcrÌuir.d L! i.dÌiego!L:Ì.ment inlcslnrent\p.nd!'grasd dr'r ''

ÌrhrÌethetil{1.\lÌrtioli rLndi.rlt!'.\rÌi.iìlltedjuned end.('i\g.\rr"r"tinresttì'nt

sprn(lLng. I his , trle is l$s Ìc\i.ì.Ì \ c thaÌÌ tlÌr \trÌrjÌii\ end Grrr th L'r.l IoÌ 11!() rer:on\:
hrsL :in.e it l:]nll Ìeiers 1. lht .l.ì .rÌÌv alju5l.{Ì dtÌì.jl .atlt). it doe\ ÌìoL lnleúeÌr r'!LÌr
tlÌ. .ttrâtllrì.1thr a!i.!nrtir nihlÌ 7er \. .uÌd í'.orÌ!l lLâll.r\rìÌ(ìÌt'\cop'I(ÌnN'turei

H.rerrrilì.GolderÌllüÌ,'i\noL(cÌlde\iEnrdiittot'ì':.1n.Lrnrle!ÌìtÌr'drlÌÌrtiolorr
lr.irl r.rrlon( borrcìr ngtoÊrri.tIg(\enÌìL'nlm\ÈsLnìrntÌrn'3rrnÜì$lhetIÌ)rud"1
lÍìÌlÌ)oLi.\Ìrouldnoliì.dit(i,nxlnìnìrìridbo r\iÌìSjtncn jt\hr\rld b. Ìrcrmititd !Ìrc
logn lt|iÌÌd Lhc G(ìLdc. TÌuÌt i5 thrL tht trllc.l dìllirrn.. btLÌ\reì .ons(!nìftioÌì iì|d
i.lcnrnrnt iilhatúrcslmtÌriProrj.ìe\a riìl( () Ìetrrr| i. Lhc Luiure \i!ì.' Lnle\tnlfnL
briÌ! d retÌiír, lÌrú i!niiú Ì,oÍon ns nì ÈÌÌan.c Lt LlÌc frohlcm ÌliuÌ tlìis iigümerÌi l'
LhrÌ Ìt 1.1ìLs t1:).li\tiÌrsrish bttÌ\... L.1t\tmeÌÌt l-ìírgLuìnx's lhâL {Ì' ìnd no noLhÌÌÌiS iÌ! i
r níÌ return tÒ the 3o\ c'.ment

Ìr i\ irì\ì.rrent t. Ê 5l Ìnrl..Ìf.ìr lhrt thf dr.llion,rb.lLl Ìlhtthel tlìi i'lrÌnnÌenl

nr(rÌ(1 !. iìhced (iilì i. in\t\lmrnl ÌrÌ.jt.i d.liÌì( \ o. (h. .r)trlÌrrivm brll\ctl tlÌ!
.o\t drnl th. n)cúlrntc o ÌetuI.(). lhe pr!1..1 Ihe!r.iL 'rL.oirtt!1n.iìnb'(1e'(!n
ra rÌio br dt.i!ìlr(.1 ,r o'S a llit
fotd irÌ1.i frllatc (Ìu,f\ aÌÌd .at!Ì.rÌ Ìetrrr.si l:'ctlìnri
icrrni rlim..! .n ìÌúo.rslr ÌetuI.s rfLl ÌrorÌ .,riÌr llri dr.Lsioì t! !n.LcrLiÌc tlrr
tr.le(tjlìndrten!ien1. lÌre!!i!Ll.f!lho llih( nlLr.Ììiln..(i lllitoÌÌ.ei ltilc'tìi
xÌÌ)r)\ !i. iÌ\ fhrrr(t.r \tL.r Ìr (. tì\ or tirc (.j| nn(ì MÌ .rsh .1)nrloÌrc!rtr.l t|c rctlt Ìr
bc.(!ÌrrÍL.r'i.ü!thrt!\uc!iirlrr'LhrÌji\iÌ!!dÌ1nrÌr.rdbrLi\rl!(ÌrLìrb\bo,,o\
Lns. \ Ììr.j..l thai rìl ft)l Ìrrirr! .i\ir ÌetLÌnr\ i\, iÌom thi flrstr.tirc oi ÌrrìllnL lscìÌ
f.li(). rcuú eÌeÌú t...nsun+r1i.. !ÌlcndlÌ: b\ LÌrrS(\en]ÌÌì!'nLi.iÌ\Ìrouldlrei"n'td
Ìr\ rrisi lf taration lh.I'lllÌ.nlrrÌrllrnt.lìi!n. b(ÌÌ(r\iÌìSnrlr.rncttireiÌÌ\rsLnr'nt
l,rìl!.t lLhc.alÌririi.i ctulÌri..aÌttnn\ìi\..Ll.atte!l!rlt!1i.ÌceljlÌer!5triLL'.

5 4 The logi€ oÍ existing rules

Lr Ì,rlfg to fiÌr drlrn ìr .s!c$ tirt rr!!.rLÌrls tÌÌiri ìiìl1 h.(i rLtd to \!PPoÌl tlrt
iÌrirotì'Í li(!r !l tlÌ'!\iniÌÌt i\ hrlttul t() r!fi nii ih. aÌgrDÈrÌt\ thll iÌ liìtt
1ì5.i1 Ìulc!. it
 .: ]::: ' í99

ìolÌcv.ânbcusedi:
-:ì€laryunioninwhichtherearemuìtlplclLscaÌauthoriticr!(andariDglemo etary
ìme is worlhwhìÌe :. ':::lrandlhorethatretat€totheslandaÌdsltuationolasinSìeliscaÌ and singlc
. benelìts eÌreecl5 tÌì-
::Ìnenl spendiÌìg nri:
::rie.Ì d€1ìcilt!itÌ Ìi!:
- sjnglê fìscâl authority and a singlê monetary authority
, iinglc fiscal and nìonetar! autlÌority, lf thc governÌÌìent sccks k) nranrtaiÌl out
. .r \r thc cqúilìbritrm, it can. âs wc havc scet, do !o b)'using a baìance.l budget
rilu\tcd denclt.arr , .:-rn. Ncvcrrhcless, the govennnenl nìar find it conlenicnl to ute deÍìclt lìn.nl:c.
r: jPending (as a Íìri: - -ik oI dclault jn.Ìcases through such a PÌocess, t1Ì€n lhc centraÌ baú nÌâ)' lccì
r. iÍltodclusethnÌiskbv onetizin g l h c dcbt. TÌìe cenl raÌ bank Ìelaxes ÌÌÌoneta ry
:ÌìÌs aìÌows the govennÌient to pursue a lìtcal Pollcl, that it coulcl otherlvisc not
..-.. lhe rcvcnuc comes lronÌ teignoragc' o. the 50 câÌlcd ìnnatl()n tax atÌd has thc
' :- : reducilÌg thc rcal raìueolthe governmcnL\ (trústandingdebt
:rrnrcnt ìnvestm..: - I llultiple fiscal author;ties and a single monetary authority
r.t lor t!!o rea50Ììi ' ::ihe tìsc.lrulcsof lhcNÍaa\tricht ÌÌcnlynndthe St.billll en.l Gro$tlÌfact ol the
:i not interlere iÌ :. ::rn UÌÌion Ìlcs thc con ceN tlÌât .t ors lioíl€r sri.Ì, Lrlit€s m ay leacl to 1ìsci I irrcspo ns
: t.ope ibÌstructúr: .,l01!couÌd1ìscaÌiÍcstonsibilittlnonccountry'corÌtanrinate'theothermcnìbeÌs
: :onnnon .urrcrÌ.y nrca? Il one .oÌrflry i.creases its rìsk ol delrult thro('gh Nl
'- .rpnìdent lìsral poìicìes, the rÌìarkcl Noltld Place a risk PÌemiuÌn on ì1s dcbL âncl
rrrÌesihat a trudcÌ:: ::ìÌÌ\tlÌecounúys'ouìd1incìits€lluÌìablcloborrolt.rvhyisthisofany.oncrmto
-ld bepermitte.l. rìr. ' :- :.{rÌtries? Ìf th€ olÌìcÌ couÌrties $Icrc obÌiged to'bail ouf a member statc ticing
r ronn'mption aÌr. : :. ÌheÌÌ the higÌìer rlsk prenÌnun would sp rcad to thcnì B ut there is no clcaÌ reason
:r: \ìncc iÌìvennìen: .i.h a ball out Ììorld bc un.lerr.ìken (or cxpccted). lÌìc Êti úrstitutions thcmselles
:iÌr this ârgunrcnr ii . :.idden bytreaty irom baiÌing o!t a nrcmbeÌ state.
::Ì!l .lo nor bÌing ÌÌ I _
ri aÌso been nrilS€Ícd lhat aÌÌ 1Ììcrcasc in lhe Ìisli of dclaolt olone rncnìbeÌ countrv
: èad via a 'contagion' cffect to an ilcrcase ir thc rjst prenÌiuiÌì ìn other menr
::. r thc goveÌnmer: . :ren though thcrc s,âs no chünge ilì thc lìscaÌ $íainabilitt posilion oíthe otlÌer
.rÍrn betwecn thi :: c\. II(\!€ver, thcrc scem\ to be littlc c!Ìdence thal such cotÌtagìor clÍeciJ exist
.:urn can be dccom : .. Ìnany countries in n cttrÌencv uÌÌìon la.c a slnsle in na li on turgetìtÌg cc ntì aÌ baÌ*,
::rroscd ,ìl{)ngir dÌt .r tuAuirÌs a iscal policy thât wouÌd raìs. its o*'n inflatìdr ratr, a countr) wi1l
:r to urÌdeÌ rakc rhÉ . : l.ss haútr Ìnonetart rcstonse than Ìt ouìd do if its o rr centrâl bank Ncre u\i g
lrt o..e a pÌoj€.r:. .: rn tâÌgetiÌÌ3. Mean*Ìriìe the otlÌer nìcmbc6 fa.€ . tiShteÌ motÌetarv poìicy than
Ìr.ti cü rhc tetun: rÌreÌwise Ì!.,iìld be..u5c of the ie\poÌÌsc b,v the u ion\centraÌbanktothetiseitÌ
.:iior oÍ by borro - rrnte in|ation stemrrìing lÌÌnì t1ìe singlc jìscal erpalìsÌon. This i\ . 'cross border'
ri oifruderL JìÍa :::ìrlúv and nì priÌìciplc prctnÌe5 d rationaÌc forplacing constÌaints on natÌonaì hscal
r ilìouÌdbelìnan.e!i
i ButtÌÌorght olmorc hrca.lÌ,v, tlÌis argumcnt ls really aboutthe need to coodinate
rr.e dre inve\tm€nÌ : rn.l ÌìxnÌetar-t policy iÌr a ìÌ onet.r)' uniolì, rattrer than l.r lnÌpose arbilrary hscal
.. lo see thls. ihink ol.n alteìratile scerÌarÌo.
.:_pôsethereisaconnnorì.cgatlvedenÌandshocttotheunÌonTheunion'smontlaìv
:: NÌe \!ilL sugileÍ a relaÌatìon ol nÌon€tary pollcv. llut a rclaxati()n ol lìscaÌ poÌicl/
r,50beneeded (e.g. ifthc nominalirÌterestratci5rlreadv velvÌow) Ior rnv iÌìdivjrÌuaÌ
. iÈÌ, a Ìeld\!ìtiLrn ol Êscal pohcv \{ill (,rl booÍ lheiÌ d€ficìt and heiiihten the risk of
:::ding ihe pennitted dcficiL an.l (1,) ivill sprcad acÌo\s the bordcÌs olothermembcn,
 ?

200

l.!'lherÌr t,) iiÌie nrrh I is.rÌ a.lion lhi\ 'omÌri!Ìrt]'n Íil lcrd L'
in rht li,...ln(h i sh.!1.

6 Conclusions
rt hrrc jdefljtle.l the 'ltÌili\tdb!tiÌriunÌniLL'tì\'iLl ttrbllirtrs iÌl
t. thi5 chrPtcr,
jn+r'r'r (ÌÌ .)túflt
Ìhe eú.dÌÌr Thl tÌe5ln!c oi the nutiÌÌriti! nnìrilire^ drÌÌrferÌs th' 't
(dr bt dt'oflÌro5L1:
sÌro(Ls l. rqgÌeriìtc dÈmrrrL. ( lll!rìge\ in tlre friÌnrìI! htdg't de1ì'it

. rhf ofcÌiLloÌr oI the.rrl(ÌÌrntir \teÌ)ìliz'A rÌÌ(l

. tÌrc u5i.l dis ctio|aÌ\ rslaLPoli'!
r\.llcrÌ11 .dìrr:L!d bLLiÌStt (lejì' L ÌrÌe'r5!re5 1lìe (ij5'reti"âr\ i5{ eÌirnlrtl\e
I hc
dlPr'n(ls on 1lìr oi tnlaiio' IÌl]
thc strort nur itÌL'iÌ.t Lrl 1ìt.,rÌ t|ii'\ 'o!ìijiÌruilo'
c\fLn.ìitÌ,!ìrnlo.hona|\erp'nfilLLtúÌctrsei5ÍiÌrir|'tl LrÌnid'reDds'nuh'lht:
T!Ìr ilìr haL
th( rhrnS. lj È:.rl \t,ri1.e is 11ÊÌrcd i5 Lcn+Úrer oÌ ttrÌìrÌtr''ì 'oÌ\efL 'tc'rn ai5i
üLccn rrLtìgtt rrr,LlLipr cr rÌighÌi!hl! tlì' rrcl lhìt iL
trÌÌì li\ 1ìÌìencel !'\ÌraÌÌslÔn
,,,,ip*. u, ,n. t,..,,"*.Ìril\\i\.: bond 1ìÌìinced LÌr'rrrse nì go\tÍirerú
'lterÌdlLLÌril
,.,,,i'.,",ç* u,'n" tn." rn t'i nÌ!rÌ' lhrf d'e\ i lì\ ll nan'LÌ] eÌf in\nÌr' l krì'!cr
r

tLor.etroLtlr'c,rorrrlLir'Ìr belÌ,ìrii\Lr Lr torÍú l'ol'ìÌì!rÌú1hr\eloÌrilÌtlrtemrr1tÌrL

iÌÌnrÌÌÌr LhÈÌt ür\ lc tlttlL' Oilir'relcc bei'rtcf rrÌ ud h(Ìi lr'IÌc!'d
eÌrìr f dltÌÌn' tÌ
"
n)th"rsi rlìllctÌtr'LÌ!( rr( i(ìerúi'xl t{'euft
!r,ìmÌìrs IÌi.,r(ÌjdÌ.(lLÌifiÌtn.' rti!'r
tro,retìl]1,1s t:Lkr tl] IcoLLnt o tlLt iLLtuLr ler !bligaiil)'!
ir5s'Lirtrd \itlÌ lhe ìr\rtr .t

ollhclo\e!ìmcÌìti bu!lAcL rr!lsNrirì1 the d!'LcnÌÌirn't\ 1r it\

lÌ(Ìn the lLlrÌrìtilÌn
\,rÌ\erÌct ca b.icLÊnLLhed Tlrtkt\ d'lcÌÌÌi|inÌio !ÌL\'ic\'rÌ
. rjre I.Ljo ()i the frimaÌr dcti.lt lt) Gl)1"
. thc rerl iÌrttri:L raÌr,
. tÌr r.rÌ {!rrrih rntc, rÌld
. rh. r\jiLlii d.bt rrlio
It tÌrÈ tuaìl irì1crenate.\(rral\ thc grorlh rrt' a PriÌnrn d'Liit is r\lo'lxte'
i1h !rL ÕcÌ i!ì. ca.in! cLtbt ri'
(\r Lhe lìind ll rhe'rrontlÌ ÌntÈ 1\ iìbo\'
'1lrÊr
Ìlì. rer lntercsL rrti. r I Ln ^ !Leirit \ 'o'iinL''t \iiLh r 'onnrÌll rÌ1t sLibLt

rl.ht r.nio llol!!\er. sjn(r r ÌÌiSh dÉbL ÌaÌio Ìnrl'( a !oltrÌr!ÌinL rìn)I( rLnn!'rìÌ)ir
:roull 1lìe klilLorÌ\hlÌr !.L1re(n tlrr j'Ltrc\i Ìxtt iLnLl tlr' girrìtr Ìrtt tür' r!jt'Ae'
n hjgh ilcÌrÌ ÌiLi. c,rr ltseli pr5b thr i'leri\i rete irf rìlikln!
rÌr lLn\t' Lìl' deLri trth
n,ur" ,L.t, , !r)\cÌnrìÌ..1 tlrrl lìÌrds jtrell (tr iì' urr5trLìúÌ'rblr !LtbL Ìrrth trce:
u.tltr5n.t (lrÒi.e\ i. nrlllr/irlg ii Ìlo\t\r' r iìs'rl '('ní)LirL'rr 'Ìr lü'!!0xÌr' Ì\
roirLcÍsrrih rrrrrectrÌìer\: Ìhe.oÌìrftì\ition ot thr l'IoiÌrÌrÌt! al|. i to ÌÌnlttÌ'
.rl.Ì1S rriLh thi scri!(sne5! oi tlì. LÌÌillil Lir(rl
\lÌti\'ìÌÌ!i ìh' '('n|lrnenliìrr fo l'ie\
 . a:.. . :) . 201

::: {olcmnìcnl has acccss b high Ìrorlered nÌonev cÌeation by the central banN
-- :rgc), i! can lìnarcc increased expeÌÌditrtre tlÌrough the !r caÌlecl iú1âtion 1aa.
.-: ÌÌn1 otscignoragc rajscd deperìcls on the irÌflation ratc and the.eaL demand for
_. Horlcvcr, ar inflalion riscs to high râtes (âbout 200ir'11p$ veaì), the cleÌnand for
' . icclincs br Ír múch Oìat total seigrÌorage reveÌrucs lalì. The costs of hish .ÌÌd
-::ilatìorarctuUlcÌcnlÌthighthatiríÌatio rate\ âre rormaììykepts'ell Lrelow tlÌis
:- ::q. maxÌmizlng ìcvcÌ.
-: Jìc rcquircmcnls Íor rolrenc) ol the goverìnÌ€dt, a pÌudent 1ìtcal polict rul€
. :r -rÈ.ivcd. Such a rrlc .an be expresled i teúrs of thc constaDt tâx s1ìare of GL)Ìr
- :::ìtr€s soh,cncy. Ihc rulc alìows iar tì\caÌ policy to bc used for botlÌ stabilization
: :-:.tLtral pu4roscs. r\ conslant tax shaÌe reduce\ dislortions bv sÌnooihing, as thc
:-rtnt saves or borrows ìn the ii.e ol unforeseeiÌ oÌ lemPorary fÌuctu.tions in
.::: re.lheprudcnt1ìscalpoìi.yÌulerequirestraÌì\parcnc-Íaboutthe8o!ernmcnt\
. i r:f,re pLâ ú aÍd its a ssunÌpl io n s aborìt the real irÌteresl Ìâle an.l the ilro$tlÌ r.te. lhc
:r ide\ â benchmark agaÌnsl irhich other lìsca1rulcs intìlduced by goïernmcoLs

:.i:sÌtoN5

., ìat arc Lhc aut(xnatic stabllizer!? Howcould the metlod oÍ local 8oler!Ìtef t
ìriiôn nfl..r rhe rLrrômirì. \tibiliT$s?
I ipÌanÌ the logi. ol the balan.ed budget nìult4ti.r rcsuÌt. In!estigatc i{hetÌÌer this
--rLrÌr.of tiIuesïo ho dil

, tlìe nro.ct sutpÌv is kcpt onstant úaüro üran lhe i.lÚcsl rate);
! theÌe Í a prcpoÍicÌìa L i n.onìe t!\ (rrther than ã lúmp nì Ìtrx)
.\ hat i\ nÌeant by t h c cyc ljcaìly adìusted budgct dc licitl llow ca. il bc calculated Ì
.\ hr n it (oÌì.ettlÌâlLy cqui\.aleDt to tlì€ di!c(tjodary nscal inrfúhc? ls suclÌ a dencjt

ì$únÌìDg that ho! sehoÌds considcr boÌÌd s to be net wcaÌth, wh) do€s bo. d
:inxncìDg ofgovemmelt erpcndìtúÌe íÌift the 15 curvc IrttheÌ to th€ right than
:r. ukì otheNise be the (!se? Whl does the IM curve sh i Ít to the lelt?

eqliul.ncc? Does it impÌ) that high publl. debt

,\ hat is mcant b-v lìjcaÌdiau Í no
.a sc loÌconc.Ìn? Howwoukl)ou t.st ior itscrìstence?
l\ Ìhe \ie$ tl,ìt aunrnatic íebilizeÌs are elk'ciiv( coÌrsÌsteDt ivlth thc ticw dÌat
.ìD(retion,ìry lìscal folicy is not?
r o ún tres hrve tra dltiona lly b.Íorvedto nnance r{.rr cxpc n ditue. Is thls justincdby
.c.nonic Ìea 5oÌrnÌg?
,.\ hvìsrh. /.r./ otthegoveÌnment dcbt ratio ol any .oncer| ?
202 ::, .::

{e) Êxplai. inwo ü,hat is Ìncant by the prlÌdeDt fÌlcal folicv N Ìe. lvhal is the nlaìn
s

rersoÌr 1ì r tâx snì oo0ÌnrE'? UnderthlsnLlc, how!ÌìouìdagoverÌiìcnl reactjntlìc

fdÌorving scenaliosl
kr) deferce stcÌ1ding ìs c(t forthc foreseeable lLrture due to Lììc end ofihe (lokì Warl
(e) tlÌ€ govonnìen t compr n s.tes farnìes Íolldvirìga disease orúb rceki

(l theTre.sury reÌea\cs areport lorccastiÌÌ8 thal the(ostofthe ta1 fÌtrxlcd hcaÌth

scrvice rvilL lreble wìthìn h{ent-v''-v''earsj
decides lo coltÌibutc iroops to a r!âÌ tlÌat it expccts tobe over ìn
kl) the SovonnÌent
a nÌattÚ of tleeks. Ct
(10)'iheColdcnR!Ìei\aLrra(tjvcbecauserlthoughithâs$niedraÌlba'ks'Ìtisslperior
lo an arbilrary-\oó dclicit rulc on econolni. g(Ìtrrds and is easv to cxfìain to thc
public and lo nÌonitor''Assc$ this stltenrcnr

Problens and questions íoÍ dis.ussion

high innatìonl
QLIISTION r\. What rolc.loes scignorâge pìay 1n crealjng and suÍaining
Can you providÊ an explanatio| lorirhya ratjonâl govcÌmrent Ì\'o ltld âìÌow high
inflation? Whal about hypeliiÌfl atnul
QU|Sl ION Undcr what c!rcumíanccs might policy ÌÌìaÌeh wish to rcduce the ratìo
B.
olpubìlc debt t,r GÌlP? Whal factors shouìd ilÌflucnce thc poìicy adopted !o achie!e

QUESTÌON C. Sì1ould llscal policy be deÌcgate.l to an incLependeÌÌl authoriqr?

Ìl so'
shouklit bc lhe ianÌebody thal sets nÌoÌÌetaÌy pollq ? Di\cÌ'\s
QTJDSTION D. tìcgin wlth the scenario in Ii3 6.4(d) FolÌo
ing lhe sÌìilt to an expÌosirc
c:lebt patìr, rsntrÌìc thtt thc iÌebt ratìo has Ìì\eÌì lÜrlher beforc Lhe goverlÌmcnl rcrct\' Ìf

its obicctive is to rctltrn tÌìc delrt ratio lo 1is iÌìitial level, erpìaln usnrS:ì diagram horí it
couìd achier€ this bl using hscal policy
QUtsÌloN r' \\/hat light cìoes the tnülysis oI debt dlrnamìc! ând thc ptudent lìscal
poÌicyÍlÌc thÍrw on !he quenìon of the apPn)priatenc$ oicornmon lscaìtargets for
the transition counlrics that hale iuÍ joirÌcd the ÌiLJ and other nÌ€ bcs?
QLIËSTION !. stu.ly by the credjl raLj ng aiiency S lanclard and
lÌxn: entitled J n the
^
cnd rle are âll dcbt: agilÌg societies and ÍNereign átìngí publirhed ìn 2005 stalcdl
'NotwlthÍaÌÌdÌng the refonn t1urry otlate, withouL íurth€r adjuíment either to lhe
cuflent 1ìscal stãnce or to socltl se.urÌ1y and heâÌ11ì care coÍs, thc geneÌal goveírnìent
dchi to GDÌ) ratì6 ollrarìce, Cerrnany, andthe U.S $ilÌnüpass lhc200%olCDIJ maÌl
by the Ìniddlc otthe.urrcnt certüri" resúÌtir8 ilr dencits that wlììbe ìnoÌe âki1Ì to tho5e
cuüentl)r .ssociatecì ivith sPeculalivc-gÌa.Le \overcigns üronì th. c!uent ratlÌìg of AAA
tobetow LlLJll l. Ìr]c]eed, other tìrlols benrg equnì, í)vereign ratings coukìbegijÌ lo lall
fÌoÍLtheü cu ent lev€ls earlv in the next dec.ìdc 'lxpl.ìin thc Ìogic ofthis predi.llon
Discus\ the poljcv changcs tìrat arc rcqujre.l
 PA RT TWO

Consumption, Investment,
and Money

:h

i
-il
 Consumption and
lnvestment

ìr âlm o rhis .haptcr ìs to looN irÌ nìorc dcpth it iÍr oí thc liev corìfonent5 ol the
r cqrLaLion .ofsÌ,rÌlÌion ind iÌnrÍfìcnt brlìilio!r L. lhc 15 e.ÌLtatìon LLecl50 tar,
'i( ji a si.ìplc lincir lir\aÌeslan clnsunrplion hnctio. in r,h Lch conn'nÌÍn)n deÌrencls
:: .Ìirrcnl lncomr. NloÍ, preciseLl, consunìpllon is lakcn ar having a con\tant po\iti\e
mponcnt, Ì{lÌiclÌ st hLìr e (ill€d 'autononÌ,rLrs consulÌÌr1io. and ha\e asuDed n) be
:r r\lgrnous .onnant uÈ to noÌ!, ind ìJr.rcaÍr lirÌcarlv llirf Ìncome ÌlitÌr a maÌtiÌirl
: :: prrìsitv to consLrnìe ol Less ihrn onc. Lhc marginil tÌotensit) tr) .on\unìe pÍ)rile\
:: :.nrci.l ingredient ol the nnüt4nier proccss thírugh rìì jch aggÌeg{te denÌaDd nul\
:.hingrsingovenÌnentspendingarctransmll(dlolhcÌc\eÌoioutÌutdrÌdenÌpLot
:.ÌÌt irÌ tlì. \lÌ!rt nrrÌ. ÌÌÌ ÌlÌe triditio.al .ìodcl, lh. muÌtittier js Srerter tlÌarÌ onc
.ìtrirreRirle denÌ,ìnd nrrl\ are.ìmplilìcd. rf lnlrcducing the ìÌrveltnÌext hìÌìction irl
r1!trr 2, ìre used i liÌielr nuÌctiür in NlÌi.h thcr( is r fo\iti\e 'arìt(Ìrcnnlus'conì
rsú corììbiÌÌel uiuÌ r nesatirr dcpcrìdcn(.c oI irìlcstment on uÌe Ì€nL inter€st rntc
- cÌnplÌasirecl thdt chànses nÌ pr!1ìt lÌprclitlons or sentinent s.ÌÌÌetìrncs rcir'I1d
ò '. ÌjrÌial \pjrjts Ìlill nÌift t1Ì! invcslmc.( LLn.lior b) charÌSirÌi.i the.utononì.,6

r this chdpteÌ, Ì!e nrr! lur (onnríìpt on iì.d i.!cstmeÌÍ huÌctiorÌs .ir bc dr'rilctÌ
r the arÌrL]tj\ olthe oÌ)tinÌizirÌf bcha\ our.Iho(6.hoÌ.1\rnlfirrÌìs.l{i.ìPl$.Ithc
::ìtr are .oÌÌnuìrptiorÌ lun(tions b.srd o. lhc !cÌnra.ent jrcorÌìe lÌlpolhcil5 or tÌrc
.J\ reÌ!ted lile (\cle h\Ìr(ìtheti!. \!c 5lìill n'c 1lìiÌ theÌe it d clerr torltrasl Ìrl:1rçc.n
:. trecljctnÌú ol the con\unrÌ)tidr iLuÌ.ti,:,rì Ì!c hn!. uled up n) noÌ! .ìnd ,ì corìsuÌrf
:: liinctjoÌ deÌned lÍÌ! a siÌnple nÌodcÌ o opl nì!7ing l)ehavi!üI: ilr thr 1(cvncsian
r:nuìÌ|tiorÌ lìnrctìon, curÉnt irÌ.onìe d.t.rrnincs co.nnìÌ)tir!Ì r'here.5 in thc si.ìplt
.::ìaneÌìt irÌconre htpotheiis (flÌl).orìsrLmttion lLrn.tj(D, onl\ 'pennrìnlni ill(.omr
::rL lì) \ee Íhere thii cliltereÌì(e !oÌìì$ ir!nÌ rt Ls ÌìaÌie Írnt arnuìptions ibotlt
rÌÌ jrrcuvlchìil oÌ hou\elrcld beh.rvrs. lt is usuaÌl-\'r$umecl tlÌat feople plcirr il
'tÌÌ prttenÌ ol (onnün|ti(!Ì to .trÌc that jrInps .Ìbotrr hom \ ear t! yenr. lrl u. lÌso
.:!r t1ì.ìt the] are \er\ t.rr \ightrd iìfd hi!r'cÌrir !i!on nr tÌÌe sense tlÌât tlìcrc ls
:r.eÍinÌt! !LÌtrú theìÌ tìtüe prospc.ts ind that thcJ are âhÌe nr t)orro!! on thr samc
::rtlÌrtuÌel(arÌleqd.Orthebasisolthissctolissumtlio.r,their i\nhrâLÌrillbeablc
::.\ ìize h€rutilìtl dnd enjo! ir snÌ!.i lÌ lloÌ\ oi.orúLrmttion (^er herlile. Ì!hich !Ì.
I

: :::e r to a s 'liletirne or 1)ermr DerÌt' .onsLrn4Ìion. 1n lh c earl ! reaÌ i. dre Ìlill tvÌJica lLl
r: a to rustrin the Ljletine consunÌptiln l$!1. latLr Ò., shc wìÌÌ \a!e io as n) rep!)
...r1\ iccumuLltir!Ì (ú.ìebt üü to lLrnd t1ìe clnlirnralio. oI lhe litttiDe consrunpiion

)
 206

and disa\
ìrve1âIlcÌ retircment. ÌÌÌ n.ldition k) tlÌis broad pattern of boÍosúg' snving'
lnia âcro* the life.ycle, thc abilil) to borow also neans that any
unexpected sho'ks t'
incomc sill nol affe.t consrtmpl!on
pcrmanenl incomi
We c{plai. how a conÍlnÌplion hrnction based on ttÌe sìmple
it reaÌit-v We dÌaÌì see rhat
hvpotÌìcsìs can be dctìved and ìool '1 how t\'cìl matches
to derivc the siÌìple PIH Ìn itrdc!
lii, nec"rrorl' ru ."tat ""nc of the a\sumltloÌìs madc
impoúarrL t oi
to account for the enìpirical behavnÌtr oI consuÌnPtion e\penditlüe:1he
lrlure in'oÌnc ancì thc llnÌitcd acccss tlìat househoÌds havc lo 1ìnan
ünce.taittr âbout
lhat cutrent incomeNiÌl
.lal nÌarkt;s h olller loborroa'is highÌighlc'l' Bolh fìcloÌsnÌean
jn lh js prolides the basls lor binAini
pla) lornc ro1€ e{plaúÌiÌÌg c!rrent clrÌìsumPuun
togetlÌer the.onclusiont on modcllìng conÍtrnptìon
- ir." ,".ut cl oa.t ol lhe L|aoter 'ondu'ls a limìlar erercise loÌ inlestment lhe iiiea oi
g, r.ot.,'l.,t,ng tt." ,t"i 1'"sent vallte ol an iÌìvcstnÌ€ni prciect
ltat nÍÌodu'ed j'
'te;2 Ìn this chaPter, lhe dclernÌinant! of ìnÌestÌnent arc e\plorcd iÌì nrore
rlelaLÌ
jn
!! h o$ a connn onlr- used Ìnlestnìc nt tuÌl c lldÌ- tìre Qnn el'-can bedeiiled
rperfect comfetiuon ho*'boththc Qmodel and anotbcr conxnonly useci
'nd
'acccìtÍatof cin be sccn a\ spcciaÌ cases oían inìpcrfect competition ìnv$t
ì \{herr ae iook iÌl how wcll nrch invcstìnent lrnctions natch reaÌjt}'
ìils on the abitiÌy of 1ìrÌÌs k) bo o\L due to imperiectìon! in lhe calÌ
Ìinant iLtst 'rs ììquidity consÌraints are iÌÌìportant lor undcrstandlns

'tsbvlookilì gnlstalho$incorporatnìglonvard ÌookiÌìgbch r\ iorr

s av th€ /S PC llll modcl works Sec oll dly' it ilÌustrâtes h ow so mt
"rcanbcusedtointerpÌeta rcrl worldexaÌnpleand
toltvidÉ
'atio's for con5un]PtntÌ an'l inl'cshìent beha\iouÌ oi thÊ
hc l99Os

'hing in consumption behaviour

.dìnit by lhe ho! okl se.!oÌ o duÌabl.
sch
I irÌcÌude the purcha\e oÍ new housirÌ!
ted scNices üonr housjng SPcndìni]
ul 70olD ol U( co sumption w1ÌtÌ
'ousinil. ConsunÌ€r cxPendìturÈ
. and sc ices iÌì theeconom\ '

nPorlantto!rdeÌstând tht
'nrmPtnn bchaaiour has
spencling as a s1ìarc ot
,r(.andinavian counÚie\
, rthe 1980\ând l990s lhe
. elì! ìo$ levcls at th€ lurn oi lhe
 .'::.:. .. 207

CoÌÌsider frrst a consumption tunction wjth con\iant autononÌous consLrmption {so

., : ó, as di\cussed ir the standârclA,/lM nnxlel Itresented in Chapter2. \,Ve íÌall refcr
:othis as a'Keynesiân con mptldl itrictiorl':

.:. + rj,() r) (Keyne5ian conmmptjdl írnctioD)

:: rfe trte eulononÌous connrÌÌrption as givcn, wc shouÌd e\pect tro iÌnpoÌtant things:
I j aggÌegatc cons urnptioÌÌ is voÌa I ilc ralhcr tlìan smooth because anv chânge in
cuncnr incomc Ìs reÍÌected Ìn a changc ln corÌsumption ìn the Kelne\ìan
consumption function.
: ihere íÌouklbe Do.llffeience behveerÌ the etìect orl cc!Ìsumplion ot lra.sllory
changes nÌpe*onâl nrconÌe and pennânent chânges. Ìn the sÌrnplc Kc_rncsian
lonsruÌrptìon tunctbn, tÌre chrnge jn consumptior is predlctcd blr thc chaÌìgc !n
neanued income lrespectlve olwhether it is expected to bc tcdìporary or

Brit such predictioDs sccm too extÌeme. They seeÌn extremc ior lhrcc rcasons the
::ii has to .k) i{ith the Ìrrefe.ences of con meA, tiÌe sccond rcìalcs lo lhc ahilìtv of
_i.tìe ti) kx)k ahea.l and tonn a view about thei.irture incomc prospccts and 0re thld
.:19Ês on the abiììty ofpeople to borolv. Altemative vìe$,s ol consúnrptÌon taking these
::::.rs ìnio accoun lrrc prcposed irÌ the so calìed p€rmancf I I ncom c hypothesi 1 (?1Ì I)
\Íiltor IÌiedman in I957 and in the cl6ely rel:ìted lifc-cycÌc h,vpothetis (Ì CII) (by
.r:nco \ftrdigÌìari and Rìchad Brumberg 1n 195.1). lhcy sLlggcstcd Lhai consunÌptbn
:-r i ÍunclÌon roL ol mcasuÌed inconÌe as ir the KeynesìnÌì consunrptbn lunctl()n but
_
I craSc or c{pccLcd ifcome oÌ of the value of ìifeti
ì.olh$way lo exprcss lhis is to Jay that conlumption dcpcnds on perceived ongoÌÌg
.::llh, nol on Lhe ìncoÌìc olihe monÌent. Thirrk, lor exa dì Plc, ota final )eaÌ lar{ ltudent
_
r has ìandcd a !Ìaining contÌact with â law 1ìrnì and coÌìpare hiìn with a 1ìna1 year
r_ losoph_Ísludcnr ('ho has no cÌerrplan\ lü tuture empÌol ment. we aslunìe that both
: j..ts havc lhe samc cutrent iDcorÌe (:!nd e\isting dcbts) and aÌe ir all otheÌ re\Pects
:: rticaì. Ìn parlicuìar, a'c assuìne that they ha!e the sarrìc pÌc leÌeÌÌces. lve wouÌcj prob
.. : rìpccr thc ìaa'íudcni 1.) hare a higher Ìevel of.onsunÌptlon thaD the phil60phv
behaviour
-.i.Il1 lor lwo rcasons. 1hc law stlìdent lvìÌl lÌave l nìuch clcare. Ìdea of his earnnì3\
.-: thc
lcals ahcad and thc las' ttu.lent is more likell to bc ablc to boüo{ to suÍain
_ currcn! consumplioÌr.
-r.r
:: borh rhc lrìH and thc LCH, theemphasis was hrÍLt'onthc uscotsaving anddlssavirg
.:.n out lhc flucluatlons in nreasuied ìncome in order to producc a much smoother
r
' oi consumplìon and sccond, on the unÌesponsiveness of co.sumplìon to income
_:aqes lhaL woc pcrccivcd to be hanlitdv. The LCH modeÌ starls IÌonr the intight that
.: nìon pcoplc\ adult Ìivcs their incomes $'iìl f(tkN a reasonabÌy prcdi.Labìc patten.
_in thcl arc young thcv r,jìÌ be startìng out Ìn tlleir jobs, be rclativcÌy ufprcdlrctive
'::ru5c ol lhcir incxpericncc, and hence be able ti) .omÌnand relatlvcÌy loÍ'saìaries. At
.:. poifl in mìddÌc age mosl pcopìe Ìeâch thcjr p()ductivitt and income pcaks, a'hìch
,\ind1990s.The _:. ,lccÌlnc sìightly untiÌ thcy ÌcLÌre, at ichich pointtheir nìcomes becomc much loÍ'cÌ.
_
:i :n.oÌìcs risc lrom routh to mid.lle age, then falÌ to v€r), 1ot\'levcÌs i'Ì old â8c. Bul
' : ;rìÌ! pcoplc\ corÌsumplion ii nor extected to vaÌy so dramatìcalÌy (ln .onúasL lo
pÌedictÌon I abo\,c). leoPlc lre ttreir abilit) to boüo\! .nd sav€ to r'7ÍDr' conÍlnptntr'
\'Vherìthc-ïâÌevoüngthevbo N(sal tôrnÌor1gâgetorcnÌ ìoantandPâr"oìf thcscdcbt\
astheiri.coìneriscs.WlÌen the\ irc mìLìdte igcd'the! savcmorÌc)' ìrÌchthevthcnu5e
to 5uppoÌt themsehes iÌÌ rclìrem€nl. Thìs consunrption 5mootlÌin:j is noi p'edicled b\
the Keyncsian consunÌÍion iunctior.
The PIH â]5o locuses on.ôn5uÌÌÌPrion smoolhing' bLrl ha! i slighlÌy dilìercnl kìnd
.Í ( e,ìârlo ìn rÌìind. CorÌsidcÌ a re.c*ìon, iIÌ Í'hiclÌ aulonornous i'vestnÌent lalls Ore
sìrall coÌìsideÌ ivhy lhi\ rnighl haPpcn beloÍ'), kra.litÌg to lower in'ome lor cxamde'
some peoplc ìÌisht ìote tlÌeìr jobt Ìhe KeYd€siiìn cotÌsLrmption lLrncLion
predi'Ls that
connunptlon ÌlilL iall a\ NclÌ as nìcome, s1ÌÌ.c lhev arr reÌated llul suPpose that tìre
rccc$ion js ertect{ì onÌ,v Ìo be teÌÌrporary and (hat ercryone expc'ts tr) lìnd nc joÌ)s

quicÌJy, Ì\'hjch ar€ a: ireÌl pajd â\ tlìose Ì)elo( lheu it llnrÌcl \eenr un'le\iriblc to cxt
.on{nÌptìon .]ÌaÍÌllicâÌÌ\ onll to ralse ìt dilaìn a lel! wccks or rÌìonlhs later' Wh-v not'
ifsteacl, jusl sustaiÌr .onruÌnpliou b! boro$ing a Ìittle Ì\'hlle !rrnrplo) ecl, thcÌr pa! it
trn.t oncÈ i nc( job rs Íouncl? \\rhat coLlntsl(Ì ho muchsrc$rnttoconsunÌe,a'cordinil
tÒ Ìhe tÌH,ls nottlÌ€ il]come t\'c eanÌ al aìrv onc m.)meÌÌt) but, r:ther, lht averagc
ìncoDìe
\Lc .Ìlrc. r to bc earrÌitrg 1n an-v lime p.rnxì, be.attse it is lhit trtected incomÈ
'Ìr€lrr.qr
tlÌat truÌv .lrtcÌnr ìnes thc Ìesour.cs Ì!e have avrilaltc nÌ consunÌÚio' (since Ì!e halc tht
js a5'pernìanent
possihllitt ot sevinit and l)orro('jnsl lhÌs aver.gc inconc Ìeferrcd to

lo th€ irlH, tlÌen, lI ür.onre tìlL\ if i Ìecessio', se ììor1Ìd n()t nrccssrÌiÌ\

expcct c.msunrptioÌì to íaiL alo.g ilith it, unÌess pcopÌe\ cxpectation s ofonSoìÌìg
^ccorcllÌÌg ltúure
iÌrcomeha!,c faÌÌeÌì as elL. On lhe othcrhand' cvcn llinronre doÈs notchange' ilsonÌe
,r bout hrturc i{ages (sa})wc worú{l cxPect
thing happcns ti) change peopÌc's erpcctatldÌ\
côn5uÌÌ4r1ion to .1ìange. In gcneÍa1tcrms, uÌe disc{)veÌr- oi any e$ iniormaticÌr Íìrich
Ìca.Ìstoa changed Is5c$Den1 o I perma n ent nìconì c can lead to a (hangc ìn con\'ÌnPlionl

ìpeíìanenÌln.ome'l'oÌÚunìllio!r'
hr LÌr1lì Lhe LCH iÌn.] llH.otnunption tÌìoothins dÌÌd aveÌage ìn'omes ÌdtlÌcr than
trrÌìsllorvlnconcsrreinporlant HcreatÌeÍ$IcslraììtìcusonthesimpÌcÌI'lllnÌodcÌ The
L(ltÌ p(xÌLrces qualitaÌì\ell' similü rcÍút\'
\vc hale lheady seetÌ nì thc clis.usntr ol iscaì poLiq in (lhaptiÌ 6 one Ìnportatt
exrrÌìtìc olthe dìIleÌenc€ thc lÌlÌ rÌÌodcÌmrkes lo mâcro€.onomlc poli": its precliclions
rbout !heelle.t!I ÌunniÌìil abudSet dchcitlìuÌdcdb) bond5 lntheÍirÌÌdadanrÌv\ist\'iLh
:a ì surner pr
a Keln$ian coÌlsuÌnPtion íú.ctio., r.leÊ.it fu.(Ìc.l iÌÌcrcase in Sovernmcnt tpendills
has a higiaeÌ eflc.l on outpul LÌrâÌÌ docs the sìnì. increase if sÌlenclirÌil lìna n ccd bt hiilhcr ::-:rrìpÌjc-:
taralion Ìig
(\ee 6.1 ìtÌ ChapteÌ 6) But tÌÌe |lH nn tlÌrt this nra) not LJe so
eÌ \uggcsti
Ìl lhc ijo!exxncnL sell! bond\ to iLLn.l it! e\pcÌÌdilure. thcsc boncls !!ilÌ hivc nr Ì)e paid
ba.k at \onÌe point. That mcrns that one cìdf talics wiÌl h.!'c to be u\ed to pnv back thesc
bondr. -voÌr (,Ììctheì the taì6are raisedtod.! or in the ìLrturc makesÌÌodlÍcrencetothrÍ
eflccl on f.,rrltriú ürcoinc.L Ìl thcl aÌe râised iJr the húurc that ìrút nÌcans lhat peoph
rlÌ1ri\rnL!hr..f,tnJn.nhociÍnÌêdebli!g.frgübepr(11)rLl'rnerLhrÌr'll!rltr'tonilh fditl
\! e.if g.r rr ütlìrJrrolrrJ!iIr(asnmethúih.Ìrenìa^e.tirr(r'trreÌ.1r\nrrrrnÌhÌLitènreâ'ì'inr""e
toifif;,frtrl\ ì,redaltJ\t) Fo r aiÍ r$i Ì . r.Ìr tÌar5ibÌ( iÌn\ L\ seenlrfurl971r rdCÌrqri'r 6
.: ! 5avc Ììore todar'' lo lateÌ ln the eÌtrcÌne câsc, it màv be lhât
la) oíf these debls
:: i privale sa\ nìgs wouÌ.1úsc one for onc aith thc budi]lt delìcit' $ lhat it Í'oukl
': 10 .lÌIlcÌence to aggregaie crÌlen.llturc whether goverÌìnÌcnt lP€oding i\ fulìded
::::ç5 or bv.lebt. (Ic have scc. iÌl ChapteÌ 6, this claimcd e'Ìuivalcnce bet\\'ccn
: -úìding and t:)i lLrndìnia $as ll6t ìcìentllìcd b)' Datkl Ricardo, and is Ìcfened to at
^s
::iian cqun'alelÌce'. Ìf Ricarciiin qliivalencc hoÌcls,lhen the oÍt proposciÌ ÌenÌed)'toÌ
,::i.ionthattheSo!ernnrentslìoul.lcutta:icsi!ìÌÌsimt\nolworÌr prìvate salilìgs

:::iilan cqun,aÌence is not predictecl bt'lhc Ll eqÌralidÌ $'c ha\''" 'ofsìdered up n)

li \ve.an ìncLìrporalc it.lfan ccononÌy cxhlbits Rjca ialì equi\alcnce' üien lhat
: neans(hatarÌychn.geirÌ1.í ililillbccxactl! maiclÌed br''anequaÌand opposite

(Ricardian ecìuil'alcnce iÌì 1-\)

::r aL\o rcgaÌd rs (n.apnìlali.g nÌânl otìrer rcìate.l isslre\ lÌerc IoÌ e-\amtìe' if
.!
: noÌÌìv cxFÌien.es some sho.k that rhange! ilrtuÌe $Iagc e\pe'tatl)n\ì ft wouLd
:red to change to fcLlect lirls. supposc enonno$ oil rcseÌv€s arc discovcrc'l irÌ a
:.-. Then cven beforc lhe) rrc Ìnlred (l c. tven bctr)Ìe iÌìcoÌne\ have act!ally Ìlsen)'
: t e\p..I..Ì flrtLtre aages will Ìise and hence thcir asscssmeÌÌt ol their p$marent
- :i hare rÌscn leading nr higher consuÌnPtidl ln the /S equation, ire cnn nÌodcì
. ,a\iÌÌg that ihe discover) oÍ the oil lcse^es lcâ'l\ to a Ìi5e h ($hich i{iiL' ol
'0
. . hare r nrtrltiplieÌ eífcct simìlar to n rlsc in âutonolÌÌous úÌveínrent 'ìs discusn'd
:.rer 2).
: :ìr.$ag€ 1ìc I c ìs tÌÌat one iÌnpo Ìtant djlíc rence bctween lh e siÌìple Keyncsiân co _

'
: : . ftür.tion ancì thc LrÌlÌ conn ÌÌption flrn(tiüÌ is thãl the loÌnÌer âsstrmes thal
: i r .onÍanl ârúo olnous elcnìent oi consuÍìptioD, '.' t\e'1, íoÌ elamfìe' try the
' ::..r collsunÌÌidÌ rcquiÌed 1o \urvivc with thc corÌsc!Ìuencc thdt the ìnarlllnaÌ
:. i:i\ to consÌnÌe is lcst thin the àvcrage ly 'ontrasr, uÌe |tH clerìvcs tlÌe con
r: a lltrrction Íio a nì icbeco n onÌic nr o.Ìel of connì mc r behaviouÌ: tÌìc pÌeciicl ion
. ::rt a\eragc an.1ÌnargiÌÌal proFnsitl !o conÍ!Ìe 'rc cquaÌ n'd that lhe t1ÌcoN
-:::.ÌÌi(!Ì rcquire\ actual üÌconre to bc decomposeci irÌlo Ír caÌlc'ì permanent and
::1 conponents.

: :onsumer preferences, income, and interest rates

:onsumption and ìncomei current, future, transitoíy, peÍmanent
, :,i:. l.Ìea! ol lhe lÌÌl can be e.{plained using a tì\'o PeÌiod model We assume tlÌal
...rldsÌiveloÌtllop€riodso l' ancìthat lhq enlcÌ üÌe wrrld wilh no ÌÌealth and
. : r Ltìr no $,calth. Iirst, tle íÌo$'ho$ thc i.lea that â sftx)tlÌ 'on nÌptlon pri
' :: lhe tÌÌo prúrds is pretèrred is rePrcscnled in houseÌrokl nÌdilieÌeuce 'uNe!
: Ì rì the ÌrxlifleÌen.e curves are shoÌ!ÌÌ: both cotsunptlon this pctucì and ne\t
',-:.lriblìt€toutiÌ1ty\othehíruscholcì$'i1Ìprcfertobeoraninditìcrcnce'urvctur
:ìì lhe origin. The itÌclillereÌÌ.e cur!e\ âre conveÌ !o üre origln, $4rich ÌeiÌe'ts the
',.nÌ{noothcoDs!InDtloÌìotcttheÌifeunrelo5cetlÌis,notetlìaltheho!schold
 (íl HonJrhold indirÍere..€ culvls InLer temponú Lrudgct (on\tnriÌú
Clnnrnption in lreri.d 2 (lonsum ilnúPrriod 2

Ì+Ír'!/(L+rl

Corsuúpti.,n in lreÌn{Ì 1 ( onsuDrtÌún in pcriod Ì

(.) {ÌrLimal .onnÌrpt nrn choicÊ

(-.nrurnpÌion i. pe.iod z

r,ì+tf)/(l+,)l
ConÍmlÍn,n i. peÌiod L

Figure 7,1 Cônrumpton n a xao peroa môde

is equally happy tìt poìnts al and Donthe nìdiffeÌence curvclabeìled Ur since coìrstant
utihtv ìs.ieÌiveÌed by the.onslrmptidr conÌtrinatiolN oÌì an,v one indiUeÌence cuìïe. At
foìntD, the household has vc rt high .orÌsu nÌptlon iiÌ thc il6t petiod and lo('consunÌr
rion in the second;ât C, ìt has lhc oppolite. ìlut note that at poìnt twjth a morcbalanced
coneuìption pattern a..oss dre tso period!, utilitl' is hlghcr thc houschold ìs on a
higì1er 1ÌÌdif ference curvc (Lrz).
Ìl we mo\ e ÌÌow to fig. 7.1(,), i{e carÌ iÌÌtrodiìce tlìe reÌalìonship bclrlccn lhc housc
hold's ircorìe ineach pcriod, lhe choices tìÌ corìsunìption availablc 1c) it ln cach pcrlod
and thereì1iúereÍ ratc. lhcasÍrmptlonthathou\eholdscntcrandcxÌ1thcworÌdwllh
no \reâlth aÌ1ow\ usto conccriúate onthel iâbourlÌìcome. LaboL1l Ìrì.onìc in each pcrjod
is.l,r an.ì),, and conÍrnÌpljon in cach perio.lis r I aÌÌd.i. Ìlìercal int€reÍraleìs r. Ìfw€aÌth
iszero attlìe staÍ and tlìc nnish, the vâhìe tociay oflif€timc consumpuonnÌrst bcequal
to the vaÌÌre todJ)'of ÌÌIclinre income. ll income in period trro is not knol\ÌÌ, then.fz is
e\pect€d iÌì.ome. 1 his is l h c i nteÌtemporal budget conÍriirÌt:

.l (7.1)
+j r+,
prelent lalue oÍ lifcÌiÌnr con5úmplion prese.l !a treoJlìtetinìe nr.om€
 :..',:..: ::i::. . ...:::,..::::.,. 277

Ì g. 7.r(r) slÌoNs the iúerteÌÌìporal budget coÌìslraìnl, polnt 1 shows hor{ müch
..n5urìpllon Nould b€ possiblc in p$iod orÌe il lhcrc was Do consumptidÌ at aÌl in
:ìcriod lwo. Ìhis is the pr€sent valuc of thc entÌe ÌitcLimc income ì.e. the right han.i
i dc oI lhc abolc cxpr€ssion. lroìnt lJ slÌows the consuürptior that ivouìd be possì
:rÌc in pcrìod two il n,rtlÌinil was.on mcd ir tìÌc lìrsl feriod. If.L = 0, then., :
I-r)rrrlr. lheslope olthe bu dget .orìÍranÌt is equaì!o ll +rlsìnceaìryunitÌe.llrc
:ion in consunÌplion ilÌ period onc is üansiorrn€d inlo (ì + r) units oíconsumption ìn

llìcbudgct conÍraiú sìÌo$s all thc combi,Ìatìons olconsumpudr in the voperjocls

: -lÌzÍr+r)l :ììat are ivaÌÌiìbÌe tothe hous€hold. tìor tÌìewhole scl lo be avaìÌahìe, $ithout sltcitvirÌt
:ììc pattcrn of inconì€ in the $!o pcriods, Ìl ìs assüÌìe.l that tìre h()usehoÌcì is :!bÌe to
] rìorrosr agairút lts tuture lübou.incomc. lìorcxamplc, it lhe !nterestrate is 4%, the budget
-.nÍraìÌìt wilÌ be ide ti(â1 iÌì the casc in $,1Ìich /ì is zerc and rz is €102.000 a\ nì th€
-:\eirÌwhichtr ândL are each €50.1ì001 10 (102000,/1.04) :9E077 50.00i)
:0 0110/1.i14)).
lig. 7.1(.) c.,ÌnbiÌìes the 1ÌÍlilfercncc .urvcs with thcbudget constraÌú. The hous€hold
rlari izes its !tility Íìoorh
pattern otconsunÌÍion over the tlvo periods
by clÌoo\iÌÌg a
.t pcìtrìtL rig. 7.2(d) explores the impiÌcatÌons ol a rise in income in the 1ìrst period onÌy.
-ri\enìpern o €incomelsdepictedbynnoutrmrdshiitìnthebuclgetconstrairú.lvhl?
ìca!se higher consunÌptiotrinthc frrst pcliod ìs nos'possible; \inÌil.ìrly, nÌor€.onmmp-
::on úì t1ìe second perioci 1s possible lt lhc additlonaì ìncome is saved. Ìhe intereí raLc
.as not chirÌìged, so the t)udget constraint ÌÌrovcs in a paÌallei lashioÌÌ. lhe hoLrschoìd
:;rÌÌ choose a lÌiglÌer Ìevel ol.onntrÌìplion both noa' and in the second period. ln out
::mple exrr4rle, Ìve caÌrsee t1Ìataboul haìt(hc rlsc ìn income wi1lbe conÍmcd nowand

\\ihat hâppenr il the increâse in ircomc Ìs Ìn thc second period râthü than thc firrt
.trt 1t i\ lnown about at the outsct? Oncc again,lhis wiÌi shilt the budgcL conÍÌaint out
:.id\ and Ìeacì to a rise ÌÌ current and lul!úc consunÌÍion oi about (hc sanìe anrount.
in uncìeÌÌlnes one implication of thc lrlHr lhc lìmìng of changes in ìncome does not
ìrke much.lllference to th€ impacl on .onsunìpti()n. B), contrast, lbc Kc,\/nctjan con
:rnÌrti()n hìnciidÌ líouÌ.Ipredict a risc ln consunrptl(Ìr in tlÌe lìrst casc bul nol Ìn tìre

It i5 usehìl to note that ilthe indiffcrcncc curvcs weÍe synÌmetricaÌ abouL (hc 45o llne
:nd the interest rate ilas zero, then .onsumplio. rloukl go up ir each pcriod bl half
:re nlcÌease ir ituome, irespectile of thc pcrìod ìn which it Ìvas recelved. S-vmmctÌic
:rdiìlereÌÌce crìrve\ Ìeflect an equ.Ì rrrye.rirs acighl beirS pla.€d on .onsunìplion in
:trch peiocì i.e. neither inÌpatierÌce nor pauencc. A ze() inteÌest rate inìplies an cquaì
: n/r,.ltÌr, weisht is placed on each period in thc scnsc that nÌegonìg connmption ln ìhc

.Ltperiod isnotre$arcìecl by arincrcascÌnconsumption in the second perìod ovcr and

:ro!e the loiegone connìmption.
\{e câ tâle a thüd example: r iise in ìncome il] both peridì one and period two.
:rg. 1.2(b) íÌo$s thai consuÍÌption ìtÌ cach pcriod wiìl Ììse by the â\erâge increasc in
:rcome. By .o trast, the sirrple KeyÌresiarÌ .oÌrsumplìon ftìnction would Predict that
(7.1) :lnruÌÌÌptiotr woukl iíe less: in l.ct, it Ì\'i1Ì rìse btr thc taDre annrunt as in the case of a
:xrentperiod onlyÌise inincoÌÌìe. Wher€asthePÌtlirouseholdsatislìesits ÌitètiÌne b!dg€t
/

212. ' :'

(:.ìnrudÌptio. nr pcrnrd 2

O!rtjÌÌ.1 .o. surÌpti{ìr choice:

tncrea\e nÌ!€Ìiod Ì nrcoaic onl-v

r!+ Ly2/(Ì+/rl
CÒnsunr jon úÌ Perlod I

hÌ.rcasein in.onÌc n PeÌnni 1

(l') O!1lmàl .onsu mptnÌr choice:

ÌrÌcrea5€in pcrnrd l andltrnìd 2 if.omc

l.r+Ír,,/1Ì+,)l
(:(rìiumltion nr FriÒd l

IÌIctease ìn nÌco me úÌ pÚion I Ìiciea!€ iÌÌ ii.om e P€i n{l 2

FiguÍê7.2 ao.slmFton n a tw. PeÌ od moac : th! tjm nq 01 ..ome õnd

'ons!mpron

constraint, the l(cynesian household cnds trp ríith positiv€ sâvirrgsr thls is a conscquence
ol assunìing a coníant propcnsity to consume

1.2 2 Consumption and ìnterest rates

The two-perio.ì Ìnodcl is also usetuÌ itÌ highììghthÌil the ite olâ charìgc in tlÌe intcrcÍ
rate orr consuÌÌÌlÍion. since lhe slope of the budgel constraiÌÌt is (l + r)' it is cÌcer
ttÌit a change nì thc intereÍ rate will be rcikctecl in i chaniie iÌì thc slope The büdget
conslrnint wiÌÌ Íljvcl in â .loclwise dircction aboüt the e\iJtiÌìg ìn.oÌìe el.lo$'mcnt
poirú t ìn Iìg. 7..J bccause a hjgheÌ inieres( tate reduccs Lhe PreseÌÌt valuc of period tNo
ÌÌ.omc brlnging thc bu.lSet roDstÌaiÌú closcr n) the origin al()nil the horjTontal r\is and
râises thc yaÌue in pe o(ì tÍlo ol period one nrcomc. Ìf ìnìtiaÌly a houschoìd does no
savings so that.Ì r,rancì.i=lìasilrtig.73,rÌìÊììrh.srrb\rìtììtiorìcffc.líietìreeflccL
 213

O irÌrìl !.rnrnrfÌni. .h. ..:

Cnr\LrìlÌur Lr l,lrrd 1

:gure7.3 i. a,r.ri.r r:,Ì,.pÊ rilm.n_ ;. .. lÈ ìr:êf iÌ.

!onsÌuÌr!(io. .l Llrc Ì !c Ì. tÌrr jrÌ1!Ìr'\l .ilL holdnrN !lili1l ..nslaÌ1tì 1!ilL jÌÌ.Iralr'
rÌ3 irì 1lìr'.rirr.n L 1rlÌi.d riì(e tlÌe rcrLird lo sil jÌrS has riÍ'. Thr hou\ehrld nìolLs

.\ Ìrat iì thr lÌ.!srÌrlrld ìJìltiilÌ) Ìrorolls or sar$l lìor a &Lrt|rr hntr5ehoÌcl. the ríifrl
:.r ri\r irÌ tlÌr iÌrtrrrÍ rnt. ls ntgatì\e, trnd fg lo Ì!Íer !o.:rmftLon fo.rrrrdll.r
-Arhoìd. tÌÌe elii.ï oi a rnc !. tÌre úÌtiren r.tc i5 Posjti\ e, teÌÌdi.! nr turh clrtruLÌìfLlo.
. Thete dre ÍÌnrli .s rrtlrtcd to ri iÌì.omr or ÍeaLtlÌ.tir.li. À: \'e dull srr' th.
::Êgatecortru|lptioLìd.Lni..ìjcìte\ih.rt.|.ngòintlÌtirÌtr'r.ttrrieÌrr\ronl!.5maÌÌ
L.t (!r cors!|ìpiiiÌì: lI i.r Lhin!.l rise tc.d: L. ar\e!tlnginLÌrtdu(e(orÌsunìltit)n
\ \'ill be uÌe (aÍ- uninìb tu(ÌLL) nri.lebl,:,r hor6thoLds i| llrc siÌnl)lt tso p!'r od.r\e
.ì ú$ilLrL\ob!tr'LLroi.rtLÌjtdho!scholdsithcnrbstll(tLloneiterioutl!!'gh\tht

ì \inÌnetheoÌ\ ol(onr!ÌrrfL L)nÌ)attlonr.]ti.!ìnÌlrlttrterÌrpo,ilottjÌniriÌÌÊb.hiÌtiouÌ

i\ hL.h Ìhe perÌrì.!Ìcnt jlì..mrrìite c! rL. nÌod. L i\ JÌ eÌirnÌ c)t!tr i!Le\ dilíIrfl lÌt
: . ! t)n\ tunthe l(tlrÌ!\i.Ln ..r151Ì!Ìnìon luLr.t oÌr TÌÌeìr.lf ÌrauÌt\.li\.us\.d in tht
,r fcìi(trì !:re rre \unnnnriTcrl jÌr trble ; I ìlotc thrt.Ìì.r Ic lrten!l thl iìÌì.1-\si\
- .nLltÌ!(ì jrìcüÌ( .n.([suÌÌPtion i. L]rc
teri!d\. thÉ Éi('.1 oi aìr irÌcrer\r in tlaf!Llor)
iÌ nnicl nÌrnÌls: nliLrit t.lr. re .an slÉ thii i ll doet not nl l.l lÉÌÌntntnl tr1.o.r..
:!n c(trL!n4,ti!n sill ÌÌol .brngr ìt rLl.
nÌhel()Ll!tr1Ìr3tÌ\o5iri!..i.rt\PeLloutìnnrÒ,cdetriltlìLiÌ.rlltjc5.tthtiÌrii.ÌÌ
I orrre rr !ÌÌo\. b!'\(!rcL i\\o pcÌi(tr]\. lrÌt nÌ.ìtbiDril
:.ìl rüAunÌption iL,nct on
..ìrÊ nerdel llÌ.s( sr.1i.ft Drrltl tritlÌi] :LiÌr (drÌ lrc sklflc(Ì b\ lu!Ìpi4 Lr

, rrr ìt r r rq!,,: lil

214

Tâble 7,1 aünpàÍ ror L,ê1w.€f PIF -nd 5 mFlê Kev'ês Ón

'n 'onslmFt

lmpad on .on5umPlion thk Slmp!èPll1/LcH Kêynêsian.onsumpnoi

.oisumptionlrn.tion Íun.tiotr

ei ih'n.\ri
Ì ,, bY
l.::\j'=^lÌ
itÊ- reÍ.lsr l .r : \r = \Jil

s€clìrÌìs 1.5aÌì{ì1.6 tllÌcre ihe key in\ightt olthe interlcìnporal ÌodeÌ lor the con
r.r"nit- tr*,a"aÌ" "lplajned lve tbcn rcltürì lo e'{amnÌe lhe eÌnfÌicaì evidcnce
on consumption b€haliour'

'1.3 *Modelling the Permanent lncome Hypothesis

Considcr a rctre\cntâuve indi!id!rÌ $'ho l"c5 rÌo unccnaiÌìtv (nlr shocks) ard s'hosc
,u,tif," -ly p"r"'o t q*ndss.ìlchonhcÌconsuÍìptio' ìn ttÌât l)eÌiod' andisgilen bv
"'
l'r) : ÌÌr rr'
"
We usc a 1og iornì of ulilitr'' her€ loÌ two nÌaln
ÌÈivrns lhelìrslÌea\on1sthatit'aP
turcs some iriortant charactcÌ1st1cs we !'ouklexpect orprefcreÌìces nameÌvthatÌnorc
consnÌPtrnÌ js preÍctred k) lcss coÌÌstrnÌp1ion (ulility is incrceslng ìn consuìnPtjon)
'nd
tf."t tfr" Lt" utilitv i.lcreascs ltÌr c()nsumpllon decllne\ as consuÌnPtion
"-outi "rti.h
rìses (dìmiÌìtshnÌil marillnal utìÌity). The sccond
rerson is tÌìat' although other loüÌs of
!ttìlitl the Ìog
,'i,,',f.".,.. "ì"t,u "rnibil increâsing ü!ilitv and dlnrnÌislritg ÍÌargúÌâl IoÌ '
us withoLrt
lom isverv simpÌc ancllra(table U sÌ ng logs lÌerc rnâkei thc Ìnat1Ìs casier

sìgnin.anti) ch angi ng th e ÌÌÌaì n Ìes ul ts nì which we arc iÌÌtercsted

'ï"pp*"
il*..' lives li' l PeÌiods' ind let us initialìr âssunÌe that reaì
".rt'i.lual
jntere;rÌatesaÌezc()andtÌìalslÌeÌìasropreiercnceoverwhcninÌìctÌifeshe(olìÍunes
(Lhat is to s.y, she ìs ncÍ iìnpatìerÌt). tÌei llíetimc utiÌill is thcrcl'ìrc lust
thc nÌ of hel
lrtiÌity lÌotÌì consunÌnion iÌÌ caclÌ'rl lhose f terio'l\:

u=f"c'
,1
so that lhe
Ne\t suPposc th.ìt she is not aÌlo$ed to cìie in clebt norto ìrave anYbequcst\'
lnitial Ìve'lth
pr"."rrt tnlue ot t L,,tot ìifetime coÌÌsrmPtion is cqual io lhe $Ìn ol hcr
"r
bI read'rÚ pÌâ! rhor t ii\ \ulr r(i
iftìihÈrl.rrl)urir!.inÌumnúrnÌìNrthIhi'htlr'r!'i1'li xf'Li\ ielt Ìe

Òfúè'r ì \!Ìlber! (Ì93"r

 :; i:.:: ::, ...,i:i::'::, 215

io) pìus h cr lota1 lifetime ìncome:

\- ì"' \-
/,'

Cons er now lhc indi\'idu.l pondeÍrÌg ivhetheÌ she has aìk)caied hcr conÍrmptiolÌ
üeál\'rcrxr hcÌ lifctiine. Ior her chosen corsuìÌptìon path ti) be ideal (in thc scnsc
ìt nÌaxìmizing lolal Ìifetime utilittl, it nee.ls to be the case that, iÌ)r ânv period r, lt shc
:rere to decreâte consumption argilÌâl]y in th at pe.jocl aÌr.l ÌÌcreare it ìn the fttìowìng
,. r1.,. l-,,rdld\pr. p,,ior ro. I r. Ì rrl . .r.-'l- n jrn,r ...,
l.Ì
'
-lnmmptúnjnp$iodaandl r are 1,/ú, ) dnd 1,1lr,+rì. the corÌdltion an optlmum is

' h Lìì LJn h. reiÌJngcd to obr irÌ

tr I='r aconÍant'

rìat is to sâ)', orr repÌescntatile indi!ìdual iÌì lhis cate consumes exacrÌy lhc sanrc ìn
:1€rt period, reilar.lless of i{hen sÌre receivcs hcr inconre. HeÌ rlages, /,, might hc vcr}
. and ì59Ìv€n b) ::ÌÌìpy !ây Io\í Ì!heD t is neaÌzeÌo or rear T, bul high in the nrìddìe _vear olhcr ìiIe. Bur
:rdt makes no.llfleÌencc 1o hcÌconsumftio.. Shc smoolhs heÌ consumftion bccausc her
:i.lerences aÌe characl$izc{t b} diminish j.g rÌÌargÌnal utiljtt and because, implicilly, nc
:- e a\sumedthatshc ìs ablc !o bo rorr agai nst hcr cÌfected flitue iìrconìe.

' I .Adding interest rates and time preÍerence

r.+4rosc s'e noÍi.s!uÍÌe that our lndirniìâÌ is iÌnpatient and thal rcal ÌrÌtcrcst ratcs arc
_
:u -zcro. l hcn ou r indlvil:hìâl, $ho liv€s lor I perlod s, has ÌÌfct irì c utìl i tt givcn b''

rr',Í l) (1+ 1,)'

:. ieìc, hcr Ìatc of time prefcrcn.c (a measure ol her lmpalicnccl.

is
\\ e stilìassumc lhat she is not alÌowcd to die iÌÌ debt Ììor lo lcavcbcqucsls, so thar lhc
::isent valu. oi hcr totaÌ liictjmc consumpuon is eqÌral to thc súnì oÍ h$ Ìnì1iãl a'calth
I rÌ'Ff .\.,r\."r"oÍh rìr 'riIì",L,,-r ;r ,,rn.

),Ì) t-t
1t, 1l
:.:rnÌiÌÌij a constant rcal i.lcrcst Ìalc r.

lhriii.rnn.i j..Ìrise uriÌir_Í sÌrorÌd le DLrrLous. lhe p.d aborr rrs noL de.reâsirÌF úriltrr Ètrhei is rhe
.r:1..ê alr.nìtJrr 5 op. úingz.Loatlhr rìrxirn0n oJi ÍLLn.lrotr
 Consìdcr agaúr the i.iÌjvicìual pondering whclheÌ 5lì€ hat allocated 1Ìcr .onn'mPtion
i.ìeaÌ\ i.ross her Liletime. IoÌ hcr choseÌÌ consunÌ)tlon palh nr l)e ideâl (iÌì Lhc sense oi
nraxnÌÌizÌng r(ÍaÌliletiÌìc utilityl, it need\ to bc lhe cale thal, f.n anI Period I iltheiferÈ
t{) clecrrasc con5unÌption marSiÌÌaìl-v h that pffiodatrci in.rcase ìt in thelolLoNifgPeÌiod
bv 1!, tnì cs th e d ecrcase ìn perlinÌ I (s1ìeNouldha\e 1 rtimeia\nÌuchbcca$eoidÌi
,..i r'n.''r .rl 'rr' Ir' l l| -r''ii l

ììfetiÌÌÌe Lrtiljt}'. SnÌce tbc m ari{inaì utìÌitie! ol ro. luniption Ìn t arcl I

-l arc 1.1((l + rlrr,
an.Ì irr(ir rlr
1.,-Ìl lhìs condilion for an opl ìnrrinr i\

ll
lvhich ca. be reâúingtcÌ tu oblajn

çjt
Bt sLrbltâctitrg., r., : 1 fìonr cach sidc, thìt ctn aÌso be ivrittcn i' ternÚ ol changct ai

\. 1di\cretc llmc Ram\ey equalìr)n

1.5 The optimal consumption Path

,\n indiv ual aìÌo.atiÌìg heÌ coÌìsumptidì eilìcic.tÌt beútccn periods wlll needtob'
i.diÍïerent ns to whetlÌü sÌre takcs aDv uÌì1t of.on nrpllot i. terioci I or pcrìo'l t + I
A sìmfÌe nÌo{Ìcl oi optimal cotÌsumt ÌÌ nìgg.!ls that .1ong the oftilÌÌal consunrption

(discrclc Llme Rantre\ equalionì

TtÌe 'obiL:cLive' irtc ol interest, ,, is tlÌe úì.rcrse iu c.instrmfrion thrt vrrü gct ne\t
ped.xl I Jou nrrito orìc unit ol consun\Íion thjs Peúod. Ihr ' Ì)jectire'riLc oi tnìe
t.eìereÌìcc, r, i5 tlÌe e:Lra that youwould be prcpare.Ìto
pal.ow tobÌìng lo lardaun1Ì
of.onÍLnrption to thc pr$eÌÌt pcÌiod lÌonÌthc ncxt teúod. I ookjng at tlÌis eq!a1lon' it ì!
ob\icÌ,s lhat in a sÈecial.:âre, the châniae iÌì consrmttnÌì $'iÌlh! 7.ro i e tlÌ€iftliridtraÌ
irilLclÌoosc to ha\ e. pcriectll snìooth ìe\eÌof.onsumttion ovcÌLhclrlìletirne lÌÌÌsn'ilÌ
be tlÌc.ase iftÌre irúücsr Ìate.nd lhe rrte oitiÌìc Preferen.c c c(Ìuaì Ilboth.rccq(al
to zcro. thir Ìes!lt is i.tuitl\elt' aPpedliÌÌil:tlì.ll is nothnì8 to hc grined objeculcll b\
'w.iting'rnd nothing 1o be lon \uhìecti\eÌv
Hoh'.!eÌ. on(e thcrc Ls the objccti\e possjbiÌllv oi tÌading ol pÌ$cnt nÌ núure con
sLünplion arìcì Bi\'.rì the 1nd1\,ft1râl's \ubjectivc al1ilu.ìe t.ì lulLrrc consunrftidì il is not
Ììe.(ssaÌil) the..se lhat consuÌÌìptjon $iLl be.onsrant Ïor ctampÌc, ilthe ÌeàÌilÌtrrcsl
ratc cx.ceds the rat(. ol tnne prcicÌence ol an lfdilnìual (i.l: r > ,l then it is Ìlorth_
Ì!Ììilc lor the Ì ilidual to corìsltme Ìe$ at timc I so as to corÌsumc nroÌe at tiÌn€ I ì
lÌÌ sLrch a case, conninìpll{lr dt tlme i wouLd br Ìc* Lìran at llmc I + I \\:e would find
 ::. oppo\ite palLcrn iÌì the case of a vcÌr iÌrpatient 1Ììdniúìal. It is woÌth nortng that
:::assuÌnptionoldìminishirgmaÌginaìtrtiìitvofcons!nÌ 1on guaÌantees rhal rlÌere is
:ìe consumftion €ach peÌi( .
.rorÌ the Ramscl equation, it f.ìL)ws lhat.on\unrptio will be constant ii rhe r.te of
:::ii.Èst is e\rcllt cqual to the ìate of tjmc prctererÌce. Il the retum ro wairtng irnd the
:::ree of iìÌpalicnce €xactìv ofitet each oth€r therr the conÍìmeÌ is besr saljíìed Ì{ith
i - {Ì\tart lercÌ oi ccÌÌsunrptìon olcr rhcir liletime.l Liturime reí rccrj arc the l€v n)
:r:xlrftior. Lhc coÌltrast irith thc ijmpl. Ke!Ìle\iiln .onnunprn)n fLnrcrion is startri.1l
:. Kevnesian consuÌnpti(D furction is ãppli€d liieiallv to rn indn,iduaì, it suggcÍs that
: :n il the ltftlon lnew that drev a'&. goìng to Ìúreúi $erLth or l)enelit lrom a rlsiÌìg
:-ome, ìt aoúÌd not iÌúÌLrence thelÌ curcnt .onsunÌption.
lrt ilhrtdocs the RarìÌrev equatioD jnrpì)'lor cuirent connìmptnn?We asstrmc that ar
::È t the conslrm€r ha\ aÌr aÌnounr olnonìnman werÌth (this can beposltire, c.g. asscts
,:n as nìoncv, Ênancial assets, oÌ a housc, or nesative nìch as a loan froÌn thc banÌi)
:.1 an cslinÌate of the pÌescnt valuc ot tÌì€ir huÌÌìan weâlth. The indìvì.lurl ts assumcd
.r âblc to mâk€ â decìsio. aboul thcir nrpply ol ÌlbouÌ oleÌ tÌren.ljÍetimc in thc
..t ôi inÍornÌâtion abour thc wagc prcvaihìg iÌÌ the ÌabouÌ DÌarket. We wilì rctunì lo
::rrjdftl'hathappeÌTlfrhìsìsnoravalidassÌtrüpiio:irÌdÌÌecoxomvlvithinrolunLalv
..mpÌoyrÌÌent. it lviÌÌnorbc cc{ain Lhal a job lviLl alwa}\ be avâiLâble at the iaoing agc.
. .aìcr1latu ihe pretent lalue oÍ lhìs annuaÌ tÌo$ of labour nìconÌe. the prevaiìing
::.rest ratc nnrst tre rìsed. ìror exampìc, thc pres€nt value of€50,000 that $iÌÌbe recen'ed
inc !cir\ tirne ÌriÌl bc 50 000/(l - rì whiclÌ, 1l the inter€st rate Í 5q. anrounts to
ir o!.r €.17,'100; ilthe e50,000 r'as rc.ci\.€d in lìve ye.rs'tiÌne, th€rÌ lts present vaìue
: .,ld bc 5O.O00rrí1
- rl5 ('hich is €:ìó,l76. lhis proced!re ne€ds to be applie.l to each
:.rr5 eÌpectecl labour i.comc. Il is aìso asÍnìecl that tlÌe rltionll 1ÌÍln idua Ì $,ilÌ wanr
.on\unìe all ol theiÌ lilcljmc wcallh. lhls ÌÌìearÌs t1ì.t .t ti e r, t1ìe pr€setrt yaÌue of
r\umptjon oveÌ the Ìcnìaindff ot llìc pcrson\ lifetimc l\'ill be exactl) equül to the
: ::-i.nt valüe oftheìÌ norììunìan and hunÌan werlth iìt tiine r.
. hc patlÌ of conÍuÌpLion olcr thc ììIclilÌc will then juÍ depend on the i c:llvl.lual's
::: of tim€ preference, r, nnd lhc prcscnl valLr€ oltheirr'€iÌth, úr :
(Raìnsev con Ì!nplio n ftrnclioIl
':,c prccisel), /r is the subjccliÍc ú!c ol tÌrrìe preference, ind tl,r (c.lled psi ancl pro
:unccd si81Ì') is the sum ol lhc valuc oI non huÌnaÌì \lcalth (À1HÌ4/) ând the tre\ent
ìi. This ÌriÌl : uc ol humân weâlth (Hlrrl (ìabour inromc oler the rrrnaiÌìiÌìg lifetime cllscounte.l at

!.itnelv b)
ì!, Àrr/rú + ru'. iHlv)

: i a* u mcd tha t ân ir.lli nìuâl can ahra,vs boÍo$ at thc previiìing interest Ìate, , , iD
:ieÌ lo impÌ€ÌÌÌent then ììIeLiÌnc consumption p1an. $e return later to cons er whar

r nÌfb or tÌrc sldpÌe b!. trÌi,nl ditrgn.r usca ..rlicL. th! sÌrâF. ol tÌre iÌrdiÍÍeren.ê .uryê hà\ rJ t)c
::úuÌlÌtr\yÌnrì.ni.rl1oun.tJ\êtiftn.Ìr!.iitÌer)!dg.t.orsniifiin..Ìrh,úrherangenqbetrÌêentlìe
:::::Ì...erurkrfdhra8.l.ornrinnÌieronrÌic.15!liÌrrThnrrirtnúÍ1,(.fnrÍ..n!uDpLion!rÈa.h
214 : ,'': :: i i. ':
happens ìf lhn asnlmp!ion is noI corect lirom thiserpr$sion' itisclcar lhatanirrÌpaucnt
peúonl{jìl have a hìgheÌ lev€lotconsumptjon in th€ .urent period that a patieÌÌt onc'
Ìt is usclul t.r rvdte thit e\pressÌon nì i sÌlShtlv .liftère n t way

ct=lì+r 1i!Ì
- rÚi +(r, rlÚ/

'Ihc leÌm rrl is knowr as 'pcrm:ìncnt incomeÌ bccalúe it ìs Lhe amount tlÌal caìr be corì-
sunìcd whiÌ\t lca!1nia the value of$'eaìth utÌchanged:

rìJrr = tcrmaf entnr.one. (defi nition of permancnt incomcl

!Ve.an norí se€ how the RaÌììsev conmmptiorÌ f unctbn tics úP if ith the Ramsey e'Ìuation
and rvith ihe flH. ltr : r thcn consuÌnPtion in thc curreÌìl and erelv ntbscquent perìod
is equal t{) permanent iÌìcome. ThÌs i5 1n ÌitÌe üIilh the Ramse} equation lot p
: r sin'c
consunpti(nÌ is constr t i.c. = 0 But il r, I r, the indjvdlral is eithcr consuÌnin8
^../.
noi! at a ìeveÌ abovc oibeloN lheir'pcrmanent inconre'ând hence co sulÌÌplion iseithcr
falllÌÌg or risiril. lor examplc, if rr > I lhe Ìate oÍ iìnpâtiencc it Sreater than Lhe Ìetutì
fÌonì s'ailing. The connunption ntrì.|ìon teÌls !s lhat ill : I conmnìption thìt period
is eqüal !o permancnt ircomc tlus an .xtra bit represerting consunÌÍion ou! ofweilth'
The .onsequencc lor the paLh of consunÌption is cìear: b-t shifting some conÍ'mptiorì
tìonÌ lhe Êtìtrüe to the c!rrcntpeiiod, the itldÍridual $ill havc a 'lecÌineìÌì consuìÌption
in thc luture. lrom ihe Ììarnsey equatlon, if p > / lhen l./. : 0
Ot couÌse thc coDveÌse be truc in ihe case i'heÌe thc rate oltime prcfcrcnce is less
'\'ìlì
than the rate of inteÌelt. Ìn lhis cascÌ consúÌrtption will grow oreÌ time th€higherÌat€
of Ìrì leÌen üìakcs j t a oftlxlh ile to poíPone sonÌc connunpl Ìo n n ow (i e to savc nr orel
and !o benetìtlronr gÌowirÌ8 connrnìpLnr n overthcIitetiÌne lbirhausetuÌinsighIfìr)m
thc in ieúenÌPoral nr ode1.
llÍ'e go bacN lo the speclal case iÌÌ which the reaÌ rate ofintcrcsL is e.Ìual to the discouri
rarc, i.e. r r', rlchave thc PÌedi.tion ofco$tant consuÌnption olcÌ the lifetimc. Thls is
onc rationâlìzaljon tor tlÌc simple ItH, connuningone'!perÌÌrancnr inconÌ€ is coÌìsistent
h'iLh inteú€rnpoÌrl utilit)'ÌÌraxinizatìon ifthelntercÍrate aÌÌd lhc mte oltirne prcfffence

(Ì'jÌt1 .on s umption 1ììncl ion )

= pedr.ncnlln.oDre.

1.6 Consumption as a'random walk'

Asnolcdahove, lriednìaì1's b.si. idea in the pcrmanent incomc hypothesi\ lfas thnl con
nunption was not drlvcn by cürrcnt iucoÌne bul rather by cxpccted oÌ averâile inco'ne
The ini l iaì enÌpiricaÌly cstimated consunÌÌÍion ftrnctio bascd on ìrÌìe.1mtn's approach
used a backna looking exPe.talions h]'pothcsìs: pernìancÌìt income rlas â \r€ighlcd
average ot past ircornc. But if thc pennanent inconre hypothcsis ii coupìecì with lhc
 .: ..::. 219

:..iiodiì cÌpectatn)ns h)Ìrothesls as was ctone by ÌÌobffÌ llaÌÌ, then w. gei a chtmâti.alÌy
r::i.rcnL ÍoÌy.s In evet period the houlehold incorÌÌnate! into jls connìmptiotÌ d€ci_
. Ìr alìofthe ìntìÌnìâtiorÌ ivailnble about its perlÌÌancnt lncoÌÌìe, and iLs.ÌesÌed 1ev€Ì ol
- :ì5utrìption is constant. Anv chnnge 1n golerìÌnenl folicl wouÌd !heÌenÌe o v lead
r.hange ìn consuÌÌrption if il altered the iÌÌdivìdual's view abouL theiÌ penÌÌarenl
:::.Jnc. On tìrìs basis, aprrt fiom a randoDì error, con mption ncÌl peÌ1( ríou1d bc
- te.rcd tobe jlót the \anÌe i s .on nnnPtion tlÌis period:

r..ttcrrÌ like Lhls ìÌÌ wÌrich the Last peÌìod's v.ìÌue is lhe Ìrest prcdicLk)n of wlÌat Nilì be
:.-.r! ed Lhìs p.rìodis calÌed a iandonr ÌraÌÌ. lheonÌythingthat.ouìdptucìuceachatgc
i -:nlunÌptlon in peÌi{).1I I $'ouìd be the âÍi!.1 oÍ some iÌìlorm atioÌr a bout ji+ I lhat
:: roi linowì in pcÌiod tl

new\ ' ApcÌmanert inconìc ÀcoÌìs(tmttidr'

: rÌnterpretatlo. otlhepeÍnancnl inconÌehlPothcsjsp(xluccd LheltttÌgeÍìpiri1:a1

' :::.tun t1ìat pasl vaìucs of conÍrÌÌptìon and lÌcoÌne shoxld prcvide no nìfoxÌìalion
:: :rìn!L to that incorporate.l in cuÍent cornìnÌptìon itsell in hcìtnrs to predict tìre
' :. ìi consunptlon. This idea Ìlas ratheÌ shockiÌìg Lo ìÌacrocconomic nÌodelÌcrs tlho
' : -ticalL] us€d a consunrption [u.ctìon based oÌì ìagged !i]Ìucs of inconìe and con
-:::.n \!ith s,hÌch lo lotecastfrrturc con mptiorÌ. Wereturn to the enÌpirlcal issues
- r In ihe \ection lhal IoÌl(D!s, Haìì\ ÌeiuÌt is deriÍed T1Ìis .an be onÌitted bt goirg
. :.: nr 5ecticÌÌ Ì.7.

. -Ìhe Hall (1978) result

, ::r iÌre ldloÌ\'iÌìg uliÌity tunctlon:

,tr,):^, lr?.
.:: . :nd ú aÌe po\iti\'c constaús. Ìhcrc are two impoúaÌìt thlngs to note about thi!
..:ìLLon function:1ìrÍ, that the cocíúcient on.2 rnuÍ be negaLìve lü consumptioÌ
:..:rg tobe cLe\irable and iecorÌd, thatirehaveswÌlche.l ìroÌn lhe Ìoii utilit-Í tu n ctìon
: ::: r{l ratjc one b€ca Lrsc loÌ connÌmPlioD to lollosl a ì and on walk, cÌuadratÌc u lility

' ::r.lhat,atr 0,r,ôisknown,butfr lol! are random variabìclwith nÌeaÌì E (1,)

-, : : : lh e ÌrÌe5en.e oi un ceÌtaiÌÌt) Ìì$c, thìs tinte in stead
ol sinìply nÌaxiÌÌÌizÌng heÌ
:. : rtl . tÌ1e representa tjve ìndi! id uaì n ttead maxiÌn ize\ her eÌl..t .i Ìitètimc trliìity
Ì

. ::rl.dhlthepreser.coltìreeapcclalbnsoperâtor,Ã,ilhichhasthe\ub\cr4)l7eìo
: :::. iìretÊ\pect:tionsarclìüÌed a1 linìezeD:

"='É;r('" :'ì)
-
220 :: .. ":
The iiletiÌÌÌe rcsources constrainl lhis time Ígnen by

t\
r, lr ' ' .ì,"ír
) \ )-r, ,t/
much the sanÌe argumcnt as prevlousìv, ouÌ irclividual wÌll onll, bc al ât optinNnì
Ll,v
whc., jn peiiod, slì c a'ouÌcl rÌot changc h c r eÌpected utiÌlll'bl'rcducingherconnunp
^nl
tioninralìttÌeandillstcaiÌconsuneiÌr/)timesasnÌuchlnpcrjodr-1.Ìnthiscase,the
Ì,
margi.al trtiìities are l.r lJ.i 1(1 rr)'and(d bI(., Ì))/íl I /,)r so the conclitidì

't'
whìch ÌÌìay he rearanged lo gi!e:

'-tl
Lìrcm the definition olan erpcclcdlalue, this can bc irritten equnaleÌÌtlyas

.( r )
'a
Ììhcrc /l Í:r rl = 0. tor iht speciiìlcisc ithcÌe the ilÍeresl ratc cquals the Ìate of tinc
prelerencc, (i.e. r = /r), thìs simPlilìes to

(thc HaììÌenìltl

This says thatcon mption ftìl(^{s a randonì waÌk, changirg on\ subject to raÌìdom
shocl\. wc shaìÌ noi.lo so hcre, but it it reaÍÌÌrbÌy stÌaìghÚÌ)Na to nÌo!! that, undcl

', t=8, tr LLt

wheretissiÌnpl,vtheexpectedvaìueotateraiaeirtlrrcjrcomcpcÌÌrcÌn.Thusthellall
remlt says thal l.orsuìÌptlon Ì!'ill otÌy change betwe€n Pcrìods lI cxPeclatìons ol tìt!re
income changc, and tìren the .hangc in con mPtion Í'ill bc cqual lo lhe chaniae in
hìhue aleragclfcome.

1.7 Empirical consumption functions

With the theorctìcaì pìe.ljctions Ìn Ìrind, {e Ìrow turn to ihe empìricaÌ aÌÌal,vsis of
consumption. lf dcvclol)irÌg the ìrlH, lÌicdman í)ught to re.on.ile the eviden.c nbout
consunÌption lrom cíÍs sectionaÌdata $,ilh lhat ín)mtlme series ÌnacroeconomÌc dalâ.
The üoss s€.tloniì data rupPortcd thc Kctnesian consumPtior irtÌcticÌÌ !!ith an ìntcr
ceptterrn and a nìaryinal prcp€nsil,v to consrrme ìe* tharÌ the ave..ìge, \!he.ea! thc tlmc
ieÌie! ciâta süggcncd a Ìrther.orÌstant consumptií)n to income ratio iÌì the loÌÌU ftn, jt
 :: . :i.. .:......: : .:.. 221

Macioeconomic tnì. \!rie\ data

là.h daslìcd lnic nrrs\ â .Ìo\s ledioD ol

ditfcrcnt hous!hold! at r I)onrt in úÌe

DìspÒ\aÌrÌ!nì.onre

:qüre 7,4 Frednràn: re..n. nq.!Í se.i on nf d t me ier ès.:t: on.onslnpt..

_. Ìrilh tÌìe predictnnrs of dre llH. IÌicdmanì hypothcsÌs s,ns that the cross sectional
, r: ionslÌip iÌì.hìcle.l dr e c Uc.ts o t I ran s i I olv lncomr and I hat if thc alcrage relationslÌ\r
'..i..tsi!ecros\seclìonsorertiÌìe(andasavcrâg€in.onìcsrìsc)jsusi.dtomeaÌ[etÌÌe
: :::orìslÌip between consumftion andpcrmanentin.oÌÌrc,1hc un dcrÌl'irìg rela tionslìip
: largiüÌ pr{rensitv lo consumc highcr Ìn tÌì€ long thnn thc shon Íun and equ.l to
_: :,Ênge euÌerges (see Iìi3.7..11.i
'::rÈriheles\, puzzles Ìetrìain in (ndc6landing conr!umtLion bchavioúr.7 li{o sorts
:::i hâre been used aggrcgãtc üracÌoccononììc dala and mìcÌoccononÌjc dnta from
:\ i !1househol.l eÌÌrcndilurc.

Aggregate data
. -r 1: the ex.ess scnsiLh.itv oI co. mpticÌÌ to currcnt JÌconrc One sironit prt
i lbus tlle HalÌ :r oi the sìmple ìrlH modcì as discusscd abo\e is that changcs iÌ1ìlÌconìe th:Lt ar€
: --rble iìom past inlorìnalion shouÌd h.re ÌÌo etìect on.urrent.onsu ption (Ìor!
.rÌe 7.1). But thcrc is br no\Ì i .onsìdcrable body of work on aBgregate cobuml)
r.:ì that lugge\ts Lhis is !!rorg: it sc.nÌs thit corÌnÌr4riion responds to ì change in
-:: j!ì ttÌe pre\ntrsquancrl rhat couÌd be predict€d iionì the paÍ pâttenìotìncome
:.:br30.10o/.ofthcchangc.thÌs.mpiricâIresultisrefeÍedtol\the'er.essen
!i connÌmptjon bc.ausc io terms oftlÌe sinÌp1e |lH, consunÌptlon i\ ex.ersneÌv
: . to pÌe.Ìictabìc changcs in inconÌe. lhis is an nÌrportant remlt tì)i econonrlc

,:iÊÌinatiún.IÚ,rifnrr(ri1)nlnÌtr((ftlì.theoÌeri.alinde.ononeLr.n.dÈÌÌn!.Í..nntr.t!!n
:- : r.rÌlilds *e\leglrn r2lXrll
- : j.L r.r nÌ nncÌigrrìng irj: hfih.r i\ D.il.r íÌ992r The iÌLr.Ìe l]I \lethir 1200li I rl\o leo
222 . .. a.

poli.), becausc it mggens that.hanger nr income:ìs a resLrll, say, ol tax chaniae\ can ha\e
anÌarked clÍc.L on connünption and henceon e( olÌonÌic actilil-Í
Problenì2:thceÌcess\moothncssoíconsumptioninreÌnLionn)'ìreql Second,cl6eÌ-v
reLâted tothc predìctl()n bv thc slmtìe lllÌ thrt predictabìc changel ìn income shouid
hale no clÍccl or conrumption. is the icìea that neì\'s about a change 1n peÌmânent
incoÌn€ wìll lcad !o an ìmrnediatc rhift ìr con\uxÌption to the neir leveì of PeÌmane t
incoÌne. lhis is lhe case ìn ros.s 2 an.ì 3 ìn Table 7.1 (.hange in peÌmanent incom€ or
ìntì)mrâtion no$, abo trt a cha ge iÌì peÌmaneDt incoÌìe in thc tu ru te) ThitaPpeaisnotto
be conlìlned hthc aggregate dâta: curÌentconsumpiicnÌren.tt mu.h le* k) he$J about
changes in permarcnt ìncome than ihe theoÌt pÌedi.ts. 1hìs rcsult js Ìeferre.l to as the
'eÌcess vnootlìncss'oí connìmption because 1n teÌnÌs ofthc siÌnple PÌH, connìmptiotÌ is
tír) sluggislÌ in rcspo n ding t(r the bcws'.
hnteÌn 3: borÍowì ng and lendh g ì n a.Ìequate to ìclÌielc s núoth lng Thid, the sirnple
PÌHpìeclicts that charges ìn a\s€ts (lh íÌiiah len.ìÌÌ8 or borroiriDg) ailìalìorvthe requir€d
change in (ons!qÍìon así)cìated wìlh a.v change irì pcrmanent Ìncome to be iÌnple
mcnted. But tlÌe anall sis ola$regalc datâ indicate! t1Ìat this js not tÌre case. Iloüseholds
do not seem to enitâg€ ir the exteÌÌt otbotlwing arrcìlending Lhatwouìd be neces:ìry tc)
snrooth chanijes nì peÍìanentin(omc ovcÌ lhclife q'c1€ âs thc hypolhesis ntiaiietts.
ProblenÌ .1: ÍÌcoÌÌìplclc Rical.lian cquivãlence. IouÌth, thc sinrlìc I'lH pÌe.Licts that ii
cuftcnt:!ovemÌueiÌt socjâl sccuÌit-v pollcics and pen\io conìmìlm.ntsaÌeLrnrlLtainabl€
on lhe baiÍ ofc!úeÌìt la{ anLl contrlbuljot Ìates,lar \i8htcd h ous.h oìds { ilì anticjp:ìte
the hlgheÌ irture tar buÌden and thc loirer ìevel ol siate provision of beneht\ ft)r dÌeÌ
Ì.túement LJt iÌìcrcas i. g their cuÌrenl sali ng. (Th ì\ is a casr in le ÌsoftheTableT l ol
cu ent i lo.rnatìon about Ì{Nei fulurc jnconre.) This is . l'c6lon ot Ricardlan e.Ìuiva
ìrnce, $lÌiclÌ r'e lookcd at ln nrcre dclail in Chapter 6 \!hen wc considcred fiscal Polic)
and holv it mi:1Ìt aflccl c.onomic a.tl!ì11. Thc.vi.tence nìggcsls Lhal laÌ andsocìaÌsecu
riq tolicle\ tìre not comÌrìeteì) .rüÌdonc'bt lh. trivate sector adiuning thcir savings nl
tìrìt wa-v âlthough thcrc apÌreaú to bc somc oíIseltlnii elïe.t ofthìs süt. lhat is lo sa-Í,1u
It teÍÍ\ tlìe.vidcn.c is that

O. -\.,, < \í,{ ll . (i.complete Rica iax equivâlen.r) -ncêrÌê |t,

$lÌere r rcfcrs to theabtoÌuie v.luc ola.

1.7.2 lVìicroeconomìc data

MìcrocconoÌnetric ríorl slÌows lhat il rrrtryrr t,p,"/à.,l.ds ovcr lhc lilc.ycÌc tr.g. due 10
dc.isions about the timlÌÌs.nd numbeÌ olchildren).nd thc tact thal consumption ând
Ìabour suppÌv.leci\io s are rnadc joìntly are incorPoratcd ìn Lbc analysjs, thc |lH doe5
pmvì.le a goo.ì .lescriptioÌÌ ol lhcdata.s
Such stlìcìies test a gerÌcraÌlzcd lersion ol the lÌH !sirÌg lh. so-calìcd Iulct cquatjon
afpn)ach.lÌr ihe snnple|ÌH, thc l_ìrÌer ecÌuatìon À ttìe'dis.rlrlc linrcRanìsctcqualion', i.c.
it ls rhe iÌrtertenrporal optiÌnizatjo. .ondition. Te\tiÌrg tìÌe |lH usinil thr Lulcr cquitior
aptr)ach is attrrcti\e b€.â!se bl locusìng on the nr argjÌrâl condltion fü o ptimizauctrr, il
! lÌodúenl nr fies ir. nluftl. rr.rni.! indl'le8h!11t91)itaArinri\i. nlr\ú.r i q9il
 :. :.. :.:. . 223

:: \ oids ee.l to measu rc ternÌancn t incorììe lÌìc ge eralìzed Euler eq !rtl()n regrcsscs
lhe n

ih€ .h ange in log .onÍr m Ìt tir)n oÌÌ I h e real itÌt€rest rate, :ì ÌÌÌcas uÌe ol thc I rade oll LJetwcc n
.Jre.auti onaÌ) motives io r saviÌÌ3 ( o which we returÌr ln thc next sec tion) a n d imlâticnl.c
'
rrì{l a scL ol vari.ìbles thaL measurc change\ iÌì household (.omposition, ìahouÌ suppll''
i:.. As Ìn the R:msry cquatloÌÌ, a higheÌ iÌìter€í rate riiscs conÍrnÌplioD Írnvr' and
r€ncc impÌies hiEh€r saving. lúujtively, when prccautionary motives outlleiiih nnpa
:ren.c, raling will also bc higher and as noted abovc, the inclusiol of dcmogtaphic nnd
rLrour supply vtìiablcs rcdoces thc jmpact of predìctable changes iÌÌ ifconre iiÌotlth on

1.8 Rational consumption and the tS equation

5e previous sectidì nìggcsls:
. the siÌÌìple Kcynesian consuÌnption functnu is qujte at odds with somc ob\ ItNs
I .rr ',. , . rnprro,q ì ,\roL|
' tlÌe sjnrple UH needs lobe ertcnde.Ìinordcrtobe corsistetrtlvilh theevidefce

!v introducing eÌeÌn€nts ìnto â t1ìcoÌr- ofilÍeícmpo.aÌ all{rcation that htve bcen leit
: trt in tlÌe sinìple l]Il, tle can explalf wlÌv ai{sr€gate consunrption hâs
Í!ÌÌe l(eyneslan
.Ìements. lwo key onÌissio.s are

ij unceÌtai ty, whìch carSìvc ìì!eto savings lor prccautiona ry re: son s and

l r Ìiquidj !l consiralÌìts, whiclÌ prcvent jome h o úsehoÌds fÌoÌn Lro íoríirg as nr uclÌ âs
they would hke to ât tÌrc prev.ili.S üúer€Í rate

Ìiuth ol thesc Iactob c.ìn help to cxpìaìn 'e\ccss lensll ivit-v' of .onnìmption to pre-
-:ì.lable incomc and'e-\cess smoothnes5ìoì consumptlon to nct! intònnalion
about
:\'rnraneú iÌÌ.oÌÌ.. Ì.et us look frrst al pÌecautionaÌv saving arld then at liqulditv con_

-
8.1 lJncertãinty and precãutionary savings
. the siÌnplc lÌll, üÌe orìl,v motitâLi{lr lor saving is lo buiÌd Lrp a luÌÌìp ot asets r'ìlh
:rhich to sÌÌr ooth co sumptnÌì ovc r the Ìife cl cle Ìn th e eaily ,vcaN ol Í'ork, the house
ì.ì.1irouÌd save ìn oÌci€r to Ìepat tlrc debt tlÌat iras biriÌL uP iIÌ thc teriod drulnii !!hich
._.lriiuÌÌptjon (: peiÌÌÌincnt inconìc) rlas morc thall labour irÌ.ome rnd to pply the
d.oÍÌe for lhe ÌetiÌem€nl verÌs (rìen tatrour ln.oÌne has fâ1ler to zero BüL il therc is
rnceúairÌtl ture lob opponunitie\ or about health' for eraÌnPÌe, thcn the housc
about
rlkl ÌÌìay a,ish to put savjng\ asìdc as ìnsurance lor iulLue .o'tingeì'i€s ln the fa'e
ri ullcenaìnl-v, househoÌds ríould tend to savc nnÌe carÌy in liic thar the PlH Predicls
lnsteâd of thc aler:ìile propensit)'to connune faìling.s
jn.orÌÌe riscs o\ eÌ thc 1roÌ ki il Ìltc
rs in th€ sinìltle llH, the de5ire lor frecautionary \a!ings ìeads to savnìg carìt on $'lth
:Ènìlt that consutìrÍion r(es with jncorne úÌo1 by Ìnore than ìrìcome) eâdr'' ìn th€ lilc
:r.Ìe and lhc areirte propenslty to.onsuÌÌìe rlsct Ìâter on Ìf s.!Ìng ín i rainy day i5
rnpoÌtant, then ttle utiÌit)' pro\ iclcd by ha\irg alset\ nr lide the ho!6ehold ovcÌ if rÌeed
ne oxtÍlcighs the utilit,v that woLrld hale conìc tronÌ hìgheÌ colrÍlnrption in the earlv
224 "
years. ÌÌì the two pernd model, a houschold chariìcterized bi ch pnrdcnt pr€ference!
Ì\'ishes to sâ\eenough nr peÌiod oret{) nrakc thcrIte.relpe.ioci two consumprìongreate.

' 8.r Limits to borrowing: liquidity conslrdints

W€ carÌ exten.i tìre rinrpìe tllo peÌnxl nrodcl to shol! that liqui.litv conrtraiÌìed house
h.Jld\ Ìv]Ìl ha\ e a veÌ_Í high Ìn a rgin al tÌopcÌìsitv to conluÌÌÌe out of an incÌcase lrÌ.ureÌÌt
irÌconÌe. Ir lìij. 7.5, the unconslÌajned household clÌooses to consuürc.r' irÌ tlÌe frbt
peÌn{ ancì .j in the sccond*j.c. at folnl ,1. Now slppo\e that con mptìon in peúocl
I i! lirnited to clnìent incomcj i.c. .r :- fr. lhc n€w bldget constÌaint i5 sÌìown b) tlÌ€
hearv.lashed ììne. The hous.holcÌ maÌiÌÌi7cs utilit) .nd chooses poìnt B-clcarÌ),, üti1
itJ 1s kNer thân itr\,as at t, in úrc ürco.strain€d sitÌration. flLtperiod codÍmptiorÌ is
k8er and secoD.l perjod cons!'Ìnltìon is hÌgher tlÌan at,:1. ÌltÌìe liquidjtv constraint i\
iu.Ìcìenly eased be.aurc ol i riic ln curcrt pcriod inconìe, tlÌe househoìd\ budget con
\traint ihiftt ro thc righr í{iotlcd). The houschold now Íì.aiÌÌÌires urilitv at poidt C. lhe
entìÌe 1ncÌeâse in ìncoDrc is consumed in the .urrent period.lhe pÌercn.c oI liquidit)'
constraìnts sharplv alll:rs lh. prcdiclìons ofthe sinple llH.
An a*unrplÌon madc ln thc simpÌc PrH th.t seenÌ\ to fll nÌ the íace oI rcalitl is tlÌât
hourehokls ar. abÌc to hoÍow aÂâìnst rhcir .Ìpe.ted tutrtre Lìbour ìnconìc ar the goiÌìil
iÌrterest Ìâte. Thc Ììnd oi houschold Lhnt sives lcÌ precautiorÌary ìeaÍrns carly in lile
might not rlanr ro borror!. Uut thcÌc mat bc ot1ìers le.it. Í!dents) $'irÌr cÌpc.tation\ ol
a pÍrÍìÌe ol Ììsìng ìabotrÌ incom. thrl dcsirc to corÌnrrÌìe ore heavill eanv on thar is
pos\ible ivith curen r in co nìe. S uch houschoÌds nì.v lìÌÌd that the) can r o l jìnd Ìoans a
nÌoúilai{e í cììlïeÌent bccausc rhat n stcurcd b! the valLìe of the hou\e. Such household\
are credit râtjdre.l as drpictcd jn Iig. 7.5.

( ods unìption nì pcrìÒd 2

(
\ÍnniL consúÌìption choi.e
n.deÌ liqui.litv coníianÌt\

(l.n\umLrtion nr Ìtriod Ì

Íigure 7.5
 .. . 225

\n erplination lor the ref(rsaÌ oi banks to cxlend Ìoans to hoÌLscholds is pÌolided b-v
rseph Suglitz and r\ndrer! Wciss's thcoÌ-v of cÌr.Ììt rationing duc 1o advcrsc selectnu.r
heider is based onthenotbnthnL dilteÌenthousehoÌci\pr€sent diffcrcnÌ rjstsofdefauh
:aS oÌÌ loins but tlì.t tlÌe bâIrks harc no wav ot dlstintuishnÌs bctr,ccn good and bad
-:l\. Ìi ihe b.nk puts up the lrrcrcst ÌaLe to nrcet the cost of exprctcd dctault, Lhìs ÌlÌ
:r\e t1ìe rtÌ€ct ol attr.ctirÌg thc hÌgh ri5k high ÌrturÌ horseholds lhosc ìcss likcìv t.)
i.lìLüt will not be $illnÌg to takc oul a loan at tÌre hlglÌer intcrcst ralc. lhc Ìesult 1s
::ìt LJanls ratioÌÌ lo.ns it tlÌc going interesl rate. If holsehoÌds arc as'aÌe lhat cre.lit
:.iloning is likely so that t1ì.,v wiÌl not neccssaÌì\'Lìe able to botror,in the event ot
: :aiÌÌv dây, ihen this rÌìay mollratc precâutionary \arings. lìrl ìn this ca5e, savìÌÌit\
: i iollards â bufle. ol liquid asscls to be drann on hÌ order to smooth con{tmptidr
I clearÌv, util . .a\e ol a 1ìl1in lâbcÌri in.odrc. II the buffet 1s erhausted, thcn consunrptìon .lroP!
::J iliÌl re\t)ond selrsitilely to an)'subse!Ìuenl rìre Ìì labour inconre as we have seen
. FÌg. 7.5.
ìnother rea\on $lÌI indiliduaìs ma) Iace Ìj!Ìui.llty .onnrai.ls is because of lìmit! to
.trt car be cìone to those who .arìnoL pey tbeir debts. Considcr en entÌepreneur wlÌo
r.e ot liquiclitv :i a goocìideâ and e-\pects to bc a nìiìÌnrnaiÌc ìn a year's tirìc. Accodnrgnr the 5i Ìp1e
:l he !!ill conluÌÌre this ye.r nl thc lcveì of hìr per ânrn1 income; acco nìit to tlÌe
. :;nesian cornunption nurctìon, he consumes on\'thc nulonomous Ìevel ot.0. for
- : !.Ìte lÌll ttr hoLd, tlÌe erÌtrcprcneur is rbìe to boÍow ìn oÌdeÌ to iiDCì a very hi8h
.5 carlt in lile . :l of con mptjdì thi\ ye.r. \till a bânk lend to lÌim? lt lhings go ba.lÌy, he nìay 8.)
r::\ruft, blrt ìt ìnakes reÌativel-v litllc dilteÌerce rrÌr bankrupL he goei. This tneans thil
' i.\tecte.Lflúureutììityisboundcdonthedowrrsi.le,whi.hwouldleadhi tobeov$Ìy
_:nrjsticinhì5boünfingdecisionsâgaìntrfutureircomcbecâaieilheSetsitr'rong
..rkct lillle .lìfleÌence whether hc is unâblc n)
tây bi.k lcry hìgh cìebts as opposcd
rr.rc\'high debts. This Ìlould ìcad Lo him overcorÌsurÌing todaÌ, hÌcieisiÌÌg his rìsk
:.ieuÌL and increrslng tlÌe bank\ exPosure tu defaült. To courteÌ this, banks ljnrit
-: :rìoLrnt the) aÌe pìeprred to lc.d âgaìnst lutuÌe in.odrc groirth, therebt rcdu.ing
: r L.luaìs' âbiììtv to smootlÌ .onsumptn)n an.l üÌcrcasing the imPortance oI curent
: ::ÌrÍn i.g n) the empiìica1€vìdcnl:c, a pÌagnratic approach it n) take the vic$I that
_:r5.)nrcprcpoÌtìonolhouseholdsârcnotcÌeditconnrnin.dandtheir(onsumplion
: l c\Ìrìaire.l bv their liletime rcsourc.s (aloìrg th€ lincs suggcsted b) th€ Ì'ìlHl, olhcÁ
: ia.Ícnt.d lrcnr consunÌüÌg ic.ording lo a ìiletirr€ corìÍ1mptìon pÌan becâ!sc tlìcl
: . -rL olt lÌom l{)anr. IoÌ tlÌis group, pÌcdìctable iÌÌcre.srs i. ìncome Letd to iÌìcrcnscs
:::ì nìplion (accountinS 1ìr'eaccssscnsiljvity'to predi.tablc ìncome and l.Ì'exccss
ìlìncss' to ne$s aboutpernìancnl inconrc). AnvassetshcÌdarc f(ÌpÌecautioÌÌâryrca-
_. \ngus Deai)n poìnLout thai nìanyho$eholds in thc L,SAhâve alervmodenlcvcl
:!Ld ass.tt tìrat resenlte Ìnore clo5cly thc buffeÌ ltock assocìaled wìth precìutioÌìary
'. thir asseis associatecìwith a Ìifc-.tcìc nìotneírrsaving SiÌniìarlvÌeseârchinthc
. .':'rirs that the Ìnediân ho!seholdk hoìdin,Ì of nnau.irl I'cnìth (in bank5, buiLcling
: .:ii5. stocks an.t sharet is only €1,2-s0.r'r

.: ü iLÌ ì{ei\\ (193Ì1.lhÈ.o,ì.cpr.trdlert \clcrn.. iJdtr.tr$.a hftÌnÌ nì tihaptÈrs

226

1.9 Conclusions about consumption

Ìn thjs secti()n we lÌâle colìsìdeÌe.l.onsrnÌptÌon in more detail thân is oflcrcd in the
consump!ion flrnction iÌìcorpo ratecì in the lJ caua(ion. We have seen thal:

(1) r\ s)'s!cm ati c approâ c1ì to lhc anaÌysis ol conírnrpll{)n Ìequìr€s a modeÌ ol
houschoìd oÌ ìncìi\idual bchavìour iÌÌ r'lÌich lhc assumptions . bout thc Ììalurc ol
tlÌ€ capÌlal maÌÌet, un.ertainll and pr€f€renccs ãre set out
12) F.mpirical evidencc câstsdorìbt on hoir well actual cons umptìon conespond5 totÌìat
fredicted bf thc sinrPle lÌll.
(:ì) thìs is lo be expected givcn lhe natÌrr€ ofasynìmehic Ìúòrnìation problc'ìs and
cons€qucrt ìì.Ìuicìitt conslraints faced in fiÌÌan.ial marketsl tlìr prcscncc ot
precautlonary moti!es for savlnS, as Í'ellas th.: interaction of labour supÌlìt, fanrll\
lorrÌÌation, and conmnìption decislon\.

In íìort, optìmizinil nodeÌs of coÌÌnÌnìer bchavìouÌ prolide a cÌcar ftamc lrtk i(tr
ânaì)sirÌg thc dclcÌmìnaÌìts of conruÌÌPtion. Ìhcy hcD cÌa.iò ttÌe empirìcnl slìort.oni
ings ol \impÌc ÌrlH models ând the cotrceptu a1 íìo I lcoÌì ìDg of the Ke)'ncsian consunrp

1.10 Appendix on consumption: estimating an aggregate

consumption function
ofcon\trnption, ìt is úrstÌrìctilc to lake alook ataD ejtimated
'1o concllrLle our discusslon

aggregate con\uÍìption Iunction. good cxampìe to rìse is lhat cstiÌìetcd foÌ tlÌe uK lor
^
dara fÌom 1956 to 1,188.rr The eÍinÌallng cquatl()n nìcorporaLcs man-Í of the feaÌxre!
discusse.l abole that arc neces\ary to ãuSÌìent the linple lrlH lhc modcl aìlows f(tr
$me houleholds to bc c|cdit co strai.ed, for the efìects of unccÌleintv, ftrr an eÍimate
.í expecte.l futurc jncome (estirnatcd tÌom a rcpaÌate model), and Ior ìiquid assets (such
ar bank leposits) to have a.tlltèrent iÌìPacl on con\umption trom illiqtrid ats.tr (tuch a\
peDsi(Ìr riilhts or lÌousìng).
- lÌt eím eÌ

,I.dlt n.l / n"

0..1.:t lr, 0 20 d,1 + 0.066!4I-1 0 02a L! l
r \r \L
J.,,os r r . ,ì :.
":'(. I
À_ : 0.950, Dn = 1.93.
The depeDdent variâble is consumptiotr (durable and ron.ÌLoabìe) it
rcaÌ teÌms, ), ì!
i
Ìcaì .lisposable coÍìe, r is Lhc Ìeal 1]Ìtere\t rate, r is thc unempb-vment ìate, dd ìs the
 .. :. :::.. 227

:rlolÌrlc laluc oI lhc 8ap bcLrleeìr cuuent inconÌe arÌd its aÍffage oveÌ the tasi lìve ),€ar\,
- i is a nìcasuÌe oI ìiqrrid assets and 1Á is a nteasure of iÌliquìd assets (housing lvealth,
::!rillcs,andbonds)ardí\),/,t)ristheexpectecìgrowtholinconre.ThestancìarcìeÍors
: ihc.octlcicnls arc shown in bÌackets.
\5 Mucìlbaucr cxpìains, il js po$lbÌe to extract irÌlormalion IÌonr thls equati()n about
::. ÌrndcrlyÌng nìodcl. a.onsumptidr reacts lrith a lag to rhanges 1n 1n.ome (shown by
:::i.ocllìcicnl Lì.5Ì);changcs ìn cu ent inconre ieed through lo consumptlon an.l thls
::r bc ìntcrprclcd as indicaling the conslrmptidÌ sharc of househoì.]s drat are credit
nnrairÌcd (r-ì I7l0 5r 0 33). The ÌeaÌinterest râte lÌas a ncgalive ette.t or consrìnÌP
:::n. Unc€rtaÌntyaboul flrturc income is nÌeasured by thc change nr unemPÌoymeÌìt and
: ihe dcvlation bclwccn crrrent and averâge income andhas a neiittive elìect on con
::ÌÌptior as thc prccautionaq motìve \uiígests. Highu a'caìilì Ìaise\ consunÌption but
jtrid assets have a much bÌgger 1mpa.t thaD iÌliquid oncs. Ixpecte.l hrre itÌcoÍì€ has
rüpplv, famiÌy : rotitive elf€ct as would be c{pccte.l with írward looking PIÌI/LCII hous."holds. lhis
::rrnÌÌte of ân eÍimated ailgrcgale consumptìon 1ìrction shows the Íne of life c],cle,
::..autio âry, ând credit constraìnt fâctoÌs:

(t'" (ï)")
: tugges( that when uslÌrg thc cquatiitr, we need to be awaÌe of tlÌe likely roìc of
/i_
:::.ected income i+owth, un.ertainll, inteÌest Ìate, and I'cãlth effects i additiontoOrat
'.unent dìtÌnÁable iÌìcoÌne (andhcnce oíÌi.Ìuidiiy cons!úints) tlÌe:!d], incorl)oraled in
.: Ìielnesìan con mpti(nìlurÌction. Sincethe interest ralc rffectseenìs to be ncgative,
. s irilì ÌeintÌ)rce the neiiative in Ücs L Ìate effect on 1nçcs I Ìì ent in the d ot\Ìnward sÌoPiDg
I

I ;un e. Changes in expectâtions ol inconie gulth, in unceÌtaÌú), (p€dÌaps nìcantrecì

:: .hanges ìn unempÌovme]lt) andwealth effects wiÌl shìfithe IS c!rv€.

2lnvêstment
:: inlestment economists Ìnean cxpcnditue oìr nìân nÌadc aì.ts to prodüction such as
r rdl and nrachjDery, .lÌrelliìgs and otheÌ bulkÌirgs, and iníÌanNctrüe nrch as roads.
::r.!lmentis a 1Ìd{conceptthat trcanues such expendltltrc oleÌ a PeÌiod oftimc (such
:i r1cat. Ìt ìs impoúantto distirÌguÌsh cleaìlybeiweeniiYcslment and the capitaÌstock,
:1ichíthevaliìeotthestockolplant,machineryeic..andr.flect!inveÍÌnentspcndìng
:.r Ìnanv pÌevious peúocl\.
ln\estlneDt covers a diverse scl ol cxpendituÌe\. One paÍiculaÌÌy itÌÌport.Ììt dlvlsion
: inleJtnrent is irÌto piivâte and public te.td exÌ)enditurc, because tlÌe obiectivcs ot
restmeDt in these tiro rr€as arc not necessrÌlly the sanÌc. SìmìlaÍly, about a lìllh ol
: i!\'estment is in clweÌlirgs and thc lacLors drivìnt thìs arc likeÌy t() dìtlèr solÌÌ€what
': rm those detennlning inveÍment jn pìant oÌ nlachinery. Again, rePlacemeÌìt iÌÌvest'
_ì.nt nrav require a cìifferent explanalion fÌonr investrÌìent ainìcd at expttrclirÌ3 output.
Another inter.íjng and irnporlanl nÌnÌ of irveÍmcDt í sto.kbuildirg SlockbuìkÌing
(inveltÌÌìenl iÌr j .ven t(Ììesl may bc nei{ati! e as Ì\'clì a5 Positlve, and aÌthouiib n o I a PaÌ
tìcularly largc ilcÌn (onÌy somc 3irl of fi\ed iÌìvcÍnìcnL or 0 5110 of cìDÌ)), ll can be !eÌ)
volatil€ (as wÌlncsse.], tôr €r.rnpìc, ìn tlÌ€ de Ío.kj.g and re nocklng irì lhc LrSA i. late
2001 arÌd earÌ1 2002). Ikrlerer, aìthough tlÌere ]s a dìveìsiiv ol foxns oI Ìntcslnìent, nr
thls secticnÌ wc.oncenirate on fixciÌ capitâi lormatìon b)' the business scct o I bccaure .hí
lcÌent theories a rc n ee.led lLtr hous io g irvelt ent,got. nÌe tinveÍmcnt,nndchanges

lnleÍment plays a major ÌoÌe iÌr nr ac()ecoÌÌonÌi. Il uctuati(!Ì\ ând il adds lo thc.con
omy's pÍxluctivc capacitÌ. ft\ rolc on the suppl)/ sidc is centrll to tlÌ€ tlÌcort ot g(ttdl
(a.hapter 13). Herc r\,c conceìtratc oD i]]\'estnìellt as a coìnpor€nt ol aggrcgalc dcmand
ln booìÌ\, iÌì! estmcn t tcn cìs to 8Íow by ÌÌÌore tlÌan aìDI']aÌrcì1ÌÌ re.rssloos it tcnds to laÌÌ
b)'Ììore. ButihisÌs.oL ahvavsthc crse tòrexrnìplc in dÌe recoveryol Lhc UK econom\
-'r.,s1 . ,Ìr, cìl
'lhc sinÌte
irleÍmcnt flrnctlon ìn lìÌeJi eluâtion Ìrresented in Chaptcr 2.onlainstÌro
i.lcmcDts:I = 1lá./) ìr ere ,1 r€ prcÍìú\ erpe.tations oítutÌtre proÊ1s such as Keynef\
'âniÌnal sp1ìiti'and ris lhe reaÌrat€ oíìnteÌest. Alini'ir.vcrsion oithe invcsÚìcnl llÌnctidl
is: I = Á lJr, Ìlherc i aÌrd lJ are posìlile constarÌts. Jn Lhis section, $e folÌow thc sâme
Í..1c8] âs fd corNtrrìPlion liv tìst isklnii it ttÌe iggrcgate in\ eÍment lunclion can be
relatcd Lo a ìÌodel of ralional nÌicrocconomic b€hâviouÌ, tecond, seeing í'hal s'e shouÌcL
.lo i. the 15 eq!atiof to alìor! lo. ralionaÌ behaviorir, and thnd,lookÌìg al tlrc cmtnìcaL
.v Ìcnce or irÌleÍrnc.tbehrviour

2.1 lnvestment in the theory of the firm

i{c a$unie that inÌs alm íì mnxlmìze protìts, so thcy uncìeúâke inveÍmcnl proiectj
ìI tlìcse olfer . retLrÌn that is highcr than co\ts. lhe sllShl compli.aticÌr hcrc ls lhal Lhe
ouÌÌay on iÌìvcÍrìcnt t]Ì)icalll, prccecÌes the returns, r'hich nìy be l!mpt'' Jnd sÌrÌca.l
oler r xunbcr ol teaÌs. The !!a)' lo .leal wülÌ this is lo caìculate the 'ÌÌesent \iaìuc' (Yì
olthe expeclcd llowofprolìts Ì1,Í'ìrere [r Il]. is thc flow ol Profrts in pcriod I , cLc .
Suppose thJl Ìnlcrctt rates aie 10q,. Then if l sale ì 00 to.la| Ì will lÌa!e €l Ì0 in a ycaf5
=
tìme (1110 { Ì + l0%,1). E\t)ressed Lhe otlÌer !v.y around,Ite coull \at that €Ì Ì0 ir atcãfs
tìme ha\ thc same vahre as €100 loday. I{or€ s€nrrirÌl-r, il lnterest rüte\ are conÍant at I
the lalue ot { in ,r -yeaÌí t1ÌÌìe is lhe sanÌe as that of ÌirÍl +, )'r tod:ìv. \'Ve can calculale
the present vaìuc of our \treanÌ oÍ cxpe.tecl proÈts, Ì1, from an investment Proie.t bv:

r. ç,
LR
r I , I
Ìlheri'/ìr = (l + rLl (1 rzl.11+r,1.íoithegetÌeralcasctlhereiheìnteÌestratecatÌrarr

Ìf thc.osl of the machiÌìe is grcater than the Prelent lalue ot the iìow ot Prolìts lrom
tlì€ ml.hinc, lhcr 1t $ouÌd b€ mor. pfuÍìtabÌe not to buy lhc machine but in\tead put
tlÌe nÌoncy in the bank or nì bonds. SiÌÌ1ÌaÌÌy, if tÌÌe moncy to puÌchase the ìnlcìrine is
beirÌg borror,cd, lhrn ifthe (ost of lhe nrachine is i{rerter than lhe llÌeseDt !aÌue, bu-vinil
5n).lbuill:ling :- machìne s'iìÌ be untr)litable. (Ìì thc othrr hard, iI the preserÌt r.rluc is grcat(Ì lhan
::ç .ost, theÌr this inle\tment i\ prolì1ablc, and . proirl ìnaxiriizi g 1ìnn lÌi1l go ihcad

lhe rnÌpÌe pÌesent \aìue rnalysi\ nrgg€sls tÌÌat l1!o nÌpoÌtarÌt corÌponents dÍlvc
::.nnrent. If expecte.Ì iutlue pÌohtabilit_r rìses, thcn e{tectecì n€t reíìrrÌs Il will rìsc
.::r rLe would thirk rhat more iÌÌ!estÌncnt projrcrs ifÌÌÌ beconre !irble, otlìcr tiììngs
:,.g e.Ìual, !r we ifould expect nÌore irveÍrÌÌent to lâÌe PÌâce lÌr tlÌe iÌìleÍnÌcnt fu n.-
iÌntheLt,ÍI=t rrl, thi\ lvould bc cipturcd bt lhe..l tenn nìc.easing, slÌiltlng lÌrc
:rstment rcheduÌe land the lJ.ur'.1 to thc rÌglì1. On the otlÌer lÌand, lf rcil ln1cft:st
ìf ol SroÌlth r:.s ijse tìren tì1e pÌeseÌrt valu€ of all idvcínÌcnl pn)je.t5lalls, rÌìd i'c r,ould cìÌrect
.dmelrt to falì as !!e Ìno\ e letì üp thc irn cst,nc.t schecluLe (and in a .ìorlhji'cste r
: ..tLon alongtheIJcu^,e].
.ìnc.omtlication aÌisÊr lìÌmediâtel_t bccausc e cannot \ee into lhc Íúturc aìr.ì
'!frnrcnr dccÌsionr arc i.errri(abh connc.tcd r,ith nÌecastnu a lLoi ol lilf. p(Í
: !nccÌlri.tv is boun(l to pÌay ì..Èntral roÌc.ScntiÌìcnt rbout /itr'd rcal inlcrcsl Ìates ii
.: ' Ìrporlenl i. determining the viâbilit! of an i.!csoÌent as is tiÌc currc.l rcal Lnterest

x thc ncxr scction, ile set out i sirÌÌpk modcÌ ol nrvestrÌìelÌt. ()ur aLrÌ is to exPÌaiÌÌ
::i 1r1) omnrcnlv used mocleÌs of irìvcslnrcnL tÌre Q Ìrìodcl and the 'accelerator
drl'- lt i.kr a mor. geneÌal arÌâltsÌs oi hoa'a ìatnÌìal lìrÌn nrakcs its iÌr\e\tlÌÌent
:.:ijio.i. Thc Q modrì is a leÌl treât thror-v that can be cleri\,cd tom lrcnt ma\inÌLiÌì8
.ìr\ìour: cshalÌsccrhrtitfreclictst1ì.tlnrcs(nrc.twiÌlbeposilltc henthemaÌilnìal
:::..nÌ lrom inslaÌling r ur jt of ertri capitirl ío.k cxceeds its cosl and lhat the anÌo!nt
: :rìÌ rÍnrcnl Nllì (Ìctcnd on tlìe ÌrrrgÌnaì .osL ot a.trìJllv making adju\tmerú\ to thc
i. oi the cnpitai sluck. lts r)theÌ !irtue is thal lhc tÌreoÌ (.n br connectecìto obserl ablc
.:úbles and lc5lcd igâlnsr.latiì. How.!('f, ì1 ha! not Prolcd an unqurÌilìed $cccss ln

l\corÌtrast,lhcacc.lcral.ÌnÌodelis!cr-vcl(tdc:itisbasedo.lheideâthütch.nilcsln
\ âl(c'(I/) :::r,rnd lor oulÌrtrt d.t.mrine irÌ\'estnrcnl AÌthough cnrdc and ad hoc, accel€int,Ì_lvPe
.:::.ts ha!.c lrcqLrcnLlt bec. f(Ìuìd irÌ crÌìpiticaì lcttúril. Ìhis suggesti dÌat $e slÌouÌd .ot
rrpl{tlúo\! IarÌay,buttNnr ndersliddrìryLheac(eleÍaloÌma}ca(LiglÌtona.Luiì
: ritnìüìt bcharlo(Í. \\'c hegÌi by work!.9 throu8ìr Írì. illcoÌt Í) ai to e\pl.ìiÌÌ ürhich
:::rmplions producc llhich Ì(iÌÌd of ÌnçcsLDrcnl fun.tion. $c nraìÌ tee thrt iÌnpcrlcct
:rÌpetÍi,rn ln Lhc Ìrírdu.t nrart(et is rcqüìrcd Lo derive aÌÌ invcstÌnent fìuÌ.tion ftoÌì
. ir(Íou.dallons thet ha! an accel€ranÌ conìponcnt.

I2 A simple model of investment

'..r j.re\tÌnent I isecÌrìdltothcchangeinthecapitâlÍo.k, Kl

( t-.2)

\iL? tÌriL rslr.!rt. a.rìrrd a.Ìrfdr on !ín5 raLÌrer tÌÌf nr nLvÈÌnìÈnti !ro$ fr(Ímtrrr nrLkLes
itrìrrrto.ú\.i,rÌ)ii,,,rru.,ltn,r,r'Ìri.ndrp.rd5o.nrrJÌr,inno.kijÌ1itr.\.t'rr^.lr\.en..
r

fll

r;{;r
Figure 7.6 Opt nra .àpta Ío.t: à r5e i tlrè rêd ntêrest i.te

Suppos€ therc is a desìÌed capiiaì íocli al a.y momert of t1Ìne, (i lìecause oi cosls
ol adjustÌÌÌg from the eÌistinil to Lhc dcsircd câpìtrÌÍock, a si ple âssunìption is lhet
iÌìvcÍÌncnt nrates upeach period 5onrc ÌrÌopoÌtion.. < 1, olthedilÌ€rence betwecn Ih.

(7.3)

lhc ncÌt qúestioÌr ir to â\li n'lÌal dcL$mìncs the derire.l caPitaÌ stock. li the pÌodu.tion
Iun.Lion ìinkirgcapitri!rxl labour to oulp(ú, t. : ,i((.I)i\ conca\ e (liminishingretiüns
!o capitâÌ], the cLesÌecl c.rpital 1o ìabour Ìalnr decliÌìes as tlÌe rate ol lÌÌterest ise!. Ìl \re
assume the prccìuctlorÌ lLrn.tlo n has constaDt retlrÌns to scale we can use the pÌoduction
Iunction in Í) crlÌed iÌÌtensllc ftnÌr. \\ic djvde each side of the pÍ Lrctidi hìnction
by I an.l irrìte jt as follo$t: I it. : tiKit. 1) = l((r, Ìlheie ( = K/t.Lr The prÍhrcti.Ìì
function it shown hÌ liit. L6. l hc nope ot lhe prcductidr tìnctbn is the nÌariainal pÍÍh(t
of capitaÌ an.1 we knolv t1ìat. proll!-maxiÌrizìng n Ì $,jlÌ choose the capitaì nock sìch
that the nrargiDaÌ pro.luct of capilaÌ is cquaÌ lo Lhe Ìeal ìnterest rate: itlK = l'itJ = ,.
whlch is a$umed to be \et, ior cxamdc, bv lhe cerhaÌ bank. An ìncreare in , implìes a
l(Nei.le\üecl capital nocl.s slrown b,v poinL B. The sìope ol the ììne tiom lhe oÌìgln io
the ptucìuctidÌ turÌction ìs tlÌc outptrU.aÌriLaì Ìatio: mo\ inii fìÌnn point.,l t() poiDt B ì5
asociâted $,ith â .ise iÌì thc maÌgiDal (IíIr(l an.i ar eÌage ptucLuct of capitâÌ (Á IrKl.

rr \otc ihrt Ìr( {lrhf. r r\ i r.lelel.I outtui nì iìls.Ìì.}ìier itr lin. ÌLith üe.hipte. on are nrô t.
mcdn,n n rn.,l.:iÌr iÌr{ AÍnliJì Ìn.dÈÌ5oIClìapLer Ì3lLhere rhemtln!iv.pÌodtr.tioniun.riotrisinúodu.ed.
Ìi\ dtlìnrd tr\ontÌ,üttcÌ Nrlè..
 This can bc $rrìlten

l/À-\l:r1rl
_

\)'/
) (i = r(?ilrr (7 1)

'irÈre r
is tÌìe capitaÌ lo oulput ratio arÌd r/ír) < O, as we h:!\e seen in lig. 7.6. It rhc
:1clol outputt is noL tuìÌ1. knoM al thc ti einvestnÌent decisioxs are ma.le, then ìt is
r .:usibl€ to a$unie tÌr a I K; : ! (4 )l,f , wh€re Ì/ is the expect€d level ol outÌÌrt. ruttìng
::i ÌaÍ two equatlons togclhcr, a'c harc:

= " l"r',trl o, ,1 í7.s)

..! illunrates holv irvettmentis a llrncrl()n ol lhc ratc of inlcrcstvia Ì1ri roìc ìn dctcrnìin
_: iÌrc desüed capital Íock. The assunrpLÌon lhat o.ìv a
troportion ot lhc gap bch{ccn
1: .urrent ind the .]esìÌed capìtaì stock can bc madc up in one pcrioil compìcLcs lhc
:: innìerÌt tunction.
: \re make tlvo rnoÌe a*unrpti{)nt, then Í'c can see how to derive lhc simpìc acccÌ-
:::n. cquatio hom thn mo.lel. lìr paìÌìcuìar, s'e have to asslrme thar â = l, ro lhal
: ijün€nt,1, lììlLy makes up the diffeience bclwccn K' and /( eâch peÌiod. Thc rec-
::: aÍumptbn i5 that thc crpìtal output Ìâtio is constant, Í) f(rr) = r. \\iith thcsc two
- ,:ÌÌìptions we have

17.3t
r fri' ri ,l (âccel€rator ilÌl.estnìent f unction)

_:ijsthca..lleratorreÌatidÌ\trip:i,estÌÌìentinp€riodIiscomplctcl)'dctcrnìinedby
_: ;onslanl.apital output ratio and by the erpect€d growth in oulpul.

- : A more general approach to the investment Íunction

.:ìre ilenerâÌ atpnrach to â nrodel of invettmcrt base.l on microfour.htìons staÌtt
- :r a\liirg what ii the p.oht stÌeam deÌlved lrom Í)me paúicular leveÌ of the capitaÌ
:..K, wherel(Ìras boughl iD pern)d t : O. To sìmpÌili matters, we shaÌl suppose tlÌat
-..ìolrÌÌent does not enter the pictuÌe thât oulput is pÍrduced riÌÌpll usìng capitaÌ
:. so ttÌatI I i,(l an.l alÍ), initiaÌÌy, that ihere is no depreciati{)n. Ir l(x)king at the
:::i(rcamderì\'edtìon,(,rvearenot)etconcernediriththecostofbuvingthe.apital
: .r!. (. Ìn any otreperiod r, theprolit ftom K is

PÍ IK). (7.6)

:ii ]ris tlÌe púce level atrlhich / : l(,<l is soìd, and ('hich is assuÌned not to changc
:: ìjm€. I he shnplilìcâti oìr about on Ìy capitaì bc in g used ìn prrducti on iÌoes n o L atlcct
ure ÌeaÍDúrg ând mcans rhât rlc do nut havc to subtr.ìct l.bouÌ cons lrorÌ lhc firÌn j
re\ enue. IoÌ rimpÌì.jtv, wc irstrmc tìrât rhc lnter€st rate rerÌÌâiÌì! consranr ovcr tim.È. lÌì
orcleÌ to calclrÌate thc trcscnL vaÌuc oI thc strcam ol prolìt!, staÌting from I lì, each
pei{xl\ pÍ)ht js diÍr .t.dbvth.reaÌralcol iÌìtcrrÍ, (1 . r'r-r,Írrìratrhcdiscounted

ll I
Ì'=
,t |./Ï1rì+ *,,I'r
r + r'ÏLxl +
[+,''
,p/.(1(ì

\{e can .levelot dilfercnt thcories of i.\'c5LucÌìl bv appl_Íing a rÌumber of djUffcnr

anunrt)tjons tr) thÌs jlc.rÌaÌ rcsult that the p(rcnLvaÌuc ol thc protìt strerm geneÌatcdh\
/( is // l,(r)i,. F.ach lheoN prestrffose\ tha( Lhc rlnÌì.hoosi\ thc 1€veL of iÌrveínrcnt t.
ma\ìÌnize the tÌcsent raluc oÍ ils f rclìts âitff havirlg pJid for th€ irn ettDent. if thc coí
oftheinlesiÌncntjsai/r rhcli Ì.hoo5cs/ Lomaliinlzc I'Lr (llì= P/i,(),,,1 all/.
5ubiecttothcdclnllion I, - (r ,(j
Thet is. rhc lín .hooscs / l. DâÌimi7c

t'f( K .',
cÍì.

Thc chariìctcr oi thci .cstnìerÌ1 iunctiorÌ th.t (ìÌÌ be deived tr(rÌ thi5 maìnnizatio!:
prìt.nr dclrcndsonthc asnnìpuons thai arenÌade. Threea$unÌttionsalc ofpaúi.!lìr

{l) lh€ distirÌ(iion tretweeD peìlect ancì ìmpcrlccl cofiìpclilion iÌì uÌe tr)ducr nìarkcÌ
We íÌâlL asunre, hrt of all, that theÌe i\ ÌrffIccl co,Ìrp.titiüÌ. Ihi5 impììcs thafth.
lìrm c.n sell any incÌea\e 1Ìr output aÌ rhe nìa.kct pri.ci hcnce ]n\estmenr hes n.
clÍc.t on the price ancll can therelore be tâkcn as.onslant.
(2r Thepre\enccorabscnccotidiLt5lmcnt.ons. lhi\ reÌates to thc rost ol inve\hnenr.
Ct1) ThereaÌ.saidrobc,roadjr6rnìcitcon\ ilÌe con olinrestnrüÌr is siÌnply frI
Ìvheie I 1s lhe trnìL tÌi.c oI a ma.hlnc, .rÌcl il l,r i\ iÌrdepen.lcnl ol the anrcunt oi
iÌÌre\tment uìr.lcÌtakcn in a fÍiod.
l3l Thc rllci.ncy or ot1ìeúi\e ol the capital mârkcl. ll lhc tìrnÌ carÌ raíe ar nìany fund\
as il \llsÌrcs at the núrket .ate ol iÌiteÌetr, rhc Darkct ls opeiating ellLctcntÌv, and
the loflìúÌi lí((lr, is corect. Ì!r mch a capltal markct, the ÊÌm fa.cs no crerti:
ratìoning afd thc coÍ ol extenúÌ 1ìnrn.e lor jnrcnnìcnl is sin4t) the markct rate oi

2.31 Pêríe€t competition, no adjustment costt and an efficient cãpital market

In lhis casc, I is talen as colstaìrt ar.l rin.c lÌÌcre.r€ ro aclju\tme.r costs. the onÌv cosr
of i.vcslnlent is tlìe co\toltuÌchasìng thr (apital goodsthensel!es: Lill a,r1 The.cr
tÌofl lo thc 1ìrrÌÌ ir equaÌto l') Ìess rhe.osr oI i.vestüìetrt,lrl. Ír 1r pcr od / O,rheiÌrÌr
 _ roscs ìnveslment,I, to nraxiÌnize:

rt t.r
l [ ]! t,tr
lï \^l

- ry'!() r

t.7.7 ) (cìefr nition of nìargìniì.t)

. È\tre$l()n tell\ us thrt firms ah{ays in\.ett, to ensurc thal 4 (usuaÌl) Ìeier€.| to âs
_::sjìraÌ 4'l is alwa)s ecÌLül to one, atrcrc 4 ìs tÌre ratio of thc ÌetuÌn to the ÌnarginaÌ
_ : !ìl capitaì ìn any one
Ì)eúod ol timc !o 0rc cost ol capltal duÌÌng that peúod. 1he
.:.rar.Ì of í, rÍr((), is the Ìnarginaì rcLurn the lirnÌ Sets. his n the mari{iÌìal v.luc
(rir : :ú.t oí capitaÌ, or the púce .t ÍIIÌìch th. lnÌ seÌÌs its oLrtplú tinres tìÌe extr:ì cÌrtput
l't ( 11 .
::r a nìargìnaì unit oícapitaÌ. Th€ denonìlnnlor of {, rIJ, is thc coslof the capital cju.ing
.:ì..iodlorthe'useÌcostolcâpital),whichìnlhlsslnìple.ascsìs4,itheÌúereÍlosl
:ì: halinglr the maÌketvalueofthis nrargìnaìunit ofcapllâl beìngused.rscâpilal
I :r:rÌhin invettedlnannanciaÌasscl
r:: lhjs prcnt nraxìmìzation conditìoJr still does not tcll us how muclÌ investrncnt
. il lakc tìace. Ì.et uJ calÌ (' thc oplimaì lelei of thc capìtal 5tock lf 1\'e knoÍ' Lhc

-.-:i,rnaì iorm utl i,(J, the tòrnula

tl(K-) tl:!!:):1
. .r.i utt(r fincÌ (' explicitlv. lìecondltionihat4:IiìnpÌiesthat

í'(K'): rtrlP
-rd( exPlicit\', Ìrt u s take the exanìple of a spccln c prod u.t lon fun ctidÌ: ) fi,(l:

f'(,( ): o.s(K-) r/': rlL,1r".

K'=1li2ÍItiP)]
. rscchowmuchshould bc i.!ctled,wehaveinvcsheÌÌt,1:

:1!lztl'tit')t K t
(7.8)

::,r!.rìcraììy,

t : t(r 'Pt i)
ê market
.:- tÌìe signs abov€ ihc va rÌâbÌet itÌdicâte the dÌrcctìon of the €flccl ota change iÌÌ tlÌe
-'::rÌr on irÌvestmcnt, holdjng aÌÌ other !rriables constant. lhis gjvcs us a key remlt
'::r iÌnestm€nt fun.tion ìn tìle I5 curle, nimcÌy an ìncrease in I lmpìlcs a.Ìeclitre iÌì
:ì:nreÌÌt, ândviccversa.
í

2.3.2 PedecÌ competition. an effi(ìent capital market, depreciaÌion and adiustment

costs:Tobin's 0 model of investment
'lhc.ost of a.ljulti g tlìe.apjtaÌrtock (^er.nd abolc the cott olPuÌchasint the ne\r
capi!aìgoo.ls Ífr1)) cân bc lhoughtof as includìng lhe costs oltÌaiìrnrg woÌkers to opcr'
âte rhc ncw equDnìent and the dì!uptioÌì to currctt Pr)ductìon caused b) 1ÌÌÍiìlling
and lcitìng nea equipme.L. The asnüìption th.t thc cott of adi$tnrg the caPitii Ío.k
in.rcascs nnÌe than pioporlir)nateÌy with tlÌe amount oí inrestment ì5 cnciâl tìr th.
result. A sìmÌrle ntuclel of adjustnent cost! is írr.1214I':. We theìenÌe ha\e the cost ol
iÌìveÍmcnt as ftrlìow\:

t:\I) hl+\di2,tP112

IÌÌ üdditior, í'c noi! asnunc that K depreciates bf i cach pcÌiod $ drat 4 :'(r í1 i
K. Ì. To nÌakc the analv\is .asitÌ. we arsunÌe t1ìe podu.rjon lúrctl()n ir linear, \o t|at
t, = /i(,\!hcrclà ìstheconÍantÌnaÌgìnaìprccluctivÌll oIcaPjtal Weihallsee perhaps
ntrprisiÌÌ3Ìy h at by iIcÌu d ing q uad tatic adjrìstÍìcrÌl cos ls a verv n eat ìnvettnÌent fun c
I

tt)n eÍÌerges. lhc fiÌm chooscs / lo maÌiÌnize rl

f I . tt tt I I r
I (di2)\t2
^ .t2,.t I'Ì

17.r2

L r ,,r,r l
- !í' :
t+ò r,(1+ u r')
t:!l I'r: rl (7.13
't l't t r\

Uiitlg the detìnitjon ot'maÌiliÌìal {'introdLtccd abi^e now itrclu.lhÌ3 depreciatÌon, rtÊ

r:! ,t tl.
This is â lery ncal ioÌnruìa. lt ifs th.rt if .i > l. í) that tìre caÌritaÌ stock is too lo\t
nìveÍ Ìent wÌÌl lakc Ìtìaceto reduce tÌìis gap, and Lhatthe e\tertto which ltis ieduced irì
r T.gctihi\rr\ntnrcdìêÍa.ltlìrtih(!,rìoiir.iJrlìfitr\êresÌ .r 1r i5Ì,/iÌ

lr
Ì rl tl (ì
+rt lÌ +ì)r 1
,\Ìl
/ìr = ar I +r,r "
! F+ ]'"'

.1,, l-hl ,'- lÈl: -'

 . 23t

djustment rneperi( oftìme.lependsoní,therìaisirraÌcostofadiuÍingthccapilaìslocl The

:::! is d. the Ìe$ investmen íilL Ìnâke up the iiap iÌÌìmcdialcìt, and lhc Ììorc spcad
15jfg the n€i! ::!e pÌoce$ wiLl be.
::.h ot the factob that can ìntÌuence hÌlestnÌent aÌe considcrcd ln tur.:
r b\'lnÍ.lliÌÌH
r ì./irrtrer r .or rs. lve hâve assuDcd a sinrplc iorm ol adjrútment costs: Ìì general,
: j.lr rcqui.cmcnl for derì!.ing thc 4 modcì is thal a.ljustment con\ be conle\ i.e.
:.rjloiadÌuslmcntiÌÌcr€ascsmorclhaninprcportnDtotheaÌÌÌountolirÌvestnìerÌt.
': ,ìishcr arc thc adiunnÌi'lìl cos(s (4, ihc snìaìleÌ is iÌÌvestnÌent. lhere is a slower
\7 t))
: rJnc.l ot tlrc capital Ío.k ro iLs iÌesirc.lìevcl. we ÌeturÌ to c:liscuss this asÍimpuorì
.: idjusrmcnr cosls bcÌoir.
](, íl ,ìl
..nLleaffl1': ì.,gitL prc.7u.f of.dtitdl. Any tcchnologicâl progr€ss ora tcchnologf
'.. ltill shift tÌìc production tLrnclion and aÌlcr the vaÌu€ of the nìarglniÌ producl ot
I :.1 5inìiÌnrlv, if$,cirúrcdu.c unccíainryaboúttheírtire,then it is cìcarthat c{pc.
, : :ri ãbout fÌrtur€ ÌÌìargiÌÌal productiliL)' Niìl cnter the eq!rticÌÌ. hjgbcr ctpcctcd
: :i).outpufiÌì1l booÍ expe.tcd rcvcnucand raiseinvestÌnerÌi. ^
..r,eof.dpÍ,r.gur,À.^changcinlhepÌjceoÍcapitalijoods(4)rcÌnli\.cLothcgcncraÌ
: i\el 1l)) tlÌrough, ior exampìc, lhe ÌntroductioÌÌ of an iÌìvcstnìcnl subsidyby the
..ìnÌent \fould .hange thc lc\.rì ol úrvestDreÌÌt. A lubsidy lowc6 lhe user cott of
(7.121 : :,land thereforcboosts irìvcstnxÌrt; atax Lloeithe opposite.
t :.,,t1 ü:.rüeÍ tÍ..r\ rise ln lhc rcaì iìrterest rate Ìrcreâscs thc oPpoÌtuDity cost ol
:ì:!reÌÌt iÌì physical capital.lroür an !nitiaìpositl{)n ol equilibrlunr, a Ìise in the iuteÌ
:::. Ìeans tlÌat tlÌ€ desired catilaì stock ìs ìower than thc aclual catital stock and
...nnÌen lill occur.
.'i?r".i.,rnnrale. lhis a*unredt()be a (onnant aìLhough fasteÌ technical
is normaÌl,v
' ::-i nÌthe luture \Lillinean.cdoced p()fitsfromlÌneÍlng not!.

.rn s Q inrestment functio is d erived lrom n 1rr odel of nÌicro€conon] lc oÌr tim izatnu

ìr :our (du5 an ad hoc adjuÍmeÌÌt con lunction). InveltrÌrent is a ncgaljvc lunctioìl

'...a1Ìate of i.teÌest iustaijÌrthesimpÌeì 'cstrn e nt flìnctntì th.t Ìqc uscd in the i5
. ::,r., I = IíÁ., ). Thc thÌrìst ol lobirÌ's Q nìodcÌ ir that giverÌ t1Ì€ adiuímcnL costs,
r j!/Í.irrt
deienninaDt ol inveÍrnent. ,\Ìl thc rcìcvant expectâtional la.lors Lhât
.i. s Q modcÌi : :ìr. invesrnreìrt functioìr and lÌence th€ l.\ curvc bt changils rt are ca Lrrcdbl the
rrdìooking variable q. lve stÌâ1l retu rn bcÌow to I h e .Ìueíion ol ho\Ì onc rÌì igh Ì l.í
:r toÌtant 4 actualìy is in inuuen.iÌlg iÌìveÍmenl.
: :.Ls foint it ìs usetuì to rnne tlÌat we can use ÊÌìan.jrl market laluitions as a tlat ot
:irnng 4. As {e have seen, í is tlÌe elpected va1üc olthe pr)1ìt strearÌì Scncralcd bJ
' .irÈase iD the capiiaÌ tt{)ck dilided b_r the cost oI lhe ad.litidÌ:ìL (.pitil iloods. lhc
.-- .: 1aìue oíthe lirnr is equaÌto the \'alu€ of it\ slÌarcs fllú its net clebt. il Ne c.Ìl lhìs
:,ren ire can thìnk of \Mv.ìs the 1ìnancúl markcl's vahaii(trl oftÌìe proit nrcam
.: r smaÌl changeir the hrm\ capitâlÍock. ÌÌì othcrrlords:

puÌ.hrsc pÌi.. oi addnionaL.apital A.o.ì\

í

We can now define 'avcrngc q'or Q às i(tlows:

a= r(fl..cnrnr cost ol6n.\.rútr! crpiÌal sto.k

(detìÌìitlon ol avc.agc 4, Q

irlÌereth.rcplaccmentco\tisthc.oslo rcplacingthee tire càpitâl Ío.li at cu rrent prlcci

AltlÌough avcragc and marginnl 4 arc .ot in geneÌal the \üÌÌre, they are related to cadl
otÌrer.ìnd beciusc xveÌage q carÌ bc rncasuÌcd bv Lisirrs stock nÌarlet valuations of.otl
panle\, the Q nìodeÌ of lnvestÌncrìt.ao Ìrc lcsted.l{e retluì to tlÌ1s beLo$. ÌLú firÍ, ll Li
usetìlto relax lhc esÍunÌ)tloÌÌ olpcrlccl competition iÌì o!r b:ìsìc nÌodel.

2.3 3 lmpêrfect competition, êfÌicient câpital markets, ând no âdjustment costs

!V€ nor' usc lhc same approach lo go in a rather diffeftn( dìrcctìon.ln laÌticuìar, we iriltl
to erplorc hoi a shìiï lìoÌn a pcÌíc.tlv competjti!e prodtrcl marlicL to onc ol impeúe.
corÌDctitìon altects the irÌvcslmenr functnu. Lnder iÌÌìpcllccl conìpclìtjon the pÌi.i
ol the lìrm s product i\ trot lìxcd .logenousÌ): 1ìnns sct pri.cs so as lo nra{imi7e theil
púÈts and tÌìc prì.cthat they scLwiÌldeten.l on the expc.tcd lcvcloldc'nand lhatthe\
lace. Iüìp€dcclìI conÌretitl\,e 1ìrnú iâcc doirni{a(l slopìrÌg drnÌand.uNcs. lvc a\sruÌli
now thrt thc lrm operate\ urdcr condirions ol uìonopolislic compclllion and face\ dÉ

lt.r l
Ìlhcrc 11ì! aggregate denÌand, r is the eÌasticiq ol demand ind thcrc arc , 5c.loÌs. lìur
thcrnorc, kr keep thÌÌii! simpì., we sh âlì assume t1Ìat 1 l(() d lnolhcrNoÌds,ltr
.re Jssunrlng that the nÌarilinnÌ lar.Ì aveÌage) pÌoduct ol capital is .onstnnt and cquel tu
orc. l1 ls .ot nece\saN to mnkc rhìs astuÌnption but in order to lo.us on the diil$cncÊ
lhal rrìÌrcrlect conÌretition Dates, we want tu simplify thc reÍ oi thi'Íorl.
Nowconsl.ler the di\.ounlcd trese n t vaìue expres\i,Ìì íÌ hxrì i:

\ ltK

Lr.dcr impcÌlect competition, an incrcâsc ìn tÌre capital Ío.li, (, i\ no longer consisterìl

wirh a consrarrtÍce oloutpul, P,. RaLh$, ãn incÌease nì the capital \tocl. \lhiclÌ ilnplie!
n. i.ffcâsc jn the hrrÌ1\ outpLrt mca.s cilhft tÌrât f, tâÌls oÌ altenlativeÌy that agg.eSitÉ
dcmard,.ì rr, ìrarrisen (oriscxpcclcd Lo.irc). Letus see the con\equencer.
Ihc nÌnr chooses iÌn eÍnÌcnL ro maìiÌìizc:

lJt!)
rô 7" 1

í) the conditlorìlor profil nraxìmìzation is

I J'í\!)l t, = o.
'! (7.13l
 ..237
r,\'e now need lo ìncorporafu thc jmpcícclÌl coü4rctllirc scllìng bv substltuting foÌ the
irm'sprice,l, in thc maxilìizatio. condition, r$irìgthc cxprcssion nÌthe denrandcun e:

y,: ?a\lAlül
.j. Pt = ii \.1i ); (7.16)

.\ c pro.ccd ìn t\{ro steps, corcentrlting firstox i.r[,Prl (/(]l,rr1:

, [,",] ((]l ì
in lr, rrrr"'o]
.n fr "'1.r;,1.', rl
t c0sts
a ì
f,<' " 1.,1,1 ] (7.77)

-.n.t, íaÌrÌrÌg irom cquaiion (1. Ì5 ), \!c havc:

' lt t ,Â
,
t+n .tl t+i I
.- I L, lr l' ì
;, ,)r, n
(7.18)

(7.1+l
rlinrt this coDclition tur the optinâl capital sto.k, ,K' ilh the investment le1ìnition
r:,1bearnrsiÌr mincltheÌe aÌe no costs oladjuÍment, Í'c hâre:

/= (- Íl ó)K:l

=''l,,fl=fr1" r''
"
(7.19)
''.' '1

...5tnÌert is a íuction otthe e\pe.tcd changc i. dcÌnand. Ilthe ratc ot ìnlcrcst n con
:rat. tìren this is the acceÌeÌaior lorrnula. lhis hcìps n) explâiÌì tr'hcrc thc acccÌdatoÌ
..ÍÌnent tìurction comes norÌ. i\n irÌvcstmcnt lllrìcLlon ilitlÌ an accclcrntor corìpo
_:::t rír,ll' be cìerived tÌom nÌlcroloundalions ÌrÌ a pcÌfectl) conÌpetitivc Ìrìodcl with
:.itaìrtreturnrtoscaleivìlerehrnscansclÌnsnìuchasthellikeütthenÌaÍkclprìccbut
::arer naturally ir a settinii ollÌüp€dect cornpclition ììere the irÌvennÌc nt dccìs io n js
.:rÌateÌv connected 1!ith clemrnd €jrpeclatÌons.

- .: Data and testing

: I Puzzìes
: -:ìirical studìes of aggr!8ate invcs t nr cn I h a\ e frequentÌv found:
. :!úÌrsLanLÌaì rìe f(Ìa'scalc' leÌm (NifutoÌcashiÌo$'orbo!h).
.:Iodestroletò.câpitalcosts(measurcdbyClorilscomponentsinclLrdiÌìgthercnÌ
lr
238

()l inv€stìn€nt concìucìedrri 'Ìt aPpears t')

A clrmpreheììsivc srìn'el ol eÌnpirical nudies
,f,,r n"1",*the reap''nse olinvestmerú !o prÌce \âriahles lcncls tobe smaÌl
""tn',",,,"tr], o r'rr' rb_
'''.,,urrnp.Ilr'n ' rol been
ine p.rzfc.trrno"rsL-ÌdÌnii the dclerüÌtÌrants oíinvestrnert has 'omPÌctell
soìved but i numbeÌ oi Ìecent detelopmenls
provi'ìe sonÌi'lloiÌìtch to*'a exflaining:

. a'ìry rcl atn c coÍs nÌay be impo firnl ld inYesinìent behaviour but clificuÌt to ìnearüe
ìn aAqÌegatc.ìata and
casb nor') ls inìporta nt lor ì nvest meÌÌt although it
s
. wh\. a scaìe elfcct (such is ortput o Ì

invesimcnt tunction rhc frescnce or an output sr)*'th

,,-1*ì,.- tn" ''*otal ;'
ì"t", ,, qt*" -"tO"tu,tith mo'ìe1oÍ irveshÌ€nr u der iÌìFrfect comtetitìon Ìhe
a

Lolc ol cash tìorv sLrggests ttÌar crpitaL market

ÌmpcrfecLiotÌs are iÌÌìportanl'

taxatìon
2.42 Cost of capital:marginaland average Qand
that invcstnÌcnt depends on 4
As 1\'e hâve aLrca.ì)'scelr, therc i\ a i!a-v k) testthe
th€ory
changc Ì thc mârket valu! ot the
r,,"..ur" l,"r,t nunÌerator ofmargilral to
*. -n
"
q a
ot
nì- -n", ,n".t,n", i\ jncrcased and the denoÌrìinâtor to thc ÌeplaceÌÌrcnt cost
lhe new cnpital goods
".ck
Wc c.n nÌeanìre average (:

,!Ítr Mv
Q - .'Plo-"È"Ì t_ntÌ lìttfr'ttit t"pir"rttt"r l'f
'l
lhe firm
líir is the maÌkc! \'alue oÍ the ltnÌ a"Ì I,I( i\ the reflacement cost ol
s
where
goods'lÌ'
capitaì stock, ,(, !âluecl attlìc curentprlces oicapiLal
"ì;iì;i"ì';Jil,.n;''
existing
o rhe de orcÌPe'tations a! a determ'"ânt orinvestmcnt'
lol ,.'r{u ' rl w'r"Ìess 'rJr" '-i'\-rnt'r ''"rr'r'h rr' 'I' l'_F''ìJ
r\r'r''r'u' I r'
:",;.-;";".''.,i",,', r,Fr', 'r''r'ì'or
Íì.1rtcr\Jludhún, trhctum.l.rÌr.s\Í!r..

{lnilv ey lraljons oÍ the StocL !Ìchànge ilre!ìtabÌ! 'xeÌt

i decsile núÌrren'e on tlÌc iare o1
t''rai"g cnierrÌG€ ât I costs(areÌdúf dú1
.ì;;;;i'".;... t",","^ i, no,.*"ru u1" ne*
ru"U.t*O,**".terPrìs'can bt PUr'hased;Ì!bìl\t ltrer' h an
iÌ rcemcnl tr)\pen{lo1l
".*n'l". ttl ."l' *-r ín e\trarasìnl 5uni iÍii'in b! IoaÌ'd olr'n the stoct Èa'hanr"1
,ì t,t"i*t
"""' "

Q ca!Ì onlÌ bc nÌeasur€d easjl-v lor fiÌnÌs !hat nre Ìislc'1on ì1q!id stockcxclÌafges sÌn'e
lì1t iÌ
,rrJ.r'"'"p,i* p",tiA"t rcadjì\' a!'ailablc meâíre oi the market value ol the flrm
i, ur rit"ly tltu Lìrt" I ,-t "qtrotc'l orl the stock e:iclÌaÌÌ8e opc Ìate ulì deÌ thc perlcctly co n1
i(trÌs necenaÌ ìo r margi na l and avcrag€ to be equal r!en
fclitive aD<l iri ctlonless cond il '/
if rhe rarginal ,1 investment llnì.lìdr is a 3oo'r nìlidel Ììcalured Q ÌÌÌjsht nol b€ ver)
price!
t,,.*ry",ì" ". "",p'.U"1 ìrÌvcstmcnt nÚ'tioiÌ becâuse oí the inLltrence on sÌìiÌÌe
rt (.!ne\ r t916 lsì j qu.trd irì (:!!rf k. lÌqrl, llrrllir
 .,',r,r: 239

:iiactor\thatarcDolrclalcdtothefìndaÌÌìcnlaÌvalueolthcfrm Asdi\cussedf(rrlhcÌin
hapter8r!€ÌÌ docunìcnledphe o cna oI tads an.i specula n e bubbles iÌú1ü encc sh aÌe
L

.!ices.,\ recent study usìng US nìicro data (o!cÌ 1,000 firms lÌnÌ 1982 to 1999) shoa\
:Ita Q model ol invcstmcnt cân be succcss I tlìt estinÌâted Ì\'hcn analysts' lorecaís oÍari
-:m\ pÌice to measurc its fundaÌnelÌtalvaÌuc
€arÌrings arc uscd instea.t olstock markcl
lnotlìer enÌpiri.al rcscnrch stÌ.ìteiiy has pulsued the .rgument thai clearer cvidcncc
: cdpital coÍ c1ïccls may ì)e revealed aftcr a change i taxallon lìrat atìects th€ cost ol
:rDitaL. .^nunìbcr ol studics have pursÌrcd lhis appr)â.h by ìooknrg at \pecilìc cpisodet
ra\relorrns andhavc u.coveÌeclnìorc subslanlialcost oicapitâl ettects on invcstment
:
::rn have been found in nggÌegate data.Ì3 ln additi(u to ìts taìue as a cie!ite lor lNing k)
: ì.lorínth€ roleol.apiIalcottsi gencraìIoI investüìent bch avìour, th€ analtsìsoIthe
.r pact of tâxes on invcí mc n t is ajÌ inìportan t substantive lss uc nr nÌacioecono m ic Ìlo1ìc)
:::rì\ ris. 1lÌe return to thc invedor trom iníalling ne$I capiLaÌ e.ÌuipÌnent or sÌructures
. rifected bt tâxâtioÌÌ in n number of difl$cnl tlays: ÊrslÌ coÌpolate proits are taaecì
'deì the coryor.tion ta\ syÍenÌ; second, aftcr ttr)1ìt! havc been cìistributcd lo otlneú
., dtr ideD.ìs, the) are subiccl n) lncoÌne tax (ÌÍ lhc Ìecipienl ls ìiable to inconìc !ax); ancì
_ rLì, orlneb \!ho realizr .aPjtaÌ ganìs by sclìing slÌar€s arc subject to capitaì gaìns tax
'. rÌlinrg ìr tlÌe opposìte dìÌccti(!Ì to rcdu.c the coÍ oI capìtal âre so-calìed capitâl
.IrancestìratalÌo\!somclnvennìentexpcrdlt!tre!tobcscLagaitatc!rrcnlprofitsand
'rs rÊduce tax:ìtion. lvidcn ce tuon1 Ol!lD cou n úies nrilgcs Ls that tlÌe taxh ubs idr'' systenÌ
::j the overaÌl elf€ct ofralsÌng the cost of.apìtal.r')

: .: I
The ìumpiness of investment and the assumption of smooth adjustment costs
.:lÌe scarch nÌ â more satisfact.n v und erstand in g oflnvcíment, er4ìirÌ.nl rcseaÌchers
,iÈ lookcd !er-v .lGely at lhe Pattern of lnvcstrrie t iÌÌ ìndlvnhral lìrlìs and pianis.
i.! lound Í)mething ertrencly intereÍirìg and{Ìuite al oddj witlÌ tÌrc stvlized pictt'rc
: rÌ\'cslmentwlth the liÌÌ.Iol a.lìLútÌÌì€nt roÍs dìlcusscd above Às cÌìphasizeclin lhc
: ..ussion oI rdìrLtrÌetrt cosls, the cost ol adjuÍ1ng thc catìtal Íock wes aisumed 1o
.:!lJe m o rc th an pÍipoúionnLeÌ) ríith tÌìc izc o Í tlle inlcs tment: the .os $'a\ a tun.tion
s L

: : :]È sq uarc of invettnÌerÌi li.c. lh e aclju Ímcn I costs i!ere quadÌatn) Ihis ìednrt !nooth

: i ! Írncn I p roce$ becaus€ blg .hanges in thc .api tal nocN i n cured big adjustnr ert costs.
. -: I her cconomÍt' Ìooked atterv cìeiaili'd mlcroecononìic data tòrvcrylaÌge nunÌbers
: rlants, hc) nrun.l that con l raÌ to the id ea oI a smootlÌ nvestnÌent ÍLo1\'' nlestÌnent
t ì ì

:. iÌì firct !cÌl ìump),.rt)

.\ìr stüdy lhatuse.l clata irom 360,000 plants Ìn the U5^ Iouncìthrtn€ady one tì1th of
: : :r€ilnl c inrestment in olÌe )'cer nÌ)k phce in I 00 .)f üìe pÌan ls (wherea s onÌy about 100/o

:: rroduclion nÌtr place in thc lop 100 produ.ers) EquâlÌy íriklng was thcjr I'nding üÌ
: :.:n4rlc ol ì2,000 plant\ tòr lthjch thel had intcstment dala for seventcco vears, that
: ilÌc Ìrcdìan estabÌiúnn€nl neaÌÌ-v il0o/o of aÌl ot its inlcslment ov€r thc pcr(xl took
: .:È in onc .piÍxle (a burst oI itvetttnent ir orÌc .n two adjacent years) lhcsc re\uÌts
: rìt tolrardreÌt laÌte, iÌÌlrequcnt adiuÍments ot tìre (apital stock !luite thc opposite
ford an{ì Cummif\ r2l)(rll
i 5...n)rt\rnÌl)lc aúú'ìirl HrÍen,.rarhr,Ìrrrd{Ì99'li
i.! nÌêxanpÌe lond ar{ll(rÌkui!Ìr {Ì9e6r.
TÌìri.kxúÌgdÌr.u\\nrìdnlrtofih.nú\e!.haplerorrnwrünenlb!{xbllleúlÌ99e).
ol vnootlì. in.rcme.taÌ adìÌrÍrnc.t. Large, hÌlreqÌìc.t lìurstt of irvennÌent wo!ld bc
expected ifthffc ls a nxed costto undeÌtaÌ(irgiÌi!estnÌelìl ThlsnraybeonereaÍrÌloitlÌe
empiical diÍll ruì ies wlth fittirÌg an i t ve\hnent nrtÌction s u.h ar th e maÌgìna I q one based
L

on q!.dra(ic adjustmert coÍs. It lhere i! a Ì:ìÌile frxcd cost of nrvettnrelt, then a iliven
\ àÌu€ olmargjnal-4 can be as\o.ialcdboth ivith rero iÌìvcstment an.l wlth a large arno!nt
ol lnveÍmcnt bccâuse onÌv wher Lh e gaP between the ii rm \ actlral capital stoc k arÌd its
.ìesiÌed capital stock has l)ecorÌìc strfhcienuy Larg€ is tlÌc lxe.l cost oí lnveÍnÌent oflset
andiÌÌ!estnÌi'rÌl lriggcre.l. Althouith aggreSateserieslo. inv.ÍmentaÌeÌelative\ sÌnooth,
evdence is bcgirÌnìng to l)ulld up kr suPPoÌt the viet\'(hal a nrodeì that ÌrcorPorâtes
lunTv adj!ÍmcnL irts lhe assreitalc.Ìata ìretteÌ uÌaIÌ onc it whìch \nÌr)th adjuÍnÌent is
asunÌeci. OÌÌe pnrl oÍtìre storv thaL nray heb to re.oÌÌ.llc Lhe lumP) nrlcÍ) rnd \ oothcr
aggresate inl'estmcnt datr is the inLft).luction olthe.nlry oÍ new nnns hvith new câpitaì
stockì and thr c:iil ol nrìn5 (scrapplng ol caPital stock) l|1o the mo.leÌ

2.44 Cash flow proÍìts, ând credit consÌraints

l.ìpiricaÌ irveÍrÌÌent cquatl(lL t-tpicâllv lnchìde both a nìcantre ol the colt ol.apì1al
such at Q arcl a ÌÌe.rsurc oÍ canl ltoh andr'(Ì output. Ìhr cash flow laúâbÌe is norlnalll
bol h nr oÌe \ignihcâ nt a nd m ore iÌnpo I la nt i n accoruÌtinil lor nve\tnr eÌrt than tlÌe cost o Í
j

.npiLallarial)Ìe.Àswchaveseen,tlÌcicisnorr)mnìthenÌatgi.rl4ìnlestnÌenttuncti,Ìl
ior anv vaÌiabLe othcr lhân í lt is djtnculi tu recon.ilc lhe inrtoiÌance ol c.ìíÌ Í1oN
ior ìnlestnÌeÌìt Í!11Ìì Lhc mrrglÌìaì-4 theoÌy. The.eaÍÌì is that taNa kúkiÌìg firnì5
shouìd tnk€ into a.couìrt anr,-.redì! coÌrstraiÌÌt\ th.t thcl tace: these shouÌcl .ìhead,! b.
incorporlted iúo t, r'ith the corìscqucnce that rÌÌt rddillonaÌ cash Íloi{ varldbl€ slìoulil
add no e\pl.rnatory toweÌ.
The iÌÌÌportan.c otcash 1Ì(n! \âriables 1n estlnÌated irÌ!cs1m.tte.ÌLration\ itieminisceni
ol the importancc oI culrent and lagge.Ì ìncone rariabÌcs in estinìated connunptlorì
frnctions. ln thc consu.Ìftidì luf.rjoìr, crnrent i!ìcolÌÌc 1\'âs sholrt to matteÌ becrlìs€
theÌe âre hoLrschoìds wlth rnrll orTe(r a$et5 \ího.re dcnlcd rcce* to cÌedìt and herÌc€
are Liquidit)'constrrined. TlÌis faclor$'a\ rele\rnt to th. prcse.ce of the !r caÌìeclexces!
lerÌsitivil-v ol co.sunÌÍnÌì to prcdictable change! iIÌ income SimihÌl), the tre\en.e 01
caslì llor! lcrms in estlmated iÌìvcstmeÌrt limctioÌìs ÍronglJ n'ggrlts that dreÌe aÌe li n\
that do nol ha!.c acces\ to trictio.l.ss catitaÌ maÌk€ts. ln othcÌ Í'oRls iÍ tÌreÌe eÌe nrms
th.t .nnnol bo ÌN a\ nruclÌ as th.y wouÌ.I Ìike oÌ .annol sell as Ììuch e.Ìuil! as the)
would lÌLc in ofilrr to hnaÌÌc€ thcÌr ln\ estnrerú tìarÌs, tlÌeÌì in'cslnìcnr iciÌl be lìmited b\
their lrìlcíraì Í(urds.
lhis is soÌìctiÌnes ÌefeÍed to as the ercest sensitilit) cÍ jntcslmc.l to itlcmaì fun.ls
tor iìnÌs ljke thì5, cash tlotr 1\'ouldbe erpected tu be iìn irÌÌpoÌlan1 dclcnÌìnant ol in\ ert
rnc.l. lìrr reaí)n wh! hrÌns mit bc rati{nred nÌ tlì.Èir ac.css lo dcbl (c.g. bânk ìoans) or
cquil_\. lLnance 1s explLtred in alhafter 8 when we lool at crcdiL Ììarkcl iÌrftrlc.riots in
!h c con text of the nÌonetnr)' pol iq trrn!ìi\slon
ÌÌÌechaf js Ìr .
l'hcÌrÌtse.ce oiÌnÌuidit) or.rcdìt.onstraiÌrts ha\ beeniound i. malì-v slLrdìcs oÍ inrcsl
mcnr using .Ìisaggreslted data IoÌ â numbeì of diifer€nt .ounlrjcs.':r .\lthoLrgh lhcrc rrc

rr n1,. nÌ.rrrLÌ,1e, (-hn!ì(D ÌÌn9l)

 . : a. 241

Íill livcll dcbalci about ccononieúic nìethodoloEy, tìre rveiiìht ofcvÌdcncc seems to !ug
gcsl lhnt loÌ a substanljal prÌÍÌtion ol firms, it js not appropiiate 1o nxxlcl itve\ttnent
dcrisio.s as il lhcsc fiÌms lradacces! toâ periect capitaìnrarket.lor sucb irnìs itvestnrent
i! scJìsitìr'c lo Lhc amounl oíìDtenÌal iìnds that arc evailable.lÌìternal tunds aÉ in tlun
highÌy rcsÌronsn c t.r curÌcntptuÊts tlÌe nÌore so bccause ÌúereÍ pn)'mc.ls a Ìe 1ì xed and
firms arc rcÌuclanl to cu! di!idercìs.
cxamplc ot thc rcÍrÌts obtaired fro ì UÌ( nicrceconorììic data is lhc lollowing
^n
fÍLrd-vusjrgUKcompan,vdatalbrtheperiodÌ1175-86taundthai.ompanyinlestment
r!as signitì.an1ìy l.flucnccd bv a2 and by Ìiquidilv conttirlÌÌt\.z'z tlc lmlact ot Q rurs
lolnd to bc vcrlr smnìÌ: a l0q, Íise hÌ the Íock mnÌket vahìe of a .oÌìpany iqs as$ci
itúl\ithn. lrnnrcdìalc rìse 1n the iÌìvestmcrt .ale of o lt 2.5'/0 llash flowwas \ery
inìportanl. lhc samplc pcrìod wa\ divided lrÍo tr,o and it was folúìd Lhal the itÌpact of
Q wâs lower and thc impact ol castÌ tÌoÌ! higher in the 1ìÍ parl ot the saìnple duriÌìs
shich the UK c.onomy í'as in a deeP recession. lìitícoÌÌsistcnlwithtbeldeaolliq
unìity coÌìÍraiÌÌts biting cspcciaìÌ-v hard irÌir recesslon. AnoilÌer Íudy ures a coÌnpLet€ly
Jillerent ecoÌÌonÌ€tric metÌìodoìoiiy on nÌaüo€conomlc dat.ì lor LrK llxed intestment in
manufachrirÌg lor i968 9lì an.l1in.l\ siÌÌìilâr reÍrlts.rr ÌnleÍnÌcnl ìs í()und to depend
.Ìr al, orìtput ând orÌ tlÌc dcbL strctlú€ ol Êrnìs (sÌich câPtures thc iÌìpeÌlections in thc

z4 5 High hurdle rates Íor investment: the option valuê of waiting

ì í,ldclv discusse.l hypothesis thnt may account lor somr ol the puzzlcs ìn Ìnlestme t
rehavÌour rclaLes to the role of unccrtainly.zL The lolloi{ing thÌe€ featurcs aÌc connnon
:o ÌÌrilÌÌ_Í invcs lment decìri(Ìa:

1r lnvestrncf l cnraìlsasunkcost,ì.c. notonlvmâ) thcrebeallrgelìÌcdcoÍol

nìlrnnìcnl as discusseLl in thc cnÌìieÌ secti{Ìr but thc con ntay bc sunk,l e not
recolcrabìc in theevertolthc proiectbecomnìgunpÌohtable.
lr TheÌe is perv:si\e unccrlainty in the e.onodric environnìcnt ard iÌìlormation
ann'es gra.lü.ì1lt as iimc pâste5.
I lhe dc.lsion invoh es ìnÍ only lthctheÌ to go ahead rtith the projccl but also wh€n

Lnder thcsc.ircumstances, tlÌerc is â \'alue to waìling to undertakc an invest!ìent

rliect sìÌìcc wìlh thc passirg of timc and thP rÍÍir.Ì ôr m.re i lÔrmalion tlle costs
: deliy (Ìost frolLLs Ircm tìÌe proiccl) nrav be outríeighcd by nÌore securc i.ftÌmatlon
:r tlÌe baÌancc bct een tìre coÍs irìcìuding those sunk in the project and Lhc heneÊts
: undcrtnking it. The upshot of Ír.h coDsi.leÌatiorls is that ar elpeclcd rale ot Ìetlr
inidcrnbÌy hìgheÌ thaD the coÍ ol caPjtaltliìl be requÌred t() triilger ilÌ\'címtnt Di\it
::r Èt exarrplcs lo sho*'that in.hdlrg lhe sr calìed optjon vahìe of Naìting can doubie
:::: hurdÌc rnlc lor an investnÌent projccl to prcceecl. Ìt wllìbe oPtlÌÌìtìl to Ì\'ajl ìongeì íi e
::::re is a hÌghcr huÌdle Ìate)

: 3lÌuteÌÌekÌ (r,l2) rr (.utnrêdionrnd L:.sprf oll993)

ihr\ dn.!$idì dra$i onDixrl (r9r2) \retrlr.rirllv.kO9tl)
242 :'.:.."
. Ì\'hcn t1ìe fuluÌeis lcss ìreâ tiìy distou ntecì
. when lheÌe i\ more unccrtaitúy nbout enrnings

lmpericcl conlpclition plays a ccnhaÌ role in rhi\ Ìnodel of investment tf lhe ir\en'
menioppoÌtunity is availablct() aliiìnns' i.€ !hereisa Peúecill' coìnpetitivc nrarketwìth
fteeentr!, then thcoptionvaìue olwaiting dirapPears. A\ DixltPlrts it:

li the \n!PleexrmÌtc. (4rPortunitt kì nÌvcst ]{as âsilned tu jun or€ 6rm' But ilil ì5 â!àil'lrle
the
jea\ibìc' lhe t Dtior to Ìrâit will elpn e lccalse
to a ny )l scleÌaÌ núns, therì waiti r 3 ú no Ì(Ììg.i
r

some LÒÌnpeljtor siLl seiTÈ rhe olt.rlunúv TÌren ÍìrÌ. nm silÌ inve5i nt \oon as the caPccte{l
prese.tvaLue LÍÁs.s zeÍ). 11992i I18)

fhc mocleÌ prcvides a l1Ììk to the discussion of htÍcretis in llhâpter I lt gn'es a'
erpÌanrtion as 1o r!hy s!rnkc,rsLtwhetheÌ in \killcd $orlicrt or iÌÌ iÌcd ìn!eÍnìcnt' nìalic
lìnns on the onchand rcluctani n)abandonp.oiccLsand on th€ oth c r hanc] ÌÌìorc cautiou5
to embaìt on n$! o es. tÌerÌce the eifccts of a rcccision can persjst ftÌ a l€ngthy Peiod
: Conclusi
asnr.h effects Plal o!t and $ilÌvaiy across economiesas a conseq ucnce ol diftc rcnce\ iÌl

' the impoÌtr .eolhnn specilìc skiÌls .

. hiring and 1ìrìnii regulations

. the spccÌncitt oÍstrnkcoÍs.

2.5 Conclusions about ìnvestment

lnve(rnent remains a trickv sutJicct tòr e.onomists Much Pr)iiÌe$ has been nÌadc b\
using thc díciplÌrìc ofÌnodelÌnìg a Ìational P()frt maxnnizing nrm ds thc staúi
g point
toÌ ttre cmtirical analylis ot inveslnrent Wc have scct that lhe cost ol 'aPital and lhe
cÌpected gnrfth oloutput are .lete rnriÌì: rts ofin\eÍnrcnt in tÌrt general i peÍèctconì
atc introdu'cd, caslì í1oN
ÌteiitlorÌ case. lÌì additi.m, once.alitaÌ ÌÌìarkct impeícctions
iliÌl pÌay a ÌoÌe. the use oÍ Q to prcvid€ a dìÌect ÌÌÌcaÍue of loNa Looliìng expecicd
proitabìììtl lÌas p ived cduiricrÌl,v signifi.ant but the rcle oí capitaL cattured b\
'osts inrportant al
seernto bc
Q ircÌplaining ìn\.enÌncnl ú oftcn sÌnall l.iquicÌity .on
\tra in ts

Ìeast lor Í)me proÌtoúiLÌr ol hnÌÌs so that a cash ilo1\'tcnn lÌas lo be nrcludcd ìn emPiricaì
in!estnrent fun.Ljons. lÌrc more detaiÌ€d cxaìnirÌâiion ol intcslment nìggcÍs thàt thc
iìrveslmeri 1ìnctioÌÌ wouìd take the lorm:

r.t:F) lìnveltme.t túnctionì

s'heÌe Á caÌtres thc cxÌrecta I ionâ1 la.t(n5 ir.ludì ng üÌe cxl)ected ilrlrwl h of output that
nr
ìn|uencc the profits erpectcd to be gcneÌat€d by the inrrcstrÌÌetrt' '' is Lhe real ratc of
interest, an.l CF is a Ìneasurc otthe.ash fow ofthc nÍÌÌ Clurent'aslÌllo isafrn'tion
oftÌìe cutrent sales an.l t1ìercÍoÌe oulpui ot the firm, so \\'c can rílit€:

I (.ì.,.r)
 |: .::: 24'

LÌ practi.e t1ìc dcgree oi moÌaì hazard, the nature of liqLridilt conslÌaints, and then
:ÌÌ\ract o. cash ilow arc hnrd to.Ìuaniiíy. Expectations I\'iÌl no( alNâyl be accurate\'
::ìrasLlrcd by thc mark€t valuc oI lhe liÌm: the stock Ìn.rket (,iÌl nol aì$ats reflect the
:lndamcolaÌs'. Howcver, thcsc ìnsjghts rhoukl aìk)w us to talc nolc othos folìcy decì
:inns, íftrclural changcs, or cconomic sìn)cks may alfect tlÌc invcslnìcnl tunctioÌì that
.:r. usc in thc Á cquation. thc cÌpectatn)ns component ol Q is llìcìuded in lhe Á teÌnl
:i lonil (,il h the.xpcctrd growlh olouiput): these factor\ !!illslÌift lhc It curve. The sensi

:ritt ofinvcslmcnl1o th€ cos! otcapitaìis caplure.l by the cocífcicnL on r and ihe düect
::irct of.urrcrìt outprt oÌì ÌN.cstmcnt (e.8. f{Ì nrm\ thit.re liquìdìty constÌained) lviÌl
r: rrtÌc.tcd in thc nìultiÌtier: both otthese wllì aftect tlÌe slopc oI Lhe IS cuÌve.

3 Conclusions on consumption and investment

ì .oncìude this chapteÌ, we lletch how thc Ì\'orking of the /5 lJcivlli modcì is aUected
_: co ìnDatìng f(trr!ad Ìooknìit behavÌour ÌÌÌto I h e anaÌysi! of aggrcgn lc dc ma t d. This
n

.:,ìÌoive.lbya dircusion ollÌoÌ!thcmorc dclalicdexaminationolthc dcleÌmitants ol

:.sunrptìonandinveltDrenttr€haviourinLhischaPteÌcanb€uscdtoc{fÌorethedebate
:::.. turn oftÌletwerty hrÍ renturyin lhc USA ab{)utthe !o calÌcd NcwLconomy.

r I A Íorward-looking u curve and the IS-PC-MR model

. Lhaptcr Ì5 \{c look athoi! the behavioür olthc IS fC,ÌÍÂ nìodcl i5atfectedif
. rorìseholds âre assumcd lo nraketheÍ conntrnption declsbnsonthc basisolthen'
:\pected future incomci
..t)uscholdtlrorkouttheellectonIrlur.outÌ t arÌd h€nccon theÌ Qrent denìand
ì: Lh e consequeDces of nrock! for I h c actbns oí the cen I ral bank; ancl

':t.entrâlbanklak€saccountoftheeffectolfutureoutputoncurrcnLdcman.Ìirthe

'.\ È can slietchtlÌe iÌÌt!itlon hffcandleavethe detrils lorChapter 15. Supposc thcre js
:: rtlâtnD shock. Ilouseholds .an lorecastthât a posìtivc ìnflati()n shock ro\\r rvill lcad
':: .ÈntÌal banli to nÌltigâte a scqucnce of incÍeased (though decliÌÌnìil) interest ralcs
:i flrtlue peiiocls untiÌ eqüìÌibrìum iJ agaln reíored. Hcnce hou\eholds iÍìmcdjalcìt
r.rpen demrtrd by more thin thc imprct of an increascd short teÌm iÌÌterest rnte so as
':ÌoothtÌÌeeltèctoltlìefuturchì8herìnterestÌatesonlhcltconsunÌPtionpath.^s('c
:.È \een ÌÌ this chapte., $rith fom'ard Ìrx)klnij households, cunent denìand is a lunc_
: :.. not jlrlt ol the lagged real shorl.lerÌ inteÌest rate, bLll oÍaìÌ (erPected) tuturc rcaÌ
.Í tenÌ irtere\t r:ìtes. t hu s ho uschol.Ì deDrand imnìed ial cìv con tracts ÌÌ resÈrnse to
-: rulÌ couAe ol expected futrirc Ìcal interest rates. lhis nìcans in tum that the ccÌì
:ir baDk í) lorÌg â\ it works tlÌrough ihe iìnflications of toffar.l l(xn(irg lÌousehoid
:..r 1ou reeds to raise intcrcsl rales by less tharÌ it othcri!'ise woukl t() achieve thc
: :::rÈd Ìecìuctiox lrr ÌúÌation. I hc an ticlPakt\. behavio! r of h oúseh oìds ancì the central
244 :..'. . : ::'

bank aÌe reintorcing, \o tha! outÌÌìt lalls ard ÌúereÍ ratcs Ìi\e less than
jn ouÌ pÌeviinú
cxaìnpies (l{ilh ihe trâditionaì iS curvc) l'Vith an ordjnary iS curve, hourchoìdr do not
take into â.countthe tìturc Pattenì oldeflatidlthe ccnlraìbanl $'ilÌ iÌìpose ìn the eve t
oí a shock ol lhis kind. lhcÌef{Ìe thc .entÌtl b:ìnk has to ìnìpose a biggcr recessidt ln
shoú, the prcscnce oftìr$'ard liDkilÌg h ouseholds rcduces th€ fluctÜallons 1n the econ
oÌìvin r€sporsc to sho.ks$'hen the bchavúur oftlÌe ccnLraÌba lisrtlìrÚrdeFt(xxlaÌÌd

3.2 An example; a 'New Economy'?

In this sectnrÌ we slr aìì explore a rcaì world cxa mpÌe to illLlslrate holv the i. sì8h ls o f thìs
ch.rptcr in coo inatlon ttith thc It/'aM or 3-c.Ìuation modcl can be used to inlcl?ret a
real r'o Ì1.Ì e\aÌÌìpl€, n anr el-v tÌìc bchalioLr r o t t h.: l rS econonì) in the Ìât€ 1 9t)Lìs SupPose
that a nca dìsco\ery is nracìe or a nelv devcÌoPment oc.uls thât ìeâcl! €veryonc lobeììeve
that lÌoductlvitv 8Ìowth Ìate\ in lhc tuture arc goìni{to be higìrer (loÌ e-\ampìc, suppo\e
the devclopmert ol thc intenìet lcacìs to highct pr)ductìvlq) Since tìtur€ productìvit\
Ìevels arc now gonì8 to be hi8h€r I han previousll e\pected,lutue wages, aÌso, tloukì be
expectcd 1o be hiSher. SiÌrce peopÌc expect highcr lutuÌe wages' theiÌ as\esÍncn! of their
pennancnl inconìes har increased, and so thcy iriìl co sunìc nroÌe (e!en if thcircuÌrert
nrconìes hale not I€t rllcrr). Thi\ hì8her consLrmpLion is capluÌedin the15 €quêlion as an
incieasc in .o, irhich, bcjng an aúlonoÌnous .onuone t oi cÌPenditure, kads (lh(Juglì
the muÌlidier elfèct) lo â shitï right oltÌìe 15.uNe, ând tlìus to an incÌease io oulfut'
HowcleÌ, l)ecaus. êun)nonÌous connìmptÌon hasrisenbutÌncomehâsnot rjtcn ) et (it
jtsell)l tha! mtans
is expcchtn)n! of fLúúre incomc !hat lÌâvr riscn, not presenL ìncome
that con mer debl lcrels ri!Í have lis€n âlso (i e the diiÍcÌence between $'lÌal is con
nüncdan.lthi\ period's ìncome). Fxpressed lr lcrmrolnet savingtiatherth.Ììthc.hange
1n dcbts, lve caÌÌ sa-t lhat tavings (t r) Í\ì1l faÌl ltwe h:ìve an oPen econonì)', thc risc ìn
our p ut irilÌ le.ìd to a Ììse ìn nnpoís, and thLrs 1o ã reduction n n et expoús (aÌÌd tÌìcrc toÌe
j

toanincÌeaseinlhctÌacledelìcit).1\elhcrclorehaveanumbeÌofpÌecìidionsoÍtlhat
wilì happen il €xpcctcd future productif it-v growrlr Ìi\e\:
(1) CdrnìÍìption rìse.
'!jìÌ
(2) Outpul r'illrise.
(3) Netsavnìgs*'iÌl Iaìì li.e. d€btswllì rise).
(.1) N€t expoÌls wiÌÌlall (i.c. the tradc dclcit tlilÌÌi\e)
ÌD ttre mìd lo ìate l990s,lcalues (1) lo (4) were inde€d dirdâ)ed by tlÌe US econom)'
f(tlowinglh$!i.lespreâd bcìicfthattlìc USA hrdentered a tcweconomv phaseinr'lÌjch
hislÌer, ìrìlcÌnet reÌated, prodoctivlty growlh aas polsibìc (luÌ augìnented 15 equatÌon
oltèrs us insjghts into thit intcnÌet reÌnlcdboom. ()ne ilú$estin:! feahrre to note rclalct
toilÌc \ustainablÌÍ),'olthc dcbtìe!els.lrÌnatcial ne\{spaperconrmentaÌtic1e\ ofteÌì spcc'
ulateovffs'hetheÌ debtl€vcls in a Lroonì n rc 's ustaìDable', sÌ1h the ììnpÌicatidÌ beinil tÌÌal
if tlìe,v arc n ot sbtanÌa ble th at is daÌìsc rous. I n our NeÌ! lco. o m) exampÌe, the erpe.tcd
levelofdcblswouÌ.l ot bc s!$iaìtr:ìbÌe ÌI !ha!Ìrrcpoúiür ot incoÌnewere boÍoived ea.h
 .::245

perìodnÌe!er. Ho$'ever, ouragentsnrc ÌÌot€xpc.tinSto coDtinueto borroal dris prcpor

iio.. Once th. prc.ilrctlvitlr rìses o..ut and wagcs Ìi\e' debt Levcìs Ì{ould be expe'tcd io
;i ll b-! thenÌs€Ì\.cs. To be surc, tllese dcbt levels arc unnls laìnâ blc-Ìrut tlÌc r again no one
Ìt ex!ectìIg to Í1staìn üÌerÌì.
HoweveÌ, nÌppose nolv that, at sonrc PoiÌÌt, agcnts dccided that, ir la'|, the iÌÌcrcare
.Ìì productilitv gtrrsth $as not going to be .s hiSh as thev had erpeclcd TlÌen deht
lrfel5 would no longer b€ s(|slalnâblc bectuse thc ilagc Ìnes arc no longcr expectcd ti)
rìablc aiients to tay ofttheir debts ll llÌatwerc the casc tÍe wouìd expecl consunÌpLi(Ì]
rtars lo be reviscd.Ìoiux'irdr, outpui to lall, nct savifgs to risc, and thc tÌacLe de1ìcÌtto
:.ìll. HorÍever, i. 2001 w1ìelì lhe US ccononìy slowed, !t did nol exhibi! lhese leâlues
:iishls oltìris i onsumption co ntinued to g(N Íro ngÌv and pc rs(nÌaÌ debis rose TlÌìs suggens th at the
-nd ol the N€rÌ Ëconomt boonÌ is rìot to be cÌPlaiÌÌed as a loss ol connden'e bv wâile
:rÍìcrs in üÌe productìvity )'ieì.1 of the interncL, oÌ elsc it s!gg'sts thal cornrmcn taNe
irÌÌre tìme to rcalch uPl irÌ un.lebtarding tlÌat íuture p(rduclivity Sro lh r{ill noL be rs
.Ì!h as cxpected, at.Ìthatstren the,v do c:tch ul th€rc aill bc tutrther contraction as Ô
'rÌÌt.lncitheÌ a.Ìifferenl crplanation isnccded lo r i{hat h aPpencd in 2001
casc,
To understa d the behavio!tÌ ol thc economy ìn 2001, Ì!e shall
(o'sì.leÌ nìvcstment'
:ir it lras investÌìcnt tlÌat fellsig itìcantly and draiiged the US cconorÌv into rccersion'
.ì h! dÌ{ì Lhât happcn? Otre possìb11itv í thrt.omtani$ obtaìn iÌÌlòrÌÌratnDâboutíìturc
pricc
::lciuctivit! grorrLh eaÌlier lÌran consuDÌers, tf'l that 1t takcs somc time for lhe
.::nals arisng iron ìnveÍIncnt declsions to lilter tÌìÌough 1o corlsumption behatiout
:irÌÌaps btcause oÍ a(lius!ment.ost
Lhe ìs\rcs that wcÌe ÌeleYant iÌì dcteÌnÌini'g itn/csl
(as shjtted uP in
-.nt behavi(rr). On that iÌìtcÌretàtÌon, 'Á'if lhe invcstnÌeÌìt functìon
':. 1990s because of hìiiher iutltre prcnt expectâti(nÌs aisiÌÌg lrÌÌÌ tht 1ÌÌterÌìci' cìrivl'g
. r iÌi!€nÌìent. ln 2000 this sürtimelìt was retcrsecl' as
Ìeflecled 1Ìì the ìatic la1Ì5 in
accordjnglt
'lr'
conLÌacted Ìn
:.hnolo$'sto(ks lol!ar.i\ the end oI that ycar' Ìnvcstment
:rt casi'irc shouÌd c{pect conntrnption to loìlo! Í1ii evenluallv, at nÌarkct sitn'ls hl
:: Ìhrcugh n) rütional coÌÌsurner\ pcrhaps lca.ìlÌÌg lo I 'doubÌe dip' tccession as
'lassic
., 't.....,,,1 ,.. , .\ ì.'h.lJ\
'.
!ìn thc other hand, anothcr possibllity is that tuturc productivÌq i!i1lbc lÌi8hrr' but
.:enors have reaÌjzcd thât thc huils ol highcr PÍxi uctivit-Í ttilÌ bc taken in the lornr ol
: :ìrer $'ages a d loi\'er nargìni ThjswouldlcãdtoatalÌìntheÌnartup,r'!nou'basic
_:rctel. arà lencc in ttre rncdium run n) 1ÌighcÌ output, bLrl irheÌì inreÍors realizc Lhi\
: rÌ5o leads n) a litl back iÌì '/l' and a sh11Ì left in the i 'estÌÌrcnt schcduÌe' butthistime
:hout an! correspondlng lall 1ÌÌ lì Lo lollo$' Ìn thal case the Ìe'cssjotr of 2001 wouìLl
: be eÌPected to be nnÌo\'cdby a doubte dip since consunìptiotÌ plens do
not reed to

iúornìa
- iÌìir.l fosibill l)' rclates to crsÌl1low connraìnts tJccalìsc ofthe as,vmnÌetrìc
: : r pdrlen* cltscrrserì ÍhcÌnìChapterS,ÌoansÌnnvbealessetìcclneìormofhÌìalìce
::J eqüìty for riskyventiìres like intcrnet starl_[ps ÌIthatis so, alÌd lhefalls Ìn the ti'ch
. igt scct(Ì of Íock nÌarkets mernt lhatit ì\'ashâÌd to rai\€ cquitv for intenÌi1staú ups'
..:\irìcnt ür t1Ìc inleìnet nìav h.vc beconìc deplessed through ÍllD\' \trâìÌr ts
'ash (which 'on halc
. -\Ìnìcnl n1a\ thcn stav 1o$'until slock m.rlict senLimeÌÌ1
rccolers mav
246

jlt.todo\!it]ìrhcun(ÌerhúÌgiündi]ÌnlntaL5()ìiutLLÌeIlodu(ti'lt}andl)1,]lr!j]it].1
",ì,," ln 20t)l tÌLiÌL clìaÌrgc'ì iììe
ì^ì,-",,tt4u,,, !\ Ìlìet í!nethrnS bapfe!ìe!l
20011
'r
iÌìreÌr5r Lnc\ rcre t'ì be
..:::i:',:"ì:; r,.,"*' "'' tt t'n"" "'Lr '\pccted Ìt'tÌ5
',ì;,;",,"", b'conìe rc\\ prrÊrrb c r\ en irrLÌìu* Ìrrodu( t i\ it\'
ì:,,;";ì;,, i,',ì';,,.", ',o!ld
;"
inNm Ìl\ eL ol rl.nÌi'dl iÌìtcÌesl ÌiÌte\ 1\ /lr) lD
'

.t-'
,1.11, 111, 1 Brrttlltt 'r I 'trrrtìL .t,']
r,1,t. o conteÌìrforar\
.ìì',,i.",,i.Ìr,tt,"" "'d jÌÌresltt''t to inìrnle oar 'trücÌ\tandjns

QUESÌ10N5

nr \tord; f.r rh' resúlt\ r!'ìmrrìzed h li!lc i l

(2) |nn c.!.cìr. ertlrnatjorrs

úf.lcr the nrÌÌ!r\!iÌrg cÌr'!nnL r((\l

irr i rii! jÌÌ thr rati ol in'rrt\tì
Il)ì thc irìdÌ\ jfulLLr''!nìts nlo' nrìlatìcrt:
rr tÌr. iidn nìúrÌ'úrrxp!'lrdLrìÌrher jt\ iì hLÌÌse

(4) N:ììrlisfÌe.i!ti(trr't\iòln3l"\hntrss!!ìlL.n\itf'c.!11Í'rlÌ(':uii'nr^ iÌl

í{ì! cììliÌi'il ftLz/l'!
;I lng' nr rLisel Lld' lÌtrr!tj'nrrr rat ìn! ai.lì t
..Ìr\ú.rtti(!r b.hi\ itÌrr:'
coì1!nfij'L:
(5) \\hnltrrìo.lL)\ tlìcttnn riìd'!n\!rll'Ìri(jdrhrt('ri'ili'firiL
l.ìtÍL iÌ.Ìr nch,rl 0tLÌl

itmL\
(71- E\ÌrÌ.ìinrlriti\ rnÌÌlibl the c\"$tnrrÌhr(sr''i'.N\!ììDtj"aidrhr
.lrtrr:trcrt. b.hâ\ io! '
rhe fl!"i ilìctr if,lrrr c iN"ìr!
(8) \\'Ìr) Ìì,Ì\ |.!!rholdr Ìr(tr lI rl)L' Ì'r 11ì u\ agrirn
 : ::. : 247

!Èlabilitv of (9) Ì his qúcstlon rcLat(s to lhc.orìsumption functlon prcscnt.d ìn sectnrn l.l0. Sugge\t
whv thc rcal ìnLcrcsl rat. Ìna_v hrve a Ìregative efi€.t ôn .onsutnpúrn. Use ?nIJ
diagrãm to rcfÌcscnt lhc..nmmptj.ìn tunctjo iìnd discú$ how conn'mptlon and
hcncc thc /.! cur.c rcsfonds((ctctìs patibus)ta,
(, a highÚtropo.tjon o Í cre.litoN in the e(ononìl;
(r) rneasirgofllqu lty coríraints íc.9. bccausc of moÌe c o!Ìpetiti on in thc Ücdit

(.) nrorc ún.otaint)'about fiúure income growtlì;

(.1) Ìos'er overalÌ ile!Ìth (e.8. .lue to th c h u 6tì ng oI ! ho! sinS pri.. búhbÌc).

(lo) Using the sjmpÌe investme.t lunctìo n, I :I I'r explalr \! h at hafpcns to the IJ

(r) prontabjljti ú the íuture jsctÌrccLc.l to bc Ìowet;

(bl tlìc i('aL jnrcrcÍ ratc raÌìs;
l.) rhe lurrue Ìeal inteÌest r.rie is cÌfcct.d to laÌ1.
111) WhalassurÌpúrns are ÌequìÌedj. Òrclc.to dcrive the rcceleranrr invcsLneÌÌt
Íunctiol? lvhy does investmeÌìt takc flacc a.cordúÌStothis úrodcì?
12) Howdo.s thc inlrodr'ctìon of adj! Ínìent costs and iÌnpeúe( t co pL:titjon aÌter the
nhdc lìngol jnvcsüncnt?
l3) \'{hat the dilïerence b€th'ccn 4 and Q? Under Ìrh at assunftions is invesinrcnt
is
soÌeÌ-v a tunction of.tl Do cúDìri.al Q based inve\tnìcnt modeÌs fail be.ruÍ thcsc
a$urnptions dre hnülnl or bccarse Q ú r Poor rnensLtc oÌ iÌ?
rìe;.1. r4) (loúÌarc lh. ìr1v.stÌnent frtrÌction of (lhaf lo 2 (1= Lr)wìü the inlestÌne.t
f un.tion in scctn!Ì 2.5 í1 = L0r + rrr. \'!hy is tlìe addìtioDal o!tplt ter ì in thc
cqúarìon? HowrÍ ld theíÍlowingaÍíccltheIJ cuN c k.t.tis púì ibus):
(dl jncrcased sales;

(r) r clÌair8e jn conìpctjLìon law tlÌat wllL ülLoÌ\,1ìrnú to exploit nrorc cconomies of
scaÌe opportunitifs in th. lrúurei

í.) a falL in .orporatnrÌ ta\l

Gl) in re intereÍ raLc;
a tulÌ
â h eh r" r'
f) hislìeÌ !uttÌ,t sensitjvity oI investnent.

:roblêms ând quêíionsfor d rcu$ion

I. FSTION A. Aggregate cornrÍÌptÌon !aÌiet less tha C'D| a n d aggresat€ iÌÌ\'estmcn t

:ìÍ cs Ìnore. Can )ou reconciÌethesc obscffationtwith thc iÌssrmttìon that
::.slrmÌrtio.an.lìnlestmentd€clsÌonsarctakenb)râtionaì,toÌaa[.lÌookingâgclì1s?
.lLESlÌON ll. liaplairÌ hor, -vo u rruÌcìexpect a boom ln assetpúces to allccl !hc
í
248 :

QULSTION (1. There is s,ldcspea.l coÌrcern irÌ the O|CD cconomics about thc
Lna.Ìequacv of (íi) publi. pcnsìon aÍangeÌüerÌts ind/or (r) pÌivalc sarings to p'o!idc
ade.Ìuate\ tor retirerncnl. Ìs thí obseNatnÌì consìncnl r'ilh lhc modcì5 oI
coDmmptldÌ presenlcd ln th15 clÌapterl
QlrljsllON l). r_xanrlne how rÌcll thc Lhcorics of ìnlestnÌent piesetrted nì the.haptÊr
üccount for lhc lacr that aSgregalc lrrcímcnt js prcclclical.
QUF.STÌON E. Th€ US economv s,ent irni reces\ion
j. \,Íarch 2(l0l and, in rcsponse, the
govcr.ìnent lntÍ{hrced a la\ rebate pÍrgraDtrne hìÌjch anrou.tcd to chcques oI $300 or
$ó00 in lrllre beürg sedt to abouttrlo thirds ofUS lÌouichoìds. lhc ainì r'as to mitiSate
thc lvlÌât ÌÌ,ruÌd Lhe connuÌptnÌì theorlcs dis.usscd jn !hjs chapteÌ tredlct
recessi oD.
lobctheoutcone?[Ìo1ìr]doutNhatacíraL1]happcncd,scelohnvin,PaÌkeÌ,and
Souìcìes (2004).1
 Money and Finance

Ì hrt is the Íte of Ìnonc)'and i_rnan.c in ma.ro€conorÌics? ìn slìoÌr ând nìcdiunì nLf
:il.ro€corìonÌìc\, we ast ('hcrc Lhc qucstlons about moncvand iinancc iil inLo Ìhc /.!.P(--
,IÃ ÌÌiodel or the iJrill,t modcì. lhc a.s$,cr is that the_v mallff IoÌ thc aggÌcgatc dcdìa.d
:rrheÌ than nÌ the n'pÌrìv sÌdc ol Lhc cconom,v. lve lÌ.n c alrcaü sccn that lhc nìodcÌling
i centraì bank behaviol1l Ìs thc kcy di tcrcnce b!1w€cn lhc tno modcls. Monct' and
-.drce also lrt jnto Lhc nrÌaÌysls oI (hc l.! rcÌniion, Ì{hìch is comÌnon lo bolh modcìs. lhis
:rapteÌ deaì5 1n luÌn wilh thc inìplirations of mone) and lnance Ior the A and thc. IoÌ
:re nronetar) Ìule/LIí.
On the tl sidc, rn lrndcrstandìrÌg oI th. larÌcty of.sscts lhalarc usc.Ì as sloÌc5 oiwcaltll
_r househoìdt it trsctuÌ Íor tlrc analvsis ot consumptlon bchavjouÌ. \\ie havr tecn that
,ruúlitv consúaints pÌav a rol. i. bolh co.sumpticn a.L1 investmeÌrr beìravìrNr. IiÌms
rÌrd househoìds do Dot gerÌerallv havc acr.ss to perfcct caÌrilaì nrarkets: thq canìrot
_.rrca as much as lhcvïould likc at thc snmc ÌrÌirreí ralc al i{hjch the} couÌd lend.Ioì
:rÌìs, this hes Lhc clÍcct ofmakingeylÍ,"dlfrdr,..whcthcÌ itbe bononnrg (Ìebt nnrnce)
relsing ll.an.c bv scllinil equitt.' morc cxpcnsn,€ than iiÌlerrdl trd"... Some hÌns mav
': cntiÌcl,v rcìiarÌl on interÌÌâl funds Lc. 1lÌcr .an only un dcúake iI\ estnÌent TendÌìB
: I hcy h alc su ilìcicnt caslì tlow. 1 o cxplaÌrÌ $ìÌ)' IÌousch olds rn d nÌms can tace li.Ìrìnìitt
- :.straìnts, ('c nccd to look at why banks aÍrd otlÌcr Êna.cial instltuti{)ns exist and how
r:oínaLion probÌrrns lead to credìftationlng. ln the nìodeìllngolìnveÍment, the roleol
r_rollt c{pcc(atÌons $,as higlÌliitlúcd. Ìn thc Q lìÌcor}', tor eÌample, irNest!Ìent ÌesÌxnÌcl\
: : iìnt' dÌItücncc bctwe€rì the markct val uir tloÌÌ of thc lì r nì las measure.l bv th e vaÌLre of
:! 5harcs ljstcd on the ÍocL ÌÌÌarkei) and tlÌc replâcernc.t c.sl oÍ it\ capital 5tock. This
::Ìscs thcqucslioÌì oiho$ shiLr€s are valLrcd.
I ünìiÌìgto the monetari nü€ inthe/51'jC ,\'1,( nìodel and 1o thc a.Ií in the i.5/ lüÍ modeì,
i havc aìrcadrdlscusseci ÌnaÌÌt relcvant issuesnì chaptcrs 2, 3, and 5. Hoi{eveÌ, theÌe
:irìaid a lcs qucÍÌüÌs to tidt !p and thcsr are dealt with hcrc. In paÌticuìar, we set out
ìiìogj.olthca.gunìedtolthoseÌlhoriewc€ntralbanÌisasscLtingthemonetaÌ)hase
ri ii5umcd ln thc d€finitloÌ.Jf tlÌe-LMl ard those !!ilo f.ic$'ccnLral ìranks as sctling dre
.r.rcsl ralc. lhcmcchani.solth.monctarybisemuliipli$arcscloulandlhepractical
,:.ps bt tuhi.h thr c€ntrâl ballk â.tu.11r" sets tiÌe iÌÌter€st ratc arc cxplainciÌ, using as a.
: \àmplc lhc procedures oltÌÌe Banl of Lngland. \ Je also dis.uss lhc dcmand oÌmoncy,
:rr iL mavbc volatile.nd Ìvh! t]ÌâtÌnatt€rs.
\\ cbcgin thc.hapterwith a clis.!s\iorÌ oldilfeient a\sets aiÌd thcir.hara.tcrìsli.s lhìs
rk$ ui !o a brjel descriptlon ol ley i Íitutlon\: banks. t1ì€ .€ntrnÌ bn.k, nnd thc llock
:ìirkct. thls Ìs lollow€ci Ì)v a section on iÌúonnatnÌÌ problems and thcú sigÌìillcancc
250 ' .'' ì:
ntr the .olc ot nìonq aDCì Ê a nrc i n macrcecoDonìics. lh is e ntalls ÌrÌt(lng at the role of
1ìrms and ho$, in t(ÌmatiorÌ problcms âfiect theÍ a biÌit)'lo finance ìnvestment Thelourth
section dis.rlsscs ìnoney supplyan.lmorey denìand. lhc chaPteÌ conchìcLes by brirgiÌìg
tÌìeIJ and Àtk rclated dÀcussions t()getheÌ tu discuss lhc LìansÌission olmoneta.y Polic)'
tothe reaÌc.onoÌny and therolc playe.l bv lìnânce inthe Pr)pagati(!r olmacúeconomic
shocks. l hÌs in co rÈÌates the mo rc Ìeali\tic leatltres ol fl r ms, banks an.l other nútitutions
cìevelopcd Ìrì thjs chapter.

1 Assets
Uie beiinì br clarÌfrirg the charact.ristics ol the diflercnL assets in tlÌe economy. \Lho
hoì.lsthenÌ and wh-v. when úo.Ns to thc econonì-t or ch anges in Ì)olìcy atilcttlìe valuc
oi an asset, lve need 1o kno$ trlÌat l<Ìnd of aiaent tìolds thc assct in okÌeÌ t() be able to
prcdìct ihe likeli/ iÌìplicatiiDs for cconomìc actnity. \!iìì contumPtioD or investmürt
bc affecte.l orthedcÌìrndlornìoncl?Assets.liiferìÌììi{luldiLt,retuin,aDCìÌiskchar
a.r$istics and i the d ircct utilitf thn l !h cy nr av provid c. Com Pa rc i.n exanpÌe money,
cquitiet, ancìhousing Ì\Íoney 1\ liquid and pn^,ìdes ltilitvb.causc jt aììows tÌansactions
1o bc un.leúakerl $'Ì1h cate but it provides no retuxì. lts nominaì !aìue is lixed but ìts
value in Ìeal terÌÌs will be ìeduced by jnflation. Bv conlrãst, a bond cannot be used lor
rransactio s but pays interest; thc nominalvahìe ofa bond changcs i!ìth a change iÌì thc
inteÌest rate.lquitics haveintermcdÌate ìÌquìdì\, (there orc transacLions costJin\oÌved lÌl
Lradlng üÌenÌ], thq/ ofteÌ r1o Suarantcd Ìctum but oller an cxpc.lcd rctunr wìtb a deij.ee
ofìisk. Risklovcrs maydeÌìve !tilÌ(,v trom hol.hnit equitics but oLhctwise dreypr)vide ÌÌo
dn ect utility. Housì ng is Ìeìatively iìììqu id. It Pr)vides dìrcc I u Ìl lv toÌ oÌ{ncÌ ocQPiers Ìt
I !

pr)videsnoguaranlc.dÌetün.Ìible8.ìhataÍnm:ìrloftÌrcdcririlions,chaÌacterìnics
(liqrìnìit!, risk, nnd rctum) and iÌNcÌy hoìdr* oldiltèrent kinds oÍnslcts.

1.1 Money
ln adc.cnLraìized ecoÌÌonìy Ì\'i!h ìÌany diftèrerÌt kinds ot goodt, Ìnonel sen'es the pur
posc ol aììorljng tranlactiorÌs lo occlrÌ $ithout reqüiring lhc'doubìe coincl.lence of
wanlJ. lhe avallability of monev as a rtdtrn of!tr.rdr.(. nìcans lhat, sav, the electric
puÌÌrp mar(Iacnuer cr 1ìire ('oÌkeb who want to 1!ork in oÌdff !o Ìrurchase gn)cerìe\
iÌìd consumcr durabÌe\ not cÌcctÌic tumPs. The central rolc ot Ìno.cl it Iaciìitatlng
transactìons can expÌain !!hy pcopìe aÌe ttiìì1ng to lÌoÌd moncl, irÌ iis oarroslcsL forìn
sLrch at nores and coins oi chcque accounts even though in lcnìs ol rclurn it is doìn
i.atcdbv otheÌ satè assets thal fay ìnterest such as a term a.courìt. ln othff !!ords, the
di ÍlcftÌr ce between n.ìÍoÌ{ mon ey an d the term iìccount is liq uldil,v, I'h l.h nìcasu Ìcs the
case rÍith whÌch morÌey can bc used nn tÌansactidÌs. whilst chcquc accourÌLs somc!ìmes
pav interest, it is at a verv Ìoh'râte. other \aiè a\sets pa_r bighcr intcrcÍ ratcs bul lhcy
ofíeÌ less li.Ìui.litv. feriods ol notìce are re.Ìuired to withdraw moncy lrom high inLc!
cst accolUrtt ancì it 1s olten nccssarl t() keep a ÌÌtiÌìinÌLrm balance Ìn such an account,
rcd( r.i ng the flexibiÌit) líith $'h ich ìt can be uie.1 fì)r trârÌsactiorÌs.
 Ìable 8,1 rl r a5 rr,f"5

:r\ bl bringing

H qh.or/ÊrÊd m.n!, Íônêtã Y

ra5e cuÍei.y n L t! iÌoi
.cmme( i briL re5erÉs rì cB

. Írurtô. cepo5ó Íì ruí.nt

3'ôãd n.ìey rl;Í!r mo et F

.eprs6 i rè! rlli à..o!n1r
i!]h r.. r(rarr{ L rrssï.ied
rÉ\r - i non b/r( t iin. i

râl\ lr.d nom i. pJyfi.rt5 it

5ime.5 q.verimonth. l

. rÊ - houi oil, t = t,m

\ 1. ne-v ha s a sccond rcle .s a st r. olulir. This en abÌes pcoPle to engage i]Ì tradcs that
:1. separat€d irì !ime. Ìfa journalist is paìd ofnnnalocs' nÌe
nÌ Ìlriting ar.rucle 1n boxcs

:::ll.ee.ìto cat those t(lnatocs .Ìuic|ly bcf{Ìe tÌìey rot lÌÌ contìa\t' ifshe (ptìid irì Ìnoney
:::.n dr e ctìn wal( Ío. years b€lo Ìe tunìing lh e prcd!.|of her \!oÌk nìto con sunÌPiion That
-:t cs hei nÌcÌe I c{ìhiììtt overher trading choices
IIc thii.l iÌÌÌpoíani Íte of Ììnüev is as a "ril o/ d..o,,1 ÌÌì abaúerc'onomv il rÌc can
:ìd a .Ìou b1e .olncidence ol$'ants we nÌa)- be âbÌ€ to discoLcr that otr one lioat ìs $'orth
:.io bags of ìppÌcs, an.] that a chiclien can buy â lìâlrcut lÌuL thtt does not tell us how
:::ìn! âpples a chlcken is worth, oÌ the rclalive pric€s ofgoats and h:ìlrculs Money aÌlowr
: 1o comPare thc value of aÌl goo.l! and seÌYices iÌr leÌms of a comÌnon stancìard-the
.::r Lt of acco! nt. i'h i s is very val uable as i I p rcvicles ús irith iÌn poÌttnt ilr
Íormation about
::r. reìative vaÌuc oftasks for e{aDÌplc, ivh ether it is m ore proiì iable for lh e journalÌs L to
. ite articlesor lobe ar accountant.
ich ofthe f(rncLìont olÌÌÌorcyenâbles spccializ:tion and pronrnes eflì.icnc) ìvlorcy
Ì
.:rs down enonnousll otl thc !ime spent obraìniÌìg ilìfoÌ ation abouttÌÌc Ìelative costs
,:ì!l p()1ìtd bility o t .Ìiílerent vcn tües, and on fin.ling ÌreopÌe !\'Ì!h rlholn onc can tradc'
(strch as scjcntific discoveries or cngineerìlrg
-rile apart lrom lechnologi.aì tro3ress
.:t ancer, irnprovement\ ir thc eflìci€nrl' of the pâvnrerts syst'ni through mone)'is ã
 Í

252

'' ticdtfl' Ìnrliirli

Lr.ldúliÌ!)rrrcr.le.oroÌÌi.3ro\tlr ltiÌ!: nrflest 'r\erLr'trrrelr mo'e\ nril Ìr(Ìo\l
it," p:,tn,"rtr s..L".t c,p"rrt!': m.rc lnÌ)ollifrl\. LrrLltr lu'fti(ìÌriÌÌÂ
olirnc\tnrerìL
iÌ(\!tlrbr relr.in!th( i irtiÒ.\115\.ciattrlÌ!lri1r\scssr'311r'Ì)Í)ÌìtiìÌrllrt)
ìrÌoir.l5 SunilirÌ\. rÌr!1lriìÌ! thrtulrdenlli's
lhclLLn'ti"s otnÌ'rÌ'raiÌldi lnj\he'o
romicou4rrt. IlreÌÌÌr,sL 1(ÌtoÌl.LÌ\c1rÌÌÌÌ)li'iihìti5i'tÌrtloÌr'rÌÌi'hfrÌti'!hrl!urÌdcr
rÌlnrslhr\tor!'.trtrlhtuÌl.liono Ìnr!Ìr\ i1'd 11iì s\olrtLÌe,rilììghÌrtt\o L'rÌati!n
ls{rrìL] iÌ cr t1ìl ihiÌìtl io u\e nr.rÌ.] â\ .L Lt 't r"'irit 1rÌ Ìr ertr!'Ìnt !ir'(Ìì:tan'(s
i rcn r\,r ne(lìurn or cÌ.hrIEÈ. \ÍrÌligjn! Ìlìi'11 !!iilonlilftiiirÌ'o|lLdcÌÌ'rLhìti:rill
Ír1cit\irl..ti.nsctl!.ll\tlli\t.ttrtLaLl\ogrcatrrlnciÌìL'rtrr!lr':iLl'LìtÈLl

1.2 Bonds
.\ lroncL pÌonri\es Lti trt i \erirs!llrÌÊdl).tìcìrt: iìLh\ro date! \lr'cilrr f'\ÌÌ1tÌrLs
rr. rìJ. thc Ì Lrkt'l \iìlr('(ú llrc Ì).).{Ì carÌ b' r()r\rd (r1 |l cli{'ìr'tÌÌìS ihr'ltrernl
(ìl pn] rrÌeÌrlr rt tlÌ!'.:uÌr(rrL iltlrÚtriìL''frÌl'hrÌrtsei'thri'ltÌe\trrtcriLl'hâ'getlr'
tlÌt rìriilitt \ aìrLr ot Ìlì'
tr:srnt l aj'1. oi th. nre.r.r ot !er Ìnc'lr dÌd Lhcreiotu' 'ÌÌirfgc
irorÌd Iherr iÌt tlrrt toir nliìl $ur(!5 oi 11\lirì'$ irÌ h'Ì!lirrg r b'rÌd:

l {rhlngeiitheìn1rÌe\iriÌtcrìllchrÌr{'tÌrcÌriiÌtttiÌlutoillìclunliili\!rd
trel.rt ii rÌìnturi5.
L.li llÌ1r\|.clrd iJrflaiitÌì hlÌirírlt tlrc !a[ìe 't lhe lr"'1
\Ì]lltúrrsLiÌthtr'!ìlbe
.redilor n, tlÌc (lebiori the r(1eLc hoÌl\ lor ttlt\P"tel dr'lltrticlr

3l thei$!r.oitÌtr'bond.iì.deiiÌuÌt!rìll rS le"Ììrfân\infsbdÌlilrLfLiÌrÌÌir!bt
!nrblenrte\ bi.Ìi Ìt\ .( iÌjii)rs jÌr.lu1i!r! bondh(nrl'r: lltlr|rflennnc'l t h\'ij
p.Ìlc\ i\i.c(ÌrsistcntrtiLhcìsLLriiÌ!jtsí)L\tn'\ \etlhaÌÌlrr)r lheìllìr'reirrrisli
oi (ìctr!lL hl thr gt\ e!ìmúÌìt.ii tlÌc !'n'it ouL\1rÌÌ!iiJr! llÌr rin:tqu("c:
nrr
nra.tur.ononrì. bcha\ iour !lQÌirtirrns rchss 'trÌúr $úÌdc 11rÌtri\ltrf
jÌì LlriÌlttr 9
ijo\ ennì.nt t)onrÌs it discu\c(1

Thrr. ìre tÌto trrirr L\te\ ii tot(!nnreni boi \ Tcrr "!f'rÌ LJon']\ arÌd 'Ôuton
hcrringbln!l\ \7er!.outorÌb'n!i1r'l\Ìrrl\l r\elnLÌatrì1aÌurlt\'\hcÌttlÌt'ìit Ìit\
,, ur,all. quitt nrort c g thn'c nÌo.lhf .\ .o'r|Ìì lìrrÌnì! hr)n!ìÌ)rl5 I h\rd imourÌi
'cg!trrll le.ts flcr\ \f n. urúil mit!rirv ie.! ne \!'r6 (Ì 1hlÌL! \errs r'(ì tÌÌeÌr f i\ \'
LlrlaL.otrfonrrdLhtf,ì.crrlur(ÌtlÍbllrcL ÌLì.r]'ììtio' atÌr'Ì'dLnth'dl\'trr1üro rtr
enrlrÌonrruLlrLerestrnLLsnÌ(hrftc':injoÌìcu)unlri6ììdcÌlj'liedb"rì\ÌÌrrrhtc:Ì
lrnÌ(i.f.othrrhi\torì.rÌl\uÌìlorfuntcÌai\oiS(^enÌnr'ntLì.niÌsi\''o|s'l!'llÌ'5crr!
Lnlìnl1c lenÌl Íno Ìnrtr]rll\ !1,ìt. ì rÌú fìi a tì\ld ar!ìuil i'ieÌeÍ le\ mtnt
'(ÌÌÌìrìiÌ
lithoullÌ ìf i(h aÌr.r{Ì c.!ÌìtÌ!$ thcÌe ìj \rldnn r dr' arlt s\'nL!\rírnrentlì.l'd\
.orrìpe.\ Ì]ond: ha\r'i Ìrì\ir \t drtittlÌ ri\l tÌÌe g06 brÌrkiltft tlÌrn Lhr
gctlitlli oÌ'(ìtLr
'oirÌriìÌrI
ng 5"ill'LÌ'jruÌl hnnd\Ìr"iDi
crediL.Ìtjn.ir(ÌjnSbo.(ììrold!'\!Lìl
rriri 1lÌcr' ra! rLÍr e hL!ÌÌ rìsk (Ì
topuÌii ìÌr th( lgSrl\ he\ ':rI.rtd hisb iÌúcrcil hat
drl.üÌt lrrúu5. lhe !onìtani!'i thri ir\trclith..r ìr.rrì(ì !o h' e\ Lll '
 .:253

1.1 Equity
lqLritv oÌ slìarcs rcprc5crt a step fuftlcr aìo.g thc riskifcss pml'le: b) purchasing an
.quitlslikclnaco,Ìrpan,!,theíÌarelÌoÌdcÍi5prorÌìisednolhirgsÌrecjlrcâsaretltrr.The
nrarchoÌdcÌ galns or los€s accordiÌìg to thc Ioftunes of thc comfan). If the nìaÌes arc
Ìnapubìicllquotcd.olnpân)iÌìanecononÌy\!ÌthaLiquidslockcxchange,buli.gand
irÌljng sharcs in.uis trans.cti.trrs cons siÌnilar io those âssocialcd ('iLÌr bo..Ì trâdlng. But
r[.rt it lvil]
iithccquity s in a private .onÌpa y or tlÌ€ Ío.k e.rchiÌìge is poo nv deleloted, t nr ay be ì

'..Írdilfculltoliquldateone'snlke. 1hls hcÌps to eriplaio rnr_Í Lhc saìe ofnew e!Ìuìty is

'. iltuiìÌl non-cìistcnt as a Ìr€tlÌod ollìnan.ing ÌìÌvcstnìcfI in r:ountÌies wìth pooÌ legal

JÌio.rcmc.r of sha ÍclÌold er\' rights.']

Compafl Ìnr! cslirbllsÌìes a 'pecking ordcl in snÌlch claims are met Ìlhetr r conÌpany
rors bnnkrupt: \'vagcs and ia\e\ ar€ paid lìrsl oul of an)' .cvrurces ol dre coüìpJrÌ}, therÌ
reditorsarlpa,begiÌÌìiÌìglíithb.nÌiloansandfoÌÌcÌ\'cdbybon.Ìhokleb.Equitvo$ÌÌ
:r\.ìre ÌaÍ. LquiÌl), in tlÌe Sood tirncs, thc lìxcd (onìnÌitÌìcnts to workeb, uÌe tiìaa!thor
:Ìies, and creditors ar€ \ettLed and uÌÌless th. 1ìrm has a prcnt sìraÌint schenÌe wiilÌ its
rorlier\i lrÌÌlv equiry o\í]Ìeú beneht lro thc profits.

I 4 lll:quid assets
Ì min! r!ropcnÌ1 .ounlrics, houslng w{lth reÌrÌe\cnt5 over hdll ol alì houschoÌd net
a€ilth. l hc irìpa.t of chnngls üÌ lhc inL$est Ìate (D housiÌÌ3 priccs d.pcnds grcail-v on
:ÌÌe irÌstìtutioniÌ chiractcristics ol llìc housjng maÌkeL. The Ut( is at onc cxúcÌìc and
- outiÌÌental co u ntries lilie C ernì.n)' a.c at tlrr olheÌe\tknÌe. Oi!n€r occúpicdhousingÍ

lne.omnÌon ìn the LJKand housc priccs aÌe Ìnore lcstousi!e to irÍ.rcst ratc changer ìn
:ìrc UÌ(thaniiÌCrr aÌì_r b€ciìusethc i.lffcsl râte on Ììost Bútis1Ì lnongagct is the curent
'.1'" Èterest rate. ln GernìarÌy, lìaed inlffcst Ìate nroÌtgages are tlÌc nortr. (lrheÌ factors that
Ì\red5e th€ s."rÌsiti!'ity ot house prì.cs lo changes iìr dÌe iÌìtercst ralc in tìre UK are hiilh
::ìtior ofloans to ÌlÌelalue olthe holtsc, â smaÌl maÌliet rented scclor, and Ìeìatìvel:" Ìo$
,r" rE I r''6ì r'
fe sion .ra nBenì.nis varv grealìvacÌoss countÌìes.In \ornc counlÌLcs. trivate tensidÌ
1u s predonìiÌì.te. Households savc loÌ LhclÌ ÌetìÌement b) ÌÌrnli nii cotíibutìons to .l
1Ì thât consists of bonds and €quiLic!. Such penlon ìithts.on5ll(rúc Nealth but the)
:,Ìe an ilnl!id asÍÌ. ChaÌì8es in thc inl$esl Ìate an.l in \hare prìccs .hange the vahre ol
: rìs lleâ ltlÌ. IÌ f .onÌia n irÌ cou ntri$ s,l I h so celle.i 'u r fuìr.lel or 'pay-as-,vou go PeÌrilon

n sten]s. a pension lund in the fonì ol a Íock of asse( sp€ciÊ. lo an indivj.ÌLÌaì is not
ruitt up. lÌâther th! pension syÍerì tgovcnrmcnt bactecÌ) Ìrromises lo pal a pctsi()n on
:.tj.eüì€nt out oi current so.ial \rcurìlt.onlribuli.)ns an.l ia\.ìtion íc.9. a ilxed pr)tor
:i.Ìr ol tlÌc lìn.l s,rlarll. lf pensìon rights aÌe in tìre Ìatter lomì, thcr ('caìlh to income
ìtios in th€ country irr rn!ch lor\'cr ard LhcÌr nrav bc a nuclÌ sÌnallcr cllc.l oI a chaniae
:n the iiÌtrrcÍ ratc on bch.riour vÌa lls iÌìtacl oÌr weaìth. ln a pal as you 30 s.heme,
tnsioncrs bcnrlìt irÌ r.tirenÌent lronì las1 tírluclirily gulth at rcÍlcctcd in lhc lc\.eìof
:ÌÌrt ÊnaÌ siÌaryi in i frnded scheffc, a pcnsjoneÌ's jncone .iepends on capiLaÌ gajns kÌ
ú\ses) oÌÌ the.ccumulated iund.

I l...niitercn!ì!dij.!ÍnDrn!LÈ rllri.iÌ{lden..ÍLonÌ=9..rft.i.\,\r!ìrr. aêtal LÌ99i).

,s4

suchcro* countr) hatitu tionaì difièÌerces have been nìuch debâled jn theconteÌtoi
thcopcntionoftheEuropeaÌÌ]l4onetaryUnio.Ioreaamplc,ithasbeenshownthatin
its carÌy years, the Eurcp€an Ccnl taì BatÌl (LCB) behated ln a very similaÌ fashlt)n to the
US lìcd in ÌestonclirÌg to changcs in f(necan i!ÍÌation í'ilh ìnteÌest Ìaie adjustments lti\
.rgucd lhai'tìre inteÌest r.te dccisions ofthe lcÌl ârc rcÌnarkablv.lt)se tt) what the led
d".loi'.-'r .,1 ,... -eì .,1\'l-lu' rFr'l r' \4iJ, ,r-l- .ú ll
vier\'tha! the ICB ha\ lcted too cautìousÌv. lhese t$'o obscrvatìoni coul.l be reconcil€d
if it is lhc case that tì)r institutio.al reasons (e.g. nì hoLrsìfg and pensìr)n aÌraniiements)
clÌaÌÌgcs iÌr the ìnteÌert rate havc a i{eakei ellect oÌì output in tìre eurczoDe thar jn the

2lnstitutions
ln this sccrion, a rinple des.riplion ìs pro!ided ofNct lìnanciaÌând monetaryinstitLrtiors
il] the ccononrÌ. Rea.lers Ì\ìro are alÌeadt l.nìiÌiar Nith dÌese íÌouid \kip to thc ncxL

2.1 Commercial bankìng and finance

lvÍ().lerÌ coÌnrÌìerciaì banks erotle.l IÌonr salehouses tlÌat sinìply looked after valuable!
f{r ríeilthi/ pcoplc Cdrsider the Ívlized balance nÌeet of thc oicnc I of r safeh ouse thtt
krcks rfter gold (labìe 8.2). Let us sutPose this salehouse i5lookiDg altcÌ l0O goìd coitìs
iìrsoÌneonc and Lhâtone gold.oiÌì is i{oúh I euÌo.
TlÌe gold coìns ìn tì1e lault\ olthc sâfehouse are aÌì asset Ior lhe oiflrcÌ and the os'ner
pronÌises to rcpay the depo\itor €100. Thí tr)nì5e repies€nls a ljabÌììLy and is caìled a
cìepo\it notc. Ovcr time, ìt becaÌne a.cettahìe ftr.Ìeposit notcs 1o bc uscd Ìn lransactions
a\ â substilurc Ior phvsìcal gold i.c. they ivere accepted asnro.cJand arc ÌctcÍcd toas
custonÌnry nroncy. Sìnce th€ gold sLoÌe.t in tÌÌeú vauÌts ir.s onlJ rarcì-Í í'ilhdraeÌ, the
owncrs ol satchouses Ìealized that lhcy coul.i nÌake nÌotÌef b)'Ìcnding somc ot il out an.Ì
chnrginginL.rcslontÌreÌo:ìns.ÌhcirbâÌancesheetmightthcrìlooktrorclikcTabìc8.3.
Norc that the loans extended are a\sets of the srlehousc, bccausc lhcv rcpresent
prorliscs b) the borowers to nìakc PdvnÌents. Once deposit rìo(cs I'crcÍ'jdclr'' acccplcd
as a mcans olpaymenti goÌd was only Ìrre\'withdÌai! and tlÌc oÌ!'ner of lhc safchousc
couÌdnUord b ha\ e Ìnore depositnoles on hìrgol.Ìthan he has gold itself. ln thc situ atio n

Ìablè 8.2 B:èn.! 5heet.f õ saí.h.use

r tnrÌì2i d.d raLero (2003: 107)

 Table 8.3 Baan.e íìeetoÍ a mo€
5.Phi5r.àtÊd saÍehouse

Ìable 8.4 a bànk bãèn.Ê sheet

:I

.,bovc, hc has gol.l covering o y t0Ì, oftìrepotentiìl.laiÌì on it. We s1ìall assumc that
:\pcllcncc has thown that tlÌis ìs aprud.ìrt anrorurt to hold, 1n the \eÌÌse thal il ìs slúh
-ieni to rÌeel rhe da) to dal denìands forthe actuâL wÌlhdÌarvalofgold. lhc tnfchouse
\\ÌÌer\{ouìd makea hìgherpÌolìt ifhc cotrl.Ìlend out morc nn)ney, buthc runs lhe Ìitk ol
roi having cno lrgh goìd to nÌe€t obÌigallons actuaÌly calÌcd in (he mâ)' notbcsútllciently
:qLrid). Llanks lhat aÌe kÌ) gÌeedy, or hale bad jrìcìsenÌcnl, oÌ eveÌÌ are occasionâÌÌy ilút
:inLuckt, and as a consequence eÌÌd Lrp lacing.alls on tlÌcìÌ fund\ tlÌât thcy cannot nÌeet,
-\peri€n.c Í'hat is caìleLi bank lailurc, as we ihalL expìain 1I more dctail heltt Th!s
lankers facc a Lradc ofíbet$een prolìlabihty ancìÌiquìdìty
Deposit notcs accepled as payÌÌìcnt aÌc a ntm oltìnancìal ìnnNInent. Such notes !!ere
:ncreasìÌìgÌl acccpled and canÌe to bc.aìÌed banl notcs. Ìnitead of dircclÌy tÌanderring
Jrposit notcs,ln modeÌn bark\ chcqucs areusedtotrarsleÌbanlideposlls honr purchaser
1reller. \\c turn now to an exampÌc o I deposit creâtioÌì.
lve assumc as in Table 8..:l thât inncad of gol.Ì coins. c have casÌì thal isnra.leupof
rot€s ând coiÌrs. We couìd also iÌìcÌudc 'opeÌatn)nâl balances', which arc dcposits at the
.entrâl bankthal car bc conleúed inlo cash on cLernaÌìd. (lve Ìetuxì to thc origln olthe
:rntrâl banN shortÌy.)SimiÌarÌy, instcad of deposit ÌÌotes, wc noi! have bank deÌroslts As
ibove, the proportìon oIcash held is onìt l0% ofdeposjls Thl5 is câlled thc rcscÌve to
leposit ratio' (/d), and the pr:ìctice ol holdlng Ìe$ caslì !han cÌairns on it is Ìnown à5
'autia t rcsette bdnki,tit. By ÌendiÌìgoutÌìúltìpìeiofthccash heÌcl, bânks ctcate nr)ney
:rì i pro.css rclcred t() as depo\it.rcalion.
5upposc thcrc is onìv one bank in lhe econoÌny, â prudcnt Ìese^e asset rallo of I0o/o
nìd tlìat an addìlional el00 is deposilcd. Non ppose thc bank made ân cxlra €90 oí
l,ians ând lhcsc ar. withdÌawn in caslì í'I abìe 8.51.
\vhen thcsc Ìoans aF spent ând assunring those ÍeceivÌlÌil paynrents cieposit thc cath,
:he banNs arc agaìn in a posÌtion ol Írrpìus rcscNes, which allolÌs ftr'tuÌtherloins lobe
nÌade (ì.e. .ash risct lo 200 âncl deposits !o 1,190 so tlìe rcsc^'e delosit ratio is 16.89/d).
 Ìãble 8,5 A bà.t D;èn..
!LìÉ: ,rrh .in ,irhdr.wn r .-s r

tr?pcs1, I lr0 ai,lì

Ìablê 8.6 4..-n! h. àrLê

The nÌorìevsupdv lcash + deposits hcìd oulsldctheì)anlii !s)stentlÌasrisenasares!Ì1

olthe loan. l hc pro..is ole\tansnÌì ol thc nìonct sutPÌv contnÌrìes untiL deposits ha\,:
isen Ìo 200i-ì i |abìe 8.6).
'Ìì gen.rnllTc honr this eÌaiÌ4ìl(, .ccall thnt rd Ãrt. irhere à i\ Ìese^e\ ând 1r ì5
=
deposits. lf bn.ks íick Ììjinìl) to thc mlnlmrLm pru.]tìrt re\erle rati{) $ that to r./ is .ì
coÌìstnnt, rhcn lbc.ìtry\it ttútìo r nq)lifr is gncn bv lDrlà : li'r,/, \Ìhich, iÌÌ .Jrr
exampÌc, !s 10. Ì. pÌa.tice, \oÌnc casÌr drain lÌom Lhe l)aú can be erpected i.e. as tht
ÌÌrofcÍ sLrpltlv e\paÌrcÌ\ 5onÌe pJrl oi thf lncrcasc w1ÌÌ be held outside banl\ as castÌ, Íl - - Ìhe ce ntÍ
tlÌc dcposit.reilion ìnlìltidier r'lìÌ Lcnd lo bc smaìÌeÌ thrÌÌ thi!. It Drav aÌto be the ca\e
lhal thcrc it notLurììmited cleÌntÌnd Iorìoans, agajt ÌeducjìrS the muÌtìtlieÌ. ThìterampÌe
Ìllltsrrelcs that the vait nrajoity o lhc Ìno.c_v sutplv in the economvi{ììÌnotbe heÌ.ìri
cadr. lt it heÌd i. banli accornls and ârìlcs thÌough lhe cìeposjt creatl{)n fìocess. Thrìr to
undc6Lâ.dthemone)mppl)_irÌdcLailNcnccdtoun.ÌcbtancìÌ!hvbanl5crìstandirhrt
la.to6 delerÌine horv much thry Ìcnd.

2.1 1 Fìnanriaì intermediation

,\ bank ls n lor.ì oi lLnan.jal intennediary i e. it is an lJrslil(jtion that nânds betrwen
sivcrs and boÍorars. Brt, of couLe. u\iÌìil uÌ1\ ÌÌriddl€nìan !s not frce. 5.) Ì!h\' do \r\ eÉ
Dor sjmfìr ìc.d dirc.tlv to boìurer\? I he .€a sorÌ is that lì n a n ciiÌ iúennediürie\ serve i
nunlbcrol imporLn.t lu.chon\:
(l) Aggretatìon t}pnalsilinilsquanLilìcsic.g.ÌrgúhÌra\mgsb)houscholdslarc
much im{Ìler than tvpicrl loan rqLLircmcf ls lc.g t(Ì hnnÌrr jrvcslmc.l prolccls)
2) Matüritt tr.ÌÌíonìitlon-agent\ lvâÌìt to savc lot r nroú tinÌc, but bonow ín ü lonil

l) Sfccjâl jzati on ân.ì econonÌi€s ol scaìe paúicuÌarLy in in lo rm ati(nÌ ilatlìering \Vc

shaÌl see the ìmpoúance ol iÌìforrÌaljon lrteÌ 1n this scrlion.
ll Riskpooling some borrowers will delault, r4Ìlch might b.nNrÌtpt ìndlvl.lu.Ìs.
Largei irÌÍitutioÌìs can wilhnand a certain proporLion ofdefaLrltÌrÌ9, end hence oller
little or no ristrito savcrs.

llanks nrl part ol r lriiÌcr iüÌÌcial sc.tor lhal aìso iucludcs Pc.si{ÌÌ irnds, Ênancc
ro!ses, in ran.c comÌrânìes, and building sociclìes. f!nctions oíthe 1ìtrüncial s)'stcÌì
:ncLude paynìcrìls, sarìngs, cÍeclit (loar9, in Ìance, âdvlcc, an.] connrlt.n.)' A l-Íp
:cal lìnanciaÌ syslcm incìudes a ÌÌu bcr ot dittcrcnt 1ìrÌânciaÌ mâÌlett, nì.h as a capitaÌ
.rarli€i (iÌìcludlnS lhc sLock e{charìit€ and thc bond nÌnrkct)j núne} mârkets (incìrtdinii
r.liscount housc mnÌkcL, Lhe iÌÌterbank markclÌ a ìnarket tor ceÌtificât€s of dclotit, a
aDance house markcl, ê Ìo.aì authorit!, nÌarkc !, an intercompany nrailet, and a doÌneíìc
anÌencv coÌÌnÌìcrciaì pnpff maÌÌ(et); and a lorcign exchangc nìaÌket
Ior nÌacroeconom i.s ll is ProbabL,v ÌÌÌost lm po rLan t to uÌìd$s ta n.Ì the nrn.tiorì o I h ìran
: LaÌ lntennediâtion in tutonnntian 3otherits andtisktt ts/ò,1rdtn ? Banks havc itrì loÌtant
rd\antages over othcr ÌrÌs(ilutìon! (such as iì bond marNct) ìn tÌanslorlnilrg .isk Bank\
.an oltèr \i pLer and lcss cxpensne e.l dr L' Ìisk pooÌnÌs. Sincc iti5 inthenalure ofbanks
:. .leaÌ with ri\k, irìiorrrìalioìr aború thc riskiness ol proiccls is an imponant fact(r irÌ
l.leÌmìnÌrg bânk lending pohcies. lÌobÌcus lo do wlth lnhnnation play a cruclal ÌoLe
n drtennirÌirÌg bank behavìouÌ. Underslanding such liÌlormation problcms ìs nece$.ry
: r sce hon bankcrises.arì arise anci how cbanges in the monef mppl-ttccd th(trtiih, via
:hangcs ìn Ìencìi g .nd boÍowlrij belÌavjo(ú, to chttrges in outÌnú Whcn lheÌe is risk.
-r ìì lc rc r ces betweed the informatidÌ
posscsscd b] the bo roirers arÌd tlrc len des can bc
..Nsjgnihcant, as $Ie íÌaÌlsce.

2 2 The central bank

-r (r. havc discu$ed âLJo!e, lhc pr{rer lLüÌcliori.g ol nÌolìc} is e\treiÌìcÌt \aluabLe in
:inns oÍ prcmoting ecorÌonric rfhcìetÌcy. lo cnsure tlì.t l( can peÍìÍ]] ils íLrnctions
-i:ectircÌt' lhcÌe aÌe two main tasÌs:
-r
r The tuÌÌt\ ol noÌìev ln ust be Ìegulatcd so lh at ìt i\ Ííil cientl)' scarcc Lh at ìÌonev
crn JeÌve rs:store oiraìue, yet nrfici. n 1ì)' abunclant lhal tìreÌe i! enoLrgh of ìt to

srNice all the desired transacti(Ììs.

lr Ìh. bankiDg s-vrtem Ìnust bc sulftclent\'tub!n and stable thal cconornlc âg.nls can
have coolÌdrnce that their cuslomaìv mone-v hoÌdingi itÌ trank accounts (i e. thc
!aÍ maioril) oíthe money supplyl couÌcl actualÌy be used if reqrtlred, whiLÍ )et
rÌÌâintaini.g fÌopeÌ nrcerÌtiïcs IoÌ ìenciitrs tu go to viabÌe ând plar$ibÌe prcje.ts'
rathcrlhan rÌÌ1.Ìly Ì1sky ones.

.\ grcat.ÌeaÌ 1s wÌapped up in lhe hÌst statelÌÌenl. As \íe slÌaÌl scc in more deiaìl i.
:..tion 4, shateveÌ innru erL the ceDtr:ìl bâ t1ses muÍ havc lhe elttct ol limiljng
:

258

.i ihr t1.!ìcl.rl! Ìriì:È H TÌre it(orìrì pfinÌ lo nlik' ii 1Ìrat thdt is I t'Nir'
thc gro\lrìr
u"ui.""n,".uo,.t.*nì!{LlÌicjinÌtrlscnÌone\'í)òlo'r1'tÈn'n(lillrisf\arìr":l'
(:'trtrill'i'i\üÌrtlrcìe!rrcÌ)i!renrs!er t):Ì'
.r1,,,,frtL.l,firr.lrgtrr.'.,)nxÌrilan'hoÌ (orrrÌ)\r o' th' onr haÌr'1.r':
il":i';.:iit'.r..ì.tt.Ì.l berlver' tÌe\ inÌi rs Êf : ì'irr
inÍlation oÌr lhe !lher
ÌiLl)rjÌtri iÌlcludt:
he ÌììiìúÌ PÌr.ii.rÌIlLr(iloD: ot 'r Lr ti"l'erì

L1Ì BdÌk( to lÌre gi)1.r.ÌÌÌ!'.t ' nri tÌ'

t ('mnrri' irL hrn r'\
l o.du.t !l monclrr\ ÌloL 'l \'!Ì'tinìrs lhlr ls tìmfll Ìhe op'ülionrl ltt lr\ th(
dinreJìsiLll
t"ttt ru tÌf L"'rlt'"tt a tiÌ gtt l'Ì ìÌriliiinì
',,.ì,.,,_4" ".",S "1,*,,.tt
Sutturcsllrl:oúÌ' rdei'lctlrìinLngLhc"/nln'r)iÌÌl'nÊtiÌl
loicrrmart

i\TrÌìalcroltÌÌc cÌ.harlge(qu LliTatio' a'r'LÌÌÌ1 ic'tlÌ"'tr'tÌ\'ssro'loiloldrr!:

;,,,"iìì:,, . ."';,\ ÌL'tr i'r irr Lcr i ntìo' ìÌì the iocis!ì c\crì insr marNrrs
' "',.
a!'ntriiLì)arksrÍctr.rmLlì\'harlLLÌrìlhtll'la!koinìrirúnLÈirìsanabìeindrlLÌcjif:.Ln!.
.!..ì,,r, ",,n ,irIL!rr()rt TtÌii.rúiLÌ\,ìinÌi.g t0 matrrLriÌÌ Ltrc inrelrrli
",_.", hrftcr 5 i1'tteJì Ìnen'\fuburÌL!
r rlLLe oi ihe cuLr'ro rnLlj.Ìrnctì.r',ardirc!íedln(
t',',.Lti.rÌ 1ar3'rr irÌÌ'trslr rttli!1! 1rìc irrLcrtn tte
rhe b'r'r
ì,;i.:, ;:,,'ìì,' ,,,' "núiìr
". c\tr'lxtìof\ drn)u'h
:,"'. ;ìì; ";;" ,-;, Ìo iÌ.hi.le iL! tarstú b\ Ícìiifs t! rnlrL,cnrt rc\ ronnìjLtee incr b1
ì.ìi"ì'"",' ',,".i r' tht Lìerr iiÍr meÌÌrb'r or trìc nÌonttar t!
i',"."ntiu,. Ar c\rÌrìfÌe or rrÒn thc ltntral bxnr ii 'ìLrr( n) ÍÌ trr'
;;;ìì;,ì, ì.;;
irÌ1.rtn [te is fl|n idid úÌ st(iioÌì l heÌ!\t
"':,",',;"ìi,",i' (ìl rhe hfin(Ln s\ Í( m xì r n!nìÌrr I
,,,',, ., Lo rlrnúiÌrn tlr' itiìrriÌìtI
"
t,,ii',',,"',,.,"-.UtcÌr!ìoÌìit(ìr1rìr!le'clolDefl!nÌthtÈnin'i'l\\n'nranLltlì' Ìn!Ik'ts br aÌrelv\i'g ilì'
i"a.i'.u'... ",u,'u,".t ln\ijtutirrns rnd tjrlwtif hrìa'(i'rl
;ì,,;:.;;;r':"..',. ", br rjoic.oofcratroÌr ith i'.n raÌiÌifcr isoÌ5 LrorÌr doÌnt\Ìi'airr
'l
pL'rnLL'trngsoundt'"'nL riniirsLtr(tLLrcüÌ'rtrlritlgelr'ieÌrL
"ìì.i"iì'"i",.t, -,,or
n^ì|.ntrJìdtetllerìrcntiì!j!ÌìgenÌc.tt'1:ttrtÌiÌbi]nL!lìrr\.]15.]l]e.halg(Ìu1iht!]Ìì01rrr'i
i'ì; ì,,ì. ,ì"' ,,t nrLr;.ì.rr !\ Ìrìit oirr'Ìi oftontniiì'! nr rrrrn\ nI rll
"i,"',,"Ììt " '1r'm
I

sutpoÌl lrh!Ìt ilìjt i5 .e€dcd 1o rt oi'ì i\ 51tDrl' dJ|rr!r'

2 3 The stock market

À \tocl nrxrl.( is ÌÌherr sharc\ it Ller on a f(Ìlrrlio' 'l I crm|in\ I
rr' lÌrlL'd ShrL-j
Ln iì conìtüÌt cntì1lt 1lìc !Ìol'ìrr Lo I lroPoÌl11rn
()i tht \oL!\ irì !t!ìrril !ÌÌ'cturirs (it
LÌ]r (iDfl.\-to !le.Lde jtho h!\ dr] lo dil (l]ntF)l 'i thr 'o!ÌPrn\ jor
'ter'ìt 'na1
.'"'"ti"i ,.,'" Ls tlrc.lìici r'Ìe(!Ll!t, 'nd ('lrrì sit\ o' thihoa 'l d rictors
shrrt\
hel!l lÌrr
,r',,ritncLrtrlrtorLls.r'tìúlrrÌela\Ìnc'ltli'nornúÌiìL tttrì5r ÌreÍ:hrre 'ì'\t
 259

ilraÌrh.ldcA il c. rho:c ílÌo !lo rÌot irÌtü to e\er.ise operational .oÌìtroL .t aI]\ poiÌÌtÌ
ìtrÌdenLlsrÌrlhrrLlÌ nriÌ1r hnan.i.,l juÍihc.ìtion tor holdiÌiR !lÌ.rr\ lhrt.rctlìe\ieL!|.
l,rrevcÌ. \hrr\ .rf Lìr sold. res!Ltins in . ciìpitaL SrnÌ u loss (deprndiÌÌR on trheuÌeÌ
thrrâÌcÍt{Ìat alr gÌrcrorl.n!eÌprj...tlÌ: tlÌer irel)outhtì.
Shrret Ln comtaf rs iik. r nuÌÌÌber oi diitereni lorna tlÌost .i l,r!c pubLi(lr litted
.L)mtanies rrc irÌ.clr 1Údcd, dre r!.ìil.ble to rn! !ÌenÌbeÌ !l tlÌc !utrli. 1o bul aÌÌd seLl,
:ndrÌcjn.lr(ÌcdlnslocliÌÌÌâÌletirÌdiresLjlrthel_jÌüncialli.sSnr.kl\.hingeíIl5l)
nd.Ì:s or Lhc l)oj!.loncs lDdu\tÌirl iìrcriì!r\ lut nrürei dre also h.ld in .onÌp.nirs tlÌat
Ìâli: trn.eL{: oi (Ji.gs Ìas(on+rÌrt $ith tlÌ. p!bLicotiÌings o. th( slo.k.ì.rk(lr to
.d \ iduâls o, sr.di.i1.s.l.r!e Ì)rir,ì t€ .orÌr pà nies iìre o1Ìen t.ìl]1lÌ_rÌr!si.csscs iclcn q uitc
r g on.s, lik. Lh. Sritish ret.riler LjtiL€\r!!ds or tlÌ€ Ge nan aulo'ÌoÌ !c ifd ro.sunrc,
--nrds ÌrülLL.cr llos.hr iÌr shi(h rnÌbcrs oi i.nriLie5 hold shircs lheL irc.oL qrroL.d
1LÌrÌ .lt. \u.h.onÌparÌitr do not flort orÌtlÌe no.lnirrlet
\llp.il sto.krÌr.ìrktirnohe\triìde\irÌ\h.rerbrhrlerii.ìÌrÜ5o i.(lhillrriÌsend
:,Ì.riì.Lirchìrìi]llnurÌÌl)eÌolÌrrireirìnit!tions(srrhr\birks.pc.sion Lrnds. inrc!t
:Ììrni hous.: or natioÌÌrl !o\eÌnDrrìtsl. llÌi\ scttiÌril ol iì irN l.rg. tÌivL:Ì5 rnd nranl
:ÌìàltpÌi\rrsSi\esÌisetorrdÌl co r!li(lted d!n rìi(\. Ìor cxnnìp1., st.r.k úrrrÌttso[Len
n\ ol!. big plavers i e. (ontÌoLltÌr oi â ].rgc inÍiiLrtiür ir g. !rnrc.nc i,ü. Ììrnrgcs a
rì.Lj!r pcnsi.!Ì nìndl xlÌo\e nÌores ârr IitclÌcd.1o\ei) ind olÌô1rcrlbl otheÌtìr\eÌt.
:,:,r rrinìfk.ll...trüÌLri! pertrnÌr iì,nds i,r c sflli r! th( shaA ota comprnl, other tlader \
:rì.,Ì inl(rtÌct thit r siln tlÌat the prrÌsion lund JìiÌì.gc,s Ì.oÌr Í).rethirg l)ad aÌ)out
irs
:|c con4ì.n) rp€rllrp5uÌeirrnalt\is m!!eÍs th.t its proÊls rriÌlbc ìoÌ!1, n) thev in tum
..1Ìtfuse nÌarÈs lÌr rllditi{lr thrÌr lre thr ÌÌrarkrt nÌalrrs irlr. slrrl.t Ìerd} k) Ì)u\ oÌ
..1Ì nrrres oi prún!h ((ÌnÌrdnie\ on L,(lÌ.lt of othrr finaf. aÌ i.rrjLüti(r\ or their oÌÌn
rÌtrÌt\ I he de.j\i(Ìtr !l maÌket Dúlers cìn hà!r â sjgnilì.ifL inTr.t o thr Ì)eha\ io!Ì
ìitìrenÌrìrlet.ârìcl(ìrÌ\iirnìnceÌÌtLlrlte.tthcpricr\otpiÌÌ11.trÌrÌthrre\,()re\eDoithe

lraliÌrS iÌi Ío(ii nÌrrliet\ talie\ p]".r ritlÌ n ,ì sriil.nrc.l r{inLtr!. l)pjcr1ll, tlÌrI. i\
i tÌ\o $€el c\'(le. feople ÌN!nÌS shre\ bcl(rcc. I .jdir .I.nÉ Í eel. !nl the I h!rÍh!
:liiItren da) \ ht!r. nnr:t Ì).Lr 1lìejr d.bts on lhr I rldit. Lhc nüL.erÌtlÌ ld). SiÌrriL.ìrl!, ii
.haÌe5 arr Írld nrthi\ ÌriÌ or!, dìet rÌnrÍ br gnrrr orrr 1o Lht purchatÊÌ orÌ uÌrtÌrilr\
$jrxllr! nÌale\ (.nÌl,le\ ÌÌrlliÌrir n t(!i.\ possiblc. oÌ errnÌne, hrdeb clD So
hiJ
,!!ir' tlÌ:ti\toi\,the) cln ÌrurrlÌatÊ ÍriÍrscarhiÌì thc tÌrcÌjngNn d\ sjih nÌlnet
: ri\ don.tlÌr\r 'ÌherÌ.lrtÉÌ.dre\.!ÌÌ\elLtho\.íÌiìre!.Ììd rLÍ'LhcD(Ìrel tÌomthelater
.rLctoÌì!]olttheirerrLjerdetiL5u(lÌrrtririrs\.introrlnclliishare\a!eìitil!ürÌrÌi(e,
.iÌÌ(e price\ tÌ\o \!eel\ Later mislrt br hith.r. Sirrìihrlr tredcÌs .xn g. sìroÌt the) cau
.!ll nr.rres tlìet do rÌot \et Ì)o$es, .ìüd Lrur thcsr \haÌr's lntcl if rhc hr.tint wildo\ Íi
: Ì.ú 1lÌc1cin suÍüÌdeÌ tlìr reúili(rtls üh.n rcq!iÍrd.
h. .o|ìbiÌì.rtidr oì uÌr l)resent ol nr.ukrÌ mil(rs Ìd th. i)oíibjÌitl olgoìngÌtlrt
I
| \lìon crÉatÉ! reI .on4)Lerd\rÌanÌi.iìÌrÍo.knÌiìrlets.Ì!1 liLLÌìxlicr:ma\thirÌ(dìrt
,1rÈr\ \rilL loLlor tlÌenÌ iÌÌ t)u) nìS itthet ilo hn!. !e.r!se nÌaf _! Lrad.r rrc lrvjng n) bu).
: Ììr its.ll bi.ls rp pi.e\ rnd the rnrrlet nÌirlcrs .aÌÌ rìÌirlc .rgc tÌolLts jurt b\.eleÌ.itúg
: reirm.rrkÈi poüer \\:lÌen beha\i{\rroithis lirxl IonÌirÌ.ìt.:,1lr.Ìc.a. br !r crlÌedbuÌÌ
rÌ.rrlet\ iÌì rhi.h stlcl pÌi(ei 11\e irÌ d ÌÌÌ,ìnnrr tlÌrt nÌn) br u.ro..c.rc.l (rilÌr rnr Iui
. ìÌÌtntal iÉatLrres ol tlÌe ÌÌolìtaÌrili\ or pro\p€.t\ ol (onÌparlr5. ìltcúaltr ci), jf mal(ct
nìalicn believe uÌat othcÁ Í'iÌl foÌ1ow thcm i. sclling 1l tÌÌe! go !1Ìoú, prices cnn lall
dramatjcallv ancì â bear' market nÌa) elÌsu€.
Suchbehavl(trunÌâygircÌireto'1ìnancialbubblcs'tinratlorÌsnìt!hichÍockprlccsarc
driven up or down \inpÌ)'LhrouglÌ corÌìplìcatcd hcÌding beha\iour on thc paÍ of markeL
nÌakcÌs ancì those !!ho loÌlow thenÌ. Such bubblcs ca. hav€ inìpoúnnt nÌa.roccorromic
corìscque.ces. \,luch houschoìcL wealtÌÌ is hcld ln lhe ian of íÌâres 6ften indjrcclì],
through cÌaìms oÌÌ pension Iun.h), aÌìd as Ì\'e hatc sctn ìn Chapter 7 peopÌe\ asscssnìcnt
ofthcirrreaÌth is ver\ iÌÌÌponan Ì nÌ phnningconsunrttl(ÌÌ. Siüìilârlt, thc abÌÌityot nrms
to raisc lrance thÍnrgh oft$ing their slìares to float on tlÌe Íocli iÌìarlct ìs obvloun-\
lÌiglÌÌ_r dcpendeDt on \\,hctbcr the ÌÌÌarket as a tuìroìe ìs gonì8 !p or dolvn. lftlìc mârtet
is faÌÌlrìg, lor exampÌe, conÌpanits nìay 1ìnd it hard to Ìaise €qui\', and silÌ.c íor .crtain
kiÌìds ot projects equity rnay be a srrp€rior forÌr ol finance to loânsl thirt may nìea.
.JverinvcsLm.Dt.luürÌit bLrlÌ market b!bb]€s arÌd undeúrvestrÌìent durirg bcar nìarket

'lherr ìs .ot (nnelsal rgrccment aÌnorg r'conoÌìjtts rbout t1ìe rolc oI bubblcr in
expl.inlng nrolenrents of íock market pricrs. An aìtenative account is thc 'cllÌcient
marl€ts hJpothesÍ'. Ac.ordifg to this theory, sÌìnrc PÌ1ce\ si pl), retÌe.t thc bcÍ inlor
nration avallablc Lr) tÌaders at thc tnne. Risirg nìarlcLs aìise Ìlhe t1Ìe best ìnlormaLion
m88eÍs thnl tuturc tr)1ìts irc gojngto be hi8lìrr than pÌe\ idr\lt erpected.l IaÌling ÌìrÌ
let! arise wlÌcn cìtheÌ the positi\.c neils behitul thc ri5jng marliet (eü\es 1c) bc bclictcd, oÌ
r!hen somc prcviousì)Ì uÌìanticipate.l Lraci rÌe\!s ippcas
ll t1Ìe cllì cìcn r nr arlet! hypol h csis is clrrect, thcn íock m artiet swilÌgs â re nol Ìral ìon aì,
arÌd do nor need to be reguÌntcd, or nÌanagcd, or comper\.rted foi by ÌÌra.roc.onomlc
poli._r. On rhcotherlürÌd, if lhc ideaolÊrÌancial bubbles i5 coÍect, Íock rrk€tbootrsot
.nìslÌcs can inflate orcleprcss rotÍun ioÌì .nd lr tcsrm ert lo. reason! that d o no1 rc nccr
'real' .hanges i. the ecorÌom-Í (in tern! of i Ìovaliont o. iìÌture Prolìt opponunÌlic9,
andtÌìalmighrcreateanoppoflunÌylorÊs.alornronctaÌrtolicytoresuLatedelÌÌandso
as to comÌrcnsâte for tlÌe iÍatio n al $!hÌ35 iÌì the e.onoÌìy lnducecl by tìnancial bubbhs.

3 lnformation pÍoblems

3.1 Problems of asymmetric information

We beijni with thcqLrcslìon olwh], mÌght housch(ìdtnot belÌâPPt to depositnìoneyÌn
banks, and \!hat arc lh. conrequen.c5? Houscholds ailÌ rot LJe ep:ìred to 1eÌÌd nìodcy
to bânls if they think theÌe í too mrch risli ot lhtiì not being âLìLe to get their nìoncli
out $lÌen thq .laim it i.e. iftÌìereÌs a signilca.t rjsÌ olthe LJarÌk tì1ling. If households
woÍy.rboutbnnk iaìlure, thevÌnaynol bc plcpnrcd lo Ìend, eve at.elativeÌylÌiglÌinter€st
rates. SirÌcc ba.ks taciÌ1tate lending throúgh lhc gains fìonÌ 1ìnaÌìciâl internìedi.tion, if

Forerrrìplr,inilÍ r[ 1990\ n i ]5lreli.r.d ilrt i r, ir rnÌn.t &!L .cla td nú!ìation and.DnÌìúm.i tion5
L(hfo.gn\trrn,!,trn!nrLêadtohislÌ.ÍítrrrÉl)r)dntn\iilSrNiÌriitÌl1Ì51 i \.Ì{l..nont xl(rrr
r$úir.dÌ!ürtrtuI)idL\í5nì35to.li$irr.dH.,!r\Ér,rs(têlanflìi.hidr.f(2002ì!horviii5.xt...ì.lIhrÍl
n)1rtl.rnÌ Í,e nncrietÌìoDn isml rnrl
 ::: ...: .: 261

hous€holds \!ill not save in b:!nks, ilÌere Ì\'iÌÌ be a laÌl in lendìng to busineses and hence
a lall iÌì inveÍnÌ€nt. ÌÌì tlÌis way. perccircd risk to thc soundnes ot banlis can Leacl to .r

Next r,e ask s4Ì) night barÌks not be preparld to lcnd nrone) to hÌms, and whai ar€
iÌìe .orÌsequences? !.ÌÌks nìay not l€nd mone_r to firms ií they beÌieve that theÌe n a
nrbstantiaÌrisk of 1ìrms g.JhÌg banktupt aÌìd benìit ünabìc lo pavbacì( the loans, or ifthey
:eel! na ble to LJelie!eÊrms'ptuje.tioÌìs ofreturns tconsìdcr acase oflendürgtoacompan)
itìat ha s prevìou í) bee! itrvolved in a coruption s.ar daì ì ike that of lvorÌ.I(lonÌ in 2002,
:Ìì $,1Ìichreported profits i!ereexailileratcd). inbanklencìirÌ8 torthe\ereâs,rns
ì ould leâd to a recluctidÌ iÌr irÌ!estnìent and^reduction
hence oulput.
ÌÌì each ol thes€ \ituatiorrs tlÌere arc impodant nìacmecononÌic elfèct\ ârising trom
.lìitereÌrces iÌì iÌúoxÌìatio b€tlveen ÌeÌìdcn and borrcweìs. At its cnúest, ras),nìmcüÌc
:nlonnâtion' m€ans thtìt i)ne p€rson kÌÌor{s sominlÌÌtÌg Lhat íÌneone el!e does not knoÍ'.
,\ e nÌaI speak of a sitlrâtion ÌÌlolving asymrncki. intoÌmatidr, whe it invoh,es trans-
:..tions ÌÌ which atleast oDe oftlÌ€ paÍics to tlìc transactl()n knorís so ethìnil reÌevan1
! optinÌal .lecisbn makingthatls not knol{,n bt, the otheÌ palty.
It is \impìest to illlrltrate the icìeâ with a f€Ír€MnÌpÌcs:

1r tÌowhcalthvarcl,ou? You areljkelytr) knowthìs betterthar sonìeone hvnrgto sell

_v''ou hcallh irÍrran.e.

lr Wa\ the stereo tòr saìe at the second hand shop sloìenÌ The slÌopkecpcr is likcìy lo
be abìe to gue\s this bettertha ylru.an.
I alÌ nìl' st resìrì a co{nÌatìon
SlÌcÌrÌd I sell because the .o nìtany ìs abo ttoSo
b.nkrüpt? 1hc corporatiorÌ\ chjef accountart kno\{s this bclLeÌ than I do.5o
suppose. chìef accountarÌ1 o IIc red n) 5elì)ou a millìolì sharcs in his comPa yat iust
belowtlìe.uÍ€ntmârkei pricc-wouì.Ìyoubuvthern?
Sitúations jnlolçing artÌnnretric iÌÌlormati,rn raisc a nunìber of dÌlfcrcnl pÌoblems.5
.,io oÍ lh. most inrpoÌtant ir brnkirg and 1ìnan.laÌ seÌvices are thos. ol adtese seÌec
:Ìon and moìal hazaÌ.]. Ìn sectidÌ J.2, l{e sct oul a modeÌ thrt shows hoa atyÌnnÌetric
::ìionìarnrn prcbìems can inllLren.e rÌì.croc.onoÌÌric outcoüìes.

:ll Adverse selection

-ilr€rsc sclcction is lhc nanrc glven tu â prolJlenÌ thal can occür iIÌ situationr Nhck
:iìÈ iÌÌformaLion asynìmc!ry ãrises I'rlòr' the üa saction. IoÌ example, the ptoplc a'ho
::ron rlanI hcaÌlh ìnslrÌafcc aÌc those rxt1il€ly to be unhealthy.IftlÌ€ sellers ofhcalth
::ìnÍa.cc cannoL dlslìnguish between th€ h€aLtlÌy and lhc unhealthy, the.ons.qucncc
ì rhnt rhc maÌleL fÌicc ol health irmran.€ is likelt to be geaÌed arouÌÌd thc Ìlkclihood
::anunhcalthlpeÉonlallingìÌ1,andh€nc€prerÌÌiumswjìÌbehigher.Ìherlforchcalth,v
r:oplc nray nol bc ablc to get heaÌth 1nÍÌÍìnc€ at a rcaÍmabÌe price, €ven though jt
::ìc lnsuranc. .omfenr linc they were health) th€rc rdrld be a nÌutrìâllv benetì.ÌaÌ

' lhe \oìreÌ prre Ì{is laLded in 2001 nì r r. thrú L!Ìr'nnn Ìì1]o pio.(Ì.{l ih! trnrLy\i\ .t rârlÈ6
rh xsrNÌct.i. irrorrnrti.r: CroÍ9. f,k1Ìl.t iLhxcl Sl)er.r, and Ios.ph Stigiir LoÌ nÌè detaiÌ5 5Èe:
.iin.bcl\./r..forìi(\il.N(,t612(rl)li.lÌ!.ÒtthÈcÌ.$i.rni.ÌÈsnrÍÌ.kÌrrtn,dÌndn.usLonare,\kelÌoÍ
; 0r rrdstig iir.udwei\\ (1981ì
26,2 . ..:.:. .:': :.' i:l

ì ns trÌaìrce conüa.t. classìc c{ample of thls pheno nìcn on í tlÌe \ecoÌÌd hând .ar nÌarNc L,
^
rhe nrarket for'leÍìons'. Whr ( a carfor saÌcÌftbffc is nothing ÌLronil Ìrith it?

3.1 2 Í!,loral hazard

\,ÍoÌal hazârc1 is the nnnrc gnen io a problcnÌ Lhât can arise iÌì situations whcrc lhe
intormati()n asvnÌmetry arises rÉcrthe transa.tlon.Ior exâÌnple, onceyou lÌatcinsurcd
you Ì caÌ aijaÌÌst theft, )'o11 m a) not tâke mLr ch trouble n) Ì()ck it or to pâ rk it in a safc pÌace
lhcÌci(tre insurârÌce coÌÌrpanicswill oflertheft lnsuranceon ttÌe âsÌlÌnption 1lÌatyouwììì
not bo theÌ to take câ r€ of -1rou Ì car, nìaking the inslúan cc ìn ore erpensiÍe. l hìs rÌÌÌl malic
iJÌsrúance'tiD experÌsi\.e'so some peopÌ€ n'iÌÌ nol ÌnÌtre their cârs againÍ tlÌcft, crcn
tÌlough theÌe would bea muLurllv benelì.iaÌ ìrìsurance contr.ct if tÌìe)i coLlÌd promisc ti)

3.r.3 Asymmetric ìníormation in finance

lh€sc ìssues can beconÌe important iÌÌ a rumbcÌ of nnancial coÌìtexts. Onc ìmpotunt
exinrplc ìs NheÌe 1ìrns issuc shaÌet (i.e. eqLìit)'or íocks) butlÌÌvestors cannot distinguish
LJeí{ccn Ìow Ìjsk, hiiih proÊt lrms ând high risli, loi{ ptufit lìrms. 5!pposc lbcrc {'as â
Ìnarket in Nhìch both tlp€s of ilflÌs túed to issue slìares. The üoÍ an iÌÌvcÍor tlould be
preparcd 1opayi{ouÌd bethc alcrage Ò(pect€d rct!rr. ButtheÌÌSood ÊÍns('iììnoL ìsn'e
ÍÌarrs bccause ihe pric€ invcslots wiÌlpâylrilÌbcthan nrch shares arci\'onh Hence
lcss
this nÌaÌkct f()r neÌ{ i\s!es olshaÌes i!il1be doÌrìinaled bv bad 1ìrlns. lhìs arguÌrcnL ma)
h€lp ro cxpìaúr two intercíing facis about financiâl maÌkets. namely that sharcs are not
thc nìostinrportâÌÌtsourccoÍeÌtrrrlfinôn.Ìng tor Irnns, and t1ÌatisÍrirÌSmarkctableclebÌ
and cqujtv tecuÌities is not thc pÌlmaryr,ayin$ìrìch buslnes\€s fi!unc€ their opcralions
AdveÁe selection ard moraì hazard are aÌso.lcaÌìv imPoúânt problems ln banl lc.d
Ìng. AdleÉe selection ilÌ loans arises because thc peopìe $ho most wâú Ìoans arc llkclJ
to bc those Ìrho are irrespofsìble, or !i.k, or havc bad lucÌ(, or ilhatever it i\ that nìigh t
Ììete them a bad li\kto lcnd Lo. SiniÌarl)', oncc nìo.ey has bee Ìent to soÌneone, thcrc js
olten ìelativeLy little thc bank can do to prcvcnt thaL pebon lro Ì spenciing th.t monc-r
on extravâgant íÌort tcnì coDnunptioÌì ind Ìnlff decìaiing him\elf bankupt, tlÌercbt
gìvìnt rise to â moral hazakÌp(Ìtem.
Such a\vnÌnìeüic inlormation problcrÌÌs may mcan that lÌousehoÌc]\ and 1ìrlns facc
ìl.Ìuìcìity co strairÍs lhat ìs lo sa\', thc)'are not abì. to borow as much as they $ould
ìlke to, even iÌì .ircunìsLances rlh€re thet wouÌd bc expectecl, on average, to pay thr
nÌ)ney back srith intcrcs l . Th e presence ol liq u idill co n rtrainti i\ nnpoúant iÌì erplâüÌinil
connuìptior and inrcstÌìent beh:ì!iour, as !\t havc scen nr ChaPter 7. SubsectioÌÌ 3.2
beldv pro\ides a lormaì model to \lìoi\'hoÌ\'iríornìatìon PÍ)blenú caD leacì to credit

3.1.4 Solving asymmetric information problems

'Ihe simpÌcsl soÌulìon is to Ìemove thc asynìmcllic intonnâtion. FoÌ exanÌrle, in È[tncial
Ìnarkets, pcopìc supplyinia flÌncìs wouÌd havc tulÌ dclaiÌs about bonoweÉ. Iktí shoukl
thl\ be donc? 1hc moí diìect option Ì\'oLrld appcar (o be usìng pìivate ratinia âgen
cie\ (e.il. Standard & lo{rft. 8ut thcrc i! a probìcm here ol Í) calle.Ì fìee Ììdìng. Ior
erârÌÌpl€, supposc tfvcstor A bu-vs iiÌlorrnatìon abou! comtan) X, and on the barìs ot
 :. .j: ::..: 253

that intonìalion buts rharcs in X. Investon E, C, D, etc. (ì.c. prclly much eveÌyone else)
:lr itl do not buy inloÌmatior, Ìrut jnstea.t iuÍ tìilloí ÌnveÍor,{,lrcc-riding on his puÌchase ol
jnlornratìon. But ther A wjìÌ not nÌake any stiecjaL proÊt bi buyìng Lhe lnftrmatìon. So
no oreiriìl bu) iDfdmalion.
ÌÌr slrch situatnrrs, bank loânr have an advanrage over othcl IoÌms ol lìnatcitg. Banlis
.en lorm peÌsonaì Ìelationsh4x ilith clients an.l erÌilâge lr non-lÌãd.able loans (Ìadrer
Lhan ürdeablc equìLt oÌ bonds), which DÌaÌes ìt woÍhr{hiÌc Io. the bank to ind oot
lDfo matior abour cljcnts. lh is í anotheÌ impoúaÌú reason rnìy bantt ex iÍ.
lhis will nÌake AtâÌt fÌom using l)eNonaì Ìeìaiìonrhilx, there aÌe t$,o olhff nìain potsìble ítutions tt)
lhisltrohìem.Iirtr, lhc gov$nment could ptuvnìe lnlormation iLself. Altematìve\', there
.oul.Ì be goveÌnÌnent rcgúlatì()n to encourlse luÌeÍ rcvcìation (e.9. ìuÌes ürslíint tlÌat
irnìs discìosc inh Ìalion about thenìseÌ\es âncì publÌsh account\ in stancLa tònÌÌt.
lhc rcg!ìatorl oflion ìs coÌnmon. This partially erplaiÌrs r!h)- the nnancìal sv\teÌn i!
anìong thc ürost hcariìr rcguleted sectob oftlÌe eco onrv. Ba. ks arcun.t the ilorld f.ìce
many rcgrrlalort rcslrictlons, ìnclu.tìng cìiscÌGure Nles; rcsLri.tions on entÌy; Ìestúcticnìs
:r ot d istiÌìgxish on nsscls and a.tlljljcs; dcposil jnsuraÌlce; Ìimits on clrmpclition; reshìctions on iÌÌter€st
ratcsi and rcscrc rcqulrcnrcnls. ìúuch bankinii reia!lauof is what ìs cal lecì prdetÌtial
tÌÌal ls lo sar, ll is gcarcd loiraÌd\ pÌe\enthÌi{ banks bcing lmtrudeni in iheir lending.
lhis rcgulalion is supposcd lo tÌevent bank nra and pa.ic5.

1.1 5 Bank runs and panics

I 'bxntìng panic' arisei when througlÌout thc bn.king syrterÌì, bank dcbl hoìdeÌs nt.l
dcnlv deÌnâ.d that banks couvert t1ìeir dcbl cìaims into caÍÌ (.1 par-i.c. one fd one
Íiilh lhe depositsl to ch an ertent tlÌat banks Í1lpend collvertiblliLl. oI dcposits nrn)
cesh. As a consequence olthe cleposÌt .rcatjo n pro.cs di\cu\sed earlicr, dcPosits in banl\
rr. Ìnuch gÌeateÌ tìran the cash h€lclbl banks. l'his means th.ìt n.vbãnk {11ìbe unaLrÌe
1o pa_Í out to ever\()ne ìf all it! depositors lN 1o Í'ith.lraw tlÌeìr lünd5 al once.
lhc classi. scenaÌio ìnlohirt ban|in pnrics js lhe US^ duriÌìg thc caÌl-Y 1930\." Du.
ng lhe GÌeat Detressl()n, about 20% of LrS Lranks laìÌed. lo gct a scnse of the scale ol
ÌrÌìat occuÌrcd, and what.lifierence fitulalioÌr Ìs bcÌìe\ ed to havc nìade, note that iìÌ tlÌe
1920s !h$c $'eÌe about ó00 bank lailures pcr,vcar. Then, b€twe€n 1930 a.d I933 tlÌere
\rcrc abour 2,00O failurcs peÌ vedr. \'!herÌ mcrgcrs an.l licÌuidations arc al$ taken Ìú.)
ion5ideÌaLÌon, of tlle 25,000 US conxncrcjal banks in opeiìiion ai lhc pcât of business
in Ììid-1929, thcÌc s'cÌc (Ìrì)' 15,000leit b_r mid I933. Since nÌ,rst of lhc money suppl),
iakc5lhe lorm olbank deposits, â\ wehave scclì, thjs scale ofbankiaÌÌúrc aì5() tcsulteclÌÌ
.lr'.r ,r-'l-ri ...'r'r'rl- ,'.t 'r.fl.o.r.l--' rio..
In lhr bânting ì1teÌature there :!Ìe two main scts ot models to explain banlìng oises.
ftc nrst cìass are câÌled 1ânclonì withdr.r'irÌ rìsk' oÌ 'coo.cìirÌatioÌÌ probìcnì' nÌnìeÌs.
HoÌr.rrÌ, orr. nÌ'ud rr.igtt ttìè Ìdea iìÌa( thisÌ{is i pLolrÌrrì \pr.ilì. b tlÌat lnÌe or ph.. TlìcÍ Ì!.Í:
11.I\ern)u\ri,n[in8Ì]inìr\iÌr drr ÌrKúÌLÌre pin lc! irllÌ.182lrl.r.iLtherewei.se!.ÌrbarkiraÌìrfn\ni
ì.!Éniniaú20(r2 lhcrr{rÌrali.itrerUSlrinkifg,rir.sif lsl9, Ì3J7 l35l 1373.13Í11,1893,ieo/,1.dú
:h? Ì930j,búi theseNere iÌÌleÍ sereL. tlrin ihri.iihc.rr ) L9Jo\
Llrc.n\nledútlìêeiJitLn, ienroIlheFed!rilDcF.sitIrur.LeúÌp.huon{IDÌal)ifr'rjí lhrliL)l(l
. r..mÌÌLÌÍÍ) i nran.èt.1,.\.nbroli.l.poriii,an(lg!Jrrft'e\dìatihelr5L$100.000ota.ID5 \|iLlbÈ
::trlned BelNeen 193.ì ÌdÌ931onrr(rrHrih.tu\'rÌrt.rer ,rnÌjb rkrâilur$PrÌ\erÌ
 lhcsc .ote tìrat the ruÌderlt-ing turnctbn olbanks 1\ tu prcvìdc insuúncc agalnsL (ljq(tid
llv) risk. This means tÌì.rt baÌÌks lacjlìtate t()1ìtable but illiquid invcstmcnl. tlcncc Ìnan\
oI abânli's asseis (it! loant arc rclatl\ely ìÌli.Ìui.larìci cannol bc convcrtcd iÌìto.aslÌ on
dcma.d. i{hiìeits Ìiabilitìes ((hcdetositsil it) are \ervlNuld, a.dÌrarìNs pavoLrl cash on
dcmnrd 1n oÌcìer of ivho turÌìs uf. If there is a panic triggcr it can crcalc a scìlILtllìlìing
bclicl Lhatbanks will l:ìi1. Ìhe irrgumentis simpÌe: be. âu se tlìc dcposjloral (hc ronloÍthc
qÌrcu. wilì ceÌtaìnly ijet bâ.k alÌ hìs tlnds iïhiÌe th€re simplt trìighl lìol bc cnough cash
iÌìlhcbaDkt.rpaythedeposì1orartheba.Ì(oltheque!e(crcniilhcbanlil!csscnlialÌ\
sourìdlÌ thde ìs an ircentive to bc lhe lìrst to ivìth(ha$ lfthffc ìs a dangcr lhal cvcr-vone
mighl s,irhdraw.s Ìn this rnodel bankrlÌns an.t prnics lre problcms (nris!.gpcrlìaps trom
irratlofal 'anìnraì spìrìt\') th.t nìa)'be oveìcoìÌe Ì)) deposil Ìnsurancc, pro rala rcNice,
nÌìd coordinaled actnD.
lh. sl:cond class ofmodel stresscs the arvmmetÌic iÌúonnalion issucs wchatc jtrstbeen
considcring, paúicuìarÌv ÌÌ1or.Ì haza . Thì5 tìme tlÌe nÌoral haTaÌd problcm aPfljes tt)
the bank nìaneger, ÌatheÌ than nr thc eDhePÌeneur\. Ba tridcposllors Ììayllnd jtdillrcuÌt
to telÌ hoa'hald bank nÌanrgers woÌÌi at checkilr8 the loans thc-v make. The tist that
depositors mat withdrarí their funds acts ts a ditciplilre on lhc ba.k nranag.t, in two
\erÌ\es. flrÍ. lI dI:Ìrositrrs l)eco rsuipÌciousthatthebânkma.agcrhiìsunidcnlil'edba.l
Ìoans on hls books, lhev mry withdraw theìÌ fun.ls. lhe banÌ marìag$ LhcÌclor hat
ar irÌcentÌvc lo kccp tÌ1e quìlitl oÍ Ìoans weÌl icÌenti1ìed. SrcondlJ, il lhc bank hecomes
bankrupl lhcrc r'ìlìbe a clo\€ invcsljgatnD of alì ìt\ clealiÌÌgs. so thcrc is thc risk drat an\
iÌÌlprÌr ric l)' b_Í lhe bank ÌÌr!ÌÌagcr miiaht tìren be iclentified. Sincc hc has Lhc rjsÌ oI th1\
h.ppcnlng aL arv time {aLÌÌìost randomÌ1, ìl the banking panic ls lralìonaì), he hes a.
inccflivc rliq) 5 kr nuhÌtâiÌì hÌgh quaÌì\ Ìoans and beÍ prn.tlcc. lì|Ls ln (his modeì,
thr posibjìit) of bank lailLtrcs is, in í)nÌe senje, d 'Cood I hing'-a sorL oI discjPlin. b\
lhc rnartet drrtkeeps ÌraÌÌN nÌiÌÌager hone\i.
which oÍ these etlect! dorÌÌiÌÌalcs n, ol couÉe, ìmln)úant üÌ dctcrmirÌlng Nhat son o
banking Ìeguìatìon í best. turthc ÌoÌe, it mâÌrer a cìitìeren.c whrther lhc prcpcÍ1:on-
dúc r o í monetaÌ) poÌicv shoü ld bc geaì ed t(^1'aÌds Ìiier erÌting or aloiding Lri nklng pan !cs
(r,h ich Ìnightbe the caser)nthc tl rst ìnterfretatl{)n olbüÌkingpan ca, or, iostcad, slìould
írmetirÌesalLov thenìtolÌappcn oÌ even encourate thenì (is mìgììt br imPÌìú b-v thc scl:-
on.l clâss olüxxìel). Both tvpcs olatfDach have been tak.nb-v''.cn1r.Ì banNs irì thc pnn.
TheìestouseoltheJapancscccnlraÌbaÌìknrthecÌise\oìtheÌt90sÌ!.stoaloidb.ÌÌkins
failure\. The apprc.rch oí thc LrS ì:ederaÌ Reien,e iÌÌ the e.rly 1930s r,rs passi!'c or .vcn
en couratiÌÌ9, as witrÌes\ed L,l l lì c la Ìnou5 nìggesti(!r th at tlìe 1,5 b.nlirÌ3 cri\is ol tlìe e.ì11!
1930s \!a\ Soocìbecruse i \,ould'purge the r)ttennes out oltlÌe !] st€Ìf ." ÁlthouitlÌ the
Japane\e approâch .voids a shert coìÌatse, theÌe may neverthtless lì€ iÌìacioecono i.

'lhi\rrgurarti\r$*Ìrr!J,ú.naÍdtÌinitn,atÌooliitl Í\i!ht,h,nrr\(,\in(cr'r],roÌ,drrN.abrf.

$hi.ìiê!rrrban(nìtÌìeroú.tL!trund.rihr.rrl'crrrÌ):ih.. r\ NrnLrLljre, th..èr\rr unÌ,,'intrÍenÌ1

'.ürúÌlr Ìk'rhiL.dìtrn,.ufLimìnllrfr)u.a.a!xrlÌr\r llndcr.íÌ]rtLe5r
'ÂndÍr\vrn',,úcÌrtieúetârr.Ithil(J\nliith(trì(ur3.(itr.Ìrriein,LilÌÌÌnl,Ìi.rh.!r,nlÌ,id.nl
"
{.rl\ liquda te úrê lau?r, rdÌrquia.ÍrÍ! rnrt liÌriL I[.3e ,r rntèn!$\ .ui,,J ilL! \rì!'ì ' ( Ìütú
i,Ì lltr InrrDrriJr, 23 Sepl IO.1 ?0ír2 )
 265

rì iì'qúid .onscquence5 ifirh prr\irtenr LrnccrtriÌìty about banl \ol\encv a possibÌc .i]u\e of ía,t-

::i'ÌiìÌinB 1.2 *A model oÍ asymmetric information and credit constraints

Onc pdúiculaÌ ÌÌrodel ol asvnÌnetrjc ìnf{rÌìatÌc)n ìn nìrarce lorlglrÌall}, .tue to Robert
lownserÌ.1 Lr) hns re(ei!e(Ì much iìttertior orcr the veaÉ in eì|ìaioing lÌow credl con
iiraints at tÌrc ind ivicìuaÌ ìclcl .rn irúhrence outconÌes at tìre levcl of the nÌacroeco.oÌr!
,.sl '. . dir h,r\r, r'1.rt,rml\
rlÌocks to thc ccon,rnì). The mocleÌ has t]ro basic ingÌe.tients bascd on otrsen.ations oi
ìo\! bânks Iìnan..È projc.ls. let rìs con\i.ÌeÌ or the moment an c.hcpreneuÌ !!ho ha!
.ie\elq)ed â.cÌ! âncl promisiÌìg pÍ{hrctio. lcclÌnoL()g! rhar will gcnerate a posÌ1jÍc
:etünr at sonrc iotuÌe.ìatc.
.
11Ìe1ì6t i.gri.dientof thcnìodelisthecÌaim lhatin gener!Ìthe Ìerunr orÌthe Ìnest
:ìÊnt prcjecl is (]nceúain .1d/,/r to the enrÌeprcncur nnd to dnv potenrial ir!€nob who
:ì.ì! Lìe int€Ì.slcd iÌì inlestlns ìrÌ it. (ìÌce the pÌoicct is coÌrìpleiecì, the inrcsrors !!iLl nú
:tr arr ilf(ÌÌìallon .svmmcl ry .s conÌprred r.) rhc entrepreneur rince tÌrcr nrtll not be 1n
: po\itj(m t() obs€rve düecLÌÍ the €ntent ni which lhe project wü\ successIt.. ],or rÌ.rÌÌple,
:he€rÌtrepÌencurnÌav very $'cll .hoose d port tii mjsreport her proÊrs in odcr Lo deprive
:1ì! iÌi!estoÌs ol theil expectcd rcturÌì tlÌus keeping morc ol rhe pie tur heÉeÌt. Of couAe
:!r nN ejtors would have a.ticlp.t€cl thi! posibilitv and ü'o!ld .leman.t ro N.itc rn d
.i,rl. cont.acÌ lhat deÌi\ eÌs Lhc rightirÌcentn es rnd prot€cts theÌ stÌare otthe inrcsrnÌeÌÌt.
: i.lreveÌ, in order ld this.ontr.ct to be impÌemcni.ble inreÍor\ $ilt need ro bc able to

:ritv thc rclurn to the tÌo jccl after iis completroo.

.lhcsecondì.gÌcdirntotthìstvpeolmodcÌi\theretlretheasumpLionthatnrch.Ì
- ü rffilìcâ tion ir cotLìv:ifit líere not cosrì), tÌì.r! rloukt be no innÌmatìon asvnìmetr)
n

ìn.c (,c .ombine thc urÌcertaìn .etuÌni wjth n cosuv veú1ìcaiion pr)ccdurc sir.h r\ an
rrdiL of the pÍ)ject irc are le.l tr) a Drodeì that enÌphasize\ how extenraÌ lnnnce rxd
:rÌlâLcralplâv a nte in lhe wivtheeconoÌnt rcsponli:lsto ÍÌocl\. MoreoveÌ thcc.ononÌv
:. lÌ su flcr lroni a .Ìegrcc of nÌetïciencv as co nì par€ci ÌliuÌ one rhat .Ìoes n o I acc this kind
i iniorination asvmnìcü]

Ietusnowpr..sentasrvlizcd\ersionolsuchemodel.Oureco o iyconrítsotaÌ1unÌber
: ertÌcprcneuú aD.l banks. Â extrepÌeneuÌ in rhis conte\t i! \impìv a. indjlidu.l
.ìo has ff.it€d the bÌucprint\ loÌ a new pÌodr.rion t..clÌnologv. A bank is sÌmplv ,rn
.nitúún 1ìÌat porses5es a l.rileânÌount of llürds thatitwo!ld liletoirve\t$as lo drrive
: !3tlnn thal is a\ Ìarge ar t)ossible. hÌadcìitirrr each entrepreneuihõ apeÌtì.ulnrl€velot
:.alth*,rÌh(rcl:0,ÍtìichíÌei\prepaie.troìÌrlestirÌheroirnfÍ)ìectand(ìrlclÌ$€
i:nuÌe n)bc lhe \aÌre nÌ all cÌÌtr€pierÌeuì s. la.h cntr.Èpreneur is cljlierenr boh.cvcr iÌì the
':nse thel ca.h lÌar accesi lo bluepüú\ ol dilI.rc,rr r}rallties.Ia d,ú., each cnlrcpreÌÌeur
,.n.Í\thal onirverageproic.ts $ilLgeneÌate a rctuxì ol1 Ì)ut i\ unceÌtajn ahour the retum
:. heÌ paÌli.uÌarprcject. ìn fi.t itÍ conÌnon knowleclge thât the Ìetunr to a proje.t is a

,..)
Í
266 . ..

random vaÌìable Ì rÌherc a is unif(r!ÌÌ) distributed on lhe itteÌvaì i0.21. To sav thatÌ i5
uninÌmÌv cìistitruted on lhc iìrterval lO.2l nÌeans that thdt is an equaì pbbabilitv tha:
Ìwiìì have arÌy value b.h{ccn 0 and 2. fh€ eape.tcdlalue irther.iorehalttlayalongtht
i.terval, i.e. equaltoonc. tn oÌcìer to iÌÌitiate iì projc.l hoireveÌ, an e ntÌepÌeneur ÌÌee.ls to
puÌcha\e mâclÌinery and Ìar! nÌateriai\ which con I unìt of output.rr ThLrs, it ìs eas) tll
s.e tìrat altholìgh n1l entrcpreneuÌs âre required to ür\.csl the saÌìe amount of.esoluce!
jn rhelÌ pÍrjects \onìe r'Ìil bc ìucÌy whl1e otlÌers (,llÌ bc less ìuckv. Those entÌeptenerü!
Ìlho succee.l can do!bie thclr ìnvestment lvhile thosc ho lail s'iìl ìote eveìlthjng. ln
bcLrleen ihesetwo ertrencs, cntÌepreneub carÌ b€ morc or ìcrs succcssÍuì.
Nor alì entrepretreurs havc initìal iïealth levels ri, r' Ì thal alould alìo Lhem nr lur
suc lhcir pr)iects oÌÌ theìr os'n rvithout the eed for lnancjng ftom the banks. Thost
cn I Ìcp re neub with iÌìitiaÌ l!'calth Ìevels w < 1 will nc.d to obtâì n a l()aD of value I I
irom rhe bank\ 1n order to slalt theÌ project. Wc assume thal hanlit have nú1ìcient
funds to finan.e e\ erv r€qu$l lhey recei\e, even though as we shalì see 1t 1s not optinral
for thcm Lo do Í). lÌÌ additÌon banks have the possibllil)'to intesL abroad ìn Ì{hich
casc thc_v'' r'ill Ìeceive a return of { which i\ a kÌÌoÌ!'n lxcd constant (the vagarìes oi
ex.hangc ralc changes ar€ iìssunre.l â$'ay). Ìl a baÌìk dccìdcs Lo nìatc funds avallabÌe to
the €ntr€prcnctrÌ, ìt ríilL conìmìl tìrose llrnds atÌd expccl to rcccilc a certain amount
ol thc rclLún obtaìDecì b) the cntìepÌeneuÌ once the outcomc ol thc projed n ìealized.
Ol corrsc thc entÌeprenerìr nÌav Ìie about the r€turn irl)d cÌâinr lhat it was mucìr ìo\!€r
than ìfilis in fact. This would aììowthe entÌepren€ur lo kccÌr nroÌc rc$urces f.Ì heÌlel!
but rhcbantwouldundoubtcdltmaliel65esonitsinrcslnrcnt.l\icastunìehoweverthat
aftcr lhc prcìect ìetunì is realiTrd a bank can pat â coí . atd !ffitl ihc claim nra.Le b!
thc cnlrcpreneur. On the basls olthìs, the banÌ $ilL *'.Ììt lo i!Íilc a conúal:L lhat ensuìe\
lhar the ertÌepÌeneur h.s no incentive to misreport hcr rcaliTcd rclurn.
(lt couÌse. .Ìesigning the righ t contÌaci is not tiiviaÌ and lhis ìÌlcrnlurc has cxplored ül
dcpth how k) nnd the optirnal mecìranlsìÌ. Ìt turns out (hnÌ lor our sLyljzcd cxamPlc ji
sútilces tr) consider a di'rr .o/Ì.rd.i úr ivhìch the e treprcrìcur promlscs to pa,v a rcluÌn d
il ând only it the realiz€d duÌ. Ì excee.ls d. The .ontra.t also Íipulatcs lhaL whcneleÌ
the enhepÌeneuÌ cliims thaL she cannot pay bück the promìscd rctunì d, lhc ìranÌ( s'iÌl
âutomaricaÌÌvpâythevcriÊcrtioncost.andâuditthecnlrcprcncur.ÍtlbccnlÌcprcncui
is nm.l tu be ÌÌrilrepoÍing the tÌrìth then the lraÌÌl seizcs all aliiÌabÌc rcturns. Onc car
slÌow tìrat thÀ c.Jntract is oplimaì in the \en\e tÌÌat tlÌe rntrcpri'rÌcur wilÌ nclcr lic aboul
heÌ retunÉ. Of course thc bark Ì{iìÌÍìÌl have to au(lit in lhc case üÌìerc tlÌ€ entr€prcn.rr
í unsucce$tulhÌ order to guarantee the corÌect incentlles for tlÌe entrepreneur lÍho ls
succe$luÌ but ÌÌÌight othcmisc be tempte.l to Ìie.
Let us ÌÌow t.) and .le tc rm i ne equiÌibr nuì behrvio! r in thjs nÌodel. t irst let us .ìssu mc
thât LrarÌks are perfectiycompctitìve in the sense tlÌatt1Ìe eìp€cted r€turrÌto ârì ailr€ernent
to lend ün amorni of Ì Ì! ìs tìre \ame ir eìpectation whether tlÌe barÌk iÌìve\ts in the
entrepr€neur\ proiccl or takes the lame amorüÌt ol monc,v o!€rseis ând iÌnests there
$,ith. guaÍ.nteed rclum 4. The baú erpects to rec€ive, ìftlÌ€ entrepreneur is su..esslul
(i.e.N'lÌeÌìÌì,1)andÌ.ìrÌ-r,üÌeentÌepreneu.reportsliìilLúeandthebaÌÌklÌisto
ptìycoÍly audìting fccs. lhús the unconditi()nal expe.ted retluì io a Lr.ìnkthat $ites â

" \otedDt,rrrre,Anoriit:domin.ltÌn11fn'rnaìlqurntine\a.ê ,eìnkd ÍÌ unit\ oi Ìe outnt go.!L

 :.i. ..:':::::267
lcbL conlúcl as sÌrccilìcd abovc ii gjven hy:

Ã[ns.,,r] = Ã[Ì .Ì rd]r'r(l idl-E[../Ì ì d PÌ(l - '7]

Snrce dlstì ibute.l on 10. 21, it i! intuitive\' rcason abìc lh aL the p robabìl iq
Ì i\ uDituÌmìy
:ì < d íd,/2 an.l conleÌseìv that the probâbiiltv ofr ì dÌs(2 dl,r2. MoÌeoleÌ, we
inoir thai the expecratioÌr ofa constrnt is ÌLút ihe coÌì\tant (i.e.l[,] Ì .- dl = d) and that
:rÌihing.In :re extected vahe nr the inreNaÌ [0. d], j.e. ElÌ Ì < ./l is ,/2. Hcncc wc can ÌcwÌite ihe
- n conditidraÌ expected rerunr to the banka\

1:,,
RP :,1-.1 ,:I

ln eqLrilibriüÌì the €r.pected rclurn to lhc bank lending Ìnoney lo thc cnlrcpÌcneur
-un equal that oi the bânk that invcsts abmad, illRr.t) qll ìr). l.cl us dcnotc bv
:d iÌÌ Nhi.h ,r .rrr2 tlÌe expected verilìralion cosrs ol thebink and lnove ì1to thc ìctl hand side.
''i caÌÌnow rewrite tlÌe expression nÌrotc as

LN,,,t.ì,i:t l=ur rr'' rl (8.1)

.e oftìmaÌ debt contract $ììÌ ha\e r' choscn by soÌ\.ing the eqr.ìtion abovc.
t\'e can see horv itis chosen tìorÌÌ fig.8. Ì.()lÌ thc horizontal axis is tlÌe aÌÌrounl otdcbt,
i rnd on tÌÌe veìtìcaì, tìre exÌrected returrÌ to thc bank, Ë[À]. The .u .€d linc rcpÌcsents
::ì. ìrtt handsi{ìe olequatn)n 8.1 (i.e..l '! , so thc maximluÌÌ is at r 2). lvcdìstìa)
::.Ìl.caÌ ÌÌghrhaD.Ìslde(i.e.q(1 Ì') .-(d))oltlÌÌs e!ÌuatnÌì lor tÍ,o lcvcls oI'leahh
: thc cnlretreneur: Ì! = 0 an.l lor somc posjtir.c r < 1. The íopc oI lhc ìinc is./2.

nlÀl

0 0.2 0..1 0.6 08 ì )2 1.,1

iigurê 8,1 i nd nq tre opt ma d€bi.onüàrt ior.úrnpêr LivÊ banks

 ;; :; :'"' :ì.""; ï' I
ì:|' ;:.:jl;rl:''rï "l:'l:Ï
:t'','"t,.r'."i,'ii,, ..i ;f;',,, r,i''":,,,',
rlÊ it !ìLôttablL tortlìthJnÌ
t'nnìÌLctL'"'
LrrfLìeLÌ\ s'netr
.ur.t m'.'t t,b o'd llì$ j:
hinli lerl goodì 4
ol'p-tolì itles abroadlor tbe 'ìre
._,f,"
"t.'"'tt"tt'r'\''
.,"

.
',' ""

,,"'." -ï",1, ; ;'1 , Ï, ,t

:ì;
; :t"l:i,,:,1,1'l,ri
.:," ;.1;,"; ; :;;,i .,','i:j;. " ",.
,",,",,^,,,",:
: ;1.,.,. .,,,,",i' ;-",, -ì
,' :l::r:rI,::,. ;'"1'f i.i ,:;;:r;"'';"f. ':,'."';;: :;
t:1;:;,1i,':' "iii .''ì;''l ; "" ;-":r;
r'' ,'ii.1
..1. : ,ì; 1t;. "t,," ì::,l,iitiri'r.:'",,'::
lr,:ì,Ì::rl:i: :;:
:l;,i"" i,,';:':;
I:,:; ;:
si!ìÌ.i = d'is gjacnb,!:

E1R'"'"r'""'l =0Èlix '/ Ì; lj'lPrlÌ:d'l

:lif""::ï:ìi::ï:il::ïìiï1,ì:::ïIffì$,lc'ictrninelhccon'1j'iioÌÌaLc{tec'ie"r
ts.l
.irÌr.,,"r,""-i-'1 " 1' ï)

,,:ï:ï::ï:lïi:,""-ËÌ,ï;::'i,ïJli:ÌÏ"'ÏiìJl;::'lÏ:ï:iï:li':llfl:fi:l'Ï:
j ì]rr1'iïÏil:ï'lrj' r:':ì'ïi'ìi'r:''
#Ííi:j:jiïlìiìii=riì::ïJï{:r'
 . 269

:ne nonev in a savi.gs a..ounl. lhtrri in ordff or tlìc optjnraÌ deì)t contÌact d' to be
:Ìlte rentedtìrc rDtÌct)ÌcÌrc{1l rl:quìrcs !haL

,1,ì Ìhii i\
t';, .,.,)=, .' (, 'r) ,,,, (tj.r)

It $e now add e.Ìuatlon 8.3 lo equali()n 8.1, .valuaLing both at the e.ÌuilìbÌnrm debt
: ,ntÌact d_ ile obtain

I ì{+aid )

Iet us ìro{ conìlarc lhis out.odìc h'ith rhat in an cllLcient econom} in $hich theÌe
r : !o jrtonnation probìcfiÌs i.c, $,ilhout(.Ìcdil conslrãìnts oÌ cortÌv state veÌilicatidl.
: rn cllcicn! c.onomlr rLhere urconslraìncd boÍowing is porsìbÌe, the eDtÌepÌeneuÌ
.lmpÌcnìcnÌhcrblLrcprìnts.slongashcrcxpc.tcdrcllrnrisgìeaterthaÌÌthereturnto
::i.gslronìinlcstnÌcrÌtabroad,thatisasìongasÌ>q.ÌÌrouÌecononÌyho$e\erthe
' . i Írìcrt is only possible iltlìe retuÍìton proic.tcov.rsbolh theoppoúunitvcostÍom
: :nlng abroad and th€ banlt eripeclcd \.crilcatÌorÌ costs. l!Í(ÌeoveÌ, we can \ee troni
:-Sllhatlhcoptlmalconüâ.tr.l'lsdccr.asirgirllhcjnjtiaÌweaÌthÌevels.Thi\nnplies
lr' .r'l ll l.. , u1l.J .t l- ".q|.'
r :icnlrcprcncurs i\'ith low levels of initlaÌ callh iriÌl not be able to nnpl€nìerÌt tlÌ€ir
:: rr.ts. lssenti.llt', th€J' woulcl lÌavc to borroÍ'ÌÌrorc than the anÌount tlÌe financial
-,rliett see as feâsìb1e. ÌÌojects that $'ouÌd bc undcnakcn in an elìcient ecorlorÌìr_ .re
, . d out beci u se of the iÌìfonn.tion problcrn i.
' summing up
i t\
])e oI model suggcsls a nunrbeÌ ofchannel\ b) rílÌich lìnancial nrarkets can incìuce
rnrÌÌole volalìlirl al lhc lcreì ol the DÌacroeconoÌÌÌv. 1i cnlr.fÌeneuÌs who are not
::LoimflcmcntthcjrpÌojcctsbecoDreuÌempLove(ìasa.onscquenceandtheprcjects
:: rr. noL imflcmcnrcd\!ouÌd hal e contÍbutedin atry signjlìciìntamounttt) aggregate
:rJl, ic scc ho in lh c p fc5c n ce of cÌecìit constraintt, pictiousll un inrportant lactoA
: ì rs initjal rlcnÌth lcrcls a.d otportunities abìoad becomc sjgnjftcant. The nritìal
,: L. ìclcÌ mav Ì(:pÌcsc.l 5hnrcs osnecÌ bv the entÌepr€n€ur or a hotrsc or even Ìand
.: .in bc used as collâtcral lor the líian. A lo$ ofvahe iÌr any ol lhcs. will Degativeì),
::t rhc cntrcprcnc(r's ab!ììty Lo boÌrcw ancì hence reduce outpul and.mpblment ìn

: l\4oney supply and demand

' Money supply

. ,inÌpl€Í Èr\sible üsnìmption s'as ÌÌì.de.bout thc Ììoney mÌÌtv iÌÌ (lhapter 2:
r.::L\ th.ìt the..È tralbarrk lìxes ilÌ€ su pplt of nì.,Ììcl . An,!changesin money luppiy
. - r:nulhtibo!t bv the cenüal bank bul.iÌìÂorsclliiÌg bonds in oÌren market operàtloÌÌ\.
27o '.: ""
Ihe chain oI cvcnts is:

H+l"t-'

ln praclicc, the causaììq ÌÌÌât bc rcrcseLl: the high lnrler€d moncy Ío.kÌs thc oLrtcomc
ofthedcrision ofthe centrâl bânk losetapaúiculaÌ rate ol iÌìt.rcst:

i,I._Tí.H

l!e look row at tìrese tlvo contras in g .Lesctiptions ol centrnÌbank bchaviour.

L

41.1 Does the central bank set É/ ot set i?

Iertbook presenlatl()ns ol the lS.1ltÍ mocìel Ìelv on monclary poìÌcy opcÌatjng thrcugh
the so .allcd monctaD, ba\e nuÌtiplieì that connect\,'1, thc base nronÊy lhat is asntmed
tobeundcrthcconLÌoìofthecentralbank,andM,themonc-t5uÌrPlyinlh.handsofthe
publlc. lt ìs thcn the interaction oi thc ìnoney suplrÌ) thus dclcrÌìincd wl!h the.Ìemand
iòr nÌoney that fLrcs Lhe iltereÍ ratc:

H-M
TlÌis reprcscntalion oí centrâl bank behavl(tru IDCI of the mon.v suÌrPly bccame estab
lished ìn lhc Leaching of Ìr'ìrcrocconomics $ith Hicks'\ origÌnaì vcÁion ol the /S/liÍ
nÌodel.ir 'Íhe longevitv of tlÌe nÌodeÌ ìn the lace of elfoÍs ot nìonclary .cononrlstJrl Ì.r
show thaL c.ntÌrl banks tlo not bchave in thí ríay dÌìd havc noL donc so iot nroÌe than
a .cfruÌy !r snne cases reltects the anal)tical lx)rí€r of ihc /-s/ri.ìÍ tranrcwork and the
lailurc ola good substitute lÌ.rÌìcworkt() emeÌge. Uotlev€r, as slc havc sccn in Chaplds 3
and 5, thc Ml parâdjg provides such rn aÌternative, ernbcdding lhc 'ccnúaì banÌ 5.ts
tlìc ìnrcrest Ìate'nr a mod€t olan ìnflati(ÌÌ targetÌìg central bank u5lngn nìonclary foljc\

l'he tÌa.Ìitìonal lM \ie!! (H - ÀÍ - i)has three conÌponcrls:

. Step 1. The central bank scts lhc ÍturÌe ot the Ììronetar-t basc, H,lhrough opcn
marketoperatidb lhe choicc oírr ìs u\uaÌÌv asuÌned to bc ar cxogcnous olìc-Ì.c.
not ÌesÌrrseto tèedback Iom otherecotloDÌic vüÌiablcs
a5 a

.Step2. 1hcÌÌronc-ÍíocÌoÌmorÌ€!'ÍrPpllÌslhcrìdcL.nÌ1necìbvthebehavnÌúofthe
privatc scclor-houÍìroÌd5, hüns, and binks. 1lÌc Ììondaìvba\emultipì1eÌ ls tbeìinl
from d to t/ a.dd.pen.ls on the dcskcd cislÌto dclo5ìr Ìatìo on tÌre paÌt of
houscholds and nÌms an(ìihe desircd rcscrrc ral io on lhe Part of com meÌcìaì hanks.
'lhc monctaryhase írÌ lrarldrÌS) multlplil:r. h (cnÌlcd kafpa) ì\

1+t.]
.J ,J

rOf(ofth(nolif.irb1oÌ,Ì,,nierr.Ithel.rÍ!le\!n\".LorirClri(k.rgl:hi,kÍ97/Ìinallt92JÌr,
lnllúrlf g drrr\.n anÍilhrÍ r2lJo2r.
 .. . ..... ... 271

\í : t:.H

iïhere r, is the câsh to deposit rntìo a.d rd Ìs Lhe reseNe to deposit rnLio oI commercial
banÌs. For a ÍÌoÌe cìetailed expÌanalìon ol tìrc mechanics ofthc monctar).base
nÌìlt{tie., see the Appendli.
' 5tcp 3. Gìvcn thâl lhc lcvcìofthe moìÌey supply, M, is nxed rhrNgh steps t and 2,lhc
Ìcvcl oI Lhc short-tcíÌ interest rate 1s the outcomc oI Lhe ìDteractlon b€il{,cen,V1 and
tlÌc dcmand loÌ monc,v (rl.

\1'e now corliia\tthi5 witlÌthe r.icw thal tìre centìaÌ bankscts lhe Ìnteìest rate (i . I

:rìrüÌgthÌough
. Step Ì. 1hc .cnhal Lrank uses it! .eaction frÌn.lìon to set tlÌe intcrcsl raLc i e it
r.ü,e\ responds to econom ic devebpments that th (ãten th e tÌoÌniÌì.Ì anch o r'
. step 2. Given the rhoÌt t€rm ÌÌìtcÌest Ìate, theprivate sccloÌ tespond\ by deternÌinjng
:herolunÌe of boro\íirgitÌtant! troÌn the.ommercial banÌìng 1yúenì.
.
\tcp 3. lhc commeÌcial baÌÌks respond 1o lhc cÌeclit delnands o. them by adÌustirÌg
:Ìrcjr o$'n r.ìative lnterest rate\ì markclabÌc âsscts (e.9. govcrnmcnt ìrondsi, and thcjÌ
:ì orroa'Ìng lro nr otheÌ baÌÌks !o a\ to ncct thc de Ìnand. I his dctcrmiÌres the Ìnone)' Íock
\I).ÌÌd llsbrcakdo rr into.lifferent kinds ol dcPosits. Civer lhe ìequÌed reserve ralio,
:risÊxcsthcdcmandof thecornDercialbanÌis íoÌbankrescrvcs
. step.1.I order to ma in t ain the short teriÌÌ iÌìte rcs Ì rate ât tÌìc lcvcì esiabìished by thc
:.a.tìon tunction in Step 1, lhe centÌal bankhas to use opeÌÌ ÍìârlcL oÌreÌrti()n\ to satisfy
:re .ommercial banks'dcmand nÌ Ìeserves eÍablirhecì nì Step 3 Ïre changes in hjgh
:oNerecìÌÌÌo ey used lor th c open nÌârket o pcratÌoÌr s Jìxes H. lhc nrechanics ofhos'Lhe
lrerest rate is set by tÌÌe ccftralbank is set out bclon.

I I 2 How does the centíâl bank set the ;nterêst rate?

pracÌical tcrms, ccnlral bankr do not lilcÌalÌy Jrt the intcrcí rate\ used bt high{tÌeet
r
rriìlis irÌ thcü dcalings rrith lÌousehoÌds and nms. TlÌe ìrÌstilutl{)nal aÍangctìcnls dìfièÌ
:.ross ccntraì banks. \ie shrll usc thc cxanrpÌe ol thc Bank ol Ensland lhcybalean
.\pÌnna!ior on theirwebsiieolhow !hetsettheinterest raLe an.lthefollo(rjngdjscusidr
s
: r slrmmaÌy of tìÌi\. Thellank otF.nglând\ expLânallon heiiin\:

:ìtriL banl<s have a rarielyol i€.hniqucs tor inl!encìng nú.icn Ìate5 but drey arc all dcsiS!ed,
::.ne rlit or anorheÌ, 1o atle.t Ìli. coí ol more,v to the bankiDg s)5tem. lÌÌ 9..lol tlÌis is done
: lieepilij thebânli.gsl\terÌ nìort olntrne) andtherì l.nding he Lar ì]is ÌÌìc modcl the) need
t

r rn irleÌeÍ ÌaÌe Ì{hicl the.dtral banldecides,

The centÌaÌ barÌk\ abilit,! lo influence inte.est ralcs i. the etonrrm-v rcsts ith the
':.t tÌrat ìt hâ! â nÌ.Jnopolv iÌÌ lhc suppl) of the ÌÌronetaÌ| Ì)ase (caslÌ) CoÌnnrercial

' rlrr.llr koi.nglrrl (. ü k1l:r t.ÌJ.Ì NJ. For r .xpldìrii,r, ol h.Í úìc Fr{lrr) RseÍvr rca the nÌt.Lcí
:ir'!.itifgihrìnirÌrnrJi.',lRBSìt..nonìi.t.(tÌ.rNnrnbrÌ200230,11(Ìi20{r2
banls are irÌtereÍed in nÌalilrg pronts thrtr'gh e{Lending loans to lhc privntc sc.tor
'I]ìey want to ÌÌìininÌlzc thc amorrnt of cash tìrat the) hoìd, but on thc orhcr hand thc\
m!st have enough .ash lo bc aÌrle to meet tìre deÌnaDds ol their deÌrosì1ors sccking n:)
$'ithdraw lLtrìds. 1hc LlaÌrk ot F.nglaD.Ì is bankeÌ to tÌre .ommeÌcìaì bankìng syslcm in
the U(, rÌhi.h nÌeans tÌìal lhc lransactìons betireen comnrercial banls ar. hnaliv scltlcd
betiveeÌÌ their accounts at thc Sanl of F.ngland. Thc com meÌcìaì banlis havc lo ÌÌìaÌntairì
po\itile bahÌìces at the Llank oI F.ngìand al Lhc cÌrd of each .Ìa_y. The lhrcc licl pÌa,v.
eú are the cenüâl brnk, the govcrnme.Ì, and the comÌneÌclaìbank5: lhe corìmcÍ.ìaÌ
ÌiankJ fìnds !t the Dank are tlÌe outcome ol lhcìr lransactions wlth thc Bank ard thclr
transâction! $ith ilÌe governnÌi.rìt G i n ce tÌr e l ransactjo ns between banks ca n o nll rcdis-
tribute tu ci\ beil{een thern aod canrot ollset an oçerallshoÌtage of funds al thc Bank ot
EnglarÌ,i:1).
We beilnì i!ith the situation in whjch the Bank ofEngìan.l is not tNingtl)bÌi.gabout r
change in the nÌtereÍ rat€ i.e. Ììowdoes ìtcon.ì".i ii(:.iirìtiê\i.ììrintrin rhP ifrpí'!i
Ìate unchaDge.l at the desiÌed levcl? ìlach m.nrìng aBankofEngÌand oílrcÌaìÌnatcs a toÌc
ca5t olthe cash 5hortage thâfi\'iÌl occur duÌìng thc da_Ì. Oìre element oflhis is calculalÌng
theììkeì) pâtteÌn oftax Ì)ayÌnents. lhc Bânl]ljìl also know that a ceÌtain aÌnounl oI itt
short term Ìendìng to the banking sl stcm Í'iÌl bc drrc lo he Ìepai.l bv.ommcrciaì banks
duÌing the cìay. This iencli g i! now conducl.d Lhrough retos (repurchase agÌeemenls):
the c(rnmerciâÌbanl lìâncls over an cìigibìc asscl (such âs a TreasuÌ_v Bìll) to thc Bânk of
lngìan.l arcl agrees to repur.hasc ji Íouúc.D davs ìateÌ at aprice that lnrpìies it jsÌra_Íìng
ihe brse rate on thi\ borrol\,ing. ln odeÌ io hnance its 'ÌepuÌchaseJ, the banks wiìl nced
nr borowagaiÌtlro the BarÌk arÌd lI lhe interesL rate is n)be kePt coDstant, rÌìc BanktliìÌ
relinânce the subsequerlt roünd ot'Ìcpos'rt lhc saÌìe Ìatc.
Suppose ihât ânother evcrÌt tlìar !he Bank exfects to take place durirg Lhc dav i5 thaL
:ì llritish coÌÌpan) $'ith an acco ún l al â IIK co m Ìì cÌciaì banli irìll pa\' a ìargc Lax .hcq uc
to ihe tax a!thorit],, the lnliÌÌd Rcvcnue, sav ol f.100 Ììiìlion. At ihis foinl, thc büìklng
srstem nìoves iúo a negatÌvc baìanc. vn ì vÌs lhc Bank of IngÌaDd bccausc ll translers
nìoncyÌo thcSovcr ncrìt's ar.oLúrt. As we hav. notcd, thls mbt be rcsoìvcdbÍthc cnd
ofthcday. o gct hoìd of thc cash, rhe com merciaÌ bank i{iìl seÌl som. oI its asscts e.g.
'lreasLrry tsjlls. lhlsÍ'iÌl tcnd 1o rcdoce thetrice olsuch bÌlìt and puth up thc lntcrest rate.
Ìl thc Bank ol lngland is lo pr$.cn t this cìrange ir the iDterest rate, thc Bark must nÌake
a.orr$pondingll largcr rì LtÌtrff ol rcpuÌchrse agrccmcnts.
Wc now Ìrovc lo thc siluatio. wheÌe the Bank oI LngÌan.l aants Lo .âlsc tlÌe iÌìterest
Ìalc c.g.LhcmonlhìvmcclingottheBank\ÌnonctaNpolicycommÌllcctak€sthedeci
slof to pu! llìc jnlcrcsr rarc up. Ì$!iìì now úndcr{atc llrc rclìDânciüit aÍangemÈnts b)
chaÌgìng a hìglìcr inlcrcil ratc on the'Ìepos'. In othcÌ iroÌds, il is in tctunil the iúer
esl raLe lor thesc opcralions tirat lìre Brnk ìnÍluen.es thc general ìcvcl of üÌterest rates
acíxt the economt'.'Ììc Bank oI F.nglaDd\ arnouÌrccmcnt of a risc in tìÌ€ lnterelt rate i\
.Ìuicklv iransnrittcd thmugh thc bankìDg 5vÍ.m. Thc Ìcsuìt *,ill bc i lall in the demancl
fir'ìoans bv the commercjal banking system:cÌedil wilìbecome lìghtcr.
hr a woÌÌd oíincreatjng nnaDcial ÍÌrhistìcation, in.)lder t(Ì the ccnúaÌ bankto be able
to cortroÌ tìre iìrterest rate, it is cÌucial that its a.nouncemert' âÌ. ücdìblc. lÌ! credible
$e nÌea thüt the maÌkets belìeve the policv $iìÌ be maintaìnecL conilsÌcntlr üntil it\
 . 273

olriectjves arc Ììct. |eteÌ Ìhhitt cxpìalns the inpoÌrance ol crcdìbjìiLv ln rel.tion t{) the
link ol Canada\ intcrest Ìate insrÌunrcnr lhc,operarjrÌS bancì' Ìike thh:ri
wilho!t ÍpfÒrÌive exfectitnÌr\, l!owcveÌ. r cenLriL b.nt has only hritcd s.oÌte ror.ontioLlnì8
the lelel ot a83r€ijaÌe e\pcndìtur.s. lf n(Ì one tholglÌt thât nicr.sr r.t6 Ìrclond rÌre overni8hr
Ìare \lould Lrc affc.ted b thc lank s ti3ht.nnìg, there $'orLd be littlc cftr.t (trì the longer tern
lrteÌeÍ ritcs thât nrfluen.e spc.dinS .lc.iin)n\ ir lhe econoÌr_v. \or $ontd tiÌere be anl loint
Ìn tne Bank tiyniS n) nÌeNenc dircctlt ìr l(Ìiileì rem ise( nìirlers sith rÌr! hope ol aIÍe.Lir1g
those Ìate5 lhrough Òten marÀct opciatnrns lviÌloxr nrpÈÌtìl,e expec(arions, bc.au\e nnan(ia
Ììnrliet\ have gror!. t(r) ìartje jn relrtion to th.llanl\ baLarce sheel. llirs ro fiodu.c I iÌajoÌ
ltflcttÌre llanLinn6t üàke ÌreoLrle beliele lhit thc riSlìrennìg it nnlu.es b,rralslÌìgthc ofcÌítnrij
band !iÌÌ .onÌinre until it does have an ellect. In .rÌì€r lrorÀ. tÌre a.n.unceorenr ct1i.Ì .t
trrìcÌaÌy plìct is Lrc.Ò nÌA nroÌe ànd noÌe thc prìnìàr\ chânneì Ì|i.ugh lvhich rh. ccnbal
l)ânl .an .ontrd agjlicgnt! \l)e. dnìg.

4I I lìIonetary targetingt failures and successes

i.rl.ulatirÌs
h'o conditions mu\thoÌd forir policv ofmoneraN rargcling Lobc Írcccsslul in jts obiect
irc of controÌÌiÌìg ìnfl arÌon:

. llrst, lherelâtionthipbcL!!ccn inflation arÌclthetargeted ÌnonetaN aggrcgatcmun

. iecon.l, th c cc n tral bar Ìl mlút be abÌe n) co n r roÌ the choscn monet.ry ìitgregate.

lrutteÌns can arisc at both point\: aìthough thc ccnrúl banl.nn conüol high po$
rre.l monet or a narro\! mone) aijgÌegate, iLs rclalionship lo ìnllallon ls olterÌ *."ak,
-Ìn.lermining lhl: role ol the taÌget jr shaping inlLntion cÌpcclatÌons. Ìn the UK, it rías
ãrguedthat*ìrcncr!rtheÌronetaryauth(r'it_yattcmpIcd1o(o.lroìaparlicularnìor1€tarv
rggregate as its largct, tlÌeÌe would be a response bv the lÌnanciel svsLcm in thc lorln ol
:lre emeÌgencc ol close mbstitute\ or Ì1eaÌ Dronq s thaL ru'Ìd li. oursìdc Lhc targei .nd
:ìrereiÌ)re seÌvc lo unde!ÌÌine it.r7 Shiits iÌr the.Ìcmand ftrr moncv (olrcn rcicrred to .s
r elocitv instabiìl1l) r\,i11serer the conrection beri!'ccn thc taÌgcLcd moncv ppÌvaggrc
late and inllatlon, nìalirÌg Dronetar) taÌgetìng i.cllccli!c. Thcsc probìcms uodernÌirÌed
rnDetary taÌgcting iÌì the USA, Cana.Ìa, an.l rhc LrK. Morc dclail is providcd inthe next
irction aboul lhe uÌ( care.
Bv contÌní, nÌon..tary taÌgetìng is vierÌed as a su..css lI sccuring lor! iúÌation iÌr
;emaDv and Switzerlünd nnl{ncìng ìts adopLion ln t91,1. Howcvcr, anaÌtsis of tlÌe lun
jÈsbank's Ìnonctary policv sugges that it did not .dopl n rÌgid polÌcy of tarilethÌg the
:nrrth ot morclarv-- ai*Ìegate5. Iìrderd jts bchaviour sccms to bc well câptl[ed by a
g
r\ìoÌ tvtc moncia{ policv ruÌe. The Bundcsbink was su..cssful in ÌrsiDg the lan
:trage of monc(ar)'targeting to conrmllrìcatc to llÌe prbÌÌ.lh€ orientition olnxnetaÌ),
. nicv t(Nard long nm \tabllity of inflatjon at a low r.ie.Ì"
I lord.trÌl\. \c. (nx rrrii,r8,,
ai iÌ1dâ ìda,enleÌ(le9;)Ì\Drliingpaperte6idr:Ì!ÌrNrher.Ì!4,r1)Én]Ì!ss8tÌ,al
274 .' :' :'
4.2 Money demand
Thestandard moÌìc!dcmandhì ctio. usedin Chapter2retlc.Lsbolh Ìnotcl as aDredtum
of excharÌse as rcÍÌcclcd iìr the tr.nsactúrns nrotive foÌ holdlng moncy and nroÌÌey as a
ÍoÌe olvalue as rcllc.led 1n the asscl oÌ sPecuÌatìve motivc. Io pmvide a sinrpìe way of
!hinking âbout th€ dcnrand lor nÌoÌìcv, lre Ìooked at tÌÌe trarìsaclions dcmand and th€
assrvsÌrecuÌitive dcmand sepaÌatel,v. Putting them togethcr pmdu.cd lhe deÌnan.L lor

\{e locused attcnlion on the inÌracl of the tr! sactions velocit}, rr, on the iÌìter.sl
scnsltiviqr olthc assct demaÌìd lor money, i, aÌ on thc role olexpectatiors iÌÌfinan.ìal
m aÌket! that .an d riyc sìriíts nì thc speculative denìand (l).
In this se.tion, a'c deepen the analysis ofthe de and loÌ money by ldrkilÌg atmodcls
ol ìnteÌest sensitivil-r using ÌÌlentory and poútìÌio modcls. We then retuÍì tothe isÍic
oi thein5tàbility of thc drnranci lor monevtunction.

42.1 lnterest sensitivity of demand for money:inventory and portÍolio models

ft i5 quite stralghúoúlarcl to in.oÌtorate in ihe dctrând fd tnorìe) fun.tìon a nroÌe
Í4rhisticatcd appmach to tlÌe tran sactions ouvejn which the balan.eshcl!ì arca lunc
tion not only ot the leveÌ of income but also of lhc rate of itÌter€st Ìhis is imPoÌlant
becâus€ il pro\.ider an erplanalion fü the demand Iot,tdtrÌv nìon€v as a fLüì.tlof of
botlÌ ìÌì.omc and the Ìúeren ra!e. Early e mples arc Lhe so c.ìlleci inventory modcÌs.
The idca Í'as a sìmpÌe one: lÌourehokls $'ould reccirc irâiies p€riodicâlly (e.g. orÌcc a
nì.nthì and a'ouìd choose thcÍ lcvel ol narrorÌ moÌìcv baìance! to âÌlow for â smoolh
erpendiluÌc path b), tradnìg otl
. thp tntnsd.tiols t os! ir\roh'cd in switchiÌÌil betNecn bo n ds or interest Lre.ìriÌÌg but
ìlliquiiÌ'neaÌmone-v'such as term cjeposits and ÌìarroNnìone)' ((ash and cheq!e
account deposltt a d
'ttuappoÌ1iiìit),.on.í)lttdingÌÌ.rrcwmoney,asnÌeamredb-tlhcìntcrcslraLe
N.Íodels of lhc demaìr.i tbr rrrow nronel that erÌÌerge lrolì morc rcccnL utjììt)
ma\imizing rnodcìs in i{hich ho!schoìds gain utìÌity tìonì bolh.oÌìÍtÌnplion and Íonr
hokliÌìg monc_Í, or ìn whìch nÌonct is assumed to be ne.cssary ln ord$ lo Purchase
consumptìon goods, are sìmjlai to thc cârlj.r jnventd)' nÌodeÌs.
ÌÌì addltion to the ftte of tlÌe intcrcst Ìatc ir explaÌring the Ìerel ol nÌorìey baìanccs
held lor lradsacrìons purpo\es, it h'iÌl influence the rte of nìoncy in an individuaÌ's
portfolio oI axeLt. Inrm a 'store oI Íalue'or rÍealth peÌspectilc, it is obvloús tlìal Lhc
narrow$l dclrnitúns ol nrcney (coins and notes) and cheque a..ounts (ÌrÌ.Ìudcd in lhc
narrorv neÍ aggreijaie) âr€ strictly domi n ated bv ravings and ti'rnÌaccounts (inl:lLrdcd
nr o

in broãd nbnev) ì.e. bt (rpitaÌ sale a*ets drat pay lnterest (rclcr to lablc il.Ì). lhc
pontoÌìo anaìysn crnnot explain thc deman.Ì í()r narroÌ! moncy bLrt it maybc Ìmponant
iÌÌ explairing lhc drìnancl ior broad moncl agSÌegatet that iÌì.lude sâvirÌgs and ternl
 . 275

H.Lr\Fh.Ìd ìndilleÌ!nce cule\

.:-/

Figure 8.2 Ì.bLn'5 m.dê oÍportÍ.1óàlo.ãio.

:..ounts. lhe cìeÌÌìand í()r broad mlrÌìcv wili dcpeÌrcì on ho1{'househoìds allocate üÌeir
!.ãlth betwcen assels tlitìr .liflcrent risk arci rclun prof'les
l i Ìnes Ì obi ÌÌ's thco N of Ì)ortiolio cÌìoice add c*es thÌs
decìsìon probìenÌ fig 8 2
Ì
'an
ri Ìrsed t,r iÌlurtrate thc lheory. ule corsiderthc (hoice bctween holding moncy (savings
r tcm accountì andbon.ìs Ihc modcl caÌÌ, hoseverì be ertcnded easill
to anallse the
:iìoi.e betwcen a Nitlct Ìange of a\sets úc1Ìrdìng ecìüìlies Ìhe v€rticrl a)ris represenls

::re cxpectcd Ìetunì lroÌn th€ pofttò1io ancl thc horizontai a:Ìs the rìsk
a\socirted Njtll
wìlh
:r:. Lr(;tfoÌio. The iÌìÍcstoÌ is uncertah about the capilal ganì or bss, C' asso'ìated
::\cstiÌÌg €1 ìn boÌÌds such caÌritâl ganrs or l'(\ê\ r'{ìlt lroìn eithtr fâlÌs oÌ rises
Ìn
mean ol
::i{rcst râtcs in the lutue shc has a pftúâbìÌil-v distrlbutior t()r C that has a
::Io. The rcLurn oÌÌ ihc poÌtlolìo .ìepefds or thc lntercÍ ratc on bonds' on atÌd on
(AÌ I A2 - Ì1, wh€rc ';'1Ì i\ the
:::. p(Dortìon Á, of lhe poÍfolio that is held in bi)nds
: rÌÌÌtion hcl L1 ÌÌ .ash âncì.1, the propoÌtion h'liì in boncìs:
l? = j, (i+ Cl
:rcÌeÃis theÌehrrÌÌon tlÌeporlftnio ÌheerpcclcdretÚnontheporlioliois

Ã(nì lr :.r: i

: _.e the expccteclvaÌucofthe capitalgaìn iszero. TobiÌìÌneasurcdthe riskolthe poÌtlolio

r'the\tarrdaÌ.1cleliatÌonolthcrenrrnonthepontolìo,dR Aporlfotio Ìs risk) {'hcn th€rc
, : high probabiliqr oI ìaÌiae devìat1oÌìs (i e capital gains atrd Ìossen fioÌn tlÌe exlected
:.:rm. lhe üsk ol lhe
/,i. or, .Ìepe ds on ihc prcporlion of lhe porlktìo in
PoúfoìÌ),
r:rds and on the starldaÌd cìeriation of lhe capital gaiÌìs, 't,
r

lh!s, in lrig. ,s.2 it ìs possjble to rcprcÍnt the opporLunitv locus fa.ing thc intcÍor
15 a straight lnre úÌor\'j,r3 the coí in lcrÌns ot tr€.tcÌ risk a\sociated with irttaÌnìns
a highcr c{ttctecl return. The oppoÍLtnìtv Iocrìs i\ r,r = (i,1'dr ând has a sloti
'rr€pres€ntcd h)'th!
eqlal to thc interest ralc div ed b)'tr.. An aÌl Ìnon.l poÌtf(nlo i!
oÌisirÌ siicc lhe e\pe.tcd retuuÌ and rìsk are both zero A. aìì bond portfolio {.'1, : 1
will occur Ì!hen the risk on the ponloÌìo is equaÌ to Íd. Ììi3. 8 2 nnN! tÌìe 'rpporlunitr
ìocrìs .sso.latcd irith nn jntere\t ratc oI i as OXÌ. ln thc sanre .liagÌauì the indiffcrenG
curves oi househoÌ.I\ arc drartn. lhcsc a'jll be po\itivel-Í sloPe.l sirce risk âversc hotr5e
hoÌcls \!ill Lrc in.Ìifferent bcl eerÌ somc ro mbi natioÌÌ ,:Ìl loir mean and variancc (i.c loÌr
ÌetrúrÌ and Ìoi Ìisk) ând high rnein i.d vaÌiance (hlgh retun aDd hiSh riskl. !n thc
dìagram, thc ìndìfteÌence cune\ are concete uP!!âds: es the Ìíkiness ol thc poÌtfrtnì
incÌea\es, thc indn'iüral rcquìÌes a lÌÌghct atcÌ higher i.creare ìn the return lo take oÌl

With thc lr!cÌe\t rate.t ir and tlÌc lü\'cr jncllltèrencc cuNe, the portfolio rcpÌcstnted
b,v poirÌt a ìs.hosen A highcÌ nÌt€reÍ ralc srileÌs CxÌ to OXri the faÌriliarjncome and
strbstltlìtloiÌ ctic.tr conÌe inlopìav. lhciÌìcomeeffe.tis thc nr(^e, _,.ndthcsltbstln'
Llon eftect is thc Ììove, " ..l{hile thc ln.onre eïïecl mal ìead to a reductjon in thÉ
prol)oÌti(!Ì ofthc poÌtnnio hcld üÌ bonds, thc substitúlon cffect ìncÌedses boÌÌdholding\
slnce lhe r€turn atÍ)ciated wìth I Si!€n vnÌiance has ii.Ì.ase.t Ìt i\ nornallt arsunÌed
rhar the s!bstihr{ion etìect outweighs thc lncome elìecl 1o cnsuÌe an irn erse rcÌalìonnrip
bcti{een the in Loest rate arr d Lhe deÌrìand l o r m onev. l ob i t \ ÌnodeÌ ol portlolÌo scÌcctlt! Ì
pìo!icìe\. mjcÌoìared €.{planation for lhc iDveúe reÌalìonsìrip betweelÌthc intcrcst ratt
an.ltÌÌe denrand ft)rÌÌìoncy attlÌeli\cÌ o thchousehoìd

4.2.2 Specuìatìve demand foÍ money

Tobirfs lrnalr''sìs i\ brsed on the ide. that u.ceúaiÌÌty abotrl hot\'ìÌìterest Ììtes alÌd lhur
capital valÌa I'ill mov€ makcs holdiÌÌil bonds Ììtlv Keljnc5 inlrcduce'l a cìifler€nt arg!
ment, Ì!hich ìs tÌrat the g..craì nÌârkei scrìlimcnt aború lulurc intcÌest Ìates ne€d ÌìoL bc
tÌÌat the-v Ì!'o ul.Ì nnÁt likcÌy 5 ta-Ì tìs thcy arc at tresent Ìf lhc gcn.Ìalbellet i! that ilÍl:rcst
rate\ $ouìd lall (Ìrerhaps Lhc! w€re Ììigh rclalìve to normaì lclcìt), then people wouìd
also bclicvc that bo d prlccs $ould risc. r\ccoÌdìntly ihcì r dc Ìì â n d ntr monet $ouldb.
loÌler lh. overalÌ return on bonds iir(crcst Ìrhb capìÌaÌ Sain) i{ouìd be less ln terlll5
as
ol lobiÌr\ djaiaÌauÌ, thc rclon io.Ìrs, OJ, wouìd trivcl upi'ads at.Ì the.lemand ior
Ìnoncy rlo(l.l ÌrrcLJ.blv bc ìower than lt thc cxpectation a'as lor no cìraÌrge üì iÌìter.sl
rrtes. Conrcreì), a itencrally e\pected rìs. in interen rates (Ìn]pìying câpltal Ì65es on
bonds) r\'ouìd nrean a lÌigbcrdemrnd lor monc! ìn K€vneís tiÌnìinoÌog), theÌe wouLd
b€ a spcculatn,e dernaÌÌd lo hold ÌÌÌoney in ordcr to lnveÍ in bonds lâtcr atleÌ the fìlÌ iÌì

Ihc..t Ìe Ìt of Ì(eyncs\ aÍSuÌnent is thal Lhe expected iúcrrÍ rilc cnlcrs jnto the
f(1í)ction deteÌmhÌiiÌg thc demand formc)Jlc)'. Thjs i\ extrelncly imporlanl ìn Lhc contert
otrhccentraìbank\.onductolnÌoÌìetarypolicv.Suppo\e.hikeirthcshoí1erÌnlnteÌen
rntc is rcen a\ a sisn of ilìc {overrnnentl dclcrmiÌration t,r squeeze out infalìon Ìf ihe
bond nrarket norv belìe\,cs lhat iÌÌterest ratcs olcr lhe mediü term wìÌl bc high$ than
previorrsìÍanticipated, thcn tìre-v willexpecti lall iÌr bon.llÌicesas bondholdcrsst!itch n)
highcrïlcldjng nn)ú teÍì nsstts iÌÌ o erto prolcct themseL\es froÌÌì such capitaììo*ei
 lhc) i{iÌl unloa.l theìÌ bondr ìroií.Ibnd pri.cs lalÌ ind the lont tern iÌÌtcr(Í ralc Droves
up. Thi5 un.leÌÌine\ the decisive irnport.ncc ol cxpc.talio.s úr the beharìour oi fnanciel
nr a Ì kets a..Ì thlrs the conduct ol nÌonetirt poli.y. Movcm ent\ iÌÌ the short tcrm Ìnl c rc5 L

.rl hr thc rarc can helery powertuìifthe) mo\e the sen€raÌ Í.tc olexpectaftDs iÌì the appí]prjalc
l': lì dir.ction. Of cornse,.eactions can be perrersc. A slÌarp cut nr the short term lìtcrcsl ratc
r.lrlunitv drtring a Ìecessìon can, il mlshrndled, vÌ$r that the cenú41 bank Ììas ncs,
lead to thc
inlormation 1mtìling the Ìecersion is ìrorsc thin cÌpccted eveÌÌ a\ bond prlccs rìsc,
rquity pÌ1.es coulcìtaÌÌas lnvestoú expe.t ÌoNcr frolìls ãnd dividetrd\,.nd thc bcncl.ìaÌ
inìpact olthe interest Ìate cut wouLd b€ nrútralizcd.

,12 3 Empirical demand for money functìons

I h€ dcmand l{rr moncv is onc ol the nÌost irÌterÌ\i\'Élv studie.l a$Ìeg.rte e.onodìic rch
tloffÌìips.lìor a nunÌbcr oI adran cecì count.ies, v..rv long data series are avnilablc, alìoN
i : estimation lc) rLrn lrom sonre time ìÌÌ tlÌe nin€i€enth .cntü) to the end ol lhc ttlcn
iietlÌ clniur-r. rcccnl sludr lor tìre UK,ri estiÌììaiÈs thc demand for broad nÌonct lÌom
lS78 to 1993. ^lh. nÌodcl is scl ut a\ a ldrg Nn spe.ilìcalion jimiÌar to onc dis.6sed
:Ìr^e: the demand for rciÌ monrv baÌrnces is â furclio. ol the Ìelel ol rcal lnconre (a
!rcâlLeds..li'varlablclnfdamcaÍtreoltheopportuniqcostoflìoldÌrÌgmoncl.Itì\
:rnìnÌed ihat tlÌerc arc !nrioLls liindr of trânsactions .osts así)cirted Nllh adlusti.S ÌeaÌ
rtr Ìàn.es to thcir dcsj rcd lo ng- ru n leveÌ. It is t1ìerrlorc . cce$aN to üìodcl l h c 'cq uiììbÌ1Ltm

-.rrection nÌi'charlsÌì' tÌÌroLLgh irhìch t1ìe adjuÍrÌrcnL t(^larcl the long_tur leveÌ trhes

hr estinrtiÌìg thc dcmand Íor Ìnone-v htrÌction, orrc centraÌ problcm ls Lo .Ìeci.Ìe $lÌât
ÌoDev ir JrÌd hos, to handÌi'.ha.8er ìtr it\ delìnition oter tiÌne. Sin.c troney ji a Írcial
.stitlrti(lr iÌNeÌìted tìy hunÌans kr oveÌconÌe the probìcnrt and.ons o organizlngbaúer
]rangements, it is to bc r:p.clcd that 1ÌÌìolations ill occul ind Lhat ìÌonev' will
:ìeienrrechajÌSe.ÌhisploblcJnìsÌllkedtotlÌellcqucnlÌ-vdiscu\scdissutoldreiÌÌstabilltl'
: the denÌadd lo. moÌìc_v''.
lhi5ìÌbljltÌtnr$eÍsthallomo.leìtÌÌedemandloÍnr)neloreralonghitt()ii(alperiod,
: iì nece$ìr) tcr allotu for chenget iÌi the (Ia-t thal nn)ne)' is dciì'e'l an'lto lor
'lloiÌ
:novatirÌÌ ânc] lor.h.ÌÌ8cs lrì the irstitutioÌÌal sct'uf le 3. changc! Ln ÌegulatidÌ tlÌit
:".ct how noÌÌ banN lìnarÌclnl institutidÌs operate). \,loÌeo!er. . nìodcÌ tstlnaied o\er
:r. tnÌe period ..ÌÌnot be cxpc.te.t t{) predi.t wrll Njtìr more re.cnt dâta ìl these ia.
6 rÌe not takeÌÌ iÌúo account. The woÌk ol lricssorì cl aì ilLuÍratcs th6e i\{et The-t
:iÌn iïith a rÌIL{lel thai appcars tr) teúonn well lor Ììcarly a ceÌÌtuN trom 1878 to 1915
:::il then l@k to see ii it is .o.sìstert ilith tlÌe neh data ld the l9t6 93 PeÌn)d. lhe
rrit ÌnocìeÌ iÌì.lLrdes dunìrnt rariable\ to tale ic.oLìnl of nrifìs iiÌ thc dcmaDd for broad
:: ìne\ trr ea.lÌ ì!,rrld Nir afd tho5e asrocirted slÍh thc cìeclit conlroì rcgulations oper
:: r! lrom 1971 to 1!t5 iÌì thc lIK. UJherÌ ihe elghlccn Ìrei! )enrs arc ad.Ìe.Ì to tlÌe claÌn
.:. the cleÌnand lor nÌc!Ìc-t rqualjo. PeÌlo ìs poorl)'i thc \hort ternÌ lnloest rate i\ rÌo
iser signilìcarÌt and neithrr is lhe equìlibúunÌ correclion tenÌi GepÍcsc.ting the \hoú
: adjustnìeÌÌt proclss). 1lÌc aulhoÌs aÌii!e thrÌ nrch a nrechâniÍi. appnrach to mod
. ìg iÌÌe cienÌand lor monev ('iìÌ not Ìlork ii is ne.cssâÌv to recogniTc tlrat chaDges
:r.ii.f.IÌ.nd r rfll rr.$n ì rl9c8l
í
I 214
I

in the econoÌÌÌic cnvircnnÌerÌt iÌì thc most Ìecert t$o decades rcquilc chânges in the

I IiÉt, the definitÌon ofb()rclÌÌÌonctchangts ür the late i9lit\ and thjs itrìplics a chaniae
jn the opportunity coit oí holl ing m on c!. StecilicalLl , thc n.Í'dclì. i tìon in cl údes buikl
jngtucìet! deposlts, snrich areirÌtcrcí bcaring, with tlÌe conscqucn.c lha! !hcrc ìs xsha4)
Ìeductidr irÌ tlÌ€ opporLonity .ost of hoìdi.g nroney. Sccond, financlal lnnolation and
dereiiuÌatioÌì werc dÌâmatic itÌtÌìc l!80s an.l 199(\ n'lth thc in(rcd[cLion of intereÍ
bcaÌinij cuÌr€nt accounts, credit cad5, dcbil cadt, ând .aslì nÌa.hincs. The) 'chan8ed
(he de olmorÌe) rs an asset iÌÌ ponfoljos, as a s)urce of liquidit), nnd iìs lhc majn com
pone.t olthe transarlioÌrs Ìnedi!m'.j l. the UK, there Ncrc also slldÈranging chantes
ir the ÌeguÌatort eÌìvironment inllialÌ)', as marNet üìe.hioisnìs pÌal'cd e laryer (te irÌ
dcrenìnrúrg rates ol rcturn on asscts and lateÌ as non biÌìk tìÌancial i.sLitutioÌÌs ríere
nÌloired to translcÌnì thcmseÌ\€s irÍo ba.ks. To take onr cxamplc, raìc. jntcÌest beariÌì8
cu cnt accounts \'vcrc ÌtenÌitted, thc oppoÌlunitv coÍ ol holding naÚo monev went
do n and.leÌÌÌarÌd\!cnl up.
'lhr
nrodel i\ rìodilìcd lo tale.c.ouÌìl ol lheseissues:i dilÍcrcnt mcasure oftheirÌterest
ralc h used í) a! to incorpoÌate thc changc i. the oÌrPortrnit)'1:os1, atd lhe deìegulâtion
dunrmt is usecì tòr thc pcrlod 1ÌÌ th€ 1980s (19E6 9) in.dditìon lo thc eâÌljer teúod
(Ì971-5). WheI this is done, ilÌe eÍiÌìatcd nrodeÌ is ltisl.ctor-v nrìd comtaÌabÌe to tjÌ€ : lttol
carìicl Ììo.Ìel eninìatcd Lrt to 1!r75.r2 Iut irhat are the poÌicy inÌpljcations that can be ira
drah'. lnÌ this e:ercisc? The lìrst poinl is lhat itÌ terms oi fo(casli.g the.Ìenr.ìnd
lor monev, the use oi â Ìno.leL thal lìts h'clì ma) be poor at lorccasting it the Ìelevant
chanjje\ in the econoÌìic \úuctlrc i. lbc t(Ìeca\t perlod nÍc tol kto(lr tÌ rtlt' lhe
aurhor ol this Íud-v toint out tlÌat thc cIle.t ot e.rch üorÌd $, of thu dcnrancl fü
nn)nev appeìrs to bc the rane so nl lcasl wlth hi lsisht, wc ca. sa)' thal uslnii the
cstlmate lun thc 1ì15! n(rÌ.llÌavc prcdlclcd lhe eiïect of thc sc.ond LJnlortutateÌ-v, \!e
stilì do uot knor\'ÌI this inf(trmation would bc ureirl iÌÌ pr€dictirÌil lhc cUcct oI a thi

The \ecorÌd issuc is $'hat we can ìcaír aboul dre.lirection oicausalit)'bclÍ'ccn mone)
and prjces. 1Ìì the carly 1980\, therc\!asalarge 1ncÌease nì the re.l monc-tsupfìl': lhebig
question i\ \Lhrlhcr lhis was duc to

. the onel upplv beirg rilowcd lo rìsc in lì.e irith.ÌÌ ìÌÌ.re.se in lhc!Èrì.t'd ÌoÌ
s

rÌìoney (e.9. bccaute of ihe porliolio shitts r*ociated $'ith lìnancl.Ì l Ìovalion as
ciiscussrd abovc) irìth the starcc ol monclaÌ) polic) urÌcharÌged or
! lt) a change to a looser monetary policy, ilhi.h Ì\'oL tld sÌr ow trf in hìgherinlìatìon iÌÌ

Ìl ìt $as high.r dcmand lo. nÌoney, thcn 1lììs can be lhoughl ol âs a Iettivard
due to
shìft ir the li,í curve. lhc âuthoúties Ì!oüid have had to accomnrodâte lhìs b) âlldlnÌil

rr bi.siÌì.HÈndÌt,andPÌ.nNi.Ì(19931.30s
rr liì ., , .trr rnil ute.ênnrg d dnrs lhe e.DnomeLl. ideltiLl.iLron or nÌ'
a..rrf d iurLn..,seê iÌrirl 117 13.
 779

tlÌe nìoncy suppl! lo risc in liÌìc wìth the nrcreased cìern.ÌÌd iI ouLÌtut iras nr ÌemaÌÌ
unchangcd. Altcrrìalircì_v'', iithcrc ls a ÍabÌe.Lemand tÌ)Ì rÌon€y iuncLion, then obteÌving
lÌìilìÌcÍ ÌÌroncy baÌanccs woirÌd ÍrggeÍ the cause was a rise irÌ thc JÌrone-Í r{T1)', wìÌich
s,ould,ÌrÌlunÌ,Ìcadloa.hJÌìgeirÌthcpÌiceleveìinthel(ÌìgntrÌ.Ìhcl]lÍcutvc$oul.lsìrìit
to ihc rÌghl, rnising agiycgatc dcrìand and pÌìcet thr)ugh tÌìe PhilÌiÌrs cuÌve .rechanì!Ì.
Ìhe nìodcÌ cÍìüatcd b-v lÌicsson cl al. inclúling theìÌ modificatio.s oÌ lhe change5 nr
e(ol]omìcÍruclure aftcr 1975 suggcst5lhal iartheUKthe fornì.ris ihc coÌrect inlerPÌeta
tioÌÌ lor thc cad,v 198fi.
We caì conclüdc this dis.!ssion b) Dotìng thât innovations lr Lhe Pay.rents Ìrrccess
ar Ìr:1 .lÌa nges ìn tlÌe rcgu li nrry cnrì ron Ìnent irìÌÌ alfect the duÌa,ì d fo Ì m one-v. This ililÌ

nÌ!k€ diflìcult the Lrsc ol lhc nìoncy suppÌ) as ihe ìnstnuÌÌedt o dronetaÌv Policv. \lotr
etar) t.ritetiìÌg Ìn thc UK l\'as nolably unsuccessirl Ìì the l98Os when the stN(trral
chaÌÌges discuss€d abor.e r,ere oc.uring. Under such circunÌstafccs, monetaN author
itie\ will tend to relt on changing th c i . te rest Ìate as theÌ lÌelc Ícd m.tho.l ol jtúlueÌÌciÌÌs
rìre level ôÌ r.tivitv ln the È.ô.i)Ìrv.

5 Monetary transmission mechanisms and the role oÍ

Íinance in propagating shocks
Llìe'monetaÌy transmi\sioÌÌ Ìn€clÌar ism' it tìre teÌm used to rclcÌ to the chan €lsthírugh
rhichachangeinuÍÌÌeta+poli.l(1.c.a.haìrgeìnnrter€stralcs,achal3eiIÌt]ìenìo._
ilarybase, oÌ a change nÌ the nì.ÌÌi'v supplv) iÌrÍluence\ econoÌìic activity.lt t1ìe bcgin
nüìgotthe chaìn ir a poLic,v .lec ision bv lhe monetaÌ) authoritt toeitheÌtishten or Ìooscn
ìonctary conditids. At tlÌe €rÌd ol (hc chrin that makes uP the Ìnonetary trnnsmissìon
rxrhãnism Í the impact ol a c1Ìângc in ag8ìegate rletrÌând on output.
Hcrc we tet out the mrin channrls bl tlhlch change\ in mo.etar) polic-t fccd lhrcugh
:n change\ ìn rggregate cleÌÌÌand and tt) output itr the \lÌort run. This proçjdc5 ã ÌicheÌ
'ri.kgÌound to the ânâl)\is ol nonclaD poÌic) iÌÌ Chaplc6 2, :1, and 5. lhc iim is to
irìoÌ! how the con rnÌeration! iÌÌtrod uccd in this chapter togctheÌ witlÌ those inlroduced
:r Chatter 7 ìnULreD.ethe üansÌÌisstrn oI moÌretaÌ-v policy. lve can also r€inlcrprcL the
:hiÌn.cìs explainecì below to !lÌo$,1hc Ìoìe dÌe 1ìnanclal sccloÌ .an PÌat in propagaling
iro.k5 tÌom the ÌrÌìvate sector througÌì thc economv. Bec.usc oíìntannâtioì probìcnrs,
. .rp iraÌ maÌkets are tì! iÌom peúect wlth Lh r result that tÌÌe econ om y is clÌar.cteriz.d both

r \ clcdit ratloning ancl eqx itt rütiorì i . g: n ot only is externaÌ Jl nan ce tìoÌÌì b.nks o I lro m

:ìr saìe of equitv more e\penslve than ìntemâÌ1ìnance but jl nra) not be a\âiÌirblc at all
. Ìr shÌights the Í)Ì€ ol LJalaÌÌce slr cc I cffects, which are cspcciaÌ\' iÌÌrportant fo I s maìÌ
igh
rid Ìnedium size.l 1ìÍn\. A ch.ractffistjc of baÌance sh€€t ctftcit ú thât the lmpact on
rcloteÌs can easi Ìv out$eigh that on lhcirinneÌs. ÌinmÌsSobantrqÌasa conn'qucncc
I dcflatn)n oÌ unerpecte.ì cìis1ÌÌí1atio., lhis can affect âs8rcgale demand in additìon
r Lhe tradìtionaì ìÌÌterest Ìate channcl. The ÍÌeleNìbilit-t ot ba.kNÌÍcy is one reason
::rrl baìaDce sheet etìects help to expìain s'h) Jhocks are ampliired ancì whv the €llcc{s
Trã.litìonaleÍfects
]\ higher noÌìinaL inlcrert ralc Ìeads lo a highcr Ìeal üÌtcren râte, Nhich iÌÌ turn leads 1(r
losreÌ ürvcí ment, loNer ÌN rchases oI te\i.leIltial h{)Lì sir g imortgagcs)' Ì{Ner cxpen'litL'rc
on coÌÌsunìcr durâbÌcs (e.g. Ìoans forT\isetsor cas). ard to Ìorl(Ì output

Ìi -t I Lr 1f.
A\ discu$ed, the short-lcÌm Ìnoney nÌnrttt rates Í'iÌÌ !ulckly fìllcn! lhe otì'ial raie and
baÌìksi{iÌÌrnl]oúncechaniaesjntheirbascìnteresttate\forlendiÌìg(c'g ove rallÌatesr'
{lornpctitioÌÌ amoìrgst banks an.1 buiÌdjng í)cirtics iril1Ìca'Ì to sin]iÌiìt chaniles in nÌort
iiage lcn L1iÌÌ8 rales and i. the rnLes forsa!ìnias
Llu( the transmìt\io. mechanisnÌ rcqrjre5 tlÌnl the ch;Ìnge nì tÌìc shoÌt terrn
noìninnl
rate also atìects tbe long term reaL ratc, irìri.lÌ noted in
ìs ÌeÌetant lor invcstÌnent
ahaptcr 5, therc it no nbít!lcl-v'' Ìisid connecljon beti{een changci in the^sshorÌ teÍì
and long tenn inleren rate! lht Ìong lcÌm nìtÜcst râtc deper s on the currcnlshorl
jnÌract oi
ternÌ ralc ancl thc expeclc.l tìtuÌe dìort_Lcnn ratcs: this makes it 'Ìcnt that tÌÌc
achangc in tlÌ€ slroÌt tenì Ìate depeÌÌd s .rucialll o n hos'Lhe ce tralbankis exl'cted 1o

behavcÌatero.Onepossible\.cnarioislhatariscintìreoÍLlciaìnÌtercÍrateisilìtcÌpreÌed io!$hcatlÌÌil'
byuÌe nr aÌkets ns success ltrlì)' .il nr nìg thc cconomÍard prcventnì8 ì1 trom
Iìr this.ase, itnright be thoushl thatthcoIlÌciaÌratcwouldhe Ìeduccd ìn the mcdÌumn'n
Ifthis bclieli\ hcÌ.1 Ì!1d ei,! and sl(rnillyin the frna'cial maÌkets' uÌen lhe rise in lhe úon-
rern rare colld be associxted Í'ith .ì rirll not I risc nr thc ìong t€rtn rate ALthough tlììs
Ìeactjon carÌÌìotbe nrlcd.Nt, it probabì! more olten thc case that thc nnaÌìciaÌ nrarket!
ìs

belicÍc thdt tighter ÌÌronetary conditions n'itl fcc'i to bc manìtanrcd utrtil $cndi il
output, and cmflo-vnÌcnt respond thìs mggens a ìongcÌ hoÌizon for tìghter mo'etaI\
condirl{)ns âfd therelorc a iisc iu thc shoÌt terrn rate $'ill be tì11owcd hy ü risc in th'
,ìS-r ' , l ir'-'r '/' Íl

Tobìnt Q
I.l|',. I{rì ì_ or'

I|i , .rr lL,^' \r I l' rrr '^l r" r

;ss€ts such a\ cqtrities $ill also rjse becaLrsc anv givcn erpectcd itcome slÌcam i\ dì5

.(ninlcd at d Ìcnt'cÌ Ìat€, tlhiclÌ raisej its !.lLtc. Thi\ boosts Q and invettrÌìenl rjsc\'

, i -t lii,.,Ìi -l Q 'Ì r .lr

As ÌÌc have \eeÌì jn ChaptcÌ ;, if Q is hlgh, tlìc ÌnaÌlet lallre oì Èxrìs ãs relÌected in their
jmpÌie\
stock nìarket !.lL1atn!Ì is high rcìatne to tlìc repla(€tnent cost of.aPitaÌ lhis
t1Ìai new pÌant an.l eq!ipnrent is reìatìvely cheat Hcnce $e ìlouÌd cxpect iÌN'cstment
spen(Ìing nr risc becaüsc nrms ca. bu) a lot ot inleÍnrent Soods í'ilh on\' a rclativeÌ\
rnÌall itsue ol nctt sìrrles.
h'e ha!e sccn in this.hapter, s!in3\ iÌÌ lhc stock narket nÌav .ìoL be driven by tun
^s
clamc.taÌdetrnìinants ol nnÌÌ viÌue Such tìn inciaÌ bubbìes wiLl .licct nr arlet \'aÌuati(lr
andhcnceQ. l h ìs car Ì produc e ph ases of ovcr oÌ Luìdcri n\ estÌnelÌ1, i\'ith l)ot1Ì sho rt to
 : 241

ÌedÌum lu effc.ts on outpul, enÌpÌol Ìnent and ìnilatìon a\ ìÌcÌl âs ìongcr run effcctt
!r] catitaL accunrrrlatnnÌ ând 8rt!th
Wealth
lLgher slÌarc trices boosl lhe tìnancìaÌ ì!€allh of hoüscholds' 50 their lilctinÌe re$oÌces
rr.higlÌer. lheìite cy.Ìc h ypotÌìcsìs or perrn anent iÌìco nre hypo lhesìs í'o trl'ì prcdlct thât
:hc) corÌ mc Ìnore.

I i -T /i$". 'T t!€aLth -T . -| I

Household liquidity effects
i horlseh oÌ.ls arc l i.Ìuicìit) co nstrailr cd, then a reìa\atio n of mon etaiv pohc! or a boo!Ì
. ancl fììces car release thc con\tralnt
I i ,l rì.a, )l raìrìcorll.an.irlassets '
1 LilelilÌood oinna..ìaì dbÌrc$
: contuÌIú.luÌaÌil( a.d h(ÌÉntg e\fuidilure Ì/

Ealance sheet
: ooÍoireA Lìeconre Ìe$ wcalthvthcyhrvelcssto losebl taki'grisks, soacìversc selection
._rrtJlcnìs beconìc greateÌ.nd ìe dilì g i!i11 dcc Ìease

Ì i 'l 1.".",, -l morJl ha7r ,'dveÓtí'lednD -

I hrnkl!ìa.s '. i -l I
cash flow
rìrc r interesl rates lea d lo lolvcr iìrteres t Ìraynìen ls ând tìru\ high er ca slr
flow lJr cÌea scd
:- u djt) nìakcs itea\icr 1o kno\! $het1ìc t a boÍo('eÌ wÌlìbe able to
paybackhcrL)a s'

i i 'l .anilìo\{ . nroÌrÌLizard rd{eserclccLnÌr

I l)ndkloan\ 'l I -l r
Jnantìcipàted change in the price level
'.1t pnrnìent! arc often tìrcd irÌ noÌnìnaltüms, so nn unanticip'tcd Ìis€ llì dre prjcc
-l ;edúces nrms' Ìlabllities (the reaì vaÌiìe oí lheil IroniiÌìaÌ debt) bút doe! fot ieducc
::realralueofthcfinÌs'a\sclt l lencc their nc ! woÌth in cre'r scs and nr o raL lÌazald lalls lí
_: ìneÌar)'casÌÌg lcarìs to an llrdrln
iÌrtr./ risc in lhe prìce ÌeïcÌ, this nrcchrÌ!sm piedicts
r :rre iÌì inleshÌÌenl.

P>t! -l iurâl ha7âÌ!1, r.lvei se \tlccl ion -Ì lraÌrlloans

-l I 'r
:xchãnge rate effect
- :iqÌrer inlcrest rate rcÌatile to lhe worÌd lnteres! late lca'ìs to an rpprc'iation ol the
:,..rnse rntc (a fâll lrì ., irlÌcre ìt is dclìned as donìeslic currcnc-v unils per loreigtr
242':.: : :

currenc], unlt), whi.h malies inÌports chcapcr and cxports moÌe expensive âncL hen.r
leads to lowc. nc( cÌpoÌts. Thìs ne.hanism is djs.ussed at ìength ir Chapter 9.

' l. l, '") t

6 Conclusions
Ììr tìrí châpter, lvehavc slÌown horv â d eeper nìvesuga ion oí monel and hnance alknt!
I

us to use th€ 3 equation rìodel with rnore subtlety. OÌr !he ai sl.le, we have exaNine.l
the characteristic\ of thc dilterent assets thât households.an choose as meanj ofholcìinir
theìÌ Ìreâlth. We ha\'€ sccn that i titutional leaturcs of the hnancial slstem inteÌact
sith other leaiures of thc cconomv such as tlÌ€ peÌìsion system an.] hourirg market to
inUuence tÌo\í châng€s ir
nìonetary policy are traÌìsmiltc.Ì to conslrmptidr ancì in!e\t
ment decislons. Ìn addiilon, il 1s possible thrt thc wa,v financìaì ìnttitrúbns s()rÌ( cin
bc a Írurce oldistuibanccs to the Ìeal econonÌy.lor cxaÌnpÌe, specuÌatlve bubbles ma\
cmcHe in the nocl nìarlict and pnrduce wave\ ol ex.cssìte optimìjnr orpessirÌnnÌ thìt
in I ien.e invesrmerìt rle.isions.
r

lve have \een how núonrra(ion prcbÌeÌìì! help to cxplait

. rhe cxìúence ollìnancÌal Ìrìslitrúion! mch âs banks,
' thc nccd to r gove rnment reitu latio n of the nnancìal slstem, and
. why households and lìrnrs nrar'' lace liquìdìty.onstrainls.
On the monetar)'sidc, Lhc lÌaditionalll{ vie*'assunìcs tìre centÌaìbaDk contÌoÌs thÊ
monetâry base and thc lnterest rate is tlÌe oütcomc ot lhe inteÌactìon of mone) ÌÌt\
aÌ].lc]enÌand.ll! contrasl,lhe Àíà view ass!rì€s thc opposite chaìD ofcausalìq eith thÊ
central bank settìrÌg lhc ÌnlcÌest rate; iliÌeÌì the denìand toÌ nroney, the monetary base
âcijults as reqLiircd. lhc dcÌnand to. monet$'ill be al{cclcd by linancial innovatìon and
by ch.Ììges in t|c rcguìatort' envüonmcnt. Ìhcrc lÌas bccn a slÌìit in PÌactìce away fÌonÌ
monetary poli.y bascd on moDe,v suppÌy targ€ting (and it econoÌnjc analvsit lronr the
lJ./lM modcl)toÍ'ard using the irúerest ratc as thc ìnstrumentolnronetarypoìicyin tì1e
corÌtcxt oI an inflaLion target (an.ltoward the 3 cquatlon mo.Ìel i{ith the üÍÃ).

. QUESTIONS

(1) Inagile you arerunniu8asafchouse ì'] thc cadvnineteenth centuÌ]. AssunetlÌeÌe

are 2,000 gold coÍìs d€posit.d n'Ìrh you and lhat,vou have i$ued these people with :i
depositrÌotes. Yo! halc lcnt l,800gold coins.
(dl Apart Íonl lendinS .r of cv, hat is th e Êssential seNlc e that you tÍrvi.]e?
(Õl what dctcdìiÌies hoÍ'mìch nuìevyou lend?
 . :: ]: :. ':.::] 2a]

(.) lvÌÌy rcnÌ peopÌe ÌareÌv u ithdiai! their told ?

(d) Whatjsvo r júfLjcit.cscrvcassct ratio?

(ì Ifan additional200 i{old coins are d eposited, lÌo$' n a n-Í ad.ljLìon aÌ d.posì ts NiÌl

f) Wh_Í atth. cal.u,ìtion ro( madc in (.) nol be entirely acc!rrtel

(ll) Ira nelillÌbonÌiDg vilÌage, d Lranlei was unable to nrcct.alìs on his tu!Ìds and he
s'eDtbaDkÌupt. Youdecide to iÌÌüerse youÌ reserrc âsscl râtio to 20'1,. lvìÌy Ìs jt a
bld nlea to câÌl in loans vo! hare aÌreldy made i. or.lo to nìeet the higher

(ir) Anedditi.nall,0íl0coinsarcdcpositedbvfeopÌelroÌnthe.eighbôtrringvillagc.
Hon mafv gold colns n'ìllvoú hoìd in.anr and ho$ ÌìÌany Ìoans willloullant lo
mak( il_voudecj{:ieto adjosL to Lhe ÌÌorc catrtious reseNe|sÍÌ ratio?

(2) \'Vhat is meânt b-v 'iÌr tenÌal' frnance tur Íìve\tÍÌerìt and why nay it be cheaPerthaÌÌ

(r) Ì)jslinguish bcLrrccn advÚsc selection aDd noral hazard. llluslratc rtith e\ampÌes.
Hoh'havcthc concclts oiasydÌìetÌic úrfoÌmatioÌÌ an cl nr orâÌ hazad affected our
úndc6la.dìng of Ínaoocconomics?
(4) Why is the nniìrÌciaÌ systenì hcarilt rcgulalcd?
{s) (ÌrmpaÌe the tilo brcad erpÌanatiuì s of lran k ru.s.IÌlpalticulaÌ, Nlìat js thc
Índerlyì ng difterence in the a$lnìptirÌì about bânk depositors' behavjour jn thc tt'o
atfroachcs? What do,vou see as the nì.rin problc.rs llith the5e assunìptjons about

:rriÌ $'ith tlìe (6) What jsn bull.rarkct? !\hal ìs a bear mrrliet:'llo!! can tllePreseÌrce of'nìarkrt
nìak$s' ciplain thcjr cÌislence?

t7) wlratÍ the lnoney m!ÌtiÌrlio'? Whât determines it\ siTc? What leverage does tlìis
glve ihe central baÌÌÌ o\ er th c !r one) sutpÌv?

(3) \'! h) ÌÌ ìght the cash/deposit rrtio a. d t h c rcsc n'c asset ratio be dcücâsì n g l unctnrns ol
rhe rateoiinteÌest? How d oes uÌ iÌìtqrÍjcns iti!Ì noney \! pplv alìcct lhc lM cuÌvel

I Ìl úÍÌ ate usiDg an exanple, conDari ng t h( . c$' rM a'ith the sta. dard l.n'r.

(9) Ìn 11ìat \rays L1ìd llritish cxferjence jn the eaÌÌy 1980s ììÌustrate the pÌolrÌerÌìs wjth
nìo.ctar_Ítargcting?

Problems ãnd quêstions ÍoÌ dis.usion

QUlSÌlON ]\. tÌor! does thc prcsc.ce of asynÌmetric inlornìatìon affect macrcecoÌÌomic

QLr|STION B. Ir ure early 1990s nì Russia, badcr s'as aìdesÌtreâd aÌÌd thcrc wcrc bìlìions
nt US doÌÌab ciÌcuÌatin g. lvhv $â\ the rouble not fuilììing 1is tunction as Ìnonc)'? Whal
2AA

costs did this impose oü thc R(ssìan econonÌ)? [Rea.l1ÌÌi]:see thechapliÌs bvSeabright
(200.1) relerr€d to in tbcchaplcr ard ÌetèÌeDces thereirÌ.1

II STÌON C. 'lntlaiidr targeting is . Ír.ccst but nìonq mpf\' tari{et1Ìlij was a tììÌuÌe in
CìI
rhe UK. Monel nÌpply targetidg as r mclhod olâchicvi.g ìow inU:ìtjorÌ wa\ a ccesnl
GcíÌanv.'Do vou agÌee with th€se claims? WhaL nìighl account ld these .LiÍïeren cei Ì
QUISlÌoN D. Ìn.lap.n, rbc pricc olÌealestate ciropped dr.nìaticalìv in thc ]ntc Ì9lJ0s.
Man) lâpanese Êrms lÌalc long-ic n Ìeìationslìips lvith. so cJÌlcd maìnbank. Ho$'
would you expe.t. d€terioration ot the baÌânce sheets oìJaPanesc lìÍÌÌs aÌìd oftlÌeir
maìn banl\ io affect iÌn estmcnl? \'Vouì.1vou e-\pect i!âÌ1er oi ln.g.r níns to b. nìost

j: APPENDIX:THE MONEÌARY 8A5E MULTIPLIER

lnthisânrcndix,ìrclìrovnÌerr*pìânaLi.nollhrmor.talba\rn tirtieÍâsit$.rks nLhelraditional

lM riov ln tlÌis Ì i!ìr, nutt .r€ate.l throu8h tÌÌ. of.rú)r of iÌì e tì. nerary base m rltiplier . strtPorÉ
thc.cntnn bìfr Nij rÍtre .anì ^ in rhe e.on!nÌ! iii
frintl rlìe n.lÈs and bu}'\ bon.ls in oÌ]en nìaÍl.t
oprnrtÌo.t The fuhll. hô di onlv, ir, onr tlìid ôl Lhl5 âs.asÌì an.l det.jits Ìhr Fst in corÌìlr.Ìi ì
bìfLJ ìo nìa ntâi. LÌre r.aír lo dcporit Ìiln,.l0 5. Ìhe banks l..1ge \ar Ì0Llo úÌ th!.cnÌÌ,rl b.nli lf
mâi.lai. rh€iÍ.1e5iredÉ\e[c ratio.rl eìre.dÌoan\1. the fublìf Nith thc (st tvrnÌLÌrl\ tÌiir put5s
.l ..edit.reâúÌr Nill ri\. th! nÌo..v mtÌtr bI2.5 timrs thr oriSnÌrl jfle.intì .f.rslì bv lhe.ental
Wc. rcchoÌr tÌris \!ÒÍt\ar ÍôlLow\. ÌltheìÌntiali.lcctio. Ì{as.ln0, the jnitìrlin.reas€in tlre DúneÌ
nrprilv 5.:l00 Girentlìeprhlic's.JoJ0.5,ÌlÌ( iÌìe!r'illh,ìd.nLoonelÌrirdotthc.rrhândPla.ct$o
thirds oÍ ìt o..leposil i. â.ommd.i.ìl tianl (!aíi.7i. Ìhe Ìise in delr.\itl ìÌrÌ]Ì( rontrc(ill brnkmr..5
that jt Nlll ii.!eòe ìti Ìr!cr!r\.t thr.c.rral ha.k bJ:j6.ar7. lhi\ lcrvr\ ú lÌ( to $tcra l!rh t! tÌrr
trblicu5insthrc{tn'€ôl)Íì(i\Ìr Thurl.a0€n.lupìÌlthrhuf\!lthcputÌ1.1.-A linìs.rìouschÒld\
LìoÍo$ honÌrlìcba.kl and rhÈ nhnevsuptÌl hr\nr.r(rsd ìrl rrotÌ!Ì €íi0 Thir |r.cÊ$...ti.úes ú.til
tlÌ. prblics cinì rÒ det.sir !ali. n slâbleat orc lìôlfand dir.ltìtrÌ. al banki 'esere Íali. n íable
Ìr0o/oh5Èas_rt.s€ÊrlraLLheneÌr.ashinÌlÌ(e..noÈ),!illendufpaÍtltiilhehandrolLhepublir
and|a,iÌ-rasrerer!€sollhe.r)mmrrirlb.rkJ BÈ.arse.anìr'depôsiG 0 5 an.l ÌtÍÌres/ deporils 01.
(.i\h-r.scryct,ldrpltr:06.1Ìro!.eranrfl€,detosìtswiLlhâveincÌerlcdL,yÌ00:0.6:Ì6ôlc.rh
inthchú rolÌheputJlÌ.Illlrr05i1667 lJ:ll.Hd.cthcmonc),n]fpl!,Ì\ìr.lIrlq!.lt.rÌhc..nÌ
lÌclltì thr puui.,.d iheir dÈNi tswiLh bânks,lviÌl hart itr(ra{d bv €250 nìPì\úrBi nÌo.rtârylr5r
1he incÌeise in th€ nron.-v nLptLI of €250 (i..È
' 1k]l4 ) .an bÈ tlì.lghL.l a5 lrelng nade !|.1
rhel00uritrotcnÌrn.lor!o.allcddrriiúrl.r.tc.eaLedbrLhe.e.trâlbankar.l 150 uits olnìJid.
,rrr./.rnÌrdbltLr.ontrrrrirllr.kinBslslem Whâl are th€se 150 units oJin\il! nn,ncy? lhn is the
ÌoÌrl lout oi r(h Lir ns e\te. ded hl th e c.mm0ì.irl bânks. lhcasctlnÌeolrhr.orÌìrrci.úbanlr
balan.( slì..t 51ìÒN5 €la 6li.lne{ aseG i. theíonì oÌ.a\h r\rn$ and €ÌSa lorh toth! publi( lhì\
addsuf r.;j166 trarich Èerâ.Ll_vequal LothciÌtr(rsrnÌthctrnh! drÌ)lsih e tÌì.ir liiÜÌliriÒ.
ìt Ê rLor th notirg that botÌr thc (rsh Ìo lrposii Íârnr i.d th. (..rr!.âti{r aÌe likelr to h. se.sitivr nl
Ìhrmt0olìrtrr\tlrÌthrÌnnÌÌcrG\r,loÍnti...nsldemLô.5nrâ!tlalatlrlinúìÊde.nlô.r.h.ld
..slÌor drpositdd úÌ th( l.'tfuÌ,.orr ìcrciilbâ.kllrillâlLeÌtheir,eserieh.ldnrg.lelr€.de.t.nlh€Íale

TÌris.an b€ i...rlrrated i.to Lhe L\/ ar n)Íd*: tÌrc l,V i\ dcnnrd ior n ili|ú Ío(l ot high rlow.Ìed
D.ne!. (:orntaring lhe lì/ .utre Nith ând ìrúlìout i! trìfu(st \crriÌi\( iu|Ìrlv !l rÌonr!, tr Sncn Ìijc
iI thc nÌcrcrt ratc Ì{ìll b. i$o.ìrterl Ìlith . Ìri|hr.leÌeì ofi!(!nÌ(rlìa iJiÌre.a5efuilÌ.rrirdiÍlLV:
i.r ]-,V wÌll trc i!Ìrcr. lh!lM ir r!Ínallv fosilireÌ_r nôfed l)ecaL5e ar a h ghei ifLÈÍen Í!ìe thrrr Ìs r
lowcrdenlrrd nÌ !ronr! Júl Ì,!f(r n,ri BivÈn nltlltôltì..ÈL a higheÌlerelol i...nre ne.€s\âÍ\
Ìii dÌivcuf tÌr. t.a.5rcti..s d.rìand nÍh. enLLI toclear lhe nronet mârket. \iith an irL€'eí ^ se.r Ll!e
 :. ' .:.:. 285

N)ne_r surrP\ , Ìlis etrect sÍcnúoÌrcl th0hiSheri.i(rc5trrrcrotonlJÌeducerúìÈdenìdntturnonet

but rl5o incrcasr! tlìcmpt]!, rhi.h nr plics ln eÌ,€n h iAhrr llvrl !f ir( lmr L nee.ted IôÍ nì odlv markt
'rl {r -t . .rdr ,t. , rt. ,. ,,r .r,Ê ilt r. ,t
nì...v Íor( Í 'rc"'o
Ìedu.ed.loÌ a ghe.ll.uí!c, rÌrlrc ÌritLbe a snalleÍ elÍe(r on tÌìc iÌúrÌeÌ ÌaLe r.d brn.c
.n a.nviÌv oJ â gh'e. ch.rgc in the nrofÈraÍ!, bìrc Lrc.aus€ âs rhe jfrÈÍÈÍ iÌ. n pushed up, rhe m.nrv
artpL_rerprnl!|aLrialLyolí(ttnrgrhe inirjal reducti!rotthcrúnctarybase

,:. 'lh,r .i..

 ::. PART THREE

The Open Economy

 The Open Economy in the
Short Run

ì lhc analvsjs oí nÌ.croeconomics to thi\ poiDt in thc book, rre haye asnuÌed a conr-
:ldclv .ìoscd c.ononÌv. ìlven ti)r an e.onom) the size of the USA, thìr ìr orlv a il6t
:ptroxìrÌatioo: erports (orstltute abolú 10o/o ofGDIj. Thìs is aÌ$ the care foÌ some orhcr
rrgc ccoronìi€s like lliazil, Ìndia, and lapan. Urith an c{toú share ofabove 25q, of GDl,
:ìina is far nìore iúegrate.l in iDteÌnatn)nal tÌade than.lâpan or Indir. Ìn Eun)fe, tbe
rriti!h ard Cermtìneconomies ha\.e exportsectoÌsolaborrL250l, ofGDl. hr sÌnallercoun
::iÉj, Íìch as the NetheÌlaD.ls oÌ Belgjum, expoÌtt anrourt l() Ìnore tÌÌan 509o of GDP. Ìn
,:Ììall econoÌÌìies wiuÌ hiiih le!.ìs olprccesrnrg and Ìc-cxpoÌt of impoÌted goo.Ìs such rs
::land oÌ siÌì8apoÌe, the extoÌt thare can exceed 100Ì1. In Asia, Taiwan, Thaìlan.1, and
: :nhKoreahi\ee-\poÌtiharesotbetÌ{een 40and50{r,.
\lcÌeoler, tlÌe itran(ial markets ofacìvance.l and cmeÌginii econornie\ âÌe integrated
::.:lob.l ârliets- lÌence i{e hale to understaD.Ì hoir to deaÌ with both expoÌts anLì
-Dorts ând wltlÌ the úÌtegratìon of.l()mestic and ÌnlenratnDrl lìnanclal rnailets. Ìlap
:: r. understrnclirg the cÌosed econonr_Í taÌes us a ìarge paÌt ol the Ì!ây to behÌg rble
: :ìnaltse e.ononrìes thai arc pluggcd ìnto the iroÌld cconomy. The locus nÌ riosi ol
rr chapterÀ on the smalìopcn cconomy:thn is onc thatis alsrìmed to be too \mall to
:: iÌence the leveÌofr{orld ouqrot orthe worìd inteÌest Ìate. ConditloÌÌ\ iÌr th€ r€st ofthe
:r4d are taken as given.
.d\ econonÌistr ilould thìnl of analvsiÌrg a Ìegìon ol a countr), as a clcx€d econorÌÌ)
::.ir. Ii is too ob\ ious in the caÍ' ol a ìegioìr ríithin â couutry thdi its lìna nci.1 nì.rket
:riesrate.l into the natbnaì one. Ìt is aìro evident that much of \rlÌât is produced
i :, regjon is eÌpoÌted fÌoÌì thc regbn, and nruch ot rlhat ir connnteci is nnpoúed
: :r o tsi.ìe the regnm. Yc! Lhc open Ìegn)n n not idcntical tu üÌe op€ÌÌ ecoÌÌonÌy toÌ
- lea\on!.IiÌst, unlike thc opcn c.onomy, thcÌc mavbe consìderabÌe labourmobilit)
--Ìeen dlftèrent Ìegìons in lhc sanìe econoÌny. In tacl ne make the assumption in $hat
r\5 thai theÌe 1s no ìabour mobiliL) hetween opc. ccononÌìes. Seconcl, the region
::: ro controi over monetaÌy policy, and the Ìegìon tlsualìy has onìy limitecl (rr no) say
:rrdl policy. Both monelaÌv and nscal poìicv rÌe thc pÌer)grtive ol the ÌÌatìonaÌ n( )t
. :igionâl i{ovemmelt. Ìn thc case of an open ecoronry, the natn)nal goveÌnment oÌ
: .rtrnentrnclcentÌaìbank(inLhcc^scoíânjndcpcndcntcentÌalbanÌ()cancÌec eon
-::-tart and Íìscâl policy.

:: f'ììi. mi8úlionisâ. i,ìtortrrt acattrc ot ìhÈnbdèrÌ Ì!..1d a\.ân Ìre\een lrom tLe IoôtbâÌltiSer
..r1frÌr.r. Ìlo{r.L it is u.l,lêL\ to be ííúgÌr aiÍe.tcd bt reÌatireÌr short terì.h Ìge5nrdomÈni.
nÌi. Ìl!!slre.onesimpoíibÌeÌ{Ìrentoorìâfv'ârirbl.saÌetreatedis
niÌ p.pul.l .fs rr tìr.n in nha ntÌor5
L
290 :: .

Íõble 9,1 Ìypes oÍ op.n...r.nry

0pening
'LheÌe is an exception to lhc control by the nallonal gove.nmeÌÌt (or central bânk) o:
moncraNpoÌic)'.This iswlÌcn ag(rupoleconomics slìaÌc a corÌÌmon curretÌc) , ând hen..
a conr Ìì o n nr onetar) policy, Ìlke th e meÌnber .ount rlcs of F.MU, the luropearÌ [c onolÌ]i|.
and l\.Ío netarv Union. for a m c nìbeÌ ol: comnÌon .(r Ícn.y ar ea, the nationâ1 govenì!nenì
has n o con iÌoì over Ìnonetir ry poìi cy, inclu d ing thc cxch ange rate Ai in the stand ard op€r
cconomv case ar.lin contrasl lo lhe Ìegiodal.ase, thc nationaÌ goreÌnnÌent cioes control
lìscal tolicy (srìbje.t to arì}. írles olúìe monetnl-'' l1nionì. Table 9.1 provldes a suInnìar\
of the.Ìifferences betwccÌr Lhr drree nÌain typcs oÍopcn econonv.
The flrncìamentâl con.cp ts deveÌoped for the closcd cconomv remaiu atthe core oìth€
mac() anaÌy\is ofthc opc. econonÌ),.ìnd, oncc thc lrcaLment olthe \ianda rnalloPen
economy has beerl conì plclc.l, i viÌ1be quil€ easy to cxlend the anaÌ]'sis to the case oìi
Ìegn)n rrcl to that of rn cconomy $ithin. mon€tary uÌrion. Thur the e\tra eftì)ú needed
loropereco onìy anaÌ-vsis will h ave â large payba.k ìrì Lc Ì s ol our abìÌitr''' to analvle Ìeal

Thls chapt€r is aboul Lhe econoxÌl' in the sÌrort ru., Lhat í to sây, when pÌice\ and
wases arerlven. lhc Iolloi{ing isnìes arc addrcsscd:

. ÌloÌ! i! output detcrÌìinatbn in th€ short run affcclcdb,v tÌa.Ìe and nnancìaì

. What deternrlnesthe trade balance and rlhy.Ìoes it matter?

. what is the real cxch ange Íate r dhowdoesiiâlf€ctoutÌmtandLÌadc?
. How.ionxed and tÌexible €x.hange rate Ìegìmes ilorkl

The chapter i\ organized in thc tollowìng na-\'. Se.ti()n 1 deals with th€ .onse!Ìuences
of openini{ the good\ Ìnarket and sectúD 2 witìÌ the openiÌìs of the 1ì anciâl market.
The gÍnrÍhlork for the short run open economv mocìel i\ to be found in tho\e tÌlo
secin)n\. Betureputting thenì togc!heÌ, a nroÌt sectn)n highlights how tìrecÌ and ÍlexibÌe
eÌchange Ìate sy\teüÌ! operatc. Sccllon .l pins down the bala ce of paymenti concePts
that are neecled lor ope ecoÌÌom,v m rcr). Ìn sectio n 5, the Nlu ncleÌ] Flemirg ntucìeÌis put
tí)getheÌ and usecìtu anallse lìscaÌ, moneiary, and exchanije ratepolicyin the shoÍtrun.
 .. '' i: : .::.: :ji::: 291

Ìhc ivay the ecotronì! iìdjusts to a rerí slìoÍ_run cqollibriLrm dcpend! on ho$' cxchange
rale erpectatioÌìs âre forÌÌÌcd. OneimpoÍantcasc hwherefüwald Ìooking crpcc latìons
and stlcly pric€s lead to cxchange rât€ overshootìnii. Alter scctnu 5, the hlay ir open t()
go on t() the analysis ol thc medium NrÌ in ChapLer 10. SectÌon 6 thows what haPlens
rìren we relaa th.ee of tlìc ke-Í assuÌÌÌpiions rnade nr this chafier: thât therc Ìs peúect
intcÌnatìonal câpitâl mobilily, thtt the honÌc cconoml is smaìì, ancì that intcrnaLn)nal
inanciaì a$ets âre perfect subrtitutes. ln CÌìaplcÌ 10, th€ shoú un Mundell lrlemiDg
nìodel ìrexteÌlded toinaÌysctlhat hdppens to cquiÌibúunÌ cmpìolment and jnlatjon in
thc open econo y. Chaptcr l1 puts the modcl lo work b-t anrly\irg dilfcrcnl kinds of
!Ìr ockt ancL rltenìaiive policy rcsponses.

1 Opening the goods maÍket

ln lhìs sectl()n, we takethe tòlìowìng Jieps:

,11 €xlcndthc anaÌysisofgoods nìa tket equilibriunì b,\' lncÌudlng cxpoús ancì impoÍs.
'lhis aììows us nr cìenne the opcn ecorxrnÌy 1J curvc, the ÕX,!1 cuÌve
r2) show how by rúrning a clrrr€nt account surPlus or dcficjt an open cl:onomy
iÌrcreâses or decrcascs iti weâÌth.
l) crpÌore the extent ofjÌÌtegralion oigood\ ìarkc ls iriernation alìy and ho w lìrnìs set
pri.cs ì n th e ofen econorny. lh i s leads to â d iscussìon of reÌn lÌve PÌice ánd rcÌatile
.osl dclnìtìoÌrs ot the real cÌchange r:!te.
,J) anaìyse the voluÌÌÌc nrd teÌms of trndc elíects ol:n cÌchange rate change (the
MâÌ\ìrall ì ern.r.ondìtioìrl.
5) incorpoÌate the Ìeal e\changc rate ÌÌ tlÌe l5:X,\'t cun e

Both thc pur.hase of goods and seNice\ tìom.broad (1Íìpoít and the salc oÍ home
produced orúpui ahnra.l (erporls) ÌnÍluence tÌìe lcvel of outpuL ìn the econonìy in the
short nIÌì. Holding alì else conna.t, impoits of iloods deP.ess donreúic outpul bccruse
demand lor honìc pÌoductiongocs down and convcseÌy, exporls Eíe doÌneÍi. otrtput
a5loreig. o rdcs booti .ìemand íor h ome pÌoduction We s1ìall m o.hf.v dÌe goods ÌìaÌket
rcÌuilibrìun conditnD t(i take a.coúnt ofthi\.
Th€ eritension ol the ìÌo.lel to ln.lu.le imPoú\ aÌrd e\ports raiscs a second issuc. At
tlre €corÌomt,'s shoÌt .un equilibriunì leveÌ ol outpü|, lhere nìay bc a tÌade delìcit' lrade
balance, or sltrpl us. Ìf th ere is a tradc surp]us, elports cxceed imporls tlith the reslrÌl lhat
üÌe homc cco.onry 1s increasinglls tÍealth.'?The trade su4rlus can be used to buy forcign
rss€ts or lo jncÌease the oftìciaÌ ioteign exchânge rescNes in thc hoÌne couÌìtry's ccnLraì
bank.lfthcrc is a h acle.lelìcit, thc home couìtiy is purchasingiÌÌorc lronÌ abroad than its
re.€ipts Íom lhe sale of exports. ln oìdeÌ to pây for thc impoÍs in cÌcess olexports' lhe
home counLry has to borrcw fronr abft)a.L or nuÌ do!!'n ìil loieign cÌchange reserves: lls
rrealthìs dcclining. So iÌacliÌìil thc (rade balance is iÌnportant becaLrsc ol its lmPlic.tions

' r{rignorrih.Í,.eiÌtof rctmeLeípr-vrì.nrn'dk.tment

 toÌ the cornú)'s weaìth. we shall sec, Ìrch charscs iÌì lveatrh may evcrÌroalh.afÍe.l
., Lrm or ',hi ,l,i,o..\,",
^s Ioíoh.,l--\.1.,r cFr.r.o ,.\irodss.rL
J r.r'd luulh/.,,h, re, ur i,n..rn1r',,'. .J,.t.r .-'. .r.i...r
monitoÌ!d throughou! thc analv!is olrhc op€n econorìv.

1.1 Goods market equilibrium

Rccall the goods ÌÌì.ìrket e!Ìuilibrium condition iroÌÌÌ Chaprcr Z:

v-f . (goods markcr cq uilibrlunì )

s'hcr€,- irouLput iìnd),'r ìs aggrcgatc d eman d. I|ilreiiate .lc üìJnd in rLrn depenils in the
cÌosed econonÌl.onplanned cÌpcnditrúe on conntrnptìon and ìÌÌvejrmcnt trv thc Drivare
sector and pÌanned goveÌnmcnt spcndjDg:

],i')= .(),. r.r q'cauh) + Iír..11 +g (pÌanni'd expenditure, cì(xcd economyl

Ìdìere . is .onsunÌÌÍl{)n, / Ìs pÌanned ìnvcÍment,

í ìs goÍcrÌÌment spendiÌìg, and I is
taütion, aìl ìnreal terms.
lrade jn goods has rso cffccts. Iìrst, rhc demând f(Ì thc hone ecoÌìonìv,r oulprìt is
boosted by deÌÌì.ìnd lì.om abroad, in the torm ot expoÌts, a. Second, il is dampcned by
Soodsjmportedliomabroad,,whichsubÍìtutel(rdomesli.ourpuL.DonìestÌcabsorp
tion,.1rs, Ìs dcfinecì ai to ral spcrÌdinil bv hoÌÌre âiterrts on corìsoÌÌDtion, investmcnt, ancl
goÌeinmen! pLìrclÌases trÉVe.tre ol the origin ofthe goods or sen,iccs:

íd',mcs1ir rL,\,,rttrôn)

lo cal(uÌate r7o,?r.jtn spendÌrÌg orÌ dDr frcduce.t goods ard sen.i.cs, jt is nc.essaN to
.b'd. t"'Ir\ t..J.. I..\1.^
torr:l demard or /rorz pÌo{iuccd goocìs ând servlces,
.}.t. So it' thc ÌrerÌch govexìment
pìans to in crcasc its expe ndi ( úc b! purchaslrÌg ltaÌian nr ade nretro carriages, this sh orls
up as a riseir donestic abrorptÌon 0 3) andaris€ in lmpons 0 ,, otthe samcsize. These
two jtenx canccl out ancì plaÌìncd expendirLrre on ììonìc pro.luccd Êoo.Ìs and sen,iccs
.locs notchargc. MoÌe gencÌaìÌ)',

,vD=(c l tt n+x

(pÌa.ncd expenditure, opcn econonìv)

wlÌere the trade baÌancc,fr, is

'l
lìc terDr ncl cxpoÌrs is used irÌterchangeibÌy wj(h trâde balân.e. ÌÌr oor fÌench cftDÌtc,
allhough pla dnecl expcndìiure .loer rot clÌangc, thetra.Ìe bâlance detcriorates du€ to rhc
 ., ,: .: r 291

'.!e tun noi to lhc dctcrnÌlnanls ol eÌpods and irÌportr (anrl hence ofthe baÌance of
::r.]e). Let usasume tor simtÌlciLy thalexporls arc cxogenous and Íìxed, andthatìmpoús
::rend onÌv oD thclcvcl ofdoÌÌcslÌc outplrl orlncomr. ÌJence

]11 k\.f

:ìere'/lÌ lsacorÌÍantancliscalied themarslÌÌâIpropcnsll,v1o inrpoÌt.

:hrrclore the balanceoftrâde is

ItT-x m
=, ntt r-

::ú Ììre Ìevel olircoìne at ichiclÌ tra.le is balance.l, i.e. dl 0,fr,is

frl :
i Ì

.r ìevel of outÌÌìt tr I teìls us nothlÌÌii bout the a :ì ctuaÌ Ìcrcì o t ou qr ut, onìy the Ìevel of
iitrú atwìricìr the baÌance of trade i! zero.
There aÌe í(tru difíeÌent wavs of expressirÌS th€ goods ÌÌrartct equilibÌnnn conditidÌ,
.:.h of whlch prcvides a dìffeÌeDt irsii{ht. To snnplfy, lct consunrptìon be a \Ìnple
.èaÌ fundn)n of di.slosd/]/. income and let inleÍrnenL and govenÌnent sirenclitÌil be
::.qcnous. There it a lincãr tax ftrDction: I - lll so wc havc. : ro +.t(l lrll.lhe
- !)ds nra rkeL equiìibÌì u Ìì conLlitidr becontes
/: ìl,s + ËI (8oo.ìs ìÌraiÌ(et equilibriunNo. l)
I . . ,!,

= I(,'l and lor lhc monreÌÌt, $e aslume that the rcaÌ inleÌest rate ì5 con\taÌÌt and
hcrc I
:nuaÌ lo a. Collccling llì. tcrms in f on the leiÌ hand side afd rcaranging giver the goocls
:ì:;ÌkcL cquillbrium (ofdlljon nr the tì)Ìm: oütÌrut is equal !o the nNìtiÌtier titnes the
: \ogcn ous .onr poncnts ol dc'Ì and. Thus

(.o+I+J Ì1. (goods nìarkct cqúÌlibrium No. 2)

,:herei,isthcmaÌginaìpropcnsltvtosave(r:1 .r).^sconrpaÌcdiridrtì1ecÌ()sedeco
::imy, the múltipììer, i++r is tiNer because ol the mi rgirìaì Ìr ropen slty to nÌpoÌt, ,?,
Itusellrl to th jnk aboul !he goo.ls mrrket equiÌibriuì condilion in a thid nay. IlNe
is
:ìuÌtipÌv Lhe ìel! hand sidc ot the goods narlet equillbriÌÌnì .oÌìdi lìon by th,- denomnl
:iôÌofthe nruìtìpljer, Ì!c hâv.:
(goods ma.kcl cquilìbrium No.3)
 rl +'L'i'+'' )

pà'ied trrd' Óripui

ir
FiguÌe9,1 Equrbr! orrÌptÌ (Pan.ed iniÈÍois - l_"dlà'ler); ba
'rn'ed

'Ìhii be ìn equilibrium Ìeakai'es o:

{hcn the pìa Ììcd
s1ìows tlìat tlÌc 8oo.Ìs maÌket wìll
through savings' taxation and ìnÌport\
clemand lÌonì Lhe flow ofnÌcome nì lhe econoÌnv
arecquaÌti)thcPlanned!nj€.tionsof denìan'liu lhee'onomyìnthefoÌmolautonomou!
.ons;nìption, investnìent' goveÌnmc nt eìfendìtuÌe' and exports
We can allo Ìeaúang€ the trade balance cqualìd]:

-) .

rhe lrade balaÌÌcc jn thc sanÌi'dlailram

ar.Ì slÌoa bolh t1ìc goods nìarket equilibrìtrnÌ in'
(sce Fig.9.1). Balancd rracle ouiput ìs shown b-vlÌrr the
Ìeveì of orú put at whiclÌ export!
is dÌo('n:planned leakage!
ar" to in,porLr' rL"goods market equilibrìumcondltion
"qual
. p"""-, a;"ctions tìt poìÌú '4 i c at an ouq ì$e1 ol )'o '\r this ìevel or
ut
"'" "iruno.ì-' r'"-,n" (onuarison ofimporls witlì cxports LlÌatthcÌe is â tÌade delìcìL s
",*p,i,
I ioìding .on lta n t thc mâ rgì n al proPeÌÌsÌt-v''
to i mport an'Ì thc cÌogenou! 1€veÌ ol cxp'Jn
9. 1 tra.le b.lan ce ì\'ould rc'Ìuirc a reducli on itÌ lhe sho
rt N n equ il lbÌnìnl
as slÌoifl1;Ìr IiS. ,

,.*1, fr.ls.ouìd achiele'l ellher bYâ reduclloìr in size oìthe nnnLiplicr

be
"t-,,0.11.tr,
fir-."rgr. ,,* i',',r." t'.atc oÌ bv a in t1ìc mariliÌìal propcmitv to ()nsumel' shiclì
'Ìrop
" leat âgct Ìine' or by a iall Ìn one of the cxo8enous conÌÚncnts
or
steepcr* ttrc plan necl
.ÌoiÌìcstic clcm:ìnd (a dowÌÌÍ'arLl s1ìiIL ìn the Plannecl inlcctidÚ
ììne)
ina."" ".* tt",f," ttodel to caaÌnine t|c impli'atìoÌÌs oLrlput ard dìe tÚdc
loÌ
txporbraiscsth€
balarceol, k)rexa!ÌÌplc, arÌcxogerors chaniiein exports sitÌcea Ì1seir
iÌnnìe'1iatcì! obvjou!
leveÌ of eqilÌhbrium output, tlhiclÌ in turÌr Ìaiscs irÌporl5' 1t is not
the ans$'eÌ i\
r1ìal the úa.le balancc willbc úr thc ne$' short-ruìr eqLliììbúuÌÌì Ikx\,(\'er'
!n e\Poís bâlan ced lrade oütÌÌìt
clear lronr lig.9.2 Ìn Í:sponsc to an cxoilcn ous in cÌe:ì se '
Ìisi's b\'Ìnoìt than aclual output lhe consequcnce is that from an initial position ot
hrlã.cci lÌa.Ìe,lheie is a trade nì+ttrs atthe new e'ÌuilibtìunÌ levcl ofoülÈìt lhereaíÌI
ìevel oi oültut
thal r risc in €rpoús Ìeacis to a tradc $plus is that the fc$ equilibiiLlm
ìn erporls havc been gcnerate'l
will occur irì1eÌÌa.lclitionül lcakages e'ÌuaÌ lí) thc increasc
bv a Ìile in úÌconre Since sÂtinias an'i taxatì'm aÌe Ìeakage\
1Ìì addition to imloÌts' lhe
of outÌnú m ust bc beloN the n cir Ìraltìncccì tra dc ìe\ eÌ We hate shown
eq uìl ibriLr nr lercì
ojle\ and
tlìis siÌnplc ÌÌro.ÌeÌ, butthe kc-v nÌsjght carrier olcr to nìolc compl ìcated
us1ÌÌ8 a
wilì be a rccur€n I thc nle in th c analysi! ol the open eco nonÌv
Figure 9.2 Â r5. nerports mprov€5th€ tÍnde b..n.e

ln tig. 9.2, th€ econonry is initiaLly at goocìs mârket equilibriunÌ at point.l !!'ith an
-rtp!t level of/0. Since expoús rn.l inpoúr are equaÌ at this output l€vel, th€re is kadc
rdlarce:tlÌe),rr.line goes thrNgh poiri,l. Then there is a rìse in th€ lcvel ofcxports to
ri lerlâges are equaÌto ìnjectÌ)nr atpoÌÌt,R. The new leveÌ of oirtpút is tr.^t this lcvcì
-rt output, e-\porti excee.Ì ìmpoús (rote the Ìightwârd shìlÌ oflrÌ) and /j is tlìctctorc a
ìositioÌì of tra.le ntrplus.

I 2 Sector financial balances

\nothcruscíul s'atotmanlpuÌatÌng thegoods maÌketequiiibriLun condìtion is to!\'ritc il
,. tenÌs o Í sccroraÌ saringsand investmentbalances. Thr€esector balarces arcofinlcrcst:
iÌr. fri\.arc sccLor Snancial balan.c (prlrate saÍings net ol lts i estÌneni), th€ govcrn'
mcnl sccLor nnancial balancc (LaxaÌion net olgovernmeÌìt erpendiïorc), and thc úadc
iralancc (nc! inlcslmcnl abroad). C..., i! rrtl,Ì ó, a tÌade nüplus meaN lhal slorks oi Ior
rign assers aÌc incrcasinglr rhe home economy. Thii nÌeâsures thc incrcasc ÌD lhc hoÌd
i.gs otloreìgn scaìrh in lhchomeeconoDrl an.l ìs theretìre .eferrcd to as ncl i.vcshcnt
rbrcâd. We ÌcaraDgc rhc lcatages and injections e.Ìuâtion to separalc oul laÌation and
iÌroir the sccloÌ jinancÌnÌ balanccsrr

(jj r'r"/' lo 1l - ú.Ì .r) : , n\f :

(goodr maÌket equiÌibrnún No.4)

\iher€/'j/',s disposâble iÌrcorre, /'t' 1r r,11

I hls crpr.ssion is a ver), usefLrl on€ bccarse it highìights the flow equìlibúum in the
€conomt. One sector, lor exâmple, thc prlvat€ sectoÌ, can onìy run a hnanciaÌ .lehcit
i I n.I) br ri(ÌrarÌnrrnrn n sÌr.Ìvn t,( oÌ{ in ihr rìr\i in., Ìr,,ÍrLnÌrlJ th(nLgh b\ ) nrltnìp.nstôlÌre
rilhihaniLnderndÌhrdo.Ì\iirr..r}ÌÌrrr.inrmrndn)thrlèiih..dlde Ìi lhe Í.ond ÌnÌÈ, 1'É id{ì rl
nLtnn.t r. r, r,ind thcÍjiÌ.Ili,r Ìrtuftl,etr.tihrtr +c I

\r ]l l.,l n I.! i DÌ.1

J (f rrr Jril (rr,t n I .(-\ ì,.t
ú,r,r"r .ì Jì iif Jl:i D,,l
296 .

(ìÌÌvesting DroÌe tlìan it is savìng) lÍ anotlÌeÌ secnr the govcrnrÌÌent oÌ f(Ìeign tradr
secto, runr a suÌpìus. \\ihcncvcr lhc goods nÌrrket ì5 in equilìbrlúnì, prirate sarìngs nct
ol nìv€stment (the Ìr riva I c scc I ols lì nancial balance) plus th e govcÍnÌnent budge I s u rpÌ! s
(tiÌ€ SovennÌert's lìDrnciaìbalan.c)is rqurl to the rra.le suÌtus tÌarnaiicswings in lhr
tìÌÌarÌciaÌ ìralances in tÌre lJ.ilcd SleLcs ov€rtlÌe couÌ\e ofthe I99iX.n.lirúo the 20il(\ ar.
s1ÌolínirrFig.lT.l6inChaplcrlT:ln(h€eân)199Osthecü cnl a.count \yaj vjrtuaÌly in
bâlaÌÌce rn.l the largc go'cmnrcnl dclìcit \!âs nÌatche.l bv a ìaÌgc pri\.ìte sector súrdrLr
'Ihe
SovenìÌenr ias in cfli.ct boroNiÌìg fronÌ the pri|ate scclor. Ll) 200:1, thc currcnÌ
account Ìecordcd a dcicll ofnearÌv ó110 ol CDI and the pÌn atc sc.tor wâs in baÌancc. lhls
tine the largc govcrnnrcrìt dclì.ll mcant that the ijoveìnment Í,as, iÌì eflect, boÍowing
tÌom abr)âd. As rrc shall scc ÌrÌ llhaplcr 17, this ríav of pÌese.ting tlÌr, stâte of the goods
rÌailet pÌovides â úsctul insisht inlo macroe(onomic deveÌi)Pmcnts.

1.3 Real and nominal exchange rates

lvhât âtÏe(t\ oui.Ìemand i(Ì f(neigìr goods aÌìd servic€s arÌd the demand ol fLrreign
resident\ loÌ our tÌadeabìe frducts? TÌâdcables are the goo.ls and sc^,i.es ihat cân
potentirlll be hougbt oÌ Ítd âcnr* ìnLcÍìaiional boí1ers. üìe ohlious üÌíluence on
the denìan.l f(r'hadeables is 'Ìcìatn e pÌìccs'. U our good\ are relatjrel,Í cxpcnsn e, then
.leÌnand lrom iirelgneÌs $'iìÌhe reduced and horÌÌ€ residents wiÌltend to bulÌ iÌÌÌpoúed
8oods.ÌDo eÌ to conrpaÌetrices acr^s counlrìi\, Ì{e need to (on\ieÌt tlìcnÌ to a comrÌìdÌ
.urrenc) l i.e. !!e want a neasuÌe ol1Ììcc conìpctitlvcness':

/r p,Ì.e or to,e isn goods e!I!:!1f4!m!Mctì,1

pÌìce o horì( goo.ls
t,..
- t, Ori.c coÌÌpetiti\eness, ÌcaÌ cxchiìnge ratel

whcrc/J' isthe loÌeiijn pÌìce ìerel, ir i5 thc home price level ancl. is thc norÌÌ1ÌÌrt exch angc
ralc nrcas!re.lnsthe numberofhonre cutrcn.! unit\ peÌunjtotlorcign cuÍencv:

Io. units olhomc currencv

(ÌìonrinaÌ exch ange ratel
one unìt olnÌei8n cutrcnt!

AnotlÌcrname turr, is rhe r.d/ d.àdlrÍ.,ltr' bec aure ir rneasurcs LÌrrrrte at which rlorÌìestic
and loruignjooÁ exchârg. Ior cach olher. Consi.leì a Mars baÌ, r{hich cosrs 30 p€nc€ iÌì
lhc LrK an.l ìs\Lìme that rhc uK\ cxchange rare ìr 0.6 (1,/c). lI rhe pìice ot a Ìv1ars LJar is
cll5i) lìÌ Cerrnanv, lhen lhc ÌcaÌ c{change rate í equal ro o.c (\iÌÌce, = !.i.l]!'r - 1)
ÌI lhc prlce ol. \Iaú baÌ goet ult Lo c0.55 ìrÌ Cerman) but !s sLill30 pence ir rhc UK (rnci
lherc ii no clÌanse iD the nominal .xchanSe r:te), ther thc rcaìcxclÌange raLc Ìs now 1.1:
the pri.c ol. Ìv1ârs baÌ ìn the UK js ìow rclativeto tìrat in ccrman\ On obscNlng â stritt
iìr tìre lI(\ rcrl e\change rate fn)m I to l t, we lvouÌd say rhat price conÌrcrir lenes! iÌl
the lrK had riscn ânclthat dre l,'K\ rcaÌcxchânge rate hed depl(ci.Ltecl.
Delrni.g lhe rÌoninaÌ erchâ n gc Ìatc otthehome counrry as the units oíhoÌre.ürenc)
terunjt ot lor€igncurencv ì\ onlv aconventilrn The offosjrc conventìon is uscd.ìs wetÌ.
Thc cholcc of corÌ!enti(rr .1i|ft:6 bv.ountrv an.ì eren a.mss diilerent econonìic\ booÌs
 :..297
Ìable9.2 DeÍnn!the ele and mÒvênr-"nr5 | Ìhr ÍnÌr nii.r.ran!€

r!(lgetsurplLb
DopÍe.iâtioi/ app.êrãrion1

, =: (:l r -, r:l

:n.Ìartlclcs. ÌithehoDÌe countÌv isa crüozone country (sâ),ItalyÌ rnd rhe nÌcign cou|1ry
\ the I ISA, t hen â.corcìing ro thc ebovc dc lìnition, Ìtâlv's nomi :!Ì exchange Ìare ìs í
=:
rÌ eur.x pcÍ dollârand an jncrcas. in e mca|s th.torìedollaÌ puichasesnnre eurcs,Irhi.h
mtÌics thirt tlÌe dollar has bccoDrc ..ÌaiiveÌy Inore valuable ud the eurc ìess vaÌuabÌc.
I ir snd thit the eürc has,/er,"rtua!,/against tlÌe cìollar. Snnilarly, a.lecreasc in I ìs an
rpprc.iation oltÌie eun) (scc lnblc !.2).r

I 4 Prìce setting in the open economy

\lÌer delìninii thc Ìcal er.hange r.te, \!e Ìü)k next at hor! frices aÌe sct in tÌìc opcrì
..onomy. (lì\'cn lÌral .oÌÌrpânies norinally opeÌate undeÌ impeìrèct compcLirion and
ihus face a downwaÌd-slopirg d€rÌìarÌd cuÌre, Í'e 1Ìl asrume that nnns seL bonrc tricci
oÌÌ tlÌe ba5ìr oíhonrc cons. But when it coxres t() n)ÌeìgÌÌ marÌ.iets, two aÌtenrarivc prìcìng

. thehrst h o Ìì c-cost pri.ÌÌt isth.ìt1ìnn\ set expoÌt prices ìn the sanre ilav as lor
goo.ls Ítd al homc, Le. Lìased orÌdonÌe\tic costsl
. thcsecorÌd lvorldtÌjcing- is LIìrt lÌms s.l cìpoÍ prÌccs bascdon thc prici.s of
5imilaÍ products pnrdu.cd abÌ!ad.
lnìagine that theÌe ìr an in.reas. in .osLs ln the hoDc country but nol abroad (ind
assunìe thatthe nominaì cxchângc Ìatc rcnraiÌ1s un.hanilcd).
. UÌÌd€rthe húiprìcìng htpolhcsis,lhc priccs olhome\ cxpoÍs wouÌd ito up r€1âtn e t.)
thc prì.e ol ure outÌrut ol ilrms ahfoad.'lhìs would rcducc h o oì c .ountry .onÌpetìti\ e
nes\ and iepreseDt a Ìcalapprccjallorì lorthelÌoÌrì.È countô,.
. LÌn.leÌ thc s.cond, honìe pÍxhìcers Ì!ouLì not cha n ge thelÌ expoÌ t trices bccausc ÌrÌiccs

charged ht lì.ms.broad hlve not changed. Ìn this case, theÌe js no changc i. lhc
l! = lt. prìce conrtclitìvcnes\ ol erpoús But we r{ould cxÌrcct thìs Lo hâ\'e an ìmpacl on lhc
abìÌiq ot lrms to coÌrìpete jÌÌtematidìaÌìy. Ìl lhc (osts of homt fiÌÌìs Ììsc rclaLÌ!c to
theiì compctllors b!t Ficer aie unchanged, thcn rhe prcnt maÌgins ol homc llrms arc
. irg a shift s.Ìueezed. This mcrns that home tìrms wilì bc at a rcìarjve disadvaDtagc in lhcir acc.ss

r ÌtrlrouldbÈ.1êarilÌrtdi:tusi.f.r'rÌin.irrhr.r.h rgeúre oroILÌÌ.ex.harÌt:elarebenr!tillÌ .Ì,ldr

.n!mak.\r.nreÍìrinnn.LÉ.rÌ\rhnlronìrfin,ni\hciDgrsed Inord0tomnìiDiz..onÍuion.irtrsaíesrrl
rv.idulifgihr t.Lms r* oÌ'Ìanlr'.r'Jri31r'!r'rny irr rrrrridr 1o rh.ü.hif!r rÌr.. ÌrrìrelreL ro 5!.k ro rÌìe
têrr\'iÌÌÌ,Íririjofiord.prÈ.ÌaiiôrLOÌLlhênÌcleÍnÌgnrdir.Ì.rc.hrng.rifih..\(rìrfgrÌr1.'1.Lh.ren5
{ìetiÌuiúÌf oÌ Ìr \.úr.rion'
 298 ,,,:.,
t'r intemaì frnance 1o 11ìnd turure inÍestüen
or.f,er è!,crvicc A.h""*,,,;"
petìtivenes\'iriÌt be redu.€d. Thi\ nrcâns tha
:,,;;;;,1flïflïlï:;ïi::i:'l.ïlïlïï::l
nesj anc,,he Ìca, e\.han*",",",,",",,",,,"::ïil,a".:,iiiiii::l'.:L::,ïï::::'ï

mDrrÌìonìvüed meeÍtre or compe l itivc ness s caacd rclati* unit

-.oìre and ÌabouÌ cosLs or
RULC defineci as tòlÌoÌysl
's

RlrLc !.I9g!lAtlt!9tìr costs cipÌcssed id holne cuncncy

= honÌe unit ìabour.o\r\
ULI'e
(cost (.om pctitiven essj rcal eìchanite
mte)
A rÌse in lìLrt.C irdjcatcs â rise ìn toreìgn cosis
retativc to honÌe\, i.e. an jllìprovenÌent ür
horÌÌe's corÌrprtìllvencss. A rise in RUr.c is a
reâì clepr".i"'",, , r", t,, ill,ró irì,""i
""u

1.5 Evidence on international integration of goods

markets
lhe lwo fricìnil nììcs can be corÌparcd to the so caÌled Ì aw otone
lìicc (LO,,) ancl Ìo tl,Ê
hypothesis olpuÌ.hasing po{,cr paÌjlr. A.coÌding lo
thc Law ofOne lrice, the coDrDìon
.unency price of a traded sood is idcntjcrÌin diter.n
*_n,*,. ,". g._,,; in"i,,
""),

The krgic or thc L()p is \rraightfonvard: irÌteÌnatrorÌar (rade

ílrulcì have the ertèct or
eqL'ârì7ing prices ror lhe sârìe good ir cliuereft
coLrÌÌtÌics sirce pronrs can be oÌade b\

i,ïï:'i:i,,ï3iï:1.i1:ï:,iï:il'.","#iï,,:l:fi::;*;:',*ll::;:l*,:lÌ;:;;
countrjcs, thcn this baskerotijoods wilÌ have tt-
in r,Ìe wor,.r,nu o*,"."n i. * no_ì;ì:
batÌet olBoods thatí comnnnì lo connüÌcr, 1n
;J;fï:i[ïj:j,],ï;:ï:ijì[::Ìï:ïiï:
both counh.ics,

/ I- . rJ,.., J. \
u = t,'c
:r0=1.
(a byn ute purchrsi nij poÌ!c r parit\
)

1",' ,,.,,,,, ,Anur r, ,.,.\.r<r.,.\.rr r:r. rrL,,,

.n.r,,.r..I r.r .. ,on,;.'i.,o .,.,.ir
"' " 1"" r\cd.t r.. -\ ..-,i.
lÈ cír.úìnÈ,lr,r i\ a ..t r,'. lo, ,.,r I i.,.i.d,;...r ,,, ..,, , ,,, ,; ,;,
.r
rní a\ i\ 0ì' a* .Ìr nr rrn.e br\r.r ÌìeJsuÌc oI úr Ìclr .x.Jrrnge rrre, Lonr.n.ui*,a.v ,.mpr mrs
LJ\'r rj\' i. lìÌÌL(ln a dlleÌioLaf'n'flrotni!
.,'ìpcnnÌÈn.s r.d her.eâ r.ilaÌ)rÌe.r,ii.n. 'h
 aÌì countÌles and thcrc wiÌÌ be no supcíìormiÌ prolìts. Hence, unÌìke the rÌorÌd prÌ.ìng
hvpothe\is dìscussed abovc, whffc cosls can dilfeÍ across countriet an.Ì !roiiL nìa€in5
c{n expand and .on!Ìacl, in a orÌd ol nbsolute Ì)Ì,1, and Ìrcrfcct compciÌijon, Dcilhcr
frice , Í, coÍ .om fc( i tircrÌess .an vary.
TheÌe is a great dcaì ol el]lpìrical cvidcn.c thât neì1hft rhc i.OP nor absoÌúLc I,LrIr arc
rrue. TÌanspoÌtcosrs andbarriers tolnlcInarionaÌtradcwiìììnrcÌfcrcNiLh rhc LOI,and rhc
presence of non-lradcd goods and scn'iccs ÌÌÌ the corÌsumptlon bundìc and diltcrcrÌ.cs
i. consumeÌ Laslcs arross counlrics $rììì prcvcnt tlÌc absolulc prúchasing powff parity
r(j hvpothesis lrom holdlng. tÌo(,c\.$, lranspo.t.oÍs and úade baüies are roL bìg enough
to extÌain thc dcvialÌolìs froÌÌì LOI lhal arc obsened. NoÌ n thc rtc ofnon tÌa.lcd goods
ebìe to accourL tor lhc faiLurc oi absoÌuLc lii,P to hoÌd. Ìn evaìuatinij the accumulaied
ernÌence,ObslI.ìdarguestlÌat'lalpparcnlìy.onsumclnìarketsf(nha.tabìesaÌejustabout
.P!Ì(rr',1 ' n. ior d).\.r'u " ,r..Fl\ or 'r i/l -.
:r RIrIC is a Ìcil IÌr facl, a ccnlral part olthe €xpÌanaljon rcsis on thc pcNasivenes olìmpeÌlect compe
li1ion in ìnÌcrnatlorÌaÌnìaik€ts. Mosttradcablcs both goodt an d Jen,ìces aÌe.1ìffeÌenti
itcd products and producers purnrc pri.ingstrategics to maxìmize thelr ìong run prchts.
lhjs cnlaÌÌs, for erample, taking accounl of tlÌe impacl on custonreb offre.Ìuent changes
jn prlcc (c.9. in respons€ to changes in thc ÌìonÌidaÌ c{change Ìaie) ancì \etting ditlererrt

'rrlccs ìn diflcrentnìarketst.Jtakcad!antagc ofdìlfcrcnces in theeÌanicity ofdenÌand. Arr

' 1i\. .'r \o Iriiirg rr., ". t, í1.,1b 1 'rr. 'l 'r"rF. l-\ ' r'
"maìket
€\ ÌdcrÌ.e of tÌìe widespread use ol so .allcd pri.ÌrÌg lo an.loftÌÌe nìcoÌÌìplete pass
ÌhrouglÌ of exchange rate.hanges into prÌccs: \Ìorld pÌlcnrg' inco{rorâtes both these

Ìt seeÌns that Êrrs puúue priciog Íratcgics that lie be leen the two tìlteÍÌâti\,.s oi
horÌìe .ost bâs€d and $orlcìpricing presented above. ììoúunately the nì.ìin r€sults of thr
niacro m.del do Ìì.,tdepend on Íhicholthcsc sÌmplc pÌicingh)potheses is used:the$'at
tir:ìtÍÌocl\â d policy re\poìÌ\es irc tranïìittcd!ari.sbutthe cÌu:litâtil'e results arc siÌì-
il.ìr. Result\ are only !eii dilferent 1l a modcl of high \' integrated perfe.tly conrpctitiÍc
nÌarkets 1|ithout nonÌiÌÌal úgidities or ìncrLia ì! adopted (LOlplu\ perlect cornpclilion a5
tÌÌe nìicroecorlorÌìic lÌl pothesisi purchasìJìil pos'cr paÌitl as the nìacro 1ì-tpol hcsis).
To \ee the dllference iÌÌ nÌacro ìÌnpli.ations bctwccn the 'següìented' and
iintcgralcd'
1ie$s ot'irÌtenational goocls nìarl€ts, .oosìdeÍ the lmfìÌcatn)ns ol a chüniie iÌì the nom
nâÌ €rchanite rate under the dilì€rent priciÌìg rulcs. Suppose theÌe i\ a depreciiìtion oI
hoÌÌÌe's noInlnal exchange Ìate.

Lrndcr homc'coí bascd prjcing, the domestìc cuÌrencl pii.e ol cxporls js unchanged
and Lhc pÌi.c Ìn Íorcigrì currcncl taìls. ThcÌe js a ríe 1ÌÌ ho e\ compclitivcncss and
rhc Ìcal cx.hangc ratc deprl:ciatcs in ìine with the Donìinal ex.hange ralc
UÌÌder world pricinii, the pÌice iÌì lori'ign currenc)'1crÌìs is kept conÍant (i.e. irÌ liÌÌe
wlth the plice prevailinii nr ihe e-\port Ìnarket). HeÌìcc thcÌ. is no change ir relative
prices \o pÌice coÌnpetitivenes\ reÌnâins unchanged. Ho cvcÌ, because ol the norLiÌÌaL
l epieclation, the pice of expoús nì t€rrÌÌs of hom€ cu trc n q h as risen. This Ìaises the

r obíIeÌd12olÌi aiddbeÍ!anf (rrelreÌ (Ì9971

 300 :

tDnl margìns of hoÌne nnìs r€liti!e to ttet comfctitors an.Ì home,s coÍ .ompcri
t1ç.ncsshas ìmpnr,ed.
.lì!contÌasl,underthcl_OÌrandabÍtuii,ttt,lhciniegratedgoo.lsrÌartetnìcan\ihâr
the clepreciatiorì i!ìll bc iÌnnediateh otfset by a rise ir thc price oI honÌe\ goocts Í)
.s to bring conÌmon .urrencv pÌices back ìnro €qualìtl. Thc nominal e\chanSe rare
changes,buttlÌereaìcxcluniieÌat.qlrickl)ÌÌelcrtstu.iq'Lhrougharbitrasc(buving
clÌeap, sclling clear) Ìrì the goods maÌkct.!

l'eL onc ol the big fact\ ihat hns cm€rgecìsìn.e the eÌa otÍìo.tjlg cxchânge rites beJran
,'\, ,v ri , r.\ I i. t.\,., t., , ,,,m ,,-.t '
ÍÌuctuellons in ÌcaÌ cxchânge Ìatcs. I o quore ObÍlèld\ eraluarion oI the evidcnce: ,Real
exchangc rate variabilitv iends lo be ilÌÌÌoÍ â perfect reflcc on ofnonÌnÌaì Ìatc !ìúabjì
]tv, r'ith clÌanges i. the two ÌaLcs hlghl) concìared ând jrdcprn.lenrJ]ìovemenls inprìc€
levels pÌayins a mlror, ifanÌ, Ìolc'1zll0i: 12). So an rpÌrqrriatr,ÌnodcÌ \lÌouÌd a.conrmo
ctatc lhis lact. EjLhcrthe home-.on or wortdprlciÌìS tes,oulddobur(,enraìlsli.ktoth.
honrc'.o!t based prlciÌìg rule bccause it convcnlenuv alloa,s us t{) usc th€ reâÌ cxchange
Ìalc dcfined in tcÌ ÌÌÌs ot' pÌ]ce .orìpetitiveneris. 1 he asuÌì pl ion tlìat p Ìi.es are sct bl hoDre
cosLs iÌnplies that the pÌice lcvcÌ ofhonìe pÌoduce.l goods Írd ìt home and ìn lhe expoÌr
markctistheramcancltharthcpri.eirÌhomc.urre..voÍnnpoitsisserblthcprjcein
tìì. rcÍ ofthewond (i.e. bycons iÌì those econonìies).e Hüìce we harc:

t. r, ,l .
-'1oo,

h'hcre// isthc mârk uÌr.

1.6 Exports and imports: volume and pri(e effects

Ìn lhc home mark€t, homc goocts Ìrìrh pri.e I conìpete wìth jmport, (in home currencv
' ,ril'., /.. 1".r,,t," . l it,,nirt.,.r,.
íl a;". Ìn export naÌkcts, honìe prcduccd iioo.ls (cxports) ,\,jth pÌi.c I c;mpct€ with
=
iloÌld goods pÌlcrd (jìr h.)mc currency te rmt at t.d. C\rce aAâtn, the ÌcÌati!e nri.e is our
,,.'' , .,r' rt,r,rl.,r ,r I.
retle.l the Íte oI .oÌnpetlrivcnels Ioì exportr. our sÌìire of wo.ld ourp ut !!itÌ dcpen.l o n
I rhelerrÌ!(Jk.Ìlor.oiìr0.1ìa5rLgIDriirilìâLrcqtrÌ.!tÌÌ.r

'0=k
\J..nna.t
Ì'h?Le À tn ihii.arr n!, i.1ì.n!e úr íÌcqtrtrr\ r.r rl]êinr,ÍrrsLot..pthenrroÍh.dknl
I lrq r( I trËl
nr{rì1.}r a.DrÉni.
"' t
rrrHin.Ì.on ((fr\itLrr!.iin ) orÍ,a!e\j j! r1r.\ rr dorì.ír..urÌrr.! tctrfj, rnd erNÌr
I i.era.!{ srÍrrr rrFslrìetrhJir.ÌnbÌêtÌÌrr[utoÌerÍjJrgiìiÌ.ÒÌ ]
 301

rr: nrt.rL!. tlr. maÌg!ÌrxltÌ(Ìre!\ìt) f.iIìf., l.'1r,riÌl dtÌ)endon, A ri5c L. /r rìlÌ

i!Ì
riiic !ôltrnrr oI good: e\f(!iell aÌrd dcfr$: LÌrc r.ltrnre ol loods nìf.rLcd at e.\
Lhc
l!.r.1.lhoÌn. i|úrDt.
Lh. i.nrinrl nltri t)a c\tt)11r jI honÌr .url.rì.i tcrms. I. ii t( uirl 1! Lhc l, i.Ì: ifLÌtr
ri.1Ìr.,tstlfi.!lh.\oÌuÌÌ! Tbe\oLrìÌÍ.)1iÌ!.1s.inhee\|res\.das.iÌri('o 11)rld
rrLLtLlt rrhoclhcsÌrx!:u..lLoÌì-t\iBtrÌ,ìldrp!'rd5l.rl1j\el\oD.omliliL \c.r$aiLl

, .1, r.1 Ì .rlrc ìrr l

Ìo!ettlÌ..rpori u..1Lo.i.Ì'rlterr\.\c.li\'ldr'c..ÌrsideÌ)lt!rraonr$lictÌjceÌe\eL/'

'ÌlÌiril!roilrìro,L\ \/ Ì,rlr.necxrrdÌ.] Lrnr:isLhttricclrd.\'1,,,=1'rtiÌnc\Lh.

I rnuÌnr .: ìÌnfort\. Ìir, , .,r lnt!rn.tlÌe\oli,.ì!'(lr|..d\!rÌ11ìrnrirgj.eÌtÍÌ)eÌriiillo
Ìtort.\hirh\illb.iì..!iLil1 tun.ti(Ìroi..trrPcL llrc.e!\,nnio.theÌr\eÌ(úlonx's11r

r mfoÌr! irÌ niÌììif i L.Ìm\l

I' rìt ) ' l
nri!r:rlr nrÈn\ri1 ir jirÌÌì!r laì'rPrrLLÌla'i

l.lrrifclr. inr|(,Ìt trn.lr!1nÌI..llc ir!.\t.|\jdeÈ.rrlì sidtL\ l'

rrj = 1: rr ir,
t l

l)r
=/ül|)|/1
I
l/qÌ I /j

hl\ Ìì.in. rh rr rirr ll iìr È.i r.e(ir Lr:

BT .1 ..) ittn t t.j

: Ì -!'r.. l]\l,i]r

!\..rn.or Ì.tlÌnr nÌ oÌìr olthi itnr\tlt)11\ ltt LÌut it tiì,'h!! n.iÌ!ts nii|..hr|tcÌ
l\ lìrt,lit. r nì! ìi s LÌr. L.ad. hìkÌrrel
302 :

Iìbt, Ì!e want toÌnowho$Ia.hangenr á aftectsthc tÌade balance, lÌoÌc:llng the lcvcl oí
output conÍ.Ììt.r0 We.liscuss thc Íll consequences oia change ìnl] ior thetr.de balancÊ
(ì.e. oÌr(€ outpul has adjrìst€dì Ìn the next ntb\ection
Itis not obviour lÌom the expÌcssion fdtlÌe balaÌìcc oltÍade whattÌìe elfect ofa change
Ìn the real e {chaf ge ratÊ (ÌÌ thc lrade balance is. Ì hc Ìcaí)n is that ther€ â re tüIo eflcc( s
oneisth€ volljmcclle.l atld thc secondíthe relatìvc pÌice, or teün\ olúâd€, e1ïcct The
volume etìect is thc effect on thc volume of e\ports a.d oi irìpoús due to a changc in d
Thìs i\ unaÌnbiguous: a rise in, boosts the !ohüne ol cxÌroÌt\ ('iÉ) ises as lÌomc latcs !
largeì nrare ol r,ond outputl arìd reduces the volurnc of irÌÌpoús lr7, (nl lalls as Iome t
ÌìâÌglnal pÌopensit)'b import faììsì. But a rise in lrwìll Ìaìse ure reÌative pri.c oIa given

A.otherw.ì) inl] is to usethc.oncetì

of cxp Essìng thc 'reìatn,e PÌice ellect ofachanse
ot the teüú oftradc. The tenns ol lÌade ìs.leÈÌÌed as lhe PÌi.e olerports dividcdbv dle

I
ta,,
- 1"
$'heÌea trÌcrcascìn + ìsdnimfÌo\enÌerÌtinthctc Ì ! ol tr.d e bccnusc a gÌcater lohüne
of lÌports .in bc bouslÌt ior a gneD tohmc oI eltoús CoÌì!(rscì)', an iDcìeâle iÌì ,
Ììeâns a.is€ ln lhcpÌ1.eolúnpoÌts relatireto c.poÌts:itis a dctcrìoralìon in theterns ol
tÌa.Ìe.Lr for a glvcn roìruÌìe ol ìnpoús. this ltiìl pÌoduce. de.Ìinc ìn thc LrâdÈ balance.
Ìn ntrnrnarl, gìven ilÌ€ $'a-v lhatilnpoúand cxforÌl)úces hat. bccn dclìne.], a úse iÌì ,
..r" . 1 ' lr, ' 1 ,n "
. Ìi\e in pricc coÌnpetitireÌìess
. dcprecìat1{Ìi oi thc lcale\changc raLc
. deteriorntlon ìn the ter s oI tÌa.le
. rlseìnthereâl.osl olimforts.
The outcoÌne of a change in thc rcaÌ cxchange rate foÌ thc lÌade baÌance is therelor.
ambiiauous. 1orÌg as the volumc cllccts are \uìlìcìcntl-ï slrong $ as n) ouhreigh thr
^s
counteÌvájlüìgtcrnrs oftÌacte elfcc!, LÌrrn a ÌeaÌ deprecia llo n la Ìjsc !D d) i e anirnprovc-
nrentìn honÌel pri.c coÌnpetitivcncss ttjìÌleadtuìnìrnprotcnìcnljnthetÌa.lebaLâIÌcr'
Th is Ìesult i\ retLe.tcd i n the laÌÌro lts NÍeshaìÌ LeÌÌÌer.ondiÌìon, ('h jcìr tiate\ thatâs long
atihe m olthe pri.c.Ìasticity otdcmand ftÌ expoú\ ard lhc prjcc cìaslicity oí.Lenand
ftr ìmpoÌt\ ex.eeds onc, adepre.Ìntlon tliìl ìmpt)vetlìe b.larìc€ otltadc Thc simpÌi.itt
oftireMaÌslÌall Lclncr.onditlon dclcndson the a\str\Íion thal goods ãrc in teÌfectlt
elastjc süpp\' (ì.c. Lhc trìce does nol.ha.ge âs output incrcnscslr) and lhal e beiain in

rì l\rcIo.trih.Í'oniÌ,rÌ,artiaìf.LiÌrii\e,,)ril ;)1]
ÌraìúbareÌLnepr.f|hvÌ,,the\\n..fsi!(ftrithih.r\i{Le..erÌútxrodffÌdrpr..ütiuri:i$!(iJi.d
{ithâderenoúrionoih.rì.\tc'ns.ItLxd( olrst}(nrndR.3.Jl r20|01J).
:r lt\tx)ulrLben.ieftÌìaLÌhrn.i,n,8r$uú ion5LÌúlÌrrvrr..f.LdÉinrlnltlìatnÈnhêrè{ponnoLiütort
ÌrÌiLc\x.èittâiefb!.Ìrâ.gcrifir(Ì.1Ì'mÈ50Ìdhnhnrth.lfar.f\aíation.ontideredl.Thisisdr?tÌ iti'rfr
1$! Ìan rnúfe!ìarcpr.rioidÌÉ!mpÌ.i!Jibha l Ì.rn.rrondit rürlarppÌreÌaíi.iti.sififlifÌr i ÌrrÌt
xÌe ran\$a!5topÍrv.ih.\lrrnìiÌÌ1.Ì.cÌ.!fdjtnfr ontiJnìorinnlìrerpFendixtotlri\!hrltÌì
 103

ttadcbaÌanCe,bütthecN.ìâIjnsighlotconparins|hevo]trnìewiththeleÜn\ofltadt
r'ire:am
"ïïil:,ï::ìïiL:ft''llLstratesho !ì1e\rarhaÌL-Ì.€rnerconditionworks
,,,,. """ :,'",' rih:"',;l : il ", ;":r
r::.rrge ìn /.
N h rrc tqu 1l lu luu lhe
l"i.ï ;,-"
'LL

;ÌÍise of 1qônr loreign rcìatì\'e

1ô r'
elJ5L or oÈrÌì:

ro doÌneslic pÌice!:
"I
. erporl lohìnre rites bv 0 75 to 100 75;
. impoú \olunÌc ldlìs by0'50 to 99 50;
up to Ì00 195 (snrce
. ,i"r"uO'n"tiÌ"|]-'srise\br l%' pitdÌing tÌÌc iÌÌrfortbilL
I Lìl !995=100.495)
100 75 100'195 - 0 255'
. r,,,n'r.*",,n" *uÌr* otÚadc ìnrpÍrvcs be'ause Bl -
at r') 25'
elasii'itv wat coÌìsìderabÌ-r iower iust
lf. o the other hâncì' crporl deüand
l"i \'' '\tr''r
r., I.,.,,,,-",-..,8/
''\r'"h\nli
l^; ,:,.ì.,.,i' ",
rhc elasticltics used úÌ the n,"
i.ïìì"-",,-,,"
L)"--'.h.'lll'jljì,:i"ïì, i . i,,. u* ,,r^, '"n",.ur
" ," t*ja.
ironÌ eÌnpirjcãr """
'tüdics. ;L'",,1 ,., \ ""0 u
,,Jo,.r.,,,..'".,, ,.": ,.
-,:,,",'t,r,',',.,,.",",.,_.,.,
_

ÍÌìnrthe surn of the price clts!ìcilies ot '1emôn

;;;;"""*,rr, ?-*Ì:f :il::':1"*iï.iliï ;ï:ïlïJ,,-.i:ïll ïl
ìii:i::il;' h,r,,r',
'|,.,, ., d'''o''.,',,,_,.,,,,,,"".,^,,,,','"'
'$''r" " ';ìl .,,,,-,,,.,,.
gi\'cr
r\.hanccrate, r' lhe tradebalaüce'
ancl
..,.,.,,ì,,,,, ,,,r,.J,, "'i'l:'.-'
r'roil iÌ'\
,.
,l:;,r.',|Ì.,,,, r'' : \,
,.^, É",",..",J,.Ê
"L'r '" _
t-' l'ir i
n, ''"'5" "" i 'i l '
I

- ; ': " ;';:' l": ;:

:1"'':
t:,.ì ''
,i::ì,";;ì;ì';;;"ì'"'iarÌon rhe üa'ìe bdreÌìce caÌÌ wor\cn
!r 1ì1e sÌÌon run' r(Ì rwol

,:..1Ì.ììr
'-"" ':';i.,.:,;:: :,"ï
tPttu\LnrJr.l\ I tt lrìlt r lnÌrqrtn\alue
:^"1
.. LlLLJtinrÌ l\ rnrtiJlÌ\ srìr '
...i:..tll
', ,--\ ,','r:,., l::.:"ì1,.l;;';"
"',*'''' i"",ï
\
:" j.: l'r.':;,::':
;i;i';";.J the;,' traLle bâla t{orscns
'
:rtl riscs imrnecliateì" HeÌì'e 'e

D.ÍìL!5.h(Ì99b1
304

1.7 Output and trade balan(e in the short run

The condillon Íor goods nÌartrict cqrriìibrnrm iÌì the oper e(onomt .a. bc .rÌriclÌe.l b\.
the nen imÌro.r and (ìpoÍ fun.tions ln r4Ìi.h irnports rtrcl erpoÌts dcpcnd on the real

I =.11 r+r,l .l+

h sunrÌnaÌ!, aggrcgalc dcmand ftr.toÌìcslic olrlpul ls:

t!) ltr.r.a,y.).

. lhc maqinal propcnsity to spcnd on doÌÌÌi\ti. output lies bet\\een zeìo and onc.
Hcn.c,Í'c haÍc:o < + - Ì:
. j.Ícslmc.l is Ììcg.lively rela t€d to lhc re.l irúereÍ r:ìte. He ce. + ._ O:

'Ì fr", r" Ìr., Lh ! , I,rlu.r'

'.'u\ rl, .,. ,r..r ,,.1" I. n I.l
1lÌc role olfoveÍnnenisÌrendjÌÌgind tâ\atií)n areÌrâticâllv unchanSed tÌoÌn the cl(*ed
c.ononÌ! and r.e not strcivn eatÌicitLi above. The o.ì) cxrra folnt to not.È i5 thatgovcÌn
nìent spendiÌìg on imÌroÌtj cl{)es not adclto thc aggÌcgatc dcmand for domestic ourfrn.
Wc .an noü delìne the open econorn) veÌsion oI lhc tt c(rrc: the l5-{ì.I 1s rhe goods
marlict .quilibrnrm .otrrlltion and repre\erts the coÌìbinaLio.s of t1Ìe iúere\r ÌaLc and
orLpul at s'hlclÌ doÌreúic ou4trú i\ equaÌ t{) the tlânncd cìpcnditure on donrcs(icaìl\
pÌoduccd Soods an.l\eivice\. The eq!atlon f(n the tS {À.1 cuÌvc isl

o+/, j ÍrÈ ) (opcrÌ economy IsXÌÍl

Thc di tcÍcnce bet$een ttre cÌGecìeconomv tScuNc and thc open ec(rn)mr /\Ì,\Í cur!€
Ì riÌ_ì'rh . i b. .r '\. ..,l-.,1 {..r.t1,.
(l)urlÌ! is the Ll,\lÍ steefer thân the i5.uNc? Ìhe re!\o i\ that thc sizc oltlÌe nlrÌti
tliff in the open econoÌnv becausc the rnârgiÌìil p(ÌreDsìt! ro impoÌt is pos
is rcducecl
iLivc. lhcre is arÌ adclitìonal lrurce of ìealingc ol d€rÌìa d aìvav lrom home pniuced
goods: ns inconÌe rise\, rút onlv do taxarion arÌd savìÌÌ$\ úse, bur so docs tlÌe leveÌ of

How,i:loe\ the riIM cutrc slrifr irith a chrìrìge ìn rìre ieaì exchiìnge Ìaie? A risc I
(21
, ls a depreciati{)n of hoìÌds rcal cx.hangr rate (i.e. an impr^,cmcnt i home,s prtcc
.onìpctitivene$). SlncerreâssLrmc thaL LlÌcM:ìLhall Lemer condìl ion holò, this boosts
 305

1ìiÍid!biin.riì.i.9!Il!,ìrcdcmrn.l.lì.Ìa.riÌrteÌe\tirle.lood5.rnrkrLcq'lilib,junr
n llhc(lo(orr!rnÌahl{hrrlLrdo outiÌú 1 L5eiÌrtdliitstlÌr1-\rI/(.Lhc.ighland
ì ill in /i dìliLs !L l. Llrc ltlt
rlr Hor l,rer tlÌe1-\\ìl (Lrnr 5 r il riiLh a.lri.g( i. |(!l(ìoutlüt,r __l.\rii. iÌì ror'ld
L{rlput../,ÌiJp il,Ì,Jr.ìi\e5tlÌed.rÌìi.di.r(\torr5lftrnrtheh(ÌnecorrÌtr\'1htl.flrclor
.,Ìrt úÌt(r.ìrat..Sonn\nÌ!rlrtrquilibriLLmrril o.rrLÌrlrhigherle\elo1oútp!Ì:.risrin
, nÌih\ ihc lr,\ì1 t! uÌe Ììilht.rÌìd i lill i. ) shitls iL Lo lhe lttt.
ThÊ n rrlÊ hrlân( Ê i\:

DT\ü1
=.tt:\' Htn l) l

jiìd ji( .n. rhrtu: .rr jrÌiti th{. Ìtr tL ot.LìtÌrú rt 1!hjclÌ tr,ìdc ls hilan.ed.I rì, $:

lntlÌeÍightoiÌi.th.rri!iìÌ,eLÌ!dch.itendnrtÌreLeillh(n'iialÌellenÌÌnu\,\ri\t
inocrni lhc le\ rÌ ol olÌttuÌ .1 nìri.h tÌrde it brÌrn(td rnd .
:ÌÌ pri.c clnìpclltn.ncss
rah.r lc\cl .i 1\1)' d dinr.fd hr! lhe sdrìe ette.Ì:irÌ ra.h .rÍ' thi r !, LirÌe \lÌ1ts nr thr
rlBht irÌ th. ,r-\-\,\ I dìi3ra
Lirrlier (in ll8 () li N. .:,r:,Ìil(l xt lhe c(Ìit!uerÌ.e\ k,r Lh. ltiÊÌ oi(trúput lr lol lhr
trrlle b.ì1.ìn.r ot i .hiìnlr irì cl.gcnou! c\toú5 \\:e.iìn .on l(!)k ìt \hrt h.ppr|5 Lo
.rú|nt rÌÌl tlÌe tLìir bir]dÌ.. rtlì.n Llrcrt 1\ an r\.haÌÌ!r r. L. rira.ge (Ì a clrdÌ!e iÌr 1!oÍld
rúpnt. aiortrilÈr.rì .\.1Ì.rÌS. ratc deÌ)Ìeci.ìúÌì llÌt L..n.Dr btgnb iÌÌ tsoods úarkct
.quil1ÌrÌìLur,ìÌrd rillÌ Lr.l.ìn.rd 1Ìrdr al.l ìÌì hg 9..J.\\iLh l\cd tri(e\. tht l.prc. ition
ÌÌÌ(tr e\ I)rilr..nÌp(titi\ rLìrss i.iÌ o. the u\urÌ risufìfLio. that tlÌe \lirrshi Lcm!Ì
..nriltnÌr holl\ üillri,is.nilcrtoÌlt.Thiri\tlÌe f.ìí iÌ .itrct(ú.LrlÌiìÌririIì/r.nntt
r\toú\ lirr!ied rirllrr. 5jf.. f.t rrÌr()rt\ irÌorr\e, Lh. resuli rìLL be ilì. \n.r{', ntrtÌÌ'Ì
,,iLÌ Ìi\eb\ Less ttìiLì ilÌ. n$r hrlrn.rd trade L. Èl o .ultut ancL ther. itlll Ìr!'ltrrdc
i!rÌrlu! !t tlie rÌ4 !ood\ rn.Ìk.L (ttrjlÌÌrrirn! iÌ!ììÌìi /ll
TÌrirìsnÍ\\uiÌÌ1'jg.rr.-1. lhrr-\\ìI.rnerlÌilt\tothcriihLa.dt.dorsilÌr'r'N, llft.\\t
.ì$LÌnre tlìrt tÌÌe irìterest riìt. rrÌrajn\ uI.ÌranSecl. 1h. I s. i. .et trp!rt\ l![ 1l] 1]rL'ÌLsc

FiguÌe 9,3 ìÊ.: i]!p Ê..:t.' , . r: rr,,. Ê ,; : hiir..

306 : :. -

in,, ÌaúetaggÌegaLcdcnìa.d(ftl,r\,hìch pushcs up output and iiÌconÌe uDtiÌ a ncN goods

ìÌaì ket equi ìibrì um is cs !âbl ishcd. Th e ner! goods market equillbriuÌn is eúabli th cd iqhcr
the hiijheÌ srvings, LaÌaljon, and inrpo.tt ìrÌduccd bv the rÌsc in net e\poÌts 1s equal ro
thenetinjectionofdenìand(lXMshiltsroljx,!/ialrIandoutputdsestìom!0to/rin
Iig. 9.3). The ìeÍel ol inconìc at which tÌadc is baÌanccd wiÌl bc at the level a rhìch 0r.
incÌeased ìmtoÌLi gcncÌatcd by lhc highcÌ incomes ls equal to the change ir net expoí5
Tnde brlancc ('oLrld thcrctorc oc.uÌ al a hÌghcr lclclol output th,ìn the new goods
market cqlrilibrlutrì (rNr lifc (arr )). Ouqrul is to thc left ol thc new }?f llne a.d rheÌc ls
lhcÌcloÌc a LÌadc surplus at n.

2 Opening Íinancial markets

B! the latc 1980slalucs tradcd ìn interrationaì maÌÌcLs lor lÌnanclaÌ assets lar exceeded
thc vaìue ot inlcrnalional Lmdc iD goo.1t and scNjccs. Ìt ìs tradc in intcrnational irÌânciaÌ
maÌlicLs thaL donìlnalcs Lhc torclgn exchangc marÌicl. To undcÌsland the essential âsÌrect\
oI ìnlcr.ationaÌ llna.rial markcts, jt is uteluì Lo nìakc sonìc tinr pìì fvin .rssu ÍÌptions.
. F 1 . There is ,.4..i t? rr,ì ndtiüÌd I .ttituÌ nbbility. T his meâns that, f.n examplc, hon.

ÌesiclentscanbuyorselÌiì)reigntrondswiththeh\e.ìrominalríoÌ1.ÌinleÌcslratc,i,irì
u lnnited qxantitiesrtlo$ transâctions cost.
. f2. The homc counLN is assumed to be rrrdll ìn lhc scnsc lhal Ìts behavlouÌ cannot
aflect the iroÌìd irtcrcsL Ìa!c.
. as in the sinÌple aJr'lM Ìnodel, rle as\ume theÌe are jibt iü,o dii.ir that house
Ì3. Just
lÌoÌds.arÌhold bond\ and ÌÌÌoiÌey. Llut now they can holcltoieign oÌhomcbonds. !t'e
assunìc tlütthel holLi orÌ\'hoÌne monev.
. I.r. TheÌe ìsp.É.ts"l'rtinddrili4,between lorcign a.dhoucbonds. IhiiassumItion
mean5thatthatthereirno Ì iskpÌemium on Iorcign honds.ltlhcriskiÌìe$ olftÌeign and
hoÍÌe bondr is identlcaÌ, then üe only Ìelevant diUffcfcc bclseen home and foreign
borìds i! tÌÌe expected Ìetxm on tìrenÌ. Two issucs lic Dch ind (hls assun\Ìidr. The lFt
is whether govennÌents .iiffer in their deÍatrlt risk-i.c in lhc lik€lihood that bonds
Ìlill not be honouied. The secor.l is rlhether invcslors carc about tlÌe compositìon oi
their a\set porttì)Ìnr. By a5ÍnÌing peúect ÍrìxliLutabilÌlv, c ar€ mliÌìt out dlflcÌc nccs
in th€ ri\kjrìest of bonds aD.1 assunrìn:! thaL inrcstors do not câre about thc balancr
be een hoÌne an.l ftÌelgn bondt in thelr porlloìio.
Once nc haÍ. a workingnìodel bas€d on these as mptn)ns, wc rctu rrÌ iÌì sectidr 6 of
this chapler lo disc!ss their erÌÌpirical plausibiÌity and whathappc.s in the no.leìilhen

2.1 Uncovered interest parity condition

Gircn lhathonìeres ent! have the oppoìtunjtv lo hoÌd forcign bon.t\ ìn thcìr portfolio.
Ì!'c ne€d to consicìeÌ what wiììinflLreìrceiheir cholcc.1n a Í'e11 lLìnctidrìnCcapiral nìarket
 .:307

it lor lhcÌc lo be a dlffcrent e\pected rctum on asscts $ith tlÌc samc Ìill
is inrposlible
.\s mirg that thcÌc ìs .i) ditïercrìcc ìn rÍk bet$ecn the bonds ìs ecì by thc lwo iaov
ffnmerts, Í\'o lacloÌst!ìlÌaftect thc cxpected return on hoÌÌìe as comPar€d $'llh ftrrci3n

. aÌÌy diltcrcnce lnnlterestratcs an.l

. a vier! rboui ilÌe Ìikcly dcleloPÍì€nl o t the exchrngc tate

Take an cxa nìple uslnii 8o\ erí) nìent one -Ycar bo n ds Assu nr c th at iiovcr. nr eÌÌt arúlÌori_
ties li.e. thc SovetnnieDtor the ccntìal bank) can r.i thé inr.r.\t ìrie..d that the 1ÌÌtercsl
Ìate iÌì thc UK í 6.50/. and if lhe USr\ is 'l{i1Ì Thii Ìnenns that by holding UK rathcr
tharÌ US bonds,lhe iÌnestor gcls an additional ìnteÌest rclun ol2 5'/o.ln tììe contcxt ot
bìghLy intcgrâ1cd ìntematlon0Ì caPitaÌÌnarkclr, such a situati{u olfers an oPpoÌtunity toÌ
inlestors to nìake pÌo1its bv sr'ìlching lrom ìrS to UK bonds ln ordcr lo buy UK bonds'
pounds âre necdcd ír there wiÌl bc â suril€ úì thc deìÌand IotpouÌÌds. lhis iriÌÌlead to an
inrmecìiate dfp,?ci!ún), olthe poun.l.
The erpe.talion tìrat the e{chaÌÌge rate adiusls únnÌcdìateLv, Íl:ms fìom empirì'al
observation. ÌÌì a tuÌvey ol fcÌcìsn e\(hanÂc dcaleÌ! in lhc UK, thcy irere :ìsl€dr 'How
Iatt do )ou thifk the nÌarket can a$iÌÌilalc lhe new inlonnation a'hen the loÌÌoi{in8
lrcononìic aÌÌÌìouncenents fìom themajor dc!cl()Ped e.onomies diiíct fÌomtlÌcìr nìaÌket
cÌpectatioÌÌs?'Ìr IoÌ an uÌìerpc1: Ìecì itÌtercsl rate an nounceìnentl m o re thr n two' th iÌcìs of
thc tìâders said 'ìcs5 than 10 s€conds' Ìlith moí of the rcst saling lcss thtn onc minute
ìc.oding to thls süÌve], spe€dl rtaction is most coxnnon foÌ ÌÌe(Is aború intcrcst Ìates'
lrhich also has iÌbiggeÌ inÌp:ìct on f{Ìeign cxchange IÌÌarkets thâIÌ ânnorüÌceÌÌìcnls aború
iiÌllatir)n, unerÌ\rÌoJÌnent, the trade .iehcit, lhc moreysupPly, or GNI
Noir let us askntratexpectationr about a.rd,t{l intlìe exchangc Ìate inveíoÌs would
nccd to hâve in ol.leÌ rdl to ieant to sr'Ìlch betlveen doÌÌars and Pounds despite thc
intercstÌate dìlfcrcnce of2.5r/0. lheansllclissimple:iÌn'estorsl\oul'Ìneedlobelievethal
thc toun.l 1!ould d4rtunlr'by 2.50/o ovcr lhe perìú1ior whiclì lhc ìntereÍ ditferentiaÌ is
expcctecl to persist. Then the 2.59. iidilÌ jn tem\ of higher iÌÌtcrest on porrfd
(sterling)
bonds sqìld belvite.Ì out b! thc expected ìo* fÌoln lhc cìePre.Ìation olthc Pound iror
iÌÌc cxpected return on tound an.Ì .lolla. bon.Ìs to be cqualized at thev nìuriL in t weÌl_
hrnctl()niÌÌit capi!aì nrarÌet, thc expected.apìtâl Ì{As from holdingthe poLrrdborcl\ ior
onc ] ea! becausc ot a .lePrecialion of thc poun.Ì erchange ratc has tu & cqQì to thc
iJìlerestrate gain. lhir ls the uncolered iÌìtcrcÍpaúty condition (Lr'If)
'Ihe corÌdìtiorì lhat the irÌti'rcst Ìat€ diflcÌcntial in tavouÌ of bonds denomìnated in
crrÌenc-v À nnis( bc e.lual to thc exPected cÌchange ralc detre.iallon ol c!Úcncy A o\ er
th e Ìreúoc] lor srr ì.h the int€res t dìfterentjal is expe( ted to persist ìs caued thc uncover€d
lnleÌest pa.it)' co nditìon aÌÌd can be ltated âs tôlì.ü\'

.i-, ., (uÌcovff ed lntereÍ Parit,v r

cxtJc.red deprr.ialiôn {aPti e.Lìtnrn)

r (rhrurg, arhnu, ind Mrr\h (2000:301

304 ,

wherc i is the honÌe and l'

the fo.eigr inlcrest rate, r i! tlÌc .ominaì exchange r.ìte ol thc
Ì5
hornc.otrntÌ) ani cr is lh. txpecied cxchange Ìate
Ìt ls uscíLrÌ n) take thc cxaÌnpLe a ícp lurÌheÌ A\nrÌÌÌc lhat ìnìtlaÌÌv itrterelt rates arc
.1% in both the tÌS,\ and lhe UK and inlcstoA expect no change in the e\chinll€ râlc.
lhus c staú ir equilibriuÌn: the UIP.onditiilr hold5 bccause theÌe is no dilfereÌìcc
irÌ irÌÌcrcst returÌÌ and rÌo eÌPected change in the e\chn.ge tate $ the etch.rngc raLc
adjLrÍcd retlun is equal Ior doÌlâr and Ìroun.l boÌÍls. lhc UK goveÌnnent then raircs
the intÜcsr Ìate to 6 5%. Noif rpPosc invcstoÌs hâ!e. firirÌ-Í cleaì ìdea about tlvo thÌrÌgs
lirÍ, tlÌnl Ìh. ìnterest diitcrcttìalwill Ìa!l loÌone-veâr and sc.ond, thatirhatererhappcni
to the cÌchaDge rate in thc short nrn-and the,v k o\r it rìuÍ chaniae si ce the .urcnl
situriio ìs ú.ÍbtaiÌìrblc-it wiÌ] evcnLuaìl-v com€ b.ck lo the curent le\el Ìn olhcr
$ord\ invcíoÁ thirÌl th( cÌchange ralc is at jts'coriect' Ìong Ìun ìerel luvestors bid I'p
the valLr oÍ the pound b! bu,ving pounds in oderto pur.hase the attÌactiv€ hiSh irìlcrcst
pourÌd boÌìds. Tìre Pornd ('ill apprc.Ìalc ìnstantt eousì-v'' by 2 50/ô Urhv? LlccnLlsc an
appreciiuon ol 2.50/o is cìa.l\'rlhat Ìs rcqltjrcd n) establl!h e.ÌuiÌìlrriuÌÌÌ lhe pound is
now erpe.l cd r() .letreciatc b-r 2.5 o/o lback lo ìts un ch.ngcd ìon g ì un expe.ted valuc) over
tìre course oÍ thc yeaÌ durìrÌg tthiclÌ thc intcrest advarÌtigc olUK pouncls is 2 5'lo
To sunìmari7c, i{e carÌ NorÌi out hoÌ\'mu.h the e\clÌangc rate niìÌ apPreci.te iÌìmcdì
atel)- bec.ìusc wÊ know that tra.lirÌs Ìrì thc lìnanciaÌ nìarÌict will enmre th.t irÌÌ oPpoÌ
tluities to nìatr a proÊt arc exhauÍcd This ìneatÌs that the ìnterest rate galf trom
h(ndiÌìg UK bon.ls nÌun bc offset b]'thc cxlected loss llm the depr€ciation ol the
tound cx.hange ìate oïcr the period Ior hìrich the intcrest dìiïerence pr€vaìls. Whrt
happens is lhat rvhen antr i.teìest ralc dìllcÌeìrtìat is opcned uP, theÌe is â jtrÌÌp in the
e\changl: ritr just s!tficicnt b elininilc the lnteÌest ralc gainr' Then o\er thr pcriod
lor fl'hil:h the inteÌest di tcÌcntial on lhc honcìs n edpccled t() renÌai , t1ìe excbange
Ìate apprc.iati{)n grâdualÌ} uDiïnìds and the e\chânge ratc Ìelurn\ to its erpe.tcd oÌ Using the
'corrccl' ìong Ìun \alu€. iÌnpoúan1 disLinguiihing characlcÌjstic of hnância1marNcls
(âs conìpare.l wiuÌ Sood! end labour markets) ìj th.t iuürPs jn t ces are commorìll'
^n

r;Ìod.rì!.nrÉUlt'condili.nì rr. begiiÍith thc irhihrge equauDnbrldr A$nnn: thli HÒdìe r tÌì? U(
ana thr Ìi\Ai\nieiAn. ÌIIou b.3irÌ ìr,thri1 thrn n'dihrtdrdei!\:irni\ir.Ìdunrrftrr.nêlerLft.Ìì
convrnnÌ3tlÌê$ltopound\ÍiÌreÌìd.I1h.vr)ru:úr3tÌrcrur.Ént.LnÌÌ.{(:ÌrnS.rrtcr,a.dbrviuSíeding
xnrds.lheqÌÌr1Ì1rd\nì.\rl\tlìlsistlrrrduni;ltcÌonere lrtrìn\it8tlre!Ì bbtl doÌla1lr!nas,ÌrhiLh
rrÊ c.n!eLlen tfd.i thê PeLi..l nì IDurd\ ai iÌrê IoNr d.Ìrhrnge r.te iÌìâi DreÌin5lodâ!, f, i. irr
rt ihr
nrrra.t Lobllih.Ì).nrd\i.on.pcr od\tidìenpúr.ha5ed nral) ihi!..1e6rÌren'entrnì.{.rrrg.rltÉ
urceÌtrinftv aÌl)itì8e{iÌÌennrcihritÌ,ehIt.ddriShlhtrfrl\nlr\rreeq aÌ

a(1 ii = (r + i)/r

r Ì! rnriúage.ondirion i!.JlLe(l ttÌÈ.o\eLrd irÌúliILrit) ..JirLiti.r Tt tuÌn ihi\ irúr i r.l,//rLonditnÌì, \i?
.efl.ì.erÌreL[a Ìri(]iiiÌnè! itlì úìr!nL..rn erÌ,erted rite it r + l ,rrnÌgth.irÌcto.ìui..lered in
.êÌationto.r.rars.ri\k hÌrdd,!.d w.uÍ tt,è aÌrÌrmi,úún rÌÌ1 i+ - l+I i' rnd lidlliF õ LnÌloÌrs:

,i,,,
 109
. !.ìnie r.r ofrÌr. 11..rlinS thnlr !lì r nuDffl.rl crirìÌÌt. hrt|i io ch.ii\ thjs iÌnl)oÌ(arÌr Ìchtio.shil)
.).;tirÌ.ner.irSo\!nìrì.ntho.d\ Iftiì.ìÌÌ\, jlreML r.ri.\ id thc trl) o!xh.j.s.rie
Ì.i(rt\t riìi.i !lÈ.1 .iìÌ .ìfd th. üorì ül rÌ.hin!. fure 5 0.ajs0
dr._ -
Ì)ounds prÌ d.ll.rr. herÌ suppon,(hir
:lÌÉi.teìeslrrteniheLlii\Ìrtsdnit.iri,iìnti5.\pe.ttÌ]Ìosta\ab!\.L11el,5nfuÌc!lrrn_

:.rJ:.. uL. doÌhr L)o..tj As 5r.Lfud ibo\., id 1ììr. erÌt.1rn rctuuÌ ().
irÌrdj n) bc equilired lt nrirn br LÌÌe (.ìÍ ïhrL Ìe ertrcre.Ì irornd .ìÌr.t doL]rÌ
.Jpjr.ìl t,r!s tro|r lr.l.lxrg
:lÌr for.il bo.L15 l(Ì one rcir Lre.iuse ot l !Le|ir.ciújo. ot tìr( pu"n,t ."r.t,r,rg.
,"r,. i,
:!u,rÌ to tlrc iÌìtrrL5r Ìr{e gr f. 1ÌrL6 lo \r)rt ort the e{lrnge reLc, r.. rlrt
I iI rìe|. rr rn
-\n,.ted crclÌrr{t LÌL!.l(trs Òi 2.5 f,, \ e n(d (r hir\ e r i cÌr rborLr ìe.\.1Ìdngc rat. Llrir
, Ìllpre\ â l trÌ.f. reir \ rim( (Ìrorrr5rúnÌrrjonrhdrLÌr.€\clr.nseÌrL(Ìvr;lrjsi.elr

,:ilr.lsrlÌreruÌ.toLLs.c.ÌÌ..i,lofgrDraluejlhrj,,LnrphtÌr.c\rhin3eÌrlt.útjtrrf
r \Ìr.!i.LrEnr,ìte\rrcre.q!ilatr,t.tÌrcnrh.r.\t)e.tdneÌrÌr.ì.ú)fotth.c\rhrrBe
.ìl(,bÈtÌv.(r] tinrc I a.d riiìc 2 !ÌLrsl r. url Lhe ifttÉtr Ìal. tifl:l!ÌÌtiel:

. .: -i.n
!!q1
l

hi\ nì.i]rÌ\ Ìhar o. tlìe rÌÌrÌ(üDr,r!efL oi rÌr( ri\e i. rhe LÌt intercsl irre, Lhe
fou.l
i\.1Ìe.gi Lr. irnÌncdjet,ì! ,pft, r.i/r j tro|r r Ìitc ()i 1r.aì50 ro 1r írl5 Olrr rhL:.ni|Í.
l]t
i L ìil\. r\.har nr rea. JÍÌì rÌ r. .. tlìr |o Ìrd,tlnridr..jbe.ktothr..jrinalÌ.!elr)I0.650. lr)Êrr l

I hc f rth\ oi t|c f oD j.il e\.Ìr.Ììi.te rarc rnd L Ìe trturÌri rlrc irr \Ìrtrr. jÌr f i!. rl 1

2.2 Using the U/p condition

lhr t,1| conditjon i\ r.i\ lrc rLl úe.atrsi Ìr fro\ i!ìr\ e.ìire(t ì nk rrD i .hafg!. jìr m..
.lrÍ |.lj.r ú\ h j|.h .hirÌSc\ rlrc nom nal 1ìr1r c\i ÌiìL.t to ü .be rte iÌr LÌr! erchiìnse Ìrji
lrg.9.)rn.n\th.t.lt.ondÌt..lI!dLi{.rnrNUÌtÌr!.(Ìe\triltoÌÌrìr!.reÌrÌ..rt.\t\,ìnl
is.Ì.i]rÌe{ÌriLil)ÌlLLLrì.hrürt,,Ìizcdbr thr hom. jìrrcr$l r.rte .quallnr! h!ÌroÌldjrreÌ.n
raLc i = i r.rnd ulfillcd eÌ.hiÌllc Lì1r r.\ptcrrtions,r rJ

]'''

Ìãblê 9,3 .rr.r,!.. nÌ:.Í rr!ì rr i:

I
310 . .'. ,' :, .

t
l

Figurê 9,4 Pàtlìr ót UK nterest Ìète ànd Lr]( pornd er.h:.qe ràr. ihe nrêrêí rõre on UK b.n.ls ê!.êÊd!
thdt.n u5 bo.d5 Íor I pcrod

ti r,0=
í!

Figure 9,5 Ìhe úÍroleed n1eÍesi pdrry.on.llrôr

a.hìnge in the actlraì cx.hange Ìate. Acco ìng ro rhe tr'1l condìtion, thc erchangc rate
r,lllappÌecateinÌmedialcll(juÍ+)toc so th at i rs cxp€ctecì .lcpreciarnrÌ ol'er rÌr c js
}'car
cqualto thc interest ÌaLc dì1ïerentirt. This requìÌ.ment fixe\ poiftn and deiìnes lhc Lrf

rô \.ir 11úr ia r.u,lr.nr, rÌre Llr.un1,.(.!nrÌ!, ii rillDe íêètrÌ rr.ìr íìoÌ!f if Fi{.9.s
 111

tiguÍe 9,6 IhÊ rn.oveiÊd nrerÊn pàr tv "'1,,,

rrndÌÒn Íi I n th.{orn ntereí r:t.

lhc key leaturcs olthe Lill'diâgÌa!Ìì are:

. each Lr? curve ntLt go throuth th€ poiÌìt ltt i )

Lrlf
. for a itn er *tdcliÌrleÍ€n Ìate, any 'harge iÌÌ the erpec lecì €{cha n iie 'ate shilts the
tercst ratc shifls dÌe liü'
. i(Ì agiven expccted exch.ngerate a ny chanse in the worlcl
in

cuNe s1)rks, tupfose lhere is a falÌ in $()rLd

interctt rates
illustrâtc how the Uil
-' \"'\'r''
Lo
\.., i. ,. .rr, l'.r"\- I
"'ldn8r'ì
I ll- -
, ,,,-'rt-' l i i iì
I'l // r'"r'rnirf r'|J/i
.o.-€d'
.ì',;.; r-' r'ê 'r'""u''
rate nolr abovc
tt:l,i'iil ".".i"4 *.r'"nse rate cqu'l to 4 and Í'ith tÌÌe honrewillirteÌen
lcrd io ìmtÌìcdi'ìtc
,u".".iu t'i -" ii, a'biturÌge in tlÌe finâfcirl n'rrtet 'ÌÌttl ttt
"*" " 'iaIr'-' 'a 'L'\, rlLJ r"l r' ttt '
",ô.,,.;.lr "or'I
, ,,. ,.1r, . . , ., ,, ", .''. ,", '" r r,
' ccntÌalr'.
change iflhe
iì*.,- "i'. n",pt ,,, ,t,rstrâlc thar thcre wiÌl be no exchanSeilnte
rran'r. in rrre honie country iÌÌilts t1ìc úÌtcrest
rete dow' íi that ì5 eqlLal lo tlÌe ne$'ìowcr
(
ÍoÌì.1inleÍ€st Ìat€: the econorì\ tllen slrifts ftonì 1 to
in thc lorcliiÌÌ cxchange mar
A hÌÌal exercire is the aDâÌysit ol a chanile in sentinrcnt
a",.ìti."u".t*,uo"ur.nan;cthi'irvicwabotrtthclltr'cìycaclÌangerateinrvcaislim€'
cxpcded, rhe LiI]i curlc ifil]
,ìr" urì, ."."" ,"u, ,nir,. Ìt a deprccjâtc(Ì exchatrge Ìale rs
nrch a chatrilc nÌ scntl
r,rin," tn" tt*n,. *nn,ne home ancl rúrld intercst rates cqu'ìl'
olthe erchangernleto
,rÌen ,, t rrarltnr cn"ct oftea.ting ro an innnedialcdcpreciation
,\'i\rr' -' r- r',' rio' dh 'r
' I c' ' i I'd I|JiIn
:. lll l:l
'nìI
'''po'. conditìof to
dcpreciarlon, lt nust ratsc thc iÌÌt$est rate as 5hoi\u
bl thc Ì1e(' UII'
'onÌ
pc;srtch( dc ol h onìe bonds for tì1e cxpecte'] clcprrciatio n Ìhe
soorer IradcI'expect
" O,-g" k) occur' tlÌe hiShÜ rh' htìme nÌlcrest râtc i'i1l havc ro go to
i" ".il-r" ,"" ir thc case in ivh ich
;;ìì';;";;"...ücìatcutrcha scd r rÌìs i! csp€cìa'-v rer€vant
312 '

has a tìÌe.l e:ich.ngc rate and ('hcÌe doubts enìeÌilc ahout thc 'cÍedìbjììt-v'
oÍ
r coúntrt
dìe cachinge rât('le3

3 Fixed and Ílexible exchange rate regimes

rale reglnrer' Àt one
ÌÌr an opcn econoDÌt, ìt 1\ !scfuÌto thiÌrk aborrt 1$1) poÌaÌ eJi'hange
Íul\'flcxìbÌe cÌch0nge ratc where ncìtheÌ Lhe
exLremr' ls ttre case ot a trecly 1ÌoatÌÌg,
to iÌìnuencc lhe
govenìncnt Ììor centralbtnk inten'eÌìes it the loreigÌÌ cachange nÌarkct
price afirhìch one curren.y tr'â.les Í'ith another' TÌÌe cxchange ratc Ìs th€n dete nlne'l
ncies tÌre ertrcnÌe
bvqrpÌ-vand tlcmand fortbc cuÍcncy rclâtive to t)tlÌcr cu rrc 'úhcÌ
^t
â ralc lâ so'caìÌed ptSl
is rL" cas".f l*-r ercrt^ngc ÌaÌcs whctc the go\ernment sets
the
at hich it wiÌÌ bui or \e11 ldeign e'{change âs ìreccÍar} ìn ord$ lo kecP oln'irL 'pÌice
1ìrc.l. ïhcse 5a1c! or ÈLrchrscs ol loreigf eÌclÌange bt lhe ccntraL bank aie
'alìecì lorciiin
trì1cr\'€ÌÌtloI .nd we dtìlote Lhenr b) -\n, wherc à nands foÌ
the bn'k'\
'cntÌdl
ft)reign cxchange it -\À > Íl
€rchenilc rererl'cs.l h. furclare b,v the home ccntÍal bank oi
andthesaleolnrrcisnc{chingeis\Ã_0Ìn'llcxiLrÌccx(hanger'tcteiiimc'drerclsno
of1ì1:ialinlcrventìon í-\R = 0l
t,lg. ç.r shoNs rÌre foft:igrì clch.niie matket: the homc
ex'henge rnle ìs on the \'erlìcal
aris'antl Lle qLrantity oilorciiin c\cha'3e is on tlÌc hoiizontal axls
lh' supplY rnd
er.hange arc shown As ( r the tòrcìgn currcnc\
dc Ìnand curves l()r forc igÌÌ 'depreciales 'l'
bccoÌncs moreYaluabìc and lhe suppl,v ofnrreign exchangc se\' Slmilarly lhedenrand
for torcìgn eÌ.hanile is.loÌlnwird noping l tìaìÌ)ihcmarkrtìsinc{ÌuiLibrjumwilhan
c*.rrang:".tc nr.r. S"pposc therc ìs ' ÌightÌlard sÌìill in thc ÌJp1y of
t(ÌeÌgn ex'hange
rise iÌì lhe domestic lnrer'st Ìate rclâtive (o the 1\lr d iÌìtcre5i
1r:.g. .s i ornsccluurcc of:r
than foÌeign ones at lhe gircn exchange
-r"l since trorre UonOs arc now rnore attractivc llcxible ratc regirìe'
Ìate. theÌe is an e\.rss Npplv ol ioreign cachangc' lrlÌdcÌ a erichatrge

a
t

Figure 9,7 IhF t.re!lr.r.hàn!c marl.1

 j:313

'." .re.Ìjbilì1y,of thc cxcha n gc ra tc wou kl appreci.Lte to rr arÌd theÌe world be no ofÊcial iú€rvention, i.e.

\Iì : 0. LlndÜ a 1ìxcd ea.h.ìnge rât€ l\ith a peg set .ìt qr, thc .cnlral bank $'ìll have to
nteNe.e in thc nìarli€t to ìbsorb the Òic€\s s!pplr- of lorcign exclÌangc ìrÌ order to keep
the c{chângc ralc lìxed. Hence home's oflìcial loreiilr ex.h.rÌite reserves will rise by,\,(
Irce ìrig. 9.7).
Under ncxibìc cx.hanite rates, the unco\ered lDteieÍparit)'condiuon sho$;s how irbì
bagc in !hc lrÍcxìationa11ìnanci:ìl nürket iviÌl Ìead to ch.ìnites iÌì the e!.hrnile rite iìÌ
rcsl]()nsc to a.hange iÌì:
. hoÌìc's jnlcrcÍ rate as\uÌrìing that erchange râte erpcctauons and thc world int.rcÍ
raLc rcrnajn unchiniled,

'tlÌe\lorÌclinteÌestrat.âssumìngthate\chângcÌateexpectatnÌúâtrcitlÌehonÌe
llteie\t rate ìenrain trnchanged and
. cxchnogr rite expectatiob if iÌÍereÍ rrte\ at hoÌne arìd abrcad r.nìain unchangcd.
1n ir fix€d €xchinge r.ìte resine, the itoveÍrrÌÌent requires tlÌal thc ccntraìbank arLi!cì_v''
jrÍcrvenes in tlÌe f.rr€ign exchaÌìge nÌârket i orcìer to kccp lhc cxchangc Ìalc coníant.
\s tlÌr inter€st pârit) conclitnnÌ mâl€s.leirr, ilthe €xpc.tcd dcpÌcciaLion oÌ apprcciâtjor
ot thr ed.hange .iìt€ is zero (as irÌ a Ê-\ed exchüÌile rat. rcginìc), rhen the hoÌne inteÌert
rìì te nì uÍ .lr!.ys b€ equ:ìL ro tlÌe $,orld iÌìterestrite.
Ì ig. 9.8 shoÍÌs the comparison betNeen the fleriblc cÌchange Ìate Ìegime and the 1ìxecì
each.nge rate reijirÌÌe Ìlhen there is.ìn €rogenous falì in the denran.l tor moneÌ. Iu
the !pper parÌel tflexibÌe exchaÌÌSe iâtes), the l.ì11in thc dcmand f(Ì noney ìoweb the
Ìrome iúerest rate (.1 t() B). TlÌ€ UII condition 1ÌÌ thc Ìclt hand paneÌ nntrls that úri\
Ìeads to an inÌÌìecliate .lepreciation of t1ìe honì€ er.hangc Ìate (.1/ to B/). By coÌltrast
ir the Èxecl e\chani{e Ìaie ca\e (loÌter panel), tlÌe lalì ìn Lhe demand fì)r nnÌìev plts
ilo$Ilwdrd presuÌe on the iÌúerest rat€ ind the inc4ri.nt coÌlapse irÌ the clemand fcÌ
tounds requires the centraÌ baÌÌN to ìnterrerÌe in thc t(Ìeìijn e\change nrarket to bul'
|ounds.ltüse! loreisn exchange resen es to dothìs (^,! .- 0l an.l the ienrlt is â decline ìn
tlÌe rÌìoÌìe) mpplt to nÌatch the ne$ 1oüicr dcnìand lor money úroniÀ to ill. 1lÌ€ inter$t
rate :!nd e\ch ange rate renr aür ruì.hanged (at ,{'). t h c cconon } is atìe( ted b} dom€Íic

^s
.r nÌeiijn shoclis, the .lomestic nìoney supply nìotcs aÌound jn odeÍ ír lieep . - rr
Òdún* t01. P!\ anlJ i = i' .
It is important tu l)ea! ìn miúlthdt the honÌe ÌÌìonel denrand lltncti()n is the same as
nr theclosed econonÌ). Tìre clillerence thit opennìit tÌìc ccoronry nrakes i\ that it creates
a coÌÌÌÌection betríeen the honÌe iÌìterest râte, the $orÌd inlcÌeÍ Ìate lancÌ hence nrcn€l
de ÌanlarÌdnrpplJintheÌenolthei!orld),andthccÌchangeÌate.Themone)nìpplv
i\ under the cont(n of the dorÌesii( âuthorities iÌì thc llcìiblc exchaniie rate econonÌv
but not iÌì ilÌe hred exchange rate econon\ because oftriaì inteNe.tìon to strbìÌize the
crclÌange i:ìte llÂ) endogeìrizesthe IÌÌoney suppÌv.
It is useirl to set iI context the ÌirÌl bet$een the chargc iD otnciâl reserver an.Ì the
nrolley nrpply bv sruÌÌmarìznrg tlÌe Ì!âys iÌì whichthe nÌoncys!rppì) can ìncÌease.
. $e irúro.lucecl the sìmplest case in the cl6e.l economli (alhaplcr 2). This is wheÌe
the central bank engages 1r an open nÌarket operation in ÍÌrich it u$ neÍ'ìt Printed
noÌÌet to pu(hase bo.ds fìun the publ1c. This has tlÌe clfcct ot jncrcasìng thc Íock of
3t6..
s'lÌcrc ljl ls lhc bahnce of trade .nd lNl is ncl ÌcccjÌrts of tìct(tr llconre lìÌnÌ abrrad.
f rc.ord5 prlval. nct capital iúÌos's and A/ì rccorÌÌs the net decìine ìn ofncial f(Ìeiijn

rcaftangc thc baìance ol palmc.ls cquiììbÌìum bv puttinii the incÌea5e in ftÌeìi{rÌ

ll\!c
er.lìangc rcicrrcs o. tÌre Ìelt haÌÌd sìdc,wc havcl

l,'Ì illl - l\l r i

If tÌrere ìra clurerÌt account 5urÌtus, there ríilÌ Lìe ÌÌo ch.Ììgc in oilì.ìaÌ rcscn'cs ÌI thc ncl

frivate .atital outtlo$ is cqíaì k) the cureÌú a.count Írrdrts. lhc ncl capilaì ouÌloÍ
(j.c. | < 0) Ìetlect\ tlÌe.r.4rÂitu, bl the lÌonÌe countrt ol lorcÌgn nsscts. ln thc opposilÊ
situatlon ol a crìrrent account delicit (i.e. a sltuâtion Ìn srrì.h donìcsti. salings ìs ìc$
rh an .Ì()mestic irÌ\'est üÌt)for theÌe tu beno chanile nì otlcial Ìc5ctrrs, Lhcl! m![sl be a
nc!.atilal ìnÍl(N (i.e. t : 0). HoÌne is borowing ftorÌì abroad add ihffcby acquirìng a
torcign ìiab1lìty.rg
lr ihouìd now be cÌe:ìr th.t olfi.iaÌ ftneìgn e\.hange rescFcs r,lll ÍÌsc ( \lì > 0) í'hcn a
currcntaccountsu+Ìu\e\.ecdslheneiPÌivatecapitrlo!1fo$,SimilarÌl,otn.iaìrc5cn'cs
Í'ill âll irhen a c rrert rccounL dencìt is not hülv Ê an.cd by a privalc capilaì inloi{
L,ndcÌ flexjbÌe e\châng€ ratcs, the nonìinal eachânse ralc nìolcs Lo sccurc baìan( of
pivm. n rs e!ÌuilibÌnuÌÌ withoul he nee.l f(r ofÏc ial irten c n I io n.
t

TheÌe aÌe t$o cÌLìestions aboút the balance olpa)ÌÌl€rÌts thal irc nccd Lo ansrcr:

(11 \\'hv is the b.ìlan.. otpatÌìent\ equal to zero?

(21 l)ocs it ÌÌalteÌ tìÌe cure!Ìt n.coúnt or tradr balânce i5 itÌ mrpLu\ or clehcit? Il the
1f

baÌincc oIÌre_yìnent! is alÌ!ays 7ffo, how ca. theÌe be a baLânce olpa) nÌent\ clisls?

4.'l Why is the balance of payments equal to zero? ' - -: :Jrt:nÌ

The bâlancc ol parmcnli identitv require\ thiìt

ÀP
= úT lNrr iÌ Alìl : r-)

uie betin by con\idedngtlÌc cìpoÍoíÌnobiÌe fhoneifrotn Siveden to New Zealan Lt and

ask hoi! this tianslction srill dìon up in Lh. Siredíh balance ol pa)ìÌert\ statirtics
Sileden is the honÌe couÌÌtrl in lhis examplc. The expoÌt of mobiìe phones iriÌl bc regú
tered âs â po\itlve iterÌì ln thc currcnt account (j.e. 8T 0). For the dentitl to hold and
asunÌi g lo. sirndicity tÌìat ÌÌcl inleÌettpayÌìents arezenr, there are three.ÌiUerenrwal \
iÌì which the Swedish biÌnn.c otltayments could Ìe.oÌd thir traDsaction:

' (i) an cxictly cquaì val('c oI impoÌts Íionr Ner! Zealand to Swe.len taÌes placr. IÌr thj\
cisi., tlÌc.L,rrcnt a..or1.t baìance\ and the capitaÌaccount (pÍvate and ofúcial) ls zero

r; llri6tsAhÌitnì.v\c.nrÌranÌlloinrthìta.ÈBrn\e/ÍÌrhÉl)ììncê.1ta!.iÉrsreÌ)16..iin.tr((ìui\jin,j:
rI h.rÌ..i n'rign r*.b lhi\ i\.rtl.ri.Èd bt úrê ía.t tlrat ihê balanre oIp.1.ie.a Ìr.oÌd\iho !)uÍ6 rf.
r!\,,infrìgn.Íhrfg., ihrl,rn!hJ\É.lnÌei8n aíei\,\ a úe.ÍÍ.Íê,gn eì.na.3e rnd tlÌê.êntre hr\rregrtn.
!rLxe iÌÌ ie l)ì rrrooilìlnìe.n ì...un6.
 317

fiace '
takes (i (l)
. iil aÌì eractlr €qual catital outÍlo$'
ÍonÌ s*'edcn 1o New ZeaLand
ftÌ1his cak tÌlerltircnt a'coünt
rlì. kÍÌror are tr\c't to p(trchasc Nct! ZenlancìÂsscl\'
lli:ìüì;;,;ì,;ì;'::rpnaÌaccountrsinacÈcit;IndtÌìcÌ€isnocharseinoihcLrl

:, "r -n"' *"'-'. t"

. Lr '* "r'
'r 'd'
"..Ìl,.' rü'' oi a ri'e in Lorcrgn
l:.*-i';;;;;;;;;;;itaì accouÌÌt deicn that rarcs the
:\chanSe rescÌvcs
nÌtxture) lnun trke pìace wh)7-llÌc
íor ronÌe süLtrbÌe
.l.:.:'
ane ol lhese thÌec
'ìlteÍratìles ha\e to bc râirr n)r ir ktunor 5., trÌrmsh some nca's
ì;iì;" tì"";,',, "rports
:ì;:i,,ì,"i,;;;;;ì;'Ji.b'eìouÌìd ^Ì,cÌa,ì,,heÍolllliiìiììiilililï.ilJi"iÏ'ii
, m rr. \' 'l-rr "r"'r " l

resuÌt rhar an e'tÌ-v roretroÌs

and onìissio's
ilii':ï.:'":;;;';;''"onÌ)lcte'withtì.e
r ' ;jr ' r"
belance of la-vmcìì1s Ítrn
to Tero
I

.' i,,il, "1''; :;\ ' ')'

'.,,ri'" "ad"uu, 't"r"the
' i'; ')
'J r-rr"' rl"r '''
.'' 0. ""''a
,.,.,i,
' '
:ide\ ìru-\'à$er' (c s rrncr -o ^
",
tt'"Ìl
'irh|i\'
; ('; ì' .'1 " j.
",: '"nn.]*".nu"'"
1,í,"i.-".,".."."ìu
douár5 strÌce1L'c "'i..',ï
,*ts, tìre iwccrish firn neecrsNZ
lÌÌnr w
*u""
uìì:.ì",..i",,,*u"u uÌ
. ì, ) ofi ciaÌ inÌervention, thcS\çrdish
''.,:
: :
;

I 1, ,. ,iì),1.' ' :

matter?
I2 Do cuÍrent account imbalances

. ï:: J:-::.:ï:i*ì:ï,:lÏ:ï:TÏ:.ir.,5:,,,:.ïil
l
Jï tiìï;: 1ffi *ïiïii
'.:ìì;ìì;"Ìecall that anv non zcro curre
. iÈ.cssarsto
;;;:;"',,,' .',riulli;'*ï
lï:j:ilïiÏ"ïÏ":i;
"", " ìi:ilï:
,.:iìï:iï1L:ì: ::'ìi; :]"ïìï:,'',",Ïii:i:;,:;[::'*l*l:nt*lll
..1Ï',,Ïl:'i": ' l''' "''"
,,'::;:i:;,;;ïì,i;",;.i,i"trrerlLture'thct'ìdcrrtlì'ìt::ï::::Hi':[:ïlli:ì:iì:
rÌÌÌv'5 weiÌlth' ]\ tracìc cìrn(it ìLìÌl ìmti
n|tryÌecejlesaS[ilìcientnetinfÌol,oltrìleÌcnãndprci!ÌecejPt5onthei()Icii]nassels
' ìi rt ot!n5. nor iÌlÌrals the ca{. Whcu
a
iì nÊ.rìne
declüìe in werrtlÌ Írnds Ìike a ba'ì lhirÌg-btrt this i\-!..:-ì-,,."iìNcilrrìfrlì5.
werlth ÍtrL,Lu !iÌc
,enltLÌfrlì5. thc
''r""' t l {n,.lies.rheÍÊnancinl
.:ìïì:ïÌ:ìlï:ï:ïJ;;ìi..ììi* ""''' "' i'n'n""" iï::':::i:ï:'li ï'Ïï:ì:
r:i::lì:.iiìilÏ ::i,,ï; ";';,;;"'J*";; **'*'lr'tl.iïï,'lfiliiiii liiï
o
ì:,iXlïil.ïJiïÏï::ï:': ìïÏ ;"ì-ì
';'""Ìì;nt
1Ìr píúi'irbre prcjec'Ìs
'[ÌÌc
318 ::.r ':r .. .:. .

home econon\, then thc possibÌlity of bono$ils 1ìoÌÌÌ âbroad is a method olincreasing
the ríeâlth of the honÌc .ounLN 1n the írtoÌe. llovÌled th€ inleÍnÌents 1Ìì úÌe honìe
econonìy beiìr tÌuit, its cxporls Ìite and it is able to ÌePat its intcrrütional debts. A good
example olthisis the Notrcgian econorÌ] in the 1970s:it had persìstent currentaccount
cìe1ìcit\ as it boÍor,ed abroad Lo deveÌop it\ oiÌ reserves. IqualÌlr, for. country thât do€5
noth.ìve very proÊtabÌc in!cstment opportunities âthoÌne, ìt makes sense that doÌnesti.
sr!irÌgs a.eused forn€tÌnrcstrnentabÌoa.1. ThepurclÌâse ol fücign assetsthitthe&rr€rrr
account mryLus repr€sents mayprcvicìe a hìiiherretlrnì than r'ouÌd hiilher iÌìveÍnÌent aì
honÌe. Ìligh savirÌg economlcs in Atia luch as 5ìngapoÌe provide erarÌìples here. : Ìhe MuÌ
Ìl alÌ ecotromlc agents a.t úlionaÌÌv rleighing up the reÌatÌlc returns lrom diflererrì
ìnve\tmert opportunities, lhcn a clìrrent account imbalan.c slmply retÌects the diffcr
ence! in p.eferenc€s and in invcstìÌe oppoÌtlÌ itles âcross .ountri.s. How€ver, a pc.
listent cuent account dclìcjl Ìs not necessa.iÌy be ign.,\ .urrclìt a..ount deficit mir
not ìe1Ìect higher ijrrestÌÌrcf( at home in ÌesÌrnse to €spccially attractivc invcÍmcni
oppoÌtunities rather, it nìa,v rcflect kN sa\ inii! because of lÌlgh privJte or governnìcnt
consumptìdr or it may reflc.l ìnvestment iÌr waltetul proiccls. r\ persistent or cxcct
sirc cunent accorurt cleicit ma)'bcconre ìncÌeasins\ cljlicuÌt to lìn.nce. ln practìc€ thi! .
mcans that under tìexible elchange rates, drere may be a depre.ìatbn of th€ ex.hangi
:.i.:
raLc. tiÌrdeÌ nxed eachânge ratcs, iltri!ate counlerl)arties .innot be found to finan.e th.
dci.ìt, tìre centraÌbânk $illbe oblige.i to seìÌf{Ìeìiin exchang€ r€serves iÌÌ ord€r to maìrì
rain the excharge rate. Ìt ma,v cìamp cÌown on rhe âccess ol home residcÌÌts to lorcig.
exchange, thereby leepirÌg thcm tu)m engaijirg irÌ tlÌe purclÌnsc ol foreign tìctrÌds. Ìl sr
the asnÌmedperle.t iÌìternatlo n aì capiial mobility bÌe.ìls down i.e.itbetomesdiffi.ulr
for home resideÌÌts to lend at tlìc i{orìcl inteÌest rate. I cìr.umÍan.€s .h âs these, thi
goleDment and central barl i,iÌì be obliged t() charÌge domeÍi. policy so as to reduc.
the curent:!ccoünt deficit.
Sirce r cuirent âc.ount dcficiL ìmtlies a Ìunning do\írÌ ol the home cou trv'\ ivealtr:
{rn nÌcreü\e iÌì its lorcign Ìlabllilies) $hereas a 5u4tut rep.esents an â..urnul.ìtidì o:
wealth, ther€ is an essentlal asvmmetÌy bet$een the tlvo. Ìoreigr€rs Ìnat stop lendiÌì.
to th€ home economl': thc-Í cannot stop the honÌe e..,norn)'froÌn leÌÌdxìit dbroad. l::
ch.pter 11, the causcs a.d conseque ces of the eÌÌìergerÌce oi â larg€ cu.rejÌt âccorìÌì:
defi.it ìn thc U5^ jn thc carll 200Os âre analysed.

4.3 What is a balance of payments crÌsis?

llthe balancc ol paymcnts nìust suìn to zeÌo, what ii a baÌânc€ ofpa)nÌents cÌ1sìJ? Snr:
ilarlr'', wh,v js thffc rclcrcncc lo abaÌance of pavments '.lehcit' or 'su{nui ifthe baÌanL.
oI pn_rmcnls ls aÌú'a_\.s ir baìance? The extÌanatidr lie\ iÌì ân unntrtlurate\ noptv u!.
oí tcíÌs. l3aÌnn(.c ot patÌìcnts nuphb, delicit. oÌ cÌi\is ref€r to the state of the cuÌe.:
accoúnL plús rlìc cat itaì a ccottiÍ oclul i,t akt idl it lcpcrl ior i.e.to(ÃI+INT) aÌ.
our LerÌìinolo$'. Th$ a ìraìance of pr.,"ÍÌents mlrhú arises $hen the nìm of the cüre.:
accounr and ncL capltal jnflosa ìs positive. Thir nÌeans ihât oìlìcirl Ìese es aÌe Ìisin.
iin.cri'=0andí,9/_+INrl-íI) ' 0. tÌrir irìrplies thât là >. 0. ConleÌselv a denc::
nìca.s Lhât tlìc privalc capilal lniÌnvs are iradeqlrate to 1ìn:ìÌÌce tìÌe cL rent accou.:
dclìciL i!'ilh tlìc rcsuìl thaL oIlÌcial re\erver are taÌÌirs. The posribìlitv of a crisis sìrouÌ:
 :::':" r'': r::::: ":: 319

now be cìeaÌ. Ìl a bâlance of pavnÌents cìe1ì(it peisists, thc .crìlÌal bank ìnay eventltal\'
run out ol Ìese^es. A totcntiâÌ crisls ol this liÌtrl will lcad lo e change iìr govenÌÌent
rolicv (e.9. the intÌoduction of conüacti.ìnâry policìes to Ícm jmportsì a delallratìoÌÌ
Lri the eìchaÌrge ìate ro booÍ net expoú, an.l possibly ultirìalcly to inten'ention bÌ
Ìhe IML

5 The Mundell-Fleming model for the short run

The elements are now reaciyto bc combìncd to provìde ausefrÌÌmodel, $'lÌÌch slìorts th.
nnpact ofpoli.y aiÌd ofdomesuc a.d toÌeÌgn shocts on output and thc balancc oI lrade
Ì!r the s1ìort run. W€ !ÌÌâk€ th€ follos,l ng ars lrmp t ion r:

. MI1. ÌÌic€s ânci \!ages âre Êxed. Hcncc Ìnlalìon and e\pected inllatlon aÌc 7crc and
the real arÌcj nonÌinâÌ intereÍ rates arc cquel. (lhis alkNs us to Lrs€ arr /S,/r.M diagÌaÌn
\!ith the nomiü1iúerest rate on thcvcrlicaìa.isl.
. Mf2. lhc homc cconoÌÌv is $ÌaU. This nÌerns the homc economy cannot afiect tlÌc
$,orld in!cr$l ralc ora'orìd outplrt.
. MF3. leÍect c:ìpitâl ntobility aÌìd pffIcc L asse t ubstitrta bilÍy. Rcs idenls of th e home
s

econorÌÌt ca buy ânci sell bonds ol Lhe foÌcì8n country {l{ilh Lhc inteÌest Ìate i') iÌÌ
untimitecì anrcunts at kN trnnsactlo ns costs. Thereisnodiffercncc ìn Ìiskbet$eenthe
boncìs. This imÌrÌies that un.overed inLffcsL Ìtarit]/ hokls.

TheMun.Lell llemirg nnrdel consis l s ol tour cìcnrents:

1ìl the open economy vernrÌofthc goods ÌnaÌket equilibrium condition tìiruÌ€ holne
Êconoml nÌmDÌaÍzecL jrÌ the 15IM c!tr\.e
12) the mon€y marlict cquìlibìnun condition lor thc home economy sunìmarized in the

(31 the 1ìnanclal maÌket aÌbiiragc or uncoleÌed lnterest parÌlv .on dìti(ÌÌ mnÌnarizcd in
the LIf cuÌve and
i ll th€ conditÌoì lor lìnancial lntegration when expcctati{)ns are fu lÊllcd i n the f{n eiSD
ex.hangc markct, nìmaÌlze.Linthe i - line.
'
Short nrn equilìbriunì is rlhen the good\ mrrkct Ìs in equilltrrium and whcre the
erichangc ratc ls nol cxpcclccl to charse. Thls IÌÌeans tbat the eco onìv rnusl lic on the
i : i linc bccausc as thc U/l con.litioÌì requires, only when hom€ and I'orld inteÌeÍ
ratcs arc cquaì is l h e cxpcc lÊd exchange râte equâlto lhe actlral erchangc ratc.
'lhc nrodcl ca. hc uscd Lo anaÌvse policy choices b,v the honÌe ilovcrlrmcnL and aìÍ)
lNll+/-in thc inpli.âllons ol a changc in ecorÌomic c,rnditiofs eìnanating lrom thc rcsl ol dre
Í'odd c.g. a changc in lhc irorìcììrterest iate or a.hange ìn woÌLd aili]regatc dcÌìand
or lronì thc doDcslìc cco.omt e g. a c.Jnnrmptio. boonÌ oi a íurÌìp in lrN.cstmcnt.
\\e draw iogclhÜ thc rcsulLi nÌ diftèrent di\huban.cs under.lifferent erchangc rate
rcgÌmcs,lcaling thc lasliof oÌki Dg thÌouglÌ the detiììs o t each case as aÌÌ erercisc lo r lhc
320

5.1 The Mundell-tlemìng model and monetary policy

5.' I Fixed exchânge rates
It \.lrile jÊ(n rbort. ÌrherÌ lh. Èr.ÌÌrng. Ìrte ffg h!\ t! b. ÌììiltrirÌ!'(l thc l!iì'
c.(trìoJÌt Ì(Ar5contr)Ì. lt\ nÌ!n.\ nÌÌrL\ tr)xÌÌr'LLr'mttÌ)] ilrrhoÌrtÈ"n'ml t! usL
ÌnorÌrtnn Ìrrlì.r l: lr(ì Ììd lr) L,r lfcltc.ti\ r I il rri inlt tht .r.r'rllc ot !Ìì lrlrn\nÌli 1
Ìn!ncLi,1 Ìa)Li.\ The .r'rtiìÌ Lìr.Ìi en!r!rs i. rÌÌ .P!. nrLrl.l .rfc ati(Ìr 1lìiL 'oÌìtin\ '
rhefur.hrt1,lh.DeL,!n.]tiÌr.rchrÌÌfe111rn.\l\fintt!lrÌÌl]nrl ThtIì1'úÌ\er| L\
tr) tl̀ r ght 1Ii!. |.9 .
\\'lÌaÌ isthrnrrìr)It,trnÈq',lihÌirìnÌ?5ln.ttlì''1chLD3'retcÌ\n\r'l 'iÌuiÌibrjrLì
LÌr tlÌc ]flrrrÌrtio.el tlLì..iìÌÌÌlrÌkri {ÌÌìxìrrÌirtl l' tht Il|
rLl'Lâtes thiri lÌrt
'o'(liti'rÌ
jÌìttrr5t rtc ÌÌl!5t ht eqüel tL,1hr'r(tr1!i ifL.Ìttt ril'' Ìler(( lh' nel! equ lihrirnÌ m!\t
be rt l, ÌnorÌÊti,f t,)Li.\ lrr: .o ettt!1 hl\ it bc'r$e tlìi |LrÌ'h!\e oi honrr bo'(ì!
nl tiÌ!' ..nrrL binl L)fts uÌr th.iÌ Ìrri!Ê ind Ìrrr! ì's lÌre irÌ1' 'sl rait lÒrfn(a : nìxl
rÌrS torL.iÌ Ìr.Ìr.ls uÌrLtiÌitlil. llLú tlìe .lnrraL trinl 1\
(onì|rlllcd to nrilfl'ìúÌir]g tÌre
c\(lLìÌrit' Ì.ìtr \,r rnÌLìslt6el.r.g11t\(tìrrrSeÌe:crac\t()t!Ì'lrr\tlurfLlsindpl'rcnt
Lhr e\.hi.!e úLr rt)ÌÌ drt.e.l2Llt! llLl\ L](ÌìÌri L' the nì!fr'trÌ\ t)rsi cri'tt] 'r
lsct'
Lheiniliil L.jc.tio..lrÌ.1!hi!|P.r\trelÌìì.ntl ÌrLtìl(!r'shjit\Ltili!ìjIt)i'kl(l

5.1 z Fì€xible exchânqe rates

\\'itlÌ il!'\ibÌr r\.hâÌrSe Ìrtct. ih. !r:.ÌÌa!Ì!r rrte !iìn r'1lu5i i' i'! diÍr'fei' Ì)titr'crl
tlrr rl!rÌlnj( rn(l thc \ 1rrÌ(1úÌ1r tsl rate !r'n.Ìrttllb! r 'ÌLrrÌ!r nÌronltr]ro"Lìr) poli'\ '
{rÌerÌri.n!triLr\ Ìnorel^Ì\ Ìro i.!riÌÌÌ)u\ÌìtL( \rÌlhchonÌeirrLrbÌrrte llrlirilLÌrìllit
touÌrdbo.lr!.âttrartlr.ìrÌdlLrdn)rdrlÌe(itnrrrotÌlÌtr\rh"ge'ú!'htdtÌìll'j
:ti.r ÌrLll l!!51 nÉt eÌÌrort! oI thc hoÌÌ( r'..n(!Ìrl lnd lÌr'Lr !Ìr tht Ìtì cl ' outÌ)ut \'
(Ì!tfrrL l\$tIr{ìemrndt.rnÌon.\rilÌriÍr.(1ih!'h(ÌÌÌtiÌ1t'Í'51 rrteriLlr'Lurrt!tÌrr
\or dÌcrel \l.netaf PÒl(\ .in t|erttor,-'itlt.ioLLL|utìr tlì. 1ÌrLìtÌ)'rlin'L'
Ìhr ren rlÌ,),I ruÌ!.qLLjlil)riilnr rÌ!it lir .. tÌre i i'LirÌe\i1hÌh'c\(11ìn!lÌrtceqrL:l
t! thc c\Ìrr(tid r\(turlg. Ìair.n(11he ìÌrii niÌ ilÌÈ (q!ìlto tlÌr \i1rrÌd intefn úrc (;ì\!'n
th. n.\ lll .iÌre. lrir mer|5 thrt tÌÌt nür t!!lliÌ-'ÌLuÌÌ riLl lìf rt l.ìÌrt 1 n lig. 10
r)

F....tlìrl-\\\Í(ur(mrnshLlinrtÌÌ(Ighta.ll.lrÌre(tirollìlÌrctìI irndl=i h"

Figure99 F,:. ..'.1 Ì.r':lr. i.r:r iÊ.

 321

Figure9,l0 Eilrnjrrìrr f. ..ì.r ,.r rÌ

:LZ lh. iqhlr{iìd íÌi1Ì in tlk -'J \ì1 .!r r I ill tie brou.l r I iÌborLL bI Lh. dct(.ii1ì.n o
,

r. r\.hang. rilr. \\e rL\() lìÌ!r tlì.1th! c\.lrrn3e r.t dc!.r.l.Llon fii ls LÌr!. L,rr li.(
., Lhc | {hL. I r.rr rilL Ì)e r tirrle sLrrp]lrs iìt the neÌ! lhorl tuLn (qr llh.irLnr Ìx.iÌ!s!. rh(
ìLÌrc.iilionr!ìllhi\!irÌcrer\.do!t rtbÌ nÍireUÌinthL i..râí.ind.nr.iLl.ehírqrLio.
(iL.rÌri.k l. qÌ .rì I I :1rtrts
lJuL .I I tri thc n6r cquj
Ìroir dors ilÌr Ècoru!\ rlljun ironÌ tlÌe iÌritj.ìL rquilìb.ium
r, rLnr o 1 irnd rlìrt Írle i5 o.?lf ig.9.lÌ,N.:dÌaílhc
fLirtrd lrÌ 1lÌ. l-lli.oLìdil
rlL iÌ t,//)..lxlitioüirÌtheLeìtptìnll.lÌ!Ìn(ÌÌrbrrtlr.ilrs sdriÍ. or i glr.. rÌtÈclrd
. \.h.n.1e Íilc. r'' ìnl nlrr i rlÌrt u ill lÌìppeÌÌ t(ì tlÌe ronri.el .\.h..gc It! il r]rc LnlrÌ
.n riìl. dr\ i.ìtÉs irooÌ tÌÌe ü !rL!i rirte. I hr proce\\ ot.iirL\LÌncfL lo ürc nes equjÌÌÌ)riunì
..püìrls on h(\Ì e\.hr.ilc rate e\pe(tirtiLrnr lre llr rd. \isLLnrc thrL agrfL\ trÌrdateiheiÌ
.\rhrnSC irtr erlre(trtlr!r\ u\iÌÌr r írnrl ot rlrpti\r c{|..tatLo.\ í) lÌrrl jl LÌre eì.hange
r.,t! .lipre.iàter tro!Ì r., tLr .r. then trr nÌ.ìll â!\!!Ì!'thnL thc nor rrfected e\chanse raie
ìieqralt{)torÌ.\tterlooLiiÌrg!tihe.ìdj!\tÌìrrntIro.cs5,Íc.o.idrÌÌ!hdtheÌ)trn\itre
.,\nrnÌc rrtiLÌul r\pict:ti1!r\ ìÌrifu rrl.

:.' iI I !. .r.1(1. .Stet)l.lheÌightÌ\aÌ.1nrÌlt.tthel.\ÍcureLra.l\to,ìiallflh{rÌôÌìr\Ll.i.ldc\trate

and r\rt|ui !iier l.l Iì jitheAlì1 l,\í !lfusranÌ
. SL!'p I Lhr lall ln 1lÌt irÌ('rcsl rnLi nìfÌc\ \lâ lhe L:n !!rÌ!litj,rÌ that tlÌeIe i\
i. lrn.ìr.d iìt. dclÌr.i.úiorr oi trc !.rrhi.!. riìÌc Lri . in (rder thrt tlrr eiÌ)e(tÈ.1
if|r!..il o. li.ìl''br.lto Ì' rr.ild.ií scl Lh. c\fe.ted iÌrieren ltn\ tÌonÌ h(ìld
ig fn(rnd riLhr, lhàn d.ll bo.d\ hr drprctiìLj(rr (ì.cuì\ trecau\c honÌr re\i
drnÌs lclÌ !.rL.ds rnn !!r iolliìl: Ì!lLh rrhi.h lo pl'Ì.h$t the hi!heÌ iÌriere\t dolhr

. \fuÌ) :J. llÌr drprÉriah.n ot rlìe e\(haÌrse rete ÌÉad\ to ir rilhlrtard shliL ol th( /!\ \/
ixne n) IJIìI r rìrj.h ÌaÌrcs (trúfut tuth.Ì i,! ( irÌ 1lÌe l-\I1l dliìlrim. lhi5
lear e\ the h.De i.trÌ.sl Ìxre bÉÌür the s.rl.Ì interÉrt rrte

\,,,,, . !LL:l) r!'..!sr oi tlÌe !Lefr..iitior ii thr .rclÌàn!!' .eLL: Llìr'.\fc.rcd.\châ.ge Ì.úe
.1
.Ìri.g.5 i..oding nr ihe ad,ìlìtilr r\D!'.tâtion\ Dl. lhr fdL LIII) eÌrc.Ìo\sc\ the
l=i Ì ic rJìr' c ih! ÈÌÌJÈ.trd .r.hirrc riì1r- equils. f!c. llg.9.1ll (rircnlhrttÌre
tzz ::

: lrÌiao.

/Jl,1r (. r)

figuíe 9.11 ExÈinsoftïy monetary po .y .dj!5im€nt !nde Ílei b-" êrLhãfqe rat.5
(à 5 ofr a.liutmeÌ oí.r.h.n!. Í-1. êrpe.tàt ôú (àlapt v-è Èxpê.rât ôns):..1 ! óix dal'trÌmcÌ.í oulp!ì
an{j.mpoym.nl ÁtoAioa ìoZ
(lt m m.diàÌ. .dtLfimeii .Í Êr.hà ìqe r:tê ê&e.l!lóÈ lô thè.e$ 5hoÌÌ r!n eq! bÍúm1ràtonã
eip-è.Ìãr.nn ãna Fpa àalúnÍrêfl ól Õ!tp!t:/l to z

cÌpectcd eachang. rate 1s no$.Ì the actual e\changeÌaie Ìvi1l clepreciate tiutherto.l
an(Ìthc cconomy r!ìlìnr)ve to C' in the UIPcliâgÌaÌn.
. Step5. lhi\issirÌÌpl)arepctitionotíep3:Lhcdcprccialiorto.rshllLs(hcAl\1!lfurther

CÌÌce the honÌ€ jrÌterest rate is €qual lo thc Norld ìÌìtcrcí ralc igairÌ, ther€ $ill be no
lìrther â d j! stÌnent: t1ìe econonìy ls al lhc nc$r Íalrlc shorl-run cquiÌlbri!nÌ atZ.
We .ould take â radicallt diff€rcnr assumption aboLrt cxpcclatìons. Suppole that aÌl
agents !nd€rstand t1ìe odel oftlÌe ccoÌÌorÌÌ,v ind can iìgurc ouL th€ exchaÌÌge rate that
is coÌìsìstent Ìlith the ne$ íÌort run cquiÌìbriuiÌì at Z. Ìo do this the) nÌLrst figure outthe
.xtcnt of depreciation req!ired to slrìft lhc l.\;{ÌÍ .urvc Ílfficicntl! lar to the Ì1ght that
it intcrsc.ts th€ ne1! lM' it i i'. Thìs rncans that the)'cxpc.t the norÌlnal e\change
ratc lo bc I - ., as soon as thc nc monctar-r polict Ìs arnouoced. Thi! impÌies that
tlìc Ui P ru^.c iumps fronì trí,o 1c) UII], ìmÌÌÌcdÌirtch Gcc lìÌ9. 9.r Ì). 1/ tlÌe iioodi maÌliet
ad jlrsli cquaìlyripidlv, thcrÌ thc ISIÀÍ cur\.c nÌso iumps imnìcdiat€l! to 1JIMir,,)ând the
ccononìy nìovcs nralghl lo lh. r$! sÌrort'run cqúìlibriunÌ al Z With so (aÌle.l Ìatbnaì
cxchnngc rntc eape.tations ind rapid adjustmerÌt in the goods ÌÌrarlet, we obseFc thc

It is vcrt idìportant to note tlÌal lhc .ch'short ruÌÌ equilìbriLun exchange Ìatc, r'7, ii
,drcqualto..lhcrnovc.rlrrr.gthcinilìaÌi,ìll,cu.efionì1'toli'isítelyaconscqucncc
ol the arbìtragc conditlorÌ in tlÌc trdr.tu/ marNet given the fall iÌì hoDe\ intcrcí ralc.
The í?iÉ rl rhc Lrlr,frLrvc irom UtPl(t = eo) Ía Ltti.eL €z) refÌects comflcrelv dif-
feÌent economic lorccs: thìs rclccls the charÌgc in f that is required ir the Íor./s mar :igurê 9.12
ket to ìncÌcasc nc! cÌpoÌLs and shjft thc lJX,\,1 from l5x,\,1(c,,1 to ls-{it(.r). Tlìcrc is
: .

theref(r'e no Ìcason ntrv thc dcprcciation from .,, to er implied bv nnanciaì arbiú-
age 1s the saÌìc as lhc dcprccialion filnì f0 to ez rcquired ior tire nei! goods markct
 . 323

51.3 lntroduction to exchange rate overshooting:exãmple of contractionary

\J monetary policy
Fxchange Ìate orerslÌr)tìng occurs when agents lÌavc ratbnaÌ expectatlorÌ\ ârd thcrc
ú nugiiinr acljütnÌent ìn tlÌe goods Ìnarket.re lÌì conlrast to tÌre tilo sceÌÌârios in tlÌi'
pÌevidú sectidr, thir .loes noi ÌÌak€ €ither of tlÌe problemâtic asnunPtioÌÌ\i agents do
not repeatecLly use an erÌrneorìs lòrecasting rule (adaptne expectâtiont nor does thc
goo.lsmarketadjustlnstantaneouí).
As it happens, tlÌere 1s pÌent)Ì ol€vldence that chnngcs in the real exch.nile rate talc a
Ìílrg tìme t() fee.l th()ugìr.2') LÌ the ca s€ ol a contracl io naD nonet.ìry policy, thc /.SÌÀÍ
ctrne i{ill theÌef{Ìe th1ft onì), sÌowly to the le1ì in Ìcsponse to the r€al .pprcclalion.
Let n\ ppose that eÌpectation\ in thc forclgn cxchanije market reirct in a lonrald
Ìooklìrg way to the nronetarl co t.âction. !\Ìrich rÌeans that tlÌe expcctcd cxchange
ralc juÌnps t() the nerr cquilibrnun râte, ç aÌÌd the lìclt L'il'curle i\ L'lÌ ln lÌ8 9.12. If
outfut onlyadjusrs nug8ishll to the monetarycontraction, thenthe econonìy movcs up
thc A_XM(.o) Lo point 8 Wjth the home intereÍ ratc above the Ìlorld lnlcrcsl raLc, the
nonìjnal cxchange ratc Ììust tìÌerelore appreciate t/dÌrr than r?. Às íìoÍn in ìrig. 9.12,
thc cxchangc rare Ì!rmps !o eL. The e-\tra app.€cìationbq on.lth:!tasso.iatcd$Iith Lbe neif
sÌìorl run equìlibriuÌn ìs Ìefenecìnr âs'€x.hange ratc oveÌnÌooting'. As lhc LlXM thifts
gradualìv lo Lhe lelt jn Ìesfonse to the apprc.iatìorì, lhe ecotÌoÌlìy mol'cs down the UP,
cur\.c lrom 8' to Zr. Sìnct nui#iú adjuÍmcnl Ìn lhe goocls Ìnarkct is wcìl documented,
Êxchangc ralc ovcnhooling is belie!ed to be a fa.loÌ lyinii behind thc volatìlii) ol th€
e\changc ratc. F..changc rate oveúhooting is a t\'orrylnii phenotncnon sìnce !oìatiÌity

'1 a1 Z.

:hr rjghi rlÌar

rrtlcteìv dif
Figure9.12 conÍa.t.nõry mor€Ì.ry pÒ.y anÊtampeoiex.hàngèrâLeotetrhoot.!

l lhciriiir nl(.io(Ìrh.,tirgÌÍasdereÌopedLrtRndisrÌLÌtrnbur.h(19/6r.For)lrryrerdrbler ro
l!.üìì n)ihr LÌmbu\Lh.Ì eL, \ce r.3olL (20lr,l).
I'Iolea rple,CânIcl.l (2001)Ìq,.tìhatihêIuÌÌeÍIÈ.tonrrÌr.rt Ìrd(êtshiÌe.Ir.hrfgrjnÍi.Éal
:r.hinsc Írt. (rì(J\ncn bv (.\i(..,Ì)ciitn'ênÈsl Lales aÌ'e ro sir vur\ nr feed t]ìlon3Ìl
t24

in thr rcaì exchangc rat. câu\ed b)'lhì\ can Ìead 1o lhc nrisaLlo.iti.Ìr of rcsouÌ.es, f(tr
enamplc, awa) frorn lhc tÌacìeables scctd to the non L.edeables sector ìn thc ccononr\
lÌoduclionunit\inthccxpoÌtsector Ìna-Ìbeclosed prcmatliÌelt and ÌÌ€Ì\Iir)vcslmcnt nra\
tak. placeir resÈÌrsc Loe\chanil. rale signaÌ\that do not retÌect fu ndancn 1aÌ (Ì)n onli.

51 4 -An explicit modelof overshooting

À slmpìc Ìno.leÌ oi olcÁh ootinS is usc llrÌ to \ee erâ ctÌl h or! padicip.nts 1rì t h c cxch anse
Ìrì.rkc ls caÌculate th€ nnì ount bi ÌÌh ich th e exchaÌÌgc ralc has to â ppre.ii tc and h e nce thÈ
\ìze ot the oveútÌoourg that will occuÌ Thi\ .ìsnrmcs, oí course, that Íorcìgn e{chansÉ
nÌrrkc! usc ratidÌal cxlectatidìs to dclci!ÌnÌe the lLúürc values oi tlÌÊ
taÌtlciÌrants
erchangc Ìate. Before looklrg at otcrshootitÌil, i agitc that er€rythÌJìll adjusts imnÌe
cii.teÌ1. \{c can ciothls uslng Fig.9. Ì2 \\'etalietheslmÌrleNlrìndclÌ Iicdìingcâseolac!t
irÌ tlÌi'Ìronev tuÌrp1y undcÌ tìexiblc cxchtnge iates, sn! fÌonÌM to l1 lilÀt.Thisi\the
eqli\'aÌcnl of tìre iÌÌward shift ìtÌ thc l LÍ cu eitÌfig'l Ì2 tÌoÌn lM tol,V'. A dennition
ol equiÌibriunr is a ltabÌc cxchatrgc rate, Í) that iÌÌ thc shoú mn equìlibrluÌn at ihe e d
oi the proccss, ì,Arri loA!. This tr'ill be at Z' nÌ thc UII] .liagr.Ììì, Ìlhcrc lh. hnaì Lj//']
scheduleis L''iI) gìien byi: i'-locef losr=i'orÌ i'-l,ig.: Ì!ser = i ,aÌthoui{lÌ
we lo no( ycL kno$ the laluc of!:. Usitg the L'11conditlon e\pressed in lctnrs ofthe Ìog
oltlìe cri.hange Ìate simpìì1ìes th€ .aìcuÌatìons Lrelo\!. We aÌ\o uÍ'l:ÌpÌlcil IoÌms f(Ì the
lÀ,í and the I5{\í equationr nr ordÍ to be abÌeto cnÌ.uìate tlÌeertent oI.vctrhootiDg
L\niLisnotcìitì.ulttoirndouttlìclalueolr,.ÌhcncwecÌuilibriumlcvcloÍoutÌÌìt(l':)
lnuÍ bc Í'heÌe tlÌe lÌ1' .urve (uts the i : i_ Ìi e,rtIi.theI5lÌÍdligrinr./.Ií'1siaiveÌì
LJ\i_-ìt, rrll ,)IíatZ.SiÌìccinthene$equilibrium,theneÌ\r/-\Ittlt,rcrnei\
L .1 ,i'+ligc: t'c crn subÍitutr tìrii itriolÌl/ to gct
i = ìl rrll ,lì't = ìi.1 rri' .:f, rril /rlv
$re Ììo$'.oÌìpare this \rith thc ol.ì e! uilibrlú Dr beloÌe the cut ìn th. nrtre) mn)L)

i - ìí,1 di'+Ìog.rì !ì/

.\i .!., l"srol rul)t

nìplylfganappÌecìationbclhccntÌìeoldand.circquìÌibriLunolrfr!/,1Ìrâtis:

t' r
.-d

^
Th1\ imrnediiic adlrstment of. to its nei{ ecÌuiLibriLlÌn Ìcvcl is a.onsequence oì the
â$urÌption t1ìat thc IsrrlÀ,Í \vstem adlusts inrme.liatel),.
\'Vhat il it does rol? DoÌnlrtsch dcvcl)Pe.] hit nrodel ot ovcFhooling 1n a medllnn
rather tharÌ . íÌort ftrf contert, i.c. hc asslÌme.l thirt the objcctnc of govenìnents irÌ
(lucnrg the Ìnoncy sulttì! was to Ìoircr the lÌì.e Ìevel. hc askcd: if it taÌes tÌne
^rìd
iÈnÌe the.lecÌ1ne in outtuL as a consequence ol llre lucrease irÌthe irÌtereÍ rite 1eâds to
:re clesÌed talÌ ìn the pricc ìcvel, whât ìs the ìnrfìicatbn loÌ e\clÌatrBe raie Lìeha!iour?
\úÌce líe have not vet ir1Ìoducc.Ì pÌice changes and inUatidr iÌì the open econonÌv, Ì!e
.haÌÌ show the ertenl oi oÍershoolinij in a shorl run mo.leÌ. The logic ol the ÌnodeL is
:\acuv thc same as in I)oÌnhusch\ meditrm M exaDÌte lÌe \inPLy asuÌne that uÌe
:!onoÌnv remaln5 at B jr ìrlg. 9.12 nn a peÌlüi oI tlnre l)etlre the lali i exports ârrcl.ise
:n nnpoÌt\ have talicn placc LÌìat shift thc ttxÌí crÌ\Ìe iìom L\'-\ÌÍ(rol to I5,\Mi0:). We
rhaÌÌas\ume in fâctlhal lÌrc ccoronr) sta_\ alBtor3perioclswiththenìterestrüteatü.ll
:\.hante maÌket parLjcitânG kÌrow thls to be rìre câse, holr $ilL this.ìifect their \icw of
path ol the exchangc rnrcl (ÌÌr rhe inhoducrioÌr to ovebhootiÌì8 rbo\e, t1ìe inplicit
::rÈ
ríunÌÍìon rlas drar thcc.onoìn) Ìenrai.s at,R hrjuÍ o eperiod.l
Thus eÌchange martcL pa icipants kno$'thar i = ìr in periods Ì, 2, rnd 3j and that irì
ìeriod.:l,i=i'andll,Atr=.!f/=Ìoq.. +ìl Thev âlso krÌo(,that thc Ull' has to
rÌtveach pcÌiod. So Lhcv rcnÍÌr

iÌ ìs i_ +los..i loÂri
iz: ir,: - l'g11 loge!
'-
ir : lr, : i- + l":ri l"gr1
it ':i' :0
t'
^
\o1! the.Ìue\tìon ìr: hoir nÌrch nÌouLd ..hrÌÌge inÌnrcrliâLelv, betÌleen peri.{ls 0.nd 1,
)Ì ìeceit)t olthe ne$s about the cut in the ÌÌroney sripplv?
\{atìrenaticâÌlv thìs is rriaìghtlonvrr.l WerddtlÌcl6lthreeequatioÌ\togethcrnrgcl

:ìii! i'): l'rA'! ì(igrr

rdd then substit(te in rhe úfth e!Ìurti.rlto get

3(l' i ) kA.j lL)srr : lolto t/.r,r t.4.,

.o\/ ì" I
l
in olhcr iroÌds thcrc ì5 af iÌìmtdiate rppÍeclrtnü equal to lhc cquilibÌnìm appÍecirtion,
+I,r flis lhr addilìon aì ovc rshooting appreciati(!Ì, J(ir i l
So wlìal trcciscÌ-r is goìng on? In peiocì 1, maÌketpârticipanls cÌpect a depreciation oi
ir i tLobalanccrbcriB i rjrtere5traLgalr;tiìniÌarltinpcriod2lheveÌpectan'úher
ilcprccialion o ti, i);nndaiutheÌdetreclatn)noliü i lÌrÌpcrlod3.Thus,whatever
thc raÌuc oI .g. thcl'cxpc.l tìre exchange râte to havc dcprccìalcd cumulative\ l)\'
.liiN i-) b-Í!crlod,lr thal is, os.j = Ìog.L - 3(ir i'r.
A! lhc innrc 1imc, mnrkct paúìclÌrants have $orked oul thaL lht crchânge
ritc ir p$iod + musl ha\.c apÌrreclated bv +M ovcr thc c{change rate ìn
326 ,: -'
pcrìo.I0:hÌg€ì = L,,g.D +Ií lor botÌr Íatements lobei'ueth$c mu\tbe!nimmc
dlate appreciation ofthe.u enc) by'+IÍ+3ii' i'ì] irÌperiod ì Th s,iliisgoìng
to be above i bt ifu i'r iot 3 periods, requÌiÌìg thc cuÌren.y dcprccìates b) it i in
cacholt1ìosc3peÌi(xls,arìdifitisgojngtuetrclLrpÍ'itht drfre.ÌdtÍ,r ot +M nbove
thc initiâl ex.hange rate in peiod Lì,lhen ìt has to aPpÌeciatc bÍcnougìr in Period r (b)
l+À,r+illü i'l l to be abÌc to leprccÌate by ü i r(Ì each ol3 Pcri(xis and stìÌl hale
appreciated L,,v +itoverpcÌl{trl0.'hjsÊxtrâapprccjatìonisthcphenorÌenonololcr
slÌooti nS. Ì his cx !en Llecl exn Ìì Ple highl ights that tlÌc siTe ol tÌÌc orc sh ootir Ìg $'ill dcpcn '1
on the lejlgth oi lhe peiod cxÌrected belore the eco.ourl adjuís lo the ner! \hon_run
..quilibÌirüÌi l:iacllv the sanrc tiincide is at ríorli j. the case Ìbírbusch locus€d on
''I I.r.,dt,,r n|r ru,riJ,r' .r "r', ri m
5.1 5 Dìscrete changes in the peg: the fixed exchange íate
êquivalent of monetarY PolicY
TlÌe usc of monetn ry poÌicv c llher bl ch angirlg tlìc nìone! sLr p plv oÌ b) cìirectl-ï ang
'h
irÌg tlÌc i.tere\t rllc canrot allect thc letel ol outpul in the F{c'Ì c\chang€ ratc ccon
ou). Holleler, thc goleinÌÌrcnt or ccntÌaÌ ba has the optio. oI maliing a dls'rete
chanitc ln üe e-\change râte peg In ordcÌ to reducc outPlt, tlìc autÌrorities necd l{)
pcg l(tr t1Ìe cxchangc raler the:- must Ìevaluc thc cxchange ratc atd
ìrtervcf c at a Ìol\'ervaÌrìe ole *Ïà"-q l\iith. rclaÌuation oi lh' excha ge ratc, the
=
15,\Mcrú!esÌÌiìtstotheÌeft.ÌbitnÌturnttrl]stheinlcre\tratebcÌoÍ'theworldrntcan'ì
iÌrduccs an inclpicnl capital ouúlotr' lo mâiltâin thc nesl peg, lhc cenüal b'nÌi seìÌ\
tìreign ex.hangc( \Ã. 0).r\sLhemon.laNbaleshrlnl<s,tlìelV cur!eshilìstothcleft
'11Ìc prcces.ontinues ulÍil lhe ne$'slìort nur eqÌrillbrium at low$ output {rlith i i')

11 ls importânt lo note that il a govcrnmcnt chrÌìgcs Lhe exchaÌìgc raLe peg repeati'dl\.
this i5lileÌ) to givc Ìì\e to spc.ulation about tuture nìove\, ìlith tlÌc consequenc€ tÌìat
thr gorernnÌent wìlÌhave to charse thc inteÌest rate iI] oÌderto h.ÌÌd lhc announced pr8
]\ lÌe.l e\chang. rate syÍcm .a nol suÌvive ríith thc exining pcg i.tactilan atnìo
sphcÌe olexchange rate spe.úìatìondcvclots ThusthcÌcareliÌnitsto(hcextentto\\hi.h
.hanije! in thc cxchanile ralc can b€ rnade and a fi{cd rate s}stem nìalnlalnecì

5.2 The Mundell-Flemìng model and fiscal policy

The sanìe logjc ìr used to itâÌv\e n. L\i.Í tlÌi1ì as a consequcn.c ot a chaniie nì fis.il
poÌic_v.
...,,.j ..
5.21 Fixed exchange rates
\Jhereas thc exparÌ\ionarÍ ìnonetary poì1cy was.oÌìPÌetelv nì€ifc.tìte under lì\ed
e\.hângc raieJ. a frscal cxpanlion ln an open.'conoml with 1ìried c{change rate\, i\
very ciíccLi'e ìn rai\idgoutplìr lhc reason is thatthc jncìetsein the dcmandnÌ moÌÌe\
tÌìat folÌorls iÌom th€ fiscal expa io. leads tu an inclcase nì tlÌe ÌÌìoncy supPly ìn oúer :: I Ii:.::
tokecp lh. irterest rltc cquâÌtotlìc oÌl.l interèst ralc .i r:rsir r .; :
r\sbclorc, welooklìrí althe ewcquiì1bÌiunÌandlhcn attheâdjuÍÌÌrcntllath TheiÌÌi
tial poli.)'change is íì,r$,n jn liil. 9.r 3 bI tÌre ighl*'ard shitì olthe IJIM IÌom ti-\ì'ÍÍil
 327

'r!\r ire an imdÌ!

lrÌrs il i is SoiÌì!
r.ìrÊs bl ii /' iÌl
: 1 ri .ìì)!r.
-_\/
rì if L,eriod I rb\

lo
lir-

Fiqure9,Í3 ::!à1-r r.rf,i.i i../ rr.ri1. ìr!: it

r.,!r 6 nrr.Ì 11]

-lr,r.!t r.rr..if(l /
: l.l\Illttr . 5ì.ce lhr fcN sÌroú ru. rqrilibriLrnr nrtrsl ÌLe .n thc i = i lj.c. Lt mút he
,: thr hìther rrtÌrut l..l oi I This mcrns lÌrrl lhr / Ií.ún c murt dritt lÌom LtrÍ lo lìl'.
rrtrr Linr LioÈ\ rol Ììo!!.Ìrc.âu\.11ìc rciÌc\.hinilc ÌrL. Ìrmai.tLurchrfged $attlr€
::.v nuÌ ru. cquLlibrirLrì lhffc ls e LriLl. dcfcit (lmt.rr! br\ r i.cÌeeredr.
lne adju5lme.l tro.(.5:.(ntrcs on tÌrc imta.l .l Lhc ut1úd trÊ$ure on the hone
nterc5t Ìetc duc ro tÌrr ls.iÌc{lin!io.. lhisLLpllndlrc\5uÌeonthcì.teÌe\tÌatecreaiet
:\Le$.lemafdl(Ítorndj . LÌr,.1.r,,{n rìrhiÌngc mrrlict IÌr ordei to ÌieeÌriÌre crchdrÌ!e
.ì:e h\e.Ì, thc .rntÌil Ìri.k Ìr lÌ hIr Lt) ús. f.rflr trj.ie.ì rì(De! nì pur.Ìrare n)rei:rÌ
-rÌÌcn.l.T|cIoÌti!.c\.hrngrr!\cnr\ÌLsc \/i - ()) rith the reiìLt UÌrt UÌe !lLÌtre\ti(
Ì(De\ slÌÌ)tlvc\tâ.d! lh 5 sÌriil\ lhr LIí.uÌ1c Lo Í lL Tlìe ilten erúi(Ìr trt tlÌe GrÌtraL
,rÌrÌ\ree.ÌuiÌibìetcsth.orrlgnc\chanËcmrÌÌ.tSinNÌtaneoud)theri\ÈirÌr]rÌrÈ\nrp
,.Ì1 in the hoDe È.onÒ.ìr tr ii lhc n.Ìees. ir Llìc m.nrtar\'Ì)at a\ re\enei ri\e nÌ LirÌe
:!iththei.cÌcarc nd.nrnodì.ÌrrlntâLnstÌìr: nLcrcst rate xtthe \!orl.liìte.

i 22 Flexible exchange rates

h. fLrtì,:!ÌlÌcrci\tli.rturÌ!le.tÌr\ibleerclLrnsektcs.ìnc\parì5io..Nlli.alpol .rrrlÌl
.rdl.n.ouLìt!Ìi.iiÌrsrleÌire$i!eelle.tbe(rn\ethehÌ.rcasci!ì1Ìrcdonìr5t. nlcr(sL.ilc
,,illlc..dLoanappre.iatioÌÌollhehonÌe.!rrdÌcÌ.!1hi.hiriÌÌjrrikcnncr.aports.
o iì.il L r. Ì1cÌ! :h.trt ÌurÌ eq!iLibriLrm. \ e lnon tlìii tlìc l5-\-\1 :hiits initi.ll! ro thr
, ght 1o /t.\r./ .{r i'ìì r.rnl uÌat jrÌ uÌe n.ü ÈquilibÌi!ÌÌ thr c.o.onìr nrlsL Ìrc or th{ i i
l,.c Il li lhrrciorr .lear that tlÌe rlDreciation ()l tlÌe e!.hin!. LÌr m!Í bi \uirì.icÌrt
Ln slilL rhr l5-ï,\l to uÌe Ìelt t! lJ:\,\'L-!Ì.. . rrhi(h iÌÌerse.ts rhr i i_ lirÌe at I t\tr
1s.9.1.1). hclcrrloioxtÌrutrttlÌeüe1\\lxrtÌLÌrÌe!üilibriunÌi1 isr\.c11) thÉnrmeàs
i riat oriil nall!. Ll!tuÌeÌe 1\ a lri8her L. el ot go\ernneÌìt erferÌd iiule .r nd r ld\eI k\ rl
iI fcL c{for(t: tlÌc jncreafd 30Ì en!!uú tìe.diÌrs hd\ tu\ ded o!t sonÌe Ììet e\ports.
ih!l!.o.llrmcdb\tlÌehctuÌrttlÌetrrrlìÌreshittttothelÈtttoi]rÌer'equiliLìriLrnìrlt\s
 L
Lr lnr rLÌ !ìc

lr

Figure 9.14 Erpdr i!ìnirtr'5.. pô .lr í.r h..rL â1.3 rii.

(.ompetiti\e eri.hangc Ìate imtìie\ that tr.dc baìance srill o..ür at a lor{eÌ output Ìctcl
'lheÌe is thereÍorc e tÌade.lclì.jt at the neÌt shoÌl run equilibriunì
TÌre pÌoces! ol adjustÌÌrrnt to tlÌe ÌÌe\! cqLtiìibÌ11Ìn cin bc anaÌ-vse.l usnì.q thc siìme
5ttts as 1!€re lrlro.luced in the arÌaltsis ol thc txpan\ion.ry dìonctaÌl PoÌn) arìd Ìs lcft
,\ rn e\er.ls. hÌ the.€.ìdÜ. Acìiu\tnÌent will ÌooÌt \olÌÌc(nìal dìlleÌent 1n e?ch ol lht
expe.t.rtions s..naÌìo!:tra.k!ad loolil1g, rnÌìrtraì\!ith ripid adjr6lÌncnt ol o tpuÌ,n.d
ta ra looki.gwith íoÌ! adiu\tÌÌÌent oioutpul (i e oversho,rtÌtÌg)

6 Extensions
ln tbc Ììo.ÌeÌ ol tlÌc vìall open c.oÌ1oÌÌìl lbe aìm siìs to !rovì(I.: rnalvticaÌ claritv Lrl

usingbc.chnÌrrk (.Í\. Sl)ecifrc.ì11) s'r lì ivc deveÌrÌ)ed i modcÌoI

. a snìaÌl oPcn ecorÌonìv
. in irorll olLìcíccL caÌ)itiìlnìark.ts a!.Ì
a

' pcícct asiet \ubÍit!tabiÌìtl.

abo!t lìn anciaÌ iúegrâtion (pcítct ca|italDxnr itt and p(íccl asset
'11ìc assürÌÌrLions

$bÍilLrrabiÌitv) e(atrlish had conreb on thc so-.âlle.l ilLonsisten(t triirÌìgli'or otcn

e.o.omÍ triÌemnìa. ürl! l1ro olthe lollo\lijÌil lhrce can be nraÌúailÌed si Lrltincou5h:
(11 oprn .np ital nr arÌtet
12) h\e.l erchrngc Íalc
ìr.ì ''1. 'ri r',1 -l !
"
 329

with perle(t inteÌnarlo.âl catiLaÌ mobiÌitì,. either (!/) the ra.hanile Ìate har ro be
Ircd Nith tlÌe lÌnpìì.ation thãt nronctary pollcv c.nnot pursue dorÌÌe\tic objectnes
.r lr) nÌorÌetary poÌicy i\ uscd to pursuc donÌestic obiectives with tlÌe inìÌrlicatl{)n that
LlìccÌchinge râte üs ataryct has Lo bcglÍc(] up. LÌecau\€ tlÌe e\terÌt oliúenratlonaiìzâtfun
.lcãpitiÌnì.rketshasbe.nin.rcasinginrccrnidecades,ith.ì\LJeeÌÌmggestedtharcour
trici arc Ìn.red\ÌrBl! forccd inro Lhc hlo corn€Ìs either br" .rdoptiÌÌg a ha exchangc
rnLc pcg or by aclopting a lrcc noat. lhis is tlÌe Í) called'blpolai vie$,ot exchaDge Ìate

Wc slÌall erplore whât hnppcns lo thc slìort nüÌ belÌa\icÌ[ ol t]Ìe economv when the
ihr(! ass!nìpiids ofpcúc.L capir al nìobiÌÌt,!, snìaltress,.nd perlectis\etmÌxtitutabllirl
irc rclâri€d, büt hÌst thc cridcncc in rcÌatìor to hÌtexr.tiüralfrrÌâncial intesration is

6.1 Evidence on financial integration

L..drr thc asnnüptnrn ofl)eúect inre rarìonnÌrapjtaÌ mohlìiLv, changcs in tbc nomiraÌ
crchangc rate are caused bv deveÌotÌnenls allccli,rg lhc cepìraÌ â..ouDt. ln prjncjplc,
nnv ftrÍent accourÌt jmbaìan.e.a. he nnan.:cd throlLgh thc caltilrì account al Lhc $rorld
inl.rcÍ rate. lhis is nnnmaÌize.Ì nr the ttlr cordllion. This f.atu. of th.r lnìaÌl opcn
cconoÍì! nìocleÌ Lrises t'ro qúestions: hoÍ'signilìccnt are ctrrent accounl ìrÌbalânccs
,rnd hott Sooil i\ tlÌe Lril con.Ìitì()n ìn pÌacticc in accounting f(Ì eÌchange Ìâtr chaDgcs?
Res€ar.h iÌì this freìcì1s in an jntense phasc aDd ncw lndings arc ìikeÌ_y k) enrcryc orcr thc
t)oli(.v ârì.1i\ Ìetì
.omirÌg )€âÉ. Yet tìre ansrrcÌs kr both qucsrìons sLrggcst that the arsumprionr Ììade to
dit(,irÌthi\ chapteì aÌe opcn lo chalìenge.
.\ feahre that continucs lo di\tiìrglrish corúrLrìcs fìom Ìegìons ìs that dre cltrìell
r ccount inbaìarces th rt i rc obscn cd frÌ co lrn rìcs aÌc nruch iìrÌle. than the) aÌe iaì
L

r€ll.Ììs wlthjl coünhi.s. ln otheÌ wÌds, thcÌc ìs a tight coÌrre.ti(Ìr bet$een cÌ(!ÌÌestic
\aringsandinvestmenlalthenationalìe1elbúl\.eDÌìttÌeconnectir)nlíirenríelNlidt
Ìhe !ubmtionaÌÌe\ el. Ì.!mitcd sfatial .oÌÌrìation is c\actl) uìÌat would be expecte.lilthe
rdpiial ÌrìarÌ(et iras.Ìojng l1s job of aÌìocati.g lavings to the most prodrìcti\ e irvestDÌent
Ìirl dd il\ p.ojects Ìrespectúe olrlhcÌr the tarings r!cÌc gcÌr$ate.1. The high coìreÌation between
LrI
natidìaÌ \avìngr an.Ì inlcslÌìcnr rrtes rlas ftÌi( do.umente.l bv Fekhteúr and Ìk)ri{)ka.rl
FeldÍeÌÌ an.l Ìlornrka burd â corclatì(nr bclwccn lhc sìraÌe ol irvestnÌent 1n GDI and
Jrìvirìgr ÌÌ (lDl of 0.89 lor lhc p$iod I960 7,1' a m.Ìc ÌeceDt stud) has nrund a co e
latiorÌ ot il.6 iar OICD .ou.LÌirt bcri'ccn l9!)0 nn{Ì ì997 Lirhich Ìises tl) 0.7íj 1f KoÌea
i\ iÌìcludecli.rr Thus ercn in Llìe l99Os, natìonal boÌd.rs afpear to nratter foÌ acces\ lo
(ìpitì1. It has been âÌgu.d rcccnrlv lhâ! naLionaÌ bordcrs aÌc of.linrìnishjDg imÌroúancr
\ithiÌì the EurTean lrnion.':r
'1he L,ï? con.liti(D priÌÌicls rfal il the hoÌrc intcrcst ralc is ebole the iro d intcÌest
r.te, tlÌe exchanije ìâtc is cÌpcrÌcd kr dcprccialc. tÌo(rcvcr, a laÌge Dumbcr oI cmtiricaì
nudieshaveshoi{ìrthaLlhclnLcrcslÌarcdìtcrcntialbcrtuccnLrocuÌÌcnclcsisnoragood
predictoÌ ot chaniies in thc cx.hangc Ìatc. lror periods ot rp {o onc vcir, lhc !rcdi.lcd
i loriSo.dirúodü(infr.s.rFi!.h..(2rO r' FeÌfjrÈlr rìIJoL.ki (rr30).
)
rr ()rxitt drrd Rololl(:OO0r r/si I BÌânrhn.rLrnd(,i.ia//i(20021.
 il

330

;:ïï::liìi::ì::::ii,';:ï:iliìiïlÏÏliìill::lil;;ïïiì:Ï':'i:ïì:::[:i]':ìJ':ì;
o, eÌchansc ÌiÌte rerinh' n
r:
liïl:,1;lì:;;'ìì;.;;^ÌL rroro,rion

6.2 ìmPerfect caPital mobility

*l::::,:*:]*:'l;lL;l':11"":Ï':i:::lili:'l:il:ïl;:::::lill:ì:":''liJ::l:i'll
iïilìiiïi,:.::.ìì.ì;':''i:a*tiLrurti'r 'lenqur^Ltlï"1':1il::'J.'i.ïii::,ìlìï:|lì
illlì:ìlìïllïìiìÌì,:iÏ:iìiiïiìlll'ïlil:ïïiï'ì'l'"i"iì"'i'"""ìì""i''ìo'"''"".'""'
c';:fÌ:::;1"
!'.::iìì';.;ì';;,";,,,'',;,,'Ìdì" !n'ìlhe rÌÌÌìÌ'icdd:\ l:::i"iii::Ïìïïi::ï,

.,t.
'
.'''''''''.

lolicf t"Ì
2'
rs r c.rÌ1cntd
(ü lìoq oÌì cJPit'Ìl ÌnobiÌiÌt ití'ct lhr 'pcra
\\jc dr]llloolt alÌro t\anÌples '.!Ì:triiÌìÌ5
tl.rÌ ol mr.ro.Lon!Di' Èì1c\
e\cherÌ'lc riÌLe\'
' LÌarfti( L \lonrlrIr poÌi') undc! 1ìxed
rhenttri(t (Ìì oic'rtitìÌ'"*'." '':'llÏI,ìiìï:lï:ïli:ï lÏi,,:ì:lllì::ìi:::
Ìrâì it Ìnrnn: tÌìit monetrr! lolic\''af
lÌall
rÌr(iJ Ì,r! ì'
ïï:i:.:il;;;"ì:,;,,''.e ;.Ì c,,,iÌa,
irn lll oli the grcuÌr'] 1_úlin'ial irlcgrati(
:ìÌ:ilï:fi :ì'llïi;ìiì,:'Lilii ;\ï
:irïi#k'n:r*1*rqlr4:rhi **ïiirl*ì:,
Ï""ìì"'ì'ì'iÀì" u.."" - u.'"
iìiiiii;ìl'ìllìÏ;ÏiiÏ,'lì::::iÏÏï:"ï:Ïiiì ""'
j: rbre Ìo Ì"tÌr rhr dom!'sti'
ìiiill:;:1,,". trorÌ'Ì' b'rds' rhÈ ce'rr!rbdìr
;;; "i;"' t1't \i'n'Ìrr!toric!i'theÌL'ft)Í'eírecri\einrxiiins
liìi:,:',;^;;il;'""rLdiÌÌ,cÌ1'stl^te
:i,riïï::J-:ìiru*,r$;;.1.'çï:iïïil;ï.''Ï:ïi*
re\.!!e5
Ìrilnge ot t\tr1e\ (
l his Ìor5 oi
oliï" *-
u'", n," r".:r :l::
jLrn.Lid,üìrrÌitisÌrìcrÌin.li'l.illil]lì.11]: ïiìì:::ïl:ï,ï::::ii:ì\;ï:l::,ll:iïì,
", "u,.,".
;,.,,,,aisìÌrsìhejntfreslrr. \rÌ,jÌsr!rri'atc
r1\LirÌitrr lL)(r2
' r,nÌJitiirJrÌÌrrtú'lúì!i!n4'\'rÌlrru!Lr\rt\ú(llrrnì
' c\d|FlL !rLLl'lÌi dl{'aLÌLl rll(rÌr
'

.. !3{.rp.iio.tr, hrre
: , iteentiili ar. st,Ìl
: I can tr!! or sllÌ
'ì.! I irleresr Ìate I
n Ìea!rìr Ì1Ìr!
ìrLri
,nìtr.nlenl a poi-
r.ajìÌral.onlírs.
:. rìrlrstirÌitnJrs in
.i io inrünrtoÌÌrÌ
a i1.i.t iÌUôh\ ol
{
3a1
rncentir et to e\ a.Ì€ thcsc.ontÌoÌs are the \ame rs i. tìre pre!io!5 ..se, th! 3o\ errnn.nt
Ìid5 Ìnore rÌeecìonr (Í mânocurÌe be.xuse the accÌetio. olt!reigrÌ er.h.ngc reser!es is not
.ì.ú!!ÌecliateÌ)Ìrnnremari.a!theìunÌrìÌrgdoh'ni)freie es. \\e ha\t noted thisi]svrÌÌ
inet.\' eaÌlier. Iìr.leed iI rlrc.cntraÌ bânk 15 aÌrÌe Ìo insuÌxte ure ecoxlllìl frorÌì tlÌe elfetl\
i)t an iÌ(.eare ìÌì nÌeìgn e\cha.ge re\er!e\, the abiÌ1t\ nr u\e Ìruretarl poli.) !nderlìried
r\!hanse ratet nrcrea\cs. I. tht rnal)5i5 í) lar, Í'e ha\e.ìsnuned th.1 a clÌanS€ irÌ tor
rign e\change re5erles hâs a diÌÊ!t inÌraci o. thÊ doÌneltn nì.nìe! ìrppi! sin.e lorciiln
.\cha nse rete^ e\ turm Ìra ú o f ÌÌr e noretaÌ) l)ase. Thi s direct conne.tion .i ÌÌ b. bro kc n
!t lterilizatnn'ìr Ìro$iblc. 1\:c .lìrcu$ the Ìneannrg ol drÌri scope ior n.rll z.1ion bcÌor'.
haxrple
' 2. NlonetaNpoÌiÚ uncleÌ tÌe\jble exchdnsr rati's.
LÌouÌ odel oluÌe!nalÌ(ÌrerÌ econom!\!ith peúect cnpiÌaìnrobjìú), monetaD p(nic)
ii hislÌlveìlectiveirÌchangìnijthelevelolo!tÈrt.,\s Ìre sJ(r i. sr.1ior 5.1.2, fuÌÌÍlexibiììt)
.t the exchdni{e irte hai Ìhe etlect ol freveltiÌÌit tlÌc gotcírrnenL íÌoÌn choosing the
ìonÌestic iÌúere\t rrte ìn the ne$ íroú run eq!ilibriunì: elthotrgh theÌe ìr iuÌl nro.etar)
t(nicv aut(Ìrom! iÌr efíects ([ tÌre ecoÌÌonÌ] ìre entirelÍ thrcLLglì Lhc 5. .aÌle.Ì fÌtl'rrj.
It crpital nnÌriÌit\ i\ Ìe$ thaD ]rerfe(t then 1ìnìncìn i.tcgÌerjon ÌvÌlì not ÌecÌrìiÌe tlÌat
rÌre econonÌ! be on tììe i = i' Lnre. lleirÌs on tlÌe i i li.t mcan\ thrt a trade cltlìcit .tr
nüphb js olt\et Ì)t a capitaÌìntÌo! or o! ltLor' 1ìna nced il thc.on5t.nt Íorld iÌiter€st rate
: e. there i\ a peúectL\ eÌrnic mppL] ol citìital it thc r,ôrÌd inteÌe\t r!te li) ..ÌÍrlÍ, il
c.qrltaÌnnìriÌit\ is nnteúecì, dÌen th€re is no a!tcÌnali. íina.cìÌrg oi a cure!Ìi iìttount
.ìehcitoì dutomrtic ÌendiÌrg oia (ureÌìt a.co!nt surLìius nl theirorld inteÌestrâte. hìÍc.d,
rhe size ol the requìÌe.Ì caÌrúaÌ irúÌo! or oulllos !fill allc(Ì tÌre ìÌúereÍ rate .onsistrnl
Í.Lth shoÌt Ìun e.ÌLriliìrriunr. IoÌ eran+te, a l.r8er tradc deÌrcit imfÌje\ noÌ orÌ1) a hÍg(r
:,..nÌìulatir)n oi.Ìebt but rÌí) r Le\s ii\ouftble ralc oI LntÊÌert. lÌectìlL tlÌe b.Llan.c.i
tjl,= r,3T INIr+ | \Àì:t)
\\:c aÌe ÌooÌnng at the tleÌibÌe er!lÌarÌserate econornrÍJ theÌe i\ no otìci.l úÌtcÍ!cnllon
i.d LhcÌelore lti = 0 rnd t(r tnnpLicitt, se ilnore ncl i.ttÌe\t Ìecei|ts ri.e. e.ssLiJÌìc
,l
LP - u I t.t) ) | + t:t it : l).
r{hÈre Iii.l À ltrnrte nct.atjtaÌ ìntÌol! and i\ ü posjti!( lún.lir)n of i. The r| liÌìe nì
Iig.9.l5reÌrÌactsrhehoÌi7onLâÌi:iliÌre!trdernrpeíc.L.itilal.robiÌit).ThelIliÌìe
Ls utiraÌd noÌrLng jr th. j.trre5t Ìate orìtÌmt dirsr!nÌ and is drâwn n, I gilen leveL !l
thr realeÌcha.gc Ìarc. Ar a lorÌ Ìe\ eloioütÌmi mh rs r, /l/ iihigh Lsi.ce ìmÌ)oÌt\ aÌe
drpÌeÍÊdl. Thus ÍrrbaÌai.c oitavDents equilibrnrnÌ. thc nct rapLtaÌ L.tloi! mBt Ìre ld!,
ìn.l olh a Ìrni'i.teÌesr ntr, lr. r{iÌÌbe relluired tu ÌìrÌancc ll !.onleÌsel!. at a hìijh Lelel
oiouttut. â ücâli rdc ìrâÌirce ha\ to be olÀet irìtli,ì net cJp Lnl i.nort,l{bìch re.Ìuire\
a hjgh inteÌert Ìare, iir. \ot. rhrt tnrce i{e at ilterene.L ln ralhcr smaÌl .Ìc\ Lahon\ tionì
teúect câpitaÌ ÌnobìÌ1r!, nc !ÌraÌl asumr thrt the lll' Lirìc is llallcr thin the ltrl The Bf
332

: The larr

'J5,t,!' (d r )

figüre9.15 m!ê r.r.àptà mob 1yãrd treibÊex.hànqe atc5 . fÒ.èlâlverÊ;.!ô.

ìine shllts with a.hange ir the rcnì cxcha.ge rate. IlâtlÌ,lhcrciìcxchatgcitrr (ì.e
comp€titiveness js higheìì irAtead o11,0, then Br will be highff ãnd balance olpavnreDti
equillbrium will rc{Ìui Ìe a iì.ìller n c t capitâÌ ìn Íl o$ and hcncc â Ìotlcr i n le rest rate thrn
,.1 r" l Àr'r' 'r - l'\.' t i.
\\e turn nor' lo examirÌe 1Ìor,an exPaÌÌsi(lrary ÌÌÌcÌrc1aN l)olifl iroúld tloÌk un.ler
irìp€rl.ct capllel nrobiÌìty. $ith an c\panrlimaÌ)' nÌonetarypoììcl,Ihc LlÍ moves Lo liÍ/.
'Ihis Lcads 1o a ÌoweÌ ìntere\t ratc and an expansn]Il oloutpul. lhccltÌrcntaccount.lete
rioratcs and the exchange ntr dcpÌeciates.lvitìr tJeÍèct.apllal ÌÌrobilil!, lhc c\change
tute chang.s bc.ause oi di\ecìuilibritrm in tìre astet (Ìr.Ììd) nÌarlictr undiÌ impcrÍccl cal
itâl mobiliry, it ìs the ll(N disequiÌlbrjum ariring lì(nÌÌ t1ìe kadc ÌrÌìbalarì.c thal lcnds l.)
ex.hanjjc raLc changes. UúeÍ fetÍi.t.aÍrital ntuL)i|irl, the nc*'slì,Ít tun cqLriììbrlltm is
lt poi.t C irh â trade surplus (thc nuthr is Ìent at ilìe intcrnatìoniÌ intcrcsl ralc i l
Urldct Ít FtÍ!.t tdpìlt| ìor'liry, tht tracìe ntrphú entâils i cnpital a..oünt oLltílor'(nel
invcs !m e. t âbr)ad) th:Lt $,ill a t t ract a ìoweÌ ìnterest rüte thaf i'. lhis ls sho\!n by polnt D.
Al Ìrolrt D. sì.ce the donìestìc interest Ìate ìs beÌow i , output is incrcascd abovc its
i.iriaì Ìelel (fo) thÍmslÌ tl!o.ha.relsi

. l) tha jntobÍ tt1..hutltd,r'lìlchleadst()anroveDÌeDt.rlongdìeAIV and

. (ii) tlÌc.',t.71Ìr.r /?t..rd,rir,/ (hre to tlìc dcprccialion), ahich \hift5 dre I5XÀ,1. The
cconornt'mL1sL bc on tÌre lìt (!i!'c: hcn.c lhc ncÌ! tllt) cuÌve wiÌl go thrNgh

wc havc thc Ìesult tÌrat the nes'sÌrorl run cqlriÌibÌìLrm i!ìÌÌ Ìie between tìrat of the
closcd c.onoürv (B) a..Ì the lnall opl:rr c.oÌìoÌrìl t\,lth PcÌíect catitaì nrDiìit-v íC).
'LosúnrmariTe,capltaÌimnÌolrilltyhâsìmpìicalionrtortheefhcac-Í.fmonetar)pollcv.
LrndcÌ irxcd c{chânge rate\, soÌne rclc tor nìonctaN toÌ1.} ìn nriìuen.1ng the leveÌ ot
o!tpLrl ln thr shoÌt ÌuD isÌeüì\tated. Lrlldcrllc:iiblccxclìa.gerates, an âd.Ìitio.al channeÌ
 333

ior nrcnetrry poÌìc-v k) in|uenrc the Ìevei ol otrtÌÌìt is lnt()ciuccd: in\tead oÍ havitÌil its
iilcct entirely tbrough tìre €rchange tute, nroneraÌ) policy also alÍect! clonÌcíic 'Ìentand
dircctÌ) becìusc the hone 1ÌÌt$.st rate can diverS€ fÍom tÌÌe $'oÌld nÌteresl rate ÌÌ thc
ilxrÌÌ Ìun equilibrì0m.

6.1 The large open economy

\ìÌ the aÌÌilr''sìs in this chaptcr has asÍl]ìc.ì tìrat t1Ìe honÌe €conom) is unahìe to inlu
I-1. \urr',,rÊ \'. .r1-hrr', 'lle ,rdm'| " 4l-- '\''
inrstltutáLJilit,v assunÌptioÌìs, lhit alLol\'cd us to specily üìe rcqn)nse ol lhe ecoÌìomy to
.1o nrestic poli.Í chaniies and cxtenÌal sh ocks usitÌs the M! ndcll llelÌÌìr]g
mocìe1

lhe simpleÍ l\a) oímocl€llilìga làrile opcn ecoìoÌn,v 1s to have a w''rld conlprising just
:1!o ccononÌies. \vheneveÌ onc ofthesc c.onomies charges lscal or monetaÌy polìcy' Ì
:\ ill have an elfe.l on the oth€r-atld hcncc, on outconres for'lhe \!orÌd'' Ìn Chaplct 12
r e d cvcìop a limpÌc lwo counú-v eÌteiÌsio n of the snr aÌÌ op€rr cconoÌÌìy Ìì o'leÌ Hcrc we
!ro!lde rn Ìúuitnc cÌPlanation of ho\\'moÌletarv and 1ìscaÌ Ìrolict atlccl the outcome
ior. lÂrge opeÌÌ cconomv.
rJrgc is lrj (i.r. .\s our lrrge .oünllv, \al thc eurozonc, l{xxens monetar} poÌicl", thú $ill lowcr its
:rt.r$t ÌateÌel.tivc tothe othcÌcouÌÌtry, sr-v tlÌe uSA Asâ co n se'Ìu€nfc of Itrfecl catital
ìoblììl), tlìe exchãnge Ìate of lhe eurozone rlilÌ dcpìeciiìtc. By vlrtuc of it! sizc' lhe fìl1
:n tlÌc curozo e\ int.rest rate wiìì pull doirn the NoÌlcl iÌìtcrcn râtc' i' The ÌÌcs' üoú
:ur €quìlibÌnun lor lhe eurozone r!i1l bc at a Point Írch as D 1n ihc lclt hand panel oí
iÌg. 9.Ì6, on the n$! aIÍ' cur!'c, rvith thc world ilìlerest rate at t" nn'Ì ilith the iS-\'\:Í
,hiited 1c) rSXI'IiÉr) b)' lhe.leprccirtion
Ttì! impact on ouLput of a monetarv rìpansnm urder tlerible exchange ratcs ìn ' Ìrrgc
ìterÌ econom! cliflÜs ìn iwo rcspects lrom that of the nnalÌ open cconoÌÌì! Lribt' thcrc
r;e ÌÌor. Lwo channcls LhÌough which oulput 1\ r.lsc.]: thc eÌ"í'1.{' and thc
'rt!ilill"d'n'l
i'r.rdJr /rr. LlÌ4,1,ì€l. lhe secon.l .ìifìercnce is t1ìat the ri5c in output bc í)mex'lìat

r n br poúrt D

:]!j

Figure 9,16 F.r be ex.hrnle ràtÈ :r.le oF-èn e.ofomv

; lipàfsonàÍ! r.o.eia1] poi.t (rl ErpaÍÓnèrvi!.4 F. .v
 334 ' .::., : ,..
Ìcss than iÌì the small open economv -llÌ€
largc operì e.onomy encls llp ât
case. poÌntI) untr
bctween thaioflhe cl6ed€cononry (u) ardrhe jmall open ecoÌìomv(C).
.,,ro r\\tt ,\'t,.. \,rì.r,3.,"t ...r..rt ,,,i.\ ..o r,.t,tFt.
ÌrÌeflecti\.c in chanSing rhc Ìevel ofoutput ãnd emptovrnent becausc the erchanic
rate
moves to compÌú€\ offsct the nÌpâd ot nsl:.l poÌicy on aggrcgate deÌnând.
fÌ(rlcver.
\'t,, ^ o o\,. t ,.t. , r. ..,. .,,,.rorr r ,. e r- up o,
Lhe oiigioallÌí curve at a ponìt nìch as, in the rìghr hand panel ot tjs. 9.l6: the wortd
i|rF'-tr,r '
r '
" , r ' r . " . ) , ..r
, t- ,rè rul - J. .h,tt.,. r.r, r-\..t.
andeÌchângeÌal€channcÌsârewoÌkingtoÌc.tucethccÌpânsionaÌ\,jnìpactofúrehÌÂh€r
cv' rrnFr , .,ri r h I -.t.r F,, .tô. . .rur n.t \,, ..,..,p,.^,,1
inÌpuìtc. .Iust ar ÌrÌ the casc ot a monetary cxpânsìorl, the bclìavn)ur of thc laige open
c.onomt lies bcúïeen thar ot the closed econoÌn\, (À) .nd or rÌìe small open econ;my
(Á1, which is an intuìtivetl.appeaÌìng remtt.

6.4 Perfect asset substitutability and the risk premium

Another key as\umf[ion that wc nÌâcìe a,as thar home and toreign bon.ls ÌleÌe p€rtect
subÍitutes. lhis Dìeans thar onlv the expccted Ìctun on borÌcls jnltuen.cs the cìÌoice
berl'lerÌ theml.Ìr.l rhat âgerrs arc iÌìdiftcrent about rhe composition ofrhrirpo totio.
Sìnl:c the expc.ted Ì.Lurn i\ ìdentiral on forcign and hoÌÌÌe bonds arÌd the(
i\;o dÌfer
ence irrì\kincss, even risk âveÌsc irìvestoÌs are quirc lìrpp).to put alì rhejr eggs in thc one
baskcl. (ÌÌce the postjbilit) oí ditfcrent dcSreer oI risk betwcen rhe bonds arises,
then
isk aver\e ìn'cnors will pretèÌ a nìore baÌance.l porttdio. lt is reclssarv to âmend rhe
.r 'ô,.c1 .".tn ,,,1.rt o r., rrr..ir ...r.,\ dt,L.-.t \f.
equaìizcd thÌo1rgh arbi!raBe:
-,,r r. 1.rr.

jt=i; +4) lt,tl {rlsk adi lted U1lcoúdition)

wherc lr (rho) is the risl piemium. SpecilìcülÌy il the homc cunency is lhe euÌo.
then thÈ
h-r s.l b-,l.t r,...;r ,,,.Lr. .rü.,t
€xpectcd .teprcciation oi ihe curo plus anv addltional rist pÌeüÌnrm LlÌat 1s rcquj.ed to
comPcosate rhe iN enoi h euÌos.
TheÌc are two wavs of exÌtaining the Ììsk prc,Ììium. tirst, theÌc mav be a dÌtÍeren.. ìf
,r.Lt\..',rí1. ,r-. r..t..ir .,1i,r .,ri.r.F.,,. .. ü,-,Ì.i..
a úk prenrìum to hoÌd Russirn bon.ls irs conrpar€d wjrtÌ euÌo tronds because ot
posilive
the gÌeat€r ljkclihoo.l th.t th. RussìâD go\ernnìcnt would .lefaLrlt on it\ obÌlgations
to
honouÌ lh€ bords. Second if inrcÍob arc corccxìe.] about un.rDeclcd Ulrctu.ìtions jn
'l-., .r .- .r.. .r..so ,,"r,.,.r,.,1.
\te Ìook â t rr,o exrnrples ()f whv rhe eÌistencc of rìsk pÍerÌìnüì s can
matte I for nr acro
caonom ic outcomes:

. an inoease jÌr Ìi!k ihar o.cu6 rljlh a chanile otgovenrmcnt and

. iÌÌQ LlelìbcÌate âticmpiÌ)v the cenh.aìbank ro use changes in
Ìrortt(tjo conrDosÌrion;,
a toolol monetar poÌi.a.
 . !35

ends üp at poinr ll 6 5 Unplanned increase in risk

I (ll.
roÌÌcv ú complet€ì1 3t us srppose rììat a n ci\' goverÌìm e. r is etected and js consì.lercd more tlkch. to cleiruÌ1
:. th. excÌìaÌìge ralt ' .eL,.l' t.çr I r.UJ, úr.-.t.t p\..r. \ to --\.t-)
denìan.l. Uowe! er. r.tc (hat on thc assrnÌprìons we havc made, rlìc cap€cted exchange iate ÌcÌÌÌanÉ
fixcd,
rrÌr\ rvill end up oD .: docs the nond irúeresL rat€:âtÌrhet chânges js rtìc erÌÌeÌiiencc ofa i5ktrcmnüD Thc
, ir.. 9. ì6: ttrc lroni
:!ik âdjuÍed LIi| co..ljlion teÌìs Lrs rÌrat the domcsti. nìteÌeÍ Ìalc muÍ noN be ecÌuaì !o
' rlorthe cxchânge rat€ to remajn at its exÌrccicd Ì.ìlue.
In a tìxe.lexchiìnge Ìarc regime, ifthc gorernÌìcnt ìs to naìntain theexchanÂe râte
Ìreg,
.ì.
",1- .. . .,, .,r^,,. r,. i.
:..!r.lì t th( rhk ll enÌiunl is equâl nr thc $rorl.t inLffcÍ rate. Aj thc rjsk prenriunì enìerges,
.úÌtc rilÌwant to $rilch out oihonr. bonds. To do so, they musr sc doniesrjc .u rrencv
',ír..,1{r\tw, <,h.r...t '.F. -.t t,.rotJ r.,. l-r I.,.,"r ..r t,.n, ,.\
rlcnene kr bu! hoDre.urrenc). Thjs loss ot Ìescrrcs Ìcads to a lelh{aÍ1 shìfL tn the tÀí
:nd the intcÌcst rate Ìl cs. lhe outcomc i\ rheÌc orc a rccession tor the homc c.onônrv
A... {\..1,,o. irr,/ ,.,tÌ,r..
LrndeÌ a lcxible exchange rate Ìegimel ive Ìook 1ìrst ar re ìmmcdiate imta.r of re
rpNad rhitt jn the UiP curve. The loÍ,cr risÌ adiustcd ìnteren rctún on home hon.ls a\
.ÌÌÌpâre.lto oreignbonds(i.e.ì r<i'lpÌo.luccsad(preclatl{)nriÌrovelÌom,ltorin
Ììc letÌ hand dìailÌam. ììolloÌljrg rìrrorrgh the srandard ìoilic, the .tcpr.ciatidr lca{:ls to a
:Lghtwal(l shiit irÌ the ItXÌ,:L tlÌe nen slÌort rur eqrrjlibrirm is e\tabliilÌcd ât poin!.4rrÌ
rl nllÌich poinl tlì€ honìcinterest Ìare cx.cedsthe i!,ortd ììÌteresrÌate by rÌìe dskpÌemjonì.
lhis pÍnluccs the perhaps \u4Ìì\ing rcsult thar a ritc in the úsk pÌemtuÌn boosrs ourput
trì the honìc ccononrt. Ho!!eleÌ, tìris rcsult \hould bc treate.t with rjccpticiìn: gÌowing
.oncenÌ about the crcditworthìness ot the goleÌnnìcnt mai Ìea.t Lo ad iÌìcrease in tlÌe
denrand lornìonevand hence aìeffirard sÌìift 1n Oìc / r'/, ÍlhichrrouÌd rc!eLe flredcfrc
.iatbn andÌnduce a rc.€ssion AÌtenrativelv, specúìa[ion ma\, nouDr aÌro ut likely flúu rc
d€preciation ol the eÌ.h.ìnile rate, whi.h couìd rparli a cuÍen(y ciisìs: if rhe eÌpeclcd

Figurê 9.Í7 Rijl prcm um ilr.rt run mp .âr ônj lnder f red :.1 t er h ! er.hanoe ràr.5
U-rlirÌre neü êqú hr un !rd:r Ìr.d eÌciranqÉ:.r.i
Z.f, r dr. rew.qú lbr!m !.a.r tlì€ Írer be er.hànqe rtÊ5
erclÌanitc ralc detreclates sharplÌ, the Ltl'jcurvc shifts tu the right arìd thc golennÌent
would havc Lo raise the iÌÌtercs! Ìate lurth€rt,:i prctcntthe e\.hang. ralc lrom .oÌìaÌrsinia

6.6 sterilized intervention by the central bank

Âllhough tlÌere is.onij.leÌable sccPticì!n arÌÌorÌgst e.o.onrlstt as to Ìvhether central
bants are ab1€ to cngagr succe\sfülì-v'' 1n steÌiÌized iiÌten'icntion in the ldeign oichargc
marketldarÌ\l€ngthottììne.itisiÌìPoÌtanttouÌÌd€rstandtheprin.ilte\\ithoutLrslng
thc 1cÌm , we have onÌy con rjdered ,ì o n s te tiÌ1ze.l lo.eig. cxch ange m arÌ(et irÌter! ertions
to thls toint. To explai. hattlÌis mcans, we take tlÌecasc ofa contÌactidrart nìonetarl
poÌlcl jn a lì\ed er.hange Ìate regilìc. Ure ha\e \een thal this is fÌuitÌe\s lrlÌen capitaÌ
nraÌtrtsaÌepeÍectsinc.lhereductjo.inthemonet.r-tbaÍ:duet()theìnitlâlop€nn]arlicl
salc ofbonds is ex..Ll,v ofíet bf thc rite ìn Dronettìrr bisc dueto the Ìise irÌ ol1ìcial füci8n
cÌchange re\€rves ns lhccentral banÌi intervene\ to Ìrold lhe erchante iìte conÍa n1 r'h cn
i.Íertors leek to s$,itcìr to homc cu enc) .lenominalcd boncìs lÌi PrhÌ.iple. howcrcr,
thc centül bìrÌN can neutÌalize thc inrpact ol the risc in Í(Ìeign reserles on thc ÌÌìonc!
supÌt\'ìÌ nÌatching its rcquisition off(Ìeignassets ( ÂlÍ'ilhasaleol3o\erüÌÌcntbo.ds
í,5).ÌÌrthecentr.lbanÌbaÌan.eshcct(TabÌe9.5),Íeriììzâtl()nÌÌÌean\thrttherisci.R
is oÍhcr b) a lall iÌr li;slnce ar does not chaniae, there is no change in the oneysupply.
'lhr reaíÌi $lÌf this À Í) .llllìcuÌL k) achlele is thal lÌhen the central bânk sclÌs lhe
bords, the púe \\'ìll lcnd to iììlÌ.nd rhe nrtere\t r.tc to rìse: thit it jrbt whrt thc.cnlÌal
bânk.loes not Í,ant hecause it (,iìÌ clicìt a ìuú1Ìer capltel ìtÍÌ(t! llr theory tÌìcrc is a
r'â-v a()unl this il Lhc sales ol bonds hare a sulhcicnt cllect Ìì râ nì8 the risk prcÌìiunl
an.Ì therelor€ ìn i.núencins the pubììc\ .lesired portloÌìo Ìlthe centrtìl b.ìnk scÌls n]ore
bonds, the publi. has t() hokìa hlgheÌ tÍ{x)ltjdÌ oithc otrtstan.lini{tot!l Íockof bondsl
rhe centrâl bank r,iìÌ hoì(ì lewer and the PubÌic wiil hold Ìnore Ìl the Pxblic care about
the cornpositio. o I LhelÌ Ir)úfolio, h en th e) Ì!ill req ulrc iddlti traÌ compensation ilr thc
I (

nrm ol. risk prcnrium nr holding hone bonds. Hcn.c Lhe cenhaÌ bank i\ !ble to r.isc
tÌÌe risk prcnìium rn.l tlÌereìorc hoìd the erchanile ralc unchtnged. Thls is (onsistenl
lritlÌth.risk adjtrste.Ì LüI condjtioD because tlÌe dolÌìcsLl. interest rate is above th€ \Lorld
iÌÌtercst cxactÌ) the a Ìnou. t oi the isli premium r lh e expectecÌ cìepÌe. iation ol thc
ra r c h_v
exchaÌìgc raLc Àzer)$tlÌe pcg is nraiúaired. lhr ajm o t tìre steÌiÌizati(ìn 1s tlÌ! s to drain
liquiilillìnairâ)thatdoesnolmakehoÌÌÌetrondsmorcaltÌactìve.Man4^rldtirÌStherisk
pren]iurÌ is ir tÌìnc\rle:ì ,{ay ot donrg thjs. Io tlÌc cxlctt that steìiÌ1zecì iÌÌter\entiorÌ oi
thls ]iìrìd is po$1bÌe, tlÌe cenüaìbank i! üble to use thc inlcrest Ìate an.l the exchange rirtr
.ìs indcpcf dcnt ìn\tìuments. 7 Conclul
L.r)dcrn.:xjbìeeÌchr!lgeratcs,becau\easÌvehaveseerLhcÌclsnooffcìaÌiìrterventnt!,
thc jstrc ol'steìillzeclniterv( nlion does ÌÌot arise. HoÍ'ctcÌ ntppose tÌr at the ceniraÌ ba nl

Ìâble 9.5 aerÍd bank b. a..e ilreeÌ

' TÌr. ò rl.l

a.rairìÊnr t,'li ! f!r. !rn eÌ.r ìqp ÍÊ,:rrii H q. ro,.rid m.retr r ìãrdi rì pub r
 337

choo\rs to ìnt€rllne ìÌÌ tlÌe forcjgn cxcha.gc markcr 1n an onenlibl), tlci{ible rì.hangc
Íall: rcglmc. lÌìcrc is subst.ntlaÌ cmpirical crìdcncc drat central b.rnks ìr countrics thnt
a lreelyÍloalifgcxchangc rnLc cniiaSenÌ consi.ler.ble iúervenlion
dcrlarc tlÌat tlÌcl'ha\'r
a.tiritÌ$.']lhistlpeofer.hingcralcrcglmchasrìoannounceclerclÌâng€râtet.rgetor
pcg rhat thc govcrnment is stardlng rcady ro dctcnd (as iÌr the 1ìxed €xclÌ.rnge ratc.asc)
We ar€ therefore inveÍiilatiÌìg hos' t h c govcr Ì1rrcn L cou ld trv to núu enc€ the e\cha4c
rati'through iiÌten'ention. I.kc thc .nsc lÌhcrc thc goveÌnment is trtnìit to danÌpcrì
activit) iÌì thr ccono ) but it docs rìol wanl an apfreciatidr of the eÌchaÌÌ8c ratc (as
s,ouÌd oc.ur und€r. fleaible r.tc rcginìc il monctary poÌicy wa\ tightencd): thr ainì ls lo
r.is€ the honìe itÌt€reÍ rat€ bLrl prevcnl ân inrmcdjrte appreciâtion of the.urrcnc-Í (as
dictated bythe U/J condition). Wlìl'nrlghL lhcgolcmment lrantto do thjs? Onc postjbìe
eÌplanationisthatthe$overnmc.liscon.cÌncdnoton\aboutllÌcÀa'e/olorrtpútbut
dlso about tlÌe süucture ol the e.o.om-Í. ÌL mav lheÌì seek to danìpcn intcrcsrscnsilile
experlditure r.ilÌer thâ trâdeitrlcsacliviL).lhcc.ntralbrnkwouldhaÍctuinL.Nene
ìn the fòreisn exchange Ìn.ìrk€t in cxa.lÌ)' lhc manneÌ cìescribed for tlÌc lxcd cÌcha.ge
ìate case \ellüÌij horne botrd\ to ÌÌÌop up lhc ìiquidit) frorn t1ìe exccss Ítpllt' ol ftrrcjgn
curency. This Ì!111onl} 1íorl il ponldlo comÌrosìlior nìatter\ to lnv$lors and the Ì1sk
PrenÌnun on lìorne boncls ri!es.
These e\ample\ provicle an illustratìon oI thc mechànic\ ol an c{changc Ìate Ìe8ìme
that lies so ÌewlÌere bet$een tìÌcd a.d fl.xibìe. ÌlpoÌic) can bc r$cd lo maniÌNÌaie th€
risk preürnnn, tlÌen tlÌe irÌterest ralc ca. dh cÌgc fÌom the ìL,rrÌd ìntcres rte even wherÌ
the exchanije Ìaie i\ ai it5 expectcd valuc. (lncc aganì, it shouìd bc noted that iÌr tlÌe
.ase 1n rvhìch the tolernment is s.clilng lo (úr a l(xAe. nÌonclary Ìloìicy but pÌevent
i detreciatl()n, the use oi the ÍeriÌizalio. toììcy $'iìÌ be limitcd by the alailable loreign
cx.hâDge reserves. It must be Íressed lhal ÌislipÌcmúna (orld onìvaccount tar the kinds
ol devlatlí)n fìom the uncovered intc..sl parjL) coÌrdition thal arc obseNed errpiricalLy
il these !aÌ_v diamatlcaLÌy o\ er tirÌrc a.d in lhe manner that hns been â$umed. HolÌevcr,
altempt\ nr elpÌaiÌr rlìch prerntunÌs cürpìricalìt lia ponfolioìralance eU:ects hrve bccn
unsuccesstul. IÌence the trotion thnL sloiliTatioÌ1 c!n bc ulcd slstenÌaticalL) thrmgh
changing the Ìì\k prenÌnìms âs d.scribcd jn thú section shoLrld be tìeatecì $ith tet rnorc

7 Conclusions
In ihìr chatter, man) olthe tools rcquircd tr)Ì oteÌ1economv analvsi5 have been iÌìtro

.lh€conceptsofthcnomÌnaìandÌeaÌeachaniierât€andlheterÌ!oltrìc:leh.!ebccn

. The 15/lIÍ mo.leÌhâs been extend€d to ÌrÌcludc cxpoÌt\ and inÌpons and jttcÌnatìonâl
1ì n an claì Ìnarkets.

I ílilv. Jf{l R.ifhrÌtt2l)(r?l

 lhe i!ú€nÌâtn)nal lìnanciaÌ arÌritÌage conditjon uncovekd jntcrcÍ parity
(L'a|ì provicìe.l a vitaÌ Ììnk 1Ìom the interest Ìate to the ex.hangerate.
The \'ÍtrndcÌl-|lcming nodcl puts lhc.15Ì,!Í /lM Ìnodel togetlÌeÌ Ìlith thc L,'/P
condìtior to cnabic us lo cond[ct m acroe.onomic analysis olpolìcv cìrangcs and
cha.gcs io privntc sp.nding cmanaling from hoÌne or abroacl. A summaÌy ol thc
mod.ì in cquation fornì is providcd in the
^ppendir.
ìn lhc short ntn wìth pri.es and Nages iliven, $lÌât happeÌÌs ir resF)nsc 1o a poli.!
change or. change in private spending beha!iour deperÌd\ on

. rÌhaÌ hâppen!to the horne intercst rate relativetothe foreigÌÌ ìnreÌest Ìalc.

lnturn, the 1Ìrìplicati.ÌÌs .Jl that discrepa cvdependo

' the €r.hani{e rate Ìegime

ile\clÌange rates areÊxe(ì, tlÌen the cioDÌesticnnDev \upp\' Ì{ill au toma I i.ally
chânge to otïset any exce\s cìemarÌ.loÌ supplvfoì ìÌonev
ifcÌchangc rirt€sarc llcxìblc,lhcn I h c cxchanlle rate wiÌl ippieciate oÌ depÌeciaLe in

rcsporsc to tÌìc lntcrcí ratc diuercnrial and thls $,lll aílcct net e\ports and
aSSrcgatc dcmand

. ho('cÌchange rate expcctations arc lorm€d.

lvc hiìve set out tlÌe nÌìplic:tioÌrs of.eìarnlg the MundeÌì-ìrlcmiÌìg i\nìmptions ol
vÌallncss, p€rlect capita I Ìnobility, .nd peÍect aset substitutahÌlilv. ln a 1ârge open ecoD
onìy a'ilh perfect câpital nìobility .nd iÌì â small open economv i\'ith impeÍèct capiral
nrobiìily,irnlnter€strat.Èchân]ÌelisopeneclupthÌouglshichmonetaNpolic)canopeÊ
ate. By rclaÌingthe asnlnÌptidÌ ofperlect asset subsrìturahÌlitv, i{e.re âLìle to iDvesrigarc
how un in lcrdcd .hanges ir the risk preÌnnìm affectthc economy. We cânâl\o sìnrr how
the cer tÌal bank nÌa)' attenÌpt to inlluence the ría_y ìnonetarv pol ìct operates in thc opc n
economvbv nranipLrlatingthe risk pr.rÌÌnüÌ. under nÌed exchaoge r.te\, this n onc Í'al,
that tteÌìlized inLcrvcntion could, üÌ priÌìc4rle, woìk. 1ìr::
\'\ie are now rcadv to nÌole on to analyse inflatún and uncmployrneni in thc opcn
economv.ln alhaptcr Ì0, r\'e complemeÌÌt the \Íundeìl ììcmingmocieÌ ofthe sho( run
wìth explicil consldcration ol {'lÌat happen\ in the rnedium Ìuì onc€ we aÌÌow priccs and
wages to resÌÌr.d ln the wake ol output ìtr.Ierchange ratc changes. .í?) \1..r:.

. QUESÌrON5
1l) D.:. :.

(1) \\rhatjs thediiÍcÌcn.c bctwcc. Lhc reaÌaÌrd the nom i naì cÌchnrÌEe Ìare? cìvc an
erxmple to erpÌain rhis to a n on-c.ononjsr. ls aÌ1irìprovcmcnt iÌÌ rhe rerms oftrade
UÌe sane as an in jncrease nÌ thc rcaL.oÍ
i'ìfrovcnrcnt in frj.e (onÌpetitivencss? ls
1l4) LÌfi:
oljmpoÌti an iÌnpror.ücJì1or i deterjoraú)n nr thc tÚnrs ôltÌadel
 (2) lixplail lr!,) $ays.lneasuring the reat cxchange rarc. HoÌv ilelÌcorreiated woukì
you e-\tc.rthem to be, and $ú) ?

(3) lxplaln tiìe sensc i[iÌhicìì ân inÌpÌolcnÌentin frice coÌnfeLìri!(ness mightbe

considcred a Sood thnrg'fortìre eco.oÌny. MìghtftaÌsobeconsjdereda,bdd thnrg,?
(4) Ìs Lhc behaÍio!Ì ot rh c vo lune oI .iloÌrs a satisfa criÌy mcasnÌe oI a couÌrtÌr\

(5) (:onstÌuct a nunìoical exa!ìf lc to íÌow h o$ rhe \lars h all Ler nÚ condition h,orks.
Wlìv rÌìight its prcdj(tions not hold iÌÌ rhe lery sh.rL run/
(6) lxplain !haris.ìeaÌÌtbÍ rhc passâgc i. itati.s ìn rhe sfutemcn r thlt the
Marshâll leÌno cordÌrion relrtes to rhe impacr on the rra.le balaÍlce ota change nr
theÌeal(xchang( r.rte, roldilÌj!h( t.t.t.lautputco ntÚrl. Apart trorì thefricc
€lâÍìcit! ofdemnÌÌd whatcÌtra jDi{ÌÌutioD do}ou,reed towork ourthect}ìct on
thetrade balancc ofa chaÌrgc Ír thecxchlngc raLc?
Q) A smrlÌopcr econoÌÌÍ hê\ a gor&nment budgd sÌÌrplxs andarrlde dcn.it. txplai.
ilhctherdrcrcis a frivate 5ector urplus, .lctìcirj .. büÌaDcc. |xaminethc
s

con sequen ccs in thc shorrrun lü outpur, lhc t.ade baÌan.c, ani:l thebu.lgct balan.c
oÍa sÌìdden lalÌ in prhiate consruÌprion in this cconomv un.lcr (a) fr\ed cÌcharge
râles, (r) fìcxibÌe excha.ge rates.

lnÌperÍccl c.pitaì ürobiìirl iìarge,

'i; a open c.onomy with pcded clpjraÌ nìobihty,?
(9) Ìn an openecoromy, homc.esidents canlÌoÌ.1hoÌncor breign bo.ds iÌirlÌeii
porlnr [o. 1\'hat !s\rìm p tio. alÌows us rô srìre rhedcrìa.d formoncrin ìe otcn
economy nÌ Lhc sane sâl as in the ctoscd economv, ì... as a tuncrìon ofdomesLìc
.r', d Lll,lr ,r'prô r' l|.F\'r -.
(10) \'vhrtí mcaftby arl)tt.aBe in iDreíìârioÌaÌ!nâncialnì,rrkers? Givc a nuDeri.al
cxâmple ro c\pÌaiÌr thc (onceprsoI rhc.overed and ún.overe.l intÚcstpaú},

(11) lvhat assúüìpttun s Ììu st be naclc lor ttre Íncorered inreresr parjt) con.ljtìo n to
hold? lxpLainivhatvou wo uld cxpe(t ro hâppen to the donìcsric iÌÌreresr rât( and rlÌe
exchanSe.atenr a nnalÌopen c.o. omy totLtìliÌìg a rise ìn rhc demrnd lor nìone).,
Ì!ÌakiDg ciear thc rcle ofrhe U/P conditnrn in thi\ chain otevcnr\.
Súfpo\ethaL theÍe isless rhan peÌfed capitaÌ mobiÌìrv. t:xplêirÌwhy in thejnreresr
tarc outplt diag.lrn tìÌc i : i. Ìirìe n Ìctlaced bv rhe batanc€ ofpa_l'nrcnrs
eq(ìlllrdiunco.{:lirion:,9lt4.tl+a(il-0.\\Jhv.loesLhis,ratcruvcjnrheintercsr
ratc outputdìagram sÌÌìIrwith a (lìaDgc inr t

(13)'l)c!!Ì!atnrn.anDotalìcitherÌa.lcdehclÌbccauscthelafternrústequatthc
dillcrence bctNeen invcÍÌnert and sa!irÌ8, and ncith€r ofrhcsc magnirlrìcs is
affc.ted bythe e\chân8e rare.'lvhar is w(Dgrvtih uÌis argumc.t i theconrcrtof
an open econoÌny$,irh sric|y pÌìccs?

{1a) Lplanr the con.cpt ofe\changc râte ovcÌshooringand dcveloprwo djrìreDt

erdmpÌcs usnÌg prj!ate sectorshocks nr oneofivhich thcequiÌibÌiunr adlusrmcnt
 olthecx.hanijerarc ts!napprecìation an.t jn the orÌÌer, rh€ e!uìtjbdLrm actiuÍnent
is a depr((iation.

PÍoblems ând queíions ior dbcu$ion

QLTLSTI(I\r\. A*umc th.ìt Nagcs, prices, and the erchangc rate arc Êrecì. (d)\{illa talÌ
ìn the budget dencil du€ to a c(l in govennÌcot spen.lhg alÌ{â}s improve Lhe tia.Ìc
baÌancr? lxplàin vorran${eÌ. (lÌ) Whatij thcìmpactof ortputan{:l t1ìerÌadc bâÌancc of
a baÌa.ccd budget in.rease in govcrnrìent spcndirÌg? (ììor sinÌpÌjcity, considci â
lump slrnì tar.) Docs the changc tn oLrtpur djlfiÌ trcDr lhal in a ckxcd econooÌv
' '.,r b.r., r.,Ch'r s . .I ri\f.rd.,; r'.u,ir...t.r.\i\.tl
r,.,t"1.r.'.rn\,.'., ror lJ.1 .t .r. \ Errw,1\,
what has hipfencd to the sectoÌ tìnanciâì baÌances.
lltjlSTlON B. fiÌìd ou \,hat hüppened Lo the nominat iÌÌteresL .ate setbv the ìredcr.l
Rcservein thc USAandbvrhe tCB ìn thc eurozoncÌ an.lto rhe lj -cunr ex.harìge Ìalc
follolvjÌrgllSeptemb.r2001ítotheeDdot200l)lplotthe.laral.seethcresourccs
below ir)Ì source! of daIa.nd cììJcutsion. lhe reìcviì ni ifteres L rate\ aÌe rhe fe.teral
luncl\ Râlc íLJSI and lhcÌÌinimum bjd rateìn rhc mai reiinanciÌìi3 opcrition5 (F.ClÌ).Is
this behaviour conristcnt with the predtcrions ot lhe U1f condlionl
fRe\ources: wÌrw.bankofengÌaÌrd. co. úk/mfsd/ra res/daitvzo0 l.xÌs irìì ts e_\ceì
spreâ dsheel ot d aily ralcs ìs usetuÌifyotrr,.ntt() d.aN a
ijÌaphJ
Ím11" ecoDomist.conì / markers/cuÌren cy/8Ìaph s.cfn or wr$\I.x ratcs. com
rw!'ÍÌ.imf.org/exteÌnal /pu trs/ftlweo/2001/03 /pdf/chapte 12.pdf íor conr Ìnc Ììta n.
J,\'. ' n.' r. , r',t., ,u.,' lr, \ir.tr;
sa'w.ecb.int/stats/moncrâÌ),/Ìates/hrml/indcx.cn.htDn#data or
h tl ps://stats. ccb. int/srats/ do$nl oad/w eas0I
_02l!veaso I _02l!veaso 1 02.pdf (rìn
ÈCÌl offi.laÌ ìnterelt ÌaLc: lhìs is the l\.Íain Relìnancirìg Rate. Thc seúes spljt! in.lune
20Oi) thjs sìmph, relatcs lo thes!ìtch tronì h{cd ro varìable rite tendcrs an.Ì js a
technìcaljtv thnt \,ou.ton'l need í) worry aboutJ $.rvw.tederatÌeservc.gov/fonìc/
fuDdsrate.htnì (for US ledcral lÌe\eÌve oÍrì.iat ìnLcri,st rate).1
QUISTÌON C. Lrse lhcMÌtr eìÌ-I lcming mod€I ân.l ass urìe peÌtect câ pìlaì nÌobi titv.
',,r' \. r'r'Íe .lr'rr'r, .,rt. i|rFr- r. ,.,,.,,. ,t :\ ro.. .i \t I i,r )
contractionar) impad on outÈrL in a srÌÌrtÌopen econoÌÌìv? (r) Docs the rmde baìance
improve or deteioralc? Lrptaìn vour.ÌìsweÌ. LookârbothÊxe.lao.t 1Ìextbìe eachanpe

QLÌLSTION D. (.oüsideÌ !o cconomies: lhe honrc counrÌÍ is NorNar tcuner.! i\ rh.

,.i.jl,, ,..r.t. .\,....ttr,u.r. 1;.,1 ,,.
.ondition, alsumtJÌ! that rhc defautt rìsk
^.. ,

ictenli.al betìleen the t$o counrrtcs.Ioi

Ìs
cach of thc s(enaÌios discusscd beÌow, assLrnìe ther üÌitialh, rhc US and NoNcciâìl
r. , i I - ra rtd. ...r , --.t .r,o
r
Scenario l Th. Norwegìa. üúere\tratc is expccled to Ìcnrain ìbovcthe Us rite foÍ
one year. lvhat ftìationihìpbchíeen the int€resr rat€ ditÍercnri.Ll and.hangc in the
Krone eÌ.hanije râ1e 1!ouÌdbc obseÌve.lon aveÌagcduirg rhcveaÌ?
Scenario 2. Ar tlìc begiDning otthe vear, the Norlvei{ian goveÍÌmcnt inúoduces â
permancnt iìrcÌeasc nÌ goveíìrìenr spendüÌij. Bv ttÌe end ot the \ eaÌ, the Nonle8iar a.:
 i, :. .. . 34.1

US iÌÌtcrcst ratet tre iderÌtÌcal. Prcvid€ an account of thc acliüslnìent of thc Nos{esi'an
econorny .ÌuÌinii t1ìe ycar. \{hatrelationsh4r beíÌccn theintcrc5trate diflffentiaÌ:ìnd
.hângc in the KÍnÌeexchatgc rate tïouì.1be obseNcd on.ìvcragc LluiitÌg thc yeaÌ? You
ma-v assrrmcthat !!ages afdp ces do nota.lÌust lvithìn the year'
\\hal Ììght do your Êndlngs tìriow on the queÍioÌì oli{lÌethcr the Ull'jconditìon
'\ illi fìll tredicls cx.harge Ì.i€ changes?
!ÍIF.STION l-. r\ nct!govennÌ€nl itelected and as a co scquence thc country is
co nsì.]ere.l to bc Ìcss Íì\kÌ. (d) Lxpìaìn Ì!h.1 is Ìnernt Lìv'lcssÌi\ky'?
(,)$tiuld you
expectthis to harc apoiitiv€ or ncgativeirnpact on ortputinthe shoÌtmnina úÌe'l
ex.hangerat€ cconom)' and a flcajbÌe e-\change Ìate econom,v? Yort mal assunìc that
.: \ dYl ÌÌl
thc cconoÌr'ìy is a smaÌl olren cÌrc tlith Periccl capltai Ìnob iì1ty (.) No$ alsruncrou are
engage.ìin a discussn)n about yolrt results Ìn an nrtenÌalional economic! consulLanc!
Àsscss the plausibÌliL-v'' ofÌoui reÍnts and cxpìain how you could intrcduce iÌddìlionaÌ
corìsj.ÌeratioÌìs lnlo the nÌocìe1to cnhatrce thcir pìausibìliL)

:Érrl
APPENDIX
:i Êclll.ls
Ìhe Ma6hâll iêrneÌ condiliôn:a pÌooÍ
\$rDe that tÌndc Ì5 brlanced rnd ÌlÌri lhe Pri.r\ ol ÈrForb nfd iÌntorts noL in
'.itiaLl-r 'ÌÒ 'h[ge
rÓpons€loÌhr!Òlunìe sold. sn1(tnr Írt)l'lr,.i.rlr'tÌrt.haÌÌ3cr'thehalclraÌa"einrfsP'nse
tri r.hang! ìÌr .onì ÈLiLn ents ir

pdf ( tor :'l:: t1ttlif ü^f

Ìiút bj òn!ìf rion, r1 = 0, i e o//r)i" = r,i' irlr', and rhcrênì(

n4'
rÌliÌÌ Dn'idiÌÌBrlì(ugh bl rn),

1 tllil
n,) ni
sin(,rr :0 4+ _..0úrnd.nÌ-til

t'\t') ü';tti) 1

rur'. tlr, it ,,i,,,s tl* oosticitt or tl€Dìard nt erPorts rin.e , n llìe inlrDr or llre Ìc'l rrr
'Ê 't
lrçoremeDt lrr Ore ialancc ot trJde Lo tolloL n.m à Ììr( if .oìrP(iiln'enc$ is lhat thc n!ì ' thc

'elm n.!r r

1^ .::y -.
 342 .. : . :.: :.. .. ..
Ìhe ÍMundell Fleming modeJ:à pockelveBion
'lh 5 wrl oÍ $lrking wirh rlÉ Mutrd rll ndning m odcl h devcloFd jn Châffur I 2. I ún rhe
ljt\,t/ schc{l

t'= úx bì Llll.)
1
Ìrhere à Èthcbaìâr(cot rÍ!rì( andr,r,'d.â.rlositircconía.h. $Jecarusei ÍirÌireÌthrÌ1, bÈcauserrÊ
in nìe iolation ò zctu. B deprnds psirifcly.d rhe €rch.nge at|. (w€ a$une rhiÌ ti e M.drall r
Ì_!meL
dÌ itiof hlldn and forsimpìi.irt w€ ahme A(l
-.. Wc Lvdre rìr! ner cÌr.nres tìom 0rinitjaln)ihl
,'t',,r .o ,. ." ",.
",,, ",
1l = d^.í ,À/ +.r.
\exL ÍÌ!lI,í schcdul€ tr i: )), ! 1./ or in diffcren.e Ìúr\
]\l: ral llM
wÌÌeÌe G.rli le(e..rc.h.serÌ ro ÌefÍ€senrrh€.!nÍ!nL5 jtrÌhe ln/ cquariôr !r as roDake it 0asv t. Í.
,"J\"J., ,'r,,,./tr. ,r L L- .,."-,Lt,,r. ,.
thaÌ, .: ì. \,!e oì.nhrvÊ.
lli+ r\.
^r:: r^t
.\i ^3 !t^r,/t I lì1rl sììcÍ! lì./I - the inf oN ol nì.nrv.
f_leribl!exchar8rrare5= À,V/ O
lü€d er(hange riÌ$ : -\. : 0
Ar = 1) unloÌ b.thtugiÌnes

rli ncr,l.{ > íl ]\MrI= 0:

3l)'=0!.1.: lí
(iilrir, :.0. \l,rrr :0:
^.{

(iiil rìex, rt O. ]\ìÍII - 0

(ii')ì,ir,:\j :0 r\Ì,Íir :0:

,.rr-{) -/ln/Ir I ltl j: O
 lnflation and
Í0 Unemployment in the
Open Economy

lhis chaplffbrings t()gether dre supply si.l€ olthe econonÌ) irìth Ìhc dcÌrìaÌìd side ancl
the tÌade balince tu pìovj.Ìc a modcÌ lor anal) s]ÌÌg the open economv. lt builds on th€
únpeÌlecr conÌpetitnnr model oI thc 5upp1! \icìe (ìeveL(Ìred ir Chapten ì lo 3 and on
Ìhe Mundcll flenìing sìroú rur modcl ol the opetr economy deveìoÌr.d ìn alh.pter 9.
The modclcin beuse.Ìto a.slcÌ thc tollowirÌS question!:
. What dctermines the kveÌof orrlput arÌd eÌÌrpÌoynÌent iÌÌ the shoft Ìun?
. lvhât tìcnÌr 1nfl ucn.e the rate of unenÌpìo_Ímcnt and oútf utlcvcÌ thatcan be
suÍrirÌed in tìre mcdiunì run NithoutpÍntems olinflationl
. Why Ìì igh t a medtum ÌLnr posi tion o Ía ble núÌation but tracle inìba Ìan.e be
unsuíalnable iÌì the long Ìun l
ÌÌrlhisrhJpter,ileexpìoÌeake)diU.rcnccbetweenanopenandâdosecleconomv.In
the cìoscd €conoÌÌìy, therc js a uniquc u.cnÌlo!merÌt rate consisterÌtwith constantiDÍla
tion. ÌlycorÌtrâst, in an oÌren economr, thcrc is iì..Ìì9. olunemployÌn€rÌtÌates consì\tent
wiLh (hc absenc€ olinÍlarionaNpÌesrurc. whcreas a fis.al (xp.nsionin a.loled econoni),
draL is ìnltiiìU at equìlibrjum unempìoÍnìcnt riises oulpút in the slÌ,rú run, it Ìeacls to
highclinÍÌationa dtheonÌv.redium run.qLrÌlibÍiumìsbackat thelnltiâllevelof un€Íi
pÌo) Ììcnt: the economl goes thugh a Ìrhasc ol output abovc cqullibrntrn, ol higlÌeÌ
jnflatio. and therÌ oloutÌrut beìow equilibriunì as irìllnliorì is squcczed out oftlìe \yÍem.
In lhc ncr, nÌ€dium run e!ÌullihrÌum, ìnllatlon and uÌìcmphynÌent .re bâckat theÍ ini
tiaììcvclsandthereaÌirtcÌertrateÌshjghcr.Así'eshall5cc,thcnì.diúnruìoutcoüreoia
nrcâl cxpansiorÌlü a $ÌaìÌopen e.onoml is a higher lelcl oloutput $ith stabÌe ìnUati()n
at jLs ìnltial level un.ter both nxed and fÌoatúÌg €xchange rate reglÌnes. ThÍ posribìl
it_Í ma,v make eÌpansìonaÌv nscal toìiq'ns a nìeans of.(ìtting unemplolnÌent atrractn e
to tolic) m.N€rs ancl we shalì see that undcrstanding th€ diflerence between open aD.Ì
cÌose.l .co n orìies irÌ thir Ìespect n helÌtld ln und€rstanding ìiìportant polic) questìons
mch as Lhc ratictrÌale t()r ìmp.sìng ntcaÌ tulcs on mcnrbcrs of the eurozone. The reaÍrl
wh) opc n c.orìoÌÌÌi€s be have dìfferentll tÌo ÌÌÌ closed oÌìcs lies n ith the inuact ol ch anges
in the Ìcaì cx.Ìì.n!e rate o. real irages ând hcrÌceonthcequilibriuÌnin the labouÌmaÌliet.
The r'âgc-sctting cun'e i. tìre ofen ccononÌy is iun the siÌn€ a\ in the cìored eco
nomv: as cmplorment ìires, the wagc-sclling reâL r\ age ris€s. IÌÌ the cl6e.i economv. thc
pÌiceseLLjngrcalwageiscon5tantúrÌdo n â í1 slopiÌìBì. H..rÌce there i\ ìrút onc lcv.Ì o I
enpìotnrcnl it which i{aiae andpric.{cttìrÌil real Ì\âges ar€ eq!.rl:thir hres thc unjqtrc
 344

equiìibriuÌn Ìatc ol unenrpìoÍmcnt (tÃLIl, or ÀÁ/,tU (non acceÌcr.ting jnjÌ.tidr Ìalc oi

unenrplo) men0, as it is ()fren .aìled in eÌìpüicaÌ studies. ltut ì. the open ccoÌÌomv, th!
trice sctting reaì w.!e i\ a tunction ot thc r€a1 e\changc rate: ìt wìll ,hìft up an.] doirn
as tìrc rcal erchânge rate changcs. lhe simpl.Í way to lhinkoftìris isthail,lÌen thc Ìcal
e\change rrte dcpr€ciàtes, rhc rcâl cost oI impoÌrs gocs up an.Ì this .e.tuces the pÌÌcr
selling r€al rÌagc lve nraÌl scc that:! 1ì\cal etpan5ion produces a real apprcci.ìtion and
th.rclore an upa'afts ihift jn rlìe prìce seutrÌg Ìeal wage curve: c{luiljbriurì ulenrpìo},
mcnl thereft)rc declirìes. Thc Íl€nibility ot rhe reat eÌ.hange rarc ind hence ol thc rcaÌ
cosl of iÌnpoÌts llltans thar tlìc price sertìng reaÌ wagc .arÌ be equal to thc waAe seÌ|ns

cÌincd is the ecororn:-, tìrc nnrror\ier the Ìange of equjìibrnlÌn uncmplovmcnt rates: in
thc cÌosecl econonÌy theìe is a Lini!ue lÁLI.
Since there is a rirÌìge of consraÌìt iÌúÌatbn unenÌtoymcot rate\ jn th€ open ccorìom_Í,
can ÌìacÌoeconomìcpolicv ÌÌaliers choo!ean,!desired uncrÌÌploymcnr rate bl' usi!ì! hscal
.r, ,..1 I l\-,tt:.-r.-.r r',-..f,,, I r\ ,,.r'rp,,.w ).r
likcÌv to be cons triìiÌìe.ì bÍ
Ìhc consequen.cs ot ihelr eclions tor rhc extenrâl b.tünce. It
(hc e.onorÌt ls ruming eiÌlÌcr â persisterl current account mÌtus oÌ dencit,
there aÌc
a nunìbeÌ oI nìe.hìnisns rhat mâ) come tnto plav âr some stage lo pustì rhc ecoìrom,
l- r's, \..'r ..pu i,a,n.rril.
rcscnts a changc ln the economl't rvealth posìtioD. A chnoge in r,.ilflr can ajÌect pÌj
vatc sc.tor eÌfcnditure ard acccss to internarional câpihì martets. Lqu,ìlly, â per\i\ienr
delÌ.ìt or ntrpìus dìi), afiect exchanSe rate cÌpectati{)n5. tn the long nrn it js Ìtkely thar
the crÍrerÌt accourÌt posìtÍ)n r'Ìll place â conÍrahrt (rr thc un.Èmpìo),nÌent rare thar câf
be suíained. Ìh cver, í)thecx1üìtthâtthe.onstiaìnt corìestroìÌ theopeÌãriorì ofthr
iìireign cxchünge nriìrket, ii ìs likclyto hâ!e lcrjs etÌecton a JÌrenìber counúf oti conrmo.
cunen.Í area n'ch as tlÌe eur)zonc.
This chapterb.gins by an(lng howwages â.d prjces r.ad irì the operÌ econonìv iÌ)lìoir
tht nrove í) a ncir sÌìdt Ìun cquilibúurÌ. We then int€8rate the suppìv sicte Ìnorc
iÌìia
syÍenrati.allv into oprrÌ economv analysìs. A n€!v corc diaitrâm rhat í uscd fiom th \
poiÌú onarad\ in thc boot is i.rÌodu.ed. Thc diasram has t1Ìe reel eachangr rate and
ootput on the axes. Sc.tion :l is 5lìort it sìnrpÌy nu{s how to hâÌìídre thc âgsÌcAatc
aIr' l.d .',lt'i4 ^rnr .,ri i r,n,, r.t,.. .,rò..r,..rt1.
iourth reclion, the dcmaÌÌd an.ì suppÌ_Ísider aÌc purtogrLÌìcrto c.ealc ihe oncr e(oDom!,
n,r.l l-.it,. .r.. h.\--rrt-"\',, Lnr.i n, I ,.r\.dr.r,ÍÌ.ri,r.-r.l
ìodg nÌn íi.c. .urrent account bahncc) equllibria rre exiìmìned The chaptcr conclud€s
r,ith r discusslon ofthc .rasons wht in the tonger run, rhc cconomÍ nìav bc.oÌnrrairÌe.l
' '1 ., 1,. .. .rn r r...... b.. r\!

1 lnÍlation and unemployment in the open economy

Ìn whal wavs do \!e need ro ilier the aDâlvsi! oÍ Lh€ \uptìr stde in thc clixed cconomr; t.)
r.l'rll'r' .ttu.rF, ,,,..r ,rr ,.rrL i m.r equiljbriunrl
 145

Figure 10.1 .iL. h L Ì.Ìr.rtm:n: nr..

r\ !\ rÌgnì.ai
.:!l!illlrri!Ìrì jiì tlìr (lore.l e..norr) ir .lìrracterired lr\ .onnant irÌ1li]tiiÌì: tlÌe rit.
ìt !n.r4ìlotnrgÌt !t 1lhicÌr irúl.rtìdr ìi con5rrnt i\ ÌeleÍr.L i!.ìs ilìc t.quilibrllnì'
ii. tlìr LÀU ror -\.11,(Ur IoÌ lllu.tratne prÌrre! it i5 \iÌnplrÍ to nss!nìc.rÌin.nt
l.'rour frodu(tir it\. ì. aÌr.ì r conitrnt nÌ!ÌL uÌr (ìiruÌ 11Ìe Ìr.ìB. s.rt nS.ir(!'nfd Llì.
tri.. srtlir: rune. theÌc ir r \úrsle en4notnÌrnt lerrl t.ìnd.sso.ii(cd r'nc.rfÌo_rnrcnL
rirt.ì it lÌi.lÌ thc erÌrc(ted Ìerl rrg. set Ìr\ rr!! s.ttcr5 s.qrLiì L. Lh. tuiì r'âgc
tlÌrt is ir!plied bl Ìrr1!e rettìÌrS trrÌriour. L!uiÌìÌ)rnrnÌ rnrpLo!m..t, I , is slì.rrì Ln
iìB LÍ1.1.
ìt I. nir i Bi\ erÌ erÌrc(tcd intÌrti(!Ì r!fu. Ì!one\ | r!r'5 slill .is. i. llnc trLLh .ltcLtc.Ì
Ìnu.1ti(Ìr to deÌi\ er the Ìerl r age ( rnl Ì)Ìi(et Ì!1ll rjse irì I nc rriLh no.cr rúgcs Lt) ÌieeÌr
thr pÌoÍìt meÌgin unrhr.gtLÌ. Thxi núÌrtloÌ $ìllrenÌ!iÌì Lqunl t. its cÌtc.tcd retc, tÌrerÊ
L\.on\tantinUetiondtÃ,.AtrÌì\otheÌrmt)lo\LruÌtLr\L.lh.jtâgiiillingÌerÌÌlrgewiÌl
l,É eitìreì highcÌ tha. thÉ tÌi!Ê \etti!ÌS rerl Ír!r tÌ\lÌ.r cnrpl.) m.nt Ìr hÌghÉÌ thaÌr ll.l
.rÌ(rÌeÌ tlunthrÌrÌice lrltin{realr!ire $lÌdÌerrpl.i).ì.nLisloher lhen l.l. Therc ÌlilL
irr uÌ)ra preluÌr on inueti{!Ì iÌr tlre hr\t (a\e dÌìd don.Ì!r(Ì tÌe$ure ìÌì the \e!!r
.af. lÌÌiÌetirlr $iÌL Ì)É co.\taÌrt ouh slÌen ÈrìÌ)Lo!lnenl is nÌ / . ìrccrtrst onll here aìe tÌÌr
r\Ìtctationt !t hìth rxgc rn.l Ìrrit \etteL iì-Ì11ìllell Lhc(isn.fÌctstrÌconÌnurtirD.
Thìi js the rÌednuì n'n rquilil)rilÌ!r.
1\ ditcu$cd ìn a:hrttcÌ 3. the Ltrllìr !ürLet nNn br . r'qrLiìihr um l.r jnllxtj(lr nr
lrÉ coÌÌrtrnt. ThÉ Ìate oI lnllati(Ìr rt tÌÌe me!ìiLìm [ür ..!Ìst.nl i.Íli1io. cqu]libÌium i\
deternÌnÌrd b\ monrtar toÌi!\ l\'Ê!li\cu\redtÌ\.!liltemtmof.LirrfoÌi.!r:iLnrt\rin
iÌìe. the nÌediun m L.tlarLon rate nai iet tr\ ihe Srorth rali o lhrmon!rsuttlvând
ÌÌÌ thr otheriÌ \rì5 tetÌ\ thc iÌúÌatior t.rrtet ot tìre (erÌtrirl birk.
\\:lÌen Ne iur! nr the (Ìren e.oÌrÌnl. re |(trr tlrte lâíÌiliar qucsLl.is:

1y \\ hrt dÉtenrÌirÌes uÌr unenlplotr]ìÈnl Lìtei]t shi.h if lh1io. i\ .onrtxnt?

t2')\\het delcrÌLn!\ Llrc.o.ita.l Ìrlc ol jn llilLon rt a ÌnrdirìnÌ Nn rq!ililrriunll
rll Hori!È\iÌliÌ.ìti!rÌÌrelìr\rrrhuÌtlÌer.or!ìn)irni)tntiÌ.onsLântLnLlâti.n
t46

\'Vc slìnÌl ans{eÌthese q!eÍ1on\ irÌthischaplcr. ln 1Ììc ìntrodLtcloryscctio., ire pÌo\ ide
the inswcrs and an intuitile erplâniìtiof nrr lhcnr. lhc dclaiì ir providcd in the Ìest ol

. whal dcreÌ mines the !rleÌÌìploynìcnl rale at wh j.h inflalion ir.onstant?

afswcr to this questioriÌì the opcn cconom-Í tatcs lhe same general frÌm as itÌ th.
'11Ìe

closcd cconomv: wherÌ Ì!âge and pri.c scttt* atc i. cqliilibÌium, jnflatnD ì\ constanÌ
Oncc again, ne aÍe looking lrr the intcrscclion bctrrccn lhc I15 and Ìhe fi cuÌves. T1Ìes.
cu /es nrc dctrrÌüÌed b) the nrpplt sldc ltâLurcs ot the ìabour and pt).llrct rnarlets
HorÌevcr, rhc lìrst tre$ twist iÌÌ the opcn ccononrl ìs lhâL thc PS curve and hence ih.
.ìctu al rcaì a'age is altècte.l bt the real.osL oí inrpoís and th.ref(ne bv the ìeal exchangc
rate. rcal appÌeciation Ìreâns thit tbc rcal costof impoÌti is ÌorreÌ. Thìs Ìaise! re.ì1wâgc5
^
and ÌÌrcn.5 lhat Ì{e c.n hav€ n conslnnt inllatidr equìÌibúum at ìoneÌ unenÌploymrnL.
lhe se.ond ncw twiÍi\ tÌÌit â Êsc.l cxparsion and, nroÌe ijeneraÌly, an 1J nÌock, can shÌIl
tlÌe e.of om-Í Lo a new conÍant infÌntion e!ÌuilibÌnnn.
. Uhal dctcrÌnines the coÌÌÍint ratc ot ìnnatl()n at a me.lium rüÌ e.Ìuilibrnìnì?
luÍ is ìn rhe cìoled ecorìorÌìt it is thc Ìnonetarv policv Ìegìme that establi\hes holr
the mcdtunì'run ìríÌation r.te is dctcflÌìne.]. ÌÌr a ÍlrÌirlr'exchange rate e.orlorn)'ir1a
Ìnedìum run equiÌibliÌtrÌì, inll.tiorr irill be conrtant at the ij(^tth rate oi the monc\
Íppl,v sct b) tìre central b.ÌÌk or al lhc centraÌ bânk\ inilati(lr taÌget il it i\ usiÌìg a
moncrary toììcl Rìle sLrch as i tnr-ìor ruÌe h a /tÌ.d eìchange Ìate econonÌ)', inll.tjo.
sìlì bc conttant at thc ,s,orÌd'i.Ílation rate. In tluÌr, 'woÌld' nÍlation will be sct b)
thc gro lh Ìate ol thr mo.c)'sufpìv as nxed b_Í the centraÌ bank iD the economy to
wìrich the home €.onDnÌy\ cxcha.gc Ìâte is pegged or at that central brnk\ irÌfl.ìtnrì
largcr.
. Hoi{.ioes inÍÌation brhnvc!thclr lhc economv is not ata constant inflatl{)n

Ìn tìre cÌ{)seci economt,,lbc slìorl-Ìún lhiìÌips cuÌve crptures the Ìcspon5e oíintìâtilrn
ichen the ecoÌÌlrmy ìs ãwat tronì Lhe Ìnednìm Ìun equiììbÌ1lrm: unemtlolÌent bel.n\
the EÃU nÌeans rìsing infla(io. and r-ice veÌja. In the open econonry, when ile thh
aborìt the consequcnccs tor lnllarjon of an) cìistubance to the ccon()nr), i{e have t.)
take into âccount nol onll Ìal hashatpenedtounemplovment. i.e. the lhllì\rtcuNe
nÌechani!Ìr'ì, but aÌso whaL has hapltencd to the reaìrÌage as a conscquence ofaDv chani{e
iI the excha iteralc.
To e\plore thesc Lhrcc qucsllons tu her. we rhaìÌ take a5 i sliìíing Ìroirt an .xanrpÌe
lanÌiLiaÌ ÈoiÌì ChapLcr 9: a iscaì c{pansion. lve sÌrâll bcgin i!'ilh lhc c..nomv jn a
nÌecliuÌÌ nln €qujÌibrjum lrilh constarL iDflatìon aÌrd then i!rplcrnc.la lscalexpansìon.
ÀtÌer noting thr .cs'thoÌl run cquiljbriunr, we ark howpriccs andwagcs ('iÌl nrcvc once
th€y.re allor,cd lo adjusl. \{c shaìl see tìrat wa:les and pÌiccs nol oÌrìt rcacl !o charges
iÌÌ tlÌe Ì€ve1of outptrL (as in Ìhc cìoscd econonr_Í) loÌÌo$'ing cha.gcs to lscal or monelar_v
policy but.Ìso 1o anl change in lhe ÌealerchaDge Ìate that has o..urcd. Thii is bccause a
change inthe real cxchângc ralc aUccts rcaìwaget end lhcrctorc disturbs lhc cqLliÌibr!trm
jÌÌ the labour markcl. As {c work lhrough the chatlft, s'c slìnÌl scc tlÌat alllìough a lscaì
 .. .:. . :..:: 347

expansion takcs Lhc ccor.)n]) to a newrncdium Nn eq!ilibrium i{ithconÍant il]naiion,

r Íìonetafy cxpansion does not. JuÍ as ìn the cÌ{)seci €.onomy, a chaÌÌse in tronetaÌy
policy has onll a drorrrurn elïect iÌì ihcopc. econonìy.

1.1 Example '1. Fiscal expansion with Íixed exchange rates: what
happens to inÍlation?
Let us bcgin bv a$uming tlÌât thc smalì open econom,v is at equilibrium emPloyÌÌent
rt lo wilh a ÌeaÌ rÍaiae ol üo 6€c lrig. 10.2). We a\sumc that iÌÍÌation in the rest ol thc
lrorld is 3tl). The home econoÌnybcgins with 30/o intlation as ÌvellaÌÌd tle a$ume that thc
e\changcralc isnxe.l.TheÌed1€xchangeÌate, á : L/, ìs theÌeforeconsLant:.nired and
t_ and l'arc groNing at the samc ra[c ol30/ô. Suppose lhere is a risc in ag8Ìegate deiÌìand
is the reÍlt ot a lrscal expansion. As uNal, hiSher dcmand booÍs oulput in the homc
econ.,lny aÌÌd cmpìotnreDt incieascs ro Ë2. Thi\ is thc new rrotÌtln crÌuiìlbriuÌn in thc
\IruÌdell tÌemjng model (poiÌú.-).
The qüeÍion is wha vill happcn to wages ânc] prjccs lvhen ac alìow thenÌ to adir'st.
Sitlce employnrcnl has rìsen, rlagc sclteÌ1$ilL requirc a higher €:ipccted reâÌ líage (W.S is
slopcd). I IeÌÌce mo eywages rile by Ìnorc than 30/0, ì.c. Ìnflation goes up The
Ìro\itively
unit coÍs ot Ìromc nÌms theielorc ìncÌease. Accordìng to our uÍral as\umption about
(so
honie
tììcirÌg b€haviouÌ, home ÊÌnÌs raìsc their prices to ÌelÌect thcsc higher costs
rlill.isc Ìn ììnewith waiaesl i.c. ata rate above 3qo). Thi\ in tlun Pushe\ up consunÌer
tüces
price irÌíÌation. Sl.cc lhìs is:!n open econoÌÌìy, bome coÌÌsum.6 buy both inrpoÌtecì
0í, th€
goo.ìs ând lÌornc p roducc.Ì goods. lhcÌrÌìceofi po rLe.Ì goods has onÌ-v risen b)' 3
.ônsuÌner price indcx does not risc bt as much as doct the prìcc ìndex olhonìc prcduce']

fJ tdLZ)

jwo

Figurê lO.2 Eqú ibr um empoym€nt ir the.pen econony àl o!/,1 an.l h th B empovmF.i
Fi.. expdií!. ! to CioB tix.d er.hà.qe raies), r ro arlôA (Ílcr bê êx.hnnqe rai.n
 ç

348

!,(r\Ì\ lhis h.ì\ i \ÊIr iÌÌrt(ÌrrÌÌr 'odr((luirLrt lbe Ii\t iÌr '(Ìrmmer Ìrr1!ts itilÌ's o!
hdì'eth'relr rrlr j",r'lse\ iÌrr Lbeli
iììì.. i',.,,,,1,,,i,".j.",, "'."", 'rlst!ì
'!!,rr \t,rrtr LLÌì r blt (! 'r'nr.i'ìL"/(rìrrnr/i\ ü'll \! hL{ìr'
rr*.t..,gJ i,, reL,rLl\t1-Ìi..!hì'iÌnPll'Ìlnn\
'-l
nìnaÌ ir1 toj'l
,ì;;,ì,,,,":,,,;1,,.,..';ì,oLr r. rs rrmrrL br trrrr'rÌ a rLrlrr "nÌ' Íi\rLl
o ri *" uur.r,,r'*' iirc raBc\ n) 'ìL]j!5t nrlLoüing lisLrL 'rÌrrrìsLon rLn!lcr
'". tr,* tleir l' r buLsL ot Ìrtlrtltìtr 'ib'\ l!rr rnl thtn tht e'|"nì-1 L'nre' 1'ì

".n,"trt" ' \rg"

,"t',,ì',"",1 ""t"tt",,Ì.llrÌ)IiuÌniLìLi'rÌrt5ttrÌÌeslr:hithL'ÌÌil'\nÌ.'lanìÌtr
lrlgheLtb.rLllnrtlrÌÌrr;dljlhì1ì]]riio]con\l.LÌìLarl(ltqu]lÌ.lol]dirúletn!ì5ì|.t
i,,ì,., n".. u.rre.ìd i jì'n | liìi jìrr!rÌìt LhrÌLglì'uL tÌÌ.nag(-\cttlnsÍì'
"-'":,"u*,t

itre r'qrrnce oi e' cnr in lebÌr Ì(l I

ls nLnltrririztd
Írerlr"rg.rrr'cÌrirheLdnlrtri l()iL' rr. Ìrri \anrc
Ih'Ìth[elhterLr:ir'5'ríc!
nerr r llormerL ltr cl i. Pr\ !or i1ìr Ììishrr riiÌl ü i i'\r' he iÌrsÌi I i\
",".';;;,":, "',
i''"'u'"".",."....n"r]crlleIllnr.lblrlldlrcttrn]\oitÌi(LciLìrt]]cÌ

,',-,'""r",rr,",.Lli"gng'',n\'lunÌL'o!'\f()ILshr;iÌr'Ì'a\tdThrlS'Ìrrlethriinrer\i'Ì!
r lh r LÒrtr'lr rr oi r uxl l\ Ì LbLìlerL /'\'!r'
'' f t t-t, ".n,, i,,,tto'út'!lrÌ\ triLde ('rf clìiÌrir lìr (Ìirn tro'(Ìn! tror lclt5 :Ì'
tf,.
ì,," t,,rn''i,,. n", n,'' tiÌ 'i 'ì'
inrtiLailo Llat Lhe ope| a'tÌ !Ì':cd üÌr Ìr'rk n\omt rrÌdj lcrinrril\'
"oÌ('mlr\
lntr'c.lusc.r"ru..,n..LherL.ili]trÌÌ1!llteq(1Ìiìrlir]n]lrt!..IrìncnDL.\nÌcntL]/lLj].t!r
tÌr!lc cüÌ ìherÌ th! toLiÌ ürìrtruÌi oi r'nì|Irc\
rLn .pc. e..n!Ììr\. if rh. lerm! Lrl 'hdrgt'
rete\ scon!i\t"r
".l,llll.l"toa-..tl.t"gern(l|Il'c!tlL!Ì:is'.1oÌrllahrrd'Thl!ìt'rn\tLriLltlÌ'rci'fLì
ì,,,rr,,".,,*,,.'"-pl.,aÌn'ntrquÌÌìbrrurÌrr'ìÌLnleLr urÌt'ìlÌ(ìrtreìl
 t49

rlritoiutheab5erÌcc(ÍinLâtionaÌvpn'$u'caÌìdLìs('lfoLi'ycarìhr!camcdìrünìuÌ1cfte'1
I r rÀe,: ,IrtÌu and cnÌno-"-nenl
l

.( troo,
-'".-,*: t ratês: what
' ' Example 2. Fiscal expansion with flexible exchange
haPPens to inÍlatiÔn?
.:l.llt tÌ,l.Pt h'itth te lrtreofrheopcn€conrmlcìocsnotdc])cn'lolrrhecx'ÌÌanserêtc
,,:i;' ., .; u ' tt *p"ct'úio!r5 arÈ ratìonrl an'ìÌhoe arerìo no inrl ris ilie5
'" " 'n'n'o'
'.e.oÌrorÌtìnolcsdtlc'tÌ\fioÌnPrrint'1topolnt''linLig lLì2' Ioseehoì!theeco']
,' .'
4" I. u.-, ,,, , ,,a.ì e{.halÌge mtcs :ìrc ueiìrlc bul tlÌfre is nolÒlnal slickhcs\'
",,* th' \4uÌÌdcÌÌ
,,""'li::' . t.ìi"' in" . ,'. 'tcps as lor rrâmÌrLc 1: bcsinni's Ìlilh thc nÌove

;.1;:' ," ',,. - r',,,""' . Lo,iascoÌplce adju\,ti:"011ll::.il::ì.::.1.:1ï:ï1li:::

t't,l ",'hrÌrrcrgwekn;i!1ììataliscaìexpiÌnsidìund'rflclll)Li'cxclÌan!€rates
(l\'ÍLuÌdcll ÌìenÌjngì rqulÌibÌnun' net
:.i\ no clte.t on ortLl)uÌ sìnce iÌr the neü 5ìn)n-uÌ
' : ,Ì*ourcc. .iÌrorts âre roife, bl era.rr! trÌt 1 ücr\c, n BorerÌÌrlY:ll':Yllllì'i.Ïìi ììiïiÌ
,,,,ìï'* I"1,"-.'"ì.ì't"-,",i'.t""e\p.:jrtsÌ,çtìr€hisìÌcrsovctnmrntsPcndinii rnris'1r-)2'tlrr
'
, ;',;:i' ,:"*;;"^;',i"".!
ì ;, ::..',., p,,n,,ìo p"'" o tt'i":i:ì,1':::::ïl:::iiiì," ilii:',1,ïli,:l
\er'rrÌ'!h't'ri iir'E\Ìr'trt'ÈrL\tÍ'rrc\'LtlrrrirfcoÌÌdìúm
' I " ' '",,;.;::ill
;;'ïj .,ì,ì ì"' ;:ì;"" :' :"ntquctur5 trr Púccs eÌd 'raircs ilhen the e'oÌrdn-v Ú
it tbc
(hangedì
ri";Jrrter..-i. "'"
::i( rhoÌt run equilibriünt tiL'Lpt't it ot it' i'riLiot tcl'el (lhe Ìrat
'oÌnlo\itlon
.. n .i,.,. *.,. .. or tbc Leaì erch^nge Ì]tC iìâ5 l.]ìcu (aÌrprc.!atld]
11,

::r''ridi\aÌì ',.,, "onLeLiaLin

.',ìar',"t'-","'".''"'igt'ì;1ìcncelr:?''rl'jha\lallen) conÌrerirnc'eis has filleÌì {o

,.,r^,,"ìì ., ,iirtl n"u," ,.r"," -.rtaf rr.t.o rns er rhi\, ì!c r\r r,ÌÌcrher s asc atrd ric. seÌtcA
t'-;;,j: ..',,.0,,,r,,,',,,""otreciatnroìthcrciìÌ e)i'hansc rarc tÌÌcan\ thlt rhe rcrÌ'{rst
t Í.Ì
'. ' ' ',,;;;;";:l .ì,",rìli' ,'"' *'." -*
" 1,""'
r'
'' 'il' -
Nrrich h'rs rarÌ'nr iÌrcl 1ììercrr)re
1rÌ rhe !ìci! sh(trt (tri
""'.,,"',';;,; ,rgcstravegoneup.rootuÌsatr1it. 10 2' 1!lÌr eürtu]-::""Ìl"].
\\ì!t\'(tersâÌenotonlÌre
:q!iljÌrrlLuÌr,1heÌeil\'rl'.r'r!o\È ilr'rlLrr I r!r1') LtrLl\
beÌoi! thc Soing r'lc o1
:rrcuLtc rncLesulL*tlllelLr\\ELLìì!r() r\nlt5!ltlc!rrftsliÈ
lnÌc ltith th(ìr fullìni{
rïlario. or:j,!,r. H.me proclu.(s \riÌÌ r(.Ì!(c rh.iÌ ÌÌ1c.s üì 'osts
i.,i r,,'* u* ,,,,u* "ì,poúc{ì goo{l\ 'ontinue to ri\e iìt :}ri.'
{hiÌ\t rìonc) Iage\ hI e
" *oiraA(s trLl sìnrc])rice'o hoÌrr c ÌrÍrdu 'cd go( xls ha\ I rlselì b-v
i,.'.,. u', r-,,r,"" r,r,
an ìnÌrrolenr'ntlJì conìpetlLjltn'r\'
.rs Lrrrn tr.e prl*s or iroo.1r. tÌre rcmÌtNilìbc
"otld Nill hsin to
;,,';;,t, '"i; net {:\Ì)orLs wilh tlÌc Ìe'Ì1Ìt thit oLLrtut iìnd en\tollnetú
i'." a,," Í)uth e!sl ÌÌo|r pojÌrt D aÌ11 to Ìtst nt Ì)oìnt lJ \\i' 'arÌ
".on.""'
.trrìlnarire.s
'".'",
Ln Ìnhle Ìll 2
'onÌcs
'
lve not( lì]il iÌthoush the
ir," -,n"rl s.'t.ut Lr," Actrils ìn tÌÌc ren ot thc rlÌapter' llelc
on whcthrr th' cxchansc rrte
:Ììôú rLn elicct of ú5cil ììoli.-! !t !eÌl ':lillertnl dePcndilrg
ì(l' ntn'l
Ì\ l1erl or Uc.ibLe, lhe nrc.ìnrnr Ìun outconÌe ìs

](ì1.]!Íl.n.ii]l(lÌ!ln\.ì.r|ìlFl.ill.rri?Lìì\.ItnleitLh.5iirrtjnì!'1!liú.\riqiLlt,j?rìÌ]ll
ii\.itÌri!\l!..rrÌ?rÌrthèlnlLiLrntÌ(r r$!rìÌi'i i' ( n:rlÌrL ll rnìj'!lLilrttoìirt(rdrÌì'r'ldrL
350 ' ::: "
Tãble 10.2 Fr.à expãn5.f lnderÍer be Êx.har!È rares

j lt ,!! ]r-
d. ô. l
rÍLl Ê n:.1 rnlqu a1r \,iÊ, n -r

1.3 Summing up
Wc havc sccn that ivhen we mo\€ lrorÌ the short ro thc mcdi!nì nuÌ. and aÌlowwagc!
and prjccs to adjuÍ, the open economy behavet some ìraL ditlereÌÌuy lìom the closcd
ccononÌy. Ch.nil€! i tlÌe real er(hân8e rate affect rot oDìr agsÍegai€ clemandbur also
rcaì s'agcs. lhis has í!o coÌÌsequence\: fiút, it ìneans that inslcad of $aiiei and friccs
rcspolìding oÌÌly to sÌiilt! in rmplrln.rl turÌ the jnjtiaì conslaÌìt inflatioD e.ÌLrllibriúnì,
lhcyalso respoÌÌd to charÌite\ hÌ th€ rdl wrí. that occur as a co.scquence otaÌrv change
in lhc ft.al erclÌange râte. lve sâw thi\ clearÌv in Exanrpìe 2 nlrcn the fi\caÌ eìpansion
Ìcd 1o a nomiÌìal âpfÌeciatn)n and tlÌeretì)re üÍe.l Ìcal nag$ in th€ íÌolt run. Se.ond,
il mcans that lLrllo$irrg arÌ exp:lnsionâry lìscal poìicÍ the Ìesponsc of iv.ìSe\ and pÌìces
c n su rcs I hJt the e( ononì\' ends up .ìt a new nr edìunr run equìl jb Ìi unì with lÌjgheÌ outÌÌrtl

thc ÌìcdÌum Nn equiÌibrnün js the sâÌÌÌe irestectivc otehrthcÌ cxchanile rates aÌe lìxcd

lvht do i!'c ha!.c a ne!Í constarìt ìnflation equiÌibÌium at loÌer unemplovment fdìos
ing a ftscal boosl inthe open b!t not the (l6e.leconomv? Th. answer is thrtin the cìoscd
economy, IvJ and |J iúersect at a unique leveÌ ol enrpÌovmen!: this is tlÌe unìqúe /ìIil 2.1.1 Wage r€
Bv contÌasr, in thc open econom_v, the price lettiìrg reâl wagc is an iÌìveise lunction ol
the Ìealex.hangc rati.:chang€s in thc re.i.ost ofiìÌpollt alle.L rcal wages. Iience lolÌo*'
jng a hscal expa n s ior, a ne$r connant ÌníÌatidì equiììbÌjum Í tcasible: a reaÌ app rccial ion
Ínplie\ that I ighcr rcnlwages arÌd lowerrerl impoÌt cosrs âÌc consistenr $ith equiìÌbrlunì
lor p.ice settrh and \ragc sctters at low.ruìÌempÌovment.

2 supply side in the open economy

2.1 Wage and pÍice setting in the open economy

2.1 2 Price set
I tlÌí secti o r, lrc provide \y\tenìatic tÌearnr c n I o f Í'h! th€re i! a rangc of nÌednrm ru r
a
eluilibÌnrm u n cm pìovnìent ra tes in the open econ oÌìv. l o d €1ìne th ìs ra o8e we need t.)
setoutthederaiìsoI$ragcindpricesettüÌiiindreopcnc.onorÌ\'.lveÍicktorlÌecostplus
prìcirÌg nle iì)rhonrcp.oduced goods solcìathomc a.d cxportecì:

f :rr, - L unitco(t
ltj
irheÌe I ls the mail up.
 351

1Ìl tlr( Òf.r r.t)n.Dy. it 1\ (brt ì\ ìÌÌeini br rcal

ne(e$nrr lo bc DoÌe .rrehü ibortL
rigc5. hcr.rn)nittìlt$ecrnrÌolo.tÚtrlÌirb(núa\iÌr8.1Ì1.Èlelel. llieprl.clr\cl
thnt i: tuìc\rnt iÌì the a$e!ÌÌÌerú Lri \!oÌktA (ú tht redÌ vilLlc ol Ìnr!Ìel üaBL: is 1lìr

I hr r.fsrmÈÌ trj.e jn.le\ n(l!de\ thf prl.t's oi linaÌconnrrrì.. good! thaÌ rL- i porlcd.
lìr.onLrr:l,therealÌlasetir!ti\rel.liÌnLisrco\tnrhtnLi\th.nrone\siil.lntlnÌsô
tlÌcprndr.ltÌict,f ThtcoÌe!l,eneconoÌì!tr( eÌ.rnbebcsLúÌrder\toodìitrinr,rl:{'i
\irÌrp li.etio.:lreasurìrilütitìsonltllnrlc(nnuìtÌiloodsLhatrrenrpoltea.L.Lhc
e.o..mr. I. ChrÌrteÌ 11. $lÌen ü e \!in1 lo i.reditaie e\t!ÌniÌ strpÌrL) nro.[ s!.h is oLl
jlÌo.ks,1!. intÌo.]u!e thc Ìole oiirnpoÌi.d ÌrâLÊÌiali.
lodclln.Lhec,!r{uìerÌ)ri(eiÌ ÈÌl'iL!\âs\rnÌÌedtlÌat(o|sumcsÌrur(lÌ.sribú.dlcoÌ
Soods hon:,iìrjchareiÌnpofelliÌ,ìtcatrjceotf_.ü th.Ácrhi.lìareho cfrrdu.tcl
lÌ!!! a p, i.r oi Ir The thaÌe (ú tlÌr .o.:rmtti.n ÌIuúÌe tlÌil ls iÌìt!útd r'( jrill .:aÌÌ ,,.
I,rpüroüicc.]ltrÌ rnÌ t{)reirrÌ I 1hL..nstrmerÌÌictiÌú(ìi\:
t) I ..t,+t1). .onsúnreÌ trì(e nÍlrJr
sheÌe|È!s. thcli(.Ì lhrtI',, = 1 ..\!hln.cÌ1feu\etheÌrrnr'rexÌitrlc orr' Ì!.nrcaÌl
rbe reaL u iì!. jn 1 Ìri ô co.\umrÌÌrri.rs:

The nerl 5rcÌr l! lo:rt (uÌ *rlr dLÌll frLlc tettiÌrs l,rlÌàri.trr in ihr oP.. €.ononr\ irrrd
thrn to lo,rk ll thc Lnrfli.ationr l.ú ih. ilxge rnl pri.r Í1rL.S(!rcs
2.1 1 Wage setting
\\'age \ettirÌ! bc ri\ .{1Ì Ls lht ranÌe.Ls ln Lh. cL(tre!lecononr\ TÌÌe on -! nrt{Ìincaiion i\
r. maÌie r\pli(it thr ntc oi Lhi c(rrsrrnÌcr f ri.e nrdtr:

lhc r.egr iettiÌÌS curlt ls dcÍl.ed Ì)\

iware 5i 1l ing ÌerÌraaer

rvhere a rj:c n .mltÌol ment i\ r\!o. il..lllith r ri5. rì th. ilrire sellifg ÌerlÌ!riÉ
21.2 Price setting
A! dìtc!r\id aÌr.!c, rtt ure a r.\t plu\ P, i.lns ÌuÌe tü tlÌc.ten trono'ÌI ln the rbserr..
.f an\ irìporlcd rnxtenaÌ\. frice \eiti.g Ln lhc optrÌ ec.ÌroÌr\ i5 tlÌe \inìc ar jI the.loscd
ecoÌrnnr,ir pri.c!rÌcretr!anÌiItri !f onrnìitLrbo!Í.osts:

l\
wherel] is lhe pÌicc oihonÌe goods Íncìat hotr.: and iIÌe{porL Ììarkets and .\ js lhe leveÌ
of labour tr).Ìlìctiti1,v. To ì\ork ilh tì1e $agc_ aÌrd price settlng curve!' botlì nrust ute
the \arÌìc dchÌritilrrÌotther€aÌ(,agc.ThÍÌÌÌ!ans thative necd 1c) cxprestth€ prÌcc_5ettin!
ÌeaÌ \!agc ìn tenns of the (onsLrnìcÌtúce indcx, ì e f.
1lÌe frrsL step is to substitLrlc thc trne eqúnlì(ÌÌ into thc cquatl()n tìir tlìc .onsuDer

1''
' Ìr
Ìt t

Nagc e noÌ! ditidc cech \ide b\

In orr:ler to lìncl tlìe cxtÌessiolì Íor tìre |rice 5clrjng reâl
l= ir +.TlÌisissho$nlnline(10.1). lhc.Ìveus€lhcdcnni nÌs oi lhc real wagc
,+andofthcrcaÌe\chaÌrser.ìte,r=?tosirntìirvthee.Ìuation(ì0.2)lÌìthcthL
Ìi c,wcÌeaÌirÌÌgctheequatjoìrsoth.tthcÌeaÌÌr.gcìsinthen! Ìeralor(10:'ì).
ll 1!\ , tl ( l(l.t J

L\

il l,)ì : l ,,t r,,r (ì 0.rì

tr, l (t 0.3
ll r,ü ll "r .,
)

h thc hnal ncp, rle re.rrange t1Ìe equaLjon Í) thal the pÌice settlfg real waile is on thÉ

r ìil //l í|rlcc settirs ie.ìl(,n9., open)

LL - rt
_ '1i3
tl) (10.11

ììhffc Lhe nNersc rclatioÌÌslìip betireen lr n.d rl\ caIÌ bc dc.ottd b) a'itll ': (l
wc can see lrcnr tìrit ÌlÌnl the pÌice settÌrìg retl $â80 nì 1lìc oÌren ecouorì! is cqual to
thccÌose.leconoÌn!fri.r-5cttiniirealìv.gclie.\i1 !ll nìodilre.ÌÌrt uÌe ft'aÌ cìchani{t
rar., /1. Ìlthere arc no iÌÌÌporled goods t1ì!'Í'cight ol i poÍs ln Lhe con nuÌÌer pricc iDCler
ìszcrc(i.e.,0)aìr.l\oili!casltoseetlÌalthepri(eÍttÌngit:aìtlageisnúrcdcquaìtil
ils cìo5ed econom) vahì€,

r'pricc-sc1 li n { real wi 8c. .los.dì

Thepúce scllingbeh.ìriourothrmsrneans lhatthewirgemcaÍrrcd jn terì! ofdonrcstic

outputishxrdine\ectl!lh.samewayandnllhesarneLevelasinlhcclosedecorÌom,v.tlrt
woÌkers.hooÍ: nr Ìrend some ottlÌeir $'ngcs on inÌportcd goods.'lhe hìghertlÌc prlrc oí
iÌnpoú\. thc IcNeÌ the bundlc5 oi cìo!Ììenlc output plÌrs i poÍLcd goods (in prcpodio.s
11 .)l and ,) thev ca. atf(td. So tlÌe rcaì í'aiie i\ reduced Gì\'cn dre woÌLd prl.c of
jnÌrÌr\, |', rhe pÌice to c.nsunÌer \.rlcs alth tlÌe er.hifgc ralc see Fig 10.-l IoÌ a
.o.r tarison bc lileen t1ì. closed and open cconom) price \rttinÍlctrÌles.
 ì I i, /)\ '!1r
!
).

Figure10,3 Fr....rrir{ .:: _..r!:ì.li.r' :.!.ì?r

r a.:Èr ê:.r.fr, tr ir'rê_ Ê:rr-. 1

j'lhe
llÌishiShlislús thiitLheÌnoit lnrÌ]tÌi.!rL tetuc ot thc ltri.'_rrttlÌ! rrl waBÈ
LÌrÊnr.|.r!rÌ) irtliì Lti\rÌì\er\fli rtlrt.!l Ln rjrcrellL\.hrÌì3' !ete, r':

. e ÌL\r iÌr,, riln:! the iÈ.1 .o\l ot irnP.,led !!l]ds aÌr(l rtrrr.n!c I(lrtret Ì1Ìr' fr i't !ettiJrg
I lr I

tlr tl
2 2 Medium-run equilibrÌum
li ír .or br n! n)Sethi I Lh,, r r!t n'tliÌrS ,ì.d ÌrÌ!.t ritllng (!Í3. ü t 'in lte ihnL slnlt
r.rf \rr). thoe it r rnns( ol uÌÌ(nrflo\rì1.1 Ìrte\ rt nhnh lrise rrÌd lri'É ietL'r\ rre
ir qulÌiLrrlunr ji ÌlÌe Í.Í' lbrt ltiÌgc \etirr 5 rÌL .rÌ tlrr l1 \ .rt r e drd lri'e i'l L'Ì\ aÌr
'!ì Lhc fJ r,r .r1rrc. Àx.iilìrr h.ì\ .il f trttúÌ! lhL\ r\ t! \il thri Lhr LÌ li r o olllút fer
lÌ..d.triìg..iÌ.e irnd l ì\rrr..ir\i\trfLrjlhtÌL.eldìLirblr(uiÈuL Ìlci lrr'ìd r'n\!
J'ingr.lül(5tìIuÌreüfÌo\qrtnt \\'htnÌLnlcr!.Lfrl.c\ett'r\rrei|{ìluiLi!Ìirtì 1(
lrl hiircLaiÌ!5n...t!r\i\tr.11!ilhilì.ÌdeliitìrttÌÌrtl\'rherl'r\triÌrb['thrÌÌiÌÌl''t]orÌrrl
pr.nurr\rrcib\dri.l!51asi.ihi.l.\tdr.oft)trl.rriietÈÌ1oJÌ\ÌfcnÌrlol'r'irtrrt'
.r.d tìrt rs5.rrrre!lLer l loi (utÌ!L i.d ttrì|lnr merÌt itrÌÌi.hr:!ein(lfri"í'rter\rl(
rrrrÌuiht)ÌiLrtrrsaÌìeq! lbrlüDrr,ìL!oirrrÌ!'nìfl(^rn..r tfit'i'ltÌ!rf'lí)t'rrc'trcllo
g.Ìrinr\ (qrLllrbÌ rnÌ.
.i\ r (rÌnÌrÊtìn
ln lhe.l,\c(]!c(Ìnìì\ Lh! ilìi.ì: l(tr rril nrst'p'Ì ÌrÈ:rd rÌìcl proll\ lier Ìrrr'1 trÍ'
rquil n) (\rlPLLÌ ter nriìi !.1\ rl i \LÌr3Lt Ìr..nÌrL(ìlnr!Ìrt Iil': tjrt ll l 'rÌ\f r'(ì thf
l\.!rrirÌt.ic.trtr!ÌììqLtruÌìerlrtlo\uerìÌÌrLc lÌÌ tlrc (ÌÌ| L''oÌtÌfl lhtrrjsarrlt'
,:,1.iÌuihL,rnLmÌxtt\oi!f..rtlu\rìr..lhÌiì.tolÌ):nilorFigl0+,rlrLiÌiÌ)riLrrr]Ìett!!l
!f{mtÌt)trrr(.lrt lrnllil iaÌtsr.rn .\t l, unen+rlortrenl l\reÌrti\rÌ\ ÌÌilhandt\l
i.n\e!urLr|.(.1ììc LLtr.! Ìreì\ctlì.sili(Ìrl)Ì!oÌÌ.cÌ!j:rriherr:cxÌ\'lhlsnrerÌr\ÌhrltlÌr
\irgÉ Íliirìg ÌerÌ\tìli iÌ.Ìrtirr!Ìor'LüiftqullibriuÌÌrrLLoi'urr'nÌnLr\rìL'nl tÌtr'
ll! L
p,rct setti|!r trl \rsrnrr\txL!)r..úthlsf,'lrlÌ1d]lor\Ìe\cl 1\ìthiÌ r\tl r'iÌl irrrhi
ìiÌgiÌìÌrerrr. kÌ.tlÌtPri.c \tttiÌrgÌQÌÌrr!.Ì!llÌj)trrlrtj\tL\ lnr rhrf thtÌt']l"sl't
i{toÌtr irÌ lh. hr\L'tt .l g.,!Ì\ .oLr5ttìed l\ r.lì \eÌl ri!Ìì 1h' trnr 5':11!'g rt'i rxst
ijn).ìatrd \titb hjSh irÌìÌ).rl.ott5 i\ !Ìr(rr Ìr Lrr /ì\ /r,r .
\\'ho u..nrtlo\rx'.Ì li rì!(1ì l.rer ri l-ÌLÌrt Il. tlì. li:lÌt libour JlìiÌÌiet \!tÌeLl(!r
i.r|Ìie\ r lr glrtr rrE(n'LLlfgrerlriìg€Ìo'r.r!Ìrilìbrirtrì.11'otLin'|rtÌ(r)nÌ'nL Llrt
 11't

Figüre 10.4 &ú ibr uÌr r-re ol Lrnenìp oynreri .!r!ê (/;,(rl]
(r) l1,r'ànd /rr_.utoej lbl aRU.! e

pri(e sctting r€aÌ wag. muÍ theretdc alÍ) bc higheÌ. ììo. ihis
to be possible rlith thc
clairD ofreaÌÌrrofits pcr wo rker urÌchan ge.t, thc reat.on
ot impofted B;ods in thc baskct
of ild)ds .drs!oÌe.t muÍ bcrelatively ìoj{. This is jndt.^,",t
tryitir" pri.:" ," tti.,g ,""t ,r^g"
cur!e ìabelled t Síprl.

2.2 1 Equilibrium Íâte of ünemployment (fRU) curve

Ìr turns outlo be rcry urlul ivhcÌÌ analvsìng the open cconorÌÌy Lo work wjth a diagrâm
with tlì€ reaÌ cxch ange rate aÌÌ.IoutÌru I onthcaÌej. lhìs is
becausectÌângcsir rhcno;xÌaì
or rcaÌcxchaÌìite nrc.re frcquenttytlìe ot'art".,,"". rr"
'.,,r';'i mu,rm r,.m.1t .ii ,,vn
fòcus
-. *.ify ," ,f* ,"rr*"
sp.ce. \'V€ show the cquation for the cquiÌihriLnr
t..,-.",ir.".i -"^p . ,;
Ìat".f.""mpr"1.rrr"rt o. iriU
-""e i.
 diiÌJ1ran (boüonl
lo detivc lhe equlìiÌrÌiunì Ìate oÍ utreiÌtloymnìr 'Ìr^re ìn tì1e
'!
.trlrl ot lig. l 0 1), wc start bl alkijÌg th. questirr n h tr! 'an 'ì lot! Ìevcì of un cmpLovmeÌìt
(

pr€ssure?
:nd !he a;ociated hìgh lcvel ol outÌÌìt be suíaìned wìLhouL intLalì(Ìlary
:re lrale iüst seer, a ìow r.1c ofuÌrcmPÌoymetÌt
jnTlies lhat $'nge barganìcÁ will onìy ^s
bc
,rtisle.lbvahighrcaÌwagclorthislobeane!uiìibÌiunr'lhepÌicescltirÌsrcalÌlagenNst
rr i1 the same ÌÌigh lev€l lhis req ujres that tÌìe rcaÌcost of iÌiì poúed good s
itnrflcie tl!
.\r. At Point à i; the top laneL of Iìt 10 1 thcre is ' hìgh vahìe oI enÌplovm€nl and
Ì:rbournÌarket' wc
:rercn)Ìe a high 1€vcl ofouqNt lhis ÌneansttÌal ÍoÌequilìbriumiÌÌlhe
(seeÈrintÌJ jn the boticÌn paÌÌeÌ)
:drr l{) tÌavca toÍItalueolr so thal ìnÌportcosts eÌe lor'
i 1onra1Ì,c of , - ? nÌeans tlÌât lìre wotl'lprì'e levcl an'lIencc the prlce of iÌnponcd
exports (t) WÌth los'
..cÌ]s {l-.) is Ìow rciatilc !o the Ü!ce ofhonÌe goo(ls an'Ì lÌence oÍ
value oI ProÊts LiïÌng
,n prort costr, ,"al t^g"s can be high $'ilhout aftèctirìg tÌÌe ÌeaL
.rntÌarrls are boostecibeciÌuse iÍìpoús aÉ chcat lhìsgnesfoinlB:ìtthe(oÌìbnÌation
,ia loa !âÌue of d and a high le!el oloütput
E{nctÌ) thc çìnÌc logic lies behincl the Ìocatn!Ì oÍ foint l \{hen
uneÌÌrplo)'mcnt
s high;ÌÌd oLrtpu! is d€pre$ed' workcÁ arc in â i{cal
posltion in the labour nìaì
to bc ât
tÌ ;d thcr. i!.ì loi{ wagc settirg Ìeal wdilc' ìror lhe pri'c setlins rcal \{agc
:hiJ low leÍ.ì as is Ìequncd tor supPl-viicìe c'ÌuìlibriunÌ, tÌre cost
ol imported goo'ls

ntrÍ be high. At poìnt á there wìlÌ be a conìbination ol Ìoi! outÌNt ancì high
i poÌt
.!it\, i.e. hÌgh rl. Hcnce thc equilihÌi!nì üte of ulÌemÌllovnrenl (r-ÀU) curvc itì thc d)'
:ragram is a_oiurivarO íoping ibolt{!n pajlel of Fig l0'lì
Ìl15imPoÍanttokeeplrrmÌy
r rninA thaL tne r:,rU ctrne Ìeprcsents eqliÌìbrnlÌn iD ihc /alo'' t'drÁrr: in thc ìre{t
e tiôn. we shrll c1eÌive â rosiiirrjl sloped reÌâtìr)níÌipbet$Icen ír ancl / íroÌn the d'{í"ld'e
&^I i\ ttei n.d a' t]ìt combnìaüons oÍ the fta! dctL lie t ot nn'l o11'tu| hltl
Thc ERU ' 'tt.v
!ÌÌ!\|age\cttinEtcrÌÁa{iselltdttothtrri'!settittStent||'..leAt1l'lpaìúÚtlthtLRUturye'
ittcìúttcxthü Y te,0,isto nutlt nnd i'llnLiotl i \ tÕ st1nt

2.22 Slope of the ffucurue

\ glanc€ at !iil. 10 1 ÍtgiaeÍs nccptÌes ol thc LRU cunar ilill be impoÌtant ir
Lhat the
n.i,,g,r* -"S" cmplovmelìt Ìe!'Ì' coÌìsistent lvith stâbÌc lÌìflnti(!Ì lIdre
"r"'tp"ìand
IÂU:urgc ivas vctticaL,lhenthcre Ì!ould bcauÌÌÌque €quilibriuÌn uneÌnplovmcntrâlc
a

of elnplo'vnr ent equllibrì a

1 ery tteep tà U *'o ulcl disPl' v onÌ)' a naÍow ì aÌÌgc ün
irl ihe rtal cÌclÌange rate is rc'Ìuircd to
^
mu otvc'uNe
mears Llat a ;cÌv lariie
'ãp
lrin; aboutüìe changc
'hanilc
in the rcal cost olirnfons lhrt is neccssary lo allo$ the
tlage incl
dìeÌìt This could be becn use
p.lc":set t ing .eat tt"3e Lo t)e eq ual nt a high c r levcl ol enÌfloy
,rr" ,''po"ì"op".'iiu small so t1Ìat a verv big chângc in rclativc llÌiccs is tÌecdeci
" 'eÍv
io aìter the reaÌ con of iÌnpons in thc coÌÌsúmp1!on bundle'
It coul.Ì aLso be be.ause tìÌc Naiie lettilÌg Ìeal tlage is leÌv s
teep i'e rcal i!'ìget ar€ tery
Jcn sitÍ.c k) â .haniie in úneÌnployÌÌÌcnt Ìn nich n
ca!e' a gi\ en fall il] utrem Ìrloym ert lcads
to a lery biS rtsc in thc lÌate scttlÌìg real $Iage and hen'c tor â Sivcn impoÌt propensily'
requiieia ì:ugc cutin rhe reaÌ con oÍìnÌports (faìl in !'r alÌow thc neccs'arv Ìise in rhe
prlce \eltinil rcal tlagc
')
356

Bv cotÌtrast. a n at lrì U cu re !!oü1.Ì indìcat€ a iride ra 3e

n of dìediu nr ÌLuÌ cquiLibria lÌÌ
this câse, a hislÌ ìnÌpoú share touÌd mean that otÌi) a small íaìl
iÌì l] irould be r€q(rired
tor supply'sìiìe cquiìÌbLirrm at Loi'er !rciÌÌltovÌÌient Ë!ÌualìÍ' il renl ríagcs are rath€r
then n given lall in utÌenrflorÌIcnt be asvrciated iritb
t**itit*. ".p"y."nt '\'ilì and th'relorc onl-v''
,,nfl'^ -",,*, t,t" u, tn" r'age setllng rcaì $age aloÌìg tì]e l'V's cu 'c
I s;rall ìall nì /l js nccded to en re equìlilJrium at loweÌ untmplo-Ínent (Detaiì\ tìÌ
Ior sìmPÌi(it) wc
s|et.hnÌs the l/ìU cuAe aÌc sÌroiçn in the 'pfetldir t'r ihis chaPtcr'
sho(, the IRU cü^ e as Ìnìear.)

(l) Ìì the e.onoÌÌÌ-v is .ìosed so thât there aÌe ÌÌo imporls ii e o

: 0)' Lherr js a !ri'Ìxe
lhis
equllìÌr um t€;eÌoIoutpul end hcnce â uriquc ecÌuilibÌ1lün unenÌpÌo-vnÌcntÌatc
Ìlill.ìeÈnc a vcrticaìÃÃU .urve
' \ , .r.,.. ,. | . tr-tlt I L, r - l' \4 ri i r'r"rn
harelãtter tnU .uNes.
rcaL wages arc les! scnsìtilc to enìpÌoynrent)'
{3) Il the wagt setltrÌil clrr!e ls ÍlattcÌ €
(ì
m aì kel instit üLìons
tlÌis iriLl;ìaÌ(e lhe IRU culvt t1âtlcÌ lcononì ies in NhiclÌ labour
nÌakc tÌìc wailc+ettìng reaÌ $'a3e rnor€ intensitn e to chaogcs in uÌÌc Ìnplo-rmeÌìl havc
1ÌatlcrlïL, curve\.

2.2 3 Ofí the ERU cuÍve, the leal exchange rate is Íising oÍ falling
lvcrl point r the EÃij .uNe is a point ât which lhe Ìlage and pricc*ettirg curvcs
iÌÌtcb(t: jn1Ì.1ion ts colÌslant rnd Ír is the realerchange ratc llo(Icler' sìnce \{Iccannot
,r.,r.rffy tftnt tft" ccolÌomy adiusts lo anv distubance bY nn)vÚg ìnxnc'ìitìtcl'v
^",n,"
io a new c!Ìu ibrlunì, it ts lnÌro.tant to knoìçahüt i1 meâns to lre oÍ
the cuNe We
'lU
Ír that lhe €cono!Ìì-t aÌi!'rys on
ìt
üssuìne that prices aiÌjust ÌìoÍe raticìly !haÌì do wagcs
ietting cune Wc
tlÌc tricc seing cu^'e (i.c s - eri) but rot necessarìlv on the Nagc
i', tl.tio n 1s corìstaÌÌt ancìthatúÌ a rn"Ìnün-Nn equìliÌrriuÌ'
lÌome and
.rss,,ì." tr,ot
",oi,-r
1\'odcì irìfl atio. âre cqu.l
levcl is Ir '
l.et us corÌsìder n situalÌon showÌÌ iÌr lig l0 5 in Íìrnh the eqto-vÌncnt
'lhurghout (his dlscussion, wc hold the 1lÍcÌ of emplovmcnt constant at fr so a\ to
tr'ith the econoÌÌì'v oll thc ÃlÌu
tucus fntÌety on r"'rge arrd pri.c acìjuslmeÌì1' We bcgin
.úrle al poiÌ;l B' ì\'ilh thc reaÌeìchangc Ìaie cqual to lhis nreans that thc ecoÌronÌy is
on the,PSlÉÁ )
'!
jn thc uPpct tancl and thrt thc real s'âgc is equal to 1to
it."r lr." top panel, sten lhe e'onoÌny is orÌ thc ru culle' l']sr{)rr )' tlìc Ìeal
e, rs ,,1";,r
.\.,s |l\rl-\ ' 'l-_ o'_r'
.tr\d.. fr,.r 'r ',' 'r'.\' rr'' tsl' 'r'rPw _' vFI v\'I t\'I
ttre erp<tea pricc teiet,
settirÌg cqÌuâtìon t')
l , Ì!ag.s will be \e( accoÌdiig to thc $aile
AetivÜ tne trgtrer erpccLecì real tlagc shol\'n by thc lr'S culve (i e nt PoiJrt B) \\ihen
tlaiies the plici'ìc\e1rlscs sincc the rìse iÌÌ
producers scr ìrieir priccs lnnncdìat€Ì,v alÌer
to the prices of ìnÌpolted
i""g", ,".."n*t ,t1, .o*s. AlthouslÌ nothi'8 has hnlperÌed
rbole thc fÌice
goods, th€ rite in hoÌrrc llÌicts nìer thdt the coÌÌsünrer
price level ìs
currc
ie!,elcxDeclc.ÌrrlÌcÌr $'aiÌcs irerc set lhìs nìcans tlÌat alpoúìts abo!€ lhellÌLI
(ì1Ìre

poirrt,Riì, r' = wl'j < w" ç withthe conscqlencethrt /ì >lil

 : 157

t45

n ndd r.r, n\únt =n'

'

rplrr.d ÌrrÊstr co ì inilriiof

Figure 10,5 olÍt Ì. !RL/.u \'!

'\J; ' rò-o "i or'!r' r"\l 'Jli

.,.",... t ' ,."',. " ' -'' |l' rr'r1" "'

rr'' i n-,. Jo''J
,',-i ,.,. ., ',,
': r' r' r' /lr'r
r,..r' , . ,,-" h ' 'Ë rJ J lw' " i
,t..^ :,'' .' r'"r ' rír'rr r''1 'r"'"
",.-'"
,p,vp"" "" ':l: ,,., ,,,.r /., ,,.,
\t lì trÌìt , the sdq. rnl |r Ltsjtltinl rtdL r' 16
'Id - rr'
,Jr{.,,r'ó"' \'ldr8 r''_'l l- '"t:'l
.."."',' \r L"' r" I'or"r'/iu
;"r,,
LÌlÌâtionnrv pressures havc'lisappcared
,; ,: ;, ' ,,-
ÂL u,."LtJh-.,nr.1, r-'Tí ' r".'
'r'r'ò'lllagc and price
:li:, ,:;i'iìr Ì;r;, i' ;' lhe rppc, paner, trÌcn f -- /* HoÌrìe ìnrÌntio'r

l']lìthercforcbebeÌow$.ollr]ìntlalion,tbelceÌÌlaSlwi1lf|11'dNiLÌlin.(thcI€â]cortol
lìpons irìll ÌÍe), ând lhe ecoÌÌoÌìy tlilì mo\e back to the -LÏU .1út. at PoitÌtÁ r'jlh a

reiìÌ cxchange rate ot/Ìr.

lhcsc Ìemlts can bc slìmnÌirìzcd as ítloNs:
. On lhe EÃU cun'c, i.flation is coìrstant
. At poiÌìt\ abo\.e the-LÂU curve, thr rcnìa'age is b(lrL! Lhe l15 cur!e so thcrc ìs uPrlard
pÌe$ur€ on inflatidÌ. \\ages are too lo lo rati\fy \!age setteb atthislcvcìol
employrÌìcrì1. Fknìe Ììflalion is abovc aÌì.1ÌúLâtÌon. Ì]ence É isl.Ìlingand ÌeâÌ

. poìntsbetoÌ! thc XRLl cuNc, the Ìeal wrgc is drorrthe r\ S cuNe Í) there is
^t
.lo$'f aì.l pr€sÍrrc on ìtÌiÌalion. Wage\ ai!' loo hith lor wagc'setllng ecÌullibriunì
givcn lhe Ìow levcìot enÌplovmenr. Ìldne illnatÌ)n is bclo woÌldintÌation. Hcnce á

b rising and real s'aget ar€ lalìÌng.

3 Demand side and trade balance

ÌÌì section 1, s,e saw how chargcs in the re.l cxchange ralc induced b]. wagc and tri(e
adjrìstnrcnt fecl back to alfect aggregate deÌlônd and therctorc outÌÌìt and emfioynrent
The task herc ii t.r slìojr hoÌ! to LÌannate the kcl features ot goods an.l 1ìIÌan.lnl nrarket
e!uilibrìuÌn aÌ]cl of lrede balance lnto the ncw1]r' diâgrarn Since a úse in conìpctltile
ness booís net €xporls (asurìing as unral thnt theMtìÉhall-l.crneÌ condition hoìdt' we
shalÌ dcú,e a Èrsitl\dÌ \loped line nr ÌepiescnL g(!x1s nìarkcl .!Ìu1ÌibÌnì : a rcâl depÌe
cialjon is associatcd irìth i r]cir goods !Ììarlicl .quilibrium a! hlgheÌ output lìis step
prcpares the groúnd n)r sectlon '1 itr which the ppl-\'sjdc, Lhe .lemand sidc, a.d the
tradc baÌance are brcughttogcther tu fo ì thc oPen €cononì-v ÌìodeÌ \\€ sÌì.ll scc that
ÌrsìnglheP), di.,grn m grettl)'cla nesop€ÌÌe.onom) t alysis.Asusuâlirea\s!nethitthe
\ÍarhaÌÌ Lerncr.ondition hoìdt $ tÌìat a risc in pric€ compclitì\ eness lâ re.l exchange
ra tc .]epÌeciâ tio nl boost\ thc l rade ba La c€ (boìdint the li'tcl ol o trtÌÌú co stâdt).
. .. .t I rl" rrl.
' \ ,r''r ri. "d .

.r /ir)+.{ la ì1Ìl
:. Ilt) :t + nt,)\, t) t\t.f))\.

Notc lhalwe â5srunethat lhe lÌ,rnìe,?.rl !.tcrestrateìs cq(raì lo Lhe exogenous $orÌdr.d1
iÌìt.ru1 ralc. In ellect, wc arc a\suming tÌìa! dre Níundclì rÌcdìitg a.Ìjtúhnent pro.css
dis.irsscd in.letaiÌ nì Châpler 9, his broúghl LÌre ec(nom)'1o a shoÌt Nr equilibdLm lroÌ
rÌoNthc íocu\is on th€ mcdiumNn. Ìig. l0 ó nrow\ theconslrucliot ofthe.4D c!rvc ln
the rrl dlagram.
Figure10.6 ShorÌ nrìeqr Lbrl!ì1!.!.15&'noi.ym.r[!t) 1D 1Í!eiand Íãde eql br!n
'I'!tue

The ,lt) tua. e\h\ttg. tdt., t), inll ltr'| of autll t' r,
stlo\rs Ítìe onbìÌ1dtìon\ ol thc rcal
a|\,thitlì thc SaadJ t ketìsi cqllilihnrü iÍhtht tctlittttt& tutÍ equdl 1o th( \rarld tnÌ

It ìs positivelv sloped bccau!e ot tìre a\s!nÌptìon tlÌat lhe Marslìaìl Lenìer coD'liti'rn
holds:hlgh coDÌpetitil.cness (hi8h r)Ìaìses aggrcgate derÌ ancl ! nd o utprú Ìnusl lheretore
behigh ioÌ goocìs ÌÌìarNct cquilibriLrm ThemovclÌom.11oBcatÌbcthoughtofnscomitÌg
aboüt iÌr t*o.lilìerent a'als: eithff we hale a lìxed exchante ralc ecoÌÌomy and tlÌe
jtchangcs the peil) 1hiscatscraÌlght$'ardsìritÌinthciJcuile
ilo\Ìernmcrt.lev.ìhes (i.c.
Èisi. lrh lch Ìaise! th€ inlcrcst râte n..Ì lnduc€s a l:apitâ]iÌrnoir' ÌÌhÌch in tuÍì causes the
lM to slììft to thr risht. l'he e.oromv it th€n â1 point ÌJ The altcrnative is to Lhink of
:ì tlexlbìc excharÌge r.tc oÌld irÌttrich the SovcÌnment lNt looscns ìnonetary Policv:
jch iÌì
L\Í slÌlfls to tìre üght, $'ÌÌjch lovers lhe intereÍ ratt This.auses a dcpreciation' wh
turn causes the IJIM to shiit t.ì tlÌc Ìight trking the economl to point B

\\c can aìí) easil,v slÌo*' the tradc baÌanc€ condìtio inther1l diêgraìÌ
'lhe u'l cuat tho s the conlbninions oÍ LhercúÌ e\.hd4e ntu, A, ütu|th! l(rtl af autfut' y,
dttrhìcl1ttdttu í\ biLl ce.l: \: nÌ.
,\n ÌncÌea1e.l levcì ot pÌice conìPctitìveness (hÌgher r) Ìaise! exports (assumlng the
N.larshaìì Ì.eìner .ondÌljon ìrolds) and requires n hliaher Ìcveì ol output n) clrÍ'e uP the
.lemand lor úÌÌpoÍs ard deli!er trade baÌaÌÌ.e Hcn.e thc BT curv€ is positivel-v sÌoped
'lo the left ofthe lJ l cuNcther€ is a tra.ìe srìrpÌus and to the úghtthcrc is a üad€ dcilcit
 '11ÌerI .urre ir Uatter than the,lD cu ,e. The underÌ)lng Ì.eer. Íor this renrlt ì!d\
e\pÌaiÌÌed in.letailnr lig.9.:l rlhen Ì!e a\ked whatthe outcomc tor llìc balance oltrade
$ouÌd be ilihere was â detreciâtilrn ol the Ìeâl excha.ge Ìate. Thr aos(rcrrìas t1ìattlÌere ns.aÌf
wouÌ.| LJe a tÌücle mr u\:thi\ 1s slì.ìvn b) poìnt ll ìÌr lìii. 10.6. Th. inlrrltion ìs thrt honì
an irÌitial equilibÌnìm at poirú-4 ât ìlhich trade it baÌanced, a gìrcn i..rcnsc lrÌ lr iÌÌÌplies a
rÌe$ Sood\ nÌrrketequillbiiLun itpoiìÌtn. whe.e the ÌeveÌotoutÌrul isloh'l:r lhin \!ould be
corÌ\ilteÌÌt 1íith tìade baÌan(e. l hisis becausetheÌe aÌe ìeaÌtage5 in Lhc toroÌ olsallrÌgsirrìd
tü\atj(!r (in a.ìdìti{)n fu impoú\). l his leavet th e ec{!n)n ) ln goods rÌ a rkct rq u ili brnrnÌ
at a Ìevel otoutputbekM the le\el thdt llouÌ.1geneÌate nìtoús cqrel to lbr ncw higher

'I rl ll."... 1 o
'lhirÌk ol a government that lÌas ilro tarijec tur econoÌnic p.licÍ hi:lh ';,..r,:'
oLúput and
extenúL baÌance, a\ define.l by úade LrrLance. The torenment hâs tÌlo instrumcnls
ol ecorunìc lDÌì(l the nonÌirÌ.ìl €achünge rate aÌ lì\crÌ tolìcl. Thoc nrc lNo rcìa
tnÌLhiÌtr linÌiìng the targets arÌd the iÌÉtrument\: the A,\ìÍ equiÌibÌjuÌì h{ilh Í r')
nìrnmdrlzed iI theÁDcurve anl tlÌe baLance oìtra.le (u e.-ür.
Supp\e thât the countìv \uìlers lrom lÌish une 4rLo!nÌent an.l a tÌâdc dcllciL: th s is
thownbvpointlinFìg l0.7. hiìt íìdrld be done Ì)\ agovemmÊntthatsccksloallain
a ÌeveloioutÌtrú ol,rr anrltÌdcle b.l.n.el
ll the i{o\ enÌÌent devahìes tiÌe eachünge rate horÌi r,ì to .r, then rhe.cunorÌ}' Ììolcs
honrponÌtltopojltZ.ÊriseslÌomr,,toÉrirÌliil.10.l.1lÌede\rÌuetn)nbooslsaggrcgal.
d€rÌìarÌd drÌd thi! is strowÌì b) a ovc.longtlÌe,.{DcrìÌve.Outprúrirest.l,rbc.aLLlcoIIh.
eÌp.Lnsi.Ìr.r] eìiect ol the de!.luition. lÌut althoutlÌ outprt í hjgheÌ rnd tradc is bal-
anced at poiÌú11, tlÌis leÌ el ol oulput is lÌislÌeÌ thdrÌ uÌe SovennìÌert s taÌg.t ol,rr. ll nìust
thcr.Ioft use its other poli.l instrument (Ês.rl poli(rl in connrination irirh a smallcr
4Theo
,1D Íl l

'r: =irj

FiguÌe 10.7 J5€oÍadela!i:.nior ccslr nô.!làÍl rio (tr11.':.. po .! :o à.h è!È rìrEer Õ!ip!i
evÊ, r,r, ài. trõde biar.Ê

: L Ìn .nÌ.ÌL]1i\ i\ 1.rf \jnr lir 1! Lh. .r g riÌ siÌr?Ì \rrr! nr!..nf lrÌ ihr nrn !e.!.rÌ tre irn3r,nl itì.
ì,ün\ \ d! r, ri(h i\ isr.r.a h. r.nlif ih. Sr LrL !rÌ. anil\\ij bL \trtrÌú.iilì. iirÌrprioi .t nrrd rr!.\
 :t6t

devâhìatnD (to.r)t.r adìrìstthe ì.vcl o outprt tu ),Ì. This teaves the e.:onoÌrv at ÈrjÌú
a- with the dcsiÌcd outlÌìt Ìelel and with baÌânced ir:ìde.lrr tlÌir eìample, .onrradicÌÌar\,
Êscal polì.\' ii .orìbnìecì wìth a delelualion.
liÌ this e{âmplc, we have uied a discrcte chante nÌ the eÌcha.gc ralc as üìe polici
irÌstrunent ì. ã fìcd e\change Ìatc Ìcgimc. we h,rve seeD in Chapter 9, undcr fkriLJLe
^s
exchüniie Ìalc5, thc goreÌnÌnenr.a. usc morÌetaÌy policy to achieve Lhc sarì. renrlt: dn
increa\e iD thc moiÌe! \uppìy shìIrs lhc lM to the rislìt Ìecìucing tìrc inrffcsr rate below
the Ì!oÌÌ.1 inLcrcst riìtei thìs ìeads to a dcpreciatnÌÌ, which iI tuÌn Ìaiscs oulput via a
riitht\larcL thlll in the Lt{À.Í. The tconomv.nds up nì a ne$ shoÌt Nn equiÌibriurì I'ith
hiither ouQul nnd a higheÌ ìerel o11,. ln other word!, rve crn reirteÌpÌet th. shìfl aìong
the.1, cuNe in lhis erampÌe in the conLcÌl olllexible ercha gerate\asthecontcqLrcn.c
ol:Lldrening ol rnonetarv poÌìcv. Wr Lhcrciore ask horr tlÌe go\ erÌment can usc iÌs lwo
ÍÌstnnÌenLi o mon€taìv and nscaì Ìroìi.t to aclÌi€ve its iwo objectivet ol tÌade baìancc
.. Ìrjúì i ,') The e\amflc çrow\ that ìtwilÌgencÌaìlJbc necess:ry to usetlío irÌstnuneÌrts 1n oÌdcr Lo
.chieve thc government'\ tÌ{o trÌgcli ol rlrìternali ând 'ertefiraÌ' balance Butisposirion
il Ìealì) a posiuon ol internaÌ baìan.c? lvhat does the le!e1ol the reai erchange Ìate at
C implv tor thc re,ìlÌ!rge? Ìt tÌrìs rcal wagc .ompatible Ìlith wage \ettiÌÌii behavlouÌ in
the econonìv? the\e questìoÌÌs rignaì that we n1ust bring the aggr€itate mtÌrly and rìre
deman.Ì s idcs ol the ec ononr ) togetÌr cr ici rh t ÌÌe trade balancc condltion in orcier t() tulì!
asse\s th. clìarnctcristicj ol a toìnl such as C with tJrgct uncmplotrÌÌent and brlanced
tÌa.Le. \\ic do this in the next sectìon bv pulrlÌÌg togethcr thc opcn ccoÌìonì_! Ìnodel.

4 The open economy model

The baslc modcl nÌ anâhsls üì the smaLl open econ.mvconsìsts ol
. thedemand sidr repÌesenteclbvthe,1DcuÌ!c. On thelDcuÌve, thegoods marÌict is
jn equiÌlbrlunì ind r:,-.
. the mppi! si.le ÌepÌcscrÌtcd bI the -LÂU cune. On tlÌe l,'ÌU (urve iÌúÌâtidÌ is constant.
. the balan.coltÍade equilìbÌtum ÌepresenLcdbvlhc BT cuNc.

In thcshori ruÌì, $he. the econonr) is in goods marÌict cqujlÌLrrlum itl\'illbe onan;ì,
c Ìve. I or i iliven ÌÌomìnal exchange râtc ând a givcn prlcc Ìc!cl, lbc lclcl ol outpui 1s
nxedbvthc/U)c!,e.ThìsisnotnecestariÌÍalncdiuJn,runcqullib.ium.
For medirrÌr nin equiÌibrnüÌ, dre economy ÌÌìLrí also bc on a. lri,l .urve. CÌÌ]! orÌ
the IRLI cun'c are the ivage ancìprice settingrcnlwagcs cqLLaÌand thclabour arketln
equìlibrium.lnthemecìiumnr,therelorc,thcecono.ì1.*'ìllbcofan,lr.urretìr on

Only bv .hince rlill the !Ìe.Ììunr Mr cquilìLrriLlÌn also bc .hara.terized b) tracìe baÌ
rnce. Long Íun equiÌibriunr is ai a posllion on the lït/ curve and at crìrreÌÌt account
baÌancc. A! irc have seen i. ChaÌrteÌ 9, r,]ìcn the.Ltrrcnt a.count is bâl.ÌÌced, the coün
tÌ)'s weaìlh is coÌÌ\t.rnt. To nake rhe c{posÌtioÌr .s sxndl] as possiblÈ, $e isnore rhe
 ,l

and Ònq rli equ itrÍ: n lhe olen e'onomv

Figure 10-8 Shód{ún 'ne.lÚm run'

to delìÌre
the cuÍeÌìt accounl' Thìs alìo$.s us
aìlíeÌence betwe€n the tra'lc balan'c an'l
\ \' ,p r' r' /Ri u\' dr'' 'r-ur'J\
":*, . ";;" ',n
.I'^'n,.-*C,'ldfl ll 'r' \rldIrJ' r'I
" 'lr'-l'rç
,,'",;,;;J;;-:..ountberancernthecconomvsrcrÌpressurcs'anaÌaerÌom
;,;.".: '".,,, rçBr'r"d'n 'r'rr"ò'r'r" " "rr "o"
,";,;. ;,ì ",. .,\uP '-
nÌarket and rorce
i''lilìiiìì.ìli'i.-ì i..",,", pressuÌe maÍ mouÌrt urthe roreisn exchanse
rt' P^liLl
3ô\ cÍnxrLnr t' ihdntc
',i-,,'", rru'l i
Ìhe I

F'{!r''r'- 'r''rh' r' "L'd'

'! r"ìthe characteriÍi's ol pojnts Á' ÌJ'
À *^-pt€ in us 108 Ì et us conìp:re
"..,ì"ì"'*t
demard cun'e
. Shoú rul eqüllibriuÌn al Point'1-the ec'Í'nì\' is on the:ìsiÌÌegate
lro but not on eitÌrü the lÏLi oÌ nl cütr€s ^lIrlnt'l'ttrctevetotorlputistl'the
to d0 nnd lhe cconorni' ìs above the rru
cuí'c Ìhis rnean'
ã'";ì;;;" is
"," "u'rÌ
, oi-ì'r'18 " I\'i Í r" urg
"
;: -,',.. ".,. ir''u -' | ' " \'t\\ "" ,|'''
:,: -: ; ;, i ;: ." :' d'J ' I r'\s11
:' J -' \'ü r|s i I Lì
'r' 'l
.;,,; l,:_:'; ::,
i'll-
tl:;:
h' rD r' \' ^r,''d
:,;,".. ; :"', ," ' ' ,' " r't'\'"ìr
ôon8( rlL '", b " o 1^{r''la
P án'l /l'-thc econolnr is on /llU and l1)
. Mccìium ruì c!ÌÜìlibria such as ât Points
L,.t.ot on 6l InÍlationisconstântatpoi snandt; becatsceachis
"*rrl;Ç.ir"atl
,", ,i" a^ii'..,t'"
"t"'"'satra'lesuÌplusa!poÌnt'rlÌrecauseìtislotbcleÍollhesTcuNe
 163

inlrhrrt.dtÊ.itnlfo.LlJ t)erruìriL i5toUreÌiilhiotLh./Jl (ur\e Thc..onotrÌr can

rinÌ.rnrrtfoìotslilicrifdlJ rjtlìtrahlrüúhrnÌr.tÌ(n\..Ì, .tlÌelt!rgcÌ rrrr, pre\\uÌi:s
nì emeÌ9. ir! ! .on\r:q'Lfn.e or thr cì''L!r!.11 Ìjo\iri(Ìr ÌhrL (.nd to Ìrlúh rhf f.o!r)nr1.
iì\a\ hr)m N !rll nnürd flirÌrZ.
.Ìo.{nìneLÌr1lìbriLrrÌ.úf.ifL./ on .rD. ttl, and tL At Ìrotf l Z, laÌr(ur Dar
let erÌ'i lìÌiriLrÌn ..in.iie\ siih thc bi]lirrÌ.ed rr.adc l.rrl or .urput. lhis js litei\ trJ hL r
nÌnxrfiÌr e t!!g rlLrl posiri(Ìì loÌ th. rc!n!nr.
Hâ\jlgIuL totrdrtÌ lh.op.nr(on,)mr orl.1.Ie(ìnno\rr.LÌìrÌineth.!luati(!l
dc\.rjLreLÌ i. li! l(l.lrb.rcrl.(rllrhatLlrc!o\enDneÌrruú1 L5rn()ÌrotÌ.\ tf5(.!nìeÌrr\
.l a (hrngr Ln the.om fiÌiÌ.hinirc ÌaLc ÌcirlÌer ar tlÌc I ertrlt ô i djlcrcre.hrfg. iÌÌ itre
pr! undtÌ lrcd e\.hâ.g. rntci or dlÌe rô ir lcÌrs(xjÌrs .t nrt)f.Li.! poLjo ufdL,. llc\jbie
riìt$à.r1..idìrFtrì.fLrrlì\crLpoli.\ror(lÌiereir\rÌvotrÌgcL5,üÌede\ìÌe(ìôLjrf! e!eÌ
nlr Ì e.d Lr.i. tìrÌa... Ì!. ir5lecL thr I.rlloÌrirÌ! !uejrr(rr\r ts fositiorÌ (_ Ìcallr i fo5itjr!r
ot irÌfuÌ.rl baL.rrÌ!c? \!lrii d.€s rhc lcr.l .)t tlìÈ re.rl erlhrrgc .elc it a imÌrl! t.r thr reiÌ
ÍrìirelItLl s redÌrrgr..onlprtitiÌe r!iLh n.ri.te settiÌÌj{ l)chr!t.ur IrlÌrcco.omrt lhe5c
li!r5tirìns.in tie tunrnri TinbÌrtÌ!ingrilÌcthrrfoiÌrtt_ir(Dth!.1,(t,curr.ll so,l1Ìen
r'he e.t)fÒ.ìr (dn tr,nìiì . lhcre niiht)rrL !rotrlerA oi jÌìrÌrtLôn. 5in.r rLr.le j\ balin.rrl !t
a. it itorLld aL\o rcfrcscÌìt . ldÌ! Ìuf .!!ilitrriLrn. Il.r e\.Ì, tr tlÌt lÀLj ctrr.c li. s LreIr!
Doilta i5ilÌosfif ig 10.9,thr.( sÌìotr nrcdium Ìrúr c!ujlilÌrilÌÌn: rh. (.1 rile
; bel(nr Lh. rage sclt nf l..rl \rgc r.n ihe e.!!(Ì.r Í,ill r\pcriÊn(e utrrrÌd pre\ine
.Ìr irlleLìon: ü!tlar or I iLl ri\r rl!r. I oÍLd núÌlti(rr. Tlrc /./ìtr .!r Ê reltÌ.s..ls i thüd
LoníÌâ .l on thr ...n.!nÌ ind dìr go\trrÌmerÌt rfiÌÌ f.L br .blc to r.hL!1. jl5 lutplr
t:rrsct()irr\ithbilin.rrltirdethÌorglìihe!teoljLÌ\ttÌlofsl.uÌ enrsÌtrL|Ìha\en)
Li\es!rt1\i!Lrtoli.lír5hiltrlìel:lL.!neÍirlÌatìtjnrcrsc.Ls(hrtr(rr\.âLÌrotrlt(_.
L! t i.r,'niSrte thr rL5i .i 5!ppl\ tidc
t. ic\ Ìbre .ÌorÉÌr i. (lh.tirr i1. Friling thjj, thc
3(^emnìfntriÌlhelirDa..eprrDor.nrlrd.rtoutÌ)!traÌgelrfdLrtnÌLìrsÌelrtedcnra.rl
dc..kÌ n!l\ 1tr t.l.i l) iÌÌ tii!. lí) 91.

flljrnd 1,

Figure Í0.9 F.r a ìr ì ..: .Lt. t i.t :ìi !

164 :.ri. i i i 1i

4.1 lnïlation ìn the open economy

lnthis scctnrn, ile bliÌÌg togclhcrthe deterrninanls ot inÍlation inthe op€n ccononì1. !!.
havc aìrcady noted ho*'irfla[ion úses or falls whcn the eco orì] is ofl the lÂU clLrtc.
Wc shâlì now examine hor' the ìniÌation ratc is pitned cìown \lhell the ccononry ìs in
a Ìnedìunrrun equiiibriLÌn] Lc. when it is on an I /ìU curve wltlÌ conÍant infÌatÌon. At
any mcdium Nn equilibriunì-i.e. at a poirÌt on thc ÃRLr curve tlÌe re.l cx.hangc reLe
1scorÌsranr. Ììr the next \eclion, we erâ ine the facloh that rnight ev€rtuir lÌ-v causc the
economy to move iionÌ su.h a Ììcdnun rln €quiÌlbriltm.
U{] ?iscoÌÌitant,thisìmpiiestlÌathoÌÌì('ìÌìÍlatìonìiequaltoilorldìnÍlatlonpìus
tÌìe deprcciation of honÌe\ nominaÌ elchange ralcl
llr ÀP' Ac
tt
AÌteürativeLy, we1:an use itorefer lo lhe rate oli!úlation andwÌ1te:

" ",,{
The intuilìon it that ccÌnpc!ìliveness .emaiis (.onstant:s long as hom. and rb()acì's
prices arc rjsìng atthe s.jnc rale úr a conlmon cltrrencv. Aut h'hat dctffmÌnes the Ìate ot
homc in I a lÌon ? Th e :!n!!ver dcpend! tr1Ì whcthc Ì cxchange rates arc flÌcd or floaling
. U nLl( tãttj, the no nì jnal exchange râte rs lì xed b) assunption, i. e +
íi\.l tx.h\1ìF
il so f(Ì the .eil exchange Íate to bc conttant as itÌ the cquation above, home iÌìflation
must be equal to $'ond ìnfl atidÌ:

.=t"'l
Since hoÌÌ€ is . smaìl country, its Ìntlâtjoìr Ìate is det€xnincd by orld inÍlâti()n The
ÍÌLìare LÌacNets arc u!.dto irclicatc an cxogenou! vrliâ b1€.
IÌrìt this ìcav6 open tlìe qLicslion of how €quilibriunr ìn the home nntre,v nÌarket is
.rchìcvcd. ìroÌ e.ÌuiÌibrirìnì in thc home mon€v markcl, lhe demancì irÌ money ÌnuÍ be
€quallo thesupp\'. Letus looli úrst attlÌede ÌâlÌd for nìonq . The demand iìr money is
a luncLlon of the leveL ol outpul and the nonÌirÌâl intcrcst rate. ID a Ìne.lllrm nur equiLib
rium, t hc ìeÍel of outt)ut is lìxcd at l . The noÌÌrin.ìl intercs ( Ìaie i J e.ÌuaÌ to th e reaÌ iÌÌteÌest
ratc Ìrì$ expected ilíÌütion (l ! r ; ),'and nìir ÌÌrcdirm Nn e.ÌuilìbÌtum inlÌatidr is
at jts cxpecte.Ì Ìate. \'Vith irÍÌalion at tlÌe ÌlorLd rat€ and tlilh the home Ìeal inteÌest Ìâte
cqLraÌ to thc worlcl rate 0' | ), tle can write tlÌe equition Ior tiÌuìlibrÌum in the home
monev maÌket a! ldÌo!!s:

\"1: l"l
Ltl,. i)
r
L(.y,. rt t
Lit,.t ,-')
' Ì!eas!úìeitìwhitIoÌloÌrsthriihrxÌ)pÍ.{ÌatiorÌroÌd5.
 365

. Lo.cqujÌLÌrrltrnr nlhchoÌneruÌet lìi,rL.t lh(,cxl mone\ \rpplt, ì1..ìtsL h!

.nnstrnt \in.c xÌl tÌredrtc!rìÌndÌti(iith.dlrìird or Ìnr!ret !rt hrid. W( k..rt Llrrl
= Ikn.e lhr nro.cr mÌÌrlì Ìììun lrrt it th. {Ìogen.!\Ì\ Êi\.n lt.rld rilc.f
n lrtio. j. t)rLLeÌ lo keeÌr lhc rìonr\ nrpfL\ .onrt,rnl:

in\Êrl e\r lrrf !c rnte\l

]r!ìtÌÌeÌ ü r\ !l ii Llril lhr gror th Ìite !l lhi mônc! \utÌrl) i\ er o8e

Ìì!11ìng tlìis reiu I
.(r\ lÌ er.lÌirnle t. c.onoÌì! i. alreÌrteÌ !r. st snÌr lhât ihe morÌe] $plll
the ÊÌed
'a! rnl()ilex!u\ ìÌl tlì. ilÌort r!Ìì i. Lhc lL\eLl rate c((rÍrrÌl r h.f.'11'see that it i\ enlo!l
.(r\ iÌÌ ttÌe ueliLrr]ì nìn .r5 rlll. LÌrr\ â\ Lo.g ar nrreisn iÌìlleLlo. ÌeDdúr\ .ortr1.trÌt n.d
the er(hdÌ:e r,ìt.; i5 hÌed. illlrÌ. n lrrit)11 it ..n\taÌú tì1 th( orrjgÌr Ìrte itÌ filediuJìì nLn
r!ÌuilibÌnun \\'e r!!nÌe .onnnÌ)t 1!.rrld Lnuetll!Ì.
. lÌrrilif fÌrn!r(i rìrlÔ, irÌ mrd (Lnì nr.
Lrrl,r r{Ì!iÌjbrnrr]r. ll i5 alíJ the cxse tÌÌrt tlÌt
r!.iÌ .\.hrfgc Ìr1r. /r. i\ c(ÌrrtaÌrÌ. llen..

1t a rnedi!nÌ NrÌ etl!ìLil,riurì.11. hI Él

Ììi.
1l
=Lì
.\t tÌÌr nÌeli!nÌ r!n o(rLpLrt r.fiLi.L ai it\ c!pr'.tr'.ì Ìate lÌÌi\irìflici
l.\ cÌ, itr1Ì.rti.rn is
thattlìelÌorlìrnllrrìr\s"ÌrIl!Ììtrd3Ìrr\rltÌr.r.tr:()ihonÌeirrfiÌLl.n\\:td\rrnì!trilth!
gr.rtlÌ rat. !l thr h.nì. Ììtife\ nrppl\ i5 .\-'.gL i.o\: thìi di 1.mrLÌr$ the r.t. .i h()mt

ìroÌne ÌìroìÌ!t sutplt i(lirL!ts rt).oLÌe iLìto L nr Ì!LlÌr lhe iÌúliìL .f taÌget
\\/
L tib
Ii!t 1!hnl d.{i thjt ÌDfì\ l(ìr thr unÌninìl e\(hlrÌre IiL!? Srnle Ì)otlÌ llonrr'rfLÌ norllL
ìx1Ìilio. n,c n(nr (ìeter Di.ed erotc,r.rLll . rhr I ÉaLeÌ(hiìnS. Ìatt ÍiLL onll Ìn'...'tr.t ii
!n!d5.,cfi.ctbetl\eerÌìr(Ì!elrdrirl.Ìjniìiútrri\!1i!.rh\d..rÌn,]Ìrt'e1.nI.hìIse
oi rhr i. Ìì L.rl c\.hangc rrtel

ll h.nÌr núlrtiuÌ i\ b. l]1f rt.fiÌ Ì. .\chrngt IiL!' nrr6Ì be ((!Ì\trnlll

jrJÌatnÌr. 1lÌcÌì t
rÌ)tre.iltilÌS to lr(1, lhr r'i.l .\.Ìrrnst Ìte..rìst,ì.1 aon\eL.l). ii honre L.tÌati!ÌÌ jj
:Ììr^ e rorLd nÍÌatiou (hrrcÌ!lllbrrcoÌ\rrÌìtdrpr!'.ili(ìÌrnilÌl]nr.s.\.hxngeÌ.ltÊtr)
liert tlk ÌerL r\.1Ìiìngi r.Lc.on\trnt lÌÌ1i irìfLic\ ihrltlÌt ÌÌoÌÌri..l r\ch$gciúeis
endosrnou\ irÌ ihr Ìrìrd 1,.ì Ln, lu\t !i it is irÌ tlìi 5h.Ìt ÌurÌ !nd.. lr\ihlc e\rhiÌÌlc
366

4 2 Summing up
ln ih€ op.n ec.rÌ!nrr. lherr is a rarÌSe ol oLrlflÌt rnd rnfLol rrtrìt l'\ rÌs "rLinfnL n Lth
lortri.rnl lì.ne ìÌl1le1io. inthc Ìntdnrnì r\rn Thee.o.r)rr\ (dÌbcnLifr Ì)oiÌitorl th! ÃRL
.u\ Ê rÌl1lì c(ÌItrrl lnlÌatnr. rquaL to tlr. .-gu\uÌ Iilc ottÌÌe lÌonÍ iro'c\ irppll lhitis
\et b! ü orl(Ì ÌniÌltion jn tÌÌ. ll\ecl trclÌ,ì.Ã. ratt e..if.D\ anl bt lÌrr ht!ìe (en1râl baÌr\
in thr fcÌlble rÌ.hiÌn{e riìir' t'!orÌo!ìl r. ahrttr ' I l. re lluli Likc c\rnrÌrlrs o drocli
an.lÌ)ollct ch!Ì!g.i rfLl eÌanrLÌrc ÌÌor'lh. ccorÌonrt rtìct' t)oth i' thÉ \hoÌt ind i!r tÌr
Ìì.11iÌÌrr 1r.. TlÌr k.\ Ìe5\.tì lÌ(Ì! tlÌis s..lLo. ir thil Í!r:te\rr Lh. !Ìro(l' th. i'flrtion
ÌìteirÌihr nredìLrnr Ìui\il rctlìnrtl:]ìlslrliÌi.üIiÌ1.!nctrdj!slnìcnti5(oÌììpl'tt Thl
jÌì
melìrrrìr rrúr jniliri!Ò. ÌatÈ o.Ì) chirngr5 lI thtrt is i .harÌ!e 1r'rld innrtioi in r h\rd
e\.1ÌrnÀ( ,ate {!|oÌn\ or. .hdÌ{t iÌr th.lnilrti.rì trrlet (oI moncl iÌÌ)l\ gd\'ür rrili
ln rÌrc l.rlbÌc ìrtr .ro.oÌn

5 Long-run equilibÍium
ln tlìi t]|tn e(oJrom), tlì( c.r!Ìonì! li .Ì1 arÌ,1/ ) { Lrr \.
jf thc \ÌroÌi tun i'LÌ !I UÌ! / /11
crìr'!' ln lì1e !rr{ÌlúÌn nrrl. hItr c..c \ugilen5 lÌrìt ec'ÌloÌìic! LaÌÌ rrnliÌln Ior coÌlsìdr'l
rblr f.rjr)(1\ ri i nrtdìLrnr {n ellrLllÌì iunr on thr FÀl .LtÌlcbuì\i1lÌn'uÌÌcrltr"rrunÌ
nrìb.la..e. l\ c iooL Ìtr( at ior... Lhrt nìlslrL .1ÊÌìtrrrllt Ì.rLÌ the t.o"nr1 br(l to ihe
l.Ììg Ìr. eq!i lbrju!roÌì1helìl rrtrr:
\..nÌrtr\iLiforitio.\uchiLsìl.lìi!1lrÌ0i\jrÌrrì.ditLnrrurÌeq!ilbÌ aÌì\iuÌ'on
na.linilrti.rìbtrtÌrrri.uÌr Ì1i.(rninìrplt6.1te\!leln!diÌ1(llÌrÚfft,lhe(ouiL'Ì
prrt rr) thr (!rr..L rcrount mrpltrs sr.rÌ)it.ìli..outúir!.iLr.fantr\.1i51{'ndi'gt!th'

.)'

Figure10.10 L.rrii 'rì:qr ..r'. I ' :rrl'ìrlrrìr'r"rfi

 ....:..367

rcst of rhe worìd nt lhe $Iorl.ì iJìterest râtc acquÍiÌrg [iÌeign assct\' lì! incÌeasc in
lt is

ilre stoct ottoreign ases oir cdbvlhehomecouì1tryasirruìsatradesürpìusgcnerate\

a ÍreaÌn of interesl ìeceipls to the home
_ country that a'ìd !o thc cuÍcnt account su+lus
u.".,,"",iu rtl Ìra\ a lrade detìcit an(lisborro$inI lrom abroad to lìnâI]ce
n4Ìtl "'..",.ot,. is risìngevcry ycaÌ
tìrisls this'. therelo;e acquüing forejgn liiÌbilities: itsforeign debt
CouÌÌtryBi\
dcbt Ihúmcansthat
thrt it Nìs a tÌade delìcit Ìt ÍÌustpayìtúcreÍ on tìre accumulate'ì
deÈcitworscÌÌs as intercst
cleÌì ìI theüade dcncitrenrains consraú, the cüíeÌÌt account
pa\nìcnts nrount uf
' .q nu.l,"r ,,r q*ìi."t aÌ1\€ siÌÌcc wealth is charÌgingtlÌen the cconom-v is al-l
or B'
shitl to Z (i c wh-v miilh l tlìc Á' cuÌle shitÌ !o Á'':)?
"'li,i* "-..-y.-*"1ìy
' AretheÌe autdnaticior.es in the ccorÌomv tlìatten'Ìto Puú the ccoÌÌomy to the
ìong'uì equilibrìunÌ âl Z tlÚouilh the adiLìínreÌÌi olâggr€gate dcmand?
lo adiust
. ruc therc nÌarÌict forccs tlÌar ercrt prcsslü€ on tlÌc glrvcrrÌÌnent
,na.-ec""c,ni. poficy t,r as to shitÌ lhe econolnyto Lh€ long Ínequilibrium?
. AÌetÌrcÌe political pÌessures frcmho eoÌâbroa(lontheSoYcmnrcnttoadjustpoìicy?
Lhe ccoÌÌomy toward the
\{e first e)ramiÌìe these thÌe€ nechanisms t1Ìat Ìnisht pu\h
l.,ng nüì eqrìilìbium (wlÌcre thc EÀtr 'nd ËT 'rtves
intcae'1) At lh1\ íage' s'e âsstrnìe
ir'"i*ll"'ìs ,"" ".p*,ari{Ììs aÌe srable-ì e rhatrhevâÌenotaflcctedb}thee{tcNâl
tbc lo'g nìIì
ì)ot*,"". ur" t"-ta'""p, we look ar how th€ c'oÌìomv m:ìr- slÌift t(D!'ad
'e;ürllbrium as a conseqLÈnce ol thc lmpa't of rhe cxt€rntl position on e{changc râtc

51 Mechanisms with stable exchange rate expectations

51 1 Wealth effects
Oneâut()nìa!icnrcchanj'nÌthatmìgh!tÍoduceashìfttold]gIünequììibrìumistlÌc
;peratÌonof eâ1th etìects Àsnotc'ìin'hapleÌ9'homeconnuÌersma-vlncorpoÌatcthe
lhal acountrï
decúions lt ìs obvious
cìlangcs in ratlonal werìLh iÌìlo thcir coÌÌsunìPti'n
..''"... C* r' r '"1 'J n '"' " rLt ' I rn"
U

',, 1, '"t' l l 'r'' 'rr " I rr\il

"
r'r Ir':r"'l \rn L"r' ''l- I'i8Lil
.^-"
' and repay the lorcign deìrt A\ a
eventuaììy bc reqrLlrectin the homc economy tu scrlicr
imflenìent
,"*ii, tnit ll"y "al*, aoirni{ard iheir eÍiÌnâte or PcrmaneÌÌt income ancì $rirhi Úade
in"a".ci "0.i, -*unìption sten{ìlÌis rora'ountrvsuchascoltntrvÁ
t.'uì,,t, ,tt" '. ."'sid:râtio$ inav lca{l Í' ã risc iÌÌ lhe assessnìent ol pcÌn1'nent
"tp.t',"
ir.lme dìd h;;cc ulsuìÌpl ì{trì nr a-! ncrease l o thc e\tc
j n t ttr at tlÌc'e rcactio n s o'crü)

lhe\È Í()rces aLonearc unlileLl

theÁl) curvcwill nrìft toward thclongìun cquilibriLrm
to be poiíeírtl enoutlÌ lo guar'rÌtce long run eLÌuiìibrÌunÌ

5.1.2 Mãrket Pressure

. i.Â, i .' ' r" ,. 'l
"1'r:hr" .' .I '
''' lr"noh r\ '' r
Ê
rrr
'lt..,e " " ol
ì,,,".""i,-*r ,**., *,". "But ;couÌrtrv ithn fersìstenttÌade dclÌcil iacesabuiÌd up

I
368

L!n)rei!nLÌ.bt..\5n.lrdrLrorc.itjiLro!ibl.thrtihed!'lcitrrì5csÍÌ(,ntlrr"tÚrrr\tali'g
idl IÌtag..l Ê\1)(. iÌÌl \ortÌrbli ln\ eìrìr n L oÌrtor1(nÌtie\ rt lì!mt b\ Lìo'utin8 llonl
iìhÌri .lIn).tltLìtheìÌrr$lÌÌÌerìt\rìLÌe\crìlu:Lh b'aÌ i it in{Ì 'Ìire'th orúdirc'Ll\
nrttuf. thc.orÌìl( \ e\FoÍ brs!'rlÌo11jÌlg il lo rÌot. tÌoÌÌÌtri(]r '!encit (.) lre']c nìIplts
in; Ìep.ì\'its.ìet,i. \orrr\ pÌo\ i.lL\.ur iLLÌrslrilÌorÌ ol LhÌ\ p'r t trr ': rÌrert n'!'Ì' \tr1)\tirn Llxl
.rrÌÌerú i...tr.t tl.ll.it5 âtlrrgiÌìg .errl\ ì'ri' Ôt (;L) iÍ!rì th' nrid 19/ii5 â'd iÌÌto lnc
I
l,)S{l\ r\ thc d(ÌÌr'5tic oiL Ìf (lurtr ]tr\ le\.Ì.te!1. 1ÌhL'h \'rc l(nÌ'red b! $flL'Ís r'

li rhr \!nLlmeni iJr L.terì.Llt!Ìâl lnan.ialnriÌìiet\i5thrtllÌcLÌi(ìe!leh'ì1!'llect5lìlgh

lÌonre(onmnÌrtllrroÌrlÍ(iuÌiÌncslÌndÌt.ihcr'ìind;r'iLlcciÍ'tobea!iìlibÌttr)'otÚl
rÍ 8 at tlì. Íorld i.ltre\t rrit L'rllate e\Pc.diirrr!'rjLl tlnd L' be linìfc'cd b-t Lhe
.iìi.gejrÌ.Ìr.ììtrr.tÌjt!trìslnrddúj.Ìr.tlr.g(^trrÌentnrnllnÌrLeÌÌl!''txtishirnlrl!
ol lggrt3.l{ iÌenLrLrd f .Ììr1 1. redLL.e tÌrt trnd''en'll

5l l Political PÍessure
Ìhr.c(!Ìor:r . trt\\rLrcs (!Ì d!h.i1 .(üìtÌiei 1o rdlu5Ì art Ì)ll'ilh rtrl]r]grr thr!l lhort
(Ìì5(Ìthri.ortntrie\. \'erlrÌr Êtie|.Ls o. ron\!nrlti.rì ìÌt rÚk LhtÌrr|.orLntr'\ i5'rbI lt)
ruÌìiÌLrdrr!rflu\lorrÌrngth\lcr.{ÌoitiÌÌrl lhir mggrlt\11ìcrc irr) Lrcn'a!\nrn(lÌ\
tret\r.cÌr!lei.itco!rÌtÌ1.\Ììlrrir!ÌdstLrflu\rorLfLrie\lik'ILn'ssthtirn':Lnreniopf'r
trìnitiúrl)ronLlrrtf Li.uÌ.LrllÌrÌoiìLibÌe.tlÌ.niÍìolr'lruÚngrÌ)eíistcfLiì+r|LsL\
(lrcsLltülbk hir nìiì\ lerd L.Ì)olLicìl prc\ rt tloJrì rithiÌì Ìhr'ountl tor tltr'So\
errmeÌrttl:r boortt.t l Lt) rÌìiÌol)('etc rt.i ]ljrcr uü.'rfÌ'rÌìì!''L ratc 5urfl!\
(o!fric!
!.n rln) r.nrc ur .r loLii!..1 Ì)ri:súrt rt tlìi lnttmilioÌüL lcl'l tr) aliusÌ Ln€1r ÌJdL
'lc\
(. !. the L 5 \.\tnrd tie\ru( t!Ì th. JaÌ)drÌ(n'itrthorjlic! d!ring Llr€ 1961r5r'

5 2 Unstable exchange rate expectations

. the oP.f e!lrìonri rinlcl \i herc òsunìcü tlÌrL the eri'hingc t' r(marnr rL ll!
.\Ìt(t.d l. É1. llÌiL r\ en !ndei li\cd e\(lì.r.!t útrj, x (o!flr\ r'úh a ]rcrsl\trnt ÍiÌ(ì!
rltncit mrr nrLd ì1 (lLthi!LL !) l.Í,'..ì tÌÌ. !'\.ha!Ìir rete ltq i'i1c1inìt'ìl \\ diÍu55r{ì
rÌì (llÌ,rft.r 9. it p llail.o!.trrPirticj rr!'f.t illlns iu fÌ r'Ìri\c thr lì'mÈ rurÍ'"i
rÌì(l lì.rncr tlÌ. dcllcit. llr!Ìr tll. hfnìe .orLfrr\'t clnlrdÌ b.Ìlk rrjÌÌ lÌr\ r Ln :tÌÌ torcig'
rrrlÌ.fgcÌeiert$.Tlrtr.i5rÌúnLt(rtlÌerrt.rltt!\\hl'hth!s 5l(rribÌÈ b!''iìtst n)r'j!'
t\(hingcÌcterr\ertLirÌrllrüandborr)rnìA{o{ìÌ)fl(iìcÌÌttlritrirr\Ìr'di iLcuÌt ()Ìr'r
e\clÌn.!c ma.ltL .lc!!tr,F be3iÌr to tÌrt(!li1..n a dr\ rlu!ti!Ìr LÌr"erúLìl bi'li trr \ b'
f(Ì.rdL.LornLJin.i.tefr\Lrileris.L(ìtr\tl:]rÒ1.ìthelr.hdÌSeIillLr'güitiÌjiìL'reÌriio'
iÌrtlì. oÌeisÌÌ rì.hrn3l nrrÌ1.e1 lrtntrrrlir. tjrÉ{!\'rnnterinrnl be n)r'td L' Lrghtif
iì\.iì toÌi!\ t,r.rnltthr...n(trÌì\ nn\r ihrIinËrunlquilibr !nì l'Ìn\ 'l:]nìbLnaiioni
rri rrr.rìÌrrd ìf nrore d.LiiÌ nÌ ( hrlttr Ì1
I nrlti tÌerlbl. c\.h,r.g! Ìrlr5. tht \fubiL Lr ()t I ì.1ÌiuÌÌÌ r!| r(lxLliÌn\rü \ ìn !Ì)"ì
!lu.sti(Ìr. I lì.,r i\ rÌo .nrr\ciÌ5ÌL! rÌrrt th. sútrirÌi bilii\ .i .ì 'ìrìltrnì rrn 'q'tllLlrri!tr
t)r.nu:r ihe Pí1cs li\ rihL.Ì! u.huiËe r.tL: r\ted:rLi)n\ rre 1'r'nì'(1 ir ÌÌot Ìr'll tr'(lrr

riÌ! ri Lhl\ \cct1ür i\ l{) !h.n! tÌrrt il \ !'LiÌie ! \ rr\ tLitttr(nt.1|r'ctrtirÌl! hl foihi\i\
Ìrr
rrÌnì tlre \:unli rl orÌ! if Lhc bir:1. ÌÌÌ!cLeL llr!.tÌÌer!rrL1\!r!.rifgcclrrÌÌiii'iÌÌr For
 369
ìr r|e.ountí.takjr!
. D\ boüor1.i.! |lonr
nclly or irì.Ìireclh

.i!.n.ir reflects hjgh

Figurê l0,ll Mc.lrmnrneqli bÍilnr irB tràdÊ deJcr) ! a íúú.d b!ãn ex{hõn.re ratê leFre.iatôi

cxanÌLrÌe,lct u\ $pposethaL thcexchangc rate ì\ expcdcd to a.LjusL tnnÌÌe.ìialclyrocjeÌjvü

.rpr -\'|.'r'q' . .r'\'t.r' ' . ,l.L.t r',,..,

., =elil and onl! ìl87:0

This impÌìes that jlthcro is a rÌa.Ìc dcÊcit, thc crchanije Ìarc is eÌpected lo depieciatc and
iíthcre i\ a tmde luÌpìusl the erchange rate is expectedn) appreciate.
Id Iii{. I0.11, the cconomv í al the me.ìÌum NÌ equiÌibrìLlnÌ ai poinr tJ with â r.ad€
dclcit and coostânt intÌât]()n. Thc Íabiiity ot üÌis porjtìon dcpends on Lhe a\srnÌptioìÌ
r l1 1,.\' n i I'1., l--\t.-. .1ê.., rò rr-r- r Lr ,ti.-..'. .r.- .t.-r"\.
balanced tÌade expectitions hvpolh€sis, thìs c\pected exchange rate is not srìstaìnabìc
in the long run. A cLeprc.iatnnr ot the €xchans€ rüte witì hc cìprcte.l. Ttrc deprecìation
lcads to a mol.ernent ilon:tthe.,1t) crìNe ror,.rct tÌre noÌtlr eiìst ìs pricc.on\)etiti1.c
ncss ilnp(xi\.ó Eut wc knorr rha( rÌhen rhc cconomv is above the E,tLr cur\.e. cLomcÍt.
infÌatlonaN presuÌcs will emcÌgc.
I hbeprc.j\c.lhee..rorìti!iÌÌÌrÌrnrrooL(hex(.rlIdre.ir..btrtn)rh.Ì.h.Iüìs:/rruÌ,e1hcÍejírn
6d,ritlìeexÌJèLÌ.adeFrc.itrinrroIrheftrt.xrhângeÌrfuinrpÌrÈsrlÌaih!nìr\Ì..ÌdÈrêÌni.D 6rbeìtn(
tìrei.rdreiÌidrÍ\tmtêAhiAhrLleiÌiúrÌrrrarernl)ti1\lo{,.iouiputdrrf\roNnbì r.,ì/r.Ínè!r.i
the,lr.urr.i5dfrNrrJsrmirÌg,:r.The6nJnti,rlanritÍJgl rorailron rith Ìr(ri(r.iDii.rtmoriÌiL, ll]]li

ifnì thÈ l/..f dirion rnd !!n! tÌÌefr hit

(ì')' (+)' (ï)' (+)'

)
ì e. anupo.tedditrr.i.!or.fttìereiÌ e\LhJf!.1âre únÌrli.s ú.r úìc |,n,Ì.rÌrnrerenÌtrbniboyei rcÌrorÌd
l7O ':: ':. ' .:''

(h) o

Figure 10,12 ntera.tof ot ióreqn €x.hafq€ m.rt.Ì ãnd àLorr martet ün qle.onÍani nÍit.n
Êq! br rm iÍ ex.h.nqe ràÌe erpe.rnon5 nre o cnted to Íade bi in.e
(rl Presr!re on..nd h-"n.e ón,
(|) Presrlre on rÍlàt.f á.d hen.e or,

The two sourccs olirÌíÌatiofaÌÍ prcssure are easyto scc: on lhc one hand, outÌNt aÌÌd
employmüÌt hale ìncreascd, so Lhc irage setting real í'agc ìs hìghcr and ìnoney ríail€
increâses r,iìl Ioìlow; on thc olhcÌ hand, the €r.hangc Ìatc dclÌcciation hal increâsed
ot impoús.ìÌìd cltl reaìwages. MotÌev aagcs wìlì Ìncrcase in ÌeìÌ)n!e to this
t1Ìe reâl cosl
too. Hencc lh.re wlll b€ a 'l!g of !!al going oÌÌ is ihc cco.omt ìs puììed t(n{a the lll'
lincb_vnominalexrhârÌgi'ratedepÌecìatidr(dT)andplrlìcdbacktowarcltheERLrcurt€
(, by domestic wage ând price inflati()n. Th€ conscqucncc wllìbc rising inflatidr.
1)
lìigurc 10.12 show\ tlto paneh. lìr the 1ìrst onc, thc prcssrúet emanating tunÌ the
lorcigÌÌ cxchanije mârket lhet .lÌive the eco onìy loward Lralnnccd !Ìadc via nomitÌaL
exchnngc rate depÌeciâtioÌì or appÌ.ciatìon aÌe shoNrÌ. ln the secolìd onc, thc pÌesntres
emana[ing IrcnÌ the süpp]y sìde lhrough wage:ìnd pri.c sctting that driÍc tlìc cconomy
tolfard the EnU curve via wage and pÌice inlÌatlon (abovc or bclow r,ond inflationl aÌe

llÌrder the'baÌanced trade exchange rate erpectationí hypolhcsÌs, Lhc BT cuNe

becoÌnes tìle /n/l .Ì.lrdrg. ,tdì klt quilibì iÌri t:o (Ìitio .
tÌnderthisco dition,a.das m ìn g that iÌúlation cxpcctations arc fonn cd adaptiveìy
(j.c. Ír = n Ì) tÌìerl oÌì lhc 87 cun,e, the noÌÌìinal exchange ratc s'ill bc changing to
maintain the Ìeal erchangc rrte consistent witlÌ trade baÌance, gìven lagged Ìrìllalion:

I õ Con

On the ÃnU cuive, hoÌÌì€ j.flation wìlì be such that the reaL e\clÌrn8e r:ìte i\ consistent
with rlage ancì pÌice settif  eq uil ìb rium, given the lagited chaÌìge nÌ the exc hange rat€:

(ï) ,

The consequence is that bctnccn lhc ÁT an.l E,RLi curves there wìÌl be rising.ÌúÌâtion
(in Tone ÌÌÌ) ancì falllÌÌg iÌìflatlon (in Tonc lV) as shown in Fig. I0.13. By conúaú, itÌzoÌÌe IÌ
prrssuÌes Íom the iòreliln cxchangc ürartetand fÌom ihe ÌabourÌnarlet aie botlÌp!s1ìiÌìg
 371

"+

.]:ÁIJ

'ii hand, ourtur

iìrÌ,r
rinI rrrt\ Í.rsr
't ,, J,.,, ,,,.,,., FDlre10.13 Lrrt..-i5n't ríi:.n3qr brJn i -'ì.lai:3 trì1Ê Ê:De.Ìa:.r.:rÊ c ert.rlÌ.Í;i?
",r
l.r't\l,n\!III
t t ,\ rfi rtrt,t \
.,r!ì th. lÌLJ
cu^. dillclio. 1t.l1ìng pr cc.oÌr!cLllh'ürcs!) iì.d ìn Tonc I
ilÌe real exchange rxtr. n th. siÌrÌc
. rrilìng ti.Dì ri\iÌÌt comÌrrhljlcncssr. \! c.af thc( Íorc.on.LLìde tlÌa( Ìh. onlt sleblc fosillon ls\!h( (
url. tìrerrcuÌleÌntr:Ìíclslhrlïl rrLNc (hlvatpoirÌtlln g l0l.laÌc(irrxclìi.gcrrlc
r.. \ta notniodl ifectatiors.onsisrcnt \!iiìr baÌan.cd lridr iLrllìll€d ind (il) 1lìL: i.naliôn cÌfc.tirions
. ì!., th. prlsjurr\
.iirageandfÌi.L:s.ll(rsiuhllcd.Lhcr(isiuni!uehngruncquiÌlbritrrn,a(..luncDr-
jrtìrtontart, !Ìt)\me.t. LflLi. lhc atifn4rl Ìrr (hc irLllìorìiies i.:i rÌainlein â Ìcl.1 .l actiritì, highcr
Ln
ÌÌrxn )ru! 1rjìÌ Kluirc an crcr ln.rcas ng.{rorrth of lhc mo..t sufÌrÌ_v nì lurl lhc Ìisjrg
iÌruatlí)n. F.rÊÌ j..rcãsl.ginllnrionrriìlcrc.luill)l(adth.golernmentt.rimflementa
re\tÌicü e hscâl toÌl.l and 5ÌìitL Lhc c.ononìl to tÌìc ÌoicÌ ìrvcÌ oi enÌìo) ment thât Ìs
:(rrtiste.tiilhcÌchangcr.ii.crpc.tntonsind,ithprl.c.ã.drÌagcscLtingh.ìr[.iouÌ

:- ! l!uiriüìi

6 Conclusions
olrln (.ononì\ nÌodeL 5et out úr this chntteÌ ÌrÌ(^ icle\ the nrcls l()Ì dÌaL!tirÌS a Ìirh
hc
1arlc1! o dì:hrrbince! ni ure econonÌ! lìom ihe demancl and mpfl! sitle\:DCl conriÌril
lFm homc iÌod .rbroad. lt eDrLrles u\ to diagrore the ndtLrr ol the !ii\tLriban(es dnd t.)
dL:ntlI!lhcroleoleconomicfoÌìc)nrÌesÌaìr.Ìjrglr)thenThi5isthetaslolChapteÌ11.
hr kctrcsults ol the oÌ)en €conomv mo.ÌeÌrf.: the nnÌr)ltìng:
. _hcrc
is. r.nge oì lneüÌrÌo!ment Ìdte5 at lrhjch jnÍìaúD ìi ronttant al.l at rvhìch
lhc (c.!Ìr!lìr c!n reDìriìr iìr the medilnn Ìu..
.lherei\âni.rcr.Ì!.liti!Ìrs|lpLrclircüìtÌìere.ìLer.han.{cra{(nndlhcmrdìumnrn
L$ el oloutput ând.mpli)rrnc.( ill!rnritcd b! the 1ïl .!.!c.

A
312

lh(ri..-tco Jrìe(l Ì,r'rnrqLLiÌbrlil:njdtrjrÌrrnrr!!penr(oÌr(!ì\:jrr..nrd.t.lt

.loql (..nonÌr. Lhcft is iì rLn qur .nÌìÍ.nl irÌfirtid] !q!ìLitirnrn
lhe !rÌrgr oi DecliLÌn rtrÌr e!riljt)Ìì.ì it NjdcÌ, ihe lt\\ Ìr\Ìr()nsl\ !. s thr sr!e irttir!
real r asc n) (hr.Se! h uÌrenlrl'r nÌeÌri
.\t. rÌÍi!!ü r!n rquilibriÌ,nr Llrc rilr ol iÌÌÌ.ìtion i\ !:Lct!nnirÌeü lr \ oÌÌd LnfiL o..
iÌ rìì.i rì.h.Ì13r rrt..|.orìoml end bl h.mi \ nÌ!rxÌ.r\ f,,lic! in ì Íle1LÌtc L.\.hi.{(

lìoÌ1.ÍÌntr{Ìl!tu rxn.! lornediuD rtrn cqü ljhÌium. lÌr.r'rfìl b!.!ptrr oÌ

d(rr.rJrÌfÌ.$oÌrt)fjrllrti(Dc[Ì)c.rÌjrg.nrt]tìlhe\lrrÌìr!.n.dtodr4to\nÌeÌri

5li,Llr! IrüÌÌ à nx.dir íÌ ll1. .(lrrlli|, u.ì. i n !.\p.ìrì: l:].,rr\ h\ral p.licr leìL1s !) r nch
ÌÌÌrdnìír n €q!iLibrnrnì iL iì high!.r k\ cL oi.utp!t ÌÌlìrrr.ìr rn e\tr.\jt)frÌf
nì.n(tiìÌ\ toLi.\ or J drÌ.lu,rlion Ì.Jd51ml\ i!,ì íÌort L!n ri\r nr outÌÌú \\r !hnlÌ
r.írrn t! UÌi\.e\rlt Ìì LLìJ|tcr I l
Ìf th. Ì. n! Ìuf , n.allÌr .Iielts oÌ rnaÌ lict ÌrÌestrrr\. LncLudi.g r\.hiÌiqc ritc
ns1âìrll L\ , miÌ\ ftL!Ìr Ìhr c.o.(Ìn1 nri rÌ(1 th.l)rg ur .rruil Ìrrit rÌì 1!i1lÌ.!rent

.\rÌ] rÌtenülornrppL\ rjl]!.hinS.Lì.tslÌiit\i|!lll .rr\rnÌthrlÂlj.untÌra.tsrox

(hrrÌ!e irÌ tÌÌe irÌrs nuÌ \!rn. nib c frÌü]]ph\|rürt rLìtr

I. ( hrttrÌ Ì!! ìrrlÌ trú the Ì)aii( oÌre. rco.oÌrt Dodel t. rr.Ìk \\'r l!!l.ri JtstsÌr
I Ì.
grtc cÌrÌnarì nr..lí rn(l rt thÉ !!e oi r{gÌLsrt. (ì.ndd a.LÌ .r.hir.re ratÈ Ì)()licle\ to
Ìeïu1Lì t,) ürcnr D!mr.d.ìr(trk.ra.bicrtrsc.ìbr.hrngcsi.trnilc\rctort)elürirür
ìÌìthrh..rerco.om\.Ìlhe\.er.onrnomrÌrft,ai].\\'rnrelll.oÌii\ufpl\ \ile rÌr..lt
rg !hrngts Ln thr c\o.i\È or brrgaj.L.S t.rÌo b\' ú.i..s o . hi nte\ ìÌr trduct maÌ
ket conf!tjtLo.r Jn.l rl sLrÌrl:rÌ\ \ide Ì).lj.i6 c.g srrttÌ\ ! d. 15.,ìl nì(riìÌe5, Ìe|oaÌ r.(ì
Ì)rochìct m:Ìlie1Ìcgulrtjo.l.l:(treìirÌì tÌìd. 'Ìro.k; rirl c\t,.Ì.i s!ptLr \lrtrl.. mch a\ o l
or r,!nmodil\ fÌ ice 5hocLii, eÌe rl!) Ê\xnr.rLÌ. lÌr rl.h .x\.. Lhr inÌlrLi(rti(!Ì\ nÌ ihe.lI)
(!re,iheIÃL:.u^e.irclthrll(^ea.dlrcÌrc.a.r.ulÌrrLL..Llition.aÌÌcLtÌreÉ\tcrnrl
bìLirn(e rre úÌ\ cttigrfud

QUÉSÌIONS

(l) a.nrf:r!lhcadril.r.nli.m.LlirnìiÌÌf.(l!llll.rlfrfrrieÌiii.iL..ntiìttl(!r!rr
n\ed rnd ll.\ibÌ! cr.lìingc Itc..o.1if]\ 1\'lì,rt lr.LlrireÌL Ìn thr sh.Ìl Ì:. rrìa (lujÌrS
theid urtm..t tt) thc drc.liunr rú.1(:(fi Lr,,re\(ÌirrenrÌa itÌrth..L.nd

(2) \\hrl (Lh.dlil(r(fr(l)ft\l.r riherate \ÉttÌÌrgIúl lgr.Ì!\L rìilrr!Ì)e.rnd

.1.(kiiìnoúlriLì ì.Jl\tìi d ttrr(rÌ.rIeiÌreentìreÌrÌi.c irt rì3rr,iÌrrgec!Ìrri.
lhr.t-n:n af .L. rú(rL.(r,.1f-Ìl(\l
 ...373

(l) ilxflain wlr\ the,e is a ÌaÌÌge of coÌrstaDt iDÍÌatnÌÌ uneÌnployment rates in a[ open
cconoÍnr. \\'hri determiDes ìro$ brcad this Ìange isl \lihrt effect do the folloilnÌg
tr ige sctli.g havcon th( 9op€ oftheEÃU cuNel

(d) a chanSe ür ta \tesr donesti. consxneÌs nowtreleÌ more ntrejgngoods;

ír) neiv emplo) mc. L
frÍc.t i. n l.gislatio. rnake\ rcn wagcs lcssscnsitiv. tu thc lclc
ofunenpÌol nrc.t;
l.l th c .ou ntry rekres restrictions o[foreigÌ1Íade

(4) Ìatthere rre tiromentical $alÌopen cconomies ercelt tlÌri nÌ

^ssrmr
onc oithctì, tr!o) ant eapectrtioìrs have renúted in a hisìreÌ ÌevtL!l(ofÌnrPtìon.
(:onìl.rÍe tÌre eco omiesinterms of emlrÌo)ÌnÌent, real lraSesl trrde ba rrìcel and

(5) Compare the cliaÌ a.lc.isti.s oI lhc nÌcdì u or íúì cqúiÌibrium íe.9. iúÌation rate) nÌ an
econoÌnl$'ith an.lellÚa ÌGe ìÌì the worÌd inflrtionrate.
ljxcLl cx.hingc.alcsbcÍorc
tb the samc lor 0cxihlc cx.hangc ratcs, as(ming that 1ìÌe world nrflahon Ìrte aDd the
cÌomestic inÍlelion ratc i{oc inilialLy cLlual.
{6) (.onrtar( tlìc inÌr.d ox iÌúÌation ol;Ì. iÌì.rease in LÌ.ion drìlìlanc} ìn a cÌ6cd
cconodr)'Nith tÌìal iÌì | lixrd { ìcha.gc i atl. ilrc. c.onomy. How do the mediuü nur
cltúilihrii cl).ìf ar.?
(7) Ì! tlÌe response olreaìwages to a coutÌactiorart isc.l poll() th( saÌìc a! to a
úntrdctjonary rnoneta r-\' poli.y in r fle\ible exclÌan8( LLt.,Ìrc. cc.nornv? rxtlaìn.

{3) Wh} is lhc rl) cú(.c ì. tlìc rf diagram ÍlaLLcr in Lhr pÌesence of nÌÌpert?(t.âpit;Ìl
mobìÌit_Í?\\h_Ídocsit.oj..ìdcÍ'irhlhets/.uner\ìrentheÌejs1rrr.âpltalnr)blliq?
(9) U.dcr a tloatj.t tr(h.n8e r;Ìic rcginrc, súff.s( that tìÌe e\rluDEe rate i\ erÌreded to
adjuÍ lnìnìcdistcl), to delivcr a rLal cx.hangc ratc consistent wjth trade brlance. Is
thftc stjLl â re.g( ot!neüÌplôfnìcnt ratcs al rlhi.h iÌrlÌatnu is constxÌlti'

PÍoblems ànd queíions foÌ discussion

qIESTIO\ A. 'A iìs.aÌcxpansio. Ìcids to r new ÌìcdluÌn nuÌ eq!ilibriuì with highcr
outpuLin anopc. cconoÌnybüta monetarl expansion doe\ not.' Do vou isrcc? l)ocs
votrÌ ans!$dcltcndon ürc clichangc rrre ÌegiÌìc?
QUlSllO\lÌ.,\necorÌom)ríithaÊrede\chângerateisjnadccfÌtcesiirDa.cÌhasa
su bstantìal c! rrent account deiìcit. Would fo! ü.lvise d.!iììuelior?

QUESTION C. kÌentjtl thc conscquences i. the mr.Ìjum iun ofa fâllin the Í,orld
inteìest Ìate u.dcÌ lxcd and IcxibÌr e\changc raLcs. Q)mfâre )our r€m1ts r,ith those
obtained utjng thc Mu.dcll ìcnìi.g rìodel (QÌJf STI(I\ C in Chapter 9).
QLjIS I lO\ b. BegiÌÌ with aD ecoÌìoÌÌÌy at .ì nÌediLu Nn cquiljbrium Ì!ìrh a trâ.le
defirit.]\ssume tlìütiheÌe ì\ a tlerible erchange ÌatereginÌeand thal cxchangc ratc
e.\prct.tions.Lre iÌìitiüU stable.
17|

(Ì) !\/hv Í the current accouf( deficìt increasiÌrgl

12) Whnl Ìnay puíÌ thc ecoromt toward long nüÌ cquilibrjum ancìwhy?
(3) Asrlrme now that there is a.hange iÌì th. s'ay exPecttìiions arc lormed ìn the
foreign ex.hange ìÌarlct so lhata trâde dcjicit Ìeacìs tothe t\'id.spÌead expectiuo.
ofdcpÌeciation. !VlÌ) Ìnightthc ÌeaíÌìlngoI frÌex market partÌ.Ìpnnitcha ile ìrr
this way? Whal aÌe the Ìikcl,v cltects and hoa'slÌruld ihe goverrnÌcnt respond?

j:: APPENDIX: SKEÌCHING THÉ E8U CURVE

ll$€eapÌcsrtlìeNages0Ìti.greall{agr$u.tbnintennsolÒúLpútandulcâsinìpleÌinear1oÌnÌlÌcf

I "La lr
1Ìr.quilitÌi,Lnì.Í,rLr=wr\ÌÌenr(ilÌrcnìnLitutcthccqúâúrntÌirth.wiBea.dtii.estttürllreaÌsâgr
âraraÍangetoBctÌlìeÌe!!lotoutpúr.nlhelctihirds r,(chr!.:

",'= -,,!, ll
r

r=;t-,iÉl
wh1.h is ân rquaiiÒ. nÌ.ooueiinil clainú cqnilibriunì in tcÌms oll lrd !
Ìhe nrgdú. rÈlation brtÌ{€e'ì /, ard)'Ìhnt {t
lìa\€ rlis.ustd i. delel.fing lhe lj]ìu .!rre i5
'leaill
relìectcd iÌì rh€€qratjor. \'Ve can also s!cÌlÌ. rte.l
thc \hiI. orinìP.Í1s iri inrl of tlÌr slrsit tllt.lÌ0rl
ìvrs6 nr ô!ttnü tÌrnplÒImentJ nÌ ÌÌi8e seltitg (1ì iÌì leienìini.g the shaPt oi tÌrr a,ì{,'.útr'e
lheeasie(lvrthseethe\c(ÌÌìÍicteri{icsirto\Lel.hLÌrelÀLcrnctú\t,a$uìethalar 0lhrs
B ìes ân iÌÍerccpÌ,nì iÌrel arir of

I \/l rì
'I

Nolr.orsi.l.rwhalhâppln5whenrbc.omcsvtr\Ìa.gÊ,\\r'-,tlÌ(defomi.al.rollh.rqu.tÌo.nÌ
rh! llu Ìre.ÒD€s rrÌ} la8e an.l I . 0 Hcn.r the Ãnu cnNr iJ òynÌpnÌic Lo lhe rcÍical âair' l'i8 l 0 I 1

l{e exâNin! Úh ri hap|en! to llr e J:,Ìü.LÍ€ ó th! im!ÒÍl sÌraÍ€.hanges ,\swchnrctlÍcad-v.ole.l ii

o 0.),:.1)rr ! ) ând thij is 5inì plt Lhe cl{\ed cro.. m-t uniqre €quilibÌnìm out!Ì( lcrel (Iig 1015
wehnvrnli!'e. belopth.tin lh€.t€neconom) ÍÉ l,lheorlpuÌ10ìclonÌlÌ(tnU.úÍrewillbc.t
thc clor.d ecÒnonrlc{Ìnililìri,rÌ Ìseli i.c iÌ!: Ì,

=
t.t(, ,,,
l,
 1^(1 r) v

Figurê 10.i4 ÌheI]?U.úfue

flìU(opcn)

i^(r 4)

/ ( ,)

Figure 10.15 J {r

lhi\Sivcsu!âtoìÌrLo. thÈÒfrÌr((!nonÌyl]ìl].unc. lotìn.lase.onrlpoint.wennk lor Lhe inLeÌ.Êtr

tritlì thcI Jìi\, i.c (hen r 0 Irrhrr( rs a loìr tÌarc !limporl!, r' thln it a = 0, 1 = l lÈA tuu.n
Ìrlllhet.rÌìeri8hÌofbutquìtedoçtor +ìir rl (s.cliil. Ì0.Ìs) Hcr.. th( 1dU run I for an olen
?c.n.mv Lhai ha5 onlr r $all \haÌe.r iiì|rrts is neef
Ìlwe noÌL lake uìe.aJroJJ \rÌ-Ìoten econom_vwiLÌì a h gh nr.rre !fiDporrs, -,, rÌìr ponrÌ.ri\rLi(lÌthe
lXL.uÍeiÌrLesectsrherrrirÌ{illbcNrchJuÌtheÌtorh€rishrrìri. n rÌìe lÍevtÒ!5.a!'(sceIj!. ÌO.l5l.
And {c hnow thât at , l, rhc ll.U .mc will go thÌ gh thÊ saD€ t.inl as n rhe freli.us (ìr(l
Ì :.ìlÌ !ì. Lhc three.of trastrnB..s!r irc \Ìr!Ì{nin lig l0.l 5.
lve havc aherrly .lis.!sed lhe i.r!itro. lehiÌ tÌrc rtf0ct ol an incrrâ\cd scnritirit_v ol th€ I'aBe
setting reaÌ Naile to (rÌploy!Ìerr in {ee|e.ing the Fnll.!Nc lo \( thj\ diagrrmari.rll)r, it n eâr_v ro

l,
t76

lLrr pr l,Lr /' \ 1^1.114 a!L4

FiguÍe 10.16 a,(U.!1e5 .í tsLt lhe sÊns t v iv cf Fà w:qÈ5 iô e Ìp oym.nt

seetlutarnÌ.rersÈi.,,nonÌ.Jt.fHnìjlt\n)thrlclltheintei.etlwiththc)'.rir:r:j::- \\!
trolrlo.râtiarâlhrpplrs,rÌrÊn, I \\ithnr,iÌìÈ.ultutllv0]onrhcL(li(r\(isr +\il I
!\lnr âhighLt€nÌplolnÌcni rensitiÌr L|s(ü.(,r !\rl fl lì(nr\r :'1,iÌrelÊltÌrar.lthiltti
rÌreÃlÌÚ.uryeinrlÌe.aseôlúìehithlcvrl!f,, isg.ealer Nhcn a/ = 0tlrì. r!he., I llen.!,rhishrr
Lereloi,.mr.nrdnÈepÊr llÁÌ, o,Ìve(\eeFlg l0 I'il.
 Shocks and Policy
11 Responses in the Open
Economy

ln this chapter, the open eco no.r) mo.ÌeÌ devclofcd i. ChapteÉ 9 an.l 1O í put to woÌk
to e\rnìiÌÌe govenÌnenL Ìroìicy instruÌnents and lo anaì_vse shocÌ(\ that may di\tlub the
e(ononÌv. The teÌm thocks' is used to describc a dirtlubarce to the ecolomv Ìhat is
uü.rÌÌticipated. I1Ìms aDd households aÌe ljkclv lo he ftì$aÌ(t kx)king ancì, at Ìean to
ÍnÌÌe e\tert, aÌe abìe to iÌìrorporaLe anticipâred cha.ges 1n iheir econoDÌic envÌonment
into their behavúur. It is thc dilleÌe.t kinds ol ltnanlicipate.ì change\ in the economic
envÍo ÌÌent(D Ì{hich i('c Íocus in this chatt$. \Vc utethe moclelto anaL}1e
. agSregate cìemand shocÌis,
. suppìv shocks, and

In ea.h ìt js ne.cssarl ro djagno\e the imdicatiorÌ\ of t1ìr distriÍbancc fü tlìc

case,
tÌn'atesectorardloÌpoljcvDrâtcrs.Ì()esjtshìIlthe.4DcuNe,isit.íÌift;Ìongthc,ll)
.uÌ!e,doesÌtshittthc]J/crtrcortheÃRUcuNc?SomeíÌoclsarerelatlvcllslmpìcto
aralvse jìr thc tcnsc rhnl rhc,! hale an lmtact on only orÌe ol the tlÌrc. rclatlofship! in
themodel.OlheÌserc!ro(.comltìex ir)ÌexaÌnple. üitÌirÌg orcthanoncrclalionslìif.
The ìmpoÌtance ot thc coícct .Ìia:!norí of the tvpe of s1Ìo.N is dcmonslralcd by thc
ÈxpeÌlence of the advânccd countÌ1e\ nr the 1970s. Ìn 1973.nd again ln 1979, thc orìd
pÌice of oiÌ incÌeâscd sharpì)'. The imme.liate con\equence of the first oiÌ shock *'as a lâlì
Ln aggÌegate demand in rhc oiì imÌroÌting OIaD countiies. |oli.y iÌìalicrs rcspo,ìdcd b)
tÌeatìng it as an aggrcgatc dcÌìand shocl< one tÌrat shiited t1ìe aggri'galc dcnÌand cLú!c
r. the kÌfi. Ycl thc alrcmpt to oIÍ ct tìre inrtrd of the shock on en]plolnÌent through
úscaìeÌpansionandlooscningnìonelar)poljcrwasaccompa iedb],rap deterioration
Ln the tÌade bala.c. i.d ri5ing inllaLÌon. A rumbcl ol Eutupean countries elperirn.cd
ÌnllatnD Ìates Ìisingi\'cìì inlo doubì. digit' at â rjnrc oíÌi5Ìrg urÌenÌployÌneÌÌt. 1he se.ond
ollshockìnl979wasÌìclbyquiteadlfleÌe.tpoìi._vìesÌurse.Br"thenit!!ascltarcrlo
policv DÌaÌ(eb that the risc in lhe pÌice oloil$as an externtìl rÌrpú sho.k, which had thc
eitlct ofshìftìng thr ÁD, Bf, and ÃnU cuÌves in ar adleóe dlrectloÌÌ.
This chapteÌ bcgins Í'ilh an intÌoductor) scclion that Ì(!ts at 1ìscal, üonetar], and
suppìv s1.le polict jr thc opcn cco.onr). This rjc! logrtherthe \hrdell fl€]niÌìg arìal),sis
(fÌom ChafLer9) ith lhr nìcdiunì'ând long-Ì'L1n arìn\als 1n ChapteÌ 10. Thii ir tollowel
blareÌami.atjonotourdiltcrc.tkirdsol!hocks:domestlcaggÌegatedemancìsÌÌocks.
domestlc supp\'nrocks, orcign tÌâdc shocks, and txtcÌnal mÌ]I)Ìy shocks. lÌÌ each case.
 l-
378

r e d\lJ!hat tÌrc Lmfli.ilion oI su.h .r nr)cÌi is lr)Ì thc sÌrori ru!, rÌrÊ m(lirLÍn nrn. anl
tlÌe LuiH nn cqu jlihÌ rrÌì. lhislrcps!\n)anaÌÌsÊrLhatÌ!o!ldh.1tÌreniiLÜci.hlirÌct!l
íro(litthe gorenrnrcnL did.or r(..tto ìt.rtxÌÌ. \Ve.an tÌr.n asl nlÌrtìrer rhclc arc appr)
priate ndi araiÌabÌc tô thc gor.r.irlert ÌlirlÌ ÌLhilh k) ol scr su.h i tho.li or to nìitjs.ìtt
its ellects on the econonr_1. Sc.Llon 5 brlÌ:\ nri{etÌrer rhc inlpli.rtj{ms ot nr.t!iijcÌl\ nÌ
.ì$reBdte cÌ€Ìnr.d end o srLfph ji.l! policv mee{Ìet Io. (hr belÌ!\iouÌ ô (il Lr.tes
Sectirlr li afÌrÌlcs lhc lcisofs.l lhf clÌapter n) the âÌrali sis ol ho\ a (urr.n.! rLÌrion oper
ite\aÌrdthiarh'a.legc5ir.ddisa.lrintaBes.imcÌnbcÌnrjÌr ÌrltheiìnaÌú:L oÌ1,sc.tion:,
Ì!r \hoi! hor! L. iflÜfrct n nìofctaÌr poÌicr ìerctn)n Iun.Llon iÌÌ the otrn c.ononl\ lnl
hoÌrtherÌarth.c..nonìr'idüsrstoâdeÌnandtho.ÌidLlicrs!|derrnintârio.tiÍg.rnìil
regnÌe lÌonr i Ìr.! nr( .IllrnÌins (\.1ÌrrÌte Ìdter irith x co.rLiìni !ioì!rh Lt. oi LÌr. nìon.!\
s!ttÌ1

1 Fiscal, monetary, exchange rate, and supply-side

policies
The otcn c.ononì! ürod.1i\ !L r! !se1rü n! xnJlr\LÌrg th! lnrpicl on ilìe ec!n.rì! ot pol
icv.hrfgcs it honx iìrìd ,ìbÍoid a\ \!etla\ Ìhe inrtr.t oishilLs in priÌ ire tc.nJrb.hiÌrio!r.
The kc\ onrponc.l: ol tlìf modrl Íì oxt in ChaftcÌ ll rÌ.:
. thr.1a, cúnr lìls shorts lhr .onrl)iÌÈtìoÌrs ot rhe Ìe.l .1.1Ìax!e Lìre , and lcrcÌ oi
outÌrúr, xL(nr .h th. {oods Ìriulet i\ nÌ e!Ìuilibnuìì and lht reil iltebl riìr( ls rqui]l
to ihe itorld rciÌ in Lc( iL rnlr.
. lhr r Â1,.!ne. lhiti\.ltÌìnedat th..omb ÌììtiüÌs oitlÌrÌeaÌ.{.hanjretutern.1(rúf ut
aLirhl.lìtlÌe !ile\ettnrgreajsaF.lscq!,rlt!thepri(e\etrj.g(iÌl{.rte.ftar11 poinL
o. thi /-Â11 cune. iÌúÌrti(!Ì i\ co.tra.(
. dÌe ljI cuÌ!e. ThLs trÒrfs 1lìr: .o.ìbiÌutj(Ds ol the rcal .x. Ì.xse raÌe /' en.l rÌrr le! et ol
out|)rúr at r hich Lred. is baÌi..Ld:Ì - ,t

1 1 Timing assumptions
lhir ú nr alpíÌrrl.tr poirÌt iìt Ì!hÌ.h to 5t.l our tlìe a\\unrÌrL orÌs uÌat aÌc hcins
rlidr rbouL Lh.5pccdotadjuÍnÌrntoidL I!.(nr nìarror(o.otrìir \ ar trle\i. Llrcotr.

. lhe short rtrn. íf Llr!: slrorL nrn, tlÌe S(!)(ì! nri.kcL cquitiÌDitrnr is.niÌrÌìthed a.L]
aÌLìitrile lÌ nna.cirl nrirkcL5 cfslre\ rìrrt thc honr. l.il iÌrterest riÌtc j\ eqlÌai t.r thc
iorld reaL nrleÌesl Ìirc. n llrcslìortÌrn.n'cobní(.h.xìceti. rh. nonÌirúÌ i.rÚc5(
Ìit.,tÌenoDinal c\cheng. raLc, !utprt, a.d !nrtlornìrrÌt. ThcrfdottlìcnroÌtrLn
adiustnrextj5ÌnaÌkcdh!ÌhcnlLni nentoftlrc5lìorL r!nequiÌjbrtrLÌrontherD.trÌ!c
ln Ìhr short run, it Ì5 âstLrnr!d rh.l rrSÊ rnd tri.. scllc.J do not chanl. rÌrSes (, lìri.L-.

rr'.h. i tur?qriLrl,atr ìirrÍr.rì...\ f,i.l{,úrr.JJ.Úi\rr.rnr:1 !r.rÈ!l

 t19

. lhe nÌediuÌ Ìu.. Lhc medtunì ur besiü \!hcn 1\,rgr in.l pri.e lcltcÌr rtrrt ti)
rcspond n) tÌlo thlngs:
idl rn) (hrnge l. th.lc\ cÌoì i.LivlLl (rúP!t. rrntìol]Ìx'ol)in tÌre e.ofom) tÌìrt h.s
lo
...1 ne(l iìì thc shoÍ trn rn.l
(úl to.rnv.hinge nr uÌe Ìe.rljtâgÊ thdt lÌaj b(n bÌ(N3| L ibout bl n.hxnge iÌÌ tlìr
nonÌi!ìaÌ (ând herÌce tlìe rciì)e\clÌangc rile Ln the 5Ìro ìurÌ.
. llagr rdtiug ls r$umed to hrfterÌ Ì)eiiodi.ilÌ) lnd price \ettrrs aÌ! asrlìnÌed lo
ad úrt their Ììri.(: ,atlLlh in iiÌc (,ike ot $igc.henges Lhl!mtarÌ\thntlheactrìrlrcel
h.iÌgc nr tÌÌe economr ú rhldts rqtraL t() tlìr Prl.c \ettifg real Ì!.gc. lheendoIrht
Ìr lrrgrL Ì1{
mcdlumrurisÌn kcdbltÌrealtei.mentoithcnìcdiiìnìrune!ÌuilibriLLnrlrithtÌì...of
l]D! at the irnrr5.ctLon olth..1/).rìne.rÌd Lh. a^Lj .trÌrc. arú hcn.e $itlì conslânt

. thc ìong mn. lÌì ihc IÕ.g Nn, Lhi frÉlence ol a.|rrrnl iccouÌÌt surÌìus or !l'S'll
na\ prcd(ce hilÌ\ irÌ thr Ì /) .un e (ns .o nnuÌÌeIS rcnct Ìo thc .h aÌ ì3es ijì 1!!rìth irn!licd
s

!r tlìe ito\rnDent adju\ls fscrÌPolìcJ i. ÌetÌronsr lo nrarNcl oÌ ÌroLltì.al PÌc$ures hc

ìIr thc i!e\ eÌ(hangc
ÌrÌesen.c oI a teLinlnt surÌlÌut or dclL.it nlr\ knd lo r cha.ge
Ìate .\pccLalioÌI dre tornìrd, \!ìtÌÌ thl .rÌrte!!en.c lhrt thcrc is.orÌ\t;Ìnl inihticnl onÌ)
xt the ii(crccti(Ìì ol tlìr / iìLI arÌd ô/ cuNet as dis.ut\ed in Chdpter Ì(l This in L(rÌ'
nrdl lead thc govennncnl lo adlln lscrÌÌroLi.) 1. \hi1Ì thc eronoÌÌÌ-t lo tììe Ìorrg Ìun

ÌÌì tliis s(.lio.. ite con(,rLÌrte on thÌee kt\ re!!lls iÌolÌÌ tÌr. oterÌ e.o'om\ nÌodcÌl

. ln /rir/polj.! íii/lr lh. aggreiratÉ drrÌdrÌd.ÍÌre. $lììch iÌnfLir\ lhoe ìi

a clÌ.Lr.rr
a ne\! LcdirLm Nn eqliLìbrittnr tor tlrc cconoÌÌr) iÌl .Ì dìu(í:nt Le\rl ol ontPli ind Ìeal
(\chdÌÌil€ raL. In tÌre !bsln.È oi go!L:r.mtnt iÌn$r'ention the econonr ÌÌÌlitcs rr'u
lhc neÌ! short Ìun equilibrium to thc neÌ! ri)Ììsla.t iÌÍlilL.n Ìit!' 'i uÌìtrÌÌ!lo) ment
\in.r uÌe \hôrt Ìun eq!iLìbritrn i\ diift:Ìcnt uÌÌd.r nred a.d llcÌiblc '1cÌìarÌ8c 'ale5 tirr
i.ÌjustÌÌÌlnL tilÌr to ÌlÌc Ììc( niediÌLnr Ìun eq!illÌrrjuLì dillcb !nd'Ì h\e!l 'nd Ìle\ìblc
c\charÌlc Íalcs. Iìr Panj.LLliÌr, the impa.t on ilúÌ,rlio. lthLÌheÌ thrtu: rr a ÌÈrnporrr) rÍ'
ora temporary lelÌiÌr iÌÍÌ.t on !Leprn.ìr orÌtlÌ€ cl.harÌgr'rrLe reqiÌìc
.
achanseiÌl,rrriird,r Poli.luncieÌl(\LìteerllÌangeìrtcs.ra(hdÌìiicittherr'/rdr('
r.rn l).ï iÌr u hìcd' trchlrÌ8c,ete rtst.nì i\ r Ìriit dlr,'i Ìhr âggregilc deDrnd'rLn É
in.l lhetnirr do$ not ledd nì i neÌ! rÌÌcdirn nuÌ eqúLÌibriLrm' The LefL ls oi (trúpul â'd
un.:ÌìfÌovnÌent .hange onL] jrì lhe \1Ìorl ÌLrf A ternp.ÌaÌr risc i. iÌúÌ.ìtion i' the câi' or
jn ìÌú1al on nr tlÌe
iì d6rhatnxrif\pi.rnlraÌ\ lJr.net.rrt poÌì.1 .r r tnìfo rt liìlÌ
'a\c
o a ielaluntiüì/contÌactnÌr.ry nonei.ryfoÌi(\ Leadslhee.o'om\ b'r'ktoÌheoriS niÌ
nrcdium nrÌì cqtLiìLÌìiluì
. a.hangenrirfll, siJ.Ìr)Liq sr\ÌriltiÌì {h' Fnri rìrÁr'rÌÌÌ(l$h'Lh hÌed i'{ÌÍle\iLrlr
e\chângc ratetr. I lr 5.1ìi.ge5 bolh lbe uedllLm inct th. lo.g rtrì . qúLÌjbÌirìnÌ'

tsi:otirn..\ I \iulnirr.iLnrr t f..? r.iÌlrrg ' ntrlr!trÌì rrtlr!\rii.'i!'!nnr'r'iir\ tLÈ.rÌri

'a
,,rleiin,irl).n,.LLtl,:Ni!?srLÌnlk.:l\ri;.dìirrJr.ir:5rL'ifqÌ?iÌrri!'rÉl:tri'f
380

\'Ve arc not conccr.ecì hcrc witlÌ ah) the govc rmert rnight rvaiÌt to (se nscal or
nronetary/cachangc rate PoÌjry or$ppl-v si.ie poÌicv !!econrctothât Ìhcnwelookal
the ciiflcrcnthnìds otthocks thatÍìayaílecttÌÌ€ cconomy lor no\!, the aim ir siìnpLy to
fin d own lhe efl€cl s of cìifiercnt poli.ìcs This is casi en to u n de rttnci ii
wc begi n irÌ fd ì
equilibrirm atthe jftersection ofthcnD, BT. and flLi c!n'cs Oarnrlldarda* mPtion
ìs th.t Norl.Ì iÌú1âtion is constant nnd that undcr lrxed cxchange rates home \ets tlìc
ìnUatioÌÌrate ìn thc me.liun ru equiljbtium rt a rare equnl !otloìlcìintlal!on

1.2 Fiscal policy

$e focus iìrst on the in4rìications nÍ aggregnle denìand ol a changc in hscal polÌc-v: u e
er.nrine the suppl-v sidc astects oí Í)nÌe kinds ol1ìscnl policf latÜ on when tt'c ìook ai
suppÌy-si.L" poÌifv. supposc the ccon omv is al pointl alfulÌ€qüillbriuìÌ irlig ll l Th€
Th e agSregal c cu n'e uÌen
iio! €rrì m ent undc r tak€s an e\Pân sì()nary lìscal Poli.v 'lemând
shiltsto rhe riilht (A1iscâlrontrâctlonwillproduceancxactÌystmmct cal\etofrcsults

1.2.1 New mediumÌun equilibÍium

]\ nscaÌ e\pansi(ÌÌ impÌìes a rightward shilt ottlÌc/D cuÍ'c lhisÌeacìstoanewmediunl
run e.Ìuilibrìum at point B.r\t the nerr nrcdìrün run equilibrìum,

' outlÌrt i\ highcr and unemplo)ment lotleÌ'

.,islo rÌ (i. e. a .cal apprc.iation), an.Ì tlÌ€ rcal $aiie Ìs h igher'
. here is a lrade defi.il, and
. iÌìfÌaln)n is corrslatlt.

Figure l1.l FiLalpo .y shi15lhe.4/).!rvê n.w n.d !m rún eq! ihr ún aì! and.onPaÍ5Òn wth
r'rlr.dei i eÌ f! Prêdl.Ì on!
 38r

'lhis !ÌarìÌpìe ias discu$ed at the begì.ni.g ol Ch<rpt.r 10, where we used thc labour
nrâÌlict diâilram n) LÌis.uss th.È iÌnplicatiims oI a frs.al cxpansion. TlÌe adìustÌìcnL paüì
I onì /ito lJ deltnds oÌì tÌìe e\chànte ìâte ÌcgjrÌÌe.

1 2.2 under fixed exchange rates

As wc saN iÌr (lhatter 10, und€r fr-\ed eÌchangc ratesl output in the econonr) cxpands
\vi lh th. real erchrngc Íate corÌstâ nt. lÌì the l\í úìdcll Ì,lcming moc]el extan j io n a N ti scal
(

toììcy his tlÌe iìÌlÌmull4ìlier eltèct on outÌ tbcca(iscjn lhrncwíìLtrt run e!ÌuiljbÌium,
lh.r inlcrrst rate renrains unch.nged ar the iroÌìd ratc. tf t,ig. I Ì. Ì, tlìi\ is the núve tÌom
I to C. Llut in the nìcdium nìn, âfìer outÌÌú and cmpìovmcnt in the economv halc
e\Panded,ì{âtesan.lprjrcsrrilllìeili to resÌrÌrd. Al a Ìrosì1io. abov€thelÃlicu e(see
lìig. 1Ì. Ì), the exìnìng .caÌ n'iìge li€s úclo' the r,agcictLing rcal Í'age at the new higher
::n I ig. 11. t. Th. lcvcl of.ctivjtv (see lìis. r0.2). llìe reaÍin is rhal lhc ll,:! cúr. is up$ad nopirg: a\
rmpÌoynÌent Ìises, so does the re.l Ìlaile thaÚlagc 5ctLcÌs can cxp.cfiÌhen monev $ages
ircset.-^s a con ieq ucn.e, lt tlÌe next occa\i oD ona'hich wiìgcs ari. sct, Ì!.ge\ rireÌeÌatì\,e
to rÌpecteci ìnflariorÌ. lro ì tlÌe prjcirg eqÌuarlon (/, = + Ï), we lnolr that !!hen
mon€y wages rjse, pri.es \!ilÌ be put up bv horìc lrmi in froportnÌÌ to th.È labour cost
increise nÌ odeÌ rolic€ptlÌe nÌârk up, /r, constanl. wolhings olÌoNlromt1Ìis.
. the.leilnirioo of thr consumerpIìce index (e : i 1 .,)l +.P-e), it loÌ1o$s
lrjrst, lrcÌD
Lhat connuDer pÌ1ces rlsc in thc Í'ak€ ol the home prìce rìte. ÌkNe\ieÌ, lhc .onsumcr
price iÌìder i{ìÌÌ nol risc b}'as much .ì\ does the tÌice Ìeleì of honre produrcd output
becâuse nothing has happened to the rate oliDflati(Ìr ftr'ìmpoÌted goods. lhlsìrnplies
tlÌatthe realwâgc, (11 rr|.), h.s Ììcrease.l.
. Sc.ond,bccarsehomeinflatjo.hasrjscnarÌdnothinghashappcncdto orldÌúÌatnrn,
t p' i \1.14ì r''l- .: - i3d
Lrr o'rl-. p . r,.r, 1".- q , 1.,'r ..
thc,!r/ c.JÍ of 1.rpoÌts has dcclinrd.

Thc ccononìy therenne rìoler iD a $uthi!'l:ncrll' dircrlion doí'rÌ thc.lrljÌ ) cur!e.

This ii lhc nìirrorirnage of the ro h Í,es tffìv nÌovenìrnl ÌrÌ t hc labou r nìarliet d i.ìgrâ nÌ nÌ
lì ig. ì 0 2. llìe ho Ìe economv expe rjc nccs a t cnÌporary rlsc ln inÍÌa tlon relative to worLd

innaLìorÌ. Once t1Ìe ecoìromv is at fojnr B, ÌcaÌwages. thc rcal cìch.nge rate ând iÌúlation
ârc conÍant. ln erample is tÌoridcd i. lhc ippendi\ to this chipter to slÌolí in cletaìl
using l,hiÌlips cuÌ\es how innarion .hangcs i\ tlÌe ecoÌìomy Inoles tÌoÌÌÌ one me.lium
Ìuncquiìlbri!trÌÌwithco.sra.tirnationbarÌltlÌeronelollorrÌìg.nerp.rÌsnnar!ÍìscaÌ
poìì.}. l hc tiÌne path t of rcaÌ wag$ an d ln Uation are skeichcd iiÌ tig. 11.2. The JDÌic)'
changco..rrs ai tiÌne fu alterinrch loÌÌo(r thc s1ìort Nn i d iu stnìent: nothnÌt happens
to iDÍlation or rral,!dge\. Time tr ÌnâÌk! rhc bcgiÌÌriÌìg oI thc nìediuì run perjocl.luils
Ìlhich s'âgcs and pri.es ìeston.l. Timr t, marks the €nd olth€ nìediuÌ run âdjrútÌnent
,.ttr....
I 2.1 Under Ílexible exchanqe rates
lÌt the Mundcll lìlenÌirÌS modeÌ, the ÌncÌcâsc jn outprìt stlmulated by a lìscal e\paÌrs()n
n líiÌre.l out ìn the íÌdt ìun br the e{chânqc ritc appri.ciation ìnduc€cl bt the iact
Fìgure'11.2 Adlúrüìentoirea ú,aqe!.nd fÍà1iô. Í5.4 erpan5on !nrieI fred ex.rnnqe r.t€5

that the hoÌÌÌ€ nomi.al interest Ìate i\ temporarily highcÌ lhan lhc tÍoÌld Ìate. ln the
nredirun run, howcvcr, theÌe is higheÌ oütput at lhc ncw cquilibÌium. As ne sai! itr
ChapteÌ 10, the initiaÌ nominal exchanite rate apprcciation lo poinL D (the MurdeÌÌ
Iìemirg slÌori ftn cquÌlibriunt in lig. 11.1 impllcs thal pricc conrpctitìvenes5 has tàÌ1eÌÌ
ancì real wages havc risen. ReaÌ ilrges htìve ris€n because Lhe nonrìnaì aPpÌecìatn)n cuts
the price (iÌì donìcstic currencl teÍns) of inÌponc{ì lÌnal goods in the consuìnpti()n butÌ
dÌe (1.e. I c r | /'j. n shown at time h i.€.
=T f). the upÌlaíl iLrmp
in rhe Ìeal
'!age
lthapper$ in thc short Ìun. lrÌth€ medium flrn, wagc scltr:15 wìlì Ìcactto ihìt. \'Vith reaL
wage! at l,o .i}or.€ thc level assoclâted $ith {'agc-sctting cqtriìibrìunì, nronct tlages wilL
fall relatile to thc cxpectecl pdc€ level (refer ba.l lo Iig. 10.3). Sincc lhis Ìcduces labouÌ
coÍs for firms, homc prices are reciuced by price sclLcÌs iÌì linc wilh lÌìc lalÌ Ìn nominaÌ
r!âges. \otÌìing has happened nr lvorld inflation so !hc conÍrmcr pri.c indcÌ Ialìt b)
less than thc lalì in lhe price 1e!eÌ of hoÌne goods. Thc co.scqucn.c is thal rcal ages
do faÌl. Slrcc hoÌìc inÍlation has l.llerÌ belorÌ r'orld innaLion, pricc conìpclìlivcncss ìise!
(thc real cxchângc Ìate clepreciates). fhe improvcmcnl in.ompcliLllcncss boosts Det
cxpo.ts and rhe econom) moves iÌì â north'caslcny diÌcclion aìong lhc ÁDlr ) cun,e
tü!a.d rhc .ew me.lium Nr equilibrnrm at 1 (this mirrors Lhc south-casLcrl,v nrove
from poinr D in lig. 10.3). Ìhe ho Ìe ecororny cxp$icnccs a lcmporary faÌl in infla-
tion rclalirc ro woÌÌd intÌation. Ihe lall in real a'agcs and drop ln lúlation orn Lhc
bcginning ol Lhe mednìm Nn (1ÌoÌn lÌl are slÌoÌ\'n iÌì liig. Ì Ì.J. Once adjüÍment n .orr-
plcrc (al !imc rt, the real Ì!âge is hiilher than iÌìitìaìly and inflatìon is back at its inì1jal

1.2.4 Summing up
IoÌÌ(^viÌÌii dn erpa sionarl lls.al poÌi.v,
. urdeÌ nxe.l exchange râtes. adiustment to thc nl:w m€dium nüÌ €quilibiunÌ is via
rlsing ourÈú an.l a tenÌp,rra ry iÌÌcrease ininllatlor (lllativeto Ív,rrld núatorÌ), $,hich
\'Jrr i,Lf.rr ..-. .r"LLlir'pr" r. "\1.'r,or .
 383

FiguÌe11.3 i.,lrrr._Ì.'rÈi i,,.!.i:rn nÌir.r i....,tr;:,ii- rì:"!rhe:r.ìa'!er:tÊi

. uÌìder lÌeÌitrÌe r!fu\, adjLstÌ!rnt i\ ri. iìn iÌìitiiìl e\.1ìn.gr relc afÌrÌe.iat!(trì thrt ottiet\
tlÌc elìed ot the r\faÌri.nar! ììs.!L plli.t !n outpL ì. lrii i\ irtl(trled Ìr) atenÌ!)rart
lJlL iÌr ìÌúrtnÌr Uelatì\e to Ìror1ll iÌÍ1,ìtilÌÌ1. lÌich b.ost; co nÌretitir ener\ anrl irises

1.3 Monetary and exchange rate policy

ln 1rÌelibÌr er.heni{e ratc eLononrt üi1lÌ prrlert.iplliìÌ mobjÌú, nntretrrt poLj() ÌroIks
throlÌgh itt eJtect\ oI the .(rrnÌrL e\.hiìng. riìti. ,\s ni: 5x1t nr (:lút)ter r). r .hing. ln
no.Èt.Ìr\ p(niì aÌtÉÌ\ rhe hoÌnr ìÌrtrrrn ritc r(lìti\ c Lo the rl)rÌd intercn rrtc iìnd thls
leedr to r (hrngc nr the nomúkL er(hin.lc nrtc. J. Lhc nes tÌrort nuÌ rquilibr um llìr'
r\ ìls
nonrinrÌi.te!e\t Ìrre it on.r nÌlre eq!iì11! ih.: rlorlLl i.iere\t tutr:ni ilìrrc s a dll ctu:nt
J.r LÌ\
Ìer el ot the nomnrrÌ e\chaÌrge rìte
l\ie cen ÌecâÌÌ in!ì ChìtÈÌ 9 th!t irÌ ,ì Êrid rÌ.hânge Ìrte re{nne iÌÌ,ìÌ!Ìat PoÌ .t l;
nreiièctrìal c\€ÌÌ iI the 5ìr(ri nuÌ. lhr rl1tfiftnÌcnr Lo Ìeet ür LoüiÌÌal cl.lringc rit!
hxÈd mea.\ thìt rn) chenËe ìÌÌ donÌrni. morÌrtil! |oÌj.\ it ÍìÌied ort b! oiÍrLli.!
.hrnge5 i. the Do.eLeÌ) br5e behìre it lcts oll ihr .qftr..Ì. Thetlore tlÌe irnìlojlu. 1o
: .ll r i.lLl moneteÌ\ ÌroÌiú ì. r hÌeLL e\c[uÌSe tc.rlilnt !s tÌ]c to5\ibiLit\ tlút t1Ìe Èi.hrn8( ral.
Ìrtg .a. bÉ !h a. ge.Ì. A dcrahr.ìtnÌr Ì ÌrìÌni. \ ,ì n erpà ns o n ìÌv m onet.lr! poli.t : thc righ I
$ aÌd thift in thr Á\II Ìaj\c5 tÌredorresticiftere\t ri]1r an{1i.(lu.e\ r capital iÌú1or\. !\'hi.h
rhllt\ thÉ lìÍ nr the ÌÌghl SÌmjLail\, r rerrlLrrtir!Ì Ín Ììics a .oÌ1tÌdrtionir] Ìlìonr'tirl
t.lir Ìr\ ìnducinXrcetiLrÌ outios.
\\JÉ nos l(lni Ìnore.l(\eÌ\ ar tÌÌe \hort Jnl !È.Liunì ru. .onrequen(e\ oi (lÌinges il
ÌnonetaÌr polic\ un(ìeÌ iixiÌ)le erchrngr râte5 and . .n. ofl chaÌrse iÌr tlÌe er.lÌangr
Ìate peg andcÌ n\Êd excÌranse rate\ Lh ei iÌe\ibLe cl.hange Ìatet. monetaÌ\ Poli.) is
\er\ eliectire Ìn !xj!n! otrtÌÌrt üì the \1r]Dllell ]Lenìlng nr.rÌeÌ. \l(Det.ìrl e\prnsion
Ììa\ | stnrìS iÌnIrrtlrr.xusc olthe Ì)oon tt) issreliìte dcDrf{l.lue 10 tìre eÌ(lunire r.rte
deprrciationÌnducr.ÌbrLhcLeNtoraÌ)lallnrtheirÌteÍ':lrnLr:bcltfftheüorÌclrat,"lt$e
tuütothenre.ìjurrru..thtnreÌ(noÌrtlrrt!(hrnileiÌrtron.larlpoÌ1cvun.]eÌiÌe\lbLe
erclHrgr Ìxte5 cen.ot rhLIr the nÌedìLun Nn e!uilibriÌrnr: in Iig.1l. + the 1, cu^ r drrL
384

,"..it,

Figure 11,4 '.1.Ì. i r'.r: dri.: :1...,., !;! ti!.-.:ii Ìll. !. :.rl !- -ì È:ìr lì rm
1?.: r. ]:]i.i..] i:j l

Lhc r llrlone relrilÌr l Ì.ri Ír tlÌr rììrd (Lnì u.equilìbMìr!'ìelfsilfoi.l l L\r(tLÌ

tlr.5enrrafeL\ti.rfìf.sLnthe.r\rirlNhi.hthtrci\ìdis.'ili.hifgLi.thrt\.1ìrnile
reL.!..Ìtra hrel r,ì1.s\\le!ìLli.,ÌÌr.i l1:). rÊel:1s.1i.1r.
r(nl.riÌìS: idr\!'.ing oi loI|c\li. {,r,rt'lìÌ1 t,)li.l r, i nonrlfal dc\alu.Ìti(!r. ÌÌti
.\tt)rt\rr !!tpulr\tâÌr.ìit)r,:thc5lrorL Ì!nl\11ÌÌ\lrli Ìl!'.ìinFrqrrillbriütri\dtf!irú
A. IlorerrÌ. iÌÌ ilì!'fic(]ium n.1Ìllh Lh..co.tÌ!t ìt PolÌ1t rj, r. .r(lsr (rnrj.ìer tlÌt
imtLiratir!tr ior th. sutfh \ìir ol Ìh. ..nf.nr\. I lÌc Í'il drPr(. nli.. oa Lh, rxrharÌ!É
ÌrtcinÌ)Ìieirl !cr,.rlrrage.llÌ15 5lrr.iìrLi.tht i\cirÌtlÌ,:prjc..ii.rPorLs.i{.r"' = I I
due n) tÌrr r\clÌ,rf{r Itc.ÌrÌrrrcj.l].. iúnì riì lo .i, iÌÌl!rlii: .ì l.t!'rilrriLì.n in Lh. tcnn\
ottra.leiortiÌrhoÌr..co..rìt.\i.iilhcfri.toteÌÌ)oltjh.ì\not.hifg!'drÌis.i.the
tÌj(eoinnfoÍjlÍ,.ithÈÈnn\ol Lnd.e{i!.!ltheÌ\Ììr..iÌÌìnt h 5|.rLlsÌ.rlÍige\
Ìre(r!\e | ôrll rs..ns!rìc Ìr)th inìforLrd i.LÌ home protl!.rd {..r15 Ìlìi hi{h.rlÌ1.Èot
i!Ìroú\ trcd: d l(.1Ì\ i.n) tlrr cof5rLmr, frlfe Ìnde\ lnd .!t\ 1lì,: r.i Nig.
lnth.nìcd Lr.r nr.,rì!e\rtl.Ì51riÌl litllotheìii.irÌ!mplo)nìr,rli.dLhc/irl/j.lÌre
re!L n!8e 5i..1 Ò11tÌrül hr\ iÌl.rr'i:.d n Llr. \h.Ìt NÌr rroÌìl ì I to r thfr!'iì.r l\!o n)ttrrl
oi_prcs\Lrir p(5hlfg nur4 rLrS.r rLr, Llrr hlÌ j. !Ìre!ìplitrìreni Ìrìr.ìnj i hi3h.rÌligt
settirÌr rc.1 ÌrlÂr a.rÌ tÌre !iepr!'. nL (rn Ìrcln\ rhat the rdllrl Ìerl rrlt hiL\ iill.n nc
renrli slll b. i lÍ, iN nr(Ììer ü!gr5 Í lilnÌ Lô.\fr.te(LÌìrirej nnl!tred bt rn iÌì.rrisr n
r

1!Ìt pri.(\.i lì.Drc tr).1acel !o.(ls,.lil \. t.)rrt)rld tri(e\..\tterihr ìÌrìtiaL d(lìrr.iiì11.f.

uÌe nomiLril c\drrn!e r ate rÉnrii.i lLr!'d !) tÌr.ú thcre ire Ìh tLrnlÌtr !lLìì!c\ irÌ inrfo, L

|ri..s \5...nsrltutrce. tlk'.ons(Ìr.r f i. j.dc\ ri\i\ l)! le\i ilün ÌlorÌeÌ trr1.\:r'nl
s,rS.5.in ând Ìr.ice conÌietiiirrncss lalÌs lhLstxttenÌjtlanÌiÌìrr:tlÌeironoÌrìti\rl,rL.
Llìc / /ll-, .M1 i.d. at r r hn\. s..f h.i.,.. lhit rÊ\ult\ nÌ | ttnÌr.ú.\ tiuLt,)t in1ÌiLtio.
(ilro\. rioÌld LnÌlahonr uÌÌtil thr i!'rÌÌ!i{.lrrt L\rÌrt!rlt\tÌt.lLìalt()thtrdse\l1li.{
ri rreg. hc Ìl\e iÌì lNnx'rfhLl!f Li rr.Ìl(ì i.tlatioÌr eit\ drr\ ai thr ìÌlltinL risr irì
.o.ìPcL 1i1.f!\s .ìtrÉ to UÌ( d. fr!'. r Ll.n rd.r.aÌuali(D iiÌrl tlìe icorÌ!Ì!\ rÌ\r r\ bir.N lo
Ìì.inr l lsc( is. l l. +ì
 135

r'r!!. -r.::5 i.r: r-r !i::t

Table11,1 '.1!ì1ir', ?rÌ j! r lEr i::,-!!ír. fÈ ìt?:

r: :l l

It i\ a g,!)d idrr n) rc! hnr rhe r.llunnrnt fr).er\ ìi Ì.pr.\rftli i. th.lib.LLr .ìfuì('t
.li.r!r!Ìn. lhir i5 5lro\rr Ln lìlg. 1i 5 rnd the \teÌri aìe nrr]nÌrìriZc.l i. Lihl. I Ì. Ì.
1\|\ doer the e.(Ìr.rì\ !.d ut ira(li at itt Ìnit lLr\rl !lrnìfl.!irc.1l \Io.ctaÌ\
jl)Ììc\ rri\e.1 outÌrú ÌrtQun. Lt caused a ÌQl drÌ)re.iiition oi thi f\.1ìi.Ar r.Lr rnd Ìxlí1ì
lct eÌtrtrtt rnd thrrrÌr)rÈ r!:Ìegìte (lelrtr 8utrÌÈrLdr]r'c.ilLÒn.11t\Ì.xlÌlagr\r.d
I e hu1 tlìrt thÉ Labour rìrrlrt i5 (Dl\ ìÌÌ ecLuiliÌrÌìrur irÌ ihL i.iÌ iÌ l.1rl oi r'ÌrÌrlovmrnr
Iìl hcÌr the Ìe.Ìl sasc ! Ìr r TÌrcrÉn!e r bur\t ot !loÌÌr!\ti. ÌiiÌgc iÌnd f,i.. lf lrtlt)f
riir.!r \lrrlLlintÌetio! r'iÌl dÌtrethee..n(ìm\ l)ecl t() it\ iÌlltin Posllio.el I \lofcLaÌr
J.lìc) hr\ (rrl\ r ìhoÌl ,trn iDtr.t oìr .utfut â.d enÌflotnìc|t n 1lì,' .P.. .....m1
ihereiial)rìÌ!toiÌÌrtlxrlt)fJbore\(!l!lirirno.xÌúrbo\ltlìr nl.Ll.n Li.{rL. lnth.
rÌen nÌednuìr !un rqullLhÌ rm. ntletn!Ì i5 (Ìrce xgain r.Lu.l 1D it5 jnit nÌ lü (Ì lhc tinì.
!rthi ot tììe r ealÌlase â.(1i.flaho. ìrr ihorr in lig Ì1ri.

I l.l Summing up
o o\ln! irn r\prrri(!Ìar\ Ìloxetrr\ ljoLi(\ orrle\iILi]L .ni.tL1f'!trttÌr'nìflotnrtnr
rÌpiÌÌd d!cto iIe elte.tt)itÌÌr ri\e Ìr (oÌÌÌpetitì\erÌei\ i..i1(\foni. urrL Llì]i l! ().Ì\ ì
:irÌ1por.r\ Èlte.t: \rtrr the dr\ aLLrrtjurÌ lÌrs it\ rlt{t Lìt riÌ5lfg Llrr rriÌ .os1 .I LÌìf.ÌLs.
,!Ì.r ü rBr\ rÌÍ1 ÌÌit\ Ìt\ton.i n) thi5, tÌÌrÌe silL Lre r bo!t oi !lonr.sLl. nrig. i..l trl..
ÌrihtilrÌìÌre\.r$oi\oÌÌdjDildtìon llÌelrigher inrÌationrll .!!''5r Ìh( Ìr.nsÌ 1..Ònì
|etiiirrxe\!dÌddìerutiÌrÌerlrrse\rndtÌrre.(rr!ìlriLlI!ÌfÌÌìÌoilsor{i.iÌllo5lli..
386

Figure11.6tn 5tìÊ'r! .r fÌr..i:.d r:ï'r riil' er'i'r'''n!'

"jÈ' 'l:t:rr'r;irr 'r

I 4 Supply-side policY
to!niÌlv5ts(lth\idtÌ)oLl.ie\.\!tlÌiìt'tolLr'u\1ÌrrilttÌrt'norÌthcl'lUcúÌ1e5!ÌrlÌ\
slcte poilcles art ttr.:Ác ttL:,l ihiir tlre lÂ{' cur c €ithrÌb\
shiÌiúÌ! thc rdiic scttìÌrg'tr
'
rÌl5 oÌÌr]:hLltiÌìglheprl.escttnÌtc(LÌ\e |\L'r I L'ChiPtrì!2rn{1 + tlìr ditenÌllnaÌìti

oìthcltrlr inclp,ictn'ltju:.ur\esr{ereúrtÌodu..'l l]cr' Ite rPtÌ\' th'1 di\c!s5ion nl

li is usetul to 5lPiÌrtt otrt tlìc ta.tof ürrt shLit tll!' 11 \ c(tn e ir!Jì tho\r lhât tlìill
th(
15 ,r cur\ c. \!e.an ìe..ll fÍÌì ahiPttÌ ltlìil1!lìrnlrtinLÌxì!'rLix.iÌ1Lolhe\(tpÌrl\
\1.1. oi lhe model, it is rÌc.ti5in to br .eÌetul in del!'iDS bÕth
thc nronel ('ast and Lhe
tÌk' rr:'ÌÌüigc nÌ'n'n (Ìì th' \'eúì'al a\1\ oi lhe
Ì)rj.c ÌÊ\Èl \\'e \ti.Ì to t rc p.jfcit]e thit
ìlS rS UrgLauL ls tle rcrl s,ìge ÌÈ1.\'ant to rege s'Lteri tri\ is tlìr Ìtdl 'o'\onÌpLlt)Ìr
,rngt cìeÊ.c(l asthc'trkc ÌrorÌìc rlrlr dtuat(l bYtlì' conmmcÌ Ì)'j'( i'de\:
Ì1 r i renrÌ.I i..onÌ! Lr\ nÌÌlì i..jnÌ 5..1trúl (rcil c(!rnrÌnttiorÌ 1!igei
"=4 .nnirtì. tIi.e ltdt\ nì.lu!ìiÌr!\ \l
I 4.1 Policies that shift the wage setting cuÍve
TÌìe r,ige tetllnj{ (!rtÊ \ÌÌo1!5 thc ÌtrÌt.rNc hoxìL i 'ÌS( iÌt cach Lr\ ot enÌplr)}nìrÌì L that
rv(ìrkrr;l)rLii'lc thev hrì e n.!oljiÌtc.Ì 1\dis'u\scdinllìatter2 1he$rg'scttirÌg'(ne
liesib.\'Êtlx..ÌrìpfLltireliÌhorrs!ÌTÌ\.ÌLnÈeithcÌì)e'a(tscoìthrtÌe\etÌcc'lunion\or
Ì)e(a(sc ot cil,cienqIr3e.orÌsiil.ratir!Ì\ ttercrìc\elo ÊmlnolÌìtlt
ÌÌagc 5etlrs 5eÌ
the mo.c,- Ìlage nr 5..1Ìre thi\ reiÌl ate.asunÌil]qthrteltecìhc!rl'elevcl(illpÍcfuil
o!.r llre c!urst ol th. Ìü-qc.onta.l.
Ì\

'lh.: raBr scLtürg.tNei5 thel.io el

iriÌgÈ settiÌì..r 'eal tagcl

71
 387

ìnl polic! tiÌrt afic.Ls lh. rlagc settnÌ3 clecj\Lon iriÌl rhL r thc r\-\.un.. tÌÍicie\ ds
.u$.d irì ClÌipter I Ln.ludc .hangcs irÌ ihe ÌLorlí:fs outsid. oÌrLi.n sÌrch as ctrange\ i.
utemÌrìotnÌexi benel L. ÌaÌrour Ìcgiíirtj(Ìr, (Ì thc Ìrcg!Ljelio. bl, lhe goÌ enìÌÌÌerÌt (Í !
Ìfag$ i..ord Íith unions ind Lr4Íot eA r$o.lârl.ns.
Thr 111|.!Ie rhilts (lor!Ìl
. iitherei5.ÌlalÌin unenrt Ìt)vnìent ben c l l ! (orÌìorr pÍr.isel) irÌthe Ìe|ÌecenrnÌ .ilto,
Ìr1Ìich i5thr ÌaÌlo benelitt rr) rhe avcÌagc n'lgcl.
r:rl

. jI on ions ire
iliÌ en ltss Ì.!altr.lLcljon or brcoÌne ilealier as unn)n dcnsil! or.or er,ì!e

. it unnÌì\ agrcc Lo crercise barsainìng ÌestÌri.( lnlÌrccontc\t,i.reranÌl)le.ola

I 4.2 Policies that shift the price-setting curue for a given r€ãl exchônge rate
\\ÈtunìnowLolÌr. poLicie5tlútthiltthelt.r .u^t lhcprl.csclllng.urreth(trL\the
outlorne tr)r Ì!âl ronnrnÌÌÍio! lragÉr olthc dc.!sìorì5 ol Lhc pr .c sfittr\ irÌ the econonr!.
l).ice \etler scL lhr ir pli(er iI oÌder to recurc th( .ìa.k út ir, gnrn 1lìc unit ]Jbour coÍi
ihatthev trìc.. \\r s.r\r irr the rlosed economl thaL th.fri.c-rr:tLing.rL,cr'iLlíÌi1Ìupit

, rcdu.l on iÌì the trì irtdgc

. rechì(tion in lhc ,ÌÌarl !t), duÉ, íir 4aÌnÌrÌe. ro r.hange nr .!nrferjrirl,.ofdllio.s
. tiÌl ìJr tlÌe Ìeal lIteresr Ìat.:
':,r L|!. \u|tll. . i\eÌncllì.ic..v.su.hisichd selÌthelÈrelorthctÌe.dolÌabouÌÌrÌodtr.lnil!
SÌ(^Ìdr\olclhittlÌi\i\lileltnrbeirÌcoÌrÌrLcLÌc\entrìaÌÌ\'i.n)ÌloÌÌiÁbcli.:is ln
\vhi.h crí', Llìc ll J .!r\ e niLl slìilt !\ Íell l\Èe the.li5cu$i{!r iI llhatter ll.
ln LhcopcnÊconom\,rÌre15, cureìri ÌsÌLp shorrlng Lhxl rcal Lakc Ìrooìi.r'aÂrr
lf tlìc c.oo.!n] .(nrsi\lert Í,jtÌr fÌice retri.g b(hariotrr arr hlgh.Ì in Ìcsponn lo .nl
.I thcsc clì,]nsr\. r!e dlÍ) Ììr.i! that i. thc.fcn c..f.m!. lhr lÌic. Í:lt ng.tLn c sÌriils
ns iì .ou:cquent oi chan:r$ in thr rcaÌ cx.h.ngr Íalr Si.rc th! / /lU l:rLr!. ls dr.Ì\rrÌ irÌ
rciÌcÍ.ÌarÌle tute ouLÌrut \ta.r, aìrÌrotrglì i ching( ln rsÌri rsLhcfrcrsritiÌU.ur\e.
il Lloc! n!i íÌi1Ì tlÌe tlL; .uÌvc. 11 Lh! tricc.5L lt nt .(r^ c nriils lor d,l1, ,rrÍ r.n\!r. thìs
inrl)li(s a íritt irr the l:IìLI cur i
I ookidgi]i edclÌolth€5c Irctorr j. rum, n1lìcopcÌìc.o.ooìl,.hangcsrrth.presnìreol
fnrdu.l .ÌnÍletfoDÌÌ)etjtL.n c$ rri\c ir'.rn tadcLibcrilTiLlof po cìrs.,\ good e\rnrplÈ
Ìor I uroDcarÌ r.!ntÌir\ ir rle redtrcrio. ol târ li birrlc15 1o lradc bcli,ccn rÌÌenlbeA ot ihr
LuÌot.a. l..oÌìomi( (:omnìunit\,lrhjclr bcga,ì ir1 1957jriLhLh( rcal! ol Ronìe. lhi\
wÁ ldÌosrf d in tlìe Laie l 98r^ rvúh rn Ìn LixLlvf nr rüìorc no. lir lt barrirÌs to tràd." n)
a\ to in.rcasc pr.{luct mâÌÌitr coÌnpctirio. ln thr irÌtcL.al .ìrrk{1 oi thc L!ropedÌ L!nÌÌ.
Th.n i5 5.)ox, eridence ro strggcsr tÌret nronopoLr plrrr has tallcn i tlÌe lU n)LÌor!ìÌrg
Lhclo-cell(d'199lSingÌc\,ÍrÌkrrm.âsrÌ$.r.\ÌÌijÌcreaÍinprnl!ctÌìarletcon4)ettnÌì
lsìLÌrl_Ínotlnl!nìthiftrhcr,\.uÌ\'crLlnr.ftsbrt.l\orlÌiltthrLrS(ureclollrn!eÌd\.

' r.. r'".".,1,. lrrn LtÍi,ÌÈL .ddiÒLri: l:,erl

388

\,Íore tre$ure iÌì the p rod rcl Ìì a rkct h as the eltect of clampenÌÌt unnÌì bargaining po c I
L

Ho e!eÌ, siÌÌce both ol lhcsc cllccLs (an upwa nriiìiÌr thersirr cuÌ!e and a downNad
slìilt in the lts curvc) shilt Lhc rlLI crtrve in uÌe sane cliiectlon, we siÌnplifv herc Ìr\
consì.lerirÌgcolÌìpeljlion cllccLs undeÌ'price settlÌì8' onlt.
The anaÌv\is ol taìcs ls lcry sjnrllaÌ t{) that iÌì the cl6ed eco onìt. lhe onÌ,v i'Ìlri
consideration is thc tax úcaLnìcnl oíexports rnd im})ús ìi\poús are erenÌpt fronì valu.
ad.Ìe.l tax. The logi. oI this arangement 1s that indirect trxes s1Ìoukl b€ tlcnìJìallot
LraÍ:d' in o er that cross-counlÌv difíeÌÊnces iÌÌ tal rates do rÌot di\tort conÌpetitiorì lf
thc domestic DÌarket tor nnaì goods. ThÌs pÌüÌciPÌe means that iÌnports rttract thc vA L

rate otthe ìnÌporting coLrnlr_Í. ln lhe.Ìerivrtion ol the púce setting real !!iìse that is sct
our in dctall irr the appcndix 1o thls chrpter, tlÌe\e lactors are talien irÌto â.co!rÌ1.
'lhc impact ol â changc in productnìt-v (or iÌì the .ate ol productirity grorlh i. r
dvnimiccontext)oncqrriìbriúrìcmplo]nÌerÌidepen.l\orÌitselfect\ontlìewagc5ctting
a nd p rice settirg curvcs. II rt abs trãcl fÌ om prod! ctivity gÌoÌlth, arÌd e miocthcinìpact

olapoljcvthatrai\esthcÌcv(lotproLluctivit,v,thenÌostolr!iousetÌectistosÌìiltth(pri.e
sctllng Ìeaì irage upward.r NJorc ouÌput ter lÌead is avaiLable lor.eal Ììages al ca.h Ìcl'tÌ
of cmpìotnrent. Ld!citlon and lralnlng toÌìcie! ray have the eltèct of r.ising clficic n.t .
tJvrc.aìÌìngthe dern'ati,rÌì of thc IIiLI cuÌve (Chapter 10, \ectiotr l), itis.lcar that ân\
poli.v h i t nr ift\ the *'.ge setting cu Ì!c o Ì thilt\ ure l'.t il]I clìrve iÌnplies a \lÌift irÌ thc tli L:
t

currc. A downwaú shilt in thc L1J cunc lmPÌies r.l.ÌijPd,trrr a rightrïard slÌiit Ì'r lhe
lÀ0 .Lú\... An upiv.rrd slìlit in thc A{rl cu^ e imÌrlies.?lui5 pd, ibÌó a riilht$Iard drlll it
thc /rìU cu^e. Ure takc an cxamplc ota ÍìplrÌ-v licle polic), that shilt\ the lVJ.ulvc atd
aÌrolhcÌ that \hilts thc /'Jlr)1.r^.c.

1 4.3 Example:wage accord

h Iig. I 1.7, the Ì1.! culvc shitls doNr. This could be tì)ì aDv oithe reaínL liÍed above.ln
this cxaìÌpìe, we âssunrc lhal il shills bccause olthe negotiation ofa wage\ accord by thc
golernmert. lhe concl(!sion ol ân agreement through whìch unions rgree to €lercisc
baÌgainirÌB restrainl ìmplict a rightwad shilì ir the E,RLr cuNe, as erplaired above.
Uihat aÌe the impÌlcallo.s tor lhc ccononr)? Consìder an ìnitiaÌ positi()n of niedi!
Ìun e.ÌuilibÌiunÌ. Ìhcn shÌIÌ rhc lv)_ cuNe doivn. Tìrjt Ìellects the fact that at the exi\tiÌìg
empk)yment l€vel, wage sc t Lc rs i!'iÌl se Ì a ìorleÌ nominaÌ i{âge t() secuÌe th e ÌrNer eapected
ÌeaÌÌrai{e. At:ìn unchângcd ìcvclol lhr rcaÌexchrngerate íi.e. en unchaDge.lÌeal costol
lmpoús) and !!ith i glvcÌr prol_rt Ììargin, thìi i pììe\ that Ì(x{eÌ uD.nrpìoyìnent will be
compatibÌe \rith mcdiLrm-rLrn cqLliììbrium. At ìoweÌ uDcmpìovmcnL lhc ivage clainrr ot
rlage \etteL Ì{ilL be booslcd sullìcic.tì}'so as to Ìetr(i rc .qúalilt bc tnccn the pÌice seitìng
Ìeal Ìvase ei\en, and r,) and (hc wagc settúrg Ìeal aâ9.. Thc shift ìn thc age settìng
cuNelìomÌ15tot15'ìmpli$asÌìillinlhcÃ,(LIcuNctoflU'(sccfig.Ì1.7).Todcrivethe
nei! lÀU cus e ko'Ì the h,')_1/5 diagranr, note tbât al poinl.4 srllh /l = ,o IVJ = I5l40l
at arÌ eÌÌrploJ,rÌìenl Ìclcl .)l Ã0 'lhls ìs ÌcÍle.ted 1n a polnl on tlìtr ot i/o dol lvc can also

r ÌIghrr tr.ar.inii) nÌàt rln)hrvetl,rÈateú.ln!Il,n!il)er1i!ÈièìtÍÌgLnnruÌ,rtrrd\ nÌBhiLh.ór.

i r.r. Ìr,trÌld Ì,. f. ÈflÈ.t .n equülÌr.r unemDÌo_rnent. TÌrn.eni,nlt seenn a \erJibLê aÍumtL,.n I.Ì tÌre
kfr! nnÌ LÌr ilrr nrÌi to mÉd(ú n r, ÌìúfeleÌ. Ìm!. rlrlm5,ürnot adlun raÌìirÌÌ! Lr urr\pe.r.d nrilt5 nr
 FiguÌe 11.7 suppl! sdÊ pÒ .1., 1155rfÌ5.!w.
5tep 1 De:v.1h. i.,r aÃU.unê 5t.p 2
iÍ.n r. rdl'ríÌneni 1ó tle nÊN m.l !rr run

iee thal lt5r = Õiuo) .ìt erÌìplo)'nìcnl ìcvcl Ãr,1.e. at poìnt r'. This is r€llcrlcd 1n I poilÍ

\othiüghappenJÌÌthe slÌort rur bccau!Êrvages.nd priccsaÌcajmÍxd lobegiverÌ lhr

neN rncdiLrnr Ìun equiLibriLm for lhc c.onomr. is ât pojnl I wìth lo!€r LtncmPÌovÌüent
and highff fÌi.e conÌpetitivencss. lhc ccononÌy adjusls gÌadualh iroÌì Á to A in t|c
nìÌo,riÌìgwa,v: at I ítio\lirÌsthc slìjtl ln the WS (urrc,lhc cxjÍiniire.ÌÍ'age. ìto,ls.bovc
the new ÍIaÍic-scitlrg real wage on th€ rvJ cune.\loncl('agÓlatl,homepìicesl.1lin
Ìine but bc.a6e nothnÌs lÌâs happcrcd to the priccs ol jnrportecì iloods, the colÌsumcr
tìiceiÌÌdexÍnÌlsbylerstlÌrrÌdorsih(pric.ofhoÌÌì€orrl!rrtHence,thcrcalwa8efallsnnd
because donrcslìc price\ tra!e fallcn rclath'e to worÌd lri.cs. fÌice conìFtitìlerÌess riscs
The rise in , boost\ net erpoÍ dcmand and the €co.om-v nues alo.g the,1l cul'c in
a noúh eas ffì)'' .1ìÌectnÌì l.orn]1 1oÍ'ard B.In th€ top pand oíIiS l l.;, the ljinl.uNc
t

nlifts down ai rl ìì\esi the ecoÌÌom,v motcs l!Ì)nÌi to A. \Vc obsen e l.lljng realwagls and
ÌisiÌÌB ernpÌo) ment iÌi tÌì
Thereis i trade suÌÌnurâtth.. neN cqLLiììbÌ jum.
The iÌnplj.âtion ol the clo\!Ììhlid shill jn the l,v.! .uNc ftrr tìre LoÌÌg run 1\ tlÌât thc
ecoxorÌì-v-\ long nur e!ullilJrium is at ìoi,eÌ ünenÌplo)'mcnl and a highcr Ìe1eÌ of prlcc
corÌ4ì€titlrc.ts (see toirÌ Z iÌÌ liig. I I.71. The rdjuslmc.t ol lntlatìon an.l Ìeül Nigcs
oveÌ tiÌrc 1(] the ner! ÌÌÌel:lium flrn cquiÌlbriunr is slÌohn it Iì9 118

policy-cut in income tax

1.4.4 Exâmple:supply'sìde fiscãl
Whar ìs tìre coÌìseqlu.c oi a mptlv sìde poli.v thaL shift\ the lÂU cuÌve through ils
eIIccLt on the fS(úì .Lrrvc? L. ìrì9. I 1.9, thel?ir .Llrve th1ftj tu the right as a co!Ìsequc.cc
of aIaìì in tar Ìat€s. lo slÌo$,lhis, bcgin atÌroiÌìt,4 in cach taÌreÌ. LÌtlÌc llTsii]rJ r:li, gra Ìì,
.rt thc i.itlaÌ equilibriLun, to'c arc on Lhe rl(t, . ir). Lhis ú ÌeUected Ìrì the pojtÌt lrÌ írol
()n rhc ÃRLi cur!e. Nctr\' thcrc is a iaÌl 1n the trx rnlc Lo tr. Thí h:ìs thc ctfect oi shiftÌ'rs
 ..:::. :.
390 .:j: :::: j: ::

lo lÌ I, Ì nrc

Figure !1.8 AdlutmeìÌ ÓÍreils:qes -rd nÍlat'r

t!

al
./ Ìd !r mE.
Figlre 11.9 s rfP, 5n. to
lsÌrts Ì.! rÌ:p lDsr.!rÍi n'" / ÂLiLÚÂ'
5t.F 2 Eram ne adlu5tÍrent to thÈ nlvr
m.dilm run eqlL br!Ín ai,IJ

the i).s(É).ur\.e LÌp to ls(r. tÌ),whi.hnúerscctsthcWsculvcatpoint4'TlÌisisìntÌ'íl

$hich denìÌes lhe n€a Ã'RU' cuÍve (Point Á')
retlcctecìin the poirrl ilr' ü01

ho ertofocrìscntireÌl(uthesuPpÌysldeìnÌpÌlcati(!Ì\ollhetâxlâll'rveassumethat
.]
tb c i Ìnpact o n asgrcgate dcmand oí Lh e tâx cut is fúll,v off\et bl
an aPproPÌiate dccÌease iÌl
goveÌnÌÌÌent tÌrendinS. Hcnce, thc Áll culve re ainr Êred The new nredíìm-rLÌn equi_
ìiUrium rs aL pourt n wittì ìower uncÌnplovÌneÌìt ân'1 higher PÌice iompetitivcnes
lhc
nca long flrn ecì!iÌjbÌnün ìs atponrlZatloweÌ!ncmployÌ]ì'rìt ÌnthencwnÌ€dlum n

equìlibrnrm, re:ìl prc1its ate rurclÌanged b{L both ÉâÌ ivtìilcs an'l real ìnÌ)ort arc
'osts
lÌighcÌ reaÌ La\es pctirorkeÌ are loh'er'
 t9Í

thr c.oDonÌ\ .dlüsú Lo thc nrji ,Ìr.di!nÌ nrrÌ rqui!iLrilìnÌ !\ h)Llosr. lÌÌe ec(rrom)
bc.sirú at foìÌri.1 on th! l\ ri li .rLr11. lhr .ut ìÌr t.r\ iLtes te.il ìÌ[o!Ìe ta\) ìei\es the
(ì l .orìs u ÌÌrptjilr rìge. This ls slìorÌì Ìr! poin1.1 rÌrtheire$15r, rÌr(uNe.NotethaÌ
nolh r! lÌìj lÌa|ÌrcÌred Lr) 1ììr rcel (Ì.hir{c r.1e the u})rad \hilt iÌr tlìe ljirt .rnre i\
rnllr!'h dle í) the (Lú i. Lh. taì.ilc Lhrr..lüailei\rboÌÈthrrlse\eftnìgÌeeÌÍxgÈ
.ompalt 1r'sith.lrxndlh!.c.o.onr1 isl)rirn uìeIÂ1, ene.UireuureerÌ,ectedt!.e
lÒcl, ihi\ Lrad\ tL) a all ln nì.,rx'\ s.r.r.s \hel r,ri{et rt rÌe\t \rt. Lo$er moner srrgr\
.rd!.r! !rÌjt ]ll)ouÌ !o\ls ifd Êr fìs ÌoNcr lhcir prì(ei nÌ liÌìe. 11Ìere ìs nn clÌarÌEe nÌ imfoÌt
.1rst\ \o the.(DnnÌrÌ trlrr r.rr I al sbt ks\tlÌantÌÌrI)ri(otlÌoÌne-!ooli. llenleÌeal
\!aSr\ bc!jrÌ io teÌÌ.IrriG,.o.ìpct 1l!c.cjs ri\r\. llÌe e(oDonÌr nì,rrr\ rlürS the Ì)rtÌÌ tÌoÌÌÌ
.1'toloiÌÌtuilthrÌrT lÌtdìarrim;endiírnìpoint,ltop!j.t/) ÌrtlÌ.i,r liai.ti!!
llÌe rìre\tri+ iÌom thi\ c\rnìplc l! Llr it Lir.hirit€i.arì bc fscd is a suppL! ri.l€meâÌre
\loreorer. r'hen tht\ in i.tíriu..d i.l. LÌrc r.r!Ì! [ ioÌ ot lcr rc,]sirìs. ihr irnpLì(t orl
the nrpph \ide nr.trld bc Lik( n nL.i...rLnt

2 Aggregate demand shocks

15hìiÌinalÌt!nonr.rLs.ÒnsÌrn4ìti,ÌroÍirnrstm|nlor.ì.hanilc nLhcltorLd nLr.rcjl rnt.
Lìr iI rlrrL.ìtÌa(ì. l{(Ìs lÒ i slÌiJl ol Lhc ,i/) .!^r. ln tlìi5 s..ri.n, r!.l..li âL !u.h frÍ.
\hjtt\ in thÈ.1D.(Ln ( ' ( lÌarÌtr\ nì rload L .dr ìLÍr llÌiit thc r/ ).rdl.. bút tlrL:r shi I Lh.
Ãr cur c r\ rrcll rnd su.h ertÈÍril tÍid. sho.ki rre .nillsr(] h.Ì.r!. ln th,. i.âl) sii o
rrÍaìtrnL.\ \t!hiÌ!. lookinjrÌÍìncd.tijllthoÌLtlìec.orìonr..idlúsL!Lnlhc\hoÌt rn(1
ÌìctÌitrnr rrnL.asÌriii rilÌ(,11)cuoL.Ltìsfúnfce\srrtl.r(lfitLhrlrfaÌ\\lih!Ìc.\\'c
.a. !unnìe, i7{. Lh( (.\!lis r\ iollcir s. !\ c !si tlì(.rrxÌpl!'ote n.satn c rggrcgrtr dclrrnd
nrl).]i, 1... a iiÌl lf iìrLron.!ÌL\rs.oÌìsunìpl on or ln! isrnìfnL t:rc lìlg. I L la) r.
Ìlfd.Ì lll,!ir1..1,lr,r'r+,r /r(J. a nc{itir( iSg(!.tr dcrìn.d nr(! k
'Ler!L\iÌìtheilì.ilrìrinrrn.x.ÌrrngeLúedrtrtrjxtjon.(\rtLrÌúsi.rÌs!n.lìrLÌ!.dinirc
nÌoú ÌÌÌtoìÌriDr Tb!\ haf|r.\ lreciu5e thÉ ctl..t (Ìr outÌÌìt ÒttlÌÊ i.ll i..q!r.!it
ftni'rcL\ (onÌrLrtÉLr ,)l !.t b\ rhr deÌrre(iaÌioÌr ifLÌuce.lÌr tlÌe l.rll irÌ thr irÌtcrett fut(.
.ll..iüi.lh.dcfr(.lilj.)x!ut\reiLüi!rs.lri!i\t!lloÌrcdÌr!itlri{LnÌrhL.h
.lomL\1i. in I iì tlon is hishrr tlÌirn \rorl.l inllili.trr. ÍlÌirl rror.f!.omt.iLtl!cn.\s â.d
llids L. a ili ì o!iput lilÌr eLdlrÌÌ\ nÌ.t.i to poirÌtlJr.
LÌrÌlkr /'r(/tarlrrr.f I ncgâlirc .ìggÌcgrl. (1. Ìrnd tho.Ì,
'dr.J
. l.iLÌ! in Lhi jl.rl futprt poirÌt ( r.
rÌrì1nr.r lúl nr

'11ÌehlliÌrout|utiriìllorr(1b\.ìthrrrL.(ÌrL.hdomrrti.i.tÌati(Ìri\belorÌ!(ìrLd
irúlrt1(rÌ ithe e.o.oÌni nì.r.s L. |o nt rll.

|l(1Li|\rjll\llì'ìl]lL;..i.hi:::.LiLì:l!l

r riri.l i r : ri : nr lr n.hr.ürììti rÍ r i.Ì. nr!:.r.n LhiL i rLLr Llr. il,I rrn Ìi ì

392

Figure 11.!0 \lÊt.i . :!r!Í?!.:rÊ dÈri:_d:r..

l'Ì llexitjk ,rfd h\rd .l.hdISe ril$. Lhe rÌtÌL .rLllium !ÌetlullibÌLuÌn1\t]Ì.
er lìoLh
srDt iÜ). oüLtut rni .nrllo\ mrit xrt loü eÌ. frl.f co!ÌpcLlLn cne\\ is lìillÌcr and tht rtal
rrigrii Ìtr\cr. rf{lthen'is rr iÌÌrPftr\emtntif h.rr:(1.bilin.Ì'IÌríÌrti{Ìììsrnf\lantai
I theÌr is nn Ì]()Li. i.tDtio. lhen tlìe ir.ffri! lri!l r(Ìlatt hbt to lhc \h'rt NrÌ
tc! i
lquiÌibliLlrì!lLhrrei\\1iÌl.op.ili.lintererÌtjon.thenot.rL Ììr.Ìhet(orÌ.Ìì!tlilìnÍ\c
Lt)therÌ!1rnì(ìÌu!nrf.quiÌibrl1mThtq!.:Llonthaiarin'slsh.rtÌÌe:.itcr'mentc'ìn
rct}Ìtr] 1. a sh!!l oi lhl\ tn .
hLthr riÌ)Í,,iecoÌìonr\ thelo.rL!otattenti.n n lÌreriNcoir. el!.rtgirtl dcnrrn(ìrftnl
Ìr tÌÌe !fcrLÌ rith $ |l.lr lht rul()ÌnatI n]t.ììn.i\nr\ nill !tLdì LhÊ e(.rì!rìì! bi'li n) tlÌr
uni!t!r cqrrllil)rirìnÌ rLnrnrfÌi)\'Ìrcnt rate. hÌ thc r\ erú ni iì n!SrLtr e !lenÌand slr.!l!, tÌÌÊ 3 Dor
!o\ rn!uL I L ma\ iÌrir r.ne ü iih rÌta.tir!Ì.ìry ils.el toli{ or iL ma\ Ì(tLen nro'ctrÌ\
t(nict Lrl .ultÌng tlll nLcrett irlc s' ar n) \prrd trlì the Í1rLm oi tht eclnonrl L' tÌìt
e!Ì!iÌibrirLm trnrnÌph\ nrtnt r.rtr. fhe !!tloÌrl. nr, inr.r \ ..lio. is lo milllìizr th' "\ti
x\!{nt.Ll lrjlh urÌ(rìPlt)vnìenl rh.\ r tÌrt cq!iÌ hliunì rilr 5l.r rLÌlu\iÌÌÌent ,ìn(l there
n)re hish..stt I o!ld occur !t tlr. dor d\ rrrL.rd,rL!t.rtrÌt oi rreg{i rnd triLe\ i\ ri I nos
This rr.LLld hr e\.ì.( lLed i1. .r e\in4)Le, tlì(n'i! r Írnl nL.rctr rett relporìsr lo the
risrìf Ìcrl tì(ÌÌe\ brhn.tt or ii Lhe ÌttÌtrÌls..r n\È\nìr' Ôrlrl iÌì tlrr lrrtL'''sL raie
\it!nLl.n j\ (ììtlerüìt b..inìte.ìn,rSgr!'giLcLltm!Ììd rlÌo.kl.i(lt
ÌÌr th. Ì)luÌ r(on1rnrt.lhe
n) i n.1r mÊdirün ÍrLn .oÌritrÌrl Lnlletnlr equl ibrium. lÌrnlrmbcr that jÌì tÌÌe !p.n !1rJ
rÌoÌì!, Lhr unnÌrr rquillbÌnun rLnrÌnflo\ nl{Ìl ÌnL.: hr\ t)tüì r.!ìli..d hl thedorÌr\iii'l
noÌri.g IlLr c!r c. lôlloüiÌ!nshiftiÌrtlìe.11.'tÌ\t,tÌÌte.o.onì\.4.ÌetìdìrÌripolfl
lJlnthccise()ii,n.grli\eclcJ|i.d\ho(!i1sccÌh.ltJtÌÌrn.l Di i':.Ìl.larl There.Íft
iuLôÌìetic n)r.È: i. lhe nred um ur ÌelliÌrg 1o i \hitÌ br.k lt) th. LnLLjrÌ tquìLibrjuÌì
' h.: !o\enÌÌÌrrnl Ììr) be rclu.Lrirt tt) \lìt i.r Lh! t.\iLil. i.ìPi.t oi lrealth elle|.ls .n
..nsüDtti(Ìr t. kl.li jn iÌ! 1ì. Ìr!ÌL rÌn iìnd .u\h tlÌe !.oronìt brúl nì lhe LrÌì! nt.
cquiÌLÌrrlu!ì or lor tht aittreliÌL! LltÌnrnl nìl].k Lt) lrt r(Ìrrsrd in n.olhcr rì\ ' lÌr thc
Ìr.r.hnre, thr r.onoÌn\ !iicr\ thc cort\ 01 o1(Ì (u4rut iLfd higho !.enÌrLolnì..1
\!. .xaÌÌÌnre tlÌc ofli(Ììt a\ nllnbÌc t(Ì tÌÌt 80\ Ünnrcnt. Loolll]3 lìr'5t eL 1]\raL and tlÌc. eL
 : ::: .: 393

Ìf govcrnnÌenr can identity the shock is aD aggÌcgite demând ítuck and can rea.t
LlÌe
to it in the short mn, Lhetr the obvious poÌjcl tüt ro usc i\ an otftcrtirrg ns.al poÌicy lo
l;,,. D 1,.-1,,1.-., ,-t \.t,1\r, r.r \, .. ,i . ,,,, . .. p . ,/ .r J., n,. t
erchânile rarcs anct toift r urdcr tlexitrÌe riìter. Ìk'Ìcvcr, dreÌe âre problcms thar ariso
wjth usirÌg nscnl poìicÍ to offseL slÌoct\ ir lhis way. In lhe case oI a negarirc shocl(, thc
Sovernnìent ncrds to (,se erprnsìonâr) nscal policv. we havc scen in .hapteÌ 6, ü
ihe governmcnt aLread\'lìas a high debr to CDt Ìatio, ^s it nìav be rcluctaDr ro imptemcnt
a .Leil.it Êna.ced incÌcirse ir golcrnnìenL sÌren.llng ro ofÀet a .cgati\,." sÌrocli. CuttiDg
taxes lo .Jfr.sct a ieDrpor.rf negâLilc íÌock aÌso incÌeâscs the bu.lgc{ de1ìcìt. ìn iìddirion,
it may be cìiUlcult to (verse ihe folicy whcn rlÌe sÌr.)ck has disappearrd. The third oprlon
ol a biìl:nced buclget crpanrior, i.€. ün i.crrase ìÌr goicrÌnne.t cxpendituÌc mâtche.]
l)v higher taìation, js attrâ.tìve bc.âuse ir doe\ not incrcn\e the governmenl,s de1ìcìt.
But as we ha\.c seer, a change in direct oÌ jìdirect taxaLioÌÌ is tìÌieì), to have supplv sj.te
eÍlccts: a Ìisc ìr tarattorÌ wouìd tcnd to !hiIÌ the E,tU cun.c to rhe Ìelt. lhis ma_Í mdke the
gorcrrnnerl carti(trì5 Ìn uJing change\ iD tãÍ€s í) \tabiliTc the econom!.
r,\l-,s..r ', Jp,.\t., n,r.r,\ -t,,
t,.,.. o.,. r.-!-t .. r.,,j.t...t,
wc see thaL a looseninB ot monctarl polici (or a .tevalLrirtiorÌ ìn â frc.l exchangc rute
cconomy) cin Ìaite the le\eì oI actilitv to /r: thìs wouìd mean a mole tÌom poiÌÍ,
to poüÌt D Gee lig. 11.10). IÌrint1) is rol a nredium-nuÌ equìÌibÌirrrÌì, horrcvcr, rn.l
cvcntrraÌlv Lhc €coDorÌÌ! wìÌÌ ÌetunÌ to |oinl li a\ a corscquence of.lomeÍic rlagc anci
frjcc settìng rrspo. scs.

3 Domestic supply shocks

I alnples of domesti. sLrtÌtysho.ks âre changc\ nÌunìon b.hiviour, cha.g(.s j pÍ).lu.L
nÌarket .o rÌÌpetiti o n, t1ìe emergcn.e ol cooÌdüÌâtecìwage sclrins behayiour, orâ changc
iÌì'etïcie..!', {ch as. cha.ge i. (he tren.l otprort ctìviryg(Nth.Theanalysisi\exacrì_r
th€ sanre as tlÌe analvsis olrìrc inìplr,nìerteLjorÌ ota nÌÌty sjdc policl. .Ìiscu ssed eaÌÌ1cr.
r\ domcsli. mppÌy slde shock sÌrilts the {âgc or púce retLjng.un,e an.l lhcrefo.e nìi ls
thelÃLIcur!e.
'1o takc an e\amÌrlc, Ì!e arsúrÌc thai a $,âgcs accor.l coììalscs unexpeclcdiy. Ihis isan
e\anÌtc of a domcstìccos hock. lhe coìÌapsc otthe accord tn4Íies a ìetLi{aid nrjft ìn Lh€
lÂU cuNc. l]Ìe ne$' me(ììum-nLn equilibriLrü tìr tÌÌe econon\ js at hisher ruremDlov
r p ' ..' ' lor . , , r,.I i ,ii r.r .I.I
nomv adiLlst\ tra.lually to thc nc(r nìecìium-rorÌ equiÌibrj Ìrì thÍmgh ã burÍ otdomcsti(
wise and price inrlalion. It is thc lalling competjriten.ss that weakens net erpoÍs and
depre$es o(tput. Thcre is a tradc deÊcit at rh€ nerv rÌe.ljuJ]ì ruì equiÌtbrjLlÌlì. Thc ccon
,.. 1 t,. /.i' r. it
It i\ clcaÍ that onh â Írppìv-side impÌov€ÌÌÌert cân oifset dre eltc.ts ot thjs sìÌoct:
a íÌitÌ bacli of the i,{U currc, lhrough poì .j.Ès that eiLÌrcr shitt tìre rÌaAe settinjÌ cur\re
'jr,rt L.u\i t .-: -,.,.t l I I,
saÍ ír rc'cst.blìih th€ mediuft ancl Ì{)ng run eqlriljbrja at theìÌ ini al leveÌs. t.hc use
ol lì\.aÌ oÌ nÌonetaÌl/e-\changc r.te poìicÍ Lrnder rhcsc circumían.cs .an pÌovtde oÌìlr
394

FiquÍe 11.1í i r. fÊí ( a, iF i. rl.5F..l

l frúi.rl or tüÌÌpoÍaIr 5|]Ìulion lìor e\rnìtle, u\iÌrS crÌ)rn\ionJr] tìlcal |()lic\ t{) Ì)oo\t
rlÌe le\ eL oi nÌc.t jroLrld woLen rhe tnìdr cLrlì.ìt ifoìÌri ( r. Ì-inrs a Ìela\atìoÌl
en4ìLot
ot ÌlorÌet,ìr) loii.l or r dcÍlrrilLon nould Ìracl ìÌì the \hot Nn tu a tn!)\t nr eìnpÌo)
ment aDd an iÌÌrpror rnì!.rì 1 ir lh. tÌxde .ìeJicLt. 5uÌrtot tlì.'t the r\chaÌìge rate depÌr
ci!tilrÌile\ tìlLritjcìÌ r(nr,r!'d Lh. i.jtial Ìe\el ot olÌtÌrut d rerL e\!hanse rate (i.r ìt)
Ìr)iÌÌtll. llÌi\ p(r i.ks i 5oluL .n lo thr drlnettjc rL\t dr{l b!t it Í onh fumtorarv. The
depk(iàtion.ul\ ilÌc r cilrrns. a.d Ìrd\ r\ thc ec().oÌ!! ,l,rr. uÌc rÌen IÃ{-i cuÌ\ e. Ilent,
irÌ sub\rq!rn1 ro!.d5 oIrligc !tltint, Dì(Ìrc\ $atet sllL risc drtì\c n) r\tr(ted trlce\
iLnd i {rndrLiÌtÌo..r.Irft)slo. oithe irnÌ)rct on corrpetitn rnr\\ ol tirr le\ dlL'ation Ì!iÌÌ
..ni. Ir..r ,Ì hi.k rÕ ts.

4 External trade and supply shocks

4l External trade shocks

\n cÌL.rnrl tÌrd{ !Ìì..]i j! (ii:lrnLd r\ drÌ LÌnaìrticÌÌrÌted \hiit iÌr lhe lIl.trr'r rrÍl Lhc lJ /
.ur!.. Lor a !Ì1r.. lc\.ì t)I lhc Ìt^Ì erchrrge Ìxtc, the r.ÌLÌnìe ot.cl.\Ìr.115.h.ngrs
Thcfu arc tÌrÌ.. nìif tr,rso.r 1rh\ dìii !aÌr hrÌrten.

riilÌreÌeyÉÌotÍorÌcltracLenÌat.1ì.n3(. lhi\1\!(jÌ!ÌìireirÌt.lÌr15crrl(ÌrÌlí,IÌÕnìi
Ìr!úxr or! shnnp ilr ìÌÌÌtbrta tksir!ÌrltheÍ')rld.
lzl IoÌ a gjrcn lerÈÌ ol rÌÌd trade drd at a gi\en ÌeeÌ e\chrngc riÌc ind lcrrl ol
home outÌrut, the home colurtr) \ \lÌare ot $r)rld hede mar .hrnq. lhi5i5i.lì,rnÊ.
nr. shich reilect\ the home rornir\ \ \hareoi itoÌÌ.ìÊ\pof\ nr thc.ìtorL rLÌÌ.tiür, or
a !lÌarÌ!e nr the nürgnÌrl pnrÌ)erÌ\itt t! iÌÌÌtrrú. r, . ìn the iup(rt tLLn.Llon ìhii .o!ld
tie becruse (ú a (hanije in tarte\ iÌÌ uÌe noÌ Ìd e.rnoD\. (-(rrumrò nrrr tìlii thri. frel

ur!\rÌ)Í{lLrcedeÌreÌlheìe.lndúüni.Ìrolthee..nomìctoir\i.gÌc.rrÌ(n.).kr,tlÌe
e\rnr|Ìe ìt oiten Siren ot a t$o corinir\ ÌloÌLLìú \hich tartÉr chânlc nlarour!ldÌe Figüre 11.12
 :': ':: ' 395

prodtr.Ls ol onc ot the countrjes. FoÌ exârÌÌpLe, pr€lercrÌccs shift tunì beer to \!ine, ben'
.lìting ììÌeDch net exports to the detriiÌent ol CernÌa. net expoÌt\. This i\ .ÌÌ exanpÌc
olan externaìtra.]e shoct. Another eraiÌìple is líher€ thcte ìs a change iÌì tlÌe non prìcc
erúibut.s of the frcducrs ol one couütrv. Ior erampÌc, suppose that rt r gi!en pric€,
the qualiit oI Czech made cab su.lderÌÌy iÌìcÌeases. lhis Ì.presents a positive exterrÌaÌ
hade thock íoÌ thÊ Czcch Republic and .ì negati!e shock IoÌ its conÌpetitors irÌ the iuto
indusLrv.
(-lllhcworldpriccolike,vìrÌÌroÌtedÌairnraterialrn.y.hangc.ThisíachangeitÌthe
t€xÌìs oftrade at the Ì{,,rrld levclbclrleen manulactue\ and raÍ'ÌìalerÌaìs, where r (t!u)
l,'m,11,;nÌ,r, Í,here f;ìì is thcaorld pÌice in.lex of râw matcrìaÌs and P;ìrilLL is the wond
priceindeJ{ of nÌaÌÌufa ctu res. A. cÌample of an increase in r is a rite in the woÌl.lprice ol
oil. A rise ir th€ price ol oil rcÌalivc lo manufactures m.Jns lhat f.Ì the home co!ntryì
\llÌich i\ assumed to import rJ$r lììalcÌials an.l exÌroÌt nìanulacluÌes, a hiiiher voluÍìe ol
expoú\ must be sold to purchasc a given vohme ol impons. 'lhn repÌesents : negatìv.
extemal trâde íÌockloÌ tlÌe homc country and is a cleterioralìon in 1ts teÌms oitrade. r\s
we $ill 5ee iÌÌ tlÌe next section, a raÍ' materials pÌìce s1ìo.k is not onlv tn exte.nal trad.
shocrb t aÌso r mpp\'sÌnck bccausc ìt sh iíts the ÃÃU cürtc.
lhe anJÌysis ol thc lnìpa.l of an exteÍÌal irade shocl is straightlorward. ll s'iìì shift dre
.lD.urvcandlhcBl.rrrcinthesamediiection.lhchorizontalsÌìiitoflhcBTcun'eríilÌ
be greater tÌÌan lhal ot thc.,1D curle lo.tÌìe sanÌe reason that theÁ, curçe ìs steeÌrerthârÌ
the Xl cun'c (rcfcr back to scciion 2 in alhapter 10). A sinÌte wiì)'oi sccing tìris ì\ that il
$e look at tlÌe irÌitial outpul lcveÌ, t!, at !!hìclÌ the rlD curve atÌd thc B / cuFe iÌÌtersect
(seeponìtÁin|ìg.Ìr.12)!hcntllenew.1t)cur\'€,,1,D',arclthencNBT.uÌÍe,ËT',will
nÌter\ect at lo (at point,l'). 'lhú ì5 becâuse the exchange râte deprccìalbn that Ì!o!ld
teave output unchangcd Ìn the face ofth€ eaogenous fall in etexporLrmuÍìevers€tÌìe
taÌÌ üÌ net exports, aod hcr.c it must Ìeave the tradc baìance unchanged

FiguÌê í1,í2 a neqatv€ €tierna tran€+ro.[

 396 .

l-etusnoÌí eranÌnÌetheiÌÌ4Íjl:âtions ofthe extenralúadeshock. As ar cxarìp1€, we.on

sider â nesative trade sÌìo.Ì{. As js.lea.lrom Fig.I l.12, the.e$,mcdium-run cquiljbrnun
i5 atpoitriA with higher uneDÌtolDìent, a ÌrNeì reais,age, higher rcâl import.osts, .rnd
a trade././ìr ll. The irtuition behiÌìd t1Ìi5 outcome ìs thatthe tiadc shocli dcpr€sses âctn
ìty thnÌìgh the usuaì goocLs nrarket equiÌibììunr chaDneÌ. At highcr rúìcorplovm€ntì ihe
wage settìn g Ìeaì nage 1s lower. Ior pice and irâije rettnrgequìljbriúm,thcprice s€ttinil
ÌeaÌwageÌnustaÌ$belorleÌandthiscoreÌnÌrdsn)ahigheÌÌeal.ostoljmports.
The srrrt r!,r impact of lÌre tracìe nn)ck depends on the exchangc .alc rcgime. Unde.
nÌcd t{changc ÌaLcs, oullut an.l enrflo_ynre.t()nlÌact aìr.l thc cco.omvmoves to ÈrhÌt
Cbefore thrNagc and fÌjcc settìng pr)ces sets jn tÌain tìre a.lÌuslmcÌrt ftom point C to
the mediun!run equiìibÌjtrm at B ÌÌÌ a ÍÌoatìng Ìate system, a depÌc.iatioo to'iÌl occur in
thr shoÌ t ÌLrn ard lhc cconomr $llÌm^ e t{) point Á' benÌe the adjuslnìcnt dosn the,1r/
cuNc taÌics fìacc. Tbc possibilit) ot changing the exchange rate can Ìcducc thc output
.ost ol rh. adjusrÌìcnr to foint B but with the conrequence that rhcÌc js a boút oi rising
sragcs and triccs ln th. home ecoronÌ) relative to lhe reí olthe nrorld.
'Lhc dlllclcncc bcLr,ccn lhc inÌract of aìr txteÌDaÌ tÌade nhck and a purc aggrcgatc
dcnlafdshorkisllìnllhc,Bi'cunenrolesinrh.caseolanexteÌDellradc5h,r.k.1hìshas
t!!o conscquco.cs: lìrsl, polnts a- and B aÌe tosirìons of trade surd($ ii thcrc is a purc
aggrcgatc dcnrand slìocÌ and ol t!ade deh.il ìI lhcr. js rn externaì lrâdc slìocli.se.ond, in
thc casc otan cÌlcrJìnì lÌadc shock, the loDg run cqujlibÌllrm olthc cconolìyshifts (frorn

4.2 External supply shocks :. r:l!i r::

,\n ext€rÌìal suppl,v slÌocli is dciì.cd ns an un.ntlcip.ted .h.Ììite nì the worìd terÌ\ ol
úade betN€en nÌanuiiìctures .nd rasr m.teriâls: ir change in the $orÌcl prìce of oil ls a
ilood cxinple. r\s noted in thr prcrious sc.tion, this typc ol íÌocl connrlnet rhe eUecrs
oÍ an (ìtcrniÌ trade sho.k Nitb a 5uppÌl' sick, irnp.ct on thc price letting reaÌr'age cutr c.
'lhc conscqucncc ìs that thcrc js a shi I in th€.lr.urve, in the lll cü^ e, a..Ì in thc Ã,ÌLI
currr: ill.!rvcs shift in thc sarìc dlrc.llon.
lo scc (nìy lhc lÂU.(]Nc sÌììIts, c nccd to lookclosel)'at rvhatis nÌeantbv a.hangc
i. thc h'orìd pri.c of oil. ]f ('c sal thâL the rul.l price ol oil rises, this ìÌeans rhaL it risci
ÌclaLilc 1o lhc n'orld pri.€ olmanuÍaclurcd goods, Ìlhere r l);,,r'r;,r,,,,.Ì.othcrs'ords, iI fi!
llc aÌc laìking nboLrt a .hangc j. /rldrir. prices, or to put it anotheì wa), â changc ln thc
/"d1prìcc oI oì1. lhc pricr setting curvc is (lefined lor ! ili!e real exchangc Ìnlc, l]. No\,
n'fÌrosc thal lhc r,orÌd pri.c ol ojì rjscs.Ioririli\e Í1, â ri\e iI the fÌi.c ot an cssrntl.l
input ljkc oiÌ raìscs cosrs lor lrms ir Lhc home e.ororÌ\' so it nìms are ro prcrc.t thrlr
prcfit maÌgins, lhcn rciìÍ'agcs musl bc loweÌ. He ce th€ púce \etting Ì!ãltuagr.unc
nrifts doirniraÌd \!hcn thc (rond tri.c oI oìl rises (see tig. 11.1:l). This implics a leftrrard
sÌrift ìn the ÃIìLi cunc. lhc d.rivaLion otthÈ pri..È \eitiÌìilcuÌveìncoÌÌroraÌlngimport€d
.rateÌ1aÌs is tÌrsc.lcd ln i IoolrìoLc.

I rt j! s DpÌcí rD âÍtrd. rÌÌ r rÌreie r no nrÌk uf on nr rlltrfud mrn Ìj,Lr\ À$um. Lhe onÌi nìl)ort\ rÌe .f ÌIr
 397

115

Figure ll,ll A.êqal:vÊ ertÉíiâ rrpp!51ìo.k

n@úe n nreô pr.eshítrLììU.!r,!,êÍt

Wc can .oÍ'anaìtsc lhc ÍuìÌ inrpa.t of an exogenous ard pffmanent change in the
ÍrÌìdpricco an csscnLÌal1.onrmo.Ìit) tuch as oìÌ. \{e ta}ic thc.asc ola rise ìn the price ol
olì. Lbrsinrpljcilt, tlc assunrc thatthe ÌÌoDre country onll l'npoís oil
i t cìoes rot irÌìport

Ílfal goods. lhis chn.gcs nolhing e*eniial an.l aÌlo\ls for n rnoÌe djrect exanÌlnatiod ol
thc Ìssuc alhand. !\c can Ìnlcstigate the three etìects:

'.l rl. rlJ. , ìò -;or. ,1 .' 'a

(2) the lmpact on the tfadebaÌrn(e
{3) tlÌeiÌnpa.t on priceârÌd Nagc sctlinganiÌhence ontlÌ€-LÂU curc.

We have aÌreacÌv examined the first tr,o clfccts in theanaÌv\is.Jlan e.ìtcnìal tradcshock
ìn !ig. I1.12: there n a cÌ(\rtr!!ìrd sÌìo.k 1o net cxpoÌtt becruse tlÌe iÌì.rÊasc lf thc cost
olthe esseÌrtiaÌ imto.te.l raw rrìaterial .bsorbs ir highcÌ pr)Ìrtrtion ol hoÌÌìc nì.onìc at a
gìven real exchange rate. This slÌi1ìs thc,1, curl'c and the BI cu etoth!1eít.ts

{'rsêl'-|-;,\tlÈt.irÉr.de\.IlaÌLreida.drnditrüfjinÌrtcrirlrÍeq!úÈnÌedt.TÌris!Ìpli.!rrri..

ìrr) ri\r nÌ r ÍÌlÌx.5 i r tÌi,. n,nnÌg rerl Ìratìe. N.ie diai lt lill if ufìi rrrnnrl! Ìc,lüi.êÒrnt tÌnotrgh
r..ÍÈasede.rÌBJ Êtri.iè LÌ. nÌ,.rìrìÌnÈ, w.uÌf rerd to oL15et rhir.
; SirìcettÌeonpí.Ènrockniï.Ìld Fhc..,ìrfrn,nìrrr(ill,eàtalLi Ìì.rÌd a$rÈ3rle d.nrnd i na Ìï.Ì d
.utÈÍ'r-'J5rÌìlrporle6oIDin!t).htr.\!uinÌhdjiÌe{LÌÌnlsÌroll.T1ìjl$t|ì.j
inIxÌ)or1.rot I rìÍ.ri,Ìli, r'h. hJÌr t{Ì,erirf.ed ú nr.hje nì th.iL Ì!.r ih. Jrr urÌtrh t n) ÍÌ.rtlY dièú
.\Ì,.fditúr\trtÊLÌe.tlvni(.rìÌafr\rte llL\r.uÌdíenrI.Í.eilÌeleJlÌ{r shitisirrthr.lrrnrLtÌl úrer
Fìgure 11.14 Erte'na i!ppv;ho.'r

\{e tLuD to the conscque.ces of the shift in thc l/ìU .ul!c. lhc frsl obseÌvatl{)n i\
Lìrat the ìnUatloÌìary' .onrequence\ ol the corÌÌmodllv pricc risc arc .leat. Ioìkttirs thÈ
cÌi(: ral ÍrÌÌ)l) úock, lhc lnitìal equiÌibriunì poÌnL ,] ls d}ort Lhc Ìrca'IRU cun,e. Thi\
mcans tìrat at lo. tlÌ. rcal i{age is beìow the 1\'ag.-sclling rcal wagc. Thc Ìeasrn it tlÌit
the costs olho[Ìe hnns have goDe u]r ancllÌighcr dorÌcstlc priccs.út lhÊ Ìeal conslìnÌ!ì
llon *age. There ìlill bc utNajd presnue on ilÍla1!o..
ln rffms of tìre assessmcnl of the adjrLtmerÌt paths undcr flricd and fcxiblc e\chani{e
ralcsÌ ir js clear that âs corÌpaÌed r!úh a tuÌe erternal lradc slÌock, lhc coís ofthe adju\t
Ìrcnr vja e\chanse r.tc dcpÌeciatìo. (hisher inllatiof vla !oj.1 r' in lig. 1l.1 1) 8o Lìp
rcìatilc to the costs of adiustment s'ith a Êred cxchangc ralc. This ìs .leaÌÌÌ iìhbtrated
b_Í Ìeference to tlÌe tÍ,o oìl nn)cks in the 1970s.lrì rcsponsc lo lhc lìÌstoiÌthocÌi in 1913
manl countúes focüscd (in the agjaÌetate demrnd.onscqucnccs and sought t{) oiìset
rhem vh expansiona q' fiscâl and motletarv poli. ics lf('cìook al Lhc conscquences oian
.",,r '.1 rr"" r" rrl"r).r'i h'A Il'lr""Ì
The conseLÌuence r\'as lhe on\et of í)
calied stâgtÌaliolì: risirÌg uncmplolmcn! and rí1ng
iDÍlatlon 1a! the e.onom) eveDtxaÌly acÌiu\tecl lrom,l to8'Ì\'ith uncnÌplo,vmcn! rjsing
rn(l , hìrrst 1)l inflat onl.
\Àrlrèn thÈ \É.ond oil shocÌ( stNck ir 1979. the nalurc ol lhe slÌock was bc(lcr urdel
Íoo.l atrcl nÌany countries attempte.l to Lìse tiglÌt rnonciar)' poli.t to prcvcnl cìchenge
.lep.ecirticÌÌ and hc.ce prevent a bjg upnrrge ìrÌ inÍlntjon. liì tcrrns ol Ìri8. 1l.l4, lhú
aLÌoiv! ü.ljustÌÌìcnl lrom A to al to Z/.Some count.icswcrc ablc to negouitcwagcs accoÌL1s
tunÌifttÌìeÌÌagcscllingcunecìoilnwa andhenci'offset (atl€asi p.rtiaÌlvl tlÌclcÍLrlard
úiftoithelÀir culÍc.

5 Real wages in open and closed economies

'Iheie aret]ro dilicrcnt questiont roaddÌess:

(1) what ha pperÌs to rcal rlages ove r the busile$ cyc le i.e. ir ieÌn)nreto changes in
tlìe Le!el of aggrcgatc demand?
(21 s'har happens to real $'ages l{,hen tlÌere Ìs a suppìr-sidc chingc such aslì shilt in thc
i!'âge-sclllng cLtr!e?
 :: :.: : :' 399

lhc cortrast betweer Lbc opcn and thc .losed econonìy is irúerenÌìt Ìn the cÌo\e.l
cconomv if t1ì€ prjce setting cLrrvc is llal as we norrÌÌâlly asÍlÌne and ilprice! aÌe a.ljusted
inrmcdiatcÌy to anv changc in cosrs, lÌrcn the ecoÌìomiÌ Nould âlBiys be on the trice
ic lling .Lr r!€ :ì ncì Ìeaì lragcs rÌouìd noLvnl! orertlìe c) cle.lìeâlÌvages \íouÌclbe acyclical.
A Ìisc in iggregate .lem a n d lrom an ifllial cqLrilibriurÌì r\'ould booÍ Íìone) wagesr if the
risc in coÍs is tuÌlv ìncorÌroratcd ln prlccs, ihe reì1wâge $,ill revert to it\ lnjiial Ìevel (on
lhc l5 cu rve). lldleler, iI ll lalc5 I iorc for lìrms to rÌarl their price\ up irÌ reslr)nse to tìre
h ighcr .osts, re! I waget wiÌl rjsc lc nr po rarllv. I he .eaÌ lvag€ Ì{'ll1 be a bov€ the I5 curve untiì
ulìadjustnìenilücìoccurrcd and Lh$ !ouÌd be s,rm€ clidcnce oi proc),.licâi reaÌwages.
lhc kcy res!lt 1s that in equìlibrium, ÌcaÌ r'ages ar€ d€teÍrìincd b,v the price setthÌg real
wagc. l hu \ il the fS cu Nc h appcn c.Ì lo bc dor\Ìnwad íoping, thcn re.1 ra8es Ìloukì be
count€rc,lclical. Ìneúia ir lhc adjuslÌìcnl of prices to changcs nì s'ages Í,ou1d be neecied
to oïert!rn this preddion.
lntheclosedeconomÍ,tÌrcrcsponscoÍrcaì\{agesto1ìrchratìc!ÌsiÌìaSSreitatedema.l

. the slopc olthe h'5 cuNe

' the íope ofthefi cuNc
: I Ì.1.1) go Lp . ìneÌtia lrì waÂc and púce settini{.

i|..k iìr I973, ll\' coÌltrast 1n thr opcn e.ononryÌ r'hal happens to rcaì Í'âgcs rrhcn oulpul ÍÌLr.lunlcs
depends on the rxchangc ratc rcginÌc and on dÌe natLlrc o thc shocli, as rlclÌ as on Lhc
lags in wage aDd pÌ icc scttÌrÌg and thc sìopc of thc 15 cunc. As nc halc alrcady sccn,
ìn the open eco r o my pro.rcli.aì rcaì wagcs h the rììcdi urn rú n a Ìe l ikell Lo be obsc^.eiÌ
tìtld{irgan Ll shock (c.9. consumpLionÌ j.ricslmenl, gov.rnnrentstendÌng, taxalnin) as
the economv settìes a! a nc!! rììcdìun!run cquiÌibriunr on the Ã,,ìLI curve. The econom)
movesupthe l1'.t cun c in tÌìc cvcnrotafosiLirc slìoclian.ldow. ìn theelentoíaneiaatìve
rhocÌ. Flg. 1l.l5 ilìustratcs: thc risc i. cmÌrìovmcnt lrorn F4 to à to rr is as$ciatedrlith
a úein reaÌwagei fÌom $,.1o n lon2.
::. I Ì.1.1, this ()f coluse, il actjvjlv iluctualcs bc.iltsc ot.hangcs in monctaN poÌic) oÌ shj[ts in tl]e
money.lemand tun.ljon (so .alìcd 1.t/ shocks) thcn lhc c.onoml will molc dlorÍ lhe
,]D cun'e. A ìoosening ot ìnonclary poÌìcl (associatcd i,ith a def Ìeciation) ill lead to a
ÌÀe in outÌÌrt and a risc in compctillrcncss (ll). lhis cnlails a lalì in tÌrc Ìcaì wagc. Thus
\!jth Íhrctuâtn)ns.oming fionr /.M shil(s, rcnl $'ages wllÌ movc coanlcr.vcìicaììt. Ìlnìitc
i lu.'.r ir' ' .\rl
ob\erved in thesho11 run.
'l\ I l o\'.r.;. ,ò 1" l/ ,r
"
.

IÌÌthe cÌosed econolnÍwith allal /5 cúNc, supply sldc poljcÌcs llìal5hìft onìt lhcwagc-
\€tting cuÌve have no cflcct olì Lhc mcdiurÌì-tun rcal wagc. lrì9. Ì l.l6 llìuíralcs lhis by
tâkinii tÌÌe care ola dowrward slìlÍt Ìn lhc t1'J.une. lhis coúld har.c bccn thc rcsult of a
l:ìbouÌ maÌket ktorm lhat $'calcn.d un ioÌì bargairirÌg powcr or il could harc bccn duc
to tlÌenegotìatioD oÍasocial pact. l-il hcr way if the 115 cul!'cshitls down, thc cqLrilÌbrium
unetÌpÌoyÌnent Ìalc IaÌls but ri.iÌ lvagcs rcmaiÌì !rÌchadgcd at thc ncl\'lÂU at poìnt l].
LcÌullibrnunemdov!rcntris.sbccauscolthereductionir'd.\-el/.'Jsr/.andnotbecause
ola reductn)n ìn real iragcs.
400

Ìr\

6lntrc

Figure 11,15 Pr..rr !. ':r f,it.s r ti: +ìÊ Ê,:.inÌll

:,i f .l

,/,:
rlLi\ " :

li\irin!
r. l_r
Figure 11.16 :1. r:r / \, : r. .'t 114 . I..',.ti.t qtr. Ìii \ .
i a r:r.:.._. _, ir ar:. r:.'!: r
 401

HoÌÌ d()et r d.r.Ìr.rd nÌiitirÌ the IÌ J cun. ii i.{ .li rriScsürlhropex{onúnrv.,Tlrc

llrcurredrÌd1hcu/.!r\(,renrü.iÌrdretriìrrig!.tmtÌo!.ìr.ÌdilsrrDÌrndlxbeÌlriÌ
.s'-11) dÌ!l ,rlI Ìrsfc.ti\eLr lÌÌauoten,1Ìr.omr,i5inìllirrrs!lt.rnlrrrclìit\cdt.
LIai iÌi the .lor(1 (.inünr ìi tiÌe ll(nrnhrrl shlit iJì (hr l\ -\ .ur\É i\ r(!oDtx.Lid bt
in r\prntitlraÌf jls..L polic\ nr rlìrtthc.r/).!r\c nror.j rl:] ilì. riSht n) lIl. llLËh.:.
!.rìplotnrent ÍorLld b( l!lÌie\ed Nirhout if\ ill I i.l!.rl r.lragr5. llur LnrLilic th.
(lcbel rcononrr. Llr \ i\ n()t sustaiÌì.ìl)le in Llr!.l'Ìli rÌrr Dlhrop(neronoÌnr.1r,9.rf.Ì.
i!rti(Ledelr.jl h(rerlragrha.tt)t.Ìll tt)[ lo.li iniÌtr th. d.1ì.i1, rnd r]rj\ rcqujr.i
.rtrjr!Ì!ìÌìg hIÌi .l lhe er!Ì)Ìi^r!eÌrt trj. Lfô nl ( ) L\.hinSc rirtr drprr(irtion Ì)Ìu\ e
iiÂhfunìÌ!g ol ls.ei p.rli(r riLlrchie\e th s lhr Iu.diìnr..Lii poiln ii rlÌrt iÌì rn (Ìren
t.oxonÌr. : ÌLsc if itìtlotnÌeut (drÌ .nl\ h. srLslalf{Ìl in Llrc long '!rì rr\ I lrll iÌr ÌerÌ
\ìgrt.e\erÌl s!.hat.ìLli\rrrrrequit(ìn)nrrkc|íÍ1rr.Li().prcllLiìblc i.. ererÌ\lìrI
the/.\ru!el!Llilr lheiaLliÌÌrealraije\j\nc..ssirt 1orels..o.rp.l 1ìrcn.s\d src!Ìe
r srti\lacloÌ\ .Ì1cr.âl Jr r rÌìÌìt

6 lntroduction to the economics of currency unions

LÌrc !ú(nion ol shclhc, iì..u.1r 5lìolld liold on tci itr 5ep.ìiLte (!.rerÌrl .r join r
.rL rcrì.r rÌrnrr rai5e\ min\ islrLc5 .ìll.r one it uhrtlrrr tlÌ. lors ol tlìe er.hange
ritc rrprejr.tt the Ì.$ oI. !5fhl po^ì.\ iÌrttrunÌeÌÌt. Wt (rrÌ i.r(lLe thir !uestiul \ ith
thr lr.rrìeru ii derel.f.d j. Lh s rhiì!li r. 5pecifi(rll\, \e .r\l rlÌerher irÌ the t.1ce oi dn
i]isrlt:te derìÌrrrL. rxLrÌ,ìil t.idc .l. slippll !húl the rr.hlrÌle r.1! is .ì !letul poli(\
iÌÌnnurerÌt.lfachrn!(lntrr ro.ri.i c\clÌar]seiúei\uÌ( b.:trrslrür\r't.i tì nrocltlüt
ÌÌÌ.ìtlÌitihee.!nonrr.Llìr.r.(\.grLlllrit rnnruuú lìn\ i..n, \rhì.h mun ìt r eirhtl
!P .8rjrtrt the Ìrcrellts o

. oI the micÌo....!ÌrÌi. 5 !.. irnrìì tlÌ( tli!ìÌut]!n ot llrnla.iioni .oni r\!o(intel

1!ìth (lú.9Ìng r rr'tr,.|.i.s. 11Ì.i]s\urÌrp1l.!Ìi\thrttlÌr(rÈ.rtiüÌolriinsF(urrexc\irer
Í.uÌcl he\) n, ÌdrL.!. the \€gÌrüÌrìtiln ol ì!ú!rel !oolls r!Ìrn\rt\ Ìst (-lÌrpter 9) lÌÌi5
Íould Ìroo\L ttrdt.l Ìì.rrlet (.r]ìpctjiiLÌr, \hi.h mr\ rrìje ilrr ìÌ(erÌtj\e to inÌr^atr
rDd theÌe1.tu r'nhen.. the i.tnn\ tlÌ núe. ì!i!lkl\ ot endoiler!r\ !u\tÌÌ nr I hnh .omtr
titi.n (.ìn ÌrLÍ,S,or!Lh .,rc !ii\.!isid irÌ Chrt)ftr 1 1. A \ecorÌ!i(lünrel tur !ri(Ì.econonic
LrerÌriiit lic\ r'jlh Llrc assunlptj.trl thrt r rr(ìu.iÌo. in r\.ÌÌanSr r!fu rìÌÌ.irteiÌÌt\ 11ìLrÌú
rrdu(c the nrj\aÌ1..âL r!Ì âìd i!plir.tidr ol iÌrr e5tmerÌt tr.ilitie\ ìÌr cLitterent L.ratLonr.
llÌi\ ÌrrtrìL'ces r !trri. binrh.' à: rrsN(e\ rÌe \r\ ed an!l r d\ rÌaìÌir Ì)crrfit ìi in\ e\hncnr
rìse\ r\ r r(Ìrteqtrrn.c
.o.Llì..r,.r.ir..!rrlictideacomm.n.uÍcn.rir.inrrrt,o\ldLrln.(lLLin!.5(ib
LÍhingi.fiLion.ÌrdjbìLitvitthenation.ìlâurb.riL fsl.dthitdiil.!lrto.:LiÌrl shllcm
rehÊs.Tlrl!.kiÍhLìi\e\thÉ!Ìurtti(!rotthcqurlitl o nìr)f.LrÌrÌroÌ .1 mani!.lÌÌcnr lrr
thc.rrÌÌ..rr!niolratconr|rÌe.lrLLhtÌrc..{Lrtr'\. lì!.r. ii.. r!.i!rn (h\ jrÌ friìÌfi r
quâÌjlr sÌr.(Ll!i b( hiirher in o.e thr. j. tlrr'.1Ìr.r. hr súc.i nhl .n.'!.rlibilii\ 1t\
nrtn{Ìu.cLl ln ( lÌàpirr:l end it i cttjgetd L. (lr1.ll i. rlhafLc.5.
402 .: ''
ol a siÌìgÌe carrcncy
enìbeÌshì
\\ie tü r ìì no$'l o t1Ìc ollen cìted nacrceconom ic cosl of nr P

our anal-v''srs ot tlÌc diflere' kin ds ol lhocks lhal

area: thc ìoss oì the clchangeÌale lroÌn
L

" - ':r ;, .,".,"'

.:" ,.r urJ'r' rr r''r '" rr'r' "' ":- ' '" ' ".'
;. .., . ..:,'r, '\í "r-ìr
r

bc
can bc a vahable tooI lhrec Ìeasonsslìv it
.u"*" *change rate 'an
'"in" """taU
impact oÌì conìPetilileness
íl) lt caÌìhale â subÍantìaland i mnÌecìiaLe
hv ã is not a mediuÌI{ruì
r2l ll llÌe ne*'shoÌt rutr cquiliÌrÌíln achiclFd 'ìevaluallon on cmprovment aÌÌd
.,Iíi'ii;;' ,"; ;;,' ;;;;. ii'" '^u *^"r, 't*
.,*eÊciar eírects
c;ntetiriveÌÌess can tre!erlhelcss laÍ for seveÌalvea6
achìeve(r hvr ìsa medion]'ruíl eqüÌlib-
t:ll tt,n" ."t" ,tt u.t_,.n "qüjlibrjuüÌ 'l'valüation
aÌ;its the economv lo ilel tu lhe nredium'
''''.,',íi.e. on thernir cune) lhen 'Ìel'alualion
ri,,nì
1r" 'r"' \"u'd tJi
r-' \'r'l - 'rrr"r'
',,-'-,-""rJJ -Ê-,"' r' ì"r 'l
"n.i, ';, " "5
lh'J\''r''r'lr ' rrlprv4
' -" Ê. h 'E ' i\'oi 'dì
ì:ï:;- ;,'':;''"'.;" 'o'" 'r'
nominâÌ í'agct .ìn d Priccs
aÌeâ (OCA) Robc Ìt M undcll focused on
hÌ the cìrssì. analy\is of lhe oltirnal curcncy shirt Í)
externar r!:1de shocri rancs ilì consuÌnttim
-;:;;;"-'";"ii". " "csttÌie
r'," \'-'rr"' o" rr' r'r''
;.", ', ' .o *, '13 IPoìI'nI
' -:l ;.. ;' ;i
n,"''' ro'\'
, "'r ' \, ''' \r'-ì r"'D- ' - u r'
ro (rnmend it ò an
,""r" o".aÌudtion (oÌ dcprecirtìon) has s.]nìerhing
thc erlernaì trade shock
,-"rr1idÌ hetps to niitigarc thc inÌpad
,"i""-",.ì,"i,,",.". of
it onr.v p(\'ides a
",""r.,*. ,"" ,.,de baìancc Howeler as $'c have arso \ccn'
,;;ì;.;;;:,i;J,,'' /rnu cun'e b'\'
;;;;iì;; ';u','"' the devaruatìon takcs thc econoÌrr-v above rhe
.ì,iii""."n ",.."ocneÈts to comPeljti!cness i!iÌ1be €Íxled iÌÌ subscq!cnt wasc-
*"*'. tu"
' -ô I r'l i \'-1rr'J1 r"^'r \'"rrr'r
". :,
ì-',;.',,'.', o, 'i.,r.v. 'h "\r.'l ''ro'trò h J ''r' rì!r tÌÌat
ïi"'i""'*u*t"- t""he econorrv such a\ a shilr ìn rastes aÌlav from tÌre soods
of both
;;;ì;;ï;,'.;'y iÌÌ, then dc'alLrtion mav diveú !ì1e attention
'o".jarizes probrenì in the suppr-v sìde or trìc
rrom t1Ìe sourcc or the
il;;";,i;'"i;1".i,,, "ctors
.'ìi" olanominaìexchange Ìate
ut"."t."t n* ttCA 1il'r:ìtuÌe tlÌaicompares the use

.hânse {'jth a charsc in $âgcs can aÌso bc clalìned

llÌ the cxtrcme case of redl wage
a ncw nìedìunÌ-
;:iÏ;,;.ì;; ilJ-"'s verticaÌ and a. cxternal uadc shock imPÌies thc debat€
mì;ì'il- ; '"'""nsed output but Ì\'ìth row€Ì Ìeal wâs's rn this câsc'
$age and price
:ill*;;,,i;"'"*"ti'on rri.ies onLv on tne pre\ence or
r 'dtr.1,^.r.' l\"É' ''ìrr'' 4rr'l n"'l r" "lêr'rle ê.
'o'ri"r/
'r rj1''r'r'çin' it\
,;.; ,, n' h
.Ï,.:. ""' " "' ' and 'u pÌiccs arc'Isticky
n e*' medi trÌu_ run equiìibriuÌrì
at c' 1ÌÌ Ìri ia l l i T ll n onÌii aÌ wages '
in". " rr""ritu "'i,'-tc ratc chanile (ilì nìsutatc the ccononÌv-itl orúput ternìs
a commo'1cutrency
t,,,- "'. Uìocl<rnore crfecLivell tlran is possÌbÌ€ under
"",".,U"**
 .i.:....:].1::...:].:...403

À,ìai (rerL .a 1I)

)z

.'--",zto
| .:rniìabilitv ofa

Figurè 11,Í7 AÍeí ìq the r. e.l deva latiof

:rúnÌ runcquiì1b-
\{ith veD tticky i{agcs and pÌices, the economv w(mld have to go lo L'bclorc adjusting
clrnturllv to ar thrcugh a pcÌnxl of intÌrti()n bekr! world iúlalion.
We can draÍ'a sc.ond Ìcsson bycombiDìng the ana\ sis olslÌifts ìn tlrc l-IìU ctr^'r rvlth
thc anaìvsis ot lhc roìc ofcxchange rate changes. A suppl-v sidc poli(n lhat shilts lhe InLi
cuNe to lhc Ììghr aìÌoars lhc econom) t{) move to a Íìedium-nlr Posithn slth kNer
un.mploymcnl. Hor{cvcÌ as note.l above, the acljustmenl proccss nray be teÌ} norv as
wages and prìces tall relarìve to s1)ÌÌd pices over nìcccssìlc rounds of rlaije iettirg. If
rhe govenrment has thc postibiÌity of cle!aÌuÍÌS the cxchange rate, a rapld shitï to tlÌe
ncw ìncdiunr-Ìun cquÌlibÌiunr is possjble. TlÌe possibilÌ1y ot dcliteÌinij cÌuicl renrlts for
cuplovmcnlnìatmalic!lcasieÌnrgainâpprovâliìrtlÌcsuppìvsidepoìicvle.g.âwa8€s
a.coÌd). Thc combination otwage accorcl at1.l devâl! rtjo n to acconrpan), poÌicies of1ìscal
.onsolidalion was impÌcrìcnred bv a number ol Ìluropcan countÌles in the 1980\ Gee
Chaplcr 6 tor ftlrlhcr dctaÌls). Thí pollcy combirration is nol avaiìable lnside a curren.y

'lo sudrmarize, il an cconomy charâcterized by lhe coÌnpÌete :ìb\ence of norninal

1s

nl(.kincss ol wagcr and pÌiccs, the exchaÌÌse rate reginìc is iDeÌe\ ant a dthereìsnocosl
to thc ìoss ol lhc cxchangc rate ilÍnrment. Ìl th€r€ is nomiral Íickiness, in thc ricnse
thar mon.,v wagcs and pÌices Ìesponci slos'ly to changes in the leveL ol activit)" and il
thc IY.S cuNc is rclarìvclÍ steep, there is a .ost !\socialÊd lÌ1iìr the Ìos! of the nonri.al
exrhangc ratc as a nìclhod of adjrút1Ìrg th€ reâ1 ex.hange rate rapidlv ((dnpare thc
llal wlrh thc slccp tIiU jn l:ig. I1.17). Hence. unless Ìl is believed that membership ot
:pth side oÍ the
i .ommon curen.y arca would reduce the Ìikelihood ot cxtemaì tÌacle ÍÌocks or altcr
thc cconoÌìy\ nonrìnaì ìnotìa oÌ ÌeaÌ ilrile 1Ìexlbility, such an econonÌy might !ïish
lc) rclaln rhc cxchangc rarc instÌruÌÌent ruÌles\ the oth$ benehts ot meÌnbership Nerc

7 Monetary rules in the open economy

In this section Ì{e see how t() nuclel arÌ iÌúlâtion targcling centÌal bank irr t1Ìe open
Êconomy. we n)cus on ihe flexibÌe exclÌânge rate.ase slrìcc lrnder h\ed exchânge rates,
the economy has no iDdepen.lent ÌÌìonetary pollcv. LrndeÌ lÌexìble exchange rates, thc
404

c(rìtrr\ii\biiÌf.ri1rroìel.rI'tt)lìcl!\irÌ8anrÒnt!nÌrILtti.qrL / \íì a5 L. ort trt!tÌÌrfÌrL

oitÌre oprn c.n.om) ut, t.1Ìrl! l!irÌ1.!Ìd i nì.felaÌ\ NLc l\r/ìr
'Ìo ìrl. ih. dj\.rú\ion..r1rrete. ÌrÈ.t,...nlrate irÌ lhis s..Li.f o. aÌr aSilÌl!.LL'
Lltm!nd slìo.Ì su.n d\ rÌì cx.geÌtr: pos L]r c b(!)tr iÌr d1:)nìL s1i. i.lcrmeÌri :iÌì.. Lhr
ninrre oi lh( Do.etrr\ poÌ .1 Ìelirn( dor! nÒt aitert thi n pPll sirlr. 1re Ì!.oÌr tlÌal lh(
Ìne.ìirìnÌ nrn .quLlibriurÌ n llÌ ht tlÌc s!nì( rih.rhcr nurcli( r.li.:r Lr lÍl oÌ lil b,ìjcd
Jtrn !s r ! hi\ c cnrtharir.d lrlrdì cln+ìiriÌr-{ f lt.Ì rÌ(L fl!'iibl..r.hìn{t Ìrte\' it i\ onll
thr alj!\tÌìrr.L terh tÌLrt i\ iiltct.l t)t thc nronetar\ p.ll.t rrgjnrc \\'c qti.ll\ rrLi
ihrìLìgh tlìt.ofÍÌluen(e\ .li r to\iti\e àg{..gilt dt ard sho.li u.(ÌÊÌ ìn tll Lìrs!.(i

rl rn ÌìnrhiÌ.9.11 t)trtÌrut le\el rith Lhc

1Ì) The rÌer i\l{i.dcll lLeÌììi.g c!l!iLibriLrnr is
lutritr)d.nr.sti.r!!rrqnlcdemrÌlil.1r.ì1)l.l!Ìl ()llsrlhl i.oflÌe.tn!rirÌÌÌetcì''p.Ìl!
duÉ n) tlÌc.\.hxnse ri]1r iìÌrÌrre.iriioÌì
2 Ì1o1Ì.r'o. lhi\ ii nol e nrecLiurìì rrn rtÌuiÌiÌrriLrnì b.cìutt the ipprL.liLlof ÌrÌre\ rerl
ri!!.5. rhj.h. i1h .trtÌÌrt !f.hrtgtd. Ltl!L\ i. i LÌrÌ) in iÌúÌrti!n r.ÌrtLl. n) \orLo
jrÌiili... IJr!ì!r'\.onrfÉtiti\ !'n..s rnrÌrrn t\ dìd Lht e!r!Ì!r!) ri ifiL5 l.lrigher o!t
ÌJ!i. h...trìr.iunr MreqÌi h lttìjrrthiSh.,ôulÌ\úanrLrlÌi!h.rrcal!\chrngi
irir (i(.ltrrer; tlr.f lfjlirlL\.
l ü o k.\ tor.tt enÌeÍÊi lr(m t| 5 stLmÌìer\. 1lÌt Ììo.rlnaL e\(hdÌ!t ..1!' f hl \ r roÌe irr
iheíìor1Ìr1.(ül\iìÌldiìijun!ÌrnL t)Ìrthetholt lothenrclìrrrilun.qrtllibÌLuÌntrlis
phrr Lhn)!gh rrS! iì.i1 tÌj(e .ìdirrtme.t. lÌroilrr rì1 to prt thjj j: Llìit ln the rhdÍi
rÌ, thc Ì.rl erchdÌ3.,ilt r!li!:Ls cflLÌel\ Ì)e(.r!sc.l.(ÌnirÌal e!.iìnÌì{. rât. LharÌ!e\
r lÌ.rrns i. lhe !Ìe!li!nr i Lür, tÌr. 'cal .1cbrÌrst rriL iÌdl6lr entirtLt !!.,ì!si .i.hrnËct iÌì
a{rs inrl tÌ1(e\ IlrrÌrodeÌtlÌr',.nìr'lÌ.du(eiLrgÍ\ins\irÌtÌÌeÌÈ.rtcr.hifg.raÌeri
thr.....mtr{(iit1:)trocLrrtilloíc{Ìh)\LortI.lìi.gt\iÌr,!ìri!enLrttr'i.r.rndtri!e
rdiuiLÌrrnL.Thjri\ihr.rú.oxrro rlarsj\en!nÌliLrrtfolj.\'
lnLrrlrjrcl\. it tro!lLÌ sctnÌ tlÌil rn Lrlil! !rt.IfiÌi.gm.nttar])oLi.\.iì.e\oLúthe
tr.ndcn. nrr uÌ( rcil .:Ì.har:rrxLctoo\erdúoì'nth.\r\dt(ribed \\. isstDetÌle
...rÌrl brnl't irúlili(). lirsrl l\ thc I oÌ!d Lúe !1 ìnllrrjol. i_. rnd irúhtlof l\ a\nDÌcl
Lo bc dÉhnell .s lsrriÌ jn tenn\ ot.lnnuneÌ fri.r in lati.rÌ Ìhe (tnlr,ìl bi.k ! lrlteren
riLr'ruÌÊ itÉe (llÌnpl.r 5J ÈÌÌ\ 1t to b|( n.1l)\ rai\iIì! Lh. LnttÌert *te iir rr\Lil'fsi L. rilher
i .1c\ lâlnlr ot iÌú1.1i,r. irlnr tnrict t)r !f (utlÌìt lrofr .LÌuiÌiÌrnun loLL!sifg iì to:LLjrt
egsÌrsrte !knÌ.rnd tì,)cli.
íÌ)ourf,utri\es. \ssLLmlngtlÌal i.1Ììifg hrtÌreÌll lo f lrti)f jf tlrt iÌbrt nrr. Lh.
.!ntÌìlbrnl cL!es Ìì!1hitg.ìn!i \i.r. Ìhc intrÌert ratt is Lh.('lor c u..hangt!L!t tlÌ! tr!d(1
lnLcÌr\t rrte. tlÌe c.i.onrr !n !'5 L(, 1.. fci\ tÌÌ.rt Nn cquiÌlbÌltrD riih r .ox\t.ni r.il
cx.hange rate riro fL l, jÌr Ii!. lL ÌSì Lf.Ìccd. t!ìij i: Llrc drt)rl ru. ì!hr ell ÌLelr. lfg
c!ÌtriÌjÌrÌnrnÌ !ndü Iriì Ê\cÌra gr rl.\.1
ilì Lo \trcr the r.ofoÌìr'brrL( to r'!r il brlrtnr rt ilìt inlÌ(r(io. Lnr{.1. tlrc .c.tral Ì,rrÌl
nruiLÍolit)!tthe(!ÌÌ\rqLrcfre\():11Ìcsho.k11)ÌirútrciÌÌÌiìti!rÌÌi111ÌtsL.-t.LLlri:..oÌr(Ì!\
on L. Lhc atfnÌÌì.rir ìr/i li.c. (;ir r thii t r( n'i\ e Ìrer nrrdlurìì rü. cqtLllih, Lrnr. the IÍÂ
lifcjriÌl Lntcbecttiìr!rli.1lr1ìoxindlhrnirc,lujliLrIiLrr]ì.utp!t crrl:thLsirìLlr'lr)
rlork orLl lt\ ÌrÌeleÌrrd p.: Llo. (!Ì l1Âr. tlì. .!'ntÌ.Ìl brÌrl n!cis to ( o,k n(11 thc lhiLlll\
r!nÌ nr trÌj(trì:. rlì rlì ]fc (.1Ìl ihr 11 . ft)Ì ìr(trt \iÌì.i 1lÌr l'1r llit:rtLrr'uiÌÌ !!
 .t\ ln ourtreatìÌÌer:

trÍxd
:i
Figure 11.18 I:ül rdl!5rÒenilo ì.Íras.l
]ôleíÌreni5pcnd;n!,wth .ídrôn à.d Èx.lìõ.qÊ

th(Ììgh Lhc point rz, iÌúìation wjil ise to Ír (poinL Ëì, rïe can de.tilv rhc /,C(n, l. l hc
ceniÌaì bank\ prefeÍ€clpotitnrn on ì,ÍÃ! 1s thercloÌcpoint Q.
(3) lo get the econonry o.to ì,Ílìj, thc ccÌìtral bink raiscs tlÌc intcrcÍ rate abo!€ t1Ìe
Ílorld iÌìterest rate to ,n. lo thi5 poinl nolhÌng has happcncd 1o (hc cxchangr rate or to
intlation,sothene!!LtcruvejsIS(íj.r0lanrÌlhi.ncwr/)c!r^,eis,4Dto.grl.
(ll lÍrn poinls C, a-,, ard Cr, the ecoÌÌoiÌÌ), adjusts to ,, 1ì, and ,r throush tlÌe
tollowing \i m uìtar co Lr slv o pcratiog nÌcchani\nÌ\:
rr) Since output i5 bclo$r the Ììc$' eq uilibriu throuilhoutthis staite, irÌllation \!ill be
laÌling ì. cach pcrÌod.
ring a posi(ive ( l,) AÌlhough it is laÌÌìng, inflatnnr is above iorld inllâtjon an.Ì competiiivcncss ìs
lalliÌìg. lhi\ lÌâs two eflects: it thlfts the i.\ (:urÍc doirn ard it raiscs real wagci, rÌh i.h
Ìcìnlorces the prccess of laÌliÌÌg inflation.
{.) \'Vith the homc intcreÍ rateabovethe woÌLd ìnterestrJte, the norÌìiÌìal exchan:te
r:ìte apprecjalcs.e lhìs rlinlor.esthe doilnwad nÌtÌ ofthe/5. Àst1ìe €conomv

t \a'ir,.rifltlìrÌeideÌoldìc.e rS.ÌJr.rrdrinÌr\l r (r r ncD.nbcÌ

tl,.tt.ÍrftÍ.r,1P.ondjÌlon,i, i" ì,,tsri r ìi,q., Ì\ii r ih.: jAhtírLSeihrt-r

,,,='.!.lrL":d'
Ìhirkolt]ìlsasúreelÌftnfÌÌrhi Ìl, - /_,rlìenrÌrÈer.tÌ rÊem lÉrÌ{iÌÌodÌ!benìequnnÌu.
rú thc lhijÌtix itjii\rxFr.l.d úìeh.''ernrrrÌ!ri rdqnai.n..rndÌripeoul rrrc fr.rcnrafurh anL.geolhoÌdn!Ìronìe !
LÌúr
.urrn.! \oÌlhrle*ÌdereÍÌnÌs.LÌrd*Iubtirf\4 rnlrr r .rmutrrdjLrituFoÍaoÌrn)rorlìxLl.!. i5
bdÒÌlì.,g4 rhvì i Irexpe.htnÌúareiie iaLìòd,$4 r ., ,ilrine,\Ì.
406

rptrcachrs 11. .er! eqLr libÌnun rion lhc \ÍÃ, th..\lÈnì n) Ìrhi(lì homÈ\ lÌttÍ'il
rnL. cx.eels thc hlÌLl i.Lt!e\t Ìrte dimi.i\he\ Lì.d cach m.(essi\'e appÌccÌrÌnÌì is
snriÌler. Th!s Lhc.ÌD cun c dììli! Sradualìv Ì{) thr rlghl

llÌ. r.,)norx\ aditrstt to lhc neÌ! nìrdìrLÌr MÌ eqLLiÌlbrjtr.r rÌdÌ8 th( r!r/i clue: thi\
ìs tlÌr I!.tÌaÌnental dLfterencr 15 co!ÌPrrrd Lo atÌMas'd morÌ't'ìrl
x.ìitìnnrcnl trn.{ÉÌ
tSirì., NheÌe adlr6tÌnerÌt il.tr the \h.irl run Ilundrll lìÌcmìDB etlujÌbrltrtr lÌriÌÍ /
tl) tlÌc dr.Lljunr N..!Ìuilibl rm trÌ(es Ph.c rlons thr 1D!uÌ\etlìr!ughllagearÌdfri'r

lÌì th. .rtlarÌàtlon,)ltÌÌe ì//ì Ì)elecLrljüsLnìcnt. t$'o \\ I

eíunÌÌi(!Ì\ hilc h.:t. Ìnal!.
ha\ears(rÌìeduÌati.lLati(rìis.haÌd.terirrdh)i.eiÌii,juita\Ìnthe.los!'dc.ononÌl lcí
Ì)Ìau\itrh, e\clÌrngr Ìale e\pcctiLio.t dre lcìnncd ln a br(krtarl
e trr\'c esstrmed lÌrat
Ìo.kiÌÌg Í'al i e 1lìiìt the €r'hanse irtc cÌle'tell ior 'c\t Ì-reÌn{l i5 nsL fcÌi{)d s "Lllal
er(hing. rrte.1\lth thÌ\ d\ nÌrtlorÌ.tlÌel,i INÌ!eshiitssLeadiÌ\'t!ilìclcItattheirìtL:rc\t
Ìateis..llrtrledb\th..entr.ìlhanl(.A\srdÍtr$edilrChxÌrteÌ!r,Ìhi:lìiÌslheL!úlltu'rtc
nìpli.it on th!t ln crch frrl.LÌ \ heD (r.hinge rÌiìrlir'L oferanìrs .Ìpr.l a dep'€'inLl'n'
rhe.É i\ jn lact rÌì iftrclirtion Ìt$e\sit.hrL)thens5tLntÌi(tr!olritlonilelchdÌì8crate
r\tect.nio.s. thr ior!'lgn e\chrfge nürlet rân Ìrlrk.rú rhc Ìerle\.]Ìa!ìgc ratÈ rtthc ncr
cquiLilrrjrL$ rrl. l Lhis (r\r, in\reed ot tlÌc c.oÌrornt morj.g Êrn io PolnL E, ÌlÌ€ r;Ìlld
i.ìju\tÌÌlffLofttre cr.haÌìsl rilt LrÌ(ei tlÌt c.onouÌl ilriight nì p.iÌÍ l) lhcne$eq!llLÌl
riuÌn. ti th. rlchrngc Ìaìe idjr6ls jnnnediiLcll, tÌie rciÌr'ige riie\ tu its noL eq!iLibrittnl
Ìr\el\oLhcjncÉascin(trúpüLdoernot:p.rÌoildÌ-trisci.iÌrtÌlti.rl.rr\\'ìtholìtrrì5ci'
iniÌirtion âÌro\ rtlìc LxÌget.rndnilh olìtÈr1il theürltcqtrilibÌirnÌ )I thfÌ.aÌerÌos.{nrlt
totlìr'...tÌdÌ bnnk lo (hnngc the ìÌiÈrc51 ratt llì15 is r. jìriere\tiÌì8 r.sujtr e\en niLh
lkrt i i. Lìre nÌfi]Ll.ir |Ìo.c!\. ii Ìhere.r!' ,atjr!úl clf.clrtìons irÌ thr IoÌcign eÌ.h.nge
nÌnÍkrl.theecouoÌrr.Ìnc5{ÌnectÌ\t!tlc.e1!nÌedjLLmmre!Ìuilìbrirm.ThÍi!tr€.iLtrc
tlìe .lri.ge 1I tlÌc i.reisn tÌ.hange rrt. is i. rÌtelìir1!1r Lrì wx!,e ajÌd pricc m.\ enÌents

7'l Central bank does not know the equilibrium has changed
LÌ thls câre. uÌc.{'ntÌal tinJrk (]oe\ nlt hilc i lheorl ibnLtL lhe e!Ìnilibriu ol lhe e(!
nonrl 5trÌrtose iÌ btlit\e\ 1lìc e!ÌuiÌiÌ)riLrlÌl is ifiti.ìlLl'ri r,r Ìt ìÌìitrs thit 1ìrc e!ui
librnrÌr lerel ,úouÌtutÌÌiìs ncÌta\cd iiii obí:Ìrt\ - brlon - 1!jthlì 1,! Sin(Ê
- r L + r,lt 1.,r, tlrt..nrÌaÌ harÌl rif lroì' out thl n$L1xÌtre oir, iir = r, r' !i
i,1,1, i= i': r HdrrÈr rr rf\:trrrrrr..tr. lLì.\Lln.r\.\iirtr!..nÌ.mfúoìlhr''l r '
t,ìr.rÌriÌ 1(.rrnrÌ.u t r.Ì rlì!!rtÌ!rrlì lf r I
r l..:r\.xnr,rìrrìlrrbrrrr.rrìlfrlÌi=, Ìr,r\,irÌÌFf =ì rr.rrdir 1 =e rr!,\
nr'$. reur!iLl) 'rrìr!$nr r.:nlÌlr':inÌb:i.a.ì:irr: - Í':'iir'rr\'r:!rÌl!ilnrLÌri'rfril"ri
irrri(lril !.n n . \rrr Lr r:LÍ!lr = 'ì - i'
I hür Lh! nì: oìL \ r\rìÈ.k!i !\r rìrrlr f,t! r\ \,.n iii r\ rnrLrÌ( tr LÌrr
L

r_rrrri,!l,eiLhr!{hi\'lrll .rì.iri1rrr\r|.rirlt.rir'
lìr.r.Luìleid!!rr r'ìnJ!ìrrfrthúl norlrr.rì!.ìrrr!rnr:r?LliLiiìjr"
i rlrrli iìn r\1Ll|L1li,:ì:.ìnrLi ìr\lÌiirii'r
 . .. ... 407

doe\ thir as lolloìls:it ob <Í r{ith 1, r,.0.Ilence it infcrsthatthe nei\,

cquiljbrium,ti is giyen by

l.r .t,i d r(Ì Ì )

ln otheÌ words, ure c.nlriÌ bank knoili thar the corecr nnrl run lihlllìps cun e Ìnuí go
!r urÌì (poìnt r:) t]Ìough lhccorrecirffli.alÌ,hillipscuncat Í r. lhecorectPhiÌlipscur\enruíalso go
tlÌniugh thc obseNation Ír.1, The conccl 1)hiltjlÀ cune is thcn dcrned b) joining up
the5e two poiÌìt!. Thc nc\! €quilibÌilün output leleÌ is rheD gn en b)'the outÌtrú ìevcl at

Itthn argumerú ìs correct, the centraìba.k cirn irÌÌnediateÌy infrr tronì arÌv new data
$]Ìrt the n c$' leveÌ ol cq uÌiibriilm outNt, r. is.ltth€r..foÌe behaves no diftereÌÌtlv fÌom
1..,r ',,.',,1 .. l\,.r,. lirlr,ror"t.,,,.,r\F,t:\ r. .,.
âccolurt of nÌeâsluemcot eÍor\ :!nd ran.lorÌì fÌuct!âtioÌÌs in the economv. the centÌaÌ
bank might think, lor iÌìstan.e, that thc ourprt irÌcrease does not itrìply an in.reâsc
in equiÌÌbriLm outpul but siÌnply repÌescnts a one o1Ì.lemaD.Ì ihock. tÌolrever, it ìs
inteÌpÌctcd as bei r g a..oÌÌÌparÌiecl l)y a nrcasurerÌÌeú eroÌ in ttre Ìare oI iúLiìtion, hence
explaìnlng why lnflalion is uÌìerpecrecLly loi\i. Ì!r tlÌât ca\e, ii the c.núal bank was nue
of its anal)sis, it wouÌd rai\e iÌìteÌest rates according to the pre exíting MÂ aiter nÌâtiiÌrg
vrme assunìptidr âbout Ìlhat the 'tnìe'inflalion rat€ llas.

7.2 Summing up
AclÌustmcot tu a lhocli id a Ílexible exchange Ìalc opc. c.onomy i\ cllllerent ahc. nìon
etarvpolicvi\ operatedsltha moÌìetarvNÌe fÌonr h cn l hcrc is a nìonetaÌv iin)wtlr l a rgct.
Wìth lnlÌatiorÌ ireÌtir, bLrt rational e\change Ìâ1c cxpcctari,Ììs, the econonrÍ wilÌ nìolc
dÍecllv to the new mcdiunÌ nuÌ equiÌibrnnÌ whc. rhc monúar! nrle i\ jìr pìacc. Thc
reaìeachanB€ iâte ove rsh ooting .h.râ.teristic oiâdjuímc.( rÌitlÌ a moÌÌe), ÌrplvtaÌgct
díatpcars. \{hen exchangc rite enpectatn)ns also cÌhjbit incrtia, the n€l! mediunr ÌLrn
d ecÌullibriLlm is appr)achcd alongthe ì.ÍÀ LjIe. ÌÌr thc case oIa positì!c agilrei<ate denrand
rho.kwìtlì the (rÌomlnaìand rcill €i\clÌaÌÌge rate aptÌeciaringand ìnllation lalling Aradu
alÌrback to t1Ìe target lcr:Ì.

8 Con€lusions
ln thìs chapter the opcn €conoÌn) ÌrrocLel has bccn uscd to exanìÌìe the jmpa.r on
the econonÌ! of a jerics ol diiferent kiD.ls ol polirics nnd shocks. ItcaÌ policy, Dron
etary/exchange Ìate poli.y, ind suppl) sj.le poliq halc bccn iÌìre\tigatecL. The anallsis
has becn appiied to thc queÍion olho$,real wag€s nìove or€r the cycte and Ìo thc coÍs
ol joinjng a conÌmoìr curretÌct.reâ.
. AggÌcgatc demand shocks that shiit the,U) curvc and theiefore the mcdluÌÌr rln
equiÌìbrluÌü âre changes in autonomoui coosumption and i vestrÌent.lhc short ruÌÌ
ettecLs ot an agijÌegatc demand sttuck caD bc beÍ ollset bv usnÌii tìscal policv.
408

' Chantes 1ÌÌ ÌÌìonetaÌy poÌlLt' ìn a ÍÌexible eÌchange rate Ìe8nne or discrclc changes in
the exch.ìngc rale peg in a lxcd Ìaie syÍem lead to a nrift alcÌÌg thc l,D cuÌve and
LheÌetìredonolchangethc nìedúm nuÌequilìbriuDÌ
' 5uppÌy shocks ìÌÌ.1riupply side poÌlcics are clelìncd as thoÍr that \hitÌ eith€r thc ('age
setting cune, tlìe prjce tettilÌg cur\.c (lor a tnen rcal cÌchenge rate) or both. ln lhe
open cconoìnv, a sLrpplv nÌock or poÌìcy 1s one thal shiits Lhe Ãnu curle and hence
slìiltslhc mednun and Ìong ntrÌ eqLrjìÌbÌ1lrm iâtc otuncmpìo)nrent
. ÊxtemaÌ trâdc shock\ arc dcfineLl as tlÌ,rsc that chante ilÌe lerel of ncL c\Poús tor a
gìven ìeal ex.Ììa.ge Ìate. Srtch shocÌs slìiit lbe AD and the rl .Ìrncs and thereforc
changetheshort, meciiLrm, an.ll(lril nüÌcqlriìihrir
. Ìlrternnìsuppl-v \lìo.ks mclÌ,r\ a.hange iD tÌÌ€ ltorld frice of an e$eÌÌti.l co Ìì m odity
sÌìilt all lhrce ofthe.,i,D, B?, ünd l-RU cu^'es
. 'rhe model prcdict' tiÌ:t lh.re wìÌÌ tÌot be a ìxecì r€lationsÌìip bcLwctn real $âges nnd
cnrplovmerÌt c.g. prccycjicaì oÌ counterc,vcli.aì reâl t!ages iÌì th. oPc. econonìy 1hc
patteÌÌ $ili d.pcn.l o thcnaLureofthcslìock(e315shock,/ttshocli,ormppl-v_sldc

. The.ons olgnirÌit up the nonÌiÌÌal cÌchange ratl: bl ioitingaconnnon.Llrrcncvarea

clepend on the n!turc ol ttre íÌocÌis the ecotÌonrl' is likely n) encounter,
jls strlrctlìrül
charactcrÌstic\ (e.g. thc lags nÌ Ì!ag. an.l price scllìng and the Ìesponsivcncss ol th€
\{:ìge sctllnia Ìe.ìl r'agc nr changes ÌrÌ unemployrncnl) en.l the availabilit} oÍ compÌe
ÌÌÌentaNpoÌicies (c.g. lr tcal policl , suÌrPly lide poÌlcjct
. TheoperÌeco.omvnodcì as extencled b-v'' sh owinii hoì! an inÍLn t ìon targetÌrg cent raì
banl i!ì a íÌl:xiblc exch.ngc tate rmaÌl open cconom-v re\pon.ls to an aggtegate iieÌna nd
shocL. ÌlÌc m ajoÌ .lifìercÌr ce that châr.ctcrlTcs tìre núation targcling reglnÌe lronÌ thc
Nrnev supply-Ìargeting ote ìs that the .cnlral banl adì!sts thc ln(crcÍ Ìate so is to
keet the e.onoÌnv closc to the constânt infali()n EÂU liÌÌe bt' protrPling aPprcIÌiatc
chaìses iÌr lhc nominal cxchaniie rate. lÌìc cconornl adj!Ís to thc ncw nrednur Í!ì
ecÌullibrn,m along t1Ìe Ìrtì liDe. Required changes nÌ the re;Llexchangc Ìat. aÌe dÌerefore
aclÌieved wìLhout thr ìargeÌ than ne.essary slinii! nì tlÌe nonÌinal ratc chartcteristi.
of a ÍloJrlng ìegirÌÌe with ân lM ba\ed oìonetarr'' polict. With ralional e\chang€ ratc
e\pectirtÌons, the nÌoÌìclâÌ) targeti g rcgirìc sìriiìs irnuediúeÌ)_ to thc nes' me.liÌ'm
.-,rrr"l -r 'Í.- 'r'-

', QUEsÌrONS

(r).\.opcneconoÌnycÌpcrienceranunex!rctcdiaìlin.lomesticaggregatedenrand
(:o.rfa.. the poll.v rcsfoÌrses alaiÌabÌetothc aÍth{rrìtìes iltheeconom) is {4

12) C!trtrid(r a lì \cd exclÌ,r n gc ratc c.o n omy operatj. S at m cdìúnr run cquiÌibÌnr m ÌritÌì
 (d) \\hv is thc.onìbinatio. oIa$'ages ac.o andad(valÍatjon falticulaÌll useful
lô a folic! dìakLÌ ìl it Í'ishes to Ìestore trade Lralüì.c?
(r) Ìlow $ould the econonÌy adjun ilthc !agcs ac.otd tlas Dot ac(o,np,Ìnied bt a
devaluation?
(.) \'!hatn'oúLd happcn ifonÌ) the .ìevahatbn ila s succcs fulÌv iÌÌ pÌcÌnented l e.g.
th. \!ag.s ac.ord c.lLapscdl?
(/l Whrt n the alteüutlve 1i!r a policv nrakcr to rcstore tuade ba aÌr.e il it.ân.ol
devalue (e.S. it is in a rnonetrryunion Nith its majortÌadÍrSpaltnrrs) or
neilotjate a wages accoÌd (e.g , clatjons tlith tra.ìe uDicÌr rre Ìrüd) ?

Ílr ir.' ir '.r'r,.r'', ,i rd '"1 '1.' J-Â -.r. l.''

nDckl I'Ìov e t$o e\ampÌes oilach a.d cLarjÍv the ditl€re.cc b-Í cxfÌorìng the
inì ications t(Ìoutput, thetrrde b.ilan.c, ancl Ídthe poljcy rcsflnrscs lhatare most

Ì 5uppìl' sìdc (ajr ìn a tloatjng cxchangc retc.conoml, whai poli.y combnraÍon can n 8o!cnìnìcnl
'- uí. n) brj.g aboút e Ínovc aÌ{Ìii{ the-EÀU otrve wìthouÌ ÌettúÌ8 !vâ8es rn.l friccs
adiust? thc poììc] maÌ<er (!r Settlìis right, $ìÌ) nijSht ìt prôlc pâíicularÌy
^runìjng
(5) I'hat is me!ì,t bl tÌre 'Ì!ÒrLd tcnns oftrade behrecn rnanufr.hìres r.d r,ìr'
nÌrtei!Ìs'? tlflairÌhoÁ a.hângr ìD then rviÌl ber.flccled ìntlÌe'.r1)','!r". and

(6) lla. jn\olrcdrcnt in â war rìrro!d 1ìeip a drunlry to recoveÍ tìo.r a re.e$jon? IIo$ i\
lolr ânsÌrr. afrì'.tcd il thc waÌ has a nÌiìjor e1ïect on world elre.gy Priccs?

t7) \\Ìii jstlÌe (ombination ot tjgh t nDnelaryÌrolicy r.d$'rSÊâccoÌd\ a bettfircst( sc

to .n adveLe erteDal s! pp ly íìock thaD e\prn\ion ary lscaÌ lnd mo. etàry lol ici.sl
fipla in by cornpaüÌg tÌÌe ! rcccs ol a.ljustment ti, th c new med nDì nÌ.

(8) (.onsidcr sÌnaÌì e.onoDy that jojns â cúifcney unloÌì lvlth iG tnaior tÌadjlì8
a

fâíncrs.l. r/
stacÊ nu!tlÌee1í'ct ol inc rcas.d PÌodu.t .r arkt I competitiorr,
i..rcascdin\.cstmcnt,aÌÌdariÌnf v.dfrodúclivitytrc.dandgilethenaltl
rcasonsi{ht lìÌcs. bcrìricial asp€.ts trav bc cÌpe.ted to oc.úr.
IstherÌonÌjrJlcxclìnn8c ratc moÌeval!rble as t poLic) itÌÍNrn(rìt to ad cconomv
17
$ith real riÌges that are highÌ) sensitive to uneÌnfLo}rnent tharì to in ccononÌ-ÍÍ'ith
Ì€s\ se.sitire rcalwagcs? Ìs it ÌnoÌe raÌ!able to an c.ornnnl Ìlitlì n high fropcniit-v to
jÌnportthâ. to..r$,ith a lower propensjty to jm fo rL? EÌpÌaúì $h).
(10) Explain rvhy a govenÌment iful it desjrabÌe ír givc contÌol of nuret,ìrÌ poLj.-v
'night
to lureÌected centralblrlkersr or lo ldcigDeÌs'.
(11) l locs ì n Lcrnarir!Ìal ca pit.l nrcLrjlitì undÜúr i. c lhe abjlltv ot a .c. t raÌ bank to cotrtÌd
inllarion in a .oun rÌv wjth 1Ìoitirìg exchan gc ratcs?

(r2i Co.sideras.raLlop(. c.onomvwithr frred ex(lìângc rate aDa ltnperlcctll

'? coÌiDetitile Íìarl,€ts Ior oúLfrt an.l lalìo!Ì. Ther€ is donìinal sti(kiÌre\s olpri.cs and
!va8es, but only j. th( írort ruD l'racetheeffecisôn otrlputald tÌÌetrade balinccoi
410

,Lr.an.trorìini..frnct.t\1!11at'oÌrn trlslLfriltlriiLriLìÌ\!ilhe!.ltrnNent!ir
nr'!r' thÌoü!11
r.úitrt rilh a Êreü '1(hIr!c raÌi lo Ìnlrnrúr i high ltÌ 'Lof 'altt) rrÌrcìJtr: L!r
r

tlcrscr'fÊscr ÌìrÌi.l IHtr\ oÌld \oìL trl)"ì \ú'| 'onnÌrnrts

PÍob êms and quenionsíor d scÚ$ion

()lILSTÌ()\.\.LÌìrnoLìc11('onoÌÌtniillitÌe\jÌri'rÌ'brÌÌgtÌr1!'thlgoYcÌÌnÌÌ'Ì1t
meÌìt ii"i s rl' oi Lrre rlÌr!1tr iorle brt has
rre'n r'r'r\ed thrì
;^;:';,,.:. nr Ìiìr'ÌÈ rciriÌirc
";;,ó,.\ r h at t
,ì."'.ì,';;',t ì;',, t; t,.. .u.iiÌiÌrrrQÌÌ ltt L-Ìlri 'ircrrmsi'rÌr'.
..ìi.ie\\tbi(lrrtortld.rnabÌttlìc!o\ÊIniìenllofilir\eltsunLiìÌ)Lo\ÌÌe'loblcctì\t\\ h\
nÌjrhi *crr P'.ur'\
iii i,ì;.;'ì; ,,,,.,i','',,,s ri1fliÌLì;Jì re! ' tr1r \ïìÌ'ìL l
'onsin 'r:'
ì't Í'hr'rrÌìl t') irì tr'd1 ( ts theÌrì
nriSht tÌLc fo\.ünìÊnt
r)ì FSIIO\-lJ alln\idcÌi nnilLoÌrerÌl'(trÌrrÌn\ TÌÌcÌeiife.;!'ct'aFit'LÌ
ìobìljttrnlr
tlìc t"Ì!rm\ is oÌr"I (o'ltiìrì L nìllatlr n
ìi",,'i' ".. ,",*,',."" t uc iniÌili t!s tiorr 'r rnr(er!'1t' hc ÌÌrârr'edr\ L'tr.tr rì
,,;;;',ì;.ì,....- t.irs rltcÌ, tn'trÌrr 'r Ììì'ìrt r\
ìl,i,,ir'.,', -rll*'a ".' rrlÌ 6 !i hrtllLj'n r! rLr'ltr't r'1\rlh\f'Ìhe\srt)otúrhetÌrr\
"
hrPterrr.ì iÌr lh. intrú tÌìi''g ferl"1 iìí d1s'ar\\ú1

ihte..tr.nr\ c\ft'LtÌ].e(LitoilLnrig3r'!!g'(lr ìdrdn!:r'Ì'

r \l5lcrn lrere iÌn|l!'nretì1ecL'
Srì!Ììl\ 5rde rctonì\ 1t) Ìlìe NlÌrr market rnLl\tcÌ1

tlì're lìtt.thc\'s S'rgge\L thc Ftl'rn\ iÌì lh! d'ìtr Lhal

t\fleúÌ tht Logic of eiÌ.h ol
c.tr\jsLeÌÌl \ìlh tJ'Ìì jìl polhesis
liould be
ot p e\nLre
ol l.SllO\!1.(l!n\id.!n.(ÌìnrÌì'uÍcncrrÌeri(ll'{ lroe\i\ LÌrc '1ÌrserÌ'L:
5ct tr) Lht ÌunÌ' ol
;ì:',;;i';,,;",'.'..;",.r( rÌLìiriet inr rht Ìa't tlrrÌ iiíratrÔ'
'drtriÌi
ÌìerÌ1 rat'
ìi'" ii't -*,ìu," ÌemÌrtr counll a'hi'rc iìrì\ !lrsirer rLneJììrrro\
" 'rrÌ
ïtìi,,',,,,"ì1"*,.""',,"borrrÌ)írbLenìsoiritliLio't)rlri'ìebiÌlan"r\\haÌ'LrL:th'
lon\equtrÌcL:5nrltl]loFlrÌj.noIthe|'.llf,\|lei
hìgh rÌúliÌiLlr
ol I STION D. tI ÌiÌn!a \ 2llÌlÌ \lih'n Lric(lnrdÌ srÌnL that illh'u'rrh dÌc\iÌnìl'rbehiì\iorf
,iìn.iutn*,,,,,,".-,,r,".l(i\iouoi'1Ìpr\iLL'er5ro'LLt]rrrdL(iio' ..1
".' rìs'!l l1ÌrLriJì 1rIr ìn$cÌ
lhJt lte \ho!ld noL he
'jl tri'r
.oÌ1.'rrÌla1ìt).)tú
rSSÍrlrt! dt rnd 5h'ck ironì rn .ì39ÌrgitÊ
QUtSlk)\ ! l1 i\ po$ibÌe to.lislins!ilr Jn
ìf1,1':,,'"n'u',..r',,.q"tÍheth'rth({b:r!ucnt'h'uÌÂ'snìo(ttlJ!tendi'tÌ'rrLoÌìiÌÉ
.,tiritlt"r, ., .lt .,Ì rL lrtcd Do\(ragre'nìthÌhi:srrtinìerú?Ì'unrd!nns\1r
""g^ti' or thL'loicd e'o 1'nr] or the ottn
('onoml or both
i,.'. ì'.,"",',"ì.
".,.,acÌ or har lc'1ÌÌÌa'\
QlrSlt lOX l. r:on."t, ^troat thc ÌrÌr!'ÌeÌì Eolenìnefl
(|xÌLg's 'ÌeLrl
g'\
'oúÌrtrictlo
cÌrìnenl'\frndituÌe
nÌ
iÌììrrÍlLrccr'orlclesLot^to!edüceit ÈÌd!rouÌd
t! bc rìoÌt
.r,nr,,.,"..,'-, f,ap o.,tt.1e thi\ p'lLc) obje'ti\ e iÌ'd \ihi'lì ÌilLlI
js

"i,".,u"tt,n"4"r"t""ì?\ïotrÌ'liÌlortnS'1'lÌ'ntenÌeÌnel(tthct'L\kcasjrtornn)n'
dillì.!Lt? \!oril \ o! Ic.orInk'nd polni'!'
'thcr
 : a :. ::....- a::.::- :..:..a :::,.aa 411

APPENDIx: OPEN ECONOMY INFLAÌ|ON AND SHORÌ-RUN PHILLIPS CURVES: AN EXAMPLE

Jl mat be userúlt. norÌì tÌtrlngh in eìdntlrÌo shoN in dct.trÌhoÌ\ trìfldtÌor (lltrrscsarÌh! c.onomv
movet trnÌ one mediünì ntri cqriliÌr.iunt tô anothrÌ -f.tr cxìxiplc, i. rne aftrÌnìrth !f ìr.ilgrriilc
lemrnn lho.li. lhG iLLunútes lìor! the ìrhilliD.uÍv(.rrllrr Ò|eraiÈs i. rhe Òfen eco.oÍì!. A5 an
r\rnÌplc, ÌcÌ us take tlìe care ú.de.1lx€d€a.han8e.âLe5 in whl.h the 8.rcÍnment d€.ides ro lse a Ír.aì
r \ pi. r or tu pn \h tlÌr rcororÌt Lu lüler urentlotnìe n t The .liagraÌnmãtic analtsn k ìess mest iL lre
rÍume rhÍ cxpr.Ìld Ìnfiâtnrn in th. e.onoDr is equaLrorïoLtl nrJlatior throughout.
.aifeÍtiâlorad,ftivr(ìplctir Ìn rlnld jìtrt rrctrsil) heus.d brt tÌÌú d ivcft artc!Ìior ^nlsrmptìon
tìonÌ Ìhc nrüÌ\
iÌr lhe Ì)hilliln.u('e caused l,y.hrnil.r üÌ tlÌr rcirl (ì(hange núc
lheeMmplejrdevel.pÈdusiJìitrherldiagrarì.iÌì.uaB.5rlrlnAafdpÌiceretLingdiagranì,âfdLÌìe
l'hillipr.!rve diagraÌn (Fig 1119).1h€e.onônlybegirsart.iÌìtr$ilh.uLPtú.Lfrândoenìdoj''
ÍÌdt ol tro. lhc govennre.t urd€rtaker a lis.al er|a.rion ro trkc tilr c(onúny to poìDt z ât loìv.r

1!

\ ,-,-''
l5(ú!)

:.h ìnflatìon
ljl

ll!l
U u)

Figure 11.19 Ph I ps.!rvc5 i the .p.r c.on.my .Íàlon Ío ow nq a oo5en nq oÍ

1s.d pó q' rn{leÍ irel ex.hãnqe rat.s
412

unenìpl.tmenl.lromorr,f,,1\rls.LthcD.fìlìm ntrÌfrr{lè1,Ite k..$ thâLtherci\i.c( m.dnÌm nrJì

equilibrium rt I aÌ !rÌri.h i.JlaLn!r Ìúll br.o.rtant. 5in.e rhis n à dxed cx.hângr nrtu r.ororlÌ, rìì.
nrl rúìÌ Ìrfu rt I Ìs .qlal Lo rïor ld nÌll.Ìnnr luna\ltrasar]1 ntÌwhath.ppcrrÌotrìfl.nonll,nìerhÈ

L. tÌris exanìple, we aiiunr:

{+
Arpriftr.h.meirâgerÌldfrncinnalnÌrri!equllÌoworl(l .flaLnnì. ThÈ9.!errnrenl in.Leâre\ spüa
rnN ft.Ìì& Lo {j lhr,ìlJ(Í!enìjlL\tothcrightlÌrtÌtsÌr.ÍtÍrrì,therheinâggrcgit0dcrrradú(\
L| ô!tln'tând 0DìpLo!n(.i ìhúlgh rhr rnril nnrhifliêr lr.cets lPonÏ, il thcÌ!p Lìatrcll.
Ìle noì{ tÌutrÌ! tÌi. nìedi! n ruD. lhr k.! cqrarnrns â,e lh0 ioll!Ì\irÌ!:

'lri,
:lI 1I1r

ÌriÌiÌ i .l empLovnr.L, Ã 1r? .an !er JIon tlìr Ì\aile a.d ]r'i.e s€lLing LliâgÌrDì thaÌ tl,!
JirSÌr!Í Ìerel
Ì\r3r n1ri.8 Nigc ri lr i\ trell aho!. thc.xisúÌs rrrl \'a8e ol rr li. thÉ n d[ FncL, ronÌÌÌr..
.eâL

fÒ1.18.. Lhe fri.r rlttnìu !L,fe l5ir!r ÌrÌÌlÌ lìoirÍ a. ThÈ n.rea\eiÌr noncl $â!r\ ú.t dÌi! ilivs n\É
io can be rerd otfÌÌ!fr iììÈ lhiLLiD.rnr li.,ilninr: rlì. Phillits ctrr!0 th.til rl!r.rÌ t!ìPoiIÌt! iJrhe..É
dcrin.db!exre.rediDflrtÌ!.oi(+)'+-,rrÌ'".r,,1Ìb'i!mtr.Ên,tl.vDent,âteotLl.(Ì{lÌtr
tlìe lll! rnÌ\c nÌÌ!.c.n rìre tslrr r .ur(r.l\'T,tì.Ì trage i.lìârn!r 8o!r nF to tLr lrÌ!l rluú bv fÒL.L F
iu tlÌ( l,hilÌÌpr.r^edlag'anr (boitonr tJâ.ell HÒdre I nìsNill iÌÌmcrliittl\ rltrl tptlìrt fri.esht tlr.
\.m(ÌrfÍ.eÌúa8Èlomrir.td(sfriLngeqrati.n.lreknol!th.Ìpf(!i.i,rlnnìofh.nì.fr.dlGdgo.dì
dnd nÌvi.ei rriLLequll th( rrfu di Ì{hich unil laborr co\t! lìrÌ( i...eâs.d
ìsr{e hrv. s0cr ir(i!r(, ihÈ..ucìil Poirt úthaÌ.otrnnÌ(r Ir.€5 d...t rlse blar mr.h itdomrntr
tr..1u.0Ì pn(!r lÌìr Érs.n s lhrt (ornrnÌu pn.. i.llition detend\ on \{oÌid nrllltnrn lÌhr nrÌr,r
whi.htlÌ(trir(5.Ínì|.t€dúrúil!o{Ì5.i5e),.ÌÒ..eíi.Iij.eìÌÍlltnÌn,rndon,,t[cÌ!ti!htoin{rLrf
iloodJ i. tìì...nsúmtlj.n bundÌr \oLììlng has haf|e.ed to Ìrlrld úúlltilr.ra !rir
(!rÍi.t Hen.É
(,,.nuìÈÍ rÍi.es ,is€ bI [$ tlÌ.r iììÈ tÌi.es ol honre lrlo.]rL.trÌ 3o!ar ú r. +' = +
' + ' +
r'..; ) I
th. rrrl {.il! riJrs fr.Ìì trr LorLur t l,'ll! frrn) d tid, The e....nr 15 ..Ìt at t.int a; Ih0tf\iÍr
nnit !f tlr( tri.e selLi.g .!Ìv! ìr \ÌrÌr. n ilìe .efrm taneL: úri\ n0ans Lhit the cquilibÌnrm Ìrlr !:
lnf ìfl.]nìÈft har.le.rcrscd to l/ 1 nelt I'hiÌÌ f5.!re nìrbt thurÌor ú drÌ{n Ìt ú nÌlcrd lìÌ ÌÌì.
Ìerelrr(i€/11,úr,)[lJrì,rsrhatjnthÈ]nl1üri.gteÌbl,nuÌ.vÌrtr8rs{Ìllrir(lìÌlcsthiÌ,.rÌì:
tÌeì iou\ Jl|rnxl. llÌ( Ìri!nì L\ írajghÌfdNrÌ.1: th0 Ìc.Ì w.Bt Ìrd! rise. .l!5rr t,, tlre \.n,e d rhe 'r43.
{ttn3 rralÌ\irrrr {,i ThLú lherc ir 16rli{rcprDr! b.ÌÌr(!f ìlìe reâÌ Ìti8e rhd N,Ìker a. Li.iirâie an!.
tbc[.!.ttì.v].rrallrre.eire,Nhi(lÌnrtÌr!ÌnÌQrthiiÍrteinJlaln rhasL.È{.eedÈ\|ecle.linlÌitn,L:
Ìrv i snìallÈÍ ]rÈ'L:e.tâSe.
Ì. srhsequ€nt lr.riods, Ì{iS(\ !nd |'i.ei i.ÌeasÊ a..ortliÌrg t(ì thc rb.v! t.rtfuÌn (i c.+ = ìr
+ -;!i rrnl_rlnnrillherÊalÌrâgeseqeLl.qrtrnlrh!rülrx.luns.ÌrÌrúrqralto.
lhe e.on.my lvill thrn L,e iÌ th. ne{ Dedlúnr ,ú. €qlllibinìm.t poÌnÌ Z ]\Ì lÌonï I, ill = ,i =
+ :-: rnlÌhrrtrr!.rtinri.llatnlrat theloreÌ un0ntlovnrnÌ ÌiÌr, l, Ì llÌrrilr.trindiÌr.
rcrl rì.hltr3! nrtc rrna'...nnanL rl drc !r[105 r, r:
 413

APPtNDIX:THE pFICE-SETÌtNG CURì/E tN Ì!E OpEN tCONOMy WtTH ÌAXts

rlrer.gÈd0nidÌrrri(rrrl.Ìrirm.iÚrrtrii..\1.|alLuri)tìÌnr\ j.
rrÌieÌ Ìr1r rh .rluLlr! rtìr n.rmê Lr\ ifJ y). rl\e.riri rlÌoAr!rNigeliür!th.
r'ìr're iL rir'rtÌrr.ro br Lrr rìtr rr'rÀ'f
'rÌ,' riì. !Dfr01. r'i nri.,i\r.r,.;, .;;,;;ì,il ; ììì"'rtr 'radr
:,h"'r,,,,'i,,''h;it.ì;;;;,,:;:-"'rrr'Ìihlar'.lrritt'rr"rrÉ'|uDnriÌÌzedúrtrr.\irn-

r,r- r lt:

Ì L.rd\Ì trril0n{ thÊfÌi.. \rrLjr{Ì.ri r!rje

i:ii j r!!Í
::rtr;llÌ:lÏ;tirt;ìiÌi:ïìtÏilï.ïi,:ïrilt::iì:ìì;ïlï;iìltììtì::;:::ìï:i
hrnre !or.rnf\ \ ìLi\ !1ird1,Ìinrf!Ìredli.aì

l' I ..t) .t). I l

iìli,:ì::lilì::,ìJl::i;:ï,Iìï:;ii",tiil;ltitïÌìill,, .liìì;:ì:1,I",*,,"'".",...,,,",.'',.',,,
.r1 ,,
., I i I i/ I
lld rr ri .r I
Ì Ìrorlf itrti.l_.rf $!r! li.! (,r Fl!.:. rr L.,,r ti
n,, p, ., , ,
Jn rr
u!,.,,,,.s,0,,,,,,,..i;,i,,".,,.,;ìi,,1,1,:.1ïl.lilï1.:,1ì::ìliì;i:;i;i:i:li:,
::::i
i.L\rf!Ìr(l]l.4i-È!ÌjF jrtÌ rì!riilr!ìSeútrlrrÌrltnr!rìrt!thel\ t .rnrd.,r.r.íl\
 lnterdependent
12 Economies

r. Lhc anaÌrsl5.I lh( opcn c.o.onìl lo Lhis foi.l, n'e ha\e 1!inn.ì11) assuÌIrd thal lhc
c.ononìl Ìn qucs(lor is so nnall tha( iLs c.ononricbchi\'ìouih!! no r.nìifrc.ti.trÌs b(i ond
ils oNn bordcÍs. .\t the erÌd oi ChapLcr !, r!L: Looli a lìAt lo(nt at iÌìteftlepend€n.c arìd iÌ
lÌo1! pcti.\'.hoi..s trì one 1ârgr c.o.om-r sÌri1Ìolcr to aftèct anotlÌeÌ. Lì Ìhis.hiLrt.rltc
ü.lc i \lstenÌati. eÌ.rÌiintìiion ol hol! opcn.con.rìier núerrct ÌlitlÌ eâ.h othcr. lì.rc
ar! 1\ro oÌânì gorls. llÌe hLt is 1o dc!.iot looÌs lo ânalvse ihe iÌÌterrrtions brttr'rcn lhc
ÌÌr.ìjor econ.Ìnic bLocs irr uÌe {oÍld c.g.bcL(,rcn tÌrc LrSAandtlÌeruÍozoncorbcl(aI.
tlìe 1,5.\.nd Japin. lhe iecond li lo (.drtrlind better tÌre iÌÍenÌiìl htÍkiJrgs ol lht

\te begnì th! .hapler iÌì se.tlon I b-v sclljng.ul r w!! o1 nÌodcÌlj.g Ìna.roc.onoÌnic
iÌìteftependence !sìrì3 a \ÌLÌLd thal consisl s oi 11ro ÌrìSe econoÌÌÌlcs ior ìrlorsl. ftt c\rn
pletheLrS.\arÌdtheeurcrone.\piÌlo!,c6.enhcf.sit1\eorneS.tir!':on!:counú)a.tjIg
iÌÌ it\ orn irÌteren nÌ.ì\ pulu.c il.i.tcndtd bc.cíìls or con\ f!r n.otho.ou.lÌr. l!e
ìntÌoduce t\\ o lonns ot ïiìLl!ler thit ..Ìn laliL: pìa.c Ln the írori ruf: l lo..nroli\ e etttct
ta Ì)oiitì!e denìdÌ(l ïiìllo\ eÌ]. ülÌcÍ. c{ÌriÌnsio. lf t)ne econoÌÌr} produ.c5 tx|an\ion lÌ
the other, anda beirSar uÌ\ neilhbo!r.llc.t ln.:gitne ïrilLo!.rl lth.ir:(:\pan5io. ìÌìorÌe
ecorÌorÌr iÌüut\ (ontÌicu.xr in th{'othcr. \\ihcn Ìhe aliunnrc.l oi rlages xnd püts il
nuitgidr, nÌort nuÌ elle(t\ mclÌ is lhr5c r:r. cÌcalc Ìen\nÌr brlltccn thr blocr. TÌri\ rai\es
ttre cj!enjorÌ ol lrlÌeuÌeÌ there nrc Ìrc..llls ftoÌì lhr iÌìternâtioraì .ooÌ.]iÌrati(D olPoLi.\.
lhe rÌe\t nep eÌftore(L iÌÌ Í'|.tlon 2 is l.r go belond thc Jrort ru. to eremire how
endotenou\ trüSe arrcl pÌice rd !s1m( f 1! rllct lÌr. shoú nìn spiÌlotcÌ ctlcctt.
5ectnÌr :l l)rnÌg\ n)letlÌrÌ uÌe:horl iìfd nrcdium nuÌ rn.ìlrsls n.LÌ \cr! out Ìroth a
.liagÌdDnnatic and rlteÌr dic Ìrrrthod o N)rÌlng Llìrough !lilìercnt(.l5c\ Ìn rcchon {,Ì!e
ntru\ Ìrecilìcrllv orÌ the rnall \is of thc r{rcionc..ononÌt, nìcìtriÌìg
. h.r.lô.1.Ìl\. Ìh...f\ÌÌrlfl\ on rlre erÍ./(Ììe r\ ! 1!hoÌc.
. tlÌe role ol tlrr LuropedÌ Central lliìnli lra Bl ln f.:\ÌnÌrlìrrs to srnrnìc1ri. thocÌs an.l
. hoÍ'lhccur)Torec.ononrtbehd\etnlÌenthrrearrdilicrÈ.cesÌretÌleen.ountlicsnr
a\l ÌìmÈlÌ1.:\ho.lis.

lhe logi. cìlr eurororÌe n\..r1poÌ .1'nrÌ.lhaL 5lnrt(Àed frÌ its ÌÌrrmÌr$! is outìLne.ìiI
se.tion I irÌ 1lÌe .onte\t ot the dt.uisio. oi sfilloleA. hr section I 1s .onscqu.n.e\ n)r
nÌa..oecorÌorìi. rdjustnÌent nre erarn n.(1. 8! srLli.g (ú a sjrnple nÌodcÌ, s,c nrrll te€
thate\erÌiiuÌenìfpltsideoltlÌec|.o.ornloii,ìcÌìberlountrtiseriì.tltLh.sim..d
1lÌat oi ihe other rÌÌeÌÌÌber\. it ma\ gcl sLú.k lrilh Ìrigh uÌren4totnÌün I Pr vilc s.:cl(Ì
416' ..

aggiegatc dcÌnand is \er) w€akand ifit ìs constrdined from using lìscalfolic) because ot
a lìscaliúlc 5uch as tìre St:ìbilitta.d Gtuwth lact. We also c{anrine the trse ofsìtPÌv side
policies lr thc.ontext of lMU.

'1 The 2-BIoc Model

ln th ìs scction , we e&ÌÌÌincnterelations bch{cc n tiro ma Ìor tradnÌs blocs in I w(r rÌd

I h c i

ol pcllcct catital nÌobilltv. \{e set out . syÍcmntic â! of analysnÌil iÌúe epcrdcn.Ê
iÌÌ borh the shoÌt and mcdium rluì under dificrcÌrt exchâng€ rate arr.Ììgemcnts Thú
turrnaliTes ancì e\terÌds thc sketch at thc cnd ol (lhapter 9: the íÌort rLrn lmplì.alìons
of ilscal and ìÌonet.ìry poli(n chrng€s iÌì a largc open economt lie bcttlccn those f.n
th€ cÌoscdeconon!). andlorlhcsmallopencconomy. We !lÌallmailÍain ourassunrftiim
thrt itlobâl capltal markets iÌrc hiSh\ irÍegrated 11h.r LIr corÌditiolÌlÌoldsl, whcrcasgood\
rÌìarNcrs aÌe segmented br.auscofinÌperf€ct compctillon a d dilfer€ntir tcd prod ucts We
reler to lhc firo coluúries as 'Hoìn e' â nd 'ijoreign'-Hoìne's !.ìriâbles arl slìoÍ'n asÌ and
Foreign\ as Ì . Before settilÌg oui the odeÌ, Nc cxltÌaìn the nìaill eccÌÌürìi. lssucs rhat
.ri!.r!1.:

(1) tÌÌe rature ofthe spillovcrs betireeÌ economlcs nrav be positive or ncgalivc.
l:iamplcs olerch âre tbc 'loconìoti\,e' iÌìd 'bcggaÌ th)' neishb.,u r' effc.ts
Í2) lp1ÌtLrver\ can ìcadt{) apúsoncfs.Ìiìemma saln€ bettlccn econonrie\'
(3) lhc logìc oi IÚÌi.) to,rrdìnatidr.
lhc kel ÌeluÌts Ìelating Lo the spillol'€r ol poìicy actidÌs betileelÌ countrics arc lhe

. rh ere is a po\itire aggrcgalc.letrÌa nd spiÌjovcr ollc n Ì eterred to as a /d..rrít ir. €Íi.r (j c.

\r > 0 and -\r,_ -' 0) oí a lÌdne €npir1ìslofaN lìscal policy under tlelibl€ exchangc
ratej. Unlike the nìalì open econonìv in snìì.h Honre's outÌÌú ÌetrüÌÌs to iÌs orlgi_
ral Ìelel tìDllowing a fitcaÌ erpansion. thc cxchange Ìate aPpiecirticÌÌ is less in thc LI SpiIlo
iìrtercleperÌ.|€nc! casc i{'ith the result that Homc\ dúput is lÌisher íAi ; O). 1he rca_
ÍD ForeigÌÌ\ outpuÌ alÍr Ì1ses is dl]e to thc dcpr.ciatìon of its e\change rate whcn
Ìldne's âppre.ìiìtcs: thú booÍs Ìorrlgn\ Ììcl cxpoÌt\ an.l outÌÌú ri!e\ (À1']_ :' Lì).
A UoÌÌÌe eipansionary monetar) polìct undcr nxcd exchange rate\ also has r loco
nrÍi!e eltèct: th. r'ond more) suppÌ,v ris€s and pushes .lown the i{orkì iúer€st rlte
\o output clipands in both Ilomc ard [orc]gn. To tìre extent tÌÌat e\Poú\ respond
positively io h jghcr outfut ir tlÌ€ othcr counü-v, thc loconrotive eiïectt are reiÌúoi.ed.
. th eì e ìs a neitati\ e \pillovÜ rcleì .ed to as a ,lïjrr r/il-l'd,.ílìlro!r €fi€cl (i .c. \f : (l an d
< 0) of a Horne cxpansionrrt Ír(ÌÌetary poliq undcÌ fcÌiblc cxchangc Ìaies.
^f'
IÌome's núnetaN eÌpinsio. pr).]uces â det)reciâtion ior jl and hcn.c an apprcciation
ft)r the ia.eigtr country, rvhjch .lepresse\ itr net exports nnd outlÌtt. I ilicwisc a Home
nscal eÌpansion urÌ.ler fixcd cxchange ratet Í corÌtra.tìonary tur lorcigr: thc Í'orìd
inteìest rate is pu\lìed !p and thn depÌerses outt)ut âbroid.
 lrÌthe Ìnedirì nür, i.e. after waiiei ancìpÌìce\ at IkÌne ând.ìbroad havc âdjuste.l,
. shorliu. Donct.r! policy oflecis disappear:Horne a.d l.orcign rclLún lo lhcjr inlliaì
qujììbrluÌr ìcvcÌs of output.
. irÌ the mednün rüì, the eliects ot a IÌome úscâl expan\ion dre ir epetrclent ol the
erchange râ te ieglÌne. Th e outconÌe is À/ -- 0an.l^.f .: {). lÌr the ÌÌew nÌ€.LiLtrü Nnequi
librium, iÌúÌâti.Jn 1Ìr l)oth rcoìronrle5 is conrtant but outpüt is lìigher nì llorrìe. IloÌrle's
Êscal erpJrÌ\ion tlÌeiefore has abeggaÌ thy neìghbour ettèct.
. Thus, thc lr).rrr).iw i.f('.r ot i HoÌìc lscal cÌpansi()n un.le! tìexibÌe exchani{e Ìates
is ÌeleÌse.l in thc mcdiurì run, so Orat in lhc .cw cquiÌibriunr \t - 0 an.l lt- - 0.
The ihoÌt Ìun locomotivc cltccl hr ìroreign comcs l!nr the exchange rate .lepreciatioÌÌ
but thls pushes ìroÌcign oLúside jtt ÃlLI cur.c and ìnÍlati(nr goes up once $:ìges arÌd
tÌìces Ìerpond. A5lls compclitì!cDc5i dcclincs, Ìl rcÌurns to the EÃU at Ì(Ner output thüÌÌ
jts jnitiaì eqúilibriúnr. bc.nÌLsc lÌr. r!oÌìd Ìntcrcil rale is hiiiher. (ldÌverseL,v, the llome
c(DoÌìv rcinlorccs jts outpLrl galn as lalling infalìon hoons .omfetitileness.
.lhebeì:it'thf.1(í!hboü,.//i.lofiìHomelìs.,rÌeJipansionundcÌnxe.lexchangeÌatet
previìils i.e. -\r : 0 ìrÌ.1 \lr':0butis.tlenu.t€diÌìthcrncdiumrun.ThereaÍ)nlsthat
output iÌì Ioreiiln lall\ in the s1ìort nrn at a gn,en reJÌ cxcha.ge rate (becrüre of the riie
intherÌorld intereÍ rate )j diis leaves loreign ìIÚide its /rÂLr ivith falììng iÌÍìatidr and uÌe
resultiÌrg rlse iÌì coÌnpetiti\eness tòr lìorclitn olfsets som. otthe ìnìtiaÌoutÌrú iìlÌ.
'1hc nìcchanlsÌÌrs.t worl iÍc c\aclly lhoic thel have been used nì the \rnall opcn
e.onoÌÌÌl model. ln s€ction 2, iÌc shall scc thal a simple ertension ol the rrr dii8ram
alloÌ\'s thc nìrdiLtÌn ruì renrlts ior thc 2 bìo. casc lo be ea\il! vlsuaLized. r\n ilgebrai.
ÌÌl€thod ol dernÌiÌÌg tlÌ€ renìlts is also prcvi.Ìcd.
üìce s,e.cc€pt ihe Loiiic olthc bcggaÌ-Lhy-ncighboLn phenouìerÌonl i.c. thit a.ounút
can use . policy to inÌprlrve its cconomic outcom.s at the erp€nse ol anothff countN,
this opens the $at foi,r.rrdlll damaging policics irhen l,dl, counúies pursuc thcir oNn
nÌtereÍs iÌì this !!av. ÌÌì tLrrrÌ, tÌris !cli Lhc co.lcxl lor dÍcusi.trÌs oi poÌicy coordìnation.

1.1 spillovers and the case for policy coordination

To dÌairpoìicv nÌpìicarbns üom thepherx!Denonof spiÌÌovcrs end Lodis.ursthe casenÌ
Ìroìi.) cooÌdination, il ìs usctuÌt.) taÌe an e\amtle.I his eÌìtaiÌs looÌiìng at tlhat happens
shen borh Home and ìrorcìgn in.ÌependentÌ,v choo\e . poli.-v thiL is in ftch countÍv\
oan bert lnteresl bur rlìiL Ìcsults 1n a wobe outcone tòr botl than iould hate occuned
hâd the ta1) counÍics coordinâtcd theìÌ tolìcl choices.
Suptose that Hom. and oÌejgn aÌe icÌenticaÌ econ(nnies witlÌ a lloaLingcxcharge Ìate
an.ltìratthe initialposìrio. oitìre'world'ij thateach co!ntrfisoulsidc ils f/lLr curverljtÌl
the result that iDflation ir both couìrtìies, and heÌ1ce iÌì the world, is rising. This couì.1
be thc outcomc, f(Ì cìampìc, ot a conrÌnon extenral \upply slìock su.h as a risc in iro d
oìl trices. No$', süÌtposc lhar erch colrntÌf wishes to reciuce inllatlon bul al rnininrum
cort in tenns ot rhc assoclalcd rise in trne!Ìto) ment: il the) siÍnrlt.ncousÌy iÌìplc'Ìcnt
the apprrtriale monclary conlÌaction, each niìl retum to a Írb1€ iúÌation cquiìibrìúÌì
with higheÌ urcmpìolmcnl and Í'ilh ân Lnrchanged exchange rate. We s1ì.11go thrcugh
4ta , :,

the details ìn sectlon 3. H(Nevcr, jt HomeiÌÌÌplemcnts a nÌore reírictìve nronetart/ pol!9-

rhân ìorcìgn, 1t wilÌbcneÈt fronr íronger ciisìrÌtlatnu since ex.hangc Ìate apprecialìon
wiÌ1reirìIorce the downward prcssure on iÌìflauon comÌÌg lìom thc redu.ti(tÌiÌÌ oulput
Convcrscly, Ioreign ìs hamìedbl Home\ unilal c raÌ action becal$c Lhe impÌied dcprecì
ation olIorcigr'\ ex.hange ratcí'iìl exacerbatcloreig'\ inflalion. Hence, bythcsame
bgic, Ì,oÌclgn ha\ an incentivc nÌ o lo únplemcnl an overl) reÍ.iclìve moDetary poìic-v
UJe knoÍ' Lh at the exch ang€ ral c o t both econo m ies caÌìnot apprcciate ancì the nc1 re ìt
of the morc restrictìl'c ìnonetalï poìicies impÌcmented bv bolh is an unDecessary and
coÍ\'risc Ìlorld interest ralcan.Ìreduction iD ilorld outpu!.
ìn the
TlÌis problenÌ has lhe structurc of a so c.llcd prisotÌers'diÌcÌìnra game' which i{a\
intÌoduccd in Châptcr'1. lhere arc tt!{) policv oPtidÌ\ for i'ach Ph}er in thls case'
each (oun1ry: eitlÌer to impÌeÌÌìcfl a rcstÌictivc Ìnonetârv poÌicy oÌ â lery restrìc1ive one
Lach coünlry considc6 the outcome (Pay olf) lhat it Ì!111ilet
jn 0rc event that lhc other
country chooses eithcr therestrlrlÌve or\Ìeryrcstlicti!e Poli.y lìoÌHonÌe' ifforcign weÌe
ro choosc the restrictilc poÌicy lÌÌcn Home Ìlould gei a hish$ pa,v off by choosing the
veÌy restri.live policy. If Forcì8rr í'ere to choose 'very reÍri.llvc" then agah, HonÌe i\
better ofl chooslng thc verv restrlclnre oPtion Ì'xactl)' the samc logic applies to lìoÌeìian\
decìsion making pioccss. Si cebolhpìayersdobettei iÌìd€pcn dent of the cholce of the
otheÌ ifthcv inÌplemcnt the very rcshictn e poìicy, thi\ is $hnl lhev $ill choose' ln the
laìrgurge ol ganÌe theoN, this is thc ltni.Ìue Nash e.Ìuilibriu nÌ: o nly bv both pla,ving'veÌ)
reÍrictiÌc , doe\ neithc r ìra ! e an in ce nti\Ìe to cha nge tlÌ€t Í.atcg-v i e ír 'chenl''
Ìloitcvcl, we know that il boLh countries iÌntleme t thc vcrt restrictlve poììc-v, thi!
p(xhrccs a r{orse oüt.ome lor bol h than were lhcvÌrothto clÌoosclhe Ìess restrÌclive ore
The e\sencc of the problem is tlìaL unless thcy can colÌÌe to a binding aiiÌeelnenl tot to
rerÌeger cach r!iÌ1bc lcnÌÍed 1o lighten poli.l-- Íurther (choosiÌrg'veÌy ì estrictiÌc') si nce
by doing $, the!- gain. TlÌis cxanìple Llenìons(rates tlÌe Ìlay thal ìnteÌcìependcnce can
Lroducc suboptiÌnaÌ outcomcs for lhe Ì{orld econ(nnt aÌÌd shows
wh.re the Ìotivalion
for tlÌc i.ternrtlorÌaì coordirÌatlon ol policy.onrei troDì Hol\clcl, ú aì$ higlìÌjghts
the problcms associale.l with polìcy coordinaLion loÌicy coordlnaLÌon olten r€fc$ to
agrccnrcnts nÌade byÌea.lersofcountrìes atirternailonal sunnnit JÌrcclings lveh.!cscen
tiÌat a bin.Ìing âgrccment is rccded in oÌder lor the solutioll thnl nraxinrlzes the ulilit)
ofboth taÌtie\, tobc achievcd Thebeautyofthcpìisoners'dilenxnaganreì\tlÌatitpint
do$,nthe.lillìculllolsrstainingthejoíÌt!tililynraximizingsolulionevenwlÌenbolh
panlcs aÌe icienticaÌ, the stralcgics available arc tjìÌple and kìos'n !o both Paúies, and
thffc aÌe no othe. dìsturbanrcs. It is hkeÌ-v to bc veiy nNclÌ more dillìcuìt to inìplenìcfL
policy coodiÌr:ìtiojr in r t!rbulcnl t!orÌ.| econonr-v wÌh non identicnl c.oDoìnie\ ând
'r./i1hnceÌtâiÌúr about how poÌlcyactionsüansÌate iDto outconìes.
u
jn the exanpÌc
Given the diffi.LrìLy in secLuingbindúrg ailecnrcntt betweerÌ countrics
dìscussed, it is irìlcrertir!, to ìnlcrfret the creatìon of exchatÌge rate arrangenrents âs a
rlay of eÍablishj.g a lorÌgcÊtcÌm fonÌ of poìì.-Í cool.linttion. r\s t'c hale notecì, tÌìe
locklnii ol ex.hange râtes ls a kin.Ì of policy coodlnatnn lhìs rulcs ouL beggar thy
vjr changesiÌÌ thc cxchange râte ir the casc.llscused ol
. eighbour l)oli.lcs that opcratc
ã 'competitivcdìsinflatlon'via a restÌlctile n]onctaD poÌiq/ or in the opposite cale ol.
'competitive deprcciatnnì'viaan expansio ary nìonetary PoÌic) üìc ofthc aÌgujÌìents
uscd ìn nÌDort oI (he tì)mÌatlon of tìre BrettolÌ lvoods hxe.l e-\chìÌÌs€ ratc systenÌ Ì!as
 419

n)Ìcdr.rtlìriilcÌÌlr.od!ltheo(cuìcn(o rheddrr!1l!comfrLiL \ci.nLrìrti(Ìr5thar

took|la.riÌlilìei.tffr.ìrÌrrrit)da.dtlral !nlerdÌe!lrrIroi]rÌ.1c.Ìtlnj!!iÌ\ith ti
rd.ìitiinilr.!rÌ(DL. ro!t\ì. l hc nÌ mrtLon oi tlÌe LlÌ\tiÌr t 9;!r,r rs Ìro(il irre!iiÌì 1raì1b!
ihe rniÌ!!i\ ot tlìr dinrirrrins eitc(tt oI rrsins tlÌe r\chdnle ÌxtL r. iÌ.hifre ((ìmirct Ljrr
diti!lliLi.n.LÌrtxÌrllcLiiìjhiuÌ..nrí,(oiiur!ÌÌÌeníiÌìh\.uÌ . Lhc.rertion.Irh.
cur.7o.f ]f,ìs tÌÌat in .Ì.1.r tr) prorelt rh! h. ntlìr\ hon tracle rnrlgrelion r(hir\ eLl in thc
r.üÌ.t.iÌr1LirÌi.nLsÌrLLr(lb\theSinglc\t,rrlctt,r.!ranÌmer,thrr.nrfÌationi!rc(rnútrs
tL) cnrigi iÌr roDfrriL rÉ lelt(i.úio.\ nro!Ld Lr Ìrutred.

1.2 lnteÍdependence in the short run: extending the lMundell-tleming

model
l. thir rtr\e.l!... r. \lrrrÌ
.lì(n\tri.rllrÌdthe\Ìro.(runi]nrttri\.ithrsmiÌÌotrfc.onÒnÌ\iÌrtlìe2hÌo..ìodcl:
. tlÌroÌiSino sÌrik^rreifectistr.hr!Ìo.orÌx)ti\eâÌìdl)eggxrth!n.irhbo!rettecr\j
' hoHrs(ìtn(ienth rrr'..S f.nnìt leedt[cli ei (.{ tan.rLlr.c !]Ì thr
beggâÌ Ìh\ neiÊhÌrou.r ir.Li
. lor ì)ilÌ(rcÌsgnrri5etoaÌSrrìi.Lt orpolìo cooÍiirÌrti(ÌÌ
lf Ìììc short NÌr. trj(.s if d rri!cs rre ilir en i. h.th c.ofonr r.s \\rsirìplü\ nrrh€Ìht
a\5LLmn{ilÌatirÌiÌatio.irìbotìiszrroühi.hD.ensLhâL Lhr .o.ìil.rl drl rerl intcÌe\r
ÌalÊ\ a,( rqlrl r.d trt .i. drirr lhc /-\ lìl dÌrgÌrm Í Lth Lh., .irn .il iÌìteÌe\r rare .n
thc rffLÌ..1rri\. To.ìnil!jc intrftcprnden(e. n r |la.c th. Lr//,d i{rim. rrpreientini. rhe
i.tcgriLcd c,ìÌ)ìtrlDark( (. bcn\.ccn rhe 1J lìr.ÌjxgÌrnr\ ftìr foÌ.iS. ifd HonÍ- rfjs. 12.l
l. cst.bLish ihe \rrÌLlni to .t ior uÌe inal\ t s. rhÈ djxgrinr s driÌr. rftlÌ the i ne
lthÌighr\ Lnt.(.1 'irie irÌ Ìr()th ..rn!Ìrìi!.1, i if lhi\ gurÌrnteÉr tlrrt thtr!. Ìr lÌ bt rÌo (lÌ!ngc
Ln thr r\.hdÌ!r rrtr, rrr i\:urÌÌ( tllrt the exfc.ttÌÌ r\chrn!! raÌl 5 !I!11to UÌe pre
rxl!Lln{c clÌrrÌS€Ìart, hì,irrll.|.t5UÌ.!rÌ.(rerrLÌLntÈÌe\tÌÌrjlr.o.L]irÒ.,ir]tr1ÌjcLtlÌr

iìI

_,
!qrr rhl

FiquÌe 12,1 .: 2 h -.. m,rie . .q ì''

420

erpe.lcd peÌcerr l age .ìeÈccjation oi thc nolÌÌiÌÌnl ex(hange ralc bettvee thc HonÌe an'
the l orcign (ounlry muÍ be eluâl to the excess ol ihe do!ÌÌeíjl. Ìaie oliÌÌtercsl above th'

4tL a-r,.*"1 , Ì,rse,:Ìoa., r ÌoAr,.

er!ecLed d0!reciatìon laPprcciiL i..)

(uncovered ÌJrteÌenParllr

In all the diagranr\, r rcteres to log. The cxchange ratc siìÌ Ìe âin unchanged Í'ìren
the la1) iÌÌteresl Ìâtes arc equaÌ. wc can norÌ asli tlÌe Mundell ll€lning questionsr tlhìi
happcns a\ wc charÌg€ Ìnon€tary an.] 6\caÌ policy? note.i itÌ thc lntÌr)'llÌction, thr
ÌÌatÌrrc oi tlÌe spillovers I(tÌÌ poìì.y ìn Homc kr ^s
outcomes ìn Foreign in lhe short rull
depcnds oÌÌ thc elchtìngc ìate rcgÌmc

1.2.1 Flexible êxchange íâtes

We Ìook iìrÍ at Polic!'chatÌiles l. the Homc country' whlle both lìscal ard monetar\
l.'l ì, rt, \,'Ì'ìJ"r"r"
ìiscaÌ policy: Hom€ expansion
Ourintuitlon Írggelts thatunder Ilcxible ea.hange r.tcs,lhe jPillovrr lronr Ilomc's h5caÌ

expa.sì()n ÌesLrìts fÌoÌÌì the lact thal the apprcciation ol lhc erclÌanll€ rale ld
Honìc' cìur
to ihc upward pÌe$urc on t1Ìe lnlcÌe\t rütc, cntails a dcptecìâtion for loreìgn 'nd that
this irÌll Ìrooí ils output. hÌ thc !Ìnall open cconoÌny casc, a I lonÌ€ lìscal expânslon hr\
noshoÌt runcltectono(rtprú al Honrebecausc tlÌeer.hãnge Ìate apprcciates nrllìclcntÌ\
to ÍuÌly otÏset the e\panriolâry iscallmpülsc In ân.Ìlljcal teÌnÌ\' siÌì.c is Èxed an'l
i is cxogenous t(Ì the m all o c.ononry,
spcn th c onl) possible . ei! 'Ií
slìor1_run equiììbri!Ìm
h{ith i: i'l is wilh outputba.kat Ì!s orì8nì.Ìlcvel lÌÌ thc z_bloc mociel' tÌr c r s no longer
j

an e\oge ousaaÌld intcteÍ ritc.

Thean.Ìysis i\ sho$rì inthc diagÌâm (Iig l2.2) We bcgin $ith the rÌght hand Home
qua.Ììant. lhc initial positicÌr is (io .l'o) at thc lnreÌre.tjon oI i.s-\M and l'Ì'Í We âssumÊ

,ú

r'; fi

Fiqure 12.2 Lo.oÍDlve eÍÍe.t oíà ÍÉ.ã eNanon . home

::.1r.. r|e tÌome and ilìe irÌjtial lìo.( ign e.Ìu ilibíiurÌì is !r (ii.),;I qÌÌere LüM curt l]li Ì1,ith i; = io. t hr tor
- iiÌÌrcrcsraboverÌte
ii:rÌ erchângc nÌürÌiet is irì crtuilibilrm wirlÌ rt - r0. Now gor$nrÌìe!ìt exÌrerdjlurc is
increased ir HoÌrìe. Ì!hicÌì pLrslìes the iSIIr curve to t5,\LÍr. Thc HonÌe economv lìoves
ip tlÌe lÌr cuõ'! (!ee thc uprlirls rÌ(Dlng arrow), pushìng up thc üÌtere\r ratc ro À and
.)!tnúto/. NotlÌjÌrg has so lar happened in loreitD. The Ìisc in LÌÌo irÌtere\t Ìârc jmplie\
ihat i = ir > I' i;; and this trisser an appre.iaiidr ofr trom .i to.i. FoÌeLgn is now
ailected. Th s is becausr f' .: remeÌnbff t1Ìdt Ìe lri âre i. ìogaritlÌniic nrnr. Hcnce
::!d intcrcn par itv) ilonÌe\ atprc.iation is ân cquipropoúìoralc depreclatjon nI IoÌcigo.
: L.charìged,!hen llÌeexchangcr.teiìÌltaclsoneâchcounúl,se\port\.TheapprcctarÌcÌÌjÌrII{n.ìo$,crs
_:: qucslions: Honìe erforLs, and thit ls nÌinifeÍed nr â hack!!r(ls nrjiÌ of i.\_{i,/, tÍonÌ /5,\Ì.r t.,sav,
r.ììar 1J,\ì1r. This puLls.torrn i. lìv.ontra\t, Iolcign\ deprecjation raiscs t,.rreign\ extoíi,
plnÌ]ng IS,\I'' up, sa\., Lo ôì]!:Íi. Ar thit puíres up i_. So ìong as i :. i , . wilÌ go on
appreciatjngind.deÌrrc.lJtÌngjthi\ìnturnmearÌ\thütIIomeextorrs.ndt\\i..Ír{ilìgo
!r taÌììng il1ÌovirÌ$ Ìcirhardsl and IoreiSD cxport\ â d 1JIM' r,iÌl :jo on risiÌÌijj thus so
longari:I'thereirâniLLtonìati.p(xesstuslìiogidoNrÌandi upuntilthrtÌloequâÌj7c.
\t that ltoint . Íopr atpr..iatiÌìE (r,- cleprcciaring). .{ìd 1.!XtÍ ând /tÌM_ nop movingj
d rÌew eqriÌibrium ha! bccn rea.hed. FoÌ \jnrplìcit! âs Ì!e lìa\ e dÌawn l,, rises to i; ând
tlÌ1s í equal to the neh'raluc ol i, ÌÌanreÌv ir. ln.n! ca\e, iÌÌ púrcitle, as /5XI_ nÍ)vìng
xp Ìaises i' and 1JItÍ nìolnìg dow! lolrer i, .t sonÌe poiÌÌt the t'!o inLcrcst râtes $,iÌÌ
''I.lr. r/rr' t,.rr|r;.r ,, L.
r,Ìcìg! anit that The nc(, rquiljbÌìum cxchange rate is rr. Wc hitr cÌplaiÌìecl the adÌusrmcnt pro(e$
uslng ba.knr l(ÌtiLng cÌ.h.nse rare extcclarions bur tlÌe neir stÌ)ú tun cquilibiiLun
silÌbe Ìca.hed iÌrtanrlJlfcxchiìn!e maÌketopcrirtors knor t1Ìe n( eÌandoutputadjusts
lr\t. Ì. Lhis case, thc rxclÌììnfr, rdte junt\ jnr mcdìatcl_r to er ar rhe comnron intcrest
ratÊtoir i;.IÌrtìreshorlrLm,Lrothecononrìcsbrrìclì1intenÌÌ\olhigheÌourpul lronÌ
II(Ììc'sls.alerpanrjon:lìlghcrgo\enÌmentstc.djngalHorÌÌecro$dsout.rrcxports,
\vhì.h prcvide\ deDrand lor l,or€iiln. 1tÌe highcr s,orld intcreÍ r.te entaìÌ\ Í)m. .rord
Ìnia out oI iÌn.Èstnìen1 sp.nding in both economlcs brLt highrr govennÌe.r sl)c.ding
outlrcighs the eitect oÍ this on o!tpüt rt Ik)mc and htghcr.ct c\poÌts orÌtlreighs rhis in

Some simpÌe nìâthenralics

It is usclÌrì to nnN Lhls rcsolt (trÌd otheAt analvliciÌh. Io simplil! the aÌgcbÌa, wc use
Ìinear lun.tioìs rnd b(.us on the net cha.gcs fioÌÌÌ the initial to the rcw slÌort run
e.ÌuiìÌì/lulÌ. first thc /!ì11 sche.lule i\ ilrìttcn

)':.r{ li d(ej
rvherc,l isihe baÌancc oitr.de.ìnd í,1,, andi arc positive cor Atant5. B (l.rÌtc n d s positi\ eÌv
on thc cnchante Ìârc (!Ìe â!\u Ìe that rhc VarÍrâll LenÌeÌ conditjon holds) tìnd tìn
\nÌplicitv \e â$umc Bir') .. \\,e wrjte rhc net clÌânges lrom tÌre iniLjat to tlÌe ne$
\hor1j(1o q!ilibrium, c.g.lìoÌÌrrn nrrr, rs \r r! l.o, etc. So $c.d I,rlte thisâs

lt = d \.{ l)li rlr

422 .: :

Nextthc lM schedüleis i: ìr, /rI'I of in dillcÌen.c tenÌÌs

li = ìÀt /r^M
l\lhcre Crcch letlcL arc chosen to rcPren'nt the constarts iÌì thc
tÌt equatidì Ír 'r\ ÌL
make it casl to see bor! the pirarÌcters of thc IsX'\Í an'ì of llrc
lM coìne into pla\
Ìorloreign i!€ have

fr,- =,l.g' }\,_ .\r

where ire r gain sinr Plily by â ssu miril t]ì at lorclian \ rÌa'ìe balaìrce is ts't') !
^n'Ì
t\i :,\lr,- !lI,Í .

A1so, fd conve.iencc it Í asruÌÌed tÌÌâl the schedulc! nr bolh blocs hale lle sami

rale lyslem
Noi{ bear ijÌ mìnd that a HonÌc fttcrìl cÌt:ìnsion iÌÌ a Íleriibìc exchange
impÌics lM : lÀÍ' = lG = 0 ln addìütr \i '
li_ lÌris ìs üue all poli'\
lor
ch;ngcs silh tedcct capitalmohìllt-vand ivÌththcalnÚlllonthatiÌìthcne$'shoú run
jntercstratcs dnergc duing the idiustincnÌ
ecÌuilìhÌíìn, i; .. ÌtÌotheriro s, clen iÍ
prc,ccss, thcy must elentualÌy be thc saÌÌÌc it thc exchaÌìgÊ râte ìs tu b€ ÍabiÌlTcd Nc\t'
ihesc asunrPtions are phrggcdnÌto lheloürequatl{trìs We getlotÌldnc'

Àl = d'\.{ +
'ìl\)' 'l'
Notethat-\r : ìÀ)- - \i - lll, sol/ - lt_ Hcncelìonì thetwo foreign eqüalion\

= Úìll '^c'
^I
AddÌnt thcse two equations logetlÌer

2^Y .r^J zDìAl

ì-q tr
't I]
Thi5 cxpre\sìon Sivcsus a cìeârer locu\ on ()nìPdâtivc rsuÌts:

. As wc hâvc seen, b-v conrpaison i{ith the snrau open ccononÌ) caseì -- 0 since i'
^)r
iscs. and thus ex.haÌÌgc Ìate apPÌeciation *ilh i > i does not lorce i bacÌ( a1l the wal

to ì!s original !âÌue implyÌÌil -\f : 0

The compârison s'i!h tlÌe cÌosecl econoÍÌy í â1so interestÌng: ìn thc closed
. econonr)
i sinply .itavs ai À ìn lig 12 theÌe is no prcssure lronr tÌÌ€ excìangc markcl to
2
push li ctown a8âìn. lhc c.Ìuâtion' are simplv \)' = d^Í l)lÌ and li - '\l!'
' A ;. l,rr)'r"a "rl ltirF r ii'|riw rl-_ \'n s-r'r'ldl
|'rrl-J-r
'. lu r'' r \'' 'r'l
tidìaryettè.1 olthc cxcharge rate ls obliousll i]rcater on/ lhan inthc closed cconom!
case. So Àl - t+rì \J insteacìof -\f - ipi-^.s ìn the e'onom)
'Ìose'l
 Ne can alsr use this approach to woÌk out the eilè.t ol ti\ciìlpoli.y on thc ìnlcrcí rale
xn.lthe ex.han:ie Ìate. SiÌrcc li: ì \), it foÌldv! that

\i -\,

\ote tlìat tÌìis

is an üÌcrease ol €dictly haìl lhal oI lhc increase 1n the cl6ed econoÍÌy
\'1ìer€ li - (rtàr.\. these ' renrlts conlirm thc intonnaÌ aÌsument:t tlÌe end of
Chaptcr 9, wh€re we claìnìecl tlÌat lhc rcsuìls tor lhc Ìarge open econ.,Ìny (the 2 bloc
rÌÌodcl is thc süÌìpleÍ rÌa) of annlysing lhìs) rlcrc in between tlÌo\e lor the smill
open e.ononÌy and tlÌe closed ecoromy. Súbslituting lhe previous nro equations into
-\I = dl.\- ,À.\) .-\e i plies

\'' , I ' / _'

vonetaÌ]. poÌicy wilÌr IÌexibÌe cxchange Ìates: IIrnrÌe e\paÌÌsioÌr

llo e increases th€ money mppl)'. RcmcmbeÌ in thc smaÌl open el:onom)'câsc thcÌe it
rn initiil iÌì.rease in outplt lÌom lh to ),r as Home mover down thc /JXtÍ $'ith the falÌ
irr i. Ì addition i . i', so e rises (dcpreciatet an.l thit cotÌti rcs ftshing ut exporti
and lÌenc€ puslÌing/SXM right$ards-until ihas retuÌnecìto ì'. Hcn.cb,v contÌast to the
htcâl expansion iÌì thc small economy, núnetarv t{ìic} is hlithl-\' ctlccl ivc i. stìmuÌating
outÌNi. lÌut whrt happ€ns nÌ the 2 bloc case?
As caÌì be seen in the riglÌt hand pancl of lig. 12.3, ríe Íirt at io = ii au.Ì /0 at the
lnteÌiectiur ol15IM ând lM.lM thcr Ììovcs.lown t{) aMÌ reprcscnlìng the ìncÌea\e nì
Ik)memonevs ppÌv:'lallstotr andl.ìspushedupto),r. Sincet i, isnowbeÌ{Ni- =i;,
the exch.ìÌÌge r.ìte .lepreciltes, r rislng hom .o to rr.
As ldrg a \ i < i_ , r will contiÌìu e to dcp rcciate and loÌeiilll\ cxch ange Ìate to áPuecirte,
pushÌrg LtIM rightwards ârd aJJM' lctfilards. As Lt{À,Í nÌolas righttlarcìs uptltr, i rises
and a\ LüM' üìoles le1ìwârds do$,n i.À,Í', i' falÌs. At $nìe poinl tìre Íiiitrg i eets thc
íaÌÌirg i'. Asmnìe this takes placc Í'hen LtXÀí has iíen to /Jtìíi an.] whe IS,\M' has
laÌlen to ÕXM,'; tlìis is shoÌln in tìig. ì2.3. Thut the Ìesult ot monetary eaPânsion ilr

:i:ìi

Figurê 12.3 Beq!aÊthy reqhb.!Í ett..roí à hone monetary erFàn!lo. Ilerbe er.r.n!. ÍiÌ.s
 T
424

lLonrci\lhìl Ìlomr ouiÌ\Ìt Ìl.r{sr\ tÍì! ì tr)i triìjle Fo:eigÌ (rlÌrrt 1ll! Ìonl
l.r'Tlr,,m!,ìui\ìri\t|rtnuÌetrÌ\t\paÌLiorÌiÌrlÌ(!neleadrnrr(il.Ìrr..leLl.f..
rnrl rn rfÌrÌc.irljrÌr oi lorri:n \ e\(lüÌrBÈ r:te
B\ Ìì(!ìjir Ln! :ht cquati(Ìri to ht thi\ cat ti.r ir\ t) ttil! \.! = a rf(1 \ \Í = rl
hc .â. ìroÌ!: 0út|ut:Ìrirerje\ ìÌr lÌ,!ìÌr. \ . í) ìnl ltcLinÊr jf f.Ìclgf. \r' i
rirT()tiÌr)trt|uiLn.Ìrìrr!.lt li .íl liir'lxe irÌiert\i iìte teÌÌi. \i= \l . (l 1i.i
r rÌt,)nr. \ rÌ.hrfsr ratÈ.LeÌ).r(ì.1tr\.!Ìd l(,reiËÌr r rL,ÌÌe(i.{e! \r .rl
. \ìnrL. rhrL hr|Ìref\ i. ilLìt t|È l1u\,-r !i!:Ìrtrr\ f.:ifr i. IIL)rrr trlÌs donÌr 1lr.
1.1(J.\L iL.:LÌrrÌ!.ltÌiÌrrere\irati\thrr\eraqer.rilt()tm)nÉtarifrìli.\lnlh. lÌ\
hin.siír s n.. iri\:Lsn nrt)IrtaÌì t\)h.\ üort rÌ(ìt.ÌLrrÌ!i. tIe \(ÌLd L.lcÌr\l Ìilr I.ìlÌ\ br
nì(L!hh lril Llrr i.il rl iaLÌ iÌr i 5iÌrt tlk \orL!l iÌÌirrÊ\i rrir J.ìlL\. ()tJl rr)Ìl(ì .ulllÌ:
I 1.i..Ì.ir!s Brú. n.r ll(!ÌÌr ìÌr:tiatr(lihe ìÌrie[\i Ìrte t.ì]L \bL.bmra.ilbxrt.=
H..r..ì.'.lrifgr'ÌitrtÌLl-.Ìe.1.rtÊ\.tÌÌdl(ìrciLÌrr|Ìnr(itr5.uÌrA\!'trhr(ìuleDunrhj:r
l.iLrr.'ds d.r. LÌrc l I .ur r:.tÌ\l \iÌì(e thc l]Í .rr. i\ !Ì)rdLL\ tl(Ì)jng. r' nun ia,l
\irIg ll:l .\r.Lhtitr{Ìrtirrdr.LiÌrriÌrtlÌrr(,rLlìÌtrrrr\irrÈ!Ìtitr\th.trll.T.:.
i.n: ls oLh. Ìi \. x,r,rriL: n, ai th:t Lìt .(!ÌÌÌrrtitl\! üt)re(iati.rÌ .he l'iÌÊd rrrhdl!:
rrL.i!1..rilifLlsrrÌnÌcreür\rlf,ati(ìn,je. (.rÌÌÌìetiti\ e (]t\ aLrü !r'. Thi5 i\ ihe .l:\ii!
Lrr!!rr th! .. q rb,)r'. IoÌ Lr | |er 3lÌ(rre \ 1!cÌJ.ne tiìÌÌ h.rìÌ lìiSlìer (rÌÌrtrt ÌtlLr\ (rì tlr.
.ut|!i l,r\: r lori.'!n
I 2 2 Fix€d exrhange rates
Ii5caì polic!: ÌÌ(rìe e\prÌr\i()tÌ
.Lhciirrll(Ìrn(rnonr\rarrrn(rÌe\trÌìtn!r^lÌillÌl\rtirrtr\rri..cthrirlrÌ.t:rit.
nnriìnsLrn.Ìrrfi!drf.ìlÌrcrrn!rtherrrretL'llÌÌtrÌltjÌ)lieÌittr.Ìr\-olrtÌrrt..ì,tÌrorglrtlr.
LÌ.nrr\t r nrL)nr\ s!ÌÌn\ rrnÌ!iÌL!Ì(lúÌìSe(L.n,rri!Ìr1!!(L\rnfurr\!!)n.siÌj\r\.ÌÌnri
i'lhr6rL.Snrcnln!lIÌrntÌÌiÌÌEtlÌ!llI(urlcrislrt\\lrL\.'Ìr(ìtu\ijrgiÌl.lido\n.ÌgrLr
tr)i ÌÌru' nììlf\l:urioÌri.!!rrcÉtirctirri.thÈrÌrÌrll'Ìrr.e.r).t)rÌ1 thrn nLh..(Á.1:
c..noúrr r\ lrcÌe ihe llI (ur i H!rnr\ n\rir :Ìì t[Lt !!re thr IJ .trÌ1. Dorrs !t L]rr I \l
rür\.r.drrÌiol drch{rÌl!r!\ti\Ì)luirftll]\ t|crjiirÌrirte.i ÌnrLÌc.t.
The I Ì-.Ìoc nrL)!ÌrÌ i. irÌ Ì)etÌ\ceÌr tlìerc t\\(ì.at\. \ìlrld Do.. \rr|Ìrh. \r \/ .l.
(oI\trnt. The Ìlomr r\|i!Ì\iLÌr ot tì\rrÌ f.Ìi.\ iÌritirll\ tu\he! i rbt\. i . ifd Llìls l!.id.
tr) :Ìì iÌìtÌLìr Lìt n,rci!n Ì!!ÌÌ(\: thr ir!Ì\eilrcì(e i\ .L n!r r Ì i!Ì:l oÌ thr Jl,).r. I \/ .tLn I
.iÌrdrrr(^rkJtLÌtt|Èf(,rrìirnI\l rurìri|u\rirÌÌrfi.tll\ÌÌLh(ìtì.rfÌr!Lhrlfl!r
,,i nÌ!rÌ. . l)ìt tlt rr!lu.t:oÌr irì I .rejSrÌ !Í)rÌe\ .ìppl\ Ì\'\lìe\ !t i \.Llrii id.ii5f.l il
arLl\ LBln)it\.riSiÌrdÌÌrìeL.lÌìilÌrìrt.n\úlÌr):i.1 irÌ(!ìe!.trntÌ1rLsì..ici!.ll\ctlìil
ÌrtlÌr(l(trell Êf(!ìonr\.r\eb(r'.nirthcreirrtraÌr\rert)ir()Ìl.ln..irtoHinÌ( r\ir
the!rìllrÌreÌÌe!!ÌÌ!Ì!\ÌÌÌ!i.Lr!!1k\reJtr!ti\ttl)rÌÌiÌrtlrr.nrrlltì|..!..onDnìtnÌodrl
LJf(r!ri t[Lt ti!Ì\]'rr ji Lrr!r rnoir| t. Lìit tlrr torril r.lcir!L r.Lc r \\,r rrn lolliÌL
th(\rilÌ rlÌri x!fÌ,eÌtr iÌr I i3 1r.1.
\\ . \tri . i uÌe jrìirr\È(Ìjin or ÌJ-\IÍ.tr 1IÍiÌÌll.Ìnrr.dIJ\\/ inir..\l irìldrejfÌl
\ H.,jì!.1ìi.ìL r\Lrirrri.ÌÌ pr sh.i thr 1.!\ìÍ .ur e rirlÌtÌ\aÌtì\ rtìrrÌds /-\.\,\lr \\irl:.i
ib.rr'i .lor.i!ÌìlLrìi\Ìr,iI.h.5.th.ll(!!r(urtn.\ \'rittiigl \r L.rrii!LlIr l.,nrInÌ!
Lr.'\iini rÌìrlL\l_nrÌ\,ì:d\i I Ìr!5irjxsut)i .lhu\e!ÌrLlib,LuÌ s'.,r.hclliÌrHonr!
,rÌ Llì. iÌÌr5r(ii,Ìr !il5-\.\lr ifd/11 nithi rr i-iì enrlL Ì..rrìniÌrl().rjirÌ
,ìt lì !' iÌÌii\r( iirÌr .l l5-\.\Í r|il.\Í
l üitÌÌì Ìr.ll(!ì!\lsiiÌl .ÌpiLr\iür r.rirer dÌÈ
 425

Figure'12.4 .ÌÊ'1i: Êilr jtì

r. rìll t hit
I\I
l.\/r

!
Figure 12.5 !. ì Ê -.r.-rrr e:pi r..r i
iÊrl'ri iìr ìl: iÌ:5

' \-Í- i\ roÌld iÌìtcr.lt Ì.ìte âÌì(l lhcrrnirc inrfor.s n.LÌt nÌ.i!LÌrui.)n lì(trei8rì loüorkoutilÌr'
r.strÌt!sirÌ.{lÌrte!Lì.tlo.s,henlrdloPlt \r = (1. -\;i--lli'cl \11 \ìI
(lrtlÌ'
1!ôrÌcl !ìürr_! \uttÌ\ i!.o.rtaÌìt.

MoÌÌetary poÌic): Honrc e\pan!i(tÌ

B! contra5t Í thr 5nralì (Ì)en c.t!1oÌ]]! .r\c rlìen' n(Ìri1;ÌÌl e\piì'il'n undcr lrxel
Lth
c\chrnlr ,etes has fo r' i!.t on otttÌrui. i| lht 2 blo. modÈl otúfut rilìândt equilÌ) úÌ
both.oúntric5.ArÌothcÌ1\r\.lpirttjnillìl5Lsr{)sa\11ìilìtnÌnkttnodlttreÌrerìrciher
LhÉe\p..sion.ithr.ì.Ìr!\ $pph taiie\fÌi.eiÌ!llomeorlorcign Lh'lntuiÌion lstÌÌe
renÌe,ìs ÌrôuÌiÌìg I a1.r ifrt) oue c.(1(r ÌlÌr othÉÌ (ú.r tlouslÌ ilÌthrihntten\lslhittlìÈ
Ìlrier k\ cÌ Ìi\e\ et rr|rh!Ìc untll the nìriiìrc i\ rsrirÌ fat; lÌ Lhl\ 'r\', lhc e\trn mone\
fleàd j Llcli arNnd lÌì{ 1\ oÌl!l u. Lll
jirtercsl Ìatct drt r{ÌuìÌircd rl ì ÌìÚi Ìoner
'r!Ìlron
le\eL ln ig. ll5,\|lslrrt]\Ìre1rrÌ.ettlìr ntcrectìorì! ol1-\\\l enllÌl ìndotl)\'il'
rn.llil . !henure\ 5!rftt!in(Ìrisc\b\ \ì/ â.(lthis p(6htsl-\'r ddÌnio / IIr'irìrfìring
x(utiÌìihci.tere\trnl.t.i lronri=ir j. lThe lJÌìI.uI'. 'lots rloL \hütlCiltr1
tìrat ir . i' : iii, tìnd lhÂt lhere j:.o eÌclÌifgr' rateri:k (1 .i i'\eÍ.lô iÌnnredilL!Ìl
426

transtcÌ tunds oul oí Ìlome irúo lìorcign t{) Cet the lÌi8h ratc oí ìnterest Thls lÌ'1 .or;
slÌìIrs ut ÌefÌectirg this Ìoss ol rescrvcs ât the sâÌne tirne as ÌÌ'l' move\ clorln .s lher.
fu.ds âugment M'. Thir Ìtrocess Íops as íx!Ì as nìterest ratcs arc e!Ìualìzed agaìn wjtì:
lr = j: oÌ wher€ l.Ìí2 irrtersects ll,{,M and IIÍi ilúer\ects lJ,\t/'. OtrtÈú expünds cquelÌ\
in both economics: at H(Ìne fronÌ f0 !o tì ând ir lor€igrì lrom )ì n) /r_. checNìng th.
rcsuÌts usirg thc c.Ìuati() PÌocecds as in tlÌe otheÍ cases: hcrc ÀÍ : 0 tnci Ììe assum.

Lì Adding the income Íeedback efÍect

l o rhis NirÍ. spìlìoiers Lr€tNecn c.onomies hnvc o.cured onlv through.hãnges in itri
ÌJìLeren rate and exch.nile ratc. \{e hrve nol (alcn account of the posslbilit) that:
change in lorcign irÌcorÌìe booís Home aggrcgnlc dcmând via incÌe.s€d Home e\pofi'
and vice versa. In the \ alÌ c.ononr-v aniìlysis ol (lhaÌrter 9, it $â\ âssumcd that Ilorri
policier had no cfíect on foreign income, so lbal lherc rteÌe ro leedba.k efíe.ts hoJrl
lorcign a! a rcÍ1ìl ol Home polÌcics. On th€ o(hcr hand, we clid inclLrdc woÌlcl o!tpu:
(rt) as a deterrnÌnant .,1expoÍs. lÌr the 2 bloc modcl, it ìs the case thal an exPânsìo.
ol ourput in Honìc wìlÌ ralse denìand 1n loreign sirìcc Home,s iìÌports rlsc $ith ìnconÌ'
and constitute |oÌeìiin's elpons. How are th€ rcstrlts íor the 2 bÌoc nÌodcÌ modihed fÌ
anrllilìe.l bv iiÌcome lèe(lback cllcctsl Ìn tÌìe iour.ascs Í) fai, the chargcs ìn / arÌd r'

(l) ÍÌexiblc i'r.hange rirte/ ns.al cxpansioÌì, \),' -- 0

^)',
sìon, ll :' o.
(2) íicì ihle erchân gc Ìatehrionetary cxpan -\t <0;
(3) nxed exchange râte/lìscal cÌPansi(!Ì, Àl '- (l l/' -: 0;
(,1) nÌcdexchângc ratt/nronetrr) expansion, l/. l,r-- -- o.

ln cascs (1) and (1l,whe!e rve have locomotive ellectsinplryin thc scnsethrìttheetrcct\
on ourput are posiÌì! e iìr hotlì bLocs, iulthe.po\itile lilrLages bchlccn tkÌÌe ând forcign
ourpur wiÌl rei oÌce those po\itirc cltect\. \{hat is more intcrcslìn!! js that the posj
tilc incoÌÌÌe ie€dback etièct il ÍrllìcìcntÌy nronii cân alter thc bcggar th-v tÌeighbou
pÌcdictìdrs ol (2) ânL] (:ì).
To ilìustÌate this,wetakecâse í3), a nscâl exptnsidÌLìnderÊxed cì.hange Íates llì€kc\
mo.ìlfrcatioriiì lhe equations is to adda ternÌ iD lt'to the 1-!\M cquation ancìin to
l h c ISXì,Í' equatìon. \'\'e therelore hnÍc the t$o 15,\n'Í and the tNo i ì'Í equations ^l
fün.
thc /sIM e!uâtioni nÍ ÌÌome rnd lor€ign:

A/ - !1.í l^i + d^l_

l/- : ,ii I
'7ll
aÌÌd thc i.,!Í cquati.nú arc:

li 11\ì,Í'
^A),'
 421

ì, !'s .town ir\ these

ìii Che.ting th€

Figurê 12,6 Lô.omoton eÍÍe.ú homeÍÈ.a

!1:,i\ibiÌi1y that a
erpàni ôn:Íred €t.hafq€ rate

whcrc lM,\Ì/' 0. ThetM equationsimplythit = ] \), + ]r\),',sowehavethe

r\.o êd , ed v. 'r .gS rc r. Lc r'ìd ' tL ,lior .: ^i

'r:rig',*ïË"'"'
11':1jr1.
This i\ ilLustiâted irr lig. 12.6.
ll d,iar/i ,, rl'.1 , r'e/. \ 1,..\.,.\,.11 'hr .t,\d \ lopr-
ÌiÌìe 1s tlÌe âggregate deürâÌÍl eq uation for l/ and thc s lceper that for Al" . I he €quilibrÌu nì
iJ wlÌere the), interse.t. A! tlÌe two lììÌcs harc bccn drai{n both AI and ,\/ arc posiLh.c.
As cân be seen lroln tlÌe fonÌìula for f, thc sìopc oÍ these l1ÌÌe\ depcnds on lhc sign oí
./ +. l o get botlì -y and Al posilirc,rcquiÌcsd-'9.ThereisasimplclnlcrÌrÌctation
ol this condition: it is that the posjlirc incom. cUcct oll_ on L naÌÌr€ì,v d, oulwcìghs the
negatile elfectoll viâ ; onf . nanrcly +.
I the previous $bsections withoú! lhc inconrc fee.llück elfect, d 0 so cvldcndy
,/ I - í1. hÌ tlÌat case the 1Ììt€ne.tion ot lhc trlo aggÌeiiate derÌìand lincs is in lhc loP
Ìelt quâdraÌÌh{ith AI > 0 and Àl <0lnlhcbaìancnrgcaseofd:?,sotÌÌallhcA/'
aggregate demand lxìe is verticiìland thc l/ ìinc ishorizontal, ilÌe nìters€ction oithc l o
Lines is onthe lerticalaxis with l/ , 0a.d :0. Ììr thjs case, / is zero.
^/_

2 lnteÍnational spillovers in the medium iun

lve now tLuD to anaÌyse Ì{hat hâpperÌs wh€rÌ wâges ând priccs arc all(Ne.Ì t() acLjuÍ. ÌÌì
the mednìmnüÌ, i.e. aiteinagesand prices ha!e adiusted:

. The effects olìnonerary policv acti()ns dìiaptear:Home and trorcigo rctlfn to their
inìtiaÌ equiì1bÌ1um ìevels oloutput.
 . hÌ the Ìncdnrm Nn, tÌre cílects oI a HonÌe fscaÌ expansion
are úìdependerÌt of th'
exchange r:tc regime: thc out.ome is \l' r' 0 arìd
\)i < 0 L

cr
lo.rrlotik . fc.t of a I Ìonì c lìscal erpansi{nì u n ']ei flcx iÌrÌe cxclÌa n ge rat
1i
. Th! s, the
IeVcÁeCljIthen]ediunìrun'l.hcshort-tunÌocolÌoliveelícctlorlloÌeii]ncoÌt]csflomtì].
ex.hangeratedcPrcciationbutthispushesilorúsidcits'ìUo'candinflaiionSoesuf
ir l,r.,.p"nl""t".t A".lines, ì1 rcturns to the lÀU cuNc at lor'cr orúptrt than its init1tr'
thc HoÌnc ecoronÌ\
e(iüìlibriLr;r. be.ausc the (ÍrrÌd inter$L ratc ú hlghcÌ' Conrer\cìv
re'iÌìrorces ils oülpLrt gâin as falling iÌúLntioÌì hooÍs 'olÌpdjtì!erÌcss
.Illabcj{g tl1\' ,ltlshboureÍ..r oIa tÌon€ 1ìscal expansion undÜ hxed cxchani'e rnte'
is tìrat outÌrt ìn lorei:in lalÌ!
prevaits tr-i ls attcnuateci iÌÌ lhe ine'Ìnun ìun The rcntorÌ
lisc in t1ìc worìd ltncre\t
in the shorl Nì at I gi\en rcaì exchange râtc (bec'ruse ol the
rnte); this lcaves forelgn iÌÌsjde its /''RU ctrr!e
s'itir falling inlâtior and the resuìtiÌìg rist
ouLfut lalì'
in conpetitlven.st lor loÌeign offscts some ol the iniliaÌ
,l r" jl ,. '3'r"r'
internatio.altc.sion ìrthc medìunÌrun thatis assúmed ai{a} b thesnìaÌÌopene'onoÌlr}

ivhat rlln ÌnPÌication5? l:iscal inrbilance\ 'rc associated with ire'ìl1h

aboLú the LonB
associaied with lrscâÌ elpan
tÌansleÌs bttwccn the blocs irith a cunerÌt âccou't cteicjt
slon in onc e(ononrl rlìrllicevcAr foÌthe other cconom-v ln the Írìalìopcn €conoÌÌrl
run equilibriünr x'ith falÌjtg or risÌÌg ('ealth could ìrerslst lor a
uu"san th^t a ,,,*1it-
lorg periorì. ìi!,cìúLraìÌy, lhe accomuÌitel Íoreisn deÌrt así)cia(c'l
rilh dÌc couÌÌ1r) n
üÌ priute sector denÌind ând
,U.g'" p""U"*.,,.", nuplu\ Úìgg€rs a
'ledrne
"cco!n!
u rà.iti,". in rr'e cu"enr account inrbrlance lhis
happens vlr i!€alth ellcct\ or ua e
âbout lohen')
mo* cor,nacri-tarl tiscalstance dlrectly, as a coDsequc'ce otconccÌn
ge craled by erclÌnnge ralc deprecialion as
or inclìrcctì\', âs a consequence ol inlatiLrn
jntÌrtjon
âs a nÌean' oI
i"."'g" *.i".g" anticiPate lì1e rccorft L{) a burt ol
",-r"ìs
re{ìu:jngthe dcbt. tn thc 2 bloc nrod.ì therc ir âlsono a(úonìntic!ne'hanisnr lorrcttor-
helps to e{plaiÌÌ ibe poljtìcaì
t"t i,,*"- The nnaÌvsis of inteÌdepcndelÌcc
"n"Uft.,.-.
.iii .'li" .rLü,"i"d"* ìuìated ìnternatìonal ilnbalances rÌì e\amr1e' undcr ner-
"ccuhârc seen, a lìscaÌ conlractioì
jn thc de1ìcjl couÌrlÌy has thc
iLrr" otc.,
"rcr,-tgc "s "'c cx'hangc Ìati'dtl)recìates
short rLrn efìcct of rerlucirrg output iI] lorelgn as lçcìl: Home\
ThisNilL bc reüúoÌced b,\'anylncorne ícedback effcch
an.ÌlorcigrÌ's âpprc.i.ìtcs

2.1 Basic diagíam Íor medium-run analysis in 2-bloc model

lhe b.rslc diagrrÌÌr i{e usc to analvse the mc'Ììunì rltn is a deleloPnÌenl ol thc LRU dia
gúnoíChaielsÌ0 ìdÌI IIÌclíecttlìetÌome-LÀLf iiri+am i5 thc north_erÍ {Ìtradrant'
lhe varl
;ith l,on tÌìe Ìi8ht horizontaÌ and É on th€ risnrg vcrticrl arcs (lor simplic!ty' aÌlquadra't'
abìet arc nìeasured ìn logsì. TlÌc ìroreign EÀU 'liagraÌì
occupìe\ thcÍnúhileÍ

r It h.tÌr..rnúi.\ lre utnr!. nì'nd r Ìuc nrnller lÌ'ìilrlc ê{'Ìlrrge úl's) th'r nrc 'd u(nÌenl nr dìe
(:hrpte !Ì id th( rnaÌÌ
mednn. rn rqúiÌiltrnú ÌriLl be ditieÌenÌ ijÚt 15 Ì!e h r \ren ri 'Ìre' 'rononÌ-r
\rnf riÌì ih' rrnì:r' ìÌai8hi
ì.'i,.tuuu '!tputJnjunm'fÌ '1"orir\
"'-*'-u"*.rxiÉÈxprdriiof dF rljÌrtndrr rdh kì t mdnÌrì rÌÌ
ro ihr m.dirm nÌL equiLil,riufr Ì\úh m'rê 1'r ntic isnnì$i'f\
c(luÌlLbr rm url.r r.rì tiaLr ru I Ìe!t.n'uiboÌh r'rnhi$
nÌiN'1,Ìt)Ìookrn'ÌeÌiN'iJÌit undern!ede\'hinge
,*ê\.iÌe.I'rÌ.dÌen nn.l.rodúLvrclL:e'L
 :. 429
f.ieperdent of rhe
with , on thc Ìefï horizontaì aÌis and l- on the fatìirÌg verri.al âxn. in equiìibrjum
i{'ith constant inflarjoì, .s we saw iÌr ChapteÌ 1Oj a colrÌìtr\ has lo Lre on its LRU tf rhc
n,l ,'-r-,',I -."r. \ |..-,t I,i
Ìclition to the Ìcst of lhe rloÌld-ihe .:ounrÌ}' is ynaìÌ cnough that the r.Í of lhc woÌÌd
.lo€snornotice.lnthe2blocmodel,así,eharcseeÌÌ,achanseirHoÌne,sreâlornonìif,t
',1..r .r, .|.t rr..t.r,or...r 6,, t. ;, e' r^- rFt, ú,.r.L ur.
.rl-.u ",.r',,t t.ê,r.,, iF\ i,tr\i /,, r, n úJ.iôrjrt.
l .l'., 1- ti ... .t ,.\.ot,,, I, . | . F t u . \ . . I I \ ,r J i .\..\ Â ,J t.
I I I
.
, . |

in the small opcnecononÌ\ andìs shon'n in ìììg. 12.7.

A! can be seen, the Hone,Etar i\ in rhc roúh eaÍ.ìuâdrant and tlÌe Iorcic! EtU
ÌrÌ the
'.'l . r l. \,h.m rl,.i.r i., ,r,:b.r\
is sÌÌo$!r b\ rhc Ìine in ìe nonh wesL qua.lÌani. Ìt tras a slope ot.1-\,
indtcating ll;t a
one unil iÌìcreasc in HoÌÌÌe,s conìpetitiveness irnplies a one unlr rc.luctjon iÌÌ Forcj!n,\
\, i i rr.6.rrró r... ,or.,tl,,.\ Lr ,.t,..r ../t,-rJ
lhat thc coÌnpcttti\icnes\ of ca.h btoc is consisrent wlrh that oÍ the othcr to woÌk
our
Nhatcombination5 oir,arilr, aree.Ìu l br'rìm.oÌnbirâtion\ín Llì€2 economv
\!ond as
'r ''.\..'''r1. I,t |,i1, ',, ., .'r,i I \,.,t,//rJ,, J/ j
'1\vo tcts of equìlibÌiuoÌ
combinari(rìs of t and t' âre .leriled explì.it1v ìn lhe cliaj:ÌanÌ.
l' n.\i rh'l d, '.\, ,to,t",t rh,rn., .,t"..H, /prml t,..r.,^,
ì..','l-.'"ri r.\- ,,..,., .t u.ì r,.t ,.,.r.,.,,,.tr ,-r.,
Í,âije arìd hen.c a hìgh leveto coÌÌÌÌ)etir iven elt j ds rÌÌ ean ! in ruÌn rh at com pcttiven
css
ir FoÌcig is low, lvhich jn runÌ inÌÌtici thar equitibúum output ir ìroreisn is htgh lhìAh
.r , nuto.,,,.I r. \ 1r..,.. ;t ,rir,r , ,.t ..,. . ^, , ,.
conÌrctitivencss). Thus the fì6t equitìbÌtuÌn combiÌÌatìon ^..1,.
is (yr.I;),1üich can be tound
byhacingthc drslìedlüÌethr(Ìrgh the tourq adrâ nrs of thc diagÌanr. ìly folloÌing eractlv
the sanÌe procecluÌe, Íüúing a,ith ).tr,I,c get thc.olÌÌbinaLìon (rÀ. yr,).

. LRUÈ

ll
rl tlìc ÜLr dia

i.f , )';')
ri

..
.J];
f,tuh.

Fiqure 12,7 LrÈr! no the,!.r a ÊFl]. nre

4:10 r,:,, ,. .:,' :::r: r.:::

lve delìn€d cquilìbriuÌì in eaÌììer chapieb 1n terms of constanL ÌnnaLion ralcs, and it
$'ill be usef(d to shoÍ' rh at th e Ën Lr( Ìepreseìrts conúant wo, /d n fla rìon, scc ìiì9. ì 2.8
Ì

We nì.k€ the folÌowiig asÌrmptions:

. 'i; .i
h 'F q r' /,.rlJ rc Hom rd lore sr ir n..riJn. dl d1.
arc nominaì rÍage iúÌatio nì Home:ì d foreign. this foÌlow\ lionÌ assruÌÌing Ìabour
pÌodrcri!ìty ìs constantin HorÌÌe ârÌcl ForeiSn. Next

as i),,d) 1s on tRUÊ
W>'ì

inside
--. i\ h ,ìi( un lRll.
w_-
outside

lo lrndcrsrand whv woÌl(l iúÌation is constânt Ì\'lìeì th€ Ìlorld economy is onL(Urf,
lhc sìmpìcst cate to take is lvherÌ an ecÌuilibrium outprt coÌnbiÌìatiüÌ, srìch as (/Ì_.fil),

Figure 12.8 aLàbe .Í:tÒn a ônq the EÁu,

 431

' !. ll.8

- &d li-

Figure l2,g sinrÊir. il rf. .ì l,r-Ê rÍi:.{r 5 ìi'' 'r:ii I rtn_ à r'l

ilor\|itlÌÌrolh Ììonìc orÌihrir rÈt])..lLrellìtrs llÌc iÌrgrunrrrL j\ tlìrrì

i.dFon'i!rÌ ÌJÈl.g
\reistrtior(,ar.ì:\ìÌì..;:rt=:Ji 5ll:rndsirÌ.!'l'r /'rrìarÍ1'ri1 '"-ì rrtl)otlì Ônthclr
er.h cconlnì! $ ìt silL rcmain.o.rtaiÌl l. the Íorl'ìe'o'om\ '
Ìrlerj.ÌÌ.inbecdìnr.lúÌlhcu1rrldllcÌì1l,lr'rcrrÌ1d rr "!t arÈnlto'th'i'
ÌÈ\Lìc.LÌ\elÂt,! rtlonS,ìsrÌrerorÌ.Ìe(onÔÌn\ ìroÌì LhcÌ!o l!ìlÂL \\:e\('lhi\iÌr ig 1l!
hr LhÊ e\rnìplt I r,r ' rrt rn !onrblnatirr' 1 t on tlìr I lLir' Lrirt lreitlÌr'
'quiLlbrltrn
inlÌ,ìLl.n as lo.g x\ i1Ìc risjÌrS inÍlaÌi.Ìì in Ìl{Ìnc c\a'ilf 'tt!'Ls the inÌljnS inlletjoÌ in
lorrjf.. TÌÌÌ5 it;ÌÌ Ì)e tlÌc.õe r5l.n! rs i recÌtrÌi.iÌ rs\rLnÌrtion j! rÌÌetì that is that tlìr'
IÌonì.rÌrìllip\.rttre;ì ;, ÀrLherrIrrtheorth()ilo'xÌ(Li:linceol 1!lko$L'ÌL'r
ud llLLh drÌ cqrtnaLeni ronlliljo. hlldlng toÌ ÌoreìBf 1\:e nete üiih'trt lÌ.)!in! ll
\houl{ÌìrÉ\is!iÌllvt\ ÉÌll thrlliLr'l_ is aÌr eqüiÌibri!Ìì lorÌÌìrinati'r' lheÌì1r ilrrÌìd
r'. ,. xre eq(l(ÌinaÌÌt ir'oir th{i, Ìe\Ìrr.lncIÀLj: \!1uÌir' irrln5ìdeltsLlUind I rl
rnúsi.1cit\tÏ1,ror\ì(e!.,sr).litht\e.on{Ìjiionslìnlcl.-Ll= 5+r'5ll- na r I À
arcL l- =._ l Ilen.c i\ Longai rn oulput.ombirili'rÌ ìs o' lÏLr't thrÍoÌll
LntÌ,ìtion f,ìte n jiÌbe con:tn.t rilh ÌitúÌ! lf lìtìdr in onc c'onorìr Ì)rLiìfrc'Ì l)l iiìÌÌnr!
iulÌirtlo. iÌr thr olircr.

2.2 Aggregate demand

\\ic !re\i i.tÌo.ìu.e Hont drü loreitrr iìlgÌ egrt' dcnÌ,ì rì d 'urtcs' TlÌesc oPeLìir sLniLarll
r.Lìre-.ll.rtr\t5ìÌìfhiiltÈÌ 10úteie.llon.ìr Hort\ellhereisonÈìÌnpoÌta!údllierel'L
432

In Chapteb 1r-) and 1 l, thelD cu.vel\ dr.ì$,n lff i gn en ho dinteÌestÌate\nrcethe*orld

inteÌest.ate is exogcnous n) the lnaÌl e.onon]l. The conscquence icas tÌrat erotetÌou\
shlft\ ìn the Ìlorld lnlcrest rate stÌifteci tlÌe.,i1) cuNe. Ììr thc 2 bli)c nro.leì ouÌ asumPticÌì
ol iltegrated .,r pit aì markets mearìs ìs unral thal i : i' thrcugholìti but by contÌas liih
tÌre nÌall ecoÌÌoÌÌr,v .ase, monetrÌ), a d tìs.aÌ poÌì.) cha.ge i,ri, i anLl; . f.ach a33regat!'
dcmrnd sch€dü1e is dÌairu fü a siÌÌgle vaÌu. ot i : i'. But irìren the actrìal Ìelel oi
aggÌegate cleÌnand.hange\ (eittìer becâ!s€ oi üÌ:)netary or nscal tolìcy, or l)e.ause oi
chaìrgiÌrglnfÌatiorÌlthc.i:i'wjllclÌanccarìd('.n,ôÌn'r.rfêÌ(';rD.,,nêwF(h:ll
sìroir how tÌÌis tales pÌace beÌov írr the difirrcnt.ates ot lxed and iÌoatiÌrg exchrÌÌg(
ralr! and monetary and ijscaìpoìicy.

2.3 Excess world demand

A5 apÌelìmilary, tito LrÌocs crea1('s in
r\'c slìolr ivhat happerÌ\ il agÂrcgate demâ.d in the
overaìÌjnllatidÌârtsilualion,i.e.th:ìtii.lìlìcsoutsl.letheEnLI,ftiÌÌe.1ÌìIiil.12.1i),tht
nD an.l lD liÌìes arc rcstecti\eÌv the tloÌÌrc afd ì:oÌeìiin aggÌetate cìeÌnand sch.ilulc!.
Wc asstrme that the t$ro cconomìe\ ha!.È ftcntical paÌameteA. ircÌu.liÌrg iìr thc rno.cl
Írpplt an.l golenìm€rrl cxpencììtrúe. LÌ addi(ion , : l].
Homeì\atÌroiÌìtira.dloÌeìtnatpoirÍl.lt.inbeseeìrthattheoutco eoftlÌcsc,lIl
cúNcsisthatit,.ti)isoutskleEÃulr.ândi),r)an.lit'. , aÌe outside ilìeir respccLi\r
/lÀLr schedules LJt €qual aÌnount\ so tlÌât domcttìc ìnÍlatìonary pre$!res aie thc sanr€
ìn botìr bìocs. Wc iÌso assiune e\clÌârge rnlcs aÌe Íì\e.1. ìrr)nÌ the di,r$rânÌ, it is clceÌ
rhat alth the 1eïels oi governÌrent erp.êndllurc in each countìv 1ìxiÌÌii the Á, cunc5 ai

ltÂ

EÃt,'1,,

FiquÍe 12.10 Err.$,oÍ d:qqrcliÌe demind

 413

n!:r\n.Jrì(iÌuilìbriLLmorìthcLo!|lÌie: iÌ'dtÌtr'ÌÌoÌLd/lLislDÌ)o5slbìe lhco!1ronle

\lllther.t.r;beÌi5i.glúlilloniÌìb.th.ountrìÈsiÌÌrdrisi'SltrljdiÌÌllrti{!Ì iis rÌro\tf b\
polnt n !uLsj.ìe 1lì. Ì!.rLrl I /ìLI
'Lhi\..n be ìÌÍ(r'L]Ìtte.l is JÌoLlrcr erampLe ol tÌre inrÌrl't ot spill^trs: !r(lÌ 'oún
ÍJ seel\ lô a(lìì ,'a neÌ\ .o.ttâ|l úú1,rLl!Ìr rìxìlunI íúr eilrLiìi!riunr rt k^!tÌ unrÌn
plo\ ÌÌÌerÌL bi r!tri.g lor.nì Ììent sleì i|g'Ìtth( otì1er"u|lr\ renìiL"p'rsstre
Home
rcflcr es tfls rntcomc lttrìs irâr !L1r^\ t tlìc r$uÌÌrplioÌr ii ÌÌre 5nraLÌ !Prn e'o'oDl inaÌ
srnt 1ú\ choore th( high lL\ et
r\iiì. llos,$ o, iirÌ.. both .oLrÌrÌriii reason iÌr tLÌc ' Lr()lb

oi g.lern.ìcnt \!rc.tlinil. rriLh tbc c(tÌscqtren" thrt lrt!Ìrl i'ílatio' Ìitts lhe tiÒÌìd
jni;re\t iìl. rilL Ì1ìL:n rite, 5hlftnÌg the.llJ cun es iÌr a Ì1'striciilt dìri'lron ln ca(h 'ouI
tI: dch ÌlllÌ ietul. ro ÌosLr olipttt ìrrrt it tlìe cosl !liÌ terio{Ì ol bigher ln LtnnìÌrtts lhe
ni r hnal 5fllL(trü ot thls kir!l n ilì1 üÌrtÌe el'harÌ!c
Ì,;ìtenÌ f.Ìj(\ 'Lrrr)7one
aLelrrerocarrrrirrdi\oÌrrnrotitili(ÌrJottÌrepr'serÌ'roii rsctìj p!Ìt!rule
(;ro
s'itÌÌÌì
'
ÌÌonúaÌ\ u.ron \!c Ìetunì i. !e.Llt)n I 1"ìir'!ss tÌìe StaÌ)iÌllr rnd th la'1oÍth'

'Llì. rdì!n nìcnt piìÌh ba.l to th..oÌrtt,ì'l úúÌrLlon eqrrLiLrrltLtr is shosf l' I1! 12 L1:
rhe s1sfunL br'gins.rt n in tlÌ. n tlrcenqL[ltrânlâ'liÌtl]rn'l1_j'lìreÌroÌlheaslen'l
íúlì lle\t !l(ti'ìft'Ìs 1Lìth I - rr = I )r ' \\'c 'aLl lht inlliaÌiJìltre\t rere i ír ÌlÌnt
r, Íon 1ri rÌúllir\(Ìì.ìt1ír'Atrr,intÌltìon1\rislÌr!]!jtÌìthcre!!Ltthatthereil
ìoÌrr-t nì!ph Lr red't.c.lìn b.tÌÌ blor\ al i trniiorm in{'' l brL! iÌì tcÌÌn\ lll
lìrel\'\ìI l'\'r
.li.gr,,m, ìn.'-lnt"r"sr Ìrte j! benÌg ftrnÌc'] ut rn'1 tÌk' Ìl) 'Ln es sbitt irr
r de1Ìilronif
LÌn;.1lon Ìo í'lle.i thi\' N!1r Lhat clactl! Ìhe \i 'Ì)Lr'et\i5|rÌ)p'nnÌ8lnboihblo(!íi
.o rro.e\ nr.(ì\ to iloit l)etirccn thenr' \in'e t|' c\rlrnÌrsr ale i5 l\el
en!l ìÌìflrtioÌì ls
ihe irnrt ìÌr b.iLìr blo.s. lhe n'aÌ eri.harÌ!c ÌrÌe IcirrúÌ5 trn'hansrd
Th!s lhe ris! in tÌr'

Jf,

IÃl.i

! -. ,

ì/) li ì l

Figure12.11 -,iii,,. rlil:..rirl àilr.iìÊ.i'à j ! nr:Ê:i:t:5

434'::. . . '
r€nÌ inlffcsr rate Ìe.Ìuces I andl cqu ip roto rtidrateÌ,v \o that nì tlÌe sou th ea st qu adrn n t
wc movc rrp lhe.:l5c ìiÌÌe tìoÌÌì d lor'âÌds i/. Co esÌrDdirÌitly t1Ìere is a horizontiìl shill i.
Honìc\ quadÌant, a! I ìirÌls Nhile , rcnrai.s constant and a \.È.tical slÌift in the lorcl!.
quadrant as /' fau\ with its rcal exchaDge Ìate con\t.rnt. lhis pro.ess gocs on untjÌ I =
r and Homc an.L Fo.eign reâ.h s)ìÌmetììc equilibiiunÌ vaÌu€s it . ind .-. 1he intc6:
rate is ÌnbcÌlcd is to irdic:ìt€ thal rh ìs it th c stabiÌizini{ iúereÍ rate associated l\'ith \!o rli
outlÌ( al cquiììbÌúm at Ìrìüìt d. Ìn sccLion 3, ríe rvorl through each olthe cas€s of is.el
ând nìonctar)'policl un(ìerfircd and floalÌng exchaÌ]ge r.tes.

3 lnteÍdependence in the short and medium run:

a simple model

Ìn tlìis section wc look at wherc c.orÌomics end LÌp in the nìediunì nrÌì in thc casc oi
e\pansionary lìscal and monetary polÌ.lcs undeÌ boilÌ fi\el:l ând t1e{ble erclÌnngc Ìat
Ìegirìes. h e.ch ot (hese lour câscs, \!c assnme lhat uÌele ha\ been a Honìe expa.slo!:
i{hile rÍÌÌetary.nd lLscal poÌicies nì lìorcign Ìcnrain unch.rÌ3ed DiâgraÌÌÌs are provjded
in the Appendix for cach case in addltion lo an cÌPlanati.trì oftlÌe pro.ess ol adiuslmcnt
rul.' . r nrrrl lJ rh' r'.
tachcasecnn bc descdbe(ì by th rcc cquatio.s forÌÌonÌe:15.lM,.rnd l,'ÌU, â dthccotrc
sp,rndiÌìgtlìrcc tor loreìgn, /5',lM', and Ã,?LI'. These equ.tiÌÌs âre.Ìl ìÌì Êrst diflcrcn.€
to.m, so that, jrslcad of writing l.! asr = Í d; rl, it i\ Ìlritten -\l À3 ,Ai \r:
lV be.odrcs ai : ìlt !(ln lìi atd EIU is ll' -\rr. cor€spondin8l\.
15'is -\f : l.{' dli_ /.\'t' is lÍ' = ì\)r ir(^ì.{_ .\lrl and llrl-
is Àti - fr. ^ar,
wcllas thcsc six e.Ìuationswc nlso hnvc lhc unco\ered iìÌterestPait) conditlon ior
^s
rorl Ir riílur ''r r'i l-l rjr''i . r"ts.
Jddirion LhaL.r =.,sothati l',ãndhc.ccinouÌIMandlSequatioB,wecari p.)\.
thc.onditionthalÀi=ll_.fìnaìl-Í,ncnccdtoÌeÌnemberthe.letìnltionÉ=+,sothaì
ll=Àr+ll'' .\ I GenÌembcr lh c va Ìiabìcs aÌe in Ìt)gt. \ext, ile looli at the corÌclltion!
.\l I dÊ \. 'l .r 'l ì. , L, \'' . t' r-l'rF! r'
lixcd cx.han8e rate regnnc lhjs is dcl_r.cd nÌst by = 0: the nomiral exchaÌÌti
Ìatc docs not chrrge. But thcÌc is aìso thc Ìr.ÌLriremeÌìt ^r that the !!oìlcì nÌ)ne) n'p
tÌyisgncn and the mon€y suppì,v ln ca.h c..nomv i5 encLogenous: ]\Ií+ \ÌÍ- -
ÀM. Thus un.Ìer thÍ regi c wc havc nlnc e{Ìuatìons. ouÌ oÌlginaÌ tix tlus \á =
\. \^ f ..r'L , ,ì,1 r .. r,1 .\l \\t v. A ' rl- .

,: ... \, -\' . r' r '\'1 ,, \\/ v '.

FÌexibÌe excharge raie rcgi nÌe Ì lere br con lÌast tìÌe moneÌ ÍìppÌy ìn eâch .ountÌ) i:
iiiven, Í) that \À,íjsgi\erÌ, asis ÀI,Í'. Ìn Lhiscasrthereare\evenequâtions,ouÌoììginaÌ
\ìxpÌLú = \. Al,_ l| and sclcn urknowns, \Ì .ìi. r. \Ir. ÀP'andA..
rliih lM^rtAM' A3ândlj cxogcnous. ^tt.
 r : :,. 435

lvc assuÌÌìe in whar tollows that exp€cted irlÌa )n in ihe medìunr Ìun cquÌÌibriuÌn
is 7cro, so that $e do not nccd to distinguish betlveen nonrìnaÌ ard rcal iÌìtcrest

3.1 Monetary expansion under fixed exchange rates

ID this casc Ì!e ìs\ume lÍ = .\Í' = 0. lvherever nìorl€tdr) expanljon conrrs n!m,
1.e. fì!nr Honìe or tìom ììoÌcÌgn, ìt iÌìplics in equilal€rÌt expa ion oftlÌe worìd moncy
suPply, so : 0. Tìrus iiuÌ e.Ìuations arc:
^I,l
(n)
(rs')
-\,- ìAl r,Í \ìí ÀlJ (1.,v/)

l;: ìÀ),' r(f,\l' \t,'l (rM'l

ll: s, (EÃLi)

ll - .\tr {ERLi')

It can be sccn al once frorÌì the lïi/ drat \1, Arì : 0. Thi\ ir the flUr.Ìa
equatn)n5
mentalcondilioÌìforÌne.lium nìnequilibÌtum wehrvetobeonthewoìlcì8,!li,ÌlÃUÌ1,
$ ìf ouÌpu! in onc €corÌom), rises 1t lÌâ! io tìÌl e.Ìuivaletrt\ in the other. This 1s anotheÌ
ttay ot sating that the ilorld economy has a uni.Ìue equilibrnun rate ol $orlcìoutput ld
constant a'orld inílation. Atrd each coutrtry nee.ls io be on its lïU tìÌ stable domestic

Thit mcans tlÌatwoíd demtìrÌ.| is .onÍarÌt and since Àdhasno ctÌect on ol./denÌând,
thechangcinwoÍÌdd€nÌânclis Zr-li (froÌÌr aclclirg the tìlo 15 curl'es to8etherl. tr A i O.
Ìl^i = 0, = l, froÌÌì the /5 curle but -1I : lrr 1rom ilÌe-lïU. Hen.e ll,
l, = 0. ^)
And the siìm€ is tnre lor loreign: Af' : 0. Mor€ov€. if Àd 0,^É úat
impÌjesundcrlìxedexchanter:ìte\th:rtl-l_ = ll. IÌrâÌly ^ír lronÌ the lÌ/ cu e -\ÀJ = -\1,
. ,.- .i .l '.,, r. | / tr ,f \r l/ .\,. \\r -\r .\ir ,ê-\' lv \v.
lÀ,í = aM,,2.
^M moncta4 expànsion undei frxecì exchange r:ìte\ lÌâs no re.ìÌ eflèct\ in ejther
hr shorL,
economt. Aìl that h.ppe$ i\ thât price! lise e.ÌuipÍlortionally to the ÌÌcrea\e ir the
ìr onq suppÌ). in cach ( orìnüi , .ÌÌd thât is half th e world irìcreâ \e i uÌe nÌoney nìppÌ,v.

Ì r3 l5'are
3.2 Monetary expansion under fÌexible exchange rates
He.e agair and ÍoÌ Lh€ sanÌereasctrÌs $ Ai/': \t-fl O. I here are no Ìeal etïects
üì either Ìl(rÌc oÌ lorcign. fronì lM', since lM' : 0, that inìplies that -\P' : 0. And
tìoìn lÀí, \P = \M : O. thus ihe rise nì the money srìpply, confined un.ler ÍÌexible
exchaDge rates ro Ho me, i ìplies thit lr rises equ4Ìoportionall), to M. li ally, thisnÌeans
436

rÌrat tìre norÌÌinal cÌchange ratc has to dePÌecirteì '\. :' 0, ro malntain a const.Ììt rriÌl
eÌcha ge rate , ll) : lr + À1'j' ÀP=À. ll'] Lì. sodrata.:ar

3.3 Fiscal expansion under fixed exchange rates

Ir th. neat case lve a*ume tlÌeÌe is an cxlansidÌ in 8o!enÌÌÌÌ!ÌÌt sp.nding in
tlÌis and
IÌoÌÌe, but .ot in loreigr:4,{ > O arÌd -\3_ 0. lvc sìraÌÌlee thât the renrÌt undcrboth
exchange ralc rcginres is.ì iisc ìn ÌkÌÌe's output and an ecÌual ìâÌl irÌ loreign\''lhc sÌroìt
rn begilaÍ thy-ncighbour efÍcct under tìaed ex.hange rate\ i\ $me\{hat attcnuatcd jÌr
tìre nìedium run. To see the Ìogìc ofthe mediurÌr ru. renüt, we aPpl) the sirnpìc nìodcÌ

A\ always Àr, - À1, = o (adding IÃU and ,À0' logether). SiÌÌce $orld oütpul must
ÌemaiÌì !nchnngcd. and sincc has no net eflccl on Í()rlcl denÌarÌd, i rÌ,st i.cÉese t.
oifset the in.rcasc in deÌÌr,rnd ^,
crusect Ì)v À.9. tÌcllrc, ad.]ÌÌt /5 and lJ togelhcr, ('t ha\t

li: lj lza.

It iolìoss (subnihúing (his into/.!, and using tÌ1eIÃtr requircnìcnt lhal lu = Àl_,)t1Ìat

ll, \r \r'2 l/ - l{,1'1: lrr- lr'

Whnrhaftenst()pri..s? lhisì\aÌitt1en.ÌrccompÌicated.Iir\tsince'\, lr' lf = F isc
,\í,r4, ctnolvthìt,ll'j\f_=l.grr4.ihissavsthaith€risenÌl..uscdb)'lhctitenr
3 rcqrrìrcs ân appÌe.iatioÌì ol the Ìeal exchangc rate loì Ìldne to Írv on its lliu, and tìr!\
in tur. requìÌes I to rìsc rclatjve to t". tìut bl how much do I and l'_ have to rjsc?
H$c LIí end lM_ corÌrc ìnn) pla). SiÌìce t has Ìiscn (iu both courÌtriet b)'Ai,|2r, tht
r( al dcm and f(r moÌÌe) nccds n) lise equa lly in bo lh .ountries reÌatlve to its nì ppl,v. l h us

\' . \r /
2t I

\l f
)t )

Since rhe woÌLd nominal monevnrppL}'is cooía.1, itthei{oììdtÌansadiotÌ\ deIÌÌand

as

I ) ". I , ,i d , \ , , , / \ i .a. . r t n
Ì!or1d priccs lìavc lo Ìlse bJ !r + \/Ì' = \.{idrl. TogetlÌer \{ith -\| A| \.{r'1,
\r=+(+ l) ind\r'-r..i. ll
lrom LIí, is .liar thal'thc rcal ìnoney tlÌÌÌt) nì IloÌn€ has to risc
Subtrâ.tìÌig r,V" 1t
Ìelative to th.rt in o.cign tar the net reaÌ dcdìand t(Ì mone-v t{) rise equall) iÌì both

i.\i\t llj) ilM_ Al' l + ì\.!

2t,

Si.cc ll' > \P', this implÌcs lhat mone\ ha5 tu 1Ìo$'lrom IoreÌgr to Homc, both to
alìow the nrone_y nìpplv to incir:ase 1n Ìkrnre ìeÌati\ e to l orcign and to .ompcnsalc Lht
 437

[doctj{lroilhcÌ.liÌ lrrcìinÌlrÌe) !r]Ìrl) i.lÌonrc ciure.Ìhl \l-.lr,- l.rürìthelìn

cluatilrÌ.r\I/ \\r , -\f -\]] r++ Sjfrc \l \I,-= \,( l.end \Il l]V_
-\lt 0.

,t\ \/

lÌr.r \e ir rorld srfpl\ jrì eqliLjbriLu!lt lL = 01. Ilcf.c ihis 1!] risfi blt \it\
Ìronì(Ìer5.j. lhfrlorld rieÌÌìaÌrd lorD(Ìre] sLn.. \t \t =il.th.w.'dL..lnÌonet
nìfÌ)h hat Lt) IiÌÌír t rrttherei\üÌiI.tr\e in nr.rìc\ d.Dif.lr.l,itiì. tn sLrtpl\ rÌ. eÌ
toprìthrÌ)thcift.r!rtrrte.i.LhtlherÌonrnll((,ÌÌdm)nÉr r ttl!it.onsrenL,s!r'orli
Ì)rì.et ha\e 10 ÌLsr iplJÌed uf b\ the SrÌ) lrrti\'(n Ír!ld deDind r.rÌ \útpl!ì !nlil r
ri\e5 n'ln!irf Ll! 1. cLirììiÌLúe ihe iÌ(Ìerte i. Ìr.rld tÌÈnra.(ì. .fr rlre senrr LlDr(. s Ìr.c tlÌc
nrcrtaicjnrÌ{'Ìri.disirÌll(ÌÌÌe.r ri\es!Ì r"Ìrll!,.rce\t11.Ìtj.grÌtaÌxft...ieLl..iÌ.d
ÌreÌ(e rÊqtrlrlfg rilLlÌ lì\e!lr\(hdÌge ratet thârfÌL\csÌÉLahrctof-.Tlrcri\cinr.ndLhc
t.ìlliÌìÌ.Ìl\oinrfir\11Ìatll{!Detrealrì(rìei{ÌÌtifccd\toÌj\rÌ)lmoÌ.tÌrrnlo(ir.\
\i.cr thc fr'L ('i iüìì.rr nìr u!ìe\ mrLt Ìist h) thÈ 5dDe anr)u.l if hoth .orrnLri.s.
This js r!!.e\ ilrlj br -\1' . \l llN\thc$!rld.omrnrlD(rrevnÌÌtr ha\ro lon ko.l
I(Ìeig. lt) Êo.r t. briÌig rboxt rn r|trotnarr rclartr e nrd€atÉ i. Il.rrc ! r.rÌ m..cr
.rÌÌrli.

3.4 Fiscal expansion under flexible ex(hange rates

'lhÉ!utL,ìDr nir lb. ri.l r,ìriaLrlij i5 jllüìti..rLí)uÌrfrs..l.ip.ìn:i!Ì1urÌlrr h\rd r\.h.ìngc
Ìdte5, i.e llonì. s ouLlÌrt i\ lÌillìcr rni lilrtisrÌ \ i\ lorir irÌ thr nitr nìidiLrnì NÌì rrlli
llbriuD Ind(ÌÌ tb. s!..orÌd p.u.fÍ.,ph oi tlÌe prr\ jo!\ Í..1ìo. ipfL !.s rLn.hin{r{1 i. t rls
\,1 2r. !
tlr
crsc.ltith \1 = \{ .1 -\r. l/r ld -\i \it lrì
rtfl\. l hLL\
ll(trLer.Ì...rÌmo.r\.irìÌrotf.n lìrttrr.nllomrind l...{n i\L l / 1r,
()
Í) th€ í'ÌÌiruÌ11.n c.iÌ,ringlhil rhi rcil üìonr\ 5uppli.5 nH().rL.eidlo(ig.rls.
a ìnÌnirtel! lxll\ .n ' i]rd l' c5pc.L \.1!. llÌ!s -\1, .nd \r' oÌl.ir (i (..11! rrrÌ I r/
i

rÌ LÌí.5r1Ìr!L LrLlfrior \ilndlt irrl-\ltjìe\ \j 2/ ,llÍ 1 !\i'or

\. 1

,=\.i1. - r1 r

r'lìrrtlÌe t)otnìm ecÌuxtio...m.\ r)mi / llnìal s!!nr !rLr'fÌLs!.gxt l.sL Llril/'âlls

ll\ iÌr hiÌh
i. H.nÌe r herei Ìrxr in.ÌrrÍÌÌ. Iltrt rtr.ìl hii hipp..tÌl i. lhj\ .r!c ir lhrl Lf{ sh.rrL rrLf
r$porìsi ol tlìr e\.hrnge rrtc t. th..i\t nÍisir.Pf.c.irtio.:thst'rnrrrH.nr. .sli1.
/.r!indÌoreìilD.uti1.1.I/ìLj.II.ntinlhcÌÌrcdirrnL.rìrrlilÌstrliL \. Lo rr
\!. ln(r\ th:t li = \r \/' \/' -. I
,ì lr, nr q i n \ l r.
\/) -\1' \lj- lir.5.
438

Thus ìn oÌ.ler to gct rhc Ìrcccsrâìv Ìcal appreciation of the exchangc rall: to allow lor r
to rise, r has to afpÌccìaLc by .\1, fl('s the r€al depreciatioÌÌ caused bv rh. relâtive pricr
movements ofì \,{/2/1.

3.5 Conclusion on medium-run outcomes

Ìn lhc trìcdìuÌÌr rrn, the.ìchangc rJte regine ha\ rd eliect on ÌcaÌoulconÌ€s 1ÌÌ contÌastto
thc shoÌt ru o. lxpansionary ns.nÌ policy nÌ Ìlome rÌríays nrcreascs r and reducest-, ilirh
conscqucnt reduction of 0 (r€iÌ appreciatidr tìir I Iomel an.l inffcnsc lrÌ i; âncl monetar\
policv has Ììo nì€dium run real cffe.ts. ÌÌì tÌÌe Atpencìix, we sel oul hoÌv adjustment from
lhcshot to themcdiunÌ ft n cq uilìbriLun take\ pÌace.

4 EMU: a common cuÍÍency area

In de\.cìoping thc anaìv5is of the Lrúopcan h.onorÌÌjc and \4onetarv UnioD (FMlr). ,!:
ass(me,fríst, ihat ìì!U ls c.ìmposrd olalaÌgc nuÌììbcr oÍsÌÌìalleroÌúÌnìes: eacìr econn.:
wilì Ìre as{Ìmed t() hale rD ìrÍlLr€ÌÌce on tlÌe LIIU inlÌ.tìon rate oÌ outpur lÊrel .
ìmpoÌtant point ÌreÌe 1s that, il\{e neitLect the ÌeÍ oithe ÌÌorld, we can thlnk of E]ÍL .
large cÌ(Áedeconom_v, aDCleaclÌ ofthe nember states as it\ \ectors or re:tl{)ns.IÌ tìreÌr t
unicÌue aggregâte emtloynÌent r.Ìe a t 1!lÌ1ch irÌ1Ìaiion is Í. ble. TìÌu! aÌthough i n.Ìn ii:
membes ha!e Ìittle eftèct (ilthe_ï are snìirll) on I\1tr aggregâtes, joint e\cesrive aggì r!-:
deÌnand can cause system i!id! infl.ìtio arÌd tlÌu\ câuse the ECB to Ìalse inreÌest Ì.i:.
For ihis reaÍ)n, there it a StabiLì!_ ÌÌìct which constr:iÌìs the n\caÌ policirs ol i.di\ i. :
menrÌ)erstates: otheÌwise (1tis argued)thev nÌ1glÌt betenÌpted fu use cxfirsionan r:i::
pollcies \lithout iÌúenalizing the aggresate iÌrilatidÌâry cost. A trjmaÌl motllatlo.
thi\ \ection is to tee un.ìer Ìlhat circumstarce\ hdniüraÌ membeÌ slalcs.an achi,.:.
\atlstìctort eDltolnÌent outconìes, Bi!en the absetrce ol iÌrdlvl.ìual mo.ctary ro.t,
and the presence of.ì consüaiÌìt on lì\.ül poÌi(y \rclÌ as a Stabìlit) I'a.I.

4.1 Constraints on the aggregate EIVIU economy

As wehale \een in Chapter l0 tlÌere i\ no unique unemtlovmc.l or out$rt tute irÌ d Ína
open economy. Such an econo Ì] caD undeìtâke a nscal e\fa.slon irnd th€rÌ thur!!:
a buLt ofìnUatìon above tìre Ì!orÌ.1ìnUatn)n rate e\peÌúÌncc in appreclâti(lr ollts rÊ.:
€x(hange Ìate thatin.Ìeases it! reaÌwage in ìine irjlh the in.rcasc irÌthe wage settlng ÌÊii

lvhat il âÌl econonies lvere to tr| rÌrcÌ .1o this snìr ultancousll ? lvidentlv thir i5 nL:
possible siÌìce âlÌ economie\ $oulcl be unablt to apfÌ.cialc tlÌcir real erchange !rÈ:
againÍ c,ìch other. tlo$ pÌe.irely does this work?
ltc shill ..ll tlÌe loil ol tlÌe price level ìn ecoDom_v /, 1,. Ì.cl us siÌÌÌplif! the prlc:.:
proc€ss iÌì thi\ e.o orÌÌ) so thiìt 1,, ir just set e!Ìuaì t{) thc ìog ol the ünit labouÌ crf:
 . 439

Next asrlìme thiìt a consuÌÌer ìrì cach econonÌ)Ì cons!mcs lhe sanre bu c:11€ ofgoods, jn
which each good is synnnetri.; each good is prccluced i. a different e.onom)'(thc Ì!h
good lsproduced nìeconomyl)' andcacìr good reÌlslorthc same pÌice tlÌrou gho u I ll\,ÍU
Thusthe consunÌer price indexcan b. wìilten:

r:tN '4=tN' L(llr' ),r.

Ì\'hcrc /'ìs lhc log ofthe CPI ancl there arc N ccorìomìes. lor convcnìcnce we can ilrite
t1',\ as Lhe aleÌage unitlabour.ostlorl:l\,iLl.
wc can now re*lìte the abo!e equation to gct lhe dijr(Trir€ rcaÌ wage irnplied by the
pricc-sctljng Ìeìatìonship t)r l"J curve) Íor ìllvÍtl as a whole:

ll I ;
Ìts alÍr uselìl to erpress this ìn leÌms ofcoÌÌìp€titi!.cne$, á. FliÍ..11 lhc Ìog ofthe real
cxchanijeÌaie (or .oÌnpetitivencss) of econonÌy i, n,. Sccond re Ìember thâle is frÌed (tòr
:ì l\1U), rlr ãll tnne) f(r the tMU economlcs; it i{ìll be siÌnplest to sct. : 0 and thcn torget about it
ConÌreritivenes to. the indivlduaì economy is nìeasured b) the aggrcgale pÌìce Ìe\el
rclalive to the price ol its itood, so
. LìiF-\,ll- as a
0i=P li.
TlÌis provìdcs a sl.eighttoúlarcì $at of dcrìvÌng the ríi??.qdre value ol n iÌÌÌplicd by price

,=tNÌái r' tNrr' r-ì

Thu\wecancjlhcrsayiÌratpÌicesettlngìmtlierthatA:0orlV l'] ì ltit notcìitìcuÌl

to see that ca.h impljes tì1e ot1Ì€r. Wc reintÌocìuce thc l'fi scheduÌc lor each itrdlvidual
e(onom)" nndassunre ìreÌe that th cy are the same:

w P=r n,

lf /,="+3tN tf =r+tJ,

,r'J I\ '\.'
'.r.'3 - ..P1
We can noi{ dei\e the equiììbÌium t iIÌ olre oi hlo denticaÌÍ'a}r viathe reaÌÍ'age
oÌvir tìÌe reaÌ er(h.rnge rat.. lhe fanÌiÌ1aÌ Na-tisf ia LheÌeü1s'agc (lhe IVS and |J cül'ct

w r=t
 lÌJ hrli

Figure 12,12 Drrv n,.IÂUs from Ìhe Ì15and r)S

lhit repÌodü.cs for thc aggregate ljllu ccononÌy lhc íãndâ ÌesuLts for the cÌosed cco
noìnti equiljbÌiuìn oulputs'ilÌ b€ highcr the lowcl (morc Ìenranìedl arl: ' ancì li, and Lhe
laÌgeÌ 1\ Ì.
Buiive ca. alí) ijet lhe sanie renrlt for lhe agilrcga tc cco nomv via colnpctitlveness:

rvJ Itv P) : l, +;tl ,'

/r'
' , rì
a lr''r,=-r' tN'P,=o.
"t :
ÌÌeì]ce, pulljng the Ll/S c.)n.Ììtl{)n É ) ' It togethcr with tìre rS condillon l] 0,

In the bolt(nÌ LììasrrÌn ìs lhc lanÌiliar lvs A ltlcrsectìon cliagram. AìÌthe

liil. l2.l2,
v.Ìia LìL€s lì us tìÌe úÌtersccl io t ol th.' ljsl.\ Ì I s.h cdulc an'l the Ì4{ sch cdu Ìe
n rc ateÌag€s.

show\ tlÌc cquiÌibiiuì lcleì of averagc oulput iÌÌ tN'1U .oÌìsjslcnt irith stable Ìrì lâtiou
tÌ.LÌtÌì€1op.1ìasranìthissanÌeeq!ilibrlumlsrePÌesentedbylhcinterectionol[lLiì
',, 1r l'-.\ ' ,.'1 ".r l ', ,n
tlÌel5 schedule irÌ thc Ían.Ìa $âr- in thcbottonÌ diagranì so lhâL lhe new equilìbrjunÌ
is:ìt tz. r\n.Ì ìn the top dìagnnÌ this ncN c{Ìu1Ììblnìnì is reprcscrrlcd by the Ìú€rs€ction of
lÂUr and the É - l) hoÌiz([ta] l1ÌÌe ât t,. Note tlÌât tlÌe equillbri(rÌì lallre ot n is unaìLcÌed
br thc lncÌease iÌì labouÌ prcciuctivil-v.
\'v( also nrirodu.c at this \tâse â sccond possible re.ìson Í'h-ï cquilibìiurÌì lìlLj ('j.Ìe
outpul may .iÌarÌ8c. 1\iage cìeteúÌinatìon in nÌost of the l\ltr dìcmheì states is domL
rìaicdbtcoÌlectirebargaining;arÌdinaddiLi(Dthebtìr:ainingjsqúitccooújrÌât.dalLhe
ÌÌa tnrnal k\el. TlÌu s oncposìbiÌit) Inaybc !hat ba.SairÌers canmodffaLeirage bargai.i.g
 441

Figure 12.13 Expnn! or oÍ EJúU,r.le,1D

pressLrre al .nygiven lerel otirconre. As w. tralc seen in Chapter:1, a \ìnrple way otchar
acterizing thjs nÌod.rãtn)n is b! a .ìorvnwads shjft ir thi, n,.S schedule, to t{.r,r,lnplyuÌs
"
I';' ,,-' ."r,.,.,-.;, l.\',.rl.',1,
1 r,uJ.,Ë...,,,r.,,i*,,,,.,,.,,ii,,rl,,,.
,lu .,,.- , . u,,r. u. ,J,, ..,,,.". ,,.
\\,lìaiare thc im plicario s tor âggrclarc .tem an.l? I n
lig. ì 2. 1 3, lhe ,1l) sch cduÌes .re
âgain aggregaLc schcdutcs. Thcaggrcgate dcmand
cur vc cons istent i\,itn trl,.tU rte eqLrt
llbriuììÌ is Êivcn tr) ,lrt\fto), i1,,), wheic Á0 ìs lhe ìniüal ai:rase
lcÌel of auLonomou\
]--"'"' 1 \', ,mL. \'., \r Ì ,,,,:, ,Fr.,.-,,,,,..,,;,;,.,".
;lr(rì(-1o).,1ol .utt lïLI with /l
- 0. rhc stÌlngeÌ thc aggrcgiìte autononxrs .lomcs
tic d.Ìnan.l,.1, the higher wì| ((i) havc ro bc. _Aj a reminiler, _
. , ; ."i , r A ) e. sÕ
'.
We noil'assume rhat i
u.
irrcrcase\ to Ár whjÌe jnteren rates do níÍ ctÌaDge, r=
ìr. dr-"-r-d. Jr. .,. F\., t.,,1/,. ,, j .\,-"., ,,rn,,,o,,,1,
7.\i.1ôì

ihc w(trld' as i whole, , ls ahvavs O: in aggregarc, ttre rcat erctrange

rate mLnt trc rniLy
aDd itj loB nruÍ l)ezenr. lhrìsF.\{Unìoverlromdtor.
\'Vhat hâppcns ar, depends on Ìnon€tarv poÌifl. So trc stÌrìÌ now jìrst ol
intro.lu.e the
thrce cÌilicaÌ policy nÁtruments in F.Mtr: rhe morìetaN policy
ot the LurÌrciìn CcntraÌ
Barìk (ECrll.

4.2 ECB and monetary policy: symmetric shocks

ByjoiÌÌìngrhe slngìc tuhpeân curre.(, indÌv ual econorÌÌìe\ ìose rnr control ove r r h eì Ì
,n '". pì\.,,,t-,.,o. ,, 1,i n., ,,i,,.,,
ECB lÌas never been cleârÌ) \râLcrl. Howevcr, for arÌalyrical
Ìrurp;ses, we stÌatÌ assume
thal it uic\ a rìonctary rcâctìon hìrction in Ìrhìch jt scets ro
stab ize the eLroT(rì.
e(rìomt aÌourÌ':l Ic inllition tariter. As enrphasjzcd ir (jhâpter 5, fòr
rhe ECB nr achievc
it\ inflatioÌÌ target, ii muÍ seek to minimiTe the devia on ot intÌation
frcm iaÌgct and
of outÌrul tronì equitibÌiunÌ. Ií it \eelis to a.hrevc an ourput
Larget .rror. cquiìibrium,
theÌc Ì!ìllbe an iÌúlation Lrias, Ì.c. irÍìalion at equilibú!ì
unemplovrìent wijl bc abovc
the inílariorì target. Havjng notcd thtsl \ye s1ìalì irsnrmc
lnr EMU wìdc ttìat lhe ECts\ output larger is
..quiìibÌìuoÌ outnrt.
Iìì .e\pon\e Lo \),sren s,lde \hocl\, lhe LatB wilÌ then rcspond
.. - L'i'.i l,. r\ i . , i exiìcu! lhe same N,v
.. \ ,,;..rt-.to,. .. ,.,.r
:liígÌlgatc.lemancl, n|aric!Ì, or ÍìptÌy sidc shock aflcds aÌl the cLuozone ecofl)mi.s
442 .:: .... '.:..'::.:

in lhe samc wav Lhen each membeÌ slate wilì be guided bacli to equilibriuÍÌ through
the a.rlons ol Lhc LCB. Thls anaìytis arsumes at weìì that cach c.onomlr re\ponds in aiì
idcntical rlat lo the F.CB'S interest Ìate changer. Ar set oul in dctail in Chapter 5, ihÈ
key paÌam e tc rs i n an optinr al Taylin tvpe mle th at are asÌ' Ìì cd ìdcnti.al a cross m€mber
co(nlries 1I lhis analysis ìs applied to the eur)zone nreDrbe6 arc: tlìc ìlÌtereÍ sensitivitl
oÍ aggrcgatc dÊmand, the dope olthe Ph1ìì1ps curve, and drc lâg íructLrre of output and

4.3 Asymmetric shocks

Cnen ÌÌÌorÌetâry policy as cxprcsscd in a .cntral bafk rcactioiÌ tìn.tion, alÌ econonÌie\
adjust to a \ymmetric equiÌlbrium lf thcy bchavc idcnllcalÌy. What hâppens il they cìo
not? \!elookatt$ro types otdÌsrurbaÌì.es rhal arc rclcvanr in the contertolIMU.I botlì
,,..ú...ll .\..r_rFi1i .,1! 'dl/ 4'rat 'l^-J|., \r/:r oorl dF t \u'
thât the eurozone a \ a *1Ìolc rcrr ains in equìlibriu nì . I t wc assunìe for \inÌpÌicity that thr
iúÌation taÌijet is z€ro, tlÌis rcqúücs that r )]í,/N = 0 and tÌÌat IÁj/N = A, with
}? : ; ./,i(!); note tlÌât in any case )]rr/N - 0-lhc sunì of the logs of relatile real
exchange rates is zero by dcfinition.

4.3.1 Differences in lli and rêâlexchàngê râte chânges induced by differential

inflation
$c assunì€ that thc jdcntìcal ,4D scheduìÊ goes thrugh Lhc cquiÌibriuÌn point d in
liig. Ì2. Ì4whcrc, = 0 inLcÁecttthc /ìÀU. Howelcr, dìfferc nl c.oÌìomies noÌ\'hâve differ
c.l üklcs of ír. A si'Ìple assumption is lhaL LheÌe aìe tÌ{o evcnìy sizcd goups ofÌnember
srarcs, ln thc ftrs( oíwhìch d = Í?r :, 0, and in the secaida = a2 = 0r.
'lhc silualior is shoM in lig. 12.1,1, whcrc the irst group ol ecoÌÌoÍìie\ (itr.,Lìp 1) i\
al poinl Ì rÌÌth rr > 0 and the se.ond grolrp is aL poinl T wÌth d, rrÌ < 0. Note that
becausc thc curoTonc as a ahole is in eqúilibrium (i.e. in thc laÌìguiìile ol the Ìrreviou\
sectior, lhc curozone ec()nomy í on lh. lrodd' ËRU curvc, shown b\, point r, the ICD

Figure 12.14 D fie€n.es n r€a e{.hang€ rale5 ànd reê ex.hànqe rât€,djL]nmeÌ
 443

docs nothìÌrg. There Ì5 n.ncrhcl.$ in iLLLonìati( .r+r.,nsr nìrchininrì siÌÌ.c the irÍtrìi l
cco.olìjr\ .rt Ì are charâ.t.Ìi7cd hr rlsLn! i.Ílntir!Ì and Ìhclrlo( iIì ifìpreri.ìtirÌS Ìedl
,:hatlrr 5. tÌrr cx.lrnrìgrrnteÍitlìtheÌriuÌtrhirrh.lnro\(do\ÌÌtlÌc,ll).!ÍvclorÌltslrutlìuesrr\rÌet
.xports sÌrrirÌlt. At1, \rr
=;
: 0 hisrrÌìr that ir ilrjo-\rr ;r 0. lhi\|Í)(ei\
.onLlf(,.s lntjl the grcuÌr I cco.om $ rclÌirn t! equ llbr !m at n. lh. eÌrct nÌleAe
tfoccss talc\ phce ì. lh. gÌoup 2 c.on.nrìrs. 1h.r. nliÌlìo. lnÌl\, thr rÈ.ìl er(hrnile
,i{( drpre.i.rte\. and a!!(gâ1. drnrefd iD.rr,rse\ LrrÌt]l lhrsr c.ononÌie\ oÌore brcl to

Lhis illLrÍüte\ r tundamcn Lrl toint ab.uL c.ononììc5 i. i slf.{lc.!Ícn.\ ir.r. Diltcr
cn lli I ritcs oi ìÌúÌation ar'. thc h.a! if llhi.h Lhc.rdjÌLslnìc. L ot thc rr.al cxch.ìnle tute is
brolght.Lrout. L\ en ìi tÌrc nonrj.âl cr.lìrng. rllc is i.cìoÌrblr lÌc{Ì, lhc (il cr.hir!c
rntc ls not: iÌú1.ìtir!r rÌÌorr! rcquiÌcd adjustÌìcnts to rom.: aborrt. Llìat rhis is not íLrllv
: \lÌ-.lr) borìì und.rstood in thÈ Ìek!a.t ÌrolLq..iÌ.Ì6 is lÌlnrar(d bJ a. cflsod. llìal o..!Ícd lÌì
2002 ÌÌhex the Ll- ComÌìissioÌr attcnrltr.d 1. Lrrüìg lr.Ìi.d to â..ou.l o.lls lììÃh .iÌt!.
of iú1.ìti!rÌ. hr rect lÍìirìd itas if lh. tro.rss oi ÌLsing a lrlglì i.nition rnlc Lo appr.
\ = L rìrll .iiLie it\ redÌ e\changc rilc and h.:.rc Ìo silocczc o!t ln lrLionrÌl firrsu.ct ns 1lìc lrish
ecorìo ÌÌ retrDned tt) cqu librirLm. lhis .Ìampt!' \lì.tr\'s lhat ii discquiÌLÌrÌirrDr rcf..ls ar
o\emlue!ìoÌ rn u..ÌcÌrelllcd rcaÌ.1.hangL: re(( ir 1! llb..o[c.:tcd rlc.lurllvbJ ÌcÌaln.
iÌüÌ:tjdÌnrn eDre.Ì\. H.j1,r\ c., it i\ âsr!.ìl lo notr.llìnL thcfrc5cncr olr\)rìmcLrics ln th.
-:Ìrtiai iÌúÌrtioÌldì!in1ìatio.|().csnrr)lmtrlriÌì.othillitrsLmcnt.Sttcjh.aìÌt,thcgn Ìr2
econornie\ rt z ma\ rÌrad\ ha!. ìo1! LnLlatlon i.d thcÌr nrav be gÌeat€Ì donNLa than
utlla rti.kjncn of i. flal io.,
4.3 2 Asymmetric aggregate demand shocks (,4,
1\r: nor, r.x.mine the c!!e ol r\tiÌÌnetri..LeÌìr Ìd\lÌo.ks1l:jg. i2.Ì51. lhcslslrrnasr
llholc ls ass!mcd to be nì e!!iLibrnrnÌr r, 0irnll ìSlrc{nr( orLlfúL is rL d. B.llì grôuts ol
.r...ml!\ nr. n\s!nÌed to t)e !n tlÌ.ir lÂ! .unes. ì..lolc thcir: orc thrt Lhc tiro fossLÌte
nìodcs o adjunnÌÊnt dj(u$ed rbor É.i]nnot oper,ìte:lCrJ nro..1rN foÌ .! rcÌnelns 5ct
iÌ1 r - f\ i,l t, sìn.€ 5\ ltrm $ìde.ì!!re!.tr d€nìirnd is ronsisLtnt Í.ilh cqtrjlibrLunri a..Ì lÌre

Fiqure 12,15 J I Ê Ê rÈ5 r -.q ..r . l.Írà .l !._.rlú.5

444

.utoÌÌìatlc mc.hanisÌ ol real eachang€ ratc adiustnre.t vìa diltcÌcnliâl jnflatio. ii aì\.i
nrlcd oLrt sincc both grtrìps are on th€ir ft\pcctivc ÃRUt, inrPlyìng lhal jnllaliot Ìates oi
both groups rcnìaÌn the srnìe and \{e assumc thc_ÍaÌe atthe F.CB\ rarg.t rale.
Group Ì cconomìe\ at Èriú t have no parlÌculaÌ ÌeavÌr t.r want n) adiltsÌ: the) ha\.-
highoutpulandcmplovment, togetlÌer1\'ith slabìc ìnllatn)n attheLMU wideìeveÌ. Ìt rÌ1a\
be t1Ìit thcy arc runnlng current âcco!nr delìcits (-indeed thet aÌ. in our sinrple ìno.lci
siÌìce thc.uÍcnl account b.lince is €quaÌ to, and 4L I 0), but thal futs ìro dire.i
pÌesnrre on tÌìc rìcnrìreÌ state\ intlìis group to adjusr tjnce thc,v do .oL la.e fresrlue ironr
tlÌe foreign eachangc marlet.
But i+oup 2 c.onomies at Èrint z lvcÌrld liNc 1o adjuí sjncc lhtv hale lN outfut and
emplo) ÌÌì€nt. I h c Ìc are ìr piinciple t\{ro t_v''pcs o i Ìroì icles th ev m ight use, supplv sicìe dÌÌd
frscal. lt is lmporlant to not€, holtever, thal lh.!ts P..n.nriê! rÍê frt in thêiì ,,r,,Pni
position as a rcÍ1ìL oI pply sidetàilÌrre.Ìn lhis nrodeì,thestnìcnrreofthentÌ4tysideii
captured bl an cronomv)slïU ind thelÀirs olall the member states aÌe i.ienticaL in thii
exrmpLe. l hu s .n hN,ÍU rcoÌ1oüìy !!ithout su ppì-\'{ìde t Rfilenr s tn uÌìPrepare.l or una bk
to use ÍnrctÌrral policìc5l and unprepâ red or un able to use n tcal policy isÌìterallystu.N
ìfÌ\ exoilenous dcrnandi, is too low. Such ccononries will tenrain at polnt z. \\re look iÌl
turn at tÌÌe constrainls on the use ol lì\c.ìl,rnd of s'lÌrPlv side poljcies.

4.4 Fiscaì policy under EN4U:the Stability Pact constraint

The Stabilit_y n.d Groirth Pâct of [\lU rcquircs t]rat menÌbeÌ states do not mn a P!blì.
se.tor deiì.]r grcatcÌ tìraÌÌ 30/0 oi GDf. Slalcs Lhai break the conditìonj ofthe 5GI nì41
tr€ hnan.iallt pc.aliTe.l t)y the Coun.ìlol I iÌrance ìvÍìnistex of the EU. \'Ve ana\se thi
use olfiscaì pollcy by nrdlvid u al rconorÌìics on Lhe âssunrptnin that the SGI js bìrclirrs
âlthougÌì as lss'ìdel) known several e.onornics h ale b rcken theSClconditioni (Franct
CerÌì.n)', Ìtaì)'', ar.Ì loìtxilil) without betrìg pcfaÌizcd. Thc prchlcÌns wìth thc desigu u:
the Sclr froür rhc peÌspectlve of a prudent lìscal p.nicv Ìulc LhaL cnstrÌcr long Ìun nr!.ri
nótaj.âbilit_Í are set olìt hÌ Chiptcr 6. Hcrc $,c aÌe co.cenred rlith a diÍlerenl .Ìuestiolr
namcÌ_Í rhc consequences ofthc adoptionol !hc SGI t(Ì macroeconomìcourcomes 1n th.
curozonc. In section 1 ol this .haptcÍ, 1\'c scL olrt tìre l)aric logic undcÌìying tht adottì.r
olã ruìc kr restraiìr tÌrerìs€ ofÊs.al poli._\'in a comnron cuüenc!aÌeâ: cach countÌy actìn!
ìndcfcndent\'seesa gai tromi Ês.alcripansion lhâtpenìjtslo eÌrncmplorÌìentirith
constant i.flatìon (as is tlì!.asc lor a sÌÌrnÌl opcn cconom_v) vct Llrc mcdjlrm-Ì!úr oúlcomr
ìs onc of unchaniied unerÌìplo_v-ment B'ith n lìighcÌ reaì inlcÌc5L raLc and a pcÌiod,):

!ef{rrc askìng irhat nnpa.t thc 5lìP has ìn co.slÌairing cconodìjcs, ìt ls conrc.i.Ìr:
to ajsunre that all ecoÌìomlcs ln thc.uroTonc arc tdìo ìng sonìc l,vpc oi pubìi. 5ccl.:
denclt (tSDl nratety. siÌnplc Í'al ol ÌÌrodcÌljng thit js lo assumc that ci.h ccononrr
aims tu keep its delìclt ^
at sonrc largcl pcr.c.lagc, âÌrd to siÌì!ìil,v Ìhc anal,lsis í'c assum.
that the tari{et is tìr the prinìaN dcrlcit, i.c cxcludìng ìntcrcsl payrìcnts. 1hc dcf.!:
Ìatn), D/r l.r rr,ì,1r, l\'hcrc lh. varlablcs nrc i{littcD jn na(rral nurÌÌb€rs, and $,|\.r.
=
it ]s a$umed thât go\exìmcnt rcvcnuc.ar bc mÌìarìZcd as ry. Hcnc€ ihe |5D sÌritcs
ot keepirg the ratio at somc nxcd pcrccntagc, d_, iÌìfljcs thnt /r,1t = r.{ t),1t i, o
.{ ry : rl, or j : {ò + 11i,. Rcvcningto logsí I +/, i\'hcrc k = ns(ò_ /).
 :.445
'1he requircmcnt that the .lefìcit
bc lcss tlìan or equaÌ to :ìq, of cDÌr .an be \lritten in
natural Ìrumbffs iìs r,/t, j
0.03. A siupÌc asnìmpti()n í
thar the dclLctl is the ditïere ce
between gorcrÌÌrcnt e\pendituÌe (í) and ta\ revenue rÌom a constaft proportlonal tax
ratr, tll:thus ií, tu,lr),:.0.03,or.{r <lr + 0 0:llli rvheìe r r,iìì bc liken d\ unit(Ìm
acrcss member slails ld converiencc. withu, ancl ri nolv beinij ìogs as in ihe rest of rhe
.hapter. the s(;Ìr conÍraiìrt i s

SGI':,{l .: Ìog1r + 0 031+/, : tì/'+/,

where, givcn /,,(\r': ìi.\ lost ilalÌo$ecl bv thc SGl.
Let us iìÌag:nc i íishtÌv dlffeÌent scL-up froü thar olrhe Ìatt subse.rion tìirt, Ì!e íÌall
d e1ìne .1 norÌ as h c non inteÌest sen i ivc corÌÌponeÌÌt ol pr n{i rI exogeno ús dcrìaÌìd j ihu \
I s L

totaLPrnd. clioguous denrand jst dr. U ntil no!! we have sìmpli ned bÍ iìss umtìg t1ìl t
the coeíncicol onj i! Lüritv. \\'c nowa'ritc fi -.1, d,+,J,+Íiiwhere.islhcclrsticity
ot aggÌegalc dcnìanci wlth ÌelfecL 1o gorcrmÌìent erpencliture.': Thus totãl cxogcno!s
.lemandisr.i,,{.WestiÌlÌooliaLlhcsitLratjdroldrÌa\yÌnmetric.lenrandsÌÌo.k,.rÌd
concenr ours.lve\ with aìr ccononry, i, *'ithl, beÌ(r! a!erâi{e, where a! eragc ,1 is wÍittiÌÌ
r5 1. ÌÌr tcrms oi the prevjoas srcLion, 11r ls is, ilroup 2 e.ononÌv. But we n.ir a*umc our
economt is vnall enough ro hrre no impact otr tlÌe rvenrse. lÌi tenn\ ol the lD Ior !hc
ith economv assunÌÍrg the SGI bjnds Ír that .3, tJ/ l,:

/", = .\t I ÒS ut\ + ei

At + t\ki t,) L1t, +ai.

,,1'i\ bin.ting, We Nnowthat tor thc.veirse,

lt,
('ith 15 dciìned b)

'I
So a corÌ\enìent s,a)'ol lookirÌg at aggregate cìenÌand irÌ the ìth econoÌn,v ì\ ìn tcrms ol
how ìt deviates iiom thcavcragc:

rr 1,.=(1i i)+,,it, k) +.!l/-, ),") 0,

ll
loÌo
ÌlircdcirÌe lí.ri ;t+,ilÀ, tll =Àr i\'. can .eÌvrite tlÌ€ .,llÌ eq uatnn i rs:

lhc clcÊcit ,r Ìr(.1.,1r. k. krl + (1 .)llt' r,,)

IÌ + l1 ,l(), )ii.
I $pp!5.lÌratihênnl{ i\lifrarirnatrL.ÌtrrnÌÌÌ6.r .1+..t trlìè.êtir.er govrrNrrri.{t.rditu r.
lr,en^r,r:(lJ,:ìi. l,l rf rr,,r! l." lìr\ rÂJ;! elnur8,:.!r:^ |J tlì.,e1 rrdn1,0a:,1
446

Fiqure12.16, rr lrì:Ê b.:.rt. :,Ê .: ; .i :--:r:i

l\.sÌrorrrhl\qrth!sLrnddrlrl (Ll:Ì!rìrÌ rLr! l2 lô I. ìj r rl].i5rL Ì' .i lht rdditiiì.1

.i(liL .nrÌdrrrLÌri l;.tec[l.lrhLLhmeanttlìi]l Llrr llr hrrtrtir!ì !i rl I rr i.ir
throughtì1eÌroiNl ,, =íl.r Ì.,.\.thrtÌd.i1.L.tìatioÌrÌìl.ir!'rìlnLs(Lllt\trúuiLlr
.-(..craÈi. r, liulI. \, - (l iÌÌr|liri thnL rÌr É\ir,i-\. d irL)S...Lb ütrÌrnl l\
'c(Ì(Lrrd. rÌÌeÌr'ì ! mÉar!rrdh\ lÌre\trti(.ìlrlisLrn.tL)tr\etrìr,rndÌr nì:lg ll16
oÌ gi\cÌr.1 l.i.(ìl tlÌe 5Gl'ÌcqujrtÌÌÌtnl lrr.L L i L\r -Ì,!r rrlrl ìr(^\rirìi
i.Ì!rrr t.iìL,L( \ : thlr ir \hl]lrf r. ljg 12.1 . ln Lirll\ I : l) rn. th. L'.onoÌnr it rt
jr.irltr ltthrr. 5Lhrr1:ÌriÌ[rri\ejnlhe!]eÈ(iilh: irrl iÌ\Ê I :rì:\r.n .,rÌh.ra(llrlrrrìr
]rÌL\.ìtelenÌ,ìÌrd,qtrirt!ltotnkr'tìrcÈ(.rÌorl\l.Ìr!here(luilìLrrnrÌÌÌrr!llLLL lì.rt\aÌnfLi
r.iÌì.Ìe.L\ri. lÌrc (ìtlrit r:ì1 oÌrtj.StaÌSelrdLr.lr'.1t rÌÌotetrÌÀ''.liÌtÌ.sirnoÌr
giìtlÌi(lLL\ IrÒnr r n) rr thii cntaiÌ\ iì trrrn. ell n t rìd rÌÌ .rriìn'i. (lüj:ilrriÌiÌìì
\\'e..iÌÌ ir.rr Lhr n)ÌLd\irrg.onrhi\nÌÌ.

1l ì TÌrr trn.lì1i.. i\ thrt thL 5(iT' lul\ 2 ÌiÌ!ii D| 1Ìrr r\c t)l lr\LaL uÌln\ i. Ìllik. .-sÔ.r.
nrdati.rÌaÌt d.nri.d nro(15. lhr..nLÌr1j(!rl,,r(lrrnLr i all.ìi.!.S.cl!iLitìrirrrr orLlf':t
r..\lìiLrir\tr.LlfgthÉS(;Ì'.on\LÌintÌrthat I l\' i I Thu.ìi.!. i\ to. rr!'iki.Ì
it I i\ túr \Í..gr or i i\ tr)c, . Òsr l(, iìj'. tìreÌr (drrrt\ iÍ Lll he trnrÌ)Lc to u\e Êsciìl poli.Ì
to rl!5È iiìr. SiI irjiÌr É$rìLib fLttÌrutrtI..Lr LhelLxre. neither h\(rl rÌ!r Ìll.).!'Lir\
'tÌn
ÌÌ)!i.ri\i\.ilihÌ.lor.nÌÌ|!i.lìL\enÌht!LilÌì.!11ìri()r.ho.ìLÌ.iI!5rÌÌ)L!iiri.ring$
t[ú Ìì].\ bi i í)b!ÌiÌrB ((!Ì.lr6j(Ìr in Ì)rú1.ul,rr !1..t jn thi\ e\rÌ!ÌrÌe. t(nn.Ì.1 ii\
r!!nÌ(!l nr b. es clh.lent !i th. olbeÌ ef.Ìr(Ìlif\ i| L.ÌÌrs r)l Lts IIL'
2ì Nut it rììir\ b. Lhrl htlrL poli.1 l! f.1 lÊÌÌiÌ)l\ elii'.l1\.. . Llrr' (.fr.\t h€re tlLìt r\
.qrtrnlentt,i!r\jfqLlral',i\iÌnil.lì.il\ l',=(l 1ìj.ilf.,l .\ .nf hii . .o tite.i
Figure12.17 rrpi. rltf:stiLi trirlla.friìriÍ È'!rrr1t r 5itt'ià1i l,

lr lverr ll r'È i,c .oÌÌ.c, Ìred lhdt thc SC| Ììrl bc too conn raurlrg'
it is ner rnh-eÌesr
i
c'onorlÌiri incetnitt to u5e h\'iÌl
trÌrf.rttnl 1o ÌerliTt Ìh.ìt lootenint it mì) !h e m!Ìr! arÌ

toil.\tiirìtendottttlìt.n{Ìenìirlovnìtnt lhjtìsbL:cau5cra}rnÌttrlrìtÌìe5(ìl('ìnltrrì'll
rrÔlt!Ì{rÌ eÌì5tl
ir'" ti""l"tà.tnrt.i"".in 1i'.aìerlìaf\i(Ìì L{ \tenrnÌt! th€ ir!'ÈÌÌxÌcntl
Ìhes. are slì.Ìt teÍm lindrl.laÌÌììerliets iÌrl thc ioreign e'\'hrrgc
Dr Ìct lror ro!'lrìe! lrl
*ì. .u!orô.c. dÌort ÌerÌrl interr\t r.t'rt rÍ' 'letennineil b) thc LClJ arÌd Ule
"untr'!'\
iÌÌ
raÌe Ììo lorÌgcr Èristt L(t (\ no\L:ct ot1 rÌÌai ilould
ÌidpptÌ]ii
nonrinalt{.han!r
ÌÌrentreÌ stalci iri:..1tÌrejr l \ì trÌtr.'tNnIitre\porÌ\(lorn!a\iÌrgotihcSCÌrTÌìrÍ:rl
rrtcoiiÌrtÜcsti5drÌenÌÌi'ìcLlblthÈrc!ÌuircnrerúlÌrrtt=r'oÌir=1
r)r^ 1ir ''i
Ikrì.r,i/l : ,rri. The nttrrtl teÌÌsili\i "ÌnPinÊÌìt ot pinrtÉ dcnÌn"] rr! lÌns i()
LnrÍê5ed LheÌÈ ls no
iail Ìr\ e\r.tl\ tlìr aÌno!Ìrt b\ 1!hlclì g(^er 'ment cxÌ)rn'iitur!
hrìs

(lrllnaLL\',iftnìaloli.lÌrer\p.ctì\'!'ilÈ5'rìÌroll'lisiuscrtl!nLìL\'lÌ!rÌdericeanLÌ
it ìtre curr"rr SCt',l*t.oi tnablc it 1o be !s!''ì ellc'tir ill tlì'Ìc
is iì cr5i Íor iÌì'Ìersi'S

L ntr r..noÌìics ìÌì dlIn.!11l rhiÌe Ìinìilrng I l(Ì tlìc rÌ(lâte

r'!nomv liLll Íhcthel nr
nre i ls q!jl'
.ot it Í1)uld bc poss blt lor F.coln tt) rJr'Ìlitor end c'n)r" iì'h arÌ irranlL

4.5 supply-side Policies

lÌìthi5tt.1l.n1rrÍ'tìr)\tsutpl!r r loli'j(i Lannìíl!rnLe ân cconoD\ ir lhe eüroronc
A\{ìlrcusn'.ìinClìitterliÌnd(hapt.rll sLrtth \ideorslÌ!'lttalpolicieseÌttho\etlìal
nìi I thr aÌ rorìr.\ s.hedul.s rn(ÌrlÌichtìre('lt)relnthi5corÌ1r1ttÌÌllltheIILìli1
l'-t
nI tlÌÌcr:
Ì).n!cul.rr lrt ask nìrrt .ir' tlrr conscquen'(\ n)r Jìa'roccononii cquiLibriuDÌ
i"pc'ul suppr" slde Ìrolil!: I wage iÌ"ord ioÌ ì!Ì"Die: Ìroli"l' È)llcits thrt stlnrul'1r
jncr!'n'troduct Ìììerlet !an''
Ir È"h
trbour prodLirti' 1r.. arrl poÌi.ir! tÌÌ.ìl "nìLrctjtion'
444 :

tlÌe ì.Lcroe.ononÌi.conscquencesoltlÌepoÌi.iesl(nlowlìonrthcìrjmpactonthclïL,:'
tlÌe eclrÌìonÌv corÌceÌrÌed. ]\s in tlÌe Ìan tectidÌ ive look at a mcmbcr countr)', i, rÌhich .
\o !m.r11 that it 1Ìas ÌÌo iÌìpi.t on the eurcrone ecorÌomv ar a llhoìc.
We .ssunÌe here that lhcrc isir !i sle ÌÌoÌopo\'unìon nr thc ith cconomv. \\c s(a::
b)_ showxÌg non riitoroLrsÌ_ÍÌìoÍ, a !!age rìc.ord can alter equìÌibrjtrm outpul and cÌÌrplor

rìent. Clur co ceptol€quiÌibÌi!rÌoutputrequiresthattheecononìtìsonitsl..À(]iiJìrÌ::

case ile erdore here l\,i. assuiÌÌ€ tlÌe nÌitill1,{U of the economv to bc /iRU . Lhus.rÌ::
ecorÌoÌrrr-\ irÌitiâl output, t, , is.ìt r', the irÌters."ction ofElÌLi" and rD in |lg 12.18.

4 5.1 Wâge âccord

A Nagc ar.oÌd shjtLs downwaÌdt thc bargained real irã:lc or LVJ sclÌedule. As a renÌiÌÌdr:
thc l1:t schcdtrlc ir e.onom) i is gìlrr bl

wherer,, js lhe reaÌ wage irr economv i, l1l thenomjlaÌaâge.I is lhccLLrozorìcpri.cìcr,.

which i\ the coDsumeÌ frice level ìn each euÍrzone economv (sln.c rÌork.rs bul go.L:i
prcduccd i. cach of the eutuzone econonrie5). 4ÌllaÌlahlcs arc jn logs. r,irge accor(1 , "!
rcf rcscnlcd bva dccÌease in eitheroÌboth of theconstanLs) d and :1. ^
Thc ncÌt stef is to traÌrsÌatethis inro ÃÃU terms. The Pt schcdulc is dclìned bl

/'i /rr I 11i ì,

Ìlhere /,i is the log ol th! prclìt mark up on urrit labour costs, and rcfccts lhc .oDrpcr
tn,eness olthe productÌn.ìrket. Âs u!ual labour produciiyitv js rcpÌcscolcd byì.SÌrÌ.c lÌì:
re'rl e\clÌallge rate is rri : l, l,r, iti\ eâlv to lee hoiv ând.l enrcÌ Lhc L,(U, sinccNi. ca:
'

lti = lrÌ õ it'i

^i
lhrLs iar in this ch.plff Lhc (.ommon) rïU hiìs br,en \lritteìr 1r = d li so (rc sha
assLLmc lhal /:/ìlr' is .haÌa.lcrjTcd bv d ì | r, with ì, = ì and rr - rr frÌ ill
ard J: I Thúsllthc(,ageac.odtik.stlìelormofareductìonird,lRUrìsdcÊncdlì1
rÌ : . \. r,r, rÌilh \' < 0, s,r th.t -LïL/r slÌllts outwaÌds in I pnÌaÌtcl manner th:j
can br s.cn in ì ig. I2.l8 âs thc shift lronì l,{U- to t?iJr. Nhat eÍccl docs this have ..
li?SjrccthcÁDisasumednoltosìÌìítihisi plìes a move ut alo.g thcr11r iroiÌì ! r.
d, a.d/r is gircf bt lhc irt.rsc.ti!Ìì of.11) ÌlithlÁUr
ÌÌr lig. l2.ì8,1/ìUihilttr'frcrtlc.l]!b!/- -\. $ecânthinkof/(rho)as\tündlÌr:
rÌr' Ìestrainl. Sircc f increases bv /ri2, / onlv incrc.\es bv half Lhc outrìrú s1ìifi ofl?L
Note thar beftrÌe the shjft of IIìU, /l/ìl] ìs dc1ìdrd by
 I'J.t.LÌ Ltrc / ntJ ri
. Lrih\. i, r hi.h i\

Ììünl. \\Ì sr.ìrr

: ,:rrrrd.ÌrlPlor

: li!. t? ìri

Figure12,18 !'Ìr; r!.i..!rd r-.frm-!dr- r..1, lrrL,rl

lhÌouglrout, rÌrc tl schcdule is conn,rnt

)'
8entre the srge.c.oÍ:1. ), is gi\'!'n

-,], nt+11 !\ tr tt )
'''
)t .1
.-t
\ lcr. uting thÈ taìne Ìe{ÍÌrìÌli,

':'"': + '! ))

r;"" rl"' !
T|e impÌi.rtir!Ì ir ttÌ!t tlÌrre h.5 to br' a. Ì.cÌer5e ür rlglciiitc.lenan!l nrìftìÌr! thr \/)
ourwaÌd\ ìtt i5 nì irÌcrer\r tr) morc llra. r' 2.

4.52 Structural policies to improve labour productivity

loLirìe\ thrt iÌnproro hboul irrcdu.lilit\ ha\.eìnid.nli.elcllectoÌrtlÌeIÂ!,ìsdoc5iÌ
uale!((o eÌrrbod\irÌ!iìred!.1 on Ln'.ThÍcrltiesrc.btrcrtitìnsthelÁlr

rr:.\ f . ,r),

lhrs i. !mfÌo|crìcnr i. Ìabour .rod!.1ìr itt ilnr Ì!'nds to e ÌrarrLlel outh'a,ds nrilt L. thr
//ìl,.úÌ1crr{lrnroÌrtrtrbt lD{lÌerllleÌothrnorth tan
450 :: 'i :ir. i:

4.53 Structural polìcies to improve product mãrket competition

Pohcies to inìprovc pÌoduct market compctilìon cttr oper.ìte in various ways A slatdr:i
effeci ol nì.h poiÌcics is in one lorm or another to nìcrea\e th€ e1iÍi.ìty ol pÌrdur-
deman.l tlÌât firms lace. Relerting üom ìo3t n) non loil !âlues of the varÌabìct lt)! .
nroment: if tlÌe dcJnand cuÌve facinil thc firm in ecorÌoÌny i is lr l;4,1, lhc goaÌ .':
competition poli.)'can be thought of as ìncrcasing the elâÍicity of dcmnnd, t, whe..

We need irst to shoir how ! is reÌatcd !o ìr. This is set out in detail Ìn ChapteÌ 1j
hr' il) 1 r- \-., '.n " 1. r^lô \ rl ' '. P r\r /
' '\ir
I, Lral.Al wi.ip;'r.arì). where r4ri - l'vr,/Ir' SlnceÁ isjuÍ. conÍant, thc liÌnr choo\t:
fr Lo maxinizeri
Ì r',P,'/,'.\,andthlsinrpliesP, +íL!',1,\). Ì\oa'rcv$ting back tr
ìoss an d remeÌÌtberin s thrtirÌlogsfr = Pr I an.lÌt, - lv, f, Ì\'c lÌavc:

t,: ì.g + ry, ì,

+r/=Ìosr-
It is casy to see that ân jncÌease in ,leâds to a decline itÌ the log mark up !: i{hen, sal.
| = 2,r1 : 2; a incrcase inl/ ÈonÌ 2 to -l ÌÌìf ìies a clecÌine in, \ to l 5
d, ìr rr, o i|r, thc n ì st eltect of compctitÌon policyìtto ÍÌiii
SÌncc the ElÌU is
tÌrc n,!Li ouiiarcl\ bi, rcducÌrg r,. But thcrc ìs a secoÌÌd eflect, tlÌls tÌmc in reducing tlìÉ
!nonoto\'power olthc unnrÌ. Ihis is morc coÌnPÌex, butthe iIÍujtion issLÌaightfo !ârd
r is alí) the elasticlly of the derìved dcmand for labour schedulc Hc.ce an lncrease nì
4 implies thât therc ls r greâter loss ìÌì cmpìovìÌerú lor intr giren risc in lhe reaì wage
Ihis ivìll re.l c€ thcrcal waiie denÌanded al anv gi\ en le!e1 of enìpÌoymcnt, lh ut slÌìÍtÌÌi{
down the rfs \clÌcduÌc. (The details arc scl out in châpter 15.) ÌlÌus thcrc ls a scconcÌar\
cffccr shiftnìg tÌìe rìU outwards viâ a d€cllnc in d.

4.5.4 Supply-sìdê policiet aggregate dêmand, and the 5GP constrâint

We san abovc that if rsgrcgatc dcmand Ìemalns unchangcd thcn / onì-Í incÌeases br"
50% olthc outlla nrift iÌì lhc ElU. The feasonthat output incrcascs onl,tby a tuactloÌÌ
oi th€ irmount nrade possiblc b) the supply side reform is thal oulpuL riscs because tlÌ€
supply sìdc retoÌm ìmproÍcs lhe .om petitìveness oi econom-t i nnd lhc slope of the Át
curve relÌccLs hoir thÍ is translalcd into hì:ther net exports and olrtput. lhc geoDretì, í
illustrat.djn ììi9.12.19:itthc ttUshitrsupb) /r0lo, therÌsincer, ,,1 .Í+/),rhceffectisto
increascf by the tuìÌ/0ó (notc !hallrÍ cqual to 4'lt and botlì to p);hor,cver, Lhitwouìd
is
mea. ther ! Ìs outsi.le th€ rcw EÌlLr al point b . LÌ the new medium run cquÌlibÌium at
point d, thc in.Ìease ir), is r/2.
'lhìs asmmes that j, is hcld constant. Whrt w,ruld happerÌ if tlÌc lth cconoÌìy $as
Íolìosjng a conrtant pirbÌic sectd dencit rati{) polic}'? r'€ slÌalÌ see in t'ig. I2.20, dre
^s
Ìise ìn outputbooststax rcrenue andundeÌr constant Ì'j5D policy, aÌlowsthcgovcrnment
to ìncÌease goverrnìerlt cxpendlture, Í'ìth the result that th€ risc iÌì outpLrt Ìn lhc new
mcdiunr run ecÌullibúumls grcâtcÌ than r/2.
tr a. .n.rt-lr'rlì...,J\n,...or '. / i id lLèllF. "r .l ,

As s'c saw earÌier, thi\ has a flatteÌ sìote, namel), 1 d, thrn the A, schedulc í'ilh í,
 451

Figure 12.19 Ìlà9: ir(. r ,,, rirì,rÊ.lD.r,re

r tl

Figure 12.20 |i;:t: ri.! !,. rrL r.d i, :r a p rlì . 5r.t.r n.i, t ìt ô rÒ .rl

l{e.1iÌabellÈ.1lDL,jl..l l. .ì .i ,ì, ÌÌiuÌ. slop. of l H,rrr nNch nrtre docs), rlsc (han if lhÊ
(rfcnd Lure
Ll\ed Í, .ase? Ar nroirn Ìn Ìhe iooüÌ!1r, llÌc rlirl:t ol í\'Ltchnrs torrxÌnÌrrrt
: 12.20, ih. Ìcgimts15t()increaterÌr\r12.rtrìnradoir'2:lhemÉdiruÌÌNn$!illÌrrirLDrisrt

' lÌnÌ, i.. n,B.ì((Ìd,,,, rrL!,

..1 ,1, t,.

452 .: . :':

5 Conclusions
lmporrant new insights eÌnergc whcn thc rnacrocconoÌnjc modcÌ ìs cxlc.dcd 1o ac..:.
Ior rhc ÌnrcÌdel)e.cLence oleconolìles. IÌìckcl rcsuìtsoÍlhischnplffnrc (hcloÌloirLÌr.

. TlÌe \hoú ru n nn alt's ir ÌeveaÌ\ the oFÌation of tlro kinds ol \pillo\ er: th€ 'loc! Ìr:
tive' dnd tlÌe 'beitgar-thy . eighboui' eftècts. lÌì ilÌe short ruìÌ loconÌotire e1ì€cts o.cu;-
in the seDse tlÌat outÈ1t rises in FoÌeìgn a! weLl .s in HorÌÌe tò11owiÌÌi< either . Êji:
expansim by Homc irndcr Ílexibìe eÌchan8e rltes or a monetary erpansio by Ho:
uncler fi\ed e-\chaÌìgc rarcs. B) contÌast. FoÌeiitn\ outÈrt íÌrinks in the face oì a Ho. .
tìscaÌ exp:ìnsion undcr l_rxed exchange Ìates or a Homr nìoret.r) erpiÌÌ\icÌì !ndcr 1..
ibÌe rrte\. Since ttomc\ galn À at the erperÌse of lorcign\ loss, this is refeÍed 1o r. :
'beggaÌ th) neighboul clfect.
. Ìn the me.lium nuÌ, thc sho -Ìur cftects ol moÌìetar,v policy on outtiut cìisâpp.:.
'lhcÌìcdúmnureffectsol|lcaìfoÌìctarcin.Ìependentolthee\clÌrngerâteregiÍìe:tI.
oÍlcome is tÌrat a Ihme Êsral c{fansion râises it! output butthat olloreitn declüìei a!:
conscqucnce otthe iise 1ÌÌ thc Norìd inl$csl rate that chaÌacteizes the new nrednüÌ .u:
cqujllbrium. The ìnednun fuúì cltccL oI a unilateraÌ Ìlome tìscal expansidr i! theÌefcÌ.
ahlats'bcggar th) eighboul'.
. lflorts al thc international coo ination ot macrceconomic polict stenr fÌom th.
existcrì.c ol irccntives foreconomies to purslrcbcggar thy ncighbouÌ policiet.lkrwe\ er
thc prlsoncÌs' dilenrma str!ctLrrc of thc probÌcm un.leÌÌine5 the Prcblems in tìying tLl
bulld crcdiblc ì nteür atidral .oopcrauon Jgrccm.nrs
. Ìh€ roots ot Ìhc ìogic olthe Strbilitv aÌÌd CrowllÌ l'acl oftÌìe curozone..ÌÌ be traccd
to the prisoncrs' dlìcnrÌìa 1n frscal policy. With tlÌc cxtiÌnal disciplir€ of th€ monrl
miìrket and thc torcìgn eÌchange maÌliet absent lor individuâÌ ÌÌìerÌÌber countries in th.
eLrrozonc, thc LcÌìptation to seek to reduce !nenìplovmerÌt br a lìscal erpansi.,n ls i]
potcntial problcm: if aÌl meÌnbers reâlon the saÌÌc rÌal, the resLrlt is a higher union
irÌtcrcst rarc anda Ìrhase {)t higher 1ÌúlatiorÌ tha t is conÌ_vto €limiüte. Howe!er, as it haj
bcco dcsigncd, rhe SGP can pose â obstâ.le to thc achicvenìerlt ofhigher ìctility bt i
rìcmbcrcounrÌy siìnfl), as a consequence ofiÌìadeqLrntc prìvate sector aggr€gate deÌÌÌand

r'. ri = i21)r
Lilès,\criteÌ11ìeortÍrÌii drIL ol riÀl,r by,
41"'L: r (r .ir rri'" rrÌ

t. ),: :t);
 451

iÌr thal ..llrìt[. \\ir harÌ nc. Lhiìt i]ris prnteD .rì. rri\c t\ cn tI thl suJìplr side oi dlt
rneÌnbcr.nudtriesisi.È.ti.il oriÌlc.onorÌÌ\con\tÌai.e.Ìbrrlìc!(Ìtr,ic.untr.-\pecihr
nìÌÌ)lr sid.polic\ ÍÌ ch as i Ne.iÌ,. e..nrd n!iìÌ(ìea\ci.|nÍìucri\itr.r n prld!(tnÌarket
c()mfetllion .llo\\ n, a rin ln a.Livil!. SirÌt rhj\ i!jÌÌ xl!r rclr\ Llì.5C1, .LÌLtraìÌìÌ. .ì
r(ÌnbÌnaliorì ol sLrpl)Ì\ \itÌ!: tu,irìíÌ and Ès.aL ÉatjngIriÌÌtn u.crhrlc.br)osiiÌÌorìtfur
tlÌaÌr a sutÌrh side ren)N i1...
. llr,Ìro.LrlÌnrgthc(urozone.ìslSÍN|of5nriÌ c.ononìicslsr..torsoÌÌrgi(!rtr.Í.ha\.
!Ìror!Ì111ìÉ.LrtenÌjfâ.(s ol eq!iLibrìLun uneÌrÌrl.!D.n L .rlh(!ÌroronÈr\rÌvhoLÈrnd
h.Í'itnì.\beìlleÌcdÌr\,ilrerurple.lNILrÍLd.jra{cfflrnlnL llÌ. Ì1\porÁeoithe Ë.Cl
to.onnnorÌ shock\ is str.ithttonlr nr rnrlrÍ: úsifg th. .loÍd (con.l]ì! nx rÌ when
thc nrcmber e((rronrlcs.re nÌodeLLed r\ tr ÌnnrctÌi. r.hs rll Lhc.rlc\ inl nirnelrirÌÌt.
. l\'e hâ1r shor!Ì the role thrÉd b\ LnlaLlon dìff.rrrÌ.ci betÌ\eeD nÌrmber ttat6 rs
tlÌrnÌeansIorthürìioadju\ttÌrejÌÌÈrlc\.ììiìniÌrratesiÌìrcsp.!Ì\et!r\\nÌmetÌjcsììo.lis
!rnìu.tltral (lli crüÌce\thatÌecÌ ÌÌÊchâ.lcs ÌÌuÌ.rrilcr.lÌ,ìnsrrate.

PROBLEIIS

IILIF5TIO\.\.ln thr (ere.l íì\e.ÌÌrÌiccs th. /-\\.\/.rn.lIì/ rqu.tiün tlrtlio

..
\t =d\j lJ\r \. i t2.1r
Ln lÌ\,ifq Lo
\L = , lí ,li -\. i12.2)

\i_ .\ \ì ', \\Í' 112.+l

\!c .snule jìr thÉtt LÌu.sL o.s LlìaL Lh..o(Ilì.iÈ|tsÌÌÌ.ìtdllirr.r.ro:\thct\1oÈconoÌÌÌie5

lhcrc i\ perlect ratitrÌ nrôbll L_r. ând Í ( .ssL rÌc tlìirt._ . rhroug ro!t
tir lte\(he.ge reLcs er!. lr.diÌ.dLÌrcho,ÌÌclì(Ìre\ nrp \ i\ trì.rr.ìied tr\ lü trlllnl
Ìrru.lÌrjllÌa..ìr'in..cisr?rlrÌr'h\isthisdilterrÌrtÈoÌìthe\,lundelllLeÌìrjÌrgre{lt
lor r vÌÌalle((rr!Ì) l
iiil Ìl e\che.ge Ìil.\ iri flrÌ bl( i.d,! ls iÌìrÌer\rd L,\ -\!: i,rl lr lÌos r]nrclÌ silL I rDd
,-iÌìrÌrtr\eltlrl\!h!]!thisd lc(..Ì ir onì ih! Ì,lunftll ] lcLÌriÌrS renrlt ior l !!!ll

all ESTIo\ lJ L.süìgthe\rÌnrnÍrleÌrtiIAâho\...sstrDr1l\cricr.hrns.Ìalr5 \\hnl

rrethe1rltr$.i\t.nl\r'ìitirenrÌrernÌrÌrlririncrÈa\edLn.n!.oLrfl.\bÍth.sanc
.lnoult er jl r.do.cd iÌl the oUÌerl l\tLaiÌr the mlchxnisnr iÌrxt bÌjng aboul r.(Í (suÌL
Ql:l5ll0\C\ortal(,Lh.râÍ,.Ill!.Ìibcpri.Èr llÌerq!.tiLÌrsi.iruÌetÌ\oer(Domie\

r.=d\L lÌ\i l, ll2.i

ft - \.: '-\i_ l, |2.61
 \i lA), (Ì2.;
\i' - Àl.f- {12 8
À.t = :tr (r2.9
af' : -tp 112.1t)
(12. Ì 1

(12.12t
-\i'
^i
(i) 1t there is a lLxecl exchange rate reginìe, ji n.ì th€ Yallres ol Af and J'_whcn,{ 1s
incÌca5ecl by^A (ii) ÌI Lheie is a Uelible cxcharge raLe reiliÌnc,1ì'd the !alüc] of Ai'and
lJh"ll H n n ^ r ". 1 'l\ r :r' r' r \ \r
QUL!llON D. Using the sanre odcl asiÌì C above' turd ihe vahes oll/ and Àl'ifthe
ÌnoÌì€], suÌtpÌv is incÌeas€d Ìn onc rountr,v bylhe laÌnc amount âs it rcduced in the otlter'
(d) âssumìnia tìxedcxchângc rates, an.l (b) .ssu nring llcxible erchnn ge Ìates lixplainthc
mechânjsmi that bÌint about )our rcslilts.

.:: APPENDIX

short to mediun run: how adjustment occurs

IÌrÌhciÌÌtL trtrÌ15Ì\e hi\crlreadysre. in onr crtrÌì rnrn oí rlìe Vunlcll flemlÌrgmorÌ(l' iÌìe€arhingÊ
rrtc reginrc mrtler So $haL.lo.s tììe overall lilLeür olid rshút lor'* llke? soÍÌc ÍeadeÌs nl'y
lrnd
rt ut"riiL tu s"e rr." p.ttctn. nf aai!ím.nt \ÌtrÍ'n gcondricall,v nt our LÌro coutrr' r'ìUlrl) dirn'nf

..1r)(l ,&))

.1r'(io,&,

lll'(t,,:i,i ./tRUÌ,

Fiqure 12 21 adlirÌÍfern n ih. rreô um run moiêtàrj' erFà's Ôn urde ir" êr'h:nqe rat'5 aigure 12.2
 455

1Ì2 :l l,,lonetaÌy pol.y underÍixed ex.hãnge rares

(1:.E llÌrrlfnrmir!QrlnL .ì,: ,ilg 122 \iÌrÈs:Ìrin Lhe i rrt :u .11Ì \ii. nnÌìrt.r r\|rnridÌ
iÌ H!frirìrÌÌr\ri.rllnÌi.r..h!n!rrd.rrÌ!rr,1 !rtanrl.r.r\)!rúto:LrtÌr.1lr,ifl,1l),ÀÌ!rr,f\
{ 11.9 ,f.finr,nirtÌÌ.\lDÍÌ...!)n.t! tÌ!lì iÌLÌú\r!). ind, Ìr\p..tÌÌ.1\
ll2.lli Ìf LhL. nr.,lLunr Ì! . tiÌrr(.r.Ìnr\ rnllrÌr Lr.l r: IürLr_ n tÌ ilri,l !f.r r\.r4,.ìllrr.l Ìhi\
..DLrrh.trtb..aLúeÌÌ.,nrrir,l ,trt !frfi,lrilì,ut!,lrJrri:ÌittÈ.LrÈtiìL:.u,1e;úúìatllfd/) .rc
112 I i
b.th jn.r!r\ .q 1r i iidr!.: tÌ ( rril :ìr.ier iL,| r é if t,lnÌr È..n.nr e\ LÌrtiLr hr! reÈn f!\hÉrl br.k
1Ì2.11 !tnrit\.ri8l!rlLerÈj lhÈ ,,\.Ìeftl-.i.kiiiÌrri.iri,ÌìL,i,,.rriÌrtheii.Lgrrn.
r,lonêÌàÌy êxpànsion underílex b e ex(hanqe rate5
1\'LÌ lit\llrdrÌìintrÌit!\ lldÌr\t.Lrti.t,trÌtrllDÌri{r.t Ì i.l3 l2ll ÌhÈsh. n,.ÈlÈ.1nÌ
nr.ieLa r\fr.\,,. \rlrpr(irrnnr!ltlìrr\\1i,,ìur:rifr(!i,nì|riiÈdhraLalli.i lhe laiL ln r !hiÌli
llr0 lira.Ll 1ll s.Ìr?dL,.i d,r\ixìrdi l.:LsLr.nri :.ir)a.llhrlrt:c(i.únìnmo\riLl!Ìm.utlÌr
n$.Ìlrì.hea!È!...Í.i|,,.d.gtLìtlre \e ri,rnrtrntrn[Ìrr\rnÌ!]rrrrr.l.Ì lÌ.rrrrr !r
lfrri!r. ih! aetrc.iÌi.. Ì|Lie!a fs.:.fmt!ilriÌÉfÈÍrrrLrx!L{ii!,,itÌ\tÌrirÌrrlri.friÌ
lÌrur. !lr.lÌrr ir d!:ìrÌÌd rnd n Lrtr1Ìrt: l .rrÌ!n ru r\ i. r _ lr.Í ,\i e.'iìrcsir.rrnhr Llre
Íri 3lÌt r rr\r n, tlÌr r Ì1!1rl
Ì:r .h. nìr(ìr!rìì r!Ìì. Hdnr L oL,tjillr I ilrj !!rri\rifrìtl !l,LLrf.rÈignn:.\idÉl-l|, í)| i\ÌilliÌr!
Thii.1!i.iLÌr.Ìri:i,'ì!Ì nrtpI Iì N. r\L..iifr .i..d.,rl.rÉigr!)ii\rI)bhnr!rfìrÌrlÈrtrrr,
lrÈr.!iÌìrfllftrfarfÍ.ir:if.iLlr.È\.hrnAÈrrLeÌhii|,f.!\'rfr:Ìtr,riÌtrÌtilÌlriÌiÍÌltlr,,i
rndthrrftrrri.t... tlìrÈ\.hrìiÉrrtÈhôr:frglrtrlrk,lfrrn Ìt\!rr!fill(ÌÈi ÌÌr\ !iiìinr.rr
br!lÌ.,r.ì!l I rl Ìrg tlr dalredirì.1
F Íãlexpans on úndêríxed ex.hãnge Ìàlês
Ì. Ìr.\n.nÍ!r. \ri ' lr rntljs tÌ .iL ll).iÍì!.;lrl rt t,.D.irr t!ì ! 1i!.Ì1.2:li.rtrÌÌ.!.if,!:,Ìf;
ries:ú:ìri L.i.hrr.,,tn,,ìt!r nriâLeLhrir.sLnrr e.l.t \ronHoÍrr\1rÌlrütlfr.l Ìhüi lll

..iD.iir. ! ,l

FiquÍê !2.22 ,.1 rjtn-.rt i.! rnÊf m !] n.n.;.!i\.:n5. L |Èl

 1I)(ir,jr)

rì/) (ir,ír)

a Short run cquiÌibÌiuÌì

,rD.(ir,3d) NcN.rcdiunì Nnequiiibriúm
ÌÌìitial mcdium Ì!n equilibriuÌn

.Ìl)"(Ìrr. !rïl

Figure12.23 Âc!Ím!nÌ |th.medxÌÌrlr I5.à êrpãtôn undern'rPl -"x.h;nqe ate

rhiÌt\noÌ{ni'ald\rotÌÈrighLto.ìI)(ir.rrr'sin.ctlÌcr\.hâng.úÌciJF\ed,andld.0\donor'ha'geiÌr
ÌlÌrrÌr rún., ÌrrìÍì51LncÌungcd: bÊt.e lldnr nì!!ei hoÌìzort,rllvfrÒnì tÌre inilill rquiliIrinnr atdÌ'l
ò,nì!D(iLtÌr.lhishôrizoÌ1t.'lÌDr€itrhonnb!iÌrÈ..ntìÌÌuousaÍÒ\'i.th.n)fÌi3lItlìandquaditrÌl
I.reìgn! lr 5lìjlL\uLìiÌriÌìe\hoÌtNntn.e,ha5nì.rra\ÈdroiÌÌrithlnÌir)châ.gein: ituri
.ll)'t,r j,il nr ìD'(iL J,ìì Si..erdocsr!t (hanAe irr thÚ1ntrlÍ,n, r.reign nov$ wn .allI up ll' lJk
lromí_ nrn as nì.Ì{rbv the contiÌnrous vedicalaÍowni rhe b.ll{ú lrttlÌJmì qladÍant.
LrÌ tÌìe nìedirm n!ì, pÍi.es r( lÍce Lr iì.ve Sinr( Ì!Í'ig. n in\idclIIi, P falls;an.lsin.rFomeis
!!side llllL!. ? Ìj\e\ (;ireÌ1tr hred ..mìÌrú Èrlia.Ae ÍaL€ thc (il qchânge rale rPpr(i,Írj. r'
lt- \l).:0Holdi.gi=a..níant,thi\pnrÌ!.HôÌned!ÌrrtìtrDLir.í.umtoìrlÍlsËnLirãnd
Fo!€ignnoü.ilìe.1ll-i,! r;).úr!.Ìo110'. Ìru\f lslallnÌilô.dl rsi.g
LIrÌ tÌ add 11.. th!Ìr rÍe net inirli!na.! fÍeíures ai d .esúLt ol I lraliÌÌ3 n!r! in ihe nì.rt nrr b\
nu! tÌìan lÌ has J.rllef, as iLlurtnned bv ttìe La.r thaÌ tÌre dìÔrL IUn 0.ÌuilibÌnnÌ is Òutsi.1e drr Ìr!nd
r-rlir'(see Lig.12 2-ì.Thls trtrhcs aegrÈgate tri.rruf, iurringtht Non rr.lnr.nerrrirtl-\ mdhcn.È
fÌ6hingJ u! honì ir tu ir intlÌc nÊdiun ruÌ Lhirinìlìies rhal,ll)rlntì\l,i.k !| ro.llllrr':Ìl lrd )l:r'
nrilr\utto,1I] ri):itil lhurl Í!5e\Í.nl'_Ì!.'anil!lallsfrtrrlrÌr,r.Arí..'rllomr'lorci8.,anil
rhe {orlf (o..nì-rarc ìÌl ntdLrn nulqrilil,rium, wiar l'lÌ.!j Ni..Íea*db-tlheamouDttÌürl'has
túL(r, Ì\irh â.ore\p!ndinA apPrc(i1ti!Ì' !fine.eaLex.llrBt iììe 1. damIdorLn ìúÌrti!niÍr IrÊsntrr\
iÌì HÒnìe a..l trr\lrt delÌalionary l(\nres i. ForciSn A.d i has riren n) elimnrrfu th!.eL in.ier\r ir
\'.rl.l.lÊÌnrniilrri \!.úldothcN 5e hate come frtr lr - {)
tÈcal expàniion with flexibl€ exchange Íates
lÌì tlri\.rse, ÌÌom0 n(rc.\êr.í bv -\1, Ì{lÌil.lìÒ.eign.1o.! rot.hi.8t s ln.âlfoii.y lrnd th.( is..
rhìngein ìt o!,r1_) llÌr5ìì.rtaÌrJn!1)sislhenlmìrlir!dLìttlìerÈilnìÔ.etmtPly.htri:l.rinnethet
H.nÊ..rr-oÌei!r,sogrÉni-i' n rhesho,t iur 0qtilibriu'Ì, \i r\r rll-honÌiIÍâ.dlIl
r.Lhârll:ll - 0 \in.ctlÌ( fegâLiÌe imfartorli.dl'ollhe risciÌr iìrÌlÌc9nÌc, andsìnc€l Íi5rr
he.rureotl! tlre reaLe\chaÌìBe rale$udlPLìrr.j.ttrllJlcienrll t(ìcnntr! ll: \) Ì.1úitnclyrD
purhcd rp l)) .l; thn turh(5 LÌÌr i r.lilnr t. I lnd he..e ? rlprrirt6. nÌ!d.rilinF Lhe rlse ìÌr l' 1rhil.
Figurê 12,24 Àd rjtr!Ên' h. a.. Ìtur ii.i e\Fàìj.iLn.l.rfÊ\ô.êr.f:ì!:ràtÈj

Jinrl\if,!Ì..iiÌr!Ì:thn|,...Í...,,....\rfrili=J_drlr =r_. I ii\:lr!innÌli! Ì2.21\'h!Ìr

Inrnr.a.,i !rrÌ!n:rr.lÌ.D.ì,. trrl.. :Èt|r.Li\rlr.
\.terhaL,Ììr-rilì(rlrn,.ll.mchi!in.rersÊdifdrÌui.rr-.rÊiinhaiLle.rÈriedhÌúLÌÌd!f(
rjtrin)f hi5 he.i tLÍn\irÌrlt.rniLrr tirtt rj)r\bÌ úreinrÈa.r)!rtril \l!..1.r tltlrrnslinrf !rLlì:
nÌrlNnÌrnrfr15n.f.(rlìitr i\if!arLlìlr,r,rr t .!t\nlrlllrr
lrrf!Ìci(iÌrgh.ÌrÌrÈ!eLL,, tÌrr i.r nìL1Ì rrì n,rÌ rq!ilÌlrNuÌ tÌ!rrr tlrr:. \l fÌt nrn p!jjin!Ì!. lrt r\
Í(rÌìrrrtlrÌnúlurruÌrf.iirL.nr,L l)r li6r,n( r{rtlÌ.ÍLiÍa {.f,,,re!, !!ti,(!r:lÌri:lllIl
This ìrl(!tle:rrhlrhr:. n.!L i.Lll'.hrf!Érl. - \r !.íL.Ntr.ìrh!,\ÌiìiìrÌri.{riliL,nrJl
Ì. trLrn Lhr rllr .r ritnìL i , !.Li r:nrtl\ rhat \L lr afd \L rir l rìiÌ\ i i\
ÉridÉ.ttÌì.Lrh.È.frrü)i.nraÌlr!rÌ1t.Lirriì!\{nLrÌrirlìLh.{nìelrsl.!ÊignDL.th.L.ih!,r!iìL.i
nt\rnnÉ1,1. lrl t.Ììra!L i Ìi tlÌr loÌ!i!Ìr 11) ÍhrdrLÈ t,r rh! lrtt .r ir lni\ i!!h.r! n lrg l22i if
trlirlÌ llr!Ì0 ii rt f.i.r ,l iÌ | l!Ìri:I i\ iÌ t!nrt_

IhÈaÌ!?ÌÌri\ì.r).1\:Ìf.nìf L ri.h,ì ì!.. srs.rÌ\ Ì1r]i riJ tll eq.nri.nr lir ll )rÈ rrrr trÌ!iA L

ilrrijì\c!iLr'iÌnlmÌÌì!|\.l\]!qLitúr[UìL.ÌlÌrrrlrliiÌr]lrìrrglÌ:ii1.ar
iF,ri -\ Ì íLre.,lL:Ì !ì \' | \:n3 \i ll' ìn,LlÌ .t1,.trra.Íl,lrf !ir.ir.l\
l!1llt!3eLÌ].i.1:!<:2\i\.1ì.l'\\l!LirLLÌrinlÌiÍ.L|ri.t]Éjl:l.-i-
if ìlÌ,,r:iil-\r aLlliattr. ./\,rÌ.\rf!. \t: lr 2
458

LRLir 1D(io,&)

,1D1.i2, | )

,1D tir,.!Ì)

;\E ,/

':,,|,'#,,

FiguÌe i2,25 F5.ã erpnN5.n lfdêr llêx be er.rãnqe rates:5hor: a rd m.d uf Í!. àdlln ne Ì

Tlìe more honì ihÈ shoÌ1 nrÌì cq!iliìrriunì tu Ìh. nrÈdlúnì 5!r. i. Flg l2.25: i:
run one (rÌÌ bc
nì.rnìn,HonìegôeslroÌÌÌ!iô.,andForciSrlÍtnr- Lo.- inmcliunì ru.,Hômegor!Jrni.:
^nd
a..1loÌdgnf..n.'toJ.All..'l.thercâÌ!iÌìfainrnaÌ!!($u6illrrrÌ>0),í)i lcniBtu'.
npiìÌtrcrlìe.eaÌ núncl mf pll is.nav.nr8!!onimcliug r\rd ÌhbttnìesìDa.drD- [Jt.nd Ìll]]ì::
lÌ1.dditi{rì,siÌìc.?_irÌningand?úlílliÌrA.rlsÍniÌrS lhisfÌo.cs5.oftlnresrntilloÌliB.lìiriLql
,' a.dlÌoDchúsr:lLÌJ atd.
PART FOUR

Growth
 Exogenous Growth
1 3 Theory

lo.g mÌ econotnì. girlth .letcrmìne\ ÌÌoÍ'Ìlting statÌdards changc lhe theory ot

c.onomictso{thandlhe.ÌuestiorÌsila.l.üesseswcrcitt()c:lircc(Ìjn(llÌrplcrITheaiÌìoI
thls chapter and tbc ntl()Í'irg oÌì. is l.r ioÌÌoì! up lhc Ìnaterial fÌetent.d LheÌe by slÌx!_
ìnjj in more detali hoN tht(tr! cin bc trsed to slÌcd light orÌ thc lrocess ol grNth Simpì'
ernpiÌicaÌ reg!l.iitics ot the tvpe prcscnted in ChafteÌ t hclp tr)vide n gene'aL lratr'
work Lthini!lÌi.hlodeleÌopnÌod.lsolgroi!th \'l odelliÌìg ccono!Ìic groirth cdÌÌ p rcve
chaÌlcnging ererÌ.1 an inrrÌ{trtort IereÌ :\ illcalcr use of matìreÌn.tlcâl tecl!ÌiqL1'5 is
requlrcd to expl.b lhc nrechrnics ol gÌo\Ìth nìodcls thr!Ì is lìre crsr i' lÌÌe Ìest ol lhe
ÌÌÌa.roecononÌic\ prcscnte.Ì 1n thls book Horu'cÌ, we pl(nide hÌtuilive ând dingram
nÌalÌ. e\tlarÌations bcÌore pÌetenting the atb'nrtrri'rì d'rilrriinì Òt LÌre res!lts \'{ore
cletiìilcd tecÌrnical crphnatì(n on a nuìnber oI aspcct\ of gÌdtth thcoÌv i! prcvld':d 1ÌÌ
tlÌe aptc.dix to this châÌtL.r.
'1|ls chapter nìtrodu.cs eroitenour gu!th Lh(Ìt Wc besìIÌ our exploration $ìth
tÌÌe mosl iridel! lÌìos'n fara.lisÌrr: lbe SolcN Siran nÌodcl The ÌÌrodel Ìlas loÍnìuÌate'L
i nciepc n dentlv ÌÌ 195 aì b! Robeú Solow at N11 1 i . CaÌnbIjdgc
\Íassa.h Úettt üÌÌd Lr-v TÌe\ or
S$rI1 nl the Austr.liaf Nalional LJnlteÌtitr.f iÌl I itberra '^lmo\thnÌlaceutur-voìd,itis
5tiL1a po\!ertuL \trrthg Point nrr undeÌstandlrrg c.r)noÌÌÌic gìowt1ì. Once thc ingÌedierÌts
ol t1ìe ÌÌo.ÌeÌ are .onìrinc.1, $e cnd .ÌeÌi\ e cq(dLion5 thal fìn doNn the rolc oI 'apitxl,
ia\ing5, Ìtotu ÌrtilrÌ1 gín'th, {nd lc.hnologi.iìÌ fn)i.Ìres\ ìn .leternìinjnS thr cqtrilìbÌi!rì
Ìevels oI oútÌÌìt per rtrkcÌ ìn ttÌc ceonor1ì,! Lro ol the kc) con..pts iìÌ ilÍoslLh theory
rre thosc ot the neady stâle oÌ balen.ecì groÍ'lh PatÌÌ .nd of the ír called lransltnÌì'l
d\ÌÌan]lcs, i.e. Ì!h.Ì haÌtpcnr iriÌen stead! Íatc grcilth is ditturbcd
lI1 th s chapter, 1Ìc scL out uÌe Sol{ff SÍlnn Ììo.ÌeÌ .nd see horç r'eÌÌ it\ prcdjctions
nÌ.tcl Lrf irith thc frsl lÌ\Ê oì lhc tt)lired ticls ol Srosìh thal it'ere prescnled iÌì
lllÌa!rlü L

tll Iirgeclis(repn.(.i6hetlleeÌìbolhLell]lsandgrNt|ralesofpcIcâpitàin'omc
l)rÌsìtt a(ross countÌ1e5 tÌìd iìcÌo$ tún.
i2l hÌ thc long rür e.ononìi.s exhiblt iÌ rdl.rrrl3,osÌl,Prtlr' Lìrât 1\ ouLput per c'ìpjla
arÌd .ap !lal PeÌ ( l pit. g roN at nrghll conn.ìnt positi\ e jj rorlth ratcs olcr ti e
(jl lheÌeaÌi.ìt.oÍtrÌuÌntocâpilali5approÌimâteÌ)(o.slantovcrtheldÌ!run whìle
rcaÌwases 8Io\! at a Ìate closc lothat oi ouqrutper hcad honì l:ll ancìí.Jl ll i.ll(^!s
lhat the rati.r ol capiÌ Ìto.ülfut sh.n!s no trcnd ovcr lÌme.ìnd lhc 5h:Ìes o
'rpìtal
in.Ì Ìal)orr in lotel ìnconÌe sli\ r)uilhlÍ f of rr:f Í
462

(.ll lligh inrestÌnent Ìates in botlì lhl sìcal capilaìatÌd knìÌal edü'a!ion aÌe
'losclr''
relatcd ti) lÌigh lilnrg stnndârds. 2,
(51 Lo$popuìatìon gro thisasÍ)cirtedÍ'itlÌhighìhÌÌgnandaÌcìs

Lì iyoNth Ìnodcls, the long rün 1s clÌaracleÌized as one of rtlddl rr'Ìr'.{rD!ll' l)l
eqÌulvalcntìy as a ldlar.cd3ro,1, dtt úr s'hich outp(ú and eÌnploymert iïow at corì
st;nt proportidÌ.Ì tates and ìn {hich net saving (a d
jnleÍnÌent) ìs a conÍan! share o:
l-
outÌtrú. s tle nÌ:iÌ sce,1ÌÌthc SoÌol\_Siran grorÌlh nÌodcl without tcch n ologicaÌ prctres !
outputand cìnploynìent i]rot! at tlÌc sdrt. rate ìn the ÍcaLl)' nate, ntrich nnplcs that t|'
/d!./ ol oulput per eorÌ(er rcmâins constant ln this .ase, the 8roÍ'ih Ìate ol oulput p':
:

capitâ is zcrc in thc Íer(ly shte rise Ìr thc saviÌÌgs (an'l iÌìveslÌnent) n rc of oltpL:
^
sh;íts tiÌc cconomv lo a rÌ€(I s tea.ì,v s tate charac lerized bl hisher o utÌ tper$'orkeÌ:
as thi '

ccononìI nroves from the okt to lhc new stcad-v statc' output pcr woÌler is Ì!snrg Ìhu'
!hemâinfin.1ÌÌgoítheSolo$'51ÌanguíthnnntelislhatnÌthcabsenceoitc'hnologica
p(rgressì ccoroÍìi. g(^!th, ln thc sente of the 3r,r'/r in output per \!orkcÌ' ls onÌ\ :'
(an'l liLiÌr!
iransitioniÌl pfucess To.ìc.outÌt Ior the n€ad-\ iiÍn\lh in outpuL PeÌ capita
stan.Ìar.lsl lhat lÌâs occurred o\er rccent celÌlLries, it ls therelorc necestâry to introducÉ
tcchnoloSlcâl ptugrcssto tirc SoloN Stlan rÌìod'1
Eefore scllinij ou! lìre Solow SNan model, i{e iúro'Ìuce the concept of lhe gu{lh
raLe itselfan.Ì hor'Ì! i\ nÌeasured. SccLìon 2 c{fìains ho$'the 5c)Ìow
Swan models'or}i'
an.1Ìvh.t bl a írndv stalc r.Ìuilibriunr ir rlììs mrÌle lhe determinants (Í lb'
is nre.ìÌìt
chariìctcristic\ oi the Íead! stâtc are discusscd and a'e show hott the economv rÌìort'
fronì ojÌc stead)- s1ate to.nothertthen therc is a chirI]ge irÌthe satìnia\ rate oÌ ìn the lalÉ
ofpopuÌalion grorth. In scctidr 2 thereis no technologicaÌ progrcss This is ÌrìtÌod!c"
in se.tions 3 aÌÌd a: in \ectioD:1, Solow\ rÌìelho.t of qÌrntll\i!Ìg thc
(te oltcchtologicil
ptugressÌn grc!!th ìseaplained l h is is ÌnoNJr as (Soloaì iiÍrwth accountnìil ln section -
ive acltl tcchnologlcal progrets to thc ba\n Sol' \í!nn ìÌo'lel ând shorí lÌo1r irith tÌÌir
Nìditìcali{)n. thcrc i5 constant gro$'th ltÌ oulÌrut Per itorker sìÌcn the econom} is o:
its baÌance.l ilroilth f.ìth. \\ie .ompâÌe the prc.lictìo.s ol the SoÌo$' Swan modeì *itl
tÌìesllljzedfa.tsolgrcwlhsetoulÌnclÌâLÍcÌl.Akc-vcharact€risljcoftheSoÌott5$aÌi
nÌodcì is tÌìat tcchnologìcaÌ progre$ i! introduced as an doli'rro'J í()rce lhis mean'
it is modelled as the \teadl imp Nemeni in the technoÌogv avallable t() thc cconoml
$hcrc these ünproletÌÌenls are rot the orúcome of economic forccs AìteÌ ativcs kr tÌì'
as n\ÌnnÌ of cxoijenous technoìoglcal ProgÌcs! in modelt ol ilosth aìe the Íòje(t oi
chaprcÌ 1.1.
Scctionrctri r.s to thc qtre!Uof ofwhatdclcrÌnires ìncomeclisparlti's acrcs\ connriti
5
afd ìnvestigntct the rcnson\ $'lìy inconÌe pcÌ worker ma) or nì.Ly 'ot conve'gc acÌo!'
dillcrent e.onoÌnies. Kc! coÌÌ.ctts nr uÌe discu$ion of inconÌ€ dÌspaÌitle\ are those !:
abíìute {or rLn.onditlonaÌ) ard conclitionel con!rrgcnce The 1Ì-vpotìresì\ 'Jl absolut'
conlergerì.c is that .ouÌrtries ith Ì(Ner lcve\ oi oúLlÌìt Ì)eÌ workcÌ 3ìolv tìstcr tìrrÌ!
Lhose with higher lel,cls, and lheÌeítre conlcige to lhc srm€ liçiÌrg ÍancìrÍls lI lhi:
bvtothesis is aÌrplied 1o the e.onomies of lhe world the .tata È€scrìtc'l ìn Chirpttr
and nlo$ÍÌ again nì Lig. l:ì.1 cìtâÌÌy.lenÌonstrate ihit it ir not supported lor tlÌcrc n
bc con\€rgc..e, th..rc s'ouid bc a cÌear ncgatjve relationsìrìp betwccn tìre initial 16tl
ol i.conÌe pff capita i. 1960 and grtlth lÌonr 19ó0 !o 2000, ìlitÌì lhc ìrìtiâlÌ! toor
 463

X
XYè
X

X'
ì5
X x{
';xx
ì irfd lirì.S XX
:n0:.15 .50 t.;5 8(n) r2f ir.io 8.75 tan 925 9.i0
(, L) rfê: Q rlLr lrrô0

figurê13.1 s:h..a..:." ntrrr..nr.r!.n.:) !.:ri. ii.:r ,rr.{1r .t-.t.i aLF t.r.:fri: rr.t,r.?r
l;hn inrltrita i!; rï ÌFi _:. .t. _r. -è!Ê . alr; rÊr 1r;.il

.ountrie\ lú\ iÌìg high Snn\tlÌ li.e. io|.iÌ1(.1ìn Ìh( tÒt Ìrtt hdÌd coüìrrr 1!hìl:l th{'i.itLrìÌl
r1!Ìr cornìtìie! ÌÌ()rìld tenrLn) Ì)r ìn tlÌc bollonì ri{h1..rneÌ. 1he \.rttr plol d..s noL dÌ\'
A Ìnuclì sealer notnÌ ot .oD!crs..rc ls lâheÌÌed corÌdilio.al ro.vcÌgelce. The
h\tothe\ii ol (ondìtnÌLrl conÌrrscn.c hishlighl! Ììre ir(t ih.rl c.rtntrLcs rfouÌd n()t Ì)e
erÌìrded t! (oD\er{r to tÌÌe sinr. llllng íândrf.l\ urÌle\s tlìr! iÌÌ. sinrjlaÌ in inÌrrrtd i
ÌerÌ,e(tt, mch !i hrr inS üìe iiìnÌr'si\ ngs reL,'. \!(c\lüLlste iÌìlh(SoloN S(rnDodtl,
a ÌdlrÌ ia\úrS\ Ìrte ii dr!)ci,trd r'llh iÌôrtrlc\cì olter.iLpjii n.onì. ln Llrertead)
ttrte. lt Ne I ere t! coÌ!|!Ìr ts1r.)lhr.ris. i.1.:.li.rl e!!rÌo!ìir's, ..1i'llh e high xnd Ìhe
otheÌritha11)i1 iirirgtÌrte.1ftn1lìchtpoLh.ilst)flor iti.xr.l.oIì!!,9c... \r\ \ oIÌ\
tÌìrt controÌlìng n)r tÌrr (ìiti'eÌüÌ.r\ Íì sarlfg n1.1, lhe courÌtrt th.l i5 lurLhcr lÌom jt\
rtead! itrte rill !ro\ ta5teÌ uLìn i1ì!'o.. LÌrnl is .l!ser. lÌÌjr nx'ans 1lìiìl !oor.olr.1Ìic\
uill not (itrlÌ !Ìr d aclÌie\etl. l\ nSsLeid d\oltÌÌeri(lÌlnkss Llì!'pooÌ .rrunilv
ìs rb]t to clÌaÌlSe tlie drirrrììiÌ1.Ìì15 o Ls 5tciÌd-r strte. hÌ tÌÌi\ srún!ì ltc Ìrrldgc thc grI
brnreerÌtheorranlenÌpiÌi(irla.ll-!slihri.lü1rrLnHtÌÌrt).r\ì.clcnìcnL5o c.oft)Denic
eÍirlrtidr tlÌrt rlLon \ u\ to t.n tlc.o.rL'rsc...lìl t.ihe\e! riih rc.l(litn !!ciÌrall\ÊÉ
tlÌ!tÍxneoìiheqrÌiiüildjs.I.pi..ic5LlriÌi.is,'l{heÌrNetrtnripplt(b(SnlofSlrxn
rì()tlel tu tlìe rÈ.ìl norÌd rrrÌ bc rrplalncd i lìLinri. !atìtai i\ irÌ.lirdrd (j. iìdL1llL.. l(l

Sr(tion 6 to(u\es orÌ the (lucniorì o h.lt ro !'reltriìte Í)(ial rtllirrc in tÌÌc.onL.xL ol
r.onomi. S rilì. lhìi ttro\jd!\ i ba: . r.nr(JrorÌ l(, c[\ì3niÌrs ec.non]i. poli.t (ìLrÌ
expÌorâtiolì otcaogenous g(Dlth üÌeory conclude! wlth Section 7, ithsoÌnee-\tensj(-'.'
oithe baslc tranrervoÌkof the SoÌow SìlaÌÌ ÌÌìodel
AltlÌough lhe Solosl Swan model pnvidcs Lhe lolnditioÌì for growth theorv, tht::
has beeÌÌ mr.h work on deveÌopiÌìg modcìt nr $hich thc gronh of ììvinii ltandafi'
ì\ endoilcnor$, rather than the resllt ol'cxogenous techÌÌlcal ProgÌess' A unìbcr :
.liiïerent nìodels ofendoacnoüt *rolrth arc cÌflited in Chaptcr i']

1 GÍowth and the gÍowth rate

Beturenìt.(nltrclnsthegrowthnÌodels,asÌrcctsoltlìl:nralhcnraticaÌconceptoilhcratr:
gÍníth uscd in srcwth theory üre \et oul This iectiof.rn hceitheÌbeiead and abírbç.:
nNt or it.an be iÌúìrncd anclref€Í€d ba.k to as t1Ìe.onccpts and techniques arìse ìÈt:::
explanation of the giolfl h nnxìels.

Notuii.) ustrl üt !tuitthth!o,}. throughoutthischnÌrttrweusethesocalÌcddotnotatì.

i. to rcicr Lo the ratc ot charÌge of kcy laúalrles.r 't: dot' is the Ìate ol.hange oi ou+ìr:
and is.Ìosclr''Ìeiated 1o the fìnlliarconcept ofthc change ìn outP!t betwccn pern r ar:
'rioJ t 1..\l- l \'\ t\ ' lw rPô 'r J' r

equlvaìcnt of lv and ìs defrncd as the tìme deÌivaljve of l_. that is dvlr./r' lo sumnÌari:.

(rate ol change, disücLetim.

katc olchange, contirÌuous tim.

l. tÌelious clìaptcÁ, rle 1ìâ\.c tvficaÌl) used dlscrete time Do€s it mall$ irhcther r.
woÌk iÌÌ contìnuous time or dÈcrete tlmeÌ C€neraìì-Ísteaking iÌÌ i]loÌÌth thcorl ii is ed\ii
'.1r.9r1 .. '.orr'1 r' | . rrr'ì o . rr' _ l
(PtulotLiotltll) ntc oí tt.)\\,tl, is dcnned ìtr d1\.re1c linre as

-.,, vrltLil rl, (growth rrtc. discÌcte t1Ìrì.

y

ând ìn conrinuous tìnì. as

Y .lf idl
3r:t {groi!úr rate, continuous tiÌn.
Y

Ìn cach.ase, ihegÌo$'th rate, e.ij.0.02, isnÌ,Ìlj!ìied Ìry 100to PÌoduce apeÍ d,td.{.gnnl:r:

lN.iêt1Ìt1Ìüou!h.uitÌlcdn.lÍjonol!loHihiin.t|uriire.Ì1elnnLh.1
nnlìln!ìo(nmo r:i,ìgkrÚ.iÍ .1t.51oa.f.irrorl ì.d rpp.Ì.r5.1.1Ì.trn){l.fon ndnnìLqtantiÌ.
diììeSt.Ìrlh.hrtnÌ\ I nreaÌou\ìtr l!.uirl i'denÒt?ouqnnf.r (iftr,l = r/
'
rlrÌrrnÌatÌìenútic.poirr.Il,eÍL[e.ouldp(Ì.JlL,trú.êsúÌB,ndn.rÈklnÌe.r(rll,,Ìndilrcquarii
\!r JrrÌÈ derned !ì..rtirüN ixneÍorÌ{ì hold i\ rÌÌrr\ìdâti.ns Lo tÌre dilcL.(. t rìcr.jrlt!
 lt65

t:dh'tlLtliüil gt owth nes. As this chaÌr rff is a boút econoÌn jc jtrowth ir is cruciaÌ to uÌÌ.ìeÌ-
stâfd the concept olir Sr)nth rate an.Ì how to trÌ(.rsure ìt using c1aia. Thc sirDpìcÍ noti(Ìl
of a g(ì!th ..te is the peÌccnta8e changc jI cl)1, Lretlíeen pcriods (quarter\ or ve.r\) a,
i,r'r.,l..irp.t t, r,,t,\i.r ,,u,.\r .q ,. ttt.. ,,t s.r )òü2:
biìÌion nì thc lear t r9ir (bolh nÌea rediÌì 1995 pricet. ÌtcncetheIJS cconomÍgrel!by
ì L,-\.- r 'a.r ü n'!
(lnce Ìre nìove bclon.ì grorÌth ratcs oler vcry
íÌoÌt periods, it ìs nc.e$aÌÍ to câlcu
., 1 , .,'ê.' .,.t.,r.,I I r\ i.1i,J i
on arerage annuaÌ growth ralcs over ìc.gthv
tcrnd\ ot tinrc. we takc an exampl. an.t
conìpâre thÌce methods.

. rirst, a'c caÌclaate rhe average gÌo\fth rare jn Chjnese ct)| per capita betllecr t98S
,rnd l99Eusìngi'ldrga\,€rage'mcthod: t.i Ì0. (!;i{r . 100
= 7 ìbtl p.a.
. Sccox.l, wc c,ìlcular€ the ânnual grÍlLlì rate each _vear ot the dc.iìde an{Ì l;rke ihe
avcrâ8e: the,rnÍlcr is s.71Ì p.a.
. Third, we caÌcuÌate tìrc annuatcompou..Ì growth rarr using a nrmula:AGR (ânnual
perccntiìEe gÌollth ratcl = (erl)iliiÌ0.to-Ítrrsi rlsl) tl 100 S.6Ì p.a. NoLc th.i it
=
1s th.l! lìrction or rhc câlcutaroror spreadÍìeetthat músl be ujed
5jncethis is lh€
natu ral logaÌì t hnì tì!ìrtionj aÌthough we usc tlg ÌÌ the tc\t, rhjs always releÉ lo th€
,.r, ,!or rr .

'lhe 'l(nrg a\,erage' üìeth{).Ì in.orecr bccìuse jL

ir! ignore\ conrpoLrndiÌÌs: it oversrates
1. ..1.. I'rr h.r'. !. ri,.r 1.,)
risiÌì8.r Thc arerage olthe annual BÍNth rares $iìÌÌ)c
rcasonabìe approxjÌÌatioo to tÌre
a
.onÌpo Dd growth rate tìì. Ìo(, grlr$th Ìalcs bur Ì{)s.s accuracy as thc grollth râlc rises.
''hc comparison bel een th. arcr.ge ot rlÌe
ânrlraÌ gÌorth rate5 rnd ihe compound
gnrwth ialc is .ÈÌactì)'the sanrc as betrlee. sÌrìpte ìnrercsÌ (.o Ìpoundcd arÌmrallv) an.l
conìpound nt€rest (conÌpoundcd contiÌruouív). The AGR is t1Ìe equivale t of rìrc
lor ilteresl rate\ lthc nnrìuaìfffccntâge rârc otlnteÌeí rcpoÍed on crcdtr.ü bìlìs,^ÌrR io.
cxir!ÌÌpÌe). We rÌeed to erpÌain sonìe (Ìe conceÌ)ts belorc !1,e retlun lo sholí whcrc the
Iormula for the annual conrpourd gÍnvth rate (AGR) conlcs tÌom.

1.1 Growth rates, exponential and log functions

To scc that rhc gro$th olCDt in discrete tiDrc, ^,Ì isrhesânÌcasthegrorttrratej..on
tirtroustlìre,.qr.,líhen tlÌetìmefcrÌod i!short eno gh,ìerússraútÌomrh€ oporLìonaL
grcw1h of GD| betÌrecn two peÌiods irÌ timc gìven bv, r aod I lr. (,hiÌe \r is s'ì.11
U:hcn we makc thii ìntcr\atsmallcr iìnd !Ìa er, we sâvrhnr Ì!e are taking re ÌìD jl ns lr

r 1o {c wlìr ih. riN Drihod jr nì.....r. ippt! tlr! 7 lrLrr djrÌrL sr.Ì,1h úre n) i Í.bâsÉ rrx. (;Dp rp,
'r',,,tt,
466 : r: -.

ì"-'' rÌ
_i. . ,, J r"
r'11 lr Y'J

3v

\'!c cxltrcss the pÍportional growth cxpÌcssion PeÌ unlt of time and then the nrler :
calcuÌus LcìÌur dlat if we rnake this period oÍ Ìime very smâllthe lìÌst ierìn nr tìre braclt:i
i.IolrI.ò '.r'l-.r'. r J"l riol- I d \ rr'' 'r'' t_ s .r' "r '', _' j
is Ìinown as rhe ìnnantrncous grosth ralc. Thus when we !Ìuote tf : 0.02, this mear::
ilÌirt UÌc gro lh Ìate ofCDl'jduriogthc pffiod ofinteÌest ú 2vi.
It is!cry usefuìn) seethat thcgroÌflh ralc can beeÌpÌesse.Ìin several ecÌunaleÌÌt í\'a\ i:

,,. Y dY ltìt d\EY (ecÌuivalent e\pressions, ilroÌÌth ratÉ

"' v Y dt

LÌ order to scc 1lìal lhe ldn equaÌity holds wc can use Lhc .hain rule of caìculus an.lthi
lact thât the d€riva[ive of the ]os ol a \âri.blc, v, is i, ì.c. 4r# r = rl :

L1l.i.AY tl|t'ÀY .lY dY idt

dt .lY tÌt t
We row cxpl.re flrú1ì€r Ì4'hiÌ1 e.ononìjsls nrean when they say that tutPut gror.
cxpo.cnlially'. Ì.et us Íar1 q,ith lhc pÌcvìors exampÌe s,here nt vrme eco orÌt.9r =
0 02. l. this case, if we krìos thc lcvcl ot o(lput ìritiaìÌy, ]l), and the gÍNth râte, ther
rhcìcvcl ofoutputattimc rcomcs tronr thcc.Ìuâtidr r;: lìreaÌ)(.{f t), wheÌe exÌ) is thi
cÌponcntiaì tunction iìnd lhc gro$'1h ratc {r is assrüÌred to be conrtant. This equati.Ì:
can aìso be written a\ v, l'oe{, $'lìcrc.í is used instead olír t() simplify the notatúì
How do we knoi! thìt this cquitìon dcs.rìbes tÌre e\dulìon oI ouQul Ior our econoÌrl
thar grcr.s at ratetr 002?lllscasicrtosccthìsililedotheprÌ)fin'rcvebe'.Thati\
letus staÍt lÌom theequalÌon:

ri: li.xÌ)(.lr t).

lrhcÌeti standr iìii the initìil valüe ol outpul. Takirg Ìogs oI both thc Ìcll and lhc ÌighÌ
side.Írhi\ lve.hÍrif:

Ìoq i" : ìo" YÚ +"r 'I í 13.1

lf$c n ow take deÌn atiles r\'ithrespect to tnn€ oI tlìis cxpression Ì!e obtâiÌì

./ l J P'.
,tr
=(t

i\ ol coube tìxecl .ìt .ì11future yaÌues an.] hence

Thc initìal vaìue ol output aïa = 0
ThusrÌchavcsÌrown thatJf =./l)cv././i,asexpectecl.
 100

l0 "o ro .ul ro +o so
Figure 13.2 5 m! at on oí erporent à qrowtlr.n à no m. and olirlhmÌc5..€

An undcrstardlÌrg of thc ÌcÌationshjp bclwcen exponentÌnÌ growth and logs is vel,v

ir the Ìclt hand paÌÌclol fig. 13.2 sÌÍr!,
usctul lor an,! anâlvsì5 oÍgÌosth.+ As Lhc plots
onccs,chavetheinitial vaìueforGDl,, iì,andth€iIoúh ratc,qrccanrcad ofitheÌevei
ot oítput at aÌì) nìlnequen! dare. Growth paths for GD! arc sÌÌown lor a 21lo, 5%, and
101/0grolvthrâte.WeaÌ$norctharÌhccquaÌlorÌlorlosy,islin.arlcquatÌon13.1),with
thc sÌope olthe lirÌe equal Lo lh. grceÌh ÌaLc. llcgror,th paLhs tor GL)lJ arc slÌo\{n in the
right hind pânel using dre Ìog scaìe: thc gmwtlì paths arc slraÌght lincs.
r\ sc.ond reason ld undc6tanding llìe rclalionslìip bcli!'ccn Ìogs a.d growlh ratcs is
that this relatloÌÌsh\r Ìies b.hind Íme veN usclLrl ruÌcs lor handling growlh mlcs. lhc
Iollo$,irÌg rul€! âre use.l fìequentlv:

(11 Ily:-{"thenÌ.Ay d orrx. Lhis is usefÌrl bec.usc it alloí's us to go from leveh

: ànd the right to growth r!tes. FoÌ exampìc, il wc bcgi. s,lth the lvideÌ,v uscd produ.tioÌÌ fuIlction, the
cobb Dougias,

(13.1l
v ('lr ". (Cobb DouglaspÍnìLrction functúnl

$heÌe0. d i 1 and fiÌltiakelogs:

os)'=.los,( (1 .lÌogr.
,.. "-*r' = o. L Ì.or a .or.irr trrd inriglìúrÌ dis.uÍion oI rÌre e\p.ncriir rnd l.gnnì]!hiL iun.tn'r\, íÌ (:rapi.r t in
468

thcn diflc rcntiatc (,ith rcsFcttotlnrc dft üsc th€ lac! lhat +ii'I : r! ile gct:

.l r ,,J,,ti I ,, J!.!
1t ,lt ,lL

Y
t "u!
t it ',tl
1\'e can see lronì this lhat thc growth ratc ol oÜtlut Í a wcighted averagc ol thc
g(r\ijl
rate\ oÍ capit.ìl nnd lrbouÌ iÌ4r!r1s.
(2) lbe gÌo1!1h rate oÍ tÌÌe ratio oltwo laÌirbÌcs ìs equal to the dilferc'ce Lret\lcen Ìhi
trlo gro\fth iatcs: Í! = 3r .íf This rde is uscd otìen Ìor exrmpÌcÌ ú \ays lhat tlr'
grNth rnLe ol oull)rú pcr worlter (ï) is equal to thc grcwth raLc of orúpul (ÌIl ÌÌìinus tÌì'
(1): ÌoAl+
groirth raic or Norkeb (ll. To nÌoh'rh1\' thc sanìe lcchnique is !tse'ì as lor
Ì.g,{ Ì.ef and'r 9: il!:f !++;hcnce.rr =.(r iv
(-l) The gro$tlÌrnie ol lhc pÌod uc! of t\vo laÌia blcs ìs equâ1to the sun ol thet grorLtì:
ratcs, frf .{r +ir. Thls fttlow\ thc sâme Ìogi' r\ ror 2

1.2 UseÍul definitions Íor growth theory

h g(Nth mo.ìels in conlinuous umc, the co.cept ol lhe gÌowth rate i\ Jr
: + - !#l
which we can erprc* also uring vÌ : vo erP..(! tl and ecÌui\'alcntlr- as Ìos ii
: l'rs i'
js
jf r..\snotedibo\e,tlìegÍxlthrateJr the i,rtrd'rd'rodJ growth r'âtc ând malbt
.aÌcuiated lun da!a as folìows:

Ì(is l'! : l0g l'rr + Í! I

,{r I = Ìog l'r lo!. Yo

q - l, IÌ loqll il' ! ditt.ÍLrrc nÌc lrl LL

s,heÌe l is lhen!mbcÌ ol-v''caÌr, liri\thcbase ycârleveloloulÌlut' and Ìi lhe lìnalrcaÌ Ìevel

.qrisDultipì1edLr-vì00ÌogtttheperccntagegínLtÌìrât'Th1sisofÚrÌefeiredloatth'
:log cìiflercnce' mclhol ot.aÌcuÌating the groirth rat€ \\hcn relering to th€ iltottth oi
output, econonÌists olten mean the nnnuaÌsrowth rate (thc djscÌete tinÌcconceptl' tather
Lhan thc inttantafcolìs gm th rlte (lhe c.Ììtìnuou\ tilnc concept) sÌrnìlaÌÌ), s'lÌc' di\
custhÌs inleÌest ralcs, it is Lhe annral pcrcentagc Ìate (l|R) rathertlÌan the ìnttânlaneou\
Ìate thal is tvpicnÌll reporle.l TlÌe annuaÌ perccntage growth rate (or annual corntound
gultlÌ te a\ it js soÌncl!me\ called) ìs leÌÌ,irr 1 I erprcssc.Ì as :ì per.cntageand thìs1\
tÌÌe loíìuÌa f,rr .iììcul.tjng the conrpound groirth rate provi'led aLrovc:

]\(ìlì: (r\fíf 1l 100

l^l; -, ) )'j I
ì(Í).
 :-,4i_+r4. 1 -,.. 1\
a:- ! i j. ? i=
i.l--;!-=
1r,)
;:.-i -;
,- 9
,. It f i i,i;
: T-

*:ír:2.?-i-ií7.
"',::
.;iï.
i7;-l:
;
, c ,!7 -, i:i -
l: = a --l ;, .'rr: 3
i -" -. .=:-;
= '!a-.ïz 3
==1^'a==i::+-:=:' -.-'
+
',,/'.,./ ;
:-" ''-' ;';i':"-i"' :T 2 e =tí
,i;;-'íI*2Zi=í a'a- a a
] ? -, -: ; ;,. - tr
':- ,, - . .)2:2.
:'- 2 =)t)
-:. ?:
:i=:
ïr, 'i :!'!ia;: 3':: !
i1 .= ïaií7,Eai :=ta2
)í 7
: i =':
+:Z '? i''=iít'tE
'; '; aa.:=2==- ,;. :: 7- 7 -t
= +;+::l_r: i? a:f
.l -'. =\.':= -! ;
i;r: : ;?
2 :,:,
z ,:.
i! .; 1,tZ\+Ii '.=- ?.ì
: jÈi =
i " i';
a
ti -: iiii.,Ê|t, r a":
=' )t|';'=7'=t'=r, ]: iE
"' ti
470

2 The Solow-Swan model

Ne b€gln r,ith the lffÌnaÌ model ol c.onomic Srotlth dctel{Ìed both b} RobeÌt SoL.
ancì lrevor Srlan iÌì Ì956. Deceptil'cll' si mtle, it has sloo.l the test ol timc es oìre o,'i.:
mon robtrsl pìeces of c.ononìic modclli.S lt has Ìong bcen tìre stiritjlÌg poinl i(Ì nü:'
expLoratio.s, both thcoÌeticaL .nd cÌrPjúcal, iúo th.: nature of ecoÌÌomic g(Nth lt '
ìmlrúanl lo beco c ecquahÌted s,llh Lhe asnnplions un.teÌiting thc model; âÌÌroi:
other t1ìi.gs, tìrìr dllo\ls ut to jú1ile whcther the 5olor'_Snan nnxlel is.ppìicable or.':
1r a partìcuÌat situation.
A notion oíríh:ìt is meant bl .a pìtaÌ an.l iÌì pa r Llcula r tì1e aggregatc .aPjtâÌ
(ock i:
kevprrto the Solol!-Sira nÌodeÌ. lnawat,ìtì!cìosetotheeterydayuseofthe!roÍ:
capital and it lnchdcs tÌ1üìts litrie.ars and.ornpltLcs But one needs a nÌte prc'i':
understardìng otthrconceptiÌì ordcr lo appÌvi1 1o gntlth nrxlels.
. CapitaÌ jsPro./drrÌr. but 1t does f ot neecì to bc pÌoductn'e dÌ1 thc tiÜrc An aeroplar'
tìrat lÌ.ìs bccn trmporarily tak€ÌÌ oul oi seNlce bccaose of lo! delÌÌafd fttr âir travc . lLì:
.ranÌte, (illcount! as paú ofthe capiLaìstocl oI lhc ccononÌ) hnporta n ll).' úrvenio rl''
of Ìa$ Ìr.tcrìaìs, lnternìcdiate and fiIrjdre.Ì goods arc aÌí) paú of tlì€.apì1al \tocli ol lÌr'

. Capital ìs ll scl I creatcd trcm existlÌÌg rc$urce\ in thc c.o nonr ) Í) rìg€ÌÌls la.c a tradr
oit beti{een.on{ming iome ìevmrce\ loda} or üansiorming them into.afitâl' ríhi.Ì
rÌilìpote tialìr pr)clu cc rìoÌe re\our.cs !o nn)ÌroÌ\'. Ì h c f ro.e* ot üarÌsio ín in g currjr:
re$urces into.apìtal and ai{ay iroüì currcnl co sulnption ìs calle.i t?v.stre,r'
. Capìtal rdtìs rUrl!,r,, or cq(ìvalently, i1 is a*umed tlÌat.apital caìr be rentcd al tÌr.

. Capital aÌso refrs.idl|r, i{hi.h means it be.onrcs ìess and les\ productive as tim.
progrcs5.s and it lÌilì cleÌìtu.1lÌ bc.oÌne obtoletc. Ihit is a rerJ hÌtuiti\t asPect ofcapita
jn üse today Í'ill nol berer-v us€ful
and l1 renect\ the inìtoúarÌt notìon lhat the coÌÌrPulo
irÌ scvcÌal years irom noi!: its cornponents ürc Ìround to fail and ollgoing Lcchnologi.il
progÌcst merns it Í'iÌl not be ablc lo nm the lnlctl $thrare lt i\ assumcd tìrat capital
dcprcciates at tlÌc con5trnt rate, ò_, The Ìeìl üìlff.st Ìate is equ:l to thc rcntaÌ rate.,N
minús the .lepr€clalio n râte: r ,{ I. Sitrce thc dctrccjatntrr rate i\ nornlaìl-v asuÌned
lo bc conÍarÌt, thc rcal rate of r( lLún and the rcaì ìnteÌesl Ìate rÌÌov€ togethcr.
. nloÌe tÌick) propcny, which $'|e .ân ascribc to capìtal is tha( it it l
^.o.ceptlral\
rtÌ!/.qoo.l. Thls merns lhat the usag€ ol one unit oì capital bl an indn'ìduâl neccssa Ì\
means (hatnoo e cl!. can use it. ('c nrall \ee iIÌ Chaptcr ì'1,lhere aÌe Soods thal do
not haÍc this prop.rlt' aìrd that plav nÌr inÌutant role iÌì modcìs of ecoroÌÌÌic groiçlh
^s
Mosl ìmÌroúant amongstnon rival goods f(Ì Srol{'th thcory arc ìdeas: once calcLrlus har
bccn dìscoveÌed inyone who 1ìas Ìcaíìed the appÍ)priatc nìcthods wiìÌ be able to Ltsc ú
productn ely withoul inte ering \Lith thc ose olit b-v othcrs.

Ncxt rle neel to bc Ìnore specihc about whattlìe aggregatc caÌrilaì stock ot an e.orom)
ìs. II )'ou.lorbt tlÌaL one caÌÌ âggrcgalc atpÌe\ .nd pears. )oLr mar'' he sreptical about
aggrcgatlnii all the dìftèÌent t-vpes ot cafital itÌ rn ecorotrv This l-vpe of scepti.ism
 ir' ts6r)!oífrl'iì '
(Ì1rúl è^ito3nrr ur uonrunÌ uoqrnponl)
1 'I
]t t; '"'; I
:!r uÌÌrt J^IsrÌà+uÌuÌ uoLÌ-ruÌìl uoÌr lnpord .rÌ1 àlrMJr url-ì: .
'rJÌd8q. sq1 ol x!Èr':::
)rlÌ Ìrt pèpr^ord sI rDrtl ? ol srnnrrr pü! àÌttrs ol sunrèr lo sÌdàruor èqÌ uo rrqràr-':
-1ly Ì put 71,{ = 'i s? tsrüÌèr rrìro{ Fd ul ) t rr!.l,r,s,,rrrr ül ÌPrrdÌtr pt]o lndn:
rugàp ol er sMolp Ìr ès.lrJq nÌèruJ^uor Írà^ sr uolldlin*È rlc-x o+ ÍrÌrl.r lu!lsúr-ì èL
'tuqsuoJè.\u*odúsIÉãràLlN'17 ))ír - {lÉ xilil r'Ì l là.{ sa ioD!Ì ÌPrP r('Ì s's rJ ÌÍÌd+"
,roFq )üiÌrs àLtl -iq pi*èrrul èÌP slnduÌ uloq lr rüql sü.àtrr rl iíÌÌcrèuà8 èro^ ÌtÌd+Ì11
sàÌqn.Jp ràÌÌÌrDÌrl u oÌÌrnpor.l 8üÌÌtrÌ Ìdn p l!ÌÌÌ Pè!! rqÌJo uolllzlpràuàS èqÌ s! pJzll!nsr \
.itLìrJ Ìsoru sr sÌLt.t. (snl) )tÌ.t-rs t)t e !ì1:]àttuorr.i slrqnÌxà uorÌtrunl uorrtrnPor'l rqi lÌrqr
àún\s! ÌteÌls ài\ ILlluoÌÌrppv rlrúor3 lnouètoPur prÌ! eÌourSoxà Ìo sÌàPouì uJê'{+à'Ì
I
àruèrãl Ìp àÌ11 9uÌ u Urp ÌÌl àÌd l!4uàtr ! s,{nld lÌr}Idtr o Ì srunlàr 3u L$IuItÌÌlÌr rr) uo Ìdru nssÌ:
èqÌ'L riÌdN{:) ur{roèrÌ} Llr$or8Ì() uoìçsn-xÌp ,iutrnpoÌ1uÌ .tlr ol pàÌprèìs !v uolÌruÌrl
rlorìtrnpord èqì urlndrÌIÌ1o.Ì!Ìê1Ì1or rJlrr o+7èsn.{os è.!)l nìoqcl èrÌÌÌru1rlurúrioÌdÚ'
nàèillìq è.uàràlrrp êrÌÌ lnoqìr .{Ìrci\ oÌ ê\tìÌl ÍlìeLlroÌÌ lrr op J^\ sÌãfou ql']Íor3 Ìrl
'sèrluàs iìoqPIlo ltou pÌÌÌr sètrurJs lllldÌr.r(l
sMou .)1ÌndlnoJo srlou sèlÌÍrr ÌIour rrnÌ uoÌ+rnPd d Ì1ÌÌrql rrìrJ rÌou o1 llrtlr odrul çr 1l
'suuJtÌfèÌr[à.rÌ srlq!I1Ì]^ lÌv Surls itìruÌr p puÌr àrn rsod àÌP n oqn I putÌ ÌPrr'ìer lo j Ìrn poid
lluLirrüÌ àqr àrrqM fuÌr qlooÌÌL_ !r uoÌÌ-ÌnÌ uoutrnpord èqr rr)ri,r '17 ))J = I "rr't'4
ro4rrrordàqloÌ SulPr)'Ì rruld srìÚÌ urnÌM 'uoÌrrnponÌ ur p)sn oïP sI rnoqe l poÌràd
rx)u spoo8 ou'r-ìÌrtdols!os'rndurÌrlÌd.itstprstr è Ìrtr1!iopìrun!
uo-ì àq uorìrnpoÌd LÌlr!{ urfrq r^\
lpr poot àÌjìriÁ .rll .{úouorà poog èuo ü qrns ur"PJÌs)iuÌàq
uorllun] uorDnpoid èqI L z
'.)üIrÌÌi^o ãtuÌtÌi slniÌuÌ ÌtÌrd0r puPÌultìJqì r{oÌÌ .
1ÌrÌdlno otur
pêurolsu.rl Jrc rÌr.ÌÌl pu0 ÌPl Prlo qndul èql Moq è I'uourunj uotDnpord èqr'
:làporüàqr ol slu)ruêlè Íàì oi\Ì èrÈàrèql ,íuouorr poo8 à!o
Ì ur ÌÌÌNor8lo uooÌsodxè uÌ Jpr^or.Ì M.ìu Lrlr è1\
'\uorllirèsèr èsàLll furú üÌ lrrldèà)
'.{3oÌoüÌirèrlo
çúoaPrÌrèsèr.Ìrr p)ÌrÌrndub.) prÌN IrsrÌtrr rroru ol1qor.ru (úàqlèqr lo sìq8rsür Ìmu
IJÌ lÌrql.roqs oÌ \0 luèrun8.re sÌql ol.suod!èr s,Molos pènnxÌrN.ÍÌer ìüüÌJrllrIIÌ uorr
'"a irr''r"' nir!lr ^ _ro'r'
' ll lil!!:_
Ìrnpold utnü Jrtt o+ stàÌrour poo8 ruo Lüo4 8üÌÌÌrÍ{Ììrjlrè èqM Ìnlãrüj lir)^ àq ol nÌl
qurr 't uur\\ 'ì r"Lr- l l { l' I irr-r
'. il
pàÌpFèr33! osÍ! pÌrÌr pèrni!.)tu èq uÌrtr l,rìld!r Ìelll uoudünNsÌr èqì uo turít)r slêpouI rPqr
pànip uo\urqoìÌ strèsntÌrlsslw'è:prrqllÌr:) ÌIÌ uo\lrÌìules IÌnrd PuÌ i{'rÌos lràqoìl pu.
'puÌì9ur'rtpírqürpi)ur.uorutqoüuÌofp'ì^lo^ur,isàÀorluolètp.ÌúÈi),JtÌÌsÌrÌÌ^úuì
!êleqàpsÌqÌ. s096Ì pue çoçajÌ èqr ur sl!ÌüIouorà u))r\Ìàq èrrqàP trrs\eÌi ! lJo lèìn.Ìs
llt .:":':. :
472

Othcr leature\ of tlÌc Ìrrinlfttion fun.tÌon lìav a li€v role iÌì t1ìe SoÌoi\_Siran modr
Ìn parLiculaÌ, the.onnnnt ÌetlrD\ to \calc assumpti(Ì1implle\ that avcragc and ÌnaÌtiÌÌ.
relurn5toeachlr.tordctendo 1),oÌìth.IacldÌatnr,i.e.oÌÌ(11.lithcntollo sfìÌnntÌr.
ass u Ìì ptlon of dinÌinish
jng retu rrìs to ea.h tacnÌ dÌat the a ! eraile produ. caPital, 1/i.i
ta I

and ÌÌarglnal product ofcapital, Ì/l{, arc dccÌeasiÌìil lunctions oi(/l (and the avera!.
producr of ìabour. rll'1.Ì an.l marirlÌÌal prodúct oí Ìâbo!r, rvlrl,.ìr. incrcasi.g Ír'nctltnÌ\.:

,1/)K : ftr)/( rnd.,it / = l (kl:

Ì11,( _ f,lftla.cÌì,í1,r f(rr I iÀrÀ

The derÌ!.a(ior ol the exprcsti(tr lü,VPl ls sÌroÌln in the âpp€ndil. ìror lhe renìlt! r'
the 5olor, SrÌan modeltohoÌ.1, thepÍÌlu.tlon functiorÌ nnrst bc Í'cÌl bchaled'í) at t.
ensure thal Lhere i\ a !nique sieadJ nâte cq(tìlÌbÌ1unÌ iÌì the growth nìodcl and that it i'
uniq ue. l hc ad.lìtidÌal ass umPtions ne€dcd .en be tòunl iIÌ thr i p pc n dix
ln prâcti.c ll is olten conlcnient kr ilortri wiLh a specitìc representation ol lhe Prod!i
ti(Ìr fruì.tion that has.1l thesep(Ìreúies. SLrch a ftrnctidì js the Cobb I)ouglasProdu.
tion fun.tÌon glven b)

v:Kt! ' (l3.1

r K"l (1J.J
L .U
(13.1

wh$c i{e divide throtrgh bt I

to itet it ìrÌ lnÌcn5ive turnì. L\iÌrg tlÌi' Cobb Dougìas pr.ì
ducljon tuìrctiorÌ as .n cxaìnple, nìany oI Lhc pr4reúi€s of th€ product!ôn tunctìon ì(
dcrived nr the appcodlx.

2.2 How labour and capital inputs change over time

We slÌalÌ assume that the labour Í.Ìce gÍtls at a co.sLa.l l)osiln e exponential 3roÌ(Ìl
ratell. Ìf wc irork iÌr .ontiÌìuo tts rìmc itìtnaturâi to dciÌlc (his gntlth Ìate a\:

(rlroÍ1h raLc otlabouÌ irÌut: exoilerÌous

whi.h jnrpìÌ$ thrt the labour Íorce guls e\ponc.iinìÌ-v nn.Ì lor en)' ìnìtiaì level tr. ,ri
soÌìc point i 1n the futürc lhe le\ eì olthe Ìabour lo.fc !s I : Ir.Y|irt).
'
about labo!r for.c grohlb, lhc gÌowth olthe câpital
Bv.onrÌast witÌÌ tlÌis assúmptlí)n
t'ith a cl()secì econ
sroct depeD(ìs on €corìoÌìic facnÌr. l\ie aslunr tlìal Nc ãrc dcaljng
onr),irhich re.ìnsthal.oboü\vÌÌ8fìo abroadistosihÌca.dhencesâvlngsaÌeequal
(oinlcshnent.lÌìndditioÌr,theeconon)lìâsaconslanLcxogcnouslygjvcnsa\ìntt.atej
oúr oIctrüertinco c. Iogether, theielmpl! thrt
I ilt( i I.
 413

r'i^ Jr LoÌ /(r' \È

rrnÊÍ' r i5 grì\i irr Lriì4(.1 l| \Èr horr ilr crPltrÌ n'(Ìi
cÌì'nges' i
f€rd lo d.cÌr.L (ltp rcirt ... ir 'D gi'i5lÌr\ ìr''
'\hrr 'l
(rii(
trhcr(ijithtÌrlLrt\iÌrirlr.rÌiiìrÌ(Ìcfr('Lat':'\lrlÌL'úr'frpof,riilÌri'(ÌldrtiontlÌnl
riì\'jì!s i\ tq!ìÌ1.r jÌr ÚlÌ4c.1
li='1 ')^- j] 1(/I '(
Ìlr dn jdl.g Ìlrrì!S r b\ X relrrr

,.,.=f =.Ì( ,r-, rt,r ^

gf;:nftÌr rrit nt clfiÌ.rl

\lÒcl dq)rnd: t)ÌÌ llìe 1l/( iild l: tlì!'rcír'c iì

r hirlr \r\ \ Lhrl 1Ìre !!(\\ th (ìl Lhe
'ìfilrÌ

2 3 sleady state or balanced growth

nìr" c. lrhtn lÌri.rpl1xÌ \Loil
li rr 1rÌ'( i .1r.:tiìÌìì Srrn tÌÌ rrÌf 't ihc Ìilì'r'
Ls
rr' llr

!rìÍi.S.rL tht siÌ1x' ÌrÌi l.r rÌrtn

ir 'ì
l.J l {'!l tht 5ttrdr sLite liÌìrL\rÌ
th. .afjLri liÌboÌ,r rrtiÔ ni I Ì)i c({r\t!Ììl Lhi\ i: .!L 'rpjtrÌ
nnttlr.ÍihÌrquir(\
1-i -i 'rr Òl N.1c ÌÌrtì1i.. rr rÌ ( r,Ì. \Ìr,r\ Ìr lrÌ Ì ig i-l I He!'t.:Leadi
1.ì 1
,r,,,
'f-ÁIi Lrttntì\ sLrtc.rlilìÌ .!tlui r:ìti': h Ìrr's io'nrÌilrl
loÌ iÌìt iLcr'h niìl.
Lr,ìÌrÌ \ i,)IrìttL is ui. rtÌ b(r:Ìse il Ìr!r1id. an (\flLiil c\fre\ilfrÌ

. úì ster.Ì\ !tile!nr\th.ouLÌ\r1lÌx1'rfLlrLg(rrrtlhesrDÍ'ÌriL'rithtllog'n!un\
;,.ìì';;,'":'ìì';'.,,' i,,.,rri.tr tore hÊr'i\rr'xrorlhirì'!tt!irtr'eri1rúÌLht
niÌte i5 hi3lrcr' tÌri hiSlì'r i5 lÌrr i\ ing\
Ìite iÌÌrd
' thr.ìli1aÌ dLÌÌ\rL aÌio nÌ Llrt !L€rr1\
tÌ"'l."i .,r tlì, ihÌÌi i.Íe!!tr\lhi'rLrürd!ì'frÊ'latj'tr'
rlhtrc \ u\l lÌÈ
Ìlr.rt it iì !e.onl rú\ ol ctr.Ìì'ìtrizi'3 Lhe !1'a(li riitÉ gror'Lh f'ÌI! '
Ìn,"'ì,ì",,,,"'.,u"t"*tu(ti'rÌrún'ti'nllr'o\!tìrlLÌtbt)th\irr!Lìtta]rritiorrlì'Ìr\
I rt)r.r!ril.lhrÈ\ÌrÌ\\i,rÌrlrr!rìiloilrtroLÍrfiì11 r)ÒtaiÌì:

f =,r r "r'
r1.l :
474 : ::.
hroÌdertorci!ÍjteourequaLioninter sotlonlv, wenotctlÌal

KKL

rnd nìulLipìyìng ea.h side bl (/r afd siìnpÌifving gilcs

k=+

so: : i l À . SúbstitutirÌ8 thii erpressior in equatlolÌ 13.7 and Ìeauanging, tfc obtdi::
ther .l4 e trtSabtrLqrdtn t ú/ì,Ídliorr, a'h ich .lescrlbcs ho$ capitaÌper $'orN$!an.:

k sl(r) (ò + rjr (11 :

It is worlh exploring in soÌn€ dcla!ì s'hat equation 1:ì 8 telÌ\ us lìc nÌst term slìoÌ:'
the erterì! ro which investment is addìnii to the caPitaÌ ttock per l\orÌ.Ì The seco.:
rerm sholrs the ! ounl rú nìvcÍmcnl needed to offset depreciition (d_À) and to €qd:.
âdditiors to the labour f()Ìce at cxisljng Ìe!€1s of capìtal per he.d (,ìl). Note thât ii th':'
ilere no savnrgs irthccconony ír:0) therÌ* (r,tll,tlÌ:tis,.apilalperhe!ditol:
be lalìing un.ler thc preisures oI

(l ) an ircreasÌrìg population, , :' 0;

12) capitil depreciatlon, ô . 0.

Ì t Jl{r ) > { J + trl k, capital PcÌ woÌker iÌÌcreascs becau se iÌìv€stmcn ! feÌ hea.j i\ ilrri:: :

lhan the redu.tìon in caPitaìpet head du€ to an increasing Èrpulaljon and depr€cial:..
Ìf on the other han.Ì t ikl < (,t + ,)t, capitaì feì woÌker de.rcascs bccause inleÍnì..
per he.ìd is ínalìcÌtha ilÌcrcducti()nnÌcapilaìPeÌheâdd!etoaflncrcasingtoPulìr::

We prescnl thls Ìelult in a dan.larci Solos'dìagÌam (figüre 13.-l) bt pìottìng dÌe ì:

parts of tÌÌc righi hand sidc ofequatio lS.S.Since!isafractìon.lhcshapeofüÌej:'
cuÌve is gìrcn by the propcÌties olthe producLi.f n,n.tiÔn Á ând ,Ì nre..fstâni :.:
^{
second tcrm isa Ìire fioÌrì th e oÌigir witha slolr. .fJ n Ìhedifl.rcn.cbctweenthi:
curves ata.ylevel ofi dctcrmires (.
lh€ polnl rlhere the ts'o curves iúersecl js giveÌr Lr), the leleÌ of .aPitaì per ÍLr: :
(i-) whcÌc rf(t'r - (i + ,)l'. At this poirìt À : 0 ând i 0, rìrjch Ìneans thri 1-.
levelol.afìtelpeÌlvorkcrandoutputperr\'oÌkcraÌeconÍant.r\swcha\icnotecÌìLì::
this dclnes a s/r,rdr, srrús in t]Ìe 5o1ow Swan nro.lel::tt l_ both (, and L 8rct ai:_,
samc conttant Ìate r. ln liia. i3.3, tÌìe stcadl-ttaie level ol outpul pcr hcad 0') an!:
consrrmÌttìon per head (.') are íÌolvrÌ. wc can easily see that thc s(cadv'Íate Ì€\,:
output per head i!sivcn bY

Glcadv rtate ouiÌrut Per h.::

Figure 13.3 st.n.l.rd 50our.llaqram lrtho!Ì Ìe.hnooq.: pro!reÍ)

lrhile the stead-v nate leveì ol conÍnÌftìon per head is aÌrc a constant ancì is a iÌactl()n
olsteady ÍaiejrÌconÌe. Ìt is given b)

.' : ilk I t (k') - 11 slfiÀ l tÍeady stalc consuDrplion pcr hcad)

To compìete lhe dcscription ot lhc nrodcl, (hcrc is one loore end ti) tie upr s'hat í the
gnNih Ìate of ouLÌrul, i.€ .\-r - v./v? lvc aìÌcad)'linoa frnn the Domar tbnnuìa that in
thc stea.Ì) stalc, oulput grolfs al lhc samc ralc as doct capìtaÌ anLl Ìabour. We can also
dern'e ageneral exprcssion for thc gÌo 1h otoutpul, which íusetuÌ.
Lel us Àaif diltcrcnliatc thc p.odu.llon furction, v : ,r((.I). s.ith Ìespectto tlìe atrd
ohtain (using lhc chaìn rulc):

(13.9)

nheretn i1*! 4-14 !r r,Ve dilide botÌì sldcs by y ìn oÌder tl) obtain the
"rtr.:
:rolíth rat€ oloutprìtor the Ìelthand side:

(13.10)

\eìt, ir oÌcìer to e{press lhe Ìight hand sìde nr teÌms ol giowth rat€s, r'e nÌrÌt4ny and
Jn ide each componen t b) the atpr)priaie fact(tr fÌom t1Ì€ produ.tnn function:

t^I 1r
t tt
:1hich, ll'ith a constantiirowth rüieollabour, r, caÌÌ b€ writtenas:

(gurth ì ate ot outFú)

,,here o( = + and : +. Ìn the appen.li{, it is shown tlrat rÍ + or l lby ìluler\

'r
!€orem). We roirhavean expÌessidr í(Ìthegrowih oloutputâ!the weiilhted a\erageof
thcg(Nthratesotcapital,rÌÌdolìabourinput.lnacompetÌlivccconomv,the\ei!:::
thc Iactor sÌLares oi crpìtaL ând ìabour. Ììr scc thìs, we notc thal sln.e fn i\ tlÌe n::. .
prodtrct of crìpital a..Ì urxler .onrP€titiv€ conditi(tb, this is cquaÌ to ,R the reil r.:::
ratc ol crpitâl, rrìKlll' i!..pi1al\ sÌìare and sinrilaÌÌ\', ilúl'r l' i5 ìabour'\ share. l
jg i
iÌlrsLÌâtestheÍ(ad) stateequiÌlbúu atl-, along with thc grcwlh rrte5oloutptrt,.af:::
.nd Ìab(,ur. Theg{ : iI ò cútre is d oÌln(Ia.{Ì d opinil bc.a(6caswehave alreadl sci.
-ÍhisitjustarefÌe.tionÒÌi::
thc.4lK ìi a.le.rcisingflìn.tio. ofttÌe câpital lâbourÌallo
pírpc!1ies olthr productìon iLInctl{Ìì (.onnanl rctltrn! Ìo s.aìc and dìmitrislìing rcLu::
to cnch lactorl. lhc alteDatn,c Soìowcli.ìilram {as iÌr Fìts 1-1.:t)Ìsvcr-vuseiuÌforanallti.-
theijfowth oloutpul. irhereas thc standaíl dlagra!Ì (Flg Ì-l.ll) is $eíLrÌlor a altsi.SÌ.-
itrowth oloutp!t pcr caPitü.
Bctorel{nliing in Dorcdei.rilat lhe beha vìo u Io f r'1rh.:
the nìodcì out of equìlibliunÌ, i
tlÌc.apitâl Ìabourratn) is not al its rtealr \ta1c\alue, Á',lcl us Ìevie$'the ett€ni torthi.:
the nÌodrììn it\ prcsc.t n)nÌÌ.lcÌìveb wh.t Ì\'c aiÌne.l loi, i.c amo.ÌeÌotecoÌÌonricgÌolr::
nÌth( sense olthc g.o th nì pclcapita outpul To dothis. Nc concentrate on thc slei.
jn
\tâte,5i.ce this defncs the path ol th€ econonìy when it is e!ÌullìbÌiu Ìt is aÌrÌlÊ:
tlìat allhoujih ile hatc macle Írl\tanti.l proglcs ìn undcrslandinia the rol€ ol.iìlitaÌ ::'
the eco.omÌ, !!e sulÌdo not havc au erplan.ljon ofecoÌìonricgnxldr irÌt1ìe Ícad-\'!ti:::

. hÌ thc nrodeì !1r l.r, lhe steady state i\ charn.tcrizecl by â .oníant Ìevel ot orrtput f.:
Ì!orkü,1'', or iÌì olheÌ rlords, bv i 0 ln lhc 5teadv slarc, Populatiod,nd
'aÌlÌi'
lroiratthe* e rate,$hi.h cnmre\ tlÌât cipitaìPer \rorkcr rcmains cotÌ\t.ÌÌt al I' r.:
outÌtutper work.ral),'.
. The irÍujtion f{)r tlÌis rcsult íÌouìd be clear bt nowr dnni ishúìg rcLutns to .atÌi:
(relÌesrnlcd b-v the cunrtlue ol /ik)) en\ure thal extrâ uÌÌits ol capilaì ter worl:
produ.c ìcss ancl lessi at the s.rÌìc time .leprecirtion does ot dinÌinish. EvcDtuaÌh .:
savlÌÌgs aìlìbe cìeplo-vcd to lepÌacc lhc exlstnÌ8 capitaÌ lhisistlÌepoiIìlâ1h'hìchir:'
s/ (k') tunctl{)n (rús thc i,t + tìk Ìinc in ìrig 133,1|ctoÌÍ!t\r1Ìichthccconon\$
be ìn cquililÌllrnÌ $,lth ft:0.

figurel3.4 aierràt!e 5.o(leqÌãm!Ì!rh.!Ìtrlnr úoq.n p:oqr-"s)

 471

rhir rccnìs lo bc a rathcr Lrnsalii a.lorl rcsponsc lo the chaÌlense of mxlelLjrÌS the
:ì.rsìllenL grorlth oI p$ capila oúlltuL and nrc shalì see in rectidÌ il that to prodrce
,Lcad_Í-sraLc gÌoNrh i. ourpur p$ r,(Ìter rhc SoÌoir 5wan ìnodel xru\t be e\ierÌded LJt
núoducing lcchnological pro8rcss.

2 4 Transitional dynamics:what happens out of equilibrium?

\Ìthough \nÌpÌe, the Soloo Swan nnrdel í itiìÌ MpúsiÌìitly rich slÌrcn jt cotrcs to
rdjustment t() e.Ìuiìibrìunr aD.l convergence n) the Íeidt state. \\c havc dìcnlloncd
rìÌea.Ì) (and illlistÌated i. lig. 13.3) that 1l tire capitaÌ labour ratio is bcÌoÍ' Lhc slcadl
, tate vaìue, capltaÌ lnten icìÌÌ ircrease and vice versâ if thc .apl l al labou Ì ra lio is above
s i L)
L'. The economy wllì conti.ue to a.lìLút untiÌ ( : (_. Ìo focus spccìlicrlì_r on lhe 'out
nf c.ÌuìlihÌiunr' adjustrÌcrt, it is usetuÌ to present the ÌÌÌodel ln n dighllv dìllcÌert wav.
, ...r" ' r" .1. \ i (. l òr' \r' " "' .lt
ÌrorÌcr. lììnt dividc cqtúlion I 3.8 bv k to obtain:

n=f r,r+,,t (ì.:r.r ll

s ,ìlX id r) (13.121

r\:eplotthetÌ!o.omponenisollhcÌighthaD.l5ideofthiseÌprtssìoninIig. l3.5.Clearly
i r is â posiiive conÍarÌt ând hl:ncc.an br rcÌrÌcsented bv. horiTottâl ìÌnc. As ile have
noted rbo\e. lirÌc€ / iÀ1,/l (outpul pcr un it capitaì) is uÌ€ dr,ïÍr r'odr.rrl ftpÍt'l it lalL\
r\ ( increâse!. Ìn the Íea.lt Íitc cquilibriunr, wheÌÌ * t', rlrÀ',/t' : ô - ,,. Thu! the
S(xltlÌÌat€ ol (.pii.l per workcr ls gn'cn b) the veÌticaL diilcrc.ccbeh{een the cur!es.
At ld! I, the averas€ producl ol capitaì (l lÂlirr) is high and tljth a conÍant \,rliÌìss
Í.te, tlÌ1\ produces lìiglÌ gross inleltment relati\e to thc rxìsLing capitaÌ and hencc a
.rpid irÌcreise in the capital sloek, since the arÌÌouÌt of lnvcstment ÌecÌuired to lecp thc

FiquÌe 13.5 Ìràa,t.na dlfàÍr.r n úrê !ÒÒ!r 5{an ìode

478 : . ::.:
.apital sto.kconttant is llxecìby the dcpreciatlon lackÌ ô Given thc gÌowdÌ of the Ìabol:
Íorce, r, ca pitaì stock p€r woÌker ilso groi{s The ccononÌy moves fioÌì A to B iÌì lig. l 3 ' i
SimilaÌÌy, for high (, cipÌtal stock pcr woÌkei $'ill decìine
UltinÌ.ieÌy horvever, lhe trinsìtion Path ol or4rri Ìrer \{orker is oI nroÌe interesl Lha:
Ìs lhat ofútlrdl perworkeÌ. The growth rate of outputper iLorkcr is dtnned inthc un':
Iashi(Ìr âs JÌ. = i/f. IoììowiÌÌil thc sarÌe ÌrÌo.cduÌe that we lscd tor Í(trkiuil orlt tÌ'
growth râte oI outÌtrìt, Ì\'cha!e:

LBrúrlrh ritc ôl i i! rPUr P.Í ht.'.

& lpk ir 'r.{l'
whe.e wìlh comp€tÌlive marli.ts, is capìtal's slÌâr€ ol output and is positite and 1."
'n
thrnonc. In the stcad,v statc, Lhe equâtionsLÌll holdsbccauteS, : Jr 0

2.41 Policy experiment 1:â rise ìn the 5avings rate

Let us rÌow consid$ the followìng Poliiv experimcnlr at time lr, th$c ìs an exogcnou:
rise iÌr th e savings rale. ltÌ llg l36wetricclhei pac[olthìtsho.kandshowhor'land:
acìiust as lhe economv movcs lo anew steady stat€ ln the fibtpaÌì€l this
repÌeselltcd ìr '
ìs

an upwar.Ì üi1Ì in lhe r/ (k) cuÌ\,e correspon.iiriì to the increate of s to 5'. The ecorrorrr
sÌowir adjust\ trom tìre oÌd steady stâte k' to tÌÌe rìcÍr steadl state k ilheÌe capitaÌ pÉ:
lvorkcr Ìs histÌer lhân rt r.. The tra!Ìsition dlnâmjcs are better ilÌustraled 1n the sccoÌlü
p.nclrlhere $eran inlper L gr)wtÌì ratcs diÌectly lm medj ateit âfter th c exogeDous shoc '
occun at 1r, thc gtr)wth rale of capìtal peÌ ivoLkcr iomPs up lroÌÌ zcro at poiÌìi,1 to I

k)gÍtlll

Fiqure 13,6 Po ry crp-"Í ment l d. P !!Enrls .. Pì r L úe d r q5 rtp

 . ,:. 479

As tÌÌe ecoÌìoür,v slowl), convcrgetto tlÌc new caPltal pcr irorlicr ìong ruÌ Íeadv state i",
:! Ii! 1l : th e tro\Ìth rat. & Íancì heÌÌ.c ,{r too) ialls to zeÍr' lÌÌ tlìe Ìa Í il{o Ìranels we slìot! üe timc
tÌalectorics olcâpÌaÌperworkcÌand oíluA l',11 beforc ancl a ìter time h As 1\'c h ave aÌreadv
noted. iÌÌ lhis nroLlel we onlt obsewe posjtúe iiÍxltlì Ìates in thc fer \lorker varlabÌes ìf
the e.olìoÌìy ertelierÌces a paÌametcr shitt once Ìhe s)stem.ctuÌntto lts slca'Ìy state
rle are b,rck on the Ì)alanced gr)wth pa!h wìtb zero grolvtÌÌ oi output per capita, ì e Ìlith
output..apì1aÌ, ând LtborrraÌÌg(NilÌgal the sanre relc
The expÌanatl()n lòr Ì!ha! at tuÍ ÌÌray seenÌ to bc a lurprising result lics once ailairì
nr th€ assuÌìptnÌr ol dininislÌinil relúnrs to capitaì accrmuÌali()n This mcans tlÌat thc
initiât risc ìn the 8Írwth rìrtc oftlÌe cap iLaì stock docs ,úl brìng a Proportionate iÌìcrcasc
in output. lì $ aÌ{ng witlÌ th t úse in caÌr ital per worker arÌd p roductl\'itt lheÌe is a rilc in
tÌre câpitaÌ-o utput .atlo. l h is nÌeans th at the tì Í€r (.ipitâÌ st ocli iiÌoÌÌtlÌ gcnerated by lhe
higher sirvilìijs rate lacies .!\'a-v as cleprcciâtidr elenluaÌÌy s\{all{)ws up aìl the additionaì

2.4 2 Policy experiment 2: a rise in the populatìon growth rate

to Ìrake mre thc mechanics ol Lhis
odcìâÌe cìearl considern'other expffiment whcre
the potulatiod gnNlh Ìate \(tddenly and PeÌmancntì) goes uP 'lue to an erogenour
changc nr feÍilit,v.In Iìt IJ.7,thei pactofthis shockon thcsvÍeln ls lÌaced arÌdse
íÌoiv hoi! I ,rnd )'a.Ìjlút to the neÌL stca.Ì) \tate. Ìn tÌre frrsl panei this is Ìeprescntell
s.iphìcaÌÌ-v b) a counleÌ cLockwjse ÍÍ.tion ofth€ liÌÌc conespo n'lirÌil 1o Lhe ìn(reascof'

...-!11u

Ì{rrlr'/r.)

Figure 13,7 Por.y expêrmÊnt 2: di excqeÌtrs n.rease n iertltv ,t > ,

tor,'.thccc(nun)'sloirìyadìunslromtheoklstead,vÍatcl lo lhe neNíead! stntc f
-

wh€rc.apjtal per Ì!orkcr and output pcr s1nÌer is lo c,'tharÌ al li.

I hc rcaÍm is th.t thc leveL olinvcstrÌcnt (gìveÌr an unchinÂcd sali.gi and nìleÍmcnt
ír.rc) is insuliì.ienl loeqrip âttlÌccxìstìniilevelof.apjlallnrentjtv theÌârg.rnunl
bers no cntering thc laÌrour force. L af itaÌ itÌteÌìsity thcrclorc declines until thr iÌrlcst
ÌnerÌt rcquiÌed to nÌaintaiÌÌ it conÍanl it jrbt equal to thc âcLuaì invenjÌÌent levl:ì. As
beturc, the transitnÌraìcìvÌìanÌics arc bctteÌ ilhìstra tcd lr lhr sccon.Ì Panel wheregronÌh
rates irì p$ capit.ì tcrms can be iiÌspc.le.l .tiiectÌy. Wc no(c thaL !mmecìiâtely oilcr Lbe
exogcrìors nn)rli o.curs at rr the groilLh ìate of .apilal p$ tloÌkeÌ í nesative. As the
econoDv sloirh conteÌiae! t.J the ncÍ'lonia mn ncady-s(atc level of capltal pcr a.rker
l_',1hcgtrDlthrrtcÍ(ancllÌeÌìccijloo)returlÌstozcro. ltdrel(Ne.pünelswcshoü
tlìe timc lÌaiectories oí the groì!tlì raLc ol output and capitaÌ teÌ woÌker ârd oI l.A l',rl
belorc and Âfter tiÌÌÌc rr. (h.€ tlìe syslcm returns lo cqullibrìum, $e aÌe iÌÌ a nclÌ stee.l)
!t.ìtc (,11h a ìower lctcl of orúput pcr.apita
Í'hãt
But happens lo the SroNth ralc of oÌrpdr in lhis c.onomy? To see this, il is better
to usc lhc aìternatilc SoÌov diagram e5 nro\tn ii lrì9. 13 8 an.l to Ììote thal a chaì19!
i popr Lìaljon Sro s'tb rate sÌúiÌs tlÌ!' .íÌ cuÌ\ e so th a! jt gocs th nruslÌ tlÌe intc rscctitr ot
tlÌe n.N ÌropulatioÌì gu!üi LjìÌe, ,ì' and tìre unchangcd Í& cun e $rheÌÌ the popuìation
gror\rllì ratc rÍer, ou(put iiÌoÌltlÌ also ri5a as ÍÌo!\1ì ln th.Ì Ìnove tÌom PoilÌt ]1 lo pojìrt ll
Hol\,i\.ff, since oütpuLgrt\tlÌ does noL ise Ìr), is rÌìuch as PoÌruìatidr Sror!th, lhe gntlth
aÍt\npú P( hcnLl declin5 as nÌoÌüì ln lig 1.ì.1.ln gc.ffã1, n) work (nú what hiÌrPenttc)
oultmtgolthand thegrowth oithccapìtal íock, Lhc aìlc râtive Solow di.granr nn)uÌd

Ìhcse exÌrerinÌi'Ìrts leale oprn lhc .Ìuedion oI içhat Scterates the t}?e oI sústâ1nelL
:jrorrth Ìate\ $rc hare doc!nÌcntcd ln Chapter 1 Ior manl of the $()rl.l1\ e.onomics oler
rcc.ntcentrìries. Lhe modcl so farcan only.ì..ounl hÌ lhisbveltheÌ

r 1) the prcscn cÊ ol very lo ng adjrútnÌeÌìt pffiods as the ecorÌom) tra nsìts lro m one
slcad,! stâteto al1olhcÌ oÌ

t-' ('
Figure 13.8 P. (!ÊrpÈrnìerr7 ii,Êr.!.nr!r nrreà:e níert:Urr :,-mf.à1on;l..!t!!t
2ì thcfrerri.cotrefLiL.d\ho!Lj cg.i!lcr!li]!ÌisLngràtinS\5hiÌe!riittr'Lilt
liiÌitrE ÌìrÌr!lrtiol ..r 1t\ ih rrtl

\\ ]t tÌLìL src. nrorl .o!1\i\ilrìL rìth the n\ i7(1 'tr i\ .ì m'!li1ì'eti'rÌ !I lhe
modiIìhrtiìLloÍ!nerlvslrlt3r!lrlhiÌ.LrLfutl)cr'ì|it!briÌìtrodtrrnÌ!L"hnolL)gi'rL

3 Solow growth accounting: measuring the impact oÍ

technology
lntlr..eÌt\rr1ioÌìth..Lit.(ìr 5oÌos 5ndÌüodcli\erL'ndrdÌr\ìÌr'ltdnÌ!1c'hrÌoLo_s
ic!l pn)!re\s .1fÌi.1Ìll l'rÌtr1Ìel rrtb e\1..cìirÌ.{ hL\ !!)dL'l ol !nrtth f in(Ludc le(lÌrrÒ
torr_aÌ Ì1ÌoSLrss. Sot,rt ren!ìotlìrr) !]er.l(Ìrtd e Le'ÌnÌiqut loÍ mtrlrin! ilrr
rÌnÌrirjrâÌ
.LrÌÌìt.;faÌt oi l..hnoLogl.xÌ]]ÍrSr.$ Ljì.LúerÌr:\lrirr('Ò!ÌrÌ1rrÌtÌrtcontrit'uLloit'ith!
!nn\1h;to!tp'rtmr!l(b\ thesr.Íitb()iÍi.ti)rjnfut\r('ìpitrluìdÌabour
dÌd1'biì'ntc
en. grorttL ulìaccor ti',1n,r \ ith LeclnroÌoti.illr{)!rrs!'Solol\ÌelÊrrcdtLrlhi!Ìt\idLLâÌ
r\ilirl r.nrr P rr.ìu! 1j!il\ gr)rlh Tot,rlia(to'tr)chìitl\it\'!(r\th'iftlÌÍ'itheiÌììfict
ot iÌrtiÌngibl. iiterú o huÌnrn prìtÍ\! thrt elÌoü Lìoth Ìab'!Ì rÌld calli'l
lo irÌ'($t
thelr!rft u.tilit\ llÌinkLnF!tthcter.LÌ19()irto2í)01),ÍÌrLthar e{ÌÊtlÌc e"nom\ llS

morepírú!(tn.rr\n.rsLmlìL\11ìcltì.lLhatirrÌ\lìr\cln\esLúìandbo!Shlc(Ì!pItdr'
huÌ rri rcr t!Ì.ìt Llrt iÌÌlornìltn!Ì rcn)húj.. hr! alÌo1\!d 'cr rÌÌi'húìr5br\td
rr' (oÌììluter
L.!ÌÌn,rlôg\tobcm.rIitÍìLI(ti\cJúÌ!.rL'Èrsnho!sc(ÌnPrter\Ì()l)emoÌceiÈricnt
5oÌc,Lt s nr$h,rd ol t;LlculìtìÌrg lotrl iictol t!({hì'ti\ ll\ grostir
ir Ì'D'nÌ' r5 L_v'ldr l
..irrÌri/r To \r!'lì!r tlìis n orls Í e (in sl'ìú iro ì a lr)!L!|.Llfn lLrn'Ljon dcJlntd
'r.,t!,1ri,i{.
Inle r:olcrplLrl.LatroLLr'.anclinln!i.\oltìtr'L\tLl)!1'rhÌÌoÌoEfiÌlttu1i$\3i\c'l\'l
rrbiih is a tuü.Llfn (ìi 1i.ìe:

r-lrÀ 1r t L
ll L-l r

nlìcÌef.ìs!;'.I!i\'" ! . .f.1I, 'I

rs rstcL r lrol t úÌ dc, tr inB t rc c\t('ssL(!Ì io tÌÌr !,oütÌÌ irle ol.uipul, \'t obLrrÌl

/ il( ltl 1.1, tÌLl +Ì

,li r JL t.\j l.\t

The..lrôrrthoi.trtÌrri sr.ÌLÌrltoitLÌÌr.LlorÌ. LhcAroÌrLh t'!'li'fjt'LÌ liÌh'xr'indthÉ

il Ír
L".rr,,nlurr t,t.L," lusl Ì!e lìil1 ierr lrtt!r!' it 1\ po5iiblr Lo \iÌrrflLt\ tlri\ tLìrthcr
", br'lt€tl
mrlr trrtÌÌtI n\slu!Ìrlio.! rLrout thenre Ltt c'1n{!nÌ"i LhÌ\\LllÌenrblcit
to S.t in e\timare ol th. .ontlib,lhoÌr .I te.hn'Ìosi'il trogre! irnm lilii
1\ e
'ìsstrnrt
Lhat nhorr and.:titi I rÌe tÌrdcd Ìn ..Dfe1l1i\ e ìnàrkct5 anLl:r' leid ilìrjÌ Ìe\pc'ti\ e
mrLginal prodrcts. LIlsrneaÌrsLhrttlìL:ÌrrI[in'ÌÌ]rr'du(t"Ìalroür'lir ÌL'uhocÌ'
i\ tÌìc ÌcaÌ riir., rÌrd thil tììe Ì]]iÌrgtLrl tiocLu.L ot 'tLìiLrl Ir = À rrhtÌt '1ì
Ls tlrt r'nlrL

..5tnIceÌ)i1.rìL.tÌrer.nnonrr'\(1(ìitlonrlL\']!c'ìelìnrLheS'rldrr'\inr//b!Jli -i
482 ,:4"

WecâIr nolt rewritc thecxpr.sion abovc as:

.,'-f,"-f', '-',
(13.1sì

on
Since r( = í,RKllv coÌrcspon.ìs to the shrÌe oí total incomc \pent by the economyn_'
,,-\m.nl\ w. r'r ', ll 'i \"''l r''\' '1"rlnr'r.'r\n
"' '"lr"iorr'
;';:.,,'","' . ,h{,h 'iJ' o r' \ur'

.tÀ={r d(J( dÌ,gr' (total factor producuvit,v (l lìI') grotlth: th c Soloa r€sÌ dual )

grostlÌ an'ì wcli'htcd sunì ()l in'

The Sol(M'rcsidual is lhe d!ífercnce bcMeen ouqNt
a

tor input gtrrths r'ilh wcighis given b) the

r,.n)r shaÌes l e it is the Arcwth thai i5
capital ìnpuls ll we acccpt thc maÂet
not arirlrÌrtea to tle groivth ol cith€r labout or
*" n"*ì,*d to dcrive the lornNla abovc se now havc a expr€snon thâÌ
",,ì-0,".t
car hc usetl to eslmate tlÌc Solow Ìesìduâ1(j e ÌlrP growth) íonÌ '!ual
a macrocconoÌntc
js constant Ìet!rns to s'aìe' tÌrÊ ntrn ot tlÌc ìabour
data. When the pmdüction frnclnrn
trs eq uatnnÌ 1o
capit.ìlshares ú one:ìn.Ìw€ can sinrplif,v the lÌevio
an.l

TIÌr gÍo(ìh .SR - Af '{in 11 ú(l3r

ln enÌpjÌìcal anâlr-sis, it is often ìllunìiiating to tlork in Per

cafìtr tcrnÌs and $'c cân
reaNangc this ecÌuall()n as folìo$s:

I |t growth = (u/ ,írì '(J( +

'nsi
- i) odÍr'
\Nc caÌì al$ tun thc eqüaiÌon arourcì and de'onPose
thc
lvh€rc ), - rlr = ,(/L
ancl i
nrknsìt) andtlÌr
gr"r"Ul"f p,.A".tt"U" OttotÌìe contributiolì fÌom the iyowth olcalital
conlÌib!tion oí TFf g(Nth:

.!) 'ni{ +Tll'gÍÌvlh

GÌowl h accountìrìg erc rciscs ìnâ]' also scck to separn
lelÌ idc n tily th c cont rÌbution to th Ê
rvorkcr rìom ìnÌÌoÍenÌcnts if lâbour qualit-v' c g as measuÌed
ìr\
gu{th of output úr
i..**a .f €du.aiìon ' Thjs will Ìead lo a hìrther conìponenr nr thc al)olc
"""*g" "* "

$ -o(&+(1 o()q+ l'ììl gro('th'

(per woÌker) This is ileighted
$heie 4 is thc gror'th rate of the luality oI ìaborÌ iÌÌpuls
by labouf\ shaÌe in outtrtt' 1 'í
Burca!
Ìn lable 1-l.l ivc PÌescnt an anal)'sìs ol growth accounlnrg as ÌcPortcd by the
jntercstingto note that âccoÌdnìg to growth
ol l-abor Statistics il] thc UrÌitcd Statcs Ìt is
th e \o called Ne$' fcononìy phase ol LIS Srow!h
itÌ thc late 1990\ is asÍr'iated
a.coun inL
t,
 483

Ìãbtê 13.1 t..,,'j.r1rà.ii.i!irrf-i Ú-ãLl_ Ê.r ir;iÊj,

hiithcr .oÌìtribrli(Ìr iron t.r.1.r ìIÌÈrt 8rürth esPÈciaìÌ) crpiLeÌ rìni ianrr
TFI
rritlÌ n
,.ru\th TFlgrôlrtlÌÍì thtl,lc Ì99os is. ho!úr'er 'ote5instasintÌìe 195(\.ì.1Ì1!)60s hr

i t,.pt.', r;. ì"c t"pun un lrtrÌ gnrttlì i.(oLLntnÌ: ha\ Ìre€| u\ed lo tI! to!rì"\ erlJìc ro]l
,:,ILriìc,,matioranilcorrmLìni.alr(Ììslech!ìolog)1l'Tr prod!cin3'ìndÌ(lÌ úsjugscctds
in the ll\ econom! iÌl the Lrtc lr)9ll\'
Or er the :'rnÌt econoÌnìsts he\ t .oÌìe !P itith nìrnr obje(tion!
to SoLods dtí'mft to
usc a :lÌìtÌe ...rÌuni.g idenlilÌ to meas!r' tethnoÌoliül l)rogÌtts ''
lf' Ìook 11 one ol
:htse. rht prrscnre ol l;rperl..l ronìfetition, nì the apPÈndi1'
\iu'b Ìe:car!lÌ is beirì_q
b) inchrdi'g lìnrr
.ond!.1tcì to l!ncl brllci s,ìts !t rcâ{rring terhn'ÌogicrÌ Ìì()Srr5s
i1].cep15 olÌhc irct()Is or ÌÌod(,ctlorì ÌtrrnranÌ\Li'(ìispÌrtccìhowetrr'tiÌ'rLleclÌnÔl{)!i'11
p,ugr"s .tt in,purtanL,lrit iJìg nrcc behin'l oulfut irniltlÌ iÌnd \ú' ÌìoÍ'
iÌ1corÌrÌdt !t
't ol e\oÃcnous !'..nonìi.
r, Lo th. m.rl.l Br.tr\th

4 Technological progress in the Solow-Swan model

'r\t ìrr nor, in r toiiÌb. n) iÌìrulü't tr''hÌrlogl'rL tÍigrc5t '\tli'Ìl1\ lnln tÌÌ.
ìiidÌ Snin model In tlìc gr.Í1h ÌÌÌldeÌ r'llhort tc'ìnÌolL)Sj'rÌPI'g!e\s tNtpLrl aÌrd
{ì8
.nrtlolÌnenl gr \ al tÌÌe snmt rntÈ ìÌr tht sl'ìcìl 5lilci hoÌlctcr' rnrtìri'al
lLrte
ià:Ler 1lìin l"Ìrour !r'i!Ìh
*.ir ti ^t tl," ,t".4, statÈ i5 cÌlrl.teri/"Ì Ì)l utrtPnt gutlh(-o'ri\tcnL itlth tìre notioÌÌ
!r Ì[,rL ouil)(t fer ÌLôrÌ.eÌ grÔi!\ 11 ] relittr tl! iric'
'rntriint
ri it.a{Ì\ \ì.1c aror'tlì. (.pilaÌ rrìd ontttrÌ gínÌ at lht snÌne ProÌrollionrl rxte 5{r tÌìr
.rÌr!t.Ì ;uÌpül rrtLo tÉnÌ.rln\ bÍ)idÌ) connrÌr irr 1t't it tLtÌÌs ouÌ tber in
gcner'ìL
'nL!
mo!ìiÊ.iÌtjorÌ oI th. pr.{Ìtrction tìrn'tn!ì L1eÌi\cÁ lìì! rtÍr11 t)i Ícrdr
slete Sr'rtth
.rÌre
rLth totitn. Ììtr.iÌ|iÌr !r.1rÌ!r: thÌ\ i5 crÌlrd Lht Hrtrod nt!ÍeÌ iorÌn o1 LcchnoÌoti
r.rr pFgrs. rrre Firrú ncut l sÌre(ilL'rtiüì iÌÌÌplj(! thiÌl ìlÌr
ctle'L ot tr'hnologictìl

;.-r,"rt-,."tprtsch.ìÌlnclÌed!.n)pr'LÌ!(tÔnthlolLgÌrliÌbouÍTe(h'ologi'rLPFg!e\s
i.,r."r,tt".tlr1ltt..'"'ut*thclrrdrtctìr'lL\oìr\idnr8lib(ìrrrona!L\Èrr'eÌritaìsto'kThe
!.Ìo1r SÍi,n mod.l ii oit.. lriti.i7cü ior r\5ÌLnrtrril lhrt I]ci! Ìr'hnologl aÍlie\
i' rÌìi
.conÒÌn) likeni.nÌrr lìonr hertrn |d)aÌ)L-tabeitcrl!a\lothi'kdLr'útuÌr'nrolrli5t()
LotlÌc Ìrte
*e thr t;sl i\ orÌr ol uÌì(]Ü5lxnli.g Ìro1! tht PiLh oiiÌggrtiratt oLútrt idju\ts
l,Ì.rrr d, ixr:rr.i :(urÌ fìrLrriti.r, Iti.$rrdrL nI Dj' trtL'! rl1:1ri-l
484

of popuìalio. growtlÌ ind the Ìate of technologicâl proilress, IrhaLcver the) happeD tr)
be and Io r h oÍ'clcr kng thcl. pe6ist'.7 The Solow Swannrcdel pÌovidcsnei reÌ arheoN
oíwhât ilclcrüìlncs popUÌitlon grÌrth DoÌ onc rhaL dctermires thc rari. ottecirnok)glcâl

ft hell)s lo cìarily (rÌat is special about Ìlâüod-ncutr.1technoloAical prolre\s l)r con

trastjng il nilh h{o .ÌterÌìalives. TheÌe arc djflcÌcnl wa}s of Dodirytng the pro.lucinrn
tunctior io as to laNc ÌlÌto a..ouÌrt the technoÌosÍvarÌible (which wc catl.A,) nì âdctitìon
to catiLaì and labour:

(1) 'ÌÌìcÌsneuúaÌ'ori?.traugnìcntingtechnok)gicalprcgress:y:;.lr(Kl.lwbi.re
the technol()gy varìahle at ccts the productn ity olcapital and labouÌ;
(2) 'Solow ne utrâ l' or .dpilal augmentin g rcch n ologlcal pÌoiiÌess: y fitr(.rl;
(3) 'l la.ro.l n eutÌal' oÌ /.ìrdxr augm€nting tech olotìcaì p roÂrcss: y = I l,(. .1. a ).

lÌÌ eiclÌ groilt at a consta.l cxogenously Sjven gkú1h rate Jì ancl can be
case, 7ìr
thou g1ìt of ÍÌnething lile $(ìl d tcch noÌoglcaÌ krÌow ho$'an d h cncc is ÌÌot cteteÌmined
as
by a n) orÌe economy. A ièatrìre of th c l.obb LrougÌas prlrducrìon l(n.tìonisthatthe tìrree
dilÏ€ient types of tech noloiiicaì p mg.css a ru identical â s nn)*n i n he a ppendix.
I

l1ìe lact tlüt lÌaì(xl neutraì tcchni.al progress €nhrncer thc producti!itl ol labour
means tlìat the F ndamentaì Soloa'lÍtuation is easily modifÌcd ro ìnclu.le jr. FlrÍ Ne
introduce the concept ot hbour measurcd jn cfficicrÌcy LìDits: ir Lhc pr,rductlon irnction
v rfK.,1l), the term Ál is ldLraut nedsurc.l üÌ eífcÌ.,(y,riri. To mcirsure labouÌ in eín
.lcÌì.) units Ìüeans that tlÌe amount of Ìabourl is magnilìe.l by thc rc.hnologv iacnÌ, r.
Aìlhough it turns out tu Ì)e veN conicnicnl to Ìrork with labour tn e ìci€nc_v unìrs, iL is
csscntial to renÌeÌÌÌber thüt it is olúptrl or consumption per unjl of nât!Ìal labouÌ thaL
mallcrs fü economic welfare. lt js rhclcÍorc ncci.ssary t() be ablc ro go bacÌ( t() nanúal
ìabolrr !nitsistlìe i\nìert hând dcmands lvpno$'delìne

-f
)'=n. (trúpul ltff clhciencv unit otÌnbout

(.apital pcÌ ctJìciency unìt of ìabout

whcre hats ÌeieÌ n) vâÌiâbÌes mcasured nì eftìcìencv ur ils ol lâbour.

lve repeat the sanre ttepJ as bclore but lvÌh the addcd conÌpììcaLion otte(hnologicaÌ
ltÌogrrss thital$seNerto Ìeinlorcethemechanlcs oI rhe b!!jcgÌorÌÌhnìode1. UJedividc
thc produ.tioÌÌ fLucti{m l)yÁ1, toobtaiÌÌ

yl
Ì =i ;]FIK AL):|(À t) =l(().
lustasbctorcthe r€source conrtraìnr (i.!. the requìÌemc n t that srvlngs is €qual to inrcsL-
b' rl
ÌÌrent) js givcn # d(.1{c crn no!! erprest it in €flìcjency units LJy .tìvi.ling
 445

jt=
1t

l.r.m tlÌr dclìnitiou ol i, Itr .aÌr rÌpre\\ riÌlitrL .; I( i Ìl an{l urin-g the pnJleÍj's ot
growthrrlcsLÌiscrs5(din\r.lL(ÌrIneh.!c.(r 'lr+ji1 Íj |arrLlll Lo th"LíunDLltü
t|iìl the !Írtth !l PotuÌ.rtj.!r i\ con\trÌìt iÌL Ìxte 'r, iÌ is is\!rÌr('1 thrl Lhc rntc 'I tich no
r6e I
Logl.âÌÌ)rogrcÍ i\.onstdÌl rt r!t. ! rlÌc'' r'nÌglreÍs c\og"(u\' \\ie dÌc'tn)r'
to'reteL tr rhe eri,ltn,rLr IlLt ()l UrrÍ n'ulr:1, i e lnh'ur iúgÌnefLins
lr':hnologi'rL

Hc!rre, usjns tlÌc sene t!'.hnillrtc5 nir r'ceÌra!ÌginS th' eltuiÌtn!Ì i5 belor( Ìve lÌ'ì!c tlÌr
lLLn.ìaunìlrl S.l.tri l_qurtl.n sith Ìe(lÌnolt)gì.il ÌrroiiÌc!\
-:.'
I illL l. .\+n or

r iÌ Frr

\\c n.ti irt thrt LÌÌÌÌàr'! íirnrtrlr lor lhe slcad! slate
'atìtirl

,Ir ì+r rrl iDonìrr i lo, nNlìr

ì
\\'c(.rìÌrfren'ntthtl{1Ìr(l.rnìent.ìÌSoÌorLqtrationillrsoiü!dirgrrNl'jg1J'ì$lÌlrh
Ls rerl srrllt Lo ttr'one ÌÌlrlÌ!uL re.hÌìol'tì'iÌl t!rgÌt\\
\et jnleltrìr'nt iÌì th\\l'rl
.rtitrllike\pr...it 0lrhcnllìc.trnrn'flesc'tiÌìg(/ trisrLr'\cl ò rÌ-ìrr'\lÌl'h
..',,*p."ut ìo u,"."t" Ìk'rr tÌìt nmounÌ ol5r\ lng\ ortt| ri!h! tbc enìoLtnt ol
'xÌr[rÌ]
"
. requ r,{ìnr Ì!'fla(e th..àpitrlLrrsl.ìLìe ro (letrccirti(}' i
iÀ

rcquned Lo gaiÌìidl! e fÌo\ Lhc rtl(liti{!Lìl lâÌrou! n)r" duc toprtÌati'n

to gnn!Lh
'
. rudcÌìroit.bÌÈÌr\ilìciÌcrú\e.11(trlu.1nrt)'itLìct\i\ti'gLrn)url1r(trsiì!'nrll
ot te.hn(noglül Ì)hirÌt$ LrÀ r.
(;irrn the tc.hnj(rl iÌ*x ÌÌr ltnìr 5 xÌun thc driÌte oi the poduclitD tLì'ctirtrì slt'iÌicd
iìl the bcgnnì ng ot tlììs clÌnllÈÌ 1!. ÌJÌo\i lÌll oÌltl onefoi'ttJisLii'':rr'Êtl!rndin!to
i() olLÌ
the .ititai Let.l I r. \LL.h tiìal tLì. lrLo .Ìirle\ iJrteúc'l Llìil poi'L 'olrlstr!Ìds
notluÌ !i equilihrilinÌ irheLL i - | rnct our econoÌÌrl bì\ rca(lÌrd ú\ long n
derd-r

4.1 Steady state/baìanced growth path properties

LcL trslocüs(Ììtlr( \Lerd1 rtiirrrLrrrs'lthe!ìri!ble\oiLhi\slstenr'fLltlÌrlrblhnctl
!r.rtlÌp,ìtbrandi.tt()Nhati\ttÌrtthci corr'51)orr'1t(ì1hÈn\ i7ecl1iìrl\ \rrnrÌnaÌirc'1iÌ
aa6 :.: .: 'l

Figüre 11.9 SrãndàÌrl s.owdàq.rm in 1Ììe m'deluth 1È'hno'9'à

pr'gÉí

ecoÌÌomvis gilen b\
the iÌìtro.Ìuction. FirsL we note tlÌat tì1e long lì steâdt-slate oflhe
the paÍ (i' i l. snìcc ttÌesc Ìeprescnt eqÌtiìlbduÌn valucs, s'e know thai ç' Íl - 0'
tluti'er".exp'"*5,. -.n. Ì Hcncegr' = a in equilibrluni andb-v the same argunÌent
groir at thÈ
& : r. Ihls in the slead-v stat€, outÌnú per srotkeÌ and capital per ivorker
sanie rate, givcn by lhe exogenous rate oí lechnologi'aÌ p(rtress:

Ì .C,. =.{r

ll $e take the Cobb-DoÌrglas prodrrctioÌr luÌ'tìon with lcchnoloSìcaL progìess such

tbari-i",itispossibletosohelortheÍca'l)stalcvaÌuesofl"andi_€rplicitlv lÌre
lrl { o l l t r'lrF' rr'r3 lr'
I 'rnÌì. 'r ', of Ìâbour (âltcÌ
aÌid obtâtrì t;e stcady íate vaÌuc olcapÌtal and outpul Ìltr etficicnc,v unir
nrbstituurìg for th e optìnÌd1vaÌúe of caPital iI] the production lunction):

À'=l/\\ (1.J. r 6)

.. / { \ (1:1.17)
\\ !+,'/
Iurthrrmore, wc can utethis lastexprcssüì 1o írlve íor the stcâdy statevaìue oí outÌnn

-\ rt ,.'cr
' ')
This lcìì\ us lhat .1 tìme r atteÌ thc ccorÌomy has rcached its long Ìun steady llate
grtrlth Paüì, outÌÌú PcÌ h€ad ìsl

(I Ii crcasing in lhe lcveÌ ol tcch nological devcìoÌnnenl I, ât tirnc t;

(21 incr€asingüÌthesaviÌrgsrateol the€cononìy,r;
 :. . .. atl

ri) .Ìecreasìng nì thc Ìate of popul.tion gro!\'lh',;

(.1) dccrea\ing in the deprcciatìon Ìat€ì d_

ConsiÍerll tlith out intuition, this shoils 1lÌal econonÌi€s lhat savc more'| have loweÌ
ì..íiÌ1tv, and are advance.ì tcchnologìcau wiÌl be 'iclÌer' llut notc lhat Ì!hìlst highcì
savjnss and slandards' onlJ fnÍer
loÌlei popuìation g(tlth nreaÌÌ a higher lcvel ol Ììllnil
technr)Ìogical ptugress (lÌìiaher Ì) can rai\e the srttlh ofÌ!ving Íandards
lor
'3t!
factor shares to reÌÌÌain fairÌv corÌ
One ol thc sl-vÌized fa.Ls of grolvtÌì is lhe teÌÌdcnc!
stant overttÌìe. W€.annotte( lb1\ agaìnlithe pÌe'licti'ms ol the Solow SwanmodelìIse
xsc lhe Cobb Douglas Ìr()clucLÌon lunctioÌÌ bccause the sharcs âre connânlby â\sunÌr
tion nr that.ase. lhc shaÌe oí capitaÌ ìs gi!en b,v ttÌe larâmcteÌ '! and tÌìat ol labour' bv
I n H,Í\'cveì. wecan sho*'lhate\'cn fì)r in aÌbitralv prcduction Írllction thatsalitlies
ptuiirest aL\o
orr jn ltia1 ass unÌÌÍion s, the model Í!lth Ìabour aui{nrentilÌg teclÌnok)gical
growth accoutli
inÌpliÊs conslant slìarcs. This olfer\ another pcnpectile on the Ìogjc ol
trÌil. To \ee that this is so, rle use t1ìe horÌìogeneity piopeÍy olthc PÍxlLrclion
f(riction
5ee the appendix)to r$rtite it asl

,r / rI\
1:r,^,r/r Âf 11.'l-ì Á/l-l (Ì3.19)

maÌgiülpm.]uct oflabour ( iin'cn by thc derivatìve ot the pro'hìction funclìr)n

Y
Lhe
lith resPect to Ìaboürl, nnd at llre steady ltate, Ìr i\
(1:ì.20)

,rhere , is the rcaÌ i{agc, asÍImÌnii a coìnpetilive liÌbour market' The shaÌe of ìabour is
the total nìcoìne paid out as lv'gcs to the workforce cxpÌesscd
.khrled as
'! - +, thât is
.,,^p.opn,ti,"oicu.t{eìitÌoNthalatthesleadvsratei:r.i(Árrand$ededvethe

Ì r f'' \ ,,' -rL.

",: \. I,
.\e hâ!e now sho$jÌ lhat the share olìabour n coÌr5tant ltn'j€r !he assunÌnìon of labour
nting tcchnological progÌels lhis implie\ thãtrealwaqcs {ìoÌ\'attì1e sameralc
as
lgm c

rboür pÌoducLivity, i.c atthc ratex.

lu rirnita, t"e can \lÌoi! t1Ìat trn'ìer the sâme âsslLmplions thc retr'rn kr
" i\ also co talìl Ìf $Ic tìrìrk of the rcturn to crpìlal âs the ratio of pronB (Ìll tt)
^.Sumcnt
:rpìlal
tretireerÌ thc nÌarc of
::r.: \lock oi capital, hc can lulther {ÌecoÌÌrpose tlìis a\ ihc prodltct
.!oiì!s {ÌÍolì1ítotal nìcome) !imes the oxtpuL capilal iatÌo

t] lr }"
K- l.K
' hale alreadv reen that both ofthcsc are colìstant ât tlÌe steadj' state' hcÌÌce thc return
'e
: .apitalisaìsoco Ían!.
448 .

4.2 Poìicy expeÍiment 3r a rise in the rate oÍ technological progress

Let us noh' .onsl.ler tlÌc loìl(Ning pollcy expcriment: tt tiÌne rr .Ìì exogcrìor'5ì! dek:
nÌnìed incrcisc ìn tÌÌe ratc oftechnoÌoglcal progÌest occu6. AhistoiicalcxanrPle mii{hi:.
the transitlon to a nÌore humanÀiic aud se.uÌat írcìet! thrt occu.red ÌÌl wcsLt r Fur!'l
.1uri g thc Rcnaì$auce and s'hich ninÌuiatcd cÌeative !,eniuses to invcsl lhcjr eftr ::
expLoring lhc .âtuÌal $Iond lÌee ol theolog!.al connranú5 aÌÌd prejudlrc AlteÌnati\ i.
this (ould bc the re\rlt ol a nLtaiÌÌed iiosrtrment prosrtnnne nr subsìd]7. Ìesearclì :
J l , ì.'e.' r.' 1.
In lig. 13 l0 ne trrcc the iìnpact ol this slìo.k on the s]Í€Íì and show how I and
adiust to thc .eir neâd-v state; we also scc hor! the Srolrth of orrtpúl rcsÈ)ndi ln i.:
nÉt pan€l thìs js Ìepresenlcd sìaphicallt'' bl iì steeteniÌÌt iÌì thr linc .oreÌnÌ iÌìg :
ld+r r,)k a!1ìncreâscs Lo Ì'. The economtllowÌr. acljusts irolÌr tJìc oìdstea.l)' stat. j
to the ÌÌeM'slcad-v Íate 1", where capitil p$nuker irì etìcienq uniLs is /.rrrr than il :
The trinsitlon dynrnÌi.s arc al$ iLÌu\tratcd in the secoÌÌd pancl NlìcÌe we can irìsf..:
gì oivtÌÌ ratcs d i Ì ectÌ) . lmnì cdlateÌ-v after thc cÌogerou s íÌocl o.. rLrs a t ir, rìre iiÌoÌltl â:.
of catit.l in cllcìency unils of Ìabour iunÌps down as :L reÍrlt oI lbc hìgheÌ sroìrth r::.
ol techrÌolog!cal prrgress. At nNt \iglrt, thc adiustÌnetÌt dynanÌics and tcw eq iLibriL-_:
afpear (ourÌlcr intlìitlve: tisteÌ technoLogÌcnÌ Ìr()iiÌe$ Ìeduc€s i'. lo undeAtand ülir
going orÌ, l\c m ust coÌ\idcÌ the econoÌÌÌics ot the transitiolÌ to tlìc . c steadyrtrteardii.
bow a Ìowcr/' an.l ârc nc'eÌtheÌe\s associalc.l ÌvitlÌ a lÌigher Ìev.ì oioutputlo n o'".
at elert poi.t ÍÌ!n r0 ^' o.wads an.liritlÌ highftgrcwth oll and I ln thc ne$'steadl n :
The rcason f(Ì the dc.lìne úr the irrÌìounl ol caPitâl tcì labour mcasuÌed ir elici...
LÌìits(i.c.&-0)i\thatgì\enthesavingsralc,thereisiÌìitiall,vlrsuill.jentin\eÍIrì.r:

: \ftíi

Figure 13.10 Po.v.rp. rìÈ l in!{oqero!5r...-"Íd1!. ilheràtÈ.ítÈ.in..!na pro!r.s!

lre55 ro take âdyantage of the frster ìate olteclÌnoLogi.al progrc$. A.Ìju\rment conthÌues until
rhe capltaÌ outfutratio hâs.lecLjtÌed nìtì.ientlt such Lhat theijuvth rate olthe capital
stock is incÌease.t to the noiv tìster ilrcwtlì of the labotrÌ nnce measured in texÌls of
ttÍcienc) unìts. Thì5 is sho$n irÌ uÌe second parìel in lrig. I3.l0 asii rises bacli to rero.
Ìn the Ì(Nerpaneì\ we sh(x!tireti e tra jectori€s ot th c g(ttth rate oi outPut per Ì! orker
andotÌ.s Ì",11 beiare and aneÌtnrìe lo. Wekìow t]ìat i. theÍea.tf state the itrolltlì rate
oi output per woÌker e!Ìuaìs that of te.lÌÌÌologi(rl progrc$, irhich i\ noÌ! hi8lÌer. Ìhr
Ìo$'er left panel rhows hoa the gro$tlÌ rate !l outplLl ÌrcÌ irorkeÌ jump\ !p irÌitiâllv add
rÌren sÌowlvadjust5 upwaìrÌs to re1Ìe.t thÈ n€r'(irrìd highet ìate otteclÌnological progrcss.
ln the l(Ner Ììght ta.el, the rate ol technological progÌe* gìles tlÌe slop€ ol tlÌc log ol
ouqNt |eÌ woìÌeÌ Thus outFÌt per $orker.LdjuÍs so as to lncÌease at rÌÌ iÌìcrcascd ralc,
rìri.h Ìeflects the higheÌ Ìate oltechnologi.al p.ogrcls. Once the \)Íern âttains a ícady
starr rhe economy is o. r ner! bahÌìced groh'th path, irhjch is steePer.
.lust as ìn lhe case ot the rno.lel ilithoui te.hni.al 1)rogre5i,
jt 15 !sefrrl to usi'thc âllct
Ììalìvc Sol(N diagram wh.n the locu\ is on the implicationj fì)r gro!!th prr sc ofa change
irì lhc raLc oí lcchroìogicaì trogre\s. lhe only nìodiflcatìon\ required to th€ dlailram aÌe
thaL .epìtaÌ is nreasured per eíficienc) unit on tlìc lÌoriTontal aris and th. gror!Lh oI the
i- i.:iur::
Ìabolrr lorcc is mersúÌrd jn eiÍciency units, ü hìch ,neans that tÌìe horizoflal li.c shorls
r ! ,.]uí as bct(rc, outÌrtrt gÍ\rttr is a lleighted avtrage ol capital grohlh and of the
libour lor.c (buL n o$' m.rsuÌecì irr ellìcieÌÌ.t utÌlts) |

ir = '!ír ir d(l(s1+.{r)= '(.!n + ir '&llÌ+'t

\\e can see iionì lìjg. 1J.Ìl tÌrât when the rrte LÍ tcchnicaÌ prcSress go.s up, oulput
gÍxltlÌ irÌ tlÌe econonÌv jumps uf (Ìn)irt..1t{) pohÌt lJli l1 cottìmre\ to risc unlll it reaches
the new higher groÌlth rate in thc ntw \tead) ttate. lÌì th.r ne{ stea.lt state nl point Z, ire
can seethat.if f,' r ,1 so tlÌc grorlth Ìate ()l output pff heacL is 3,

Figurel3,ll P..!êrFerìr?rÌI rr.ro!.f.ús.(.e.ràl.ii.th€rate.ít(rfoóir.;

rirôqreÍ nÌr .aions f.r outÌrut qo,rih
490 '
4.3 Technological progress and
growth accounting

- \ '|J'| 'n: " ":ìì,11. ,', 1l :;

'' "F tr.nr dJt
ó\
l the úruLl rn qrl sn
n I
",
''
c\Ìrdd1L 'rn
r1
'taìÌed total fnctor pro'ìuctlvitl iirottlr and i\ oÌten referd i'
ìii^.t., tÌì""". rno ,' s As the srostr
:ll ii:::",ïffi.;;' ;i.,'.,o'*nu p's'"'s ." gÌo(th 'e have scen'

accouÌÌlúg ÌelatlonslÌjp car bc ilrjtten a! ftnlows:

.n -t(gr+ lIÌ)growth'

attribute'ì to c'pÌtal deeLÌnLni' and 'teclìtu!

;:. . ", ' ' "" " ,
wlìcÌe tìre sÌ(nltlÌ ìn output per cÂtìta is

lôs \uJn rú'LlcÌ

'
(ìrìLe the 'i.,.,1',i
\ ,; ,., ':."i""d
;' ;":',
ïiìì.J : :' ; ,;
;,"'. ' ^" 'r' '. " "'d
(Soloa Si{âÌl models'ith tech' progrcss

$hereri'thelnleofexogcì1oüs'HaÍo.ìtleutlaLtcchnjcaÌplogÌess'SubstitutlÌìgthisin
gìves
lhe gro!ttlÌaccou litrgequâtìon'

lIl groi'th = ll d(lÌ

(gÍrwth tìccoü.tirìS)
j, = olJr + (l í! )1

ological lÍôiaè\s accounls for onìÌ a

proponion
wbìch sugÂests tÌìat exoilcnoüs tecì
o rj r'\''r''r'\'l'
.':.'l :;"' .n lir ' \P'r"'l'n' "'-"'
!rÔ.J' l
'r ''3 rrr' r' 'ì '
'o" |sl r"'url' '"rr'brÌ
l.;"; l, ì ," :: 'r' o ,, d " '" u\'r'
ìn oulPut
tnrc ìn rhe sorolv silaÌì nioder thai s('\'1h Per
;J;';ì;:;::i ;';;'"', '" it is
,-,,,-' ,',,i ,' ,.,.,' ,,or '' rt
\r:r 'l' rl ''\ r'' 'Lr\rl t "l r'dL ro;Ì's
,,,,,,'-

5 Economic conveÌgence
lhe SoÌow Sìr'anÌnocleÌ lhal iscontrorersial
OÌ\c additional Prediction can bc madeusjì1g ol tal
ì.'ì ì..i.."0-'"" o" rcsults r\ccor'lìng ro tlìc trrcdel ir tÌÌc lerd. 'rpÌ
"nfiri'alecìuiribriuÌÌr revcr ) the sros'Lìr rare $'il bc hish'
I r'his
;ï,:"';:. ;:i.;,"" 'i"cìv;trtc p'-'
--un"' n.o$inq a! m,ch raster ratrs than r!ch
'.;;Jìtì"i;"
.ììct. ìlut as
','.''.,,r,,''"
sÌìown in Ììiii l3landdiscutsedini:h'Pt;rl'ovcrthcpaÍ'entu theÌe

\trrLúi|!Ìrd6oihelunobrtÍrâblesonr.es.lgri{lhì\Ìr'llrsrÌeanrÉÌnenieíorbuiÌLe\hiÌlildor!
rh{ì nÌ ilìi\ dis!!$irÌ.
" ;'i" trìi\ í' Bir)rf1r \?Ì-
"'.,,ì.0".",*u.*",on 'I
 r:. nran) exanìplcs of poor .ountrics (c.9. Chad, lanTanja) lhat harc nol grown al all
: have expeÌi.nccd ncgativc gror,lh ratcs. lt b iftcrcsti.g Lo note thar Solo\!'did nol
:r:nk of hìs grcwlh ÌÌrodel as provìdìnil n nìodel for cxplâìning cross counlry gronth
.:úÌmance ÌaLh.r, he bclicrcd it Nas a rlavolthinkirg aború lhc groslh dvnamÌ.s ol
: !iÌrgÌe econonì]. Ncvcrthiìcss, thc modcl has becn widcìy uscd IoÌ.ross-l.ounll}'corn-
:iÌisons. In lhis scction thc thcorctjcaÌ ba.kg(Ìrnd to !hc conccpls ol condiLional and
, ncon.Ìi ii on al co nvcrg€n.e is pres€nted along\íith empiricaÌijndings and lhc mcchanics
a meanning convcrgence.

rhe hypatheslsoíu (t'11dìÍto',.Ìl.orr./grr.e stat€s ihnt countÌics with ìosft inÌriãl lclcls
i.atÌraìandoúLtÌ1t $'ill grotr, fastcr and.atch upwith those counLries tÌrar starr oUni0l
.igheÌ lelels. Wc iÌluÍrJt€ thi5 in lìlg. l3.l2 for two counlÌìes A and B, ÌrheÌe A is pooÌeÌ
:han B. (:ountN A gror\r lastcr as il convcrgcs to lhc new stea.lv state. Ìt ìs cleaÌ íronl
, jg. l3.l2 Lhal lhc rcason ihc poorcr countÍ_Í grows tasreÌ is that tÌre a\Ìerage pro.llrct ol

'rol.Ì/Â ,r\l -l .-lri .r r','l\,\,, " 'rol- rú .F' 'L.1. . r'

.arameters ot the nìodcÌ arc ìdenlÌ.aì lir each countÌt).
To see lhis marhclrallcaÌly lel us Ìelurn ro lhc lundanÌental Solow eq!ltion:

\fÀ
^
"'L Lú r.r) r 13.21)

rn.Ì ark hoa'ditlcÌcnt lcvels ot capilâl ìmfacr. on Lhe gÍrlth rrte. We tal€ tlÌe derivatìve
oi lhis cÌ pÌcssioÌl $,Ìth resp€ct lo capjtâl:

4i ksl'(rl
'lirl s if'tlr t titl {1l 22)
tk
'hi.h we r€aÍânge anci cllvide b_r k to oblain

r/ri 'k'to -1 I lvrr .rrrl <o

,lk

r: pooÌeÌ couÌr!, highcr gioNLlÌ

lli ìich€r ..untrv, lò{Ú gioü1h

ri!h. This

Fiqure13.'12 Llf.ondÌoi..onlerqef.e fthÈ50owm.dê wÌhte.hnooqL.a prolress

492 '
inlcnsity Ìì\e\'
lhissav5thatth(gÌo\llhÌ.tcoìlhecapìtal labour Íatnr decÌiÌÌcs ai ..pìtaÌ
furtherjnthc
i tt i."t,-,.,'.i,r" topcÌtics ol thc production lLrnction (dl\cussecìelpre$ion
"
appef.ìir):dnnúìslÌil];ÌetumstocapìlaÌnìca!\thatItlK' tP( Ìhis con-
since it imfÌies that pooÌ countürs
i,ïi" ,n"i'"p*r''",o "i.nconcllljotÌ'ìl convcrsencc
Í'ilh lo('câpiLall.veÌ\ willtcn'l to gÍÃ' Iaster'
So ìar it Ìì.s been r\sumed lhât all nodtlted have idetlticel prrnmeters and
'orntrics reter''lhus implicitÌ) alì
lÌavei slantlneous accesr to nexr lechnoìogy as ìt arrìves attÌìe
hrve sinriÌiìI chatacterìstics'
.ìLm,tt* n"* a,he snne lcchnoloS,v' 'lemogr'ìphjc towa s worli
".-.t
anil their topuìatio.s arc homoilcneous cnough to
halc 5rnÌilar attitudet
,n" O'ge dìversìrv alonia th$e rlinrensìon ol couÌÌúles nì lhe
s'orl'ì' il
ì"à
'"',"t'.'O,*.
tr rr,".Oi,"tt tn","a tj.1sìn\\'s thatthere is no su(h
convergcnce n ÌnoÌÌg tìreÌ\trld's
-'i
t*"tt"te tçüat happer.s ìf we lesLrict utrr 'ìttcntiof to econonìÌcs that
'ii"iì.' '-"
u'i uit"r"-,gn,.n" tì"rìtar ki cacholheÌ mch âs lhescL oloEcD 'ourtrics
orthe1ìi1\
aìi^. tt.,t", us lin)k al rìre us nales ÌÌr lig l3 1J we slìo the distributiod
'r,,",.r,i
,,i."n *-"
"
U"tU"" ((j5P) p€r $orlicÌ r'Íx\
rììe I rnites Slale\' \\e iÌnnredialcì\ n'e
"""
,"uti,''ì'rl n".,U*"n' iÌÌ GSì1Lelds in 2001' thLÌs cve' wltlÌin e'levcloltd
counlrl likc
rcsnnÚ l'o$'icleÌs oI (;slr
uì"ii"t* *" *."Ìrserve mbsraÌÌtial diltcÌeIrce\ 'c()ss
"". rInir..r stare5 andthe \4iLìwe5r' !!hìlethe
;;;,;" -,,." .,,",",,,,ì rcross thc Norlherì But this viniaì aì'lv\is is
iììi"',,"tlo* -^**.' Lo have hlsher Ìcvels oiPro'ìu'Livitv
erlrcrlen'cs hetc()gc
irnir"*ft,tÌIn-, tt,,* ollhough lt tell! us thit üie U itcd St'tcs diiícrcnt rcgnì's hatc
r""O..r p-au.,itjl-\ to'1av, ìl not lelì u5 whc!her th'
'r"o,^ 'ìocs
been coÌÌvcrsing or not

L;sÌ): D.LL.tr\ PÊ.ioll

E\S9.I . .

U $53.75r:rÌ.s59,19.11Ìol tr s:lír.513ro$l: 1901Ìtl

tr \'19,1Ìt1o553 750 Ì10r

Figurelll3 D:trItlron F_'r to iêr a'r'Í thê urried 9id:es in 2!01

'trÊa1G5F
 493

Ì0l5 111.10 l{J.65

LoB GsP È..afila I936

FguÌe13.14 Gr.Nith ao.lerqên.Ê ntr.u5a lrrrt'àieúÍG5Pp3r.rpt-Is35 20cl ,r: È!ê.[

lhusnramoretrecl\earÌal)sisrlclLÌsrconttrarctareal!ìSL'teÌcepita\eüe\lcÌtlc
pcÌLo.l l98li an.ì 2001. EaclÌ poinl oI tìrc gÌaph, Iiii. 13.1-1, coneïurcls to onc nntc
rrd nrolls ìts r\cÌüge gÍrltlÌ ritc in ('SP peÌ caPitâ o\'.r lhc PcÌi{xl 19116 to 201ìÌ and
th! Ìoijaìithm oi its le\eÌ ol C5li p$ caÌrila jn 1986. \\c aìso pìot the corresponding
I ncaÌ Ìegì e\sl(!r ÌiÌÌe (líe clls.uss i. lh c neÌt \e.ti(tÌ lÌ! 1\' to .on ttrct m(lÌ â line), rìì irh
.oÌ16Ì10.cÌs to â Ìilear trenci Êttcd a..onÌjng to the leaÍ squerei Ìnethod throuSh lhc
ilerâ toLnts. If thÊ coÌrveÌi{e!Ì.r h}'polhcsis is .oÌÌe(t w. \!ouÌd cxpect ttris 1ilÌe to bc
LloNrwaì.Ì nopìng, that i\ we \!o!ìd cìtc.L ìow Ìe\els ol GSl'jfer cafìta iÌì 19E6 to bc
asrocjated witìr a higheÌ groÌÌth ralc ovcr thi! peüúi. lt sccÌì! that thi5 predictn!Ì i5
in.Le.l met f(Ì tìre cate oi the iftl U5 slâtcs ovcr thì!period.
\eveÌthele$, ire mìght \lorrt thal this ÌcsuÌt is rot as crjsp as irc Ìna) walìi it nr bc
lìoÌ â rtaÌt, soDre states rlrch !s^lis|n a.d DC epÌreaÌ to Lre outììc6. OuÌ method olLe.Í
SquaÌe\ tìies to 1lt a \traiglÌt liÌìc throrrgh aìl the.lata poirÍs n.d rs Íìch it gi\e\ equal
ireighttoeacÌr cìatapoint. \!e crcludc Ahska aD.Ì D(l lrom ihc samÌrlt and pÌot the s.nìe
lrguìe nn the remaininii itate!. Ìhls graph is shoarr ìn Iis. Ì3.15.
Thi r hguì e taints a more heterogencoús p ic tu rc ol the relationsh iÌr bc lt{een CSI Sro $ th
betireen 19E6 ancl2001 ancìle!els lr 198ó. Níorcoler, the lìttcd Ì câst Square\ retÌession
no$'ha\ â \nalÌer neijaiì\'e sLope and 1lì c rcÌiìllonshjp Ìoolis very wcak. This opeì* uP th€
questl)n oi holv to rÌÌea5ure thi\ rrlaljonshit trc.úell rnd prrnr ì slalisLical ì.ièren.€
that wouìd aÌÌ(^! rìr to te5t tor t]Ìe signilì.a.cc oI tuch a relit onslìlp. \{c a.Ì.IL"$ tlÌis
494 . :: ':

_ 0.,1

: 03
:
7

,rh 98 100 10.2

Lo3(;SIPcr(afit,r l'ì86

Figure 13.15 GÍ.Ì!tr .oìvÉr!Ên.. rr thÊ U5A lrowlll rate oÍ GsP per .:plta 1986 2001 !s er' C::
'l
per.apta 19g6 er. !.lf! oú .ri
oL.r qs iecotrl rês.o]Lp!ì hs5"oroirlsirü.Ú

ì\sue in the ìre\t sccli{ÌÌ whcÌc s'e preser! tÌre corr.sponiÌjng economc!Ìic e\timnllo'

Let us now perfo Ì tlÌc same andlysis td countrics oI the OICD ioÌ the p$i'j
i970 2lì02. The .oÌkspondìng graph is shown nì 1:ig Ì3 1{t OrÌce agalf e tee that l
Ìinear rclâti(Dnrip cai5ts bcls'cen the gro('!ìr rate ol GLrP Ìrer capit. iìnd 50me'iÌìitii
lelel o I GDI per cap ita. Morcove r, this rela !ir)nsÌÌ1p is cÌcn rl-Í neiittile Ìbal ìs üe lo11':
the Íalljng ÌeveÌ oI GDP p$ caplta was. thc higlÌer \Ìc would exp€ct the gro'ttlÌ ratc t:
ha!e bccr over thc subseqücnl dtcades.
So iaÌ ouì .ìÌÌaltsls suggcsls that the coÌìccft of uÌÌ.oÌÌdilnrnaì con!ergcnce .ioes.':
hold for the ilorld as a ilhoic but does hold lor ÍDe
suitabl-Í choten mbset oteconoÌni.'
thaÌ slìarc similir chaÌacterÌstlcs. Thii !uggcís that there is no uni.Ìue Íeidy_state equ
lib.iLrÌn !o irhi.h aÌl ecoÌìomics conveÌile bLrt rather tlÌat thc,v nra) each convc€e tu 3
equilibriLrm thât ls ddernined bv their indilidual charictcrìstics {ch as tcchnoÌos'
ta(es. snljngs Ìat€s, and m,Ìc broa.Llv Írciaì, iesaÌ, ancl cuÌluml iÌÌstitutiolrs. lf hol1
ever, thcsc stea.l) stalcs are det$mìned Lr] relali\eÌ) similar ia.to5, as í clearÌ-v lhc ca!:
f(n thc slates ol thc LISA or for lhc courúries oI the ()ìicD, tlìc. lhelÌ neady states ri
be r€litlvcly cl6e togcther. tlcncc as a lìÌlt apPíxìm:íiôf ìrP 'nn rhìfl tìlihis srtìrset r:
economÌcsarruì.orditio alÌ,vconvergìDgtothesameÍeirdtnnlc

' F.r a .nB tunarri!\i\.i.otv.Ì11(f,.rrorr L:SÍrn\t.nì 1350 2000 1'llrÍox'dSaÌi r IÍ'nin' illr1 :
 ' , ,495

Ì0l 60 65 t.0
Lo8 GDI'ter.apt! Ì970

Figure 13.16 G .rtr..nverqerce ÍortlrÊ OEaD, 1970 .2002

These resuìÌ\ suggcst a second, Ì{eaker notidÌ of con! eriteÌÌce, nüììely . rrrÍlnJrdl . r,
:r/3d,.., wheÌe ea.h ccononìy convcrges to it\ o!!n Íe.ìd), nâte. Ì1Ìesteüdt strte irÌeach
.d\e 1s br llì€ model param€ters suclÌ âs savinss r.tes, populatioÌr growth,
chaÌacterized
ì. accessto technologv that may dilfcr betÍ,een countries. Does tlÌis nrgileÍ tÌìat poor
r.onomies wiÌl gnr! lastcr than rirh oncs? llÌe logic ol the analvsis s!8sests a poor
.o!núv wilÌ onlv grow tnstcr than a ri.h one ilit i\ ntrth€r froÌn its Íe.d| Íat€ thaÌÌ the
:iclÌ one í iìom ìts ícadv state. Ìhis is ìÌlustrateclhÌ fiil. 1J.i7 $'lÌer€ ìte coÌÌ\id€r a pooÌ
.ountÌy (A) with ìorlcr ouiput per.iìpitâ t1ìat i\ irr elery otlÌer respe.t iclerìtical to the
ri.lÌ countÌf (B) ex.cpt tÌìat it has a lol{er sayings rate. lhe diagram iÌlustÌaies hoi! it í
po$jble iiÌ the Ìi.h country to experi€n.e higheri{Írwth ol per capita ouiÌrut:the reay)n
Ì5 t1ìat Bis flrrtheÌ írom its Íead_v''Íat€ thanisA Í)tü sitlonal gÌoÌlth ÌÌ B is hjgheÌ. Once

.ouÌÌtry A and counlN Ll are at th€ir st€ady Íate, then each will gÍnv at the 5ame Ìate,
i.e. âti), = a and the poorcountlv(rill nevercatchup to tlÌeÌich otre.lt is aÌ$ cÌeaÌ that
\Ììould the \ivì.gs Ìalc ol thc poor .ountry nÌcÌease to equal thdt ol ilÌe Ìich one, then
the poor countÌv's Ícadv Íatc colncides with ihat ofthe úclÌ aÌÌ.litr iiÍrlth wouìd be
nster:1tivoul.ÌbeginIocatchupandeventuâlÌvitwoulcicon\ersetothesamebalaDced
groÌltlÌ path as the Ìich count.y. lvh€n tryhrg to undeútand why pooÌ countÌies Ìemrin
pcìor, this rejlrÌt throÍ's tlÌ€ burden on erplaining why the poor countD's tteadv sLalc
i\ ditìerent tiom thc rÌch countryt ând how ìt nright be chanije.l. In our.xampìc, this
anÌount\ ni andng ('hv r\'s savings râte is Ìower than B\.
'1o see thls ÌnoÌe loíììally,l€t us return once more to the iìndamentaÌSoìo cqualjon
1J.211. We sìve tor the savings rate ìt the stea.ll state (by settini{,{r : 0) Lo gcl
 \ .\(! !ofrÌrÍ! L \ .J\ rn\s ôqLÍ !Ì | th
ri.h'0! r' hAh r\ r!ç]tr{hrLLri^ n

'f(i)./r

ir i\ ii'

I rlr' 5oÔúr morl3 d Ííijeni q''(ih rÍêi ileÌ' Clietunt

FigurelSlT a.ill!ra 'or'eÍqexè

2l dnd re ra'::
Nos'\Ìc can sLrbstilutc tlÌis in equilnnì
L3
i = ; a Ì + rli lrllk_r'

,,='r:, ,,r(.ril,: 1) (1rr"

' ;:";" " 1, '-'1,^::

i";l l" : -," L ,' ' ,1.'
'

b
5.1 Measuring the speed oÍ convergence'
is vel}inip'i
contcrÍicnce can be rneaslüc'ìlhjs
Nc nolv coniider how tÌre slee'l oÍ
l,nllÔllrothe.ononìetrìcestinìati(nìolccon.ìmìcgrothnìo.ì€ìsancìI()r.i!tc]ììtì.i
iil:*, ;,":;;;J.''",""-':i.'.." :'Ï:'tïl::.111ï::l:ïl:,ïï::lli:Ï':,i ::::;
": ". ':
ÌeÌ\ \1'\\ lt'rcnr\ lrÌ ,,,::,,, ,",-o,.,, ,,.
*trit. rt, ' |.ers.n'i r\

,'n r" 'f "

i. .' r""'.' (13.1i
.!, = b.ll)si l,)sl l.

oí con\ €rgenceI soÌoN rÌiodd

Ú= I f(rid rr!r) tsÌree(1
 ' ith 1lìcCobb Do(gLìspnrducLionluncti(D,'(is.onÍaÌìtan.teiÌuaìto,r.Theintffp(.
::ÌnD oi lhispaÌamcterl irthar thc gnp betwcco currcni ourlNr pe r I,orter in eftcicn.v
,rú5 and the \teadv st.Lte !aÌü: oI output per workcr in eìtì.1enc,v (]nit\ di\epÌrcnrs .i
- !rstant rate, \o nì ctirnes th i! .or1\'rrgence sfced ]s eÌpre$ed a\ rhc halt life otLhcg.p,
. thc time jt takcs lor half rhc (numerjcaÌl Sap betì{een rhe currcnr ând steady,srate
rlu.r lo di\aptear. foÌ eÌamplc iIrÌe llere to obserr.Èiì \aÌLre, : il05, thi\ mcans rhrt
t: , ot the sap bcL\!€en cuncnr and \teadf slatc iÌìcorÌe le\eìs pcr rlorter ìn .Utcicnc)
,njG disirppears if oÌÌe vear. This nrggests r.lvtÌ8 for I iÌÌ the equrjon urr)i ,r) 0 5.
: heÌcIistheesLinìaie.lyaÌu.otr. lodoÍr,(,l:cansnnpi)takclogsotbothsidc5and
-
i rh c lor 1, whìch gives:

.\Ìrí i,tr-05
= l.,Airt to!2
) I r"rrit'" = l'rs2 =
06ljl

: or, - il
0s, rhis imptles r hell Ìife otrppr)ÌirÌÌatet\ 1i# =11 yeaÌi.
tis iÌnpoÌla.l to undeÌstand the iÌÌtuiti(D bchtnd theforÍÌiìta f(r t, = (t oì(rra+rl
rnd thereason i\'h] \om.ÌIramct.rs are lncl({icd.
. Roleof.:Thcpir.nereÌniscquiltotìÌeÌariooIthc,VlXto,,lt,(andthisratioiste$
than one torconca!eÌrrcdLr.1ionlLìnctidrs (dlmtrÌtshirÌS retunls tl) .:a! ìtalt.
ÌtLt= r1l It,, is high iâppr)achifg one) tlÌen th.rc ts Ìjttlc diflerence berae.n lhc nì.rrginal
an.l avcrage pÍrduct, hcncctlÌe pio.luctìon iÌLn.ttonerlÌlbitj ontvircakh
.liminislìüÌg returns Lo captral.
{2) ti.1i\ low (approâchiÌÌg zer, thcn hc nì!Ìgin al pio.luc I is mLrch snÌâ1leÌthan thc
I

averaiie prxluct, r!hich jmpÌies e slrons cun/atüe ol the tÌodu(ion frnctn)n, j.e.
stroni{Iy cìimi.iíìnìS margiÌraÌ retúúrs to capital.
(3) Ir the torÌì!l! ír'i,, ahlghcr d nìean\ íoNcr convcrgcnce and ive can Doa,l nk
this wiLh the p.e5encc olNcakl! dirDinlshi.g (.tur.s.
.lÌdeofìandr:ÌlighcrvalucsolÌindr(oÌÌl)ì'ÌpìvlaÍer.oxvergencc.ÌIÌorrì\
high, thrn holdirÌg ercÌvlÌìing else (onrtant, lhis raiscs rhe r:ì1,,( near thc slcadv Íar€,
which raiscs th€ sÌreed oiconv.rgerÌce lthe cx pcÍinÌcnt req ulre\ thar rìre ccorÌom) be
the sam. dìstancefì!m rÌrc Ícadv stare in each.asc).
. No (ìe for the sariogs Ìate j.
\{hat r.luet of l, r\'oulcì t)e Ìea$.âblc to plug into rhe tornìuln to cülcuÌate thc ratc
of conÍcÍge ce pÌedi.t€(l b! the modcl? 1ìor the US economv, lhc tollolvìng valrrcs arc
113.2i deemcd re.LÍDablc: d 00:1,Ì:002, and,:0.01.Iora. th€\alue ti'3, hichis
the approriÌnate !âlue olthe sìrâÌc ot capìrâlnr thc c.onoDrv, is used. Subrtiruri.g rtÌcse
valucs ln the exprcsslorÌ .ì bove prcduccs t) {1.0.1, i... a stccd of con\eÌi{ence oi.1% p.a.

rrlh(Ì.isn.rid,ln.ifnrurÈe\ÌÌrÌftnfrnfth.sarnìg\Rn:r nìgn. cfi..t on rìre 5IÉÉd.r(ofv..fe..e

Itar\e\tr.rìlheÍi.t iriir.sivnsrratctr..nn.ìrrIÌra.!'cLonrÌ)n"nrtD.dcÌnr.hâsúrctì,rn!.lfì.drÌ
.1É.lsennì!..tÌonilrrrrhirlì1hÈç\r.!rnre.rnllìâr:e,rÌìerÈnìlin.ong.rh.la!
498,:
which nreans â hal{ lilcof l7 y€aó. i.c. that Ltansitions betlvecnÍcad},íaLesare reÌatn.Ìr
sh o Ìt. Doe\ this corrcsF)nd to the facts? lo an swer this q u eÍion we nccd lo learn ho$ t:
cstiÌnatethe speed o I coìrvergence lrom data.

5.2 Estimating the speed oÍ convergence from data

lve a.ldress thls in llro neps: lìrst bt akj ng the casc wìÌcrc wc hale a grolÌP of countrì.'
I

toÌ which taÍes (rhc saviÌìgs ratc),lcchnoÌog) (tlÌe ratc oflc.hnological prcgressl, ar:
dcmograÌrhic paramctcA (Popul.tlon gÌowtìÌ) are considered sullcìcnlly sìmilar 1òr tl:
counties to sharc a conÌnÌon slcadt Íate. This leids lo a lcsL toÌ ahtolute con!e.il€nr.
Ir the second ícÌ], the possibiìit], that counties dÌllcr in thcìr Íead) statet is allolt.:
the lÌeaker concept ol conditionâl convergenc€
rlith the resüÌt lhat tlÌe t€st is tor
To Íìnd tlÌe convcÌgenc€ paramclcr, lj, ft). a set of.ounÍlcs wilh simiìar taste, techn.
logv, and derÌÌographic paramcicrs, slc be8ìn by subíÌlutÌÌÌg lor kiA)' = l,)s,l' bg-l :
cquâtioìr 1:1.25 so as to Ìnove to mcasurcs ofoutput per capita and oblain
lll'g) lt'ì;Ál ,ll{rgt roAt rogl- -logÁl (rrl.
dt
'lhis hokls for all countrlesln our saÌÌrplc. \{e can nos'choosc onc conrparatd counti
say the USA aÌÌd nalúraÌÌv thc saÌIc c{frcssi(trÌ wìÌl nÌso hold [.Ì the USA ând !\'c i::
..\J,,,Ëo,v1rn^ r'.'. l" o(h :

41lasIr !!4 : ,{Ìogtú Ì.c.1 lost_ + los.Á). (13.:

lve can no$, subtract equation 13.26 fìrÌÌ 1:1.27, rvh ich Sives:

dllog/,1 lost) :!
rlt = rlì(,st Nr rogl). (l.r

The expression ( 09lüi loBt,)ìs lhe prcportioÌÌal diltc rc ncc bch{een outputperü1rr\::
in the US,\ rnd output p€r workcr in the country in qucslion and is calÌe.l the lÌrlrl

at, t*1r, ,""1 = U,a (lff) Ll ì.: -

Wc car no$ rewrile equati(D 13.28 usingthls cxpÌesidr to obiain ilÌeresultthal

(13.:

wìrich means th.ìt accordlng to the SoloÌ{ Sr,an modeÌwlth technological progrcss :..
gap between ec,rÌÌomics with ide ti(a1t€chfoìo31., tastes, and demograPhi.s dccÌr.:
eÌponentialÌ-v ÌÌith crpon ential coetìcient }.
The vahìe ofr.an be estinÌaied usirg datn forapaneÌofcounhies, whereCDÌr pcÍ.ar::.
is observecl at tlqo datcs r = 0:!nd I = T. ,\s slìoirn in the Appendix, equatiotÌ 13.:l(r .:.
be rìsed to obtain arl cstinratnìg equation ofthc ktìowing t)pe:

og).r L(iAto : , ,log),r .

 499

Íâbìe !3.2 Gro!!Ír.ônv.Íqei.e re!ìreÍÕns

oE(D.oúntiès
ìndúdiruax,0c

l.ÌollÍcillànL'P+ïlünl.Í

dala in odeÌ to
Lcl us noa use lhis esliìnâting equatìon and aptl!- it to cmpirical
oÍecotromic g()wth over a certain
.Íúnatethc tlope oÍthe rcìationship between tiÌe Ìate
of the perrc'ìof anâlysis This alloiNiu\ to
teriod and lhe ie\'cìof Gl)P at the LJeginnnìg economies and to
ot
.tuaIr(ily thc concepl of cco omic convergence foÌ a given súbset
Thüs' wewiu b€ abìe to pÌeseÌrl
;erform Ía1!siìcâlinference on lhe eíiÌnated nÌagnitLrdc'
*ta** -t ,n" u rength ol th is relâtjor\b it bevord that illvcn in ligs Ì3 1'1 l-6
to be
iie rvirr bc arrle to sv n.,." rt,o" ti'ptt lhat the obse 'cd Ìelalionírìp secms vcrìry
"*.,*
line aÌìd k)
rrgatlve. t-cononcLrìcs alÌows us to cstiÌÌìale tbc sloPe of the lìtted
trhetheÌ itis sigrÌilìcantly ditìercnt fiom zero
(1r.2: ptoceeding rvÌth t1ìc inte4netâtìon
But let !s I rsi lool at the eltimation resuìls befoÌe js
ca!e' the dependent !âriable the
\\'e €s!iìn:tc equ:ìtion 13.31 lor two sanÌpl€sr iÌÌ each
ofthc leriod Thc lìÚt
:.g Aifr"*"* rt",**" *ttfut per capita ât lhe stâú and thc end
íãter'
se;rnc is g1l'cn lr! tÌÌc Oì-(lócountrics, irhilc the secondcorrc'pond'totheift-vUS
(r 3.28 jttr""r,i-rtlnn."rutor,"suÌÌÌmadzcdin lable Ì3 2 l'achcolunìnoltbctabicshowsthe
*p.rametcrVan'Ì,lrontheestìnrati'gequatnrnÌ3:ilabovcÌÌere
"ri"n"l"A*l*.f
the ro$' lâ bclìe.ì lntcraepl coÍcÌronds to thr eíimâ1cLì
!âÌue ol $lÌilc the row iabelLed
'ì Lo the
.i,,p".,".".po*tt. o'" "rti,ttuta.l valu" uf l', 'ut'i'tì h'c calÌt {câÌlcd Ú tilde) to retèr
,,r h e par;metcr rìorn our regrc*ion raÌvsìi ÌíouÌÌno'L€lholds
r

".,i,ro,"*.i. ",tit1tol "

rieeJrpcctitobePosiille,w; ciiobcne8aijve ' \'\resbalIhaletodivici€àì)) thenumber
(13.29)
tht sampre (1) to Ên.] thc enimated arnual convergcnce
rale LJnder cach
or rean in
uatL," t"e alt, repoÍ the stânda cÌìor coúcsfondlng to our esllnÌ'tc'i value
crtinat".r
easuÌe of the cstiÌnatcd prccision i{ith ilhi'h thc
r corrcspo dìng paranìelct
This is a
(13.30) \ ahì€ was oblajne.l. Moreo\,--r, i!'e nìdicate by
(.) whether thc I stalntic coìrespondilÌg
lo ea.h valuc sugilests tlìat our estiÌnale is sìgnìicârÌtÌy ctiflcrent from zcr) at lhe s'/o
corlìdcnce lo.el.i':
I' o'
.o.tn.ienr.1heÌnatjriirn.mranrÍ.otnriiti'aÌ5i3ni6cin'eindnde'nìr!Lasrrrl\rvÚ(!lNhêÈJi\the
;Íimàted.ocl6.ietirtlí,,iijì(it\\aíin(e Liourtr\eir(rnbrrrL'rÌiitdll,Idnnìrnsihcd{"Íêspofdi'3
\àNe prrrdetcr ll'ofonrêúi'
t. trt ur,* or Urc ot narrr Pai nìciêt Lr! ihê oa Nitlì thr naìdrÍl eI 'Ì 'I th '
rr.4rtcL\usúÌririra(rd(;nvrri.ìüethxtndistÌ ÌúêdrL'odnÌAtonìotdistÌilrútiofnÍNhi'rÌilì'GJü$1âf
in trListi'allalrlo\búta!
lirurr"ti tt i..n-r, go"A"ppÍìxiÍútnnÌ' Vaìuc\ollh(r dÀÌÌ ruron r'ê L'bulaÌêd
(13.:l I ) ijrlÍlÌ]l'ìbilitìelbj'l1lÌJllLeo}nrêl!i]ti*'.1\qÍeaLcÌthân2{e5i-vdütn]ll)aú!ìeiÈli5t]inti.ll]
500

0 11l8atÌdí'tisticaÌll
lclusÊrstLooliatlhecol!rnnnÌOI-CD'r)untries The\loleis
di;crent lunzero attÌìc so/oconfidcncelcveÌ lhiscoÌìe\pon'l\toanarnual'on!ergen'!
tuÍntrlr tçc h:vc pieeiolsll
r-", ,t " n'1ÌI8iJ2-vears x 100) Lrsins tlìe(i
'ìil,ì-i.,u"0", e 0 69J1/ 0131' Ìl s'c no\r
,ì"."
".i*".-, -Ìn"*,hc hall ÌlÍe to hetheabolt s3 years
cstiÌÌate ol ]r is 0'1'151 $hjch n'cms 10
..tr.,U*.."."'3""* u,r thc US slates, hali rire or 71 vcars '\i
to
;;;;;;".,,rr* t".*.,e ol onÌ] 0'e7rr0' irhich 'one5pon'r5 a
o!l
,echnicalilits ol Ì easr sqÌ1are\ Lslimation tl'cc equaì weìght
L'"rì"", u"
".Jin.,t*u
attotservati.:lnsaldttlsthlÍtnrltsarehfluencedb-Ìt]ÌeplesenceoìoutÌiers'Alask.ha!
itU"U .O.uO l"t*p, tol oll e\traction) and n( is not clelÌ a state
$'ìrìch nakc thenl
lor our convctiience thcse lroni o!'Ì
ll s'c nolç taclude
less convjnciÌÌg crf{Ìiclales 'lúb I oi 0 1237 aÌÌd â cone\pondlns
*n an eslinÌaLcd talue oÍ
i ^,ton ^,ì-*r"," ",ggen
ìs rot sratisricallr iljíIcrent IrÌ!Ì zc(r rt lhe s'I, confLLlencÈ
"r,r'it.,n" ",ge"",,,-iit
l"*r.rr''.'''pri..-rr."t''edonotha}€cnoüghnâtisticale!idcncelodislinijüì5Ìrtlìjt
i.atuc <)fthc cocllìcirnt eqúal to zero. thÍ rne.ns that
í'e onl_v lÌnlt
rrom an esLiniaLeo
iì*tia to c\en suppoÌt the (la!m t1Ìc us srates actuâll-v converscd
.\cr Lhe'ì"t,,,t.u
"",*.ce
u!LLUd 5itrcc 1"9Á
t,. ' i 'l
r

\
",,t.-
. l,n lLll 'r' ; I
- d''r"
,lr, ., I II "r' I |r" '
nÌ oltr eqúatio' Ìlcnce) bc cari'Íuì when appÌvÌni
,,rriá à,, '\'c 'lÌouÌ!l
'," 'rot "c,-,,"',r
lhese sìnÌple conceplt oÍ SrowÌh conlergen"
\incc even eco'onÌies thal Ìna! teeÌI a

Ii r ''"'r
.t-a. i 'r-r\'''r'r'
',,i'r'L,,'
aÌìdSalaj-Manin(200'1)nnclnsigniLlcrntcoÌÌ\'ergcn'eralcoì17v0ovcrtlÌcleriodtronl
tÌÌcrc i\ ro slgnilicanÌ
ì.n,ii ri,nu r,"nrì" nt*n R íÌrar€d o10 92) lrut tlÌc-! nr'ì lncìthat
,
tìÌe l98i\ and 1990s
coÌìlcrgence in the llüÌ ri{o dccadi's olthcir samPÌc'
tìrat difìer in thcìÌ stead) slate\
i"" ,,"*,,t."a.t ,n" "*rcise to in'Ìudc countrics
\a\'ÌÌ8s raÌr'
diftercnc€s lìrat.ouÌd arisc trorn ttÌe deterÌni!Ìn't! lhe sleady state: the
oí
0,,i",O,". t-"',n, ." " techn oìoilìcaì progrcss ' or dc Preciiì tlon riìte Ìheusúiì!ssruÌ+>
I
connânt a'ross
ii;rrs tÌÌa1;eprcciatì(Ìì lI) and rhe rate of rech ' oioSìcaÌ progre\s lÌ) arcth15 should varl
...",u*r-a"pt".ir,u- rtecausc thrre ìs iìo particular reason to thiÌrk
rl \ \'''' r-o'
rll\dr. L, o, l" ' 'Jl' '
,.1 ,.' ,,, r" ,'o ,.
ho$' this a$umltioÌr crÌì
te.hnoÌoS 15 iJìsttìÌrlly diÍfus€d rcross clruntri's' W€ considcr
irì
le mooiicn so rrrat ie can discu$ borv ilci{ tcchnolog\ rs ditlìrscd
across
'oltntrlcs
ratc sill be !
t.r. tut." .onsidcring / convcrger1:c' tÌìe gtN(h
'-it,rr "'" ^'" 'o'llltn'
Ìun.tionoltlÌedeterÌnil]ant\ollhestcâ.ltslate.'lheeÍimatingeCÌüationloÌconditioDrÌ
.onrcrgence ì{as derived in ManklN' RoÌÌìcÌ and \{eil Í1992)(MÌlw):
'

Lhn nìeanr ihJt \ie dìâ1i Ìe pa xniêter ri

Jí'ri Ìef\i9srr nrl
\i.nih(rntlÌditL!unIr.ÌÌzenrridì'5lh1è\rl
:;,, ,,"'',..", !, !ü'lnntr'
z*) Ir' /ìr'o'iiì'i?nÌrìf,ìrúÌ"i
i\ r ürctso'dn'$
;:,ï;""ìil '
,ruê nc oI
liúl]o(!r'
'L
,,,,nUt..,'".,-,.,"t,..
r'd rt\núEnjiì rlPnÌnÌ d n't Lt taÌi'n !tjrÌirtrÚÌt
'n!5th"Luj'riiÌ\r'lilìelr'tieÍ{"\l)e'tourrLodrln)itlh'diú
"..," -"at, -tO,t"*ntÌt. rndíLLr
"r'r'
I lor rr...nt.Litiqte.i\1iì\ì,\rellrlritl n llostÍr'Ì(ili2ì
 _
i rÈ the grorth of oúrpur per catiLa ls regÌesscd on the initiâl tcveÌ ol oulÌrut irnct the
:::i rnirÌanrs oi the srrâd1 st.te.
,ìc €rrpirical dütr suggcn\ that t ts abour 2qo pcr irìnum jn the \amplc ot O|CD
.ntries Íjt is ÌÌÌrch slowcr stitl in thc sanltes Lhi { inclLìde pooÌff countÌies outside rìre
:i l)). Ìt l' = 0 112. this gn es a haÌf Ìiii. ol :15 vcaÌs arxl the econorÌv rljìÌ onh be thÌee
' r d l. , l, ,{.,,I' j . -,t- .Ii d.
i::d ol convorgencc lrcÌn tlÌe dala Njflr rhc vatue ot, thar h,r câlcuÌarcd above bi
rging \alucs loÌ a : 1,13.d : O.Ou 1 = 0.02 n.d, 0.01 ìnLothe nÌmula tor rhe
:id olcon!ffBerÌce lrorÌì the SokN-Ssrân Ìnodcl: i.r. , ii ,ì (J a +,r1.-t.his gnes
! r-).1, lrhich jÌÌeans a hilf Ìiiè ot ì 7 teür. -this comp.rison sug|csrs urat $mcthiÌÌt
ri s.ne wmng\!ith our a prioÌi .aÌc ulari.Ìr.
:ì ordeÌ to rc.oncile tÌìc lorÌnula I,ith the regrcss on €stjmate, rhr tocus oí âftcntìon
:,d tlÌe rtc ol cápital in the .on\ c{cnce equâÌton. Ìt tlìe capitaÌ share was cÌosfr rcl
ürevaìucotr:il d)lò+Ì+,rì 03 !ilotr Lì OtE comes dow! ír tlì. ,aÌue
.:im.ltecllÌonÌthecÌoiscountrv.ìarr.ButwhercdocslIciìtditi{)naÌcnpit.tcometÌonì?
':.1r\!ehalcorìÌvuscdirrrtuD,deljnjtionofcâpilal,r,tÌichtìjcuscdonph),sìcal.:apjtat.
Ìder to obt.ìhr a capt,rl share coctfcleÌÌr thar t5 closcr to the reqúircd one in ordcr to
. rdre th. Ìrodel ÌliLh the emÌinical fndnig5, w. harc to tòcu\ or a t/olat./rr,rirn r ol
. ìital. whi.h iÌìchrlcs lrr, n rnpituIat\\eU.

:3 Human (apital
.. havc scen that ii the concept ot.apitâl is broadcncd io irìclude hunÌan capìrat, rhc
.:.rltÌ Í'iÌl fit the rmpirical ÌealitÍ bcttcÌ. NarLonaì tn.onìe rccolürt' rcìÌ us hoi! much
',r crpilirl âncl labour !!e tìave 1n rlc c.onomvj í iL must be thar the addirÌonil iIÌDt t.
.: ìdúclion conres tÌom iìctu.s that nÍlcct procLldi!l! but have rìot í) far bccn irÌcllüe.Ì
. .uÌ nÌodeL. ODc possibilìt) ìs .d!.,ralr,r. the idcã bcing thai nìoÌe e.lu.ation iÌ(rea\es
:.È nralgiÌì:L] pÌodLr.t ol labour Ior aìì Biven tercls oI ra$, phvsicül capjral and t.bour.
i Tabìc 13.3 ive prc!(nt seLected drra on educah.naì acÌì iNcÌnent jn .llflcrc nt .ou nüie,
:ro$ lhclrlobe.It shorsthepercentigc ofpeopìr agcd 25 ororrr who hare Ìcichcd a cer
::j. cduc.tiorÌ levcl as theìÌ 1ìnâl conlÌtcted edu.ation bclore p€xnan eD rÌ_Í .onnnittilg
::ÊúrscÌl,cs to tìre ìabour loìce 1n b.1h 1960and 20t0.rr
BroÌlsirÌB thnrgh the clata one ìs ìcd ro.onttnrpìalc lhc possibiÌit\ rhãL cducatidr is
:ìted Lo econonrlc perlürÌancc. Arc (re n pÌiÍrd to tnd thrt the UÌritcd states as tÌre
r rÌÌ.1\ rlchesiecononì\ Ìras onÌv ltr)olits popuìario. r,ilhout schootlnga.d rhe average
iumbcr oi \eaÁ sÌrcnt nÌ ynne io ÌolcducatnDìs12.2-siormo\tAmcrtcins,Ì!hìÌeiD
ìuc1an, ô.r otthe arorld\ pooÌert c.ononÌies, olcr ó0Ao of the poÌrulatjon has rÌo schooì
rg and on ìveÌagc its peopìe havc Ìcss than two vcars of tòxnal educaljon? SimiÌaÌÌv,
'rheì rj.h cconomics such as Japân, lhc UÌ(, oÌ Swcdcn ha!€ I verv lor! prrcentage of
:reìÌ Ìesf.tive populations lyirhotrL cdu.ation (0'11,, 2.940, and 2 00/ô Ìcspc.tì\,ett), high
i.condaN ind toÍ-sc.oÌÍìdry atrcndanc€, an.l rhciÌ Ìforkers spenr arcrúÌd t€n yeaÌr on
xeragc ìn sonìe írrÌ ol ecìucatìon. lL is perhalts n.l surprisiÌÌil that counrrje\ that ìralc
!ert(rÌrcd Ì\'ell in teÌms olgurth su.h as LlotrirenaoÌ a.hina lÌa\e 1mÌrÌorcd ilìeir e.Ìu.a-
:nìnaì s tan d iÌÌil \ign i lì cirÍlv iince rh c t ! 60r. Th c pcr.cnt.ge of tÌre pop ul.tidr wìth ou r

iron rlìe HrÍo l..r tllâ 5èr (rrrro rfa 1.. 2001r nrr rid h...id ednltidi.tri
r.ppêndr\qr21)r)i1ir1,2| r' ú.xÌ!
502 :,
Ìable 11.3 Corìp.re{l e.i!.;rnrna an,im€ntÔltoii F'p!àtoi over 2_F vÊâ6 of

No s.hoolitrq Prin y çe.oid v PÒnre.ondrÍv aveÈgà(vÁ)

!2 il

Li

and irom 52% ti) 20 9v' iÌl

aÌÌy schooìing *'cnt doMì lrom 71 +qÌ nr 28'80/o in uotsvana
ruìnber or \ears
cliina. similaLlv Ltre avcrâ:e lPenl in elucationtìl and secondar-v and
poí secondaN paÌticilation hale aÌl ìncr€astcì as a'clì' HüngaÌy, onc of thc Ean irÚÍ)
welÌ, has educalionâl ln'iicators tlÌìrl arr
;ean tìansition courÌtrìcs th.1 is peúormilÌg
is câìÌcd ftr al tìris point
ctosc to tlose ot otnerae\elopcd econonies A cautionaÌy nolc
standards an(
since a1l that t1ìc datJ iiiaests i5that theÌe ls a corrclaLiiD bcttleenliring
oì cducation: it se-vi tÌothing.ìbout câusalit) JuÍasplaúsibÌeâs lheiden
lhatnìoÌt
levcls
grolvdÌ in counLr
education Ìaiseslivlng starÌdardti\ thal higheÌ Ìivìng Íandards and
a

Ìca.ì to nrore expcndiLure on cducâtion.Ls

Setttrìs the .auraLit-ï ìt\u! to ore sÌde' s'c iurn to lhe tasli ot âugnÌcntirÌil lhe
SolorL
educatl(ÌÌ
s\!aìr m;del b) i nctudì nia hu nr en câ p l tal lÌÌ lhis colÌtcÌt thinN of
\!e cn n as â

r'ô,rrr.êntai!.u\!of.a.aLrÍliiri.b.th(ltc.únL,sêeBilirttLrìenorÌ200iìl
 .tÒxy f<\ hltnun.npiül_ OtheÌ colrponents oÍ hunìan capitaÌ nrjghr irìchrte Lhc heâlih
,i the woÌkfüce a.d the quality ot cducâtÍrn. (Ììce we have dc.ided how Lo nÌeâsure
.uman capital tlìe ncxt queÍìon is hoÌ! nr incorporite it ìn thc productlon lunction.
\jrowth modcls do rhÌs irÌ t!!o mrìn !!als: onc is to tr€at hunran cipital as ânato8ous tl)
rhï\icaì capital, iÌì rhc sen\e rhar it is n.(ruÌLrÌnlcd like phlsìcaì .apttâIând DrciÍrrectiD
.i .I',.-A ) H p.rd,ttu, ' n. ir
lÈlotecìt() hunÌan capital accumuìarjo and \ is the íraÌe .Ìevotcd to physical capitrì
r..uÌÌruÌalion). The auginerte.lCobb Dougìas production tunctiorÌis:

y:K,\H)tAU1 . i

;rhffcd.,:r < I ando + il < t.

Tlìc second approach, asso.lated with Robert Lucar, úcars the accumularion olhunran
:atit.l ditïercnllv tromLhat of physicaÌ capitâI. in this casc, it is asm.red lhat the accu-
ìulation of humân capilal dcp€rÌ.li on 1Ìrc tìme devoted Lo lt ,s weÌÌ as on the rerurs
:o íu.l)ìng. Ìn Chapler Ì,1, we nraìÌ sec how ihe Ì ucas appro.ch leadt Lo a nÌol:leÌ of
.ndoilenous grorth, whcrc th€ grcwth Ìalc irÌ the \teadv íaÌc ls dri\ en byhuman (apital

Here we ulc the tìÌst toírìolition, whi.h b.oâdeü tÌÌe co.ccpt ot capltal (,ithiÌì the
rr ginrl SoÌoN-Swar modcÌ. I ol]oÌling rhc saÍÌe \tep\ as 1n scctioÌì,1.1, Ì!e Ítvc for Ìe
itady \tate Ìcrel oloütprLl peÍ head ì. thc aulrÌÌente.Ì Solü!,-swiìn rìúdeì. ïìis aÌloilj
tr5 to deú c Lhe.nâlogo!s equation t() equation ( 1:1.18), irhich is repro.luce.Ì bcloÌï:

,rll
\i
i\ ith huoÌan capìtaÌ n.ludecl, we hâvc

. t(
\ ./ì /
\
ì
,.,/

: :.) ll) !ll i:' lhis cquâtior t.ìl! us that Ìich corlniri.Ès ha\e Lhc IoÌÌoNiÌìg .hüÌacte rn tjcs:

1)hjghsaliÌÌtí1n!.cnnìenrrareiìnphysi.alandhamen.apitalândÌitr!popuIâtion

, 2I acce\s to advarÌce5 i. lcch nolog], kÌheÌ$ ls!, the) will Dot hale a.ccs\ to .1. ).
\.Íanlii!\,, RomcÌ, irncl \Veìl l\ÍR\'!) estimâtc lììc augnÌented Soìow-SrÌan mo.teì on
data lor GDI per capita jn 1985 lorasâm eoi98countries.ThefnndtÌì.tüÌemodcl
dccounls nÌuch bctter loÌ rhe vnriarion jr cI)I, pcr câpita a.r^s coLLntrìe\ flran .Ìocs
the model without hunran crp lal. ì,.IoreoveÌ, thcy tìnd flrat rÌre impti€d \aÌues ot a
xn.l J arc eâch abort 0 :1. Thit !rcaos ttÌat thc ctasti.ity wlrh Ìespecr to outlÌri is âbout
ihe sam! loÌ each ol phlsical caplt.l, human capìral, aÌìd ìabour. lhe imptlcaLion is
that lhc slÌare of phvsicaÌ pÌus hunÌ.n capirrl ìs Lì.6, which .leÌ1!e5 a .on!eigencc ratc,
lJ:Íì d ll(r+Ì+,rr =0.1:006:002,1
504

1Ìì'ltrdilr3 ilÌve\tnìent !n bunÌii

lvhcn l'ÍRW Ìe cstimalc thc coÌÌ\'trgcnct cquation
as f()llows:
capìt.l a! a.letcmìinaÌÌt ol tì1e !leady nale

., I

i,ì 1 ir f-r.qtrr+r+ôl'''
-J

converseÌÌcc ìatc cÌosr

rhcv in.t slÌons evi.Ìence íor condillorÌal con\+Ì'ê " *'ilh(i thc
nìo'rer e about 0 02ì rhe incru
:ï]':i'ïil;ï:i:;;:* ".*,*'iìnoÌ'"""' raÌsxÌE"""1'
the (onvergencc ratc nr bc$\'ccn 1' 1 a'!:
\nrn oi htnìall capìtaÌ h'\ lhe c!tecÌ
'";-: ,'r' , " ", ' r' r"'r rr' \r '\\ri ìi rrs'r'
' "
;1,;"',' '',"., '"''',',' '| rr\'r'-' o' I

and cqulr to the rare oíexose

:ï'tì, ;^,",il;; t"'."p!ta is common acÍÁs co!ntrìes
rhal ..NIrtÌÈs irÌ rheÍ úìdcrlvins
iÏ'ì".;;ì ."t r"-ï";, ;owe!'cÌ' to trìc erlcnt 'Ììrrcr
wlÌ a cìisrúbütìm oÌ
ì;; i,";,'.",r strN1h paürs irlt be taraìreÌ r'herc be
',;;,;ì"ì:;:
';;";;;ì1,;;:"t,'," ,c-rrxs cornnics on tri:iL b'Ìran'c'l irrdlth paths' accodìns to
i," rrì couÌÌlües will grow at
uitíeÌenr ncacìy srarcs. bur in rhe ìoÌìg
,ìr" u"","r,."""
"'i,."ì"J,.t " s'!an nìocicl b-! jncL\dnÌs humdÌ caPit^Ì pr)
-t,"""tiÌìsÃ"t1Ìcgupsolow
t'"nuc"n rheoÌ! an'l rntpÍica1 nnal-vsi!- \\'e
talic ufì
",i"' ì"t' ,,i,,"",,'"'"t
"
;ì.i:ì,;;:.;;;,,,,'' ,,;'r to m;dcr sí'vlh in the conrtat or ÌÌn et5 oi cndosenou!
the process ol ltÌchnoÌ
ì;ì,;"i;ì; ,-"trr ì!1 rhaptei 1'1 but n Nt Nc iÌìlr)duce
(
bc conÌr'red \!itrÌ lhr
-;;ì;'"'ï', d",",'r mechanis* convcrsc'ce that
'in
n:.n. ftl one";;.
ìn thc Solow-Si\an ÌÌÌo'lel'
'-

5 4 Human capital, technology transÍer' and convergence

''he idea thrt we sìr?ll cìiscrìss i!r thit scction is lhtì1 c'ÌucnlloÌì sÌiecd\ up technologi'aÌ
inno\.atìon. Ìhis susilc(s
. qüite ditletrÌ1 ()Ìe ln SrotltlÌ lom that in dìc
tlì.Ìt lÌumar cJpital nÌa) p1'-v a
an catital and
SoÌoÍ, sN a n rÌio.ìel â! g meÌì tcd witlÌ h urn
.lhat.onlcrgcn(ecr.taNcllaccuìÍDghtechÌìoloil-vdiflìsioÌÌindÌÌotjuÍ\iaÌisi'3
c{pì1aÌ intensjty atin the Solo(' Swan JÌodcl
iDstnntineoLrsl-!
lr naúìcLtlar.Ne Icìrr lÌÌe a5nìnìption thitnclvtcchrÌoìotr'isavaìhLr1c
,.
:r
,","t
"ìi:;,;;;i;i;'
'l
*"*el

' ì
tech;o1osv {Ìitrüses irom the rrontiÜ
'iew
to Ìnssnrs

r'l "'
co(ntrres

' l rrl_l_ \""

't
,rr!l r'r rrr Iu
,;,-"',,r " 'r' r"r'| rI i '.r' 1 .
'..r1, l. Ifir\ ii'r'\
a -.- 'l, .. .,,|l..
'"
r' \?Ì!.nifdl'Ìrdli1l9a6
 505

.r tlÌarÌ tho\e líìth lirLle educalion. llauslblc cÌplanation tor lh is ls lhat the better
A
:rlLd larineb llere able to uìr.leÌstan.Ì a.d asscss lhc irtorürãtion on ncw r.rìetìes of
, :ì .ìnd Ìileslocli that iras avaiÌabÌe fìÌ)nr ÌÌìai]irZÌncs, thc L)cpaÌlnrcnt ol ]\srÌculture,
..
ìir.ial seed conrpanies, and the ljkc. I hc lcss Nclì-cdu.alcd larÌrcrs \!ho Ìlere not
- ,:d nt asse\sirÌg new Lechnl.Ìues and trodu.ts h'âìlcd u.tiÌ lhci. su..(ss had been
_ :!ìslrat€d beloÌe a.loptlnij tìrenr. Thc rclurn to Ììorc cdrcrcd lar.rcrs irorn eârh,
:'ii.trÌ ol lleiv tn ucr5 aDd prcccsscs is lìlgher tharì or lhc lcss cd!.ntcd ones.
::i\irúishtcaDbeintegratedh,irhdr.SoÌor'5$,anmodcÌinlhctolloanÌg!!i).1cch
)l Ìhr : ri.il prosre\s Dow consists .I rit'o .omporìcn!s: lÌìc lrsl is thc relc ol crogcnous
::ìj.al progre$, a, and tht secon.Ì is thc raÌc nl rrhl.h fÌonli.Ì tcchnolo8y is absorbcd.
! .tpeÌìds ontlÌe level olhunran capital and lhc gapbetveer exisring LcchnologÌ and
..,.r,1 , (ì,t I v.i.. rL,.r . '., ,t . .,\, Í-S. t \. . r

:.rtioìr(c.g.tcaroischoolingperNorl€r)nìcount4'l,,1isthel€velofte.hrÌologvat
''' .',. l r ê.1 .r lr . l rr". .l.r'
.,- t ì r, i). rl Jr'.r.\
:: llìcSoÌoN Swan nìodei. $€ 1Ìâ\e

:.ÌÈ Ì n cÌogcnous. ln tlÌe Nclsc!Ì lrhclps model, wc ha\.c lc.hnoÌog_Í in thc lronticÌ
rntlÍ grorri.g at rhe rdte.r .nd in tlÌc catchiÌÌs up countrics groifi.g ar a rârc Lhrr
: .ì.rds or lhcilap to tlÌe lrontierand onthelerel olcducalion:

L'1.
LL .Jn,] .r' I i, ' lt ,

I'J.o.,'Í) r lto. n .,rl,r ,,',/,

''''l .r r).. lli. ,r.r r''', r-â{' L r',' r' rrr'l rl.
:1.Ìrlnit up thíììgh teclÌÌìology diflrslon. t\ its tc.h.oÌog) gets cìoreÌ tl) the nontieÌ,
'. ga! tcrnÌ slÌrtr*s ard counúy l\ gronth rnlc.In lhe steâ.I) state, countÌy iwiÌÌ
so does
r...srowiog nt thc sanìe râte th! lronticr, i... + Ì,r'hi.hjmpìlcsthatan-vremaiìriìrg
as
-:it lo tlìc frontìer ìs .ccounted for b_\' thr ielelollÌrrnan .aÌrilal i. countÌl i. To put 1t
...thc. hav. country i s level ol technohg)_ in the stcnd,! sLaLc njìÌ be hÌgher (cÌ()ser tr)
r. ironlicrl, the hilher i! tlÌe le!el olhunìirn capit.l. lhc llst cmpì rkaÌ slud)' to tcst lor
' s Ììcchnnisnì in a.ountr] .(xs section tÌa erlork uscd gror,lh Ìatcst Ì78counlÌics
, cr a 20 lciÍ pcriod ând lo!nd that thi' interâ.ti\r' t.rm Ì{ns 5trlislicaÌll sigDilÌ.aDt.r7
ì rhc coÌrrcxt ol the Nel\oÌÌ ând Ì)helps theor), r1ìis c.n bc ln LcrprcLcd as seyìng rhar tÌre
:.1ljrn lo adoptlngnew teclÌnoLogy is râbed bv à higher lcvcl o cdLLcallon in thccoLúrlr_1.
r r slìnll rctunÌ to Íìftìels of te.hrÌology trarÌsler hÌ Clìapti.r Ì.].

Ìr.r rrribifa 5prelelíl99lr llìeeJlectÌrãsbeen.onaÌüÌedrnmoÌ.rr..ni\1fkIlÌff]i![rnaRog.Í

506

6 WelÍare and the Golden Rule

So IaÌ nÌ this chaptcr therc has been Ìlrtìe mcntiorÌ ol I'clfaÍe lconomlc agcnts 'leril:
utilÌly fìonì co.{mptnrÌ and it is thercfr)re ìÌrteÌening to ask whethcr consumptìoÌì f':
lÌead is ma-{irì ized irì the stcady (ate in lh e Solow Si!.n rn odel Although the sarings
13::
iÌÌ thìs siÌnpÌc Ìnodel ìs elogcnou\ ânil hence ln{ìeÌ)endenL ofthe dccìsions ol individu:
ajlents, irÌÌaillne lo. I oif thnt the poli.y nralier ìs âble to dclcÌmine thc salilÌgs
t^te
see Í'lÌlch saviÌìgs rate thc PoÌicv ÌÌrÂkcÌ would so asto nìr'
fhc simplcstway to 'hooseConstrmpti"
iÌrìizcco um ptltÌì pcÌ h€ad is in the í a. cìárd SokN diagram (Iis l3l8)
p€r hcad is slìoirn bI the dìslance betwcen sâvjngs P€rhcad ând thc p(Íluction
fuÌÌctL"
ioiìtput per lÌca.Ìl. \\ c iSnorc techrÌical P()grcss t() nÌakc lhe discüssion as staÌghdor\i:: l
as porsibÌe and note lhat thc rxtensÌon to tlÌc ca\e lritÌr lechrÌological lrogcss cìors
'
introdlrce any new fcanres. tn the stead-v stalc ecÌuilibrjum, the savings ritc' rl lll
ar:
the (ò + r)k linc nusl cross.'lhe polic] mâker iakes thc Pftxluctìo' íLrnction atlclr' -l
ô a! giycn and lherefoÌe Ìì!'cds to lìnd lhe levcl of l' at idrich thc slope oí the prod:_
tioÌì functìon js ecÌual k) ta ,rl TlÌe 5nvúrgs rate that nrãkes tlÌi'5llk')crrrc crosr i"
(,t + li ììne at this lctel (ifk !s the so-calÌed annde Rulc savirÌgs rnle The ìabelsli:
r::
5.r illdjcrtethc GoÌde. RuletaÌues
To shoi{ this aìgebraically,wc takethc n)ÌlooÌng steps SÌnce ive }inos that atthe
Ícii
strt€, t O, h'hich irÌplies sl ft'
= lò + nll',
- ìt tr straÌghtf(rward to fincl cotnunpL
'

.' íl !ll(À'):/{k'ì st{k'l:i (i ) iò+ lk' (11 ::

Il tÌr€ govenÌnc n \o as lo ma)i]m ize con sumption Ìn tb e erpress ion a bole :::
t choose\ r
h e \aÌÌÌe ex pÌesliof n::
is m.ìthc nr aticalÌ) equjvalent to .h oosiÌì8 À' to .s to m a\inÌizc I '

Figure 13,18 Ìhr God.n Rr e s.vinls Ídtê

 507

Neh.vcsÌrownhosto dcÌileâÌÌcxpÌeslicÌÌIor.' thatdcpetrdsonlyonl' l'heÍìstorder

condition ftn this maxinrìzation ìs give by:

l'(k )- Ìt +,Ì (1J.J.J)

rfrl $'e cãn lnvert tbis lun.tion ío it tlÌe irNrc6e tuÌÌ.1ìon) to obtanÌ an cxÌrre$loÌì lot
(hc
À,, - o(J + ,rl, where l. slancjs lor lhe Crll€, nrlr' levcl ol câpilal irtensit)'' thât is
.apitil/labour Ìatio that rìaxiìnizcs i{ellìre Ìr1 Lhe ecoÌìoÌny Wc can r1r(r'aìculat€ ironr
the st€adv-state conditlo'ì Lhe Golden R!lc savjngs ratc, which is given br'':

t na,
(Ì 3.3.1)

has to a.ÌoPt n has to

poìict iffccling tlÌc savnì8s rate thus
A iaoverrncnt th:ìt 'ollsÌdeÌ
NÌr.ther or nol i (the currcnt savilìgs Ìate of thc economv) is smalÌer or laÌger tlÌan J.
ltÌrc Golden Rulc 5av1Ììils rale) if it aims to ÌÌÌaxìmize the welfarc ol thc woÌÌ(ers in the
e.onomy. Iig. Ì3.19 compaÌcs t1ìe path lor consumPtlon Per catìta foÌlowin3 â rÌsc in
tÌìc savin8s rntìo fÌom 5 in cconomy 1 mch lhât the net! sâvings ratc, í > sG arìd nr
econonÌy 2, such that thc .er{ sâvings Ìat€ í/ . sc lhis shorls that consunÌptio' ter
hcad.Ìr)Ps in botÌÌ econornies iniliaìì) Lr!t it ür.]s up high€r in econoÌny 2 \\Ìhcte the
nra savÌìgsrale isbeÌlr$,thc Goldcn Rüle
Lls - sG thc econoÌÌÌ!_ is â.clunüÌalinia too nì u.h capìtaÌ ât lhe eapense ol currcnt cor
nrmÌtt1(Ì1. lhis ìs irhat econonÌiÍs nìeatÌ whcn they sa) that an ecolÌonry is
'I?d'rkdlll
tr.m.n'rl. lhe incfhcieÌìc)' aúses bccause tÌìc govenÌmert 'oul'l lowcr the savi'gs râte
io thc ìeleÌ suggcste.l by thc Goldcn Rule and eleryone ir lhe economy will be aâdc
bettcr off. With 5' : 5r. thc cuÌrenl generation ì\ ltorse off (hlgher saviDgs and kNcr
consumftion) and Í) aÌe all túurc generations sirÌcc lheir ronnunptÌon i\ lo$eì than
it rccd;e. Ii on the otlÌer hancì r . J.; then lhe govcmrnent may lvant to i'ocase thc
(he econonrl richcÌ
5avitìgs rate iÌì ordeÌto iÌìcrcate ìLúure consümptlon This 'ill makc
!Ì tla lons run an.l holscholò l\ill be abÌc to enjol highcr liviÌÌg standards at a 10tcr
rtagc. However, ìncreasiÌìg Lhe savings r.tc lo.lav irìll requirc hoLrscìrolds lo connÍne
lntereÍs the c unent alì d
less ìoday (see lìig. 1:ì.19). lhere is a üâde o iI betlvccn thc ')f

Figure Í3,19 PoìLt èrpermenÌ I rse n dÌÈ ravnls ÍaÌe

!! i' r!; Írrr b"a st
508

ftrturc generatlon5. Whethd thc goverÌrÌìeÌÌt chorÁes to rnisc the \nvìngs râte theìetotu'
.lepeÌìds orì thc relatì!e $eillhl it P1.r.cs otr cotÍnnption t').Ìal agalnst consuÌnPtion
tonÌorrc(. Since th€ brìre1ìts othigher cconomlc Sroi!t1ì and the 1Ìiglìcr lì!iIÌg tLâncìâíls
úÌ thc turtlìr€ rnight not matcrialiTe lor n gerÌeraljon oÌ two tlhetÌìer lhis is elc' leasibÌL'
depends oÌl thc politict ol e.ononrlc d(risìons.

7 *Extensions
'Ìhc ajn oi thls se.tion ls lo gìve: llavour oÍ oi the wav\ l'ì ('hiclÌ tÌrc SoÌoN S$aÌÌ
!Ìne
Ino{ìrì cdn hÊ e\tcn.ìed. Lrirst, it Ìs cltendc.l to incortorrt€ thc endogcnous dclcÌmì
rÌalion oì savúrgs: this ls .aÌlecl thc RanÌscy Drìdel and relat's k) tÌìe anal!\is ot cotÌ
nmftì(rÌ in Châpter 7. lìit itn'oh'es a moÌe nìathcnratic'llr- coniplcx fìaÌnerork oi
aÌìaÌ;s1sandìsuÍraìlve{ploÌcdnìÌnore\pecìaÌiredbooksoneconomicgro thandmort
advnncecl gra.luatc level courses.Ì3 ule shot! tÌÌüt thc basic iÌìsighis of the
SolcN-sirarì
nÌodcl Ìemain urÌ.hans€d once s'c Ìtìaa thc a$uÌÌìplion of 'onstant sn!!ngs lhc
sec

o d c{te sion nìos,s ho\! lhe nndcl mâ)'be extendcd $ üs 1lr ÌncÌudc taxation Thr
irÌ i
locüs here is on thc iÌÌt!itìon belÌirÌd these c\tensions ancl t1Ìe rcmÌts ârc PÌesentcd

7.1 Endogenous savings

TlÌe asÍnÌÌplion of a connant sa\iÌìgs rate plavs arÌ inÌpoÌtarú parl ln tlÌe Soìow s('aÌl
rÌodclr úr order to dcÌive thc ì:unl.rnrcntal Solor ìlq!ation (equaiìon 1:1 81, ire stirl olÌ
ìrom rhe resotrÌce.onttriilÌ1, $hiclÌ states that totdl oultut nÌ thc ccononìy is clivldelL
Ì)etwccn (onmnptìon âÌìd ÌnvestnÌcnt ll = c i Ii Now il sarifgs aÌe constant nnd
ttÌe ngcnts ln our econorn) .an eìthlr save thclr inconÌe or corsrünc lt' ìt is trì!ìaÌ to sce
thal investmcnt *'iÌl also bc a connanl ptu )íion()ltotaljncone ÌllhouglÌâconnant
sitvlngs rrtc gÌeatlt- simpliics tì1e ÌrìalhenÌitlcs oi ilÌe Sold{ Swân nr el it mal'secm
:r i |
'l ' rr J r'r8 i '-|
to cxpÌrúì (rh) sonre econoÌì!es arc rì.heÌ thrn others. llut we h'\'c not opencd up th€
qucsrìon ol rlhat {ìcter!ÌìüÌcs lhe lavingr ratc. The proccss h'herebÍ I'c tal€ nc(uú oi
hoir the savrnias rate alfc.Ls ecorLoÌÌìic tÌCntlh lvhiÌe kccling iÌÌ mi"Ì tlÌât ccoÌromì'
p r ." .. .l\ r'r 16 r'.' rr ''l r"r r- l
'. (
ü ìt\a|o1 í à ìX th t s tì t I 113s t4 t

'lhe idras un.lerlvjns this scctìon arc rho\e ot rhe optimal connunplion behiviouÌ rìl
ratir)nal agcnts, r'hlch s'c inlÌoduced it (lhaptcr 7 whelì
('c dìscu\scd ag8regilc con
strmttiof. The idca i\ that the lndi!'iduâÌ or househoLd .Ììoose\ the path oi pcr crpit:r
consrunplkD \o ns t()nì.{idrjze theirdìscoruÌtcd utìÌ1ty into thc future lhcreisno rtncer
Lanrtv irn{Ì hetÌcc the agenl can clÌoosc the olLìmaÌ co!ÌsumfLion path Íln'en thc capiÌal
accrúnuÌalion conshairÌt ol lhe econonr-v. SoÌoÍ'suggests tlÌa! tìre naturnÌ interprclatl!ì
of tÌìis is thatthe ageÌÌt is a peaiant lìorrsehold h'ith conlunÌptlon and production lakiÈS

I ato.drafaìúdidlÌrduìSpofin)eÌpÌor.rrednìLei{ì!rìr'il itÊratrLLr of 11"'mi' 3r*1dì il lrÌ

rfd!111 1 Virtirr 1100,1ì
 509

ìr:ì.c \rjlhjÌr it i.di\idrtrìtrLiibrtiÌr!inÌlìiÌ\B"s'rÌiore\'riftlsLntr'stúÌxLfnot'

ir,", ,r," D(trltl .rn ì)e intc+ìrÌ'tell rither r\ e \iì! 't thL't'iÌìg rl)oül h'r e rell
,ìrdrÌjfg".",
ntr iÌ tllnf,Ì \!!1.1 ìÌlo.ri r\ e d'i'rilÌllnn !1 h(n\ J maÌlcL
trn.',i,t lhcÌn!rl.1e(1].orn)l!h1:lÌlr!t\lì7rdridaLLmrrlttinrttlir'tion\
",.-o"t
ind iÌnlituiio.! rri nÌ.ll trÍrl
irìr'e rlu\tlì
for sLnrtÌì|. Lr. *" nl,l.tlt 1g..,,. te(h'oÌ!!i'il trogress ind laholl jÌl Ìt\ riìl rÌr irlcrtenl
tr
r.l\ ìlìN nì;th. nÌ\toÌd, Ì .(ÌÌ.ll{L(Ìì5.ltlìls 'Ì)tirnlTiìlir!ì lÌoLìL'Ìn
p.ral oPtnìuliLt.oÌ\liLlt)Ì1 1.,ìÌÌ.1 ,ì. trlcÌ c!lÌirli'nì thrl t!'ll! u\ ho\ 1'ì
hrLrn'c
'orì
s,,n,prlin t,,dat irr.-s\ arìd hejÌ.r ttxìnrr!\t I'r mort dr'LaLÌ !"
"3.,u,s1 'ì\ '(Ìr!nrÌrti'in I nì ihc
ir," i'.. i.,'Ì' thl ÌrL tholLl cclurtL" LÌrr ate ol !etur' t! :ariÌr!r' (ìl1lÌc
"pp,'*ri.
r,"*.,iì"u,.tr,,i,".o"tr,ÌÌ)t.Ìr'rhLch.onrirt\oltil'''Ìcnì'nl\: lì rhe Intc Ì)rrl
i en...l .lÌ,r!rì(lìlnrli(rl.!ilìiL (ìel. l11! Ls(o5lÌ\ rrìdliìl lhcLnfoÌ
'on{Ìtrìftn!ì
(ilt L' risi'S p'r (lfiLi rorìsrrÌfÌio'
ücÌe,ì5. ot t1ìc trrrI! nrl Lúilitr (ii rrÌìrÌrnÌrti!Ìì
lrhlclì rctÌert\ Lbe iÌlLrÌltnìporìÌr'la\tì.i11 'l \lbiliiull(!Ì ì\ \tr Ìlti rlÌerd\
reen ln
( hatir. ;. rlìrn I ir houÍ'h(rlds \rrL "n\rL ìfÌio' Ì-'t (innrrÌl i e I 1ì' lt
'
\LÌlrslituti'i
Ìrc !ÌÌrlr the jirìtlil\ j.g rinLDftion ltrrL the irìlr'Ìttn]f'r'l ÊÌ!slicrt\ tit L!

!!rLâÌ1o nnÉ,r' lh.ÌÌ 1|!'trlel (qtlii'n !rr Ò'iL(r: Lhc tolldiingl

Ìt .in Ìre u\.d iÌr roÌrj!|.tl(!Ì Ìrith llrÊ Sulo\ eq(rtio' oi m'tii' ri
hI t ptuìiL\Lì)
ìis.üs\cd. \\ r r.ìÌì theÌr \rl\ t ìor tlÌr crÌxilibÌjuÌÌ .i Ìhc e(ofrlnr
ì\ tlì'
"rÌsLLtÌ'tlo'
.ititi,l Lrrn \Lt.h ilriL , 0 rÌÌd I 0 1he Ìrr'harrl'\ !1 lhir iÌrt !LlÍÌr$rd rÌì tht
,"' ,".t ".'"ü Lhe ÌììriI rriÌrLt\ ol jhi\ '1ttrìsn!ì 1' tÌr' \oÌ1)r SÍrn trLldrl
ij,j*,t.r.,.,,,.r r"''o',rnrl tr.hnologiltl frr)SÌr( rIr Ì)r''tght be'l i'ro iJìL rÌÌodcl
"1r1*,tni..
.rlntr.'! riith ì.ìogeÌrotL\ t.ìrl.gr I t tìÌr(1 Ì[rt

ir tÌr.riÌlc.il..rÌ!fri'grr1ÌlÌ!LtìtrtÌ\rìlìtr'(Ììit'L intlr'\teid\ rintt(lrÌrrÌr(l:()'l\ on

j'g! rlir'Ì ÌlÌr
do't Ìr't
Ì!r ile oi l.chÌr1rL()gÌ.rL tio!r'\r' l "ìuSi niznÌg \r\
r 'eÌrtIiÌl
tirlÌ1Ìe o1 lhc S!l.n :trin ÌÌÌüÌcllhrt i\
S(Í1th '\o+n!lÍ
llr LÌrc Ìr\.lot !oLlut fri'r .aÌlì1r !lel{'n!li on coÌrsrtÌÌjrtit!r htÌLn lour Liu\t i! LÌr thr
sllndrnl SoÌo1Ì 5r r| Ìì.dr'l
rl) .rÌlhrn(,ìd\ nil{'grnLLh})illr.th(ìrLr!'olrrrlrlx\riÌr\'5ÌiÌtJ]tÌ\'on\trrìLaÌ
u'Ìllg r CoÌrb Ll,:'rgìr'pnircLlrrLtLLriti'ìf it'r'Ì)i\ÌrrnrÌrthiLhillrLrtof{tÌatioÌr
1hi \icr!l\ sLrte r'(1'1
rror'jrn rnd LcctÌlolrric.'.1 Ì)bgÌc$ r iLre llì' sr\ iiSt I'!t iÌr
hiSrcr !1i\.ourúriLcrtdü.e\il
: 11ìiri\i'tuiti\'Ì\ p iÌLìLrl'
f il eq! libÌirrD the fLrliÌnrl sa\ !ì!\ !Êl]I i(ìr ']ot: "t rr't\:iiiL\ rìr\irniTc
r(Ìri! ÌÌiorler!,ìlitr tlrLtir iÌsti!tÌ!etrinì!iìtLtÌr'rr\ihcriint\ 'n'ito
.uut,n,. utt." geÌÌtrilr(Ìl! L'irrnfn'ì\ \ietc {!rntiÌ PìtiÌ'
",,lt,..l,ensÈ!lirtrl'
'nif,,\iirrn\rnf .rÌri.,lrlJr:!in q':Il rrilri\r" rrr:l? \r_r rì L ntr "iii' n!:ri ll

I lll\r L]?Lr..d'., : r, lrii Ì !r rìrúi

tr\ :l:.1 r. r'1, r'! L ì nl''r''Ìì:ílúìfrr'ìrLr!2( r l ir "Lìì" t:r:iì r r \Íì t
5t0

I dr ' rpu | 'r '

rr Ôotln or 'J rnÈ'
."-., ,, rr.', ..- , c)4 lPi lol ' i -
'" '
to llÉ Llnttsh econonìi\tIknt
'lheÌ€ are selcraÌ rcasons wlÌ-\' this lnodet (oÍigìnaÌly clue
nÌodeuini' lhe fì61 ìs
u,,"*", *, n*-* ,n" ttatrdad haÌkhorse oI rÌÌacrocconomicsoros'-swnn nnxlcr ror
;:ïÌ:l ;";ì;";i;;i arLo*s ror *roe crtensrons than the
and ertrore
J;j,i,,,,'' shocks in techrorosv or ìn pretercnces'
"ì:;;i",;
'" 'ntrodúce
,,. ". i ,r't ^r r" rr n\' ' r "
it ãvoids the asgÌ€sation
ìïìi"i -ì""i t .'n"s.anrl r'rgtn srorvtr' rn acidìtìon'
r"' n"'r'-\'o'nIr'!i
"l:,;-.,:'
i.:;,i;.:
"'u
;.; ',, ,. \, , ' -' r'"
",,h , 1 o" '' i
'",; ."ì,..; ,, .r'r , ' ' r" " u'r'" / "J
alìows rtlr the anaÌ-vsis ot
RanÌse! Jnodcr also
lhe
,,ì;;; .,"-- - *'h a nr'rcìel
from one íeadr'' state to anotlìcr''lh1\
holl lhe savings râ1c chaÌÌges on the transrhon of ltrnc pÌ€íeÌence and lhe
the p rctercn'c ta rarÌìcters the rale
:,'.,..I.
h a\ the consc.lucncc that

,.',.:,.":

taxation
7.2 Economic poliry: government and
S('an m odcì a veÌv Í} lìzed
h thú scctÌon s e ilr\ estigate h o\{r t() iÌr tÌoducc iÌì Lhe SoÌo!\' rt"-''" r"v r'
:",' - ' ;,-.' ."'r" ,nr'\ ' \'
;;,, ::.
,..-ì";- ;. ''""\
''r' "r "'
tÏ';,"ì,'.;";;..nì1he'ftermatholaciviÌs'aÌ^sronsthceconomicilnpact
. , '
",,'t-'."
slro' l"' plo rtr ''or 'r"n' B r|ilo'sr^ ' " 'r'a'_"ì
ol the ciononìv iriLl havc t'ì dilide'ì cacrÌ teÌjoi
ì.,*iììl,ìì"r"'.' ,n", ,he rcvrLrrces spcndini
;;";;;";*,.. -"ìnss,aodthcainountspentto1ìranccsovcnÌìeÌì1
ï,*" tS ^ nc;ne rax,r' thcu lhe budgci 'onstraint Ìs gileÌÌ j /l(rl =
b-v

'\'l ,' ";"

"t,,ui"a*,
'' ^rt ' rl 'ü'J''
'
r"'l
' " ."'.
l,r r',"
,

'(, - 1l 'ìsf' ôKr

lhe cquatìon to ob1alÌì lhe lìundanÌrntil

an.ì $'c cìivicìeboth sides bI'A1l I aÌldÌeaÌrange
5pcndi g:
5oìoú, EcìLlrtion ofN'lolioiì $ith govenì menl '

i, (1 ')sl(ir k(,j' I rì)

 511

',. !tr. i.ir th. rlluilil)Ìiuúr Ì. cìnI.ap Lol feNorler iÌÌ ellìcjerÌct L!ìÌt\ a.Ll o ourp!l
iÌ \oÌko o.lhrcubb IÌ)ughstnrlur(iol]tun(tionl

11.J.17ì

i:
=r -\l I

\,Ìi.e thrt 1,)Ì rnì Si\en Ìrlue\ oi\. Ì, xnd,r, en if.Ìfnsc lr - ilnpLie\ a redurtirnl
irL.utÌ)ui fcÌ.:afiÌ. in ihe 5terclt strÈ lÌr l(61 th. samc nir ns n rGt in ihe !!ing5
rin'froc[ìce! a lÌifs t.rÌ rise ir] the Surth ÌrLc as tht r..no.r\ Ìr.!(s onír the Leit
I otrth lath al hLsh.r luttlt per.itit!, e.ut r. LÌre tar ÌrLr IiÌl prod!.e tÌìe \irrìe
iiie.t. lÌÌe rrlLdLLt oJ thir rrmlt cÌrÌÈrÌ.ìr on thc rsrunìrrion rhrL .onr oi t1ìe ouìer
r,.ì.dlreier5 oÌ llrr:.ìr:úeL chrrÌ!e5 sith t.ìrntio. (lnt rcrÍ)n rnrl gollrn.ìcÌÌt !oli.!
Ìrillrt dtte.t lìrc.rod.L uÌro!ilh lilleÌent chennrl\ LhâÌr rh! sr,elglrtlo !n..1 iÌì.cÌÌÌc
:Jteci modeÌlc.i .Jro\ e h.r\ to !lo \ itlÌ the .l€gtrr to r.Ìrjch co.rum.Ìs erc lon! \ithted.
It Ne en.togr.jz. sarjn!-\ iÌr tirr $!\ jrÌtr rìcd jf rhr ll.ìmsc\ modd, Íc rÌrLsÌ assumr
ilüt con\uDcs rr!. iorl.r lúliÌìit ind dnLj.itrtc coÌÌe.LÌ) LÌrc trtLrÌ. laÌ(s lht! riLl
[L\tt!fâ\.Lhui,ì]ilÌe(ortrunrer\are(.Ìr\jf.rÌÌthatataxÌeductio.t.di!nill .ìp]!
hiirlÌeÌ ta\e: Ln tlr. uture.\iÌì.etheSornnDe.rrLillhr\rnrref$,itl.ìcbr,rh.l mglìL
drúi(iÌrrte th. i"LLr( iiÌcÉase rl i.r\È\ L)t il.rea\jn! re\ì.tt t( a\. Thi\ Ìs a..ìrÌìflc
(ìt í) .aiÌe(1 rìL.inliarÌ e!Lr1\ tìlerre rDd 15 dìrctrnÈ!ì in m(ìre (ìeÌrth in ChrtLcr ô a.r1 i.
Ìhirr!iÌloI;.tin\Lìtten4)t\t(ìrtirmrl.lteiteÌÌÌroÌJr)€ron.nìcgÌoqthrhÌoügha.trti.

8 Conclusions
llÌ.\nlu\ 5\ìnnod.l f.\i.].sit.r(nLlpLìitr,rìlrÒnìrrhi.ht.b(!nlrlnud\ot
ii rit\ to
e.oxorlic gr.rrth. Tlr. Lìiilc nrod!.1 ÌÌ Lho!t te(lÌnologi.iÌ trogrcss 5hor\'s ihr
(r])it!lrrcumuÌalion is tlÌ. cngifi o: groÌrtr], i\ dlnirÌi5hin{rriur)s to.ipit.,Li\ eÌrtLr.ìLl\

. \((idr\trte!r)rrhj\.h.ìrrctrÌizLrlhrâ.o.sLrnL.rtltrl .ÌrlÌrrrtrrL nn.(l.onsli.L

rS( and frohi llÌare\ j. GI)1.
. lhtÉi\n.Sr( r'tlr o t!.,.iflli GL)lj
. .\ Ììtt j. lÌrc atln!:r iÌlr r\iÌÌÌrÌÌ r.ì te or a t.ìllnl tire Ìr!l)uiatìoÌr !nrth raÈ lca.Ì\ 1r)
s

r ireri.!i (ìurrn! Ìrlr .h !D1' p€r ..rt)itì Sr)Í! .ìr .L .o.sr!udÌt t)i thc iì.rcating .rÌri1.Ìl
lÌterÌ\it\ or fÌodrL.LllrrÌ, b!t !írü tlL r\ eÌrturll\ .Ìie\ (rÌt br.aut otthÉ n)Lr otrÌlrILnLsiri.!

. Th( lrL.l !1 !!tÌrú riÌ ..ìrrtr n tlrr 5Lriìrlr sraLr li Ìr {Ìr.r, L:ìr. lli,rlÌ.r i\ trÌt s.L\
i.g\, ÌrlcsLrÌdÌ\iriirc.rÌrtliÌrcl(!\.Ì.Llr, ii.i|l:]frLaLl.fAÌ.,r'ih hr nÌl]l.Liieriiii\
lircÍrr\ ih!. diiilÌirÌan1\ oL HhcrhrÌ r úu.1rr ls 'i.h .Ì D..'
512

. liseidenti.aìtoaÌìchone.x.cplthalithaskNsavilÌgs(.ri:::
gultlt willcatch up to thc rich one ii ì1 Ìs ablc lo Ìaitc the raviÌìgs ralc Ll.1 .
^pooÌcountrvolhe
pop(latìon
th€ poÌtulatidÌ i+os'!h rate) to equaì lhat oltÌÌe rìch couflrJ. Thi5 ls lnowÌÌ as 'ibí' :
conlcrgrnce . c.t.bi.g up takes pìacc thttrìsh a phalc ol rjsing .atital nìtensì1J
jr :.

. dy'state chariì cterisl !cs of ttÌe poor cou nt {' a rc di líerent tìlrnr I Ìr ':
As lorìg âs the \tea
otthe rich.ountÍ), the p{Ì)r co ntr} $IllÌ .o nlerge to ìts oìÌÌì n cady s trte: it $ilL nol .ô::
up wiilÌ th. ri.h one. lf lhe Ììch and the pooÌ country are bolh awa) fÌom \t€adl 't::.
gÍ)wth, thc tooì counttv'' iriÌÌ onÌ,v ilrcw fasteÌ tharÌ t1ìe rich onc il jt it initiallt Íurt.:
fÌoÌn its owr stca.l) stalc. Thitis knoìln ns '.on ditiorÌâ I convcrgcnce'
. Ìl the go! erÌì rì c nt i!.r blc Lo keet ì aisiÌìil th c savlngtitrvest ìeIÌtralc(c.3 ìnapLanii:
cconomy), therc lvìll coÌnc a poirt at whi.h thÌs Ìecìucet well.re ln thc cconomv. i!ì_.-:
tlrìs is mealurcd bythe Ícad-\' state level ol co n ÍuÌption per hrad. lh. savirgs Lrtc th::
nìaximizes conÍrmpt1(Ìì pcr hcad í kno$ÌÌ rs the GoÌclen RLìl€ ratc.
lhc Sold{ SÌ!ân rno.ÌeÌ ÌnuÍ bc nìod11iecl1l it is to Ìre consistent with tlìc sqrÌized i::
of neady g(rwtÌÌ in pcr caPit. GDt']. lhìJ is ac.onrPlished b| Ì(l!ding Haíod ne!i::
teclÌÌìoÌogicaÌ ptui+css in the odcl: i c it is assumcd Lhat the pÍxhrcti\iitt of ìabo!: '
enhaÌì.ed b)' improçcments in t€chnol)g-v orÌ thc cxisting caPitaÌ stock thit taÌe PÌ.:
at ü.onslant exoileÌìousl-v gi\enralc lhì\ DúdiÊcntìon aìÌrt$ tor bâlanccdgÌowtlÌ sÌ:
rislnll !ìt)P per capita. The rÌìodel prcdìcts
..ondìti{DrlcontcrgenceinlcvclsotGDfpercapiLaifcountriesdiiferi'rLhc
cÌìaracterìlticsthaL pir do$nthc Ícady \tate and
. absolutc conveÌiiencc it the cìeterninanls ofthe st€ady state arc ìdc.tìcal aci'rss

. Ìnrhtl(üg n, (hc mod€l predic Ls conrersen.c otgronLh Ìates olliriÌìgnandaÌd!

acrcts corntrics lo tÌre rate, -!, oI c{ogenou\ t€chnl.aì frcgìess

When tlÌe Solow-S$a modcl t'ìlh eÌogenous tcchnological prcgre\s is lcstcd usúr:
cross co ntry grolllh .lat., nn inconsì\tency enrcrgcs An estimate 01 the spccd ot co.
!ergence..n bc made i t$Io wnvs, either b)'plugging.a drtr reasoÌÌable valucs ìnto t.:
f(nnNla l.ìr 1,, lhc speed of conlcÌgence' oÌ b]' cslirìaLÌng lJ econometü..Ìly lronr ddi'
The.lata suggcs!s that con!crgc.(.c ro the sterdy-slate path is Ìnuch sÌo\íert1ìarÌ cxptct..:
b) the â priorÌ ralculatlorÌ. tlv aLtgmentnrg the 5oÌor'-S an ÌnodeÌ i!ìth th€ iÌìcllrslof :
/?rrr.rr rìs NeÌl n5 thlaicâ1capÌlal as a facn)r oì prodú.Llon, (he ircoìrsìÍetrcv is rcdu.r.
combÌred humen ancl physÌcal.npitalhasthe elíc.l ol lncrcasìng the drâÌe ofbrold.if
ital üÌ o!tpul and hen.€ i. h'ralic. ing.linnúÌrifg rclur.s Lo 'caPital'. This is conslstc|:
ifith the slow$ rttúnated sÌrccd oI conreri{encc and providcs an accouDt ofthÈ palLcÌ::
ol cross country gulth in 1cÌms of conditioül .onvc rgc n cc.
llr.' iÌìtrodrrcing the idra lÌral educati(lr lPeeds Ltp Lcchnoìogv úansleÌ. we hâle slìo\iÌ:
a alterÌralivcmechanisrnlhFughi{hichpolrr.ounlricsÌìa-ÍcaLchut.Lle ilthctccÌì
nolos' ironLjcÌ gÍtrvs ât thc cÌogcnour úte r, it Nc lcìea thc SoÌoN Swan dsnìInptl..
thiìta..css lo ne$ technolog-Í is unn'tNaÌ,
. count.ics ca. catch up b)'adotling nÌ)ntiei te.hnologics it thcir Ìclcl of educ:ìtioÌì ìs
 513

. llÌe \ie5t (ltcL up ìj Ììre.Li.ird ìn .oL1.tlics LÌr iL eÌe r Ì{!Ì! s.r! brhlnd Lhc lront cÌ
b!i lÌ,rÌ r.ì lrigh l$ (L !l idu..lio.

l hi\ ir one talrn 1!hr ecoDoÌÌÌj:ts Lìrrdictr.l thiÌL loÌne tl)rnrer Ir]rnned r..rÌü]r cs
rolìlll ..rperierÌce tu|id crtllÌ !p 8Ío!!Lh i tcr th. iaÌÌ ot (oDnnunisnÌ ri tlÌ. brgi.
.ì.9 ot Ìhe l9!r{lr lÌ(ü'É\er. thet un.kr.njnÌrtcd h.r djih(uÌt it sould be to.Í.alr
rìre j.stitutl{)n\ that rre ire.etnr\ lor thr .tl..ti\1'lun.rjo.i.S !t crt(h !p iÌì n nÌ,rrk.1

Ìn Ì)ite ot thr ìnaÌìr inrislrts it pro{idcs. tb.51rl.rç Sra. uuÈl re|riüì5 s ÌrnL o. th.
iLnrdnDenteÌ Llue\ti{)n of uhrt lies bchirìd thr stcadl Ìite iI ÌìriìÌ! Íüìdiì.d5 .bn'Ìt.d
i,)Ì manv countrie\ o\er the pl\t lÚr.c.luri.j lhit tuzrle hr\ iLrclkd lhc s{ir.h ti)Ì
moLÌeÌ\ oi r.dogen.u\ {rortÌÌ xlÌiclÌ nill bc addr.tst.l irÌ tlÌe rrl\l |.hnllcl. L. thc .ext
rhrtL!Ì rr. nralÌ rl!r .Ìch r lleeprr iÌÍo morr Ícr. f1 11ìrÌ\ orÌ tlìe e|.i.onrl.s .l gtnlÌh.
Llrl! iìl.rrs ui t(i j.rcsligrte h.r iÌrrtit!iions r.ngirìg íÌom erúreprln!nrial ll rDri to the
fitc.t s\'!ttnr. Íom th! c\tent ol.!r]4rriit rÌÌÌ i. Lh! |niuct nìirkrl 1(r 1lr. jl.rnciaÌ
s!\LrÌr mr! ln ltrcni: !n)Í rh rÌÌl .dtclÌ !p.

QUE5Ìt0N5

11) ln lhÈ\oÌLr\ 5ü rI ÌÍr(l(l(\l aì. r hat is Ìncant bt n stieLll slate rheD Pof! irtjo. is
r(D5t:nl rÌr!ì tÌrerÈ j! no t(!hnrL.gi.al ÌrroSÌt55 l\t!f (1 thr..iceÌrtio ihe !r5( i.
rìri.h lÌrc Ìr.p!Ìatnlr Eritrj.gât r.orsliÌrl*t. Iìnì.rrh rìihPrpi\IIri.\ti.
^
ritc o tcehnicaÌ f hi{re$
p) 'ììt.Lo.Ìrfiri.iLm!rs!ÌÊrÌerrt\()l\.1.r sr.nLì!!Ìtel trsi|()utUretrìe!l
t!.h rrl.gi.alfr.!rcss rn ecorÌoìì .31r\!1hl l\ hrt rr( th.ìr ihoÌ t.oÌìjÌrirs ll
.rLrtLÌ,irì!tì. o L o t.ehÌ!ì.St l
(3) lli(trÌIaúrÌÌ fu(ÌÌr b og) is ri Liltoltatrt.orúrj tLrnre.oi,rfj.!turthiÌ1nÜletr
ecünoDIe5. Dìsi!$ lr.Ìr !.t r oold nea\!re th. mflrt oiìÌú1r m.Li.. tL.hn.lo!\
on econoÌni! !rr\Ìh

{4) A$únr.lhrtrttjÌnrzeÌoilì!r( jiari.lr.oúll[ aÌnlrÌ]ìo.r.orlÌÌt ÏQàtu'lna

5.L.wrÌo dwilhoulte(Ìrrririì ltuSr.s \\hcÌrthe.(nnìlri!!arÊ!b\rr\ellrir ito
datc. th!rc is no drllÈren(r i. tlì! ila.dird.i Ìn nr! lÌ tÌL.c. the hr'o ro!rÌf lii ls this
.onsistrftÌlrtìrld)nbr.,Ì!ir..n1.r9...!:ròr.!Dalil1r.r.(!nersrnrel5fr(lt)i.ur
a$trmìrLr.Ìr5 rbouÌ tccÌìn,rL.!r. Ll.drôl]lrÌrhl. t!\te5,ì.d tolicl.
(51 (:in shÒ.lis l. t..hn.Logt e\fÌ!jri rrir.r\'.r).omic1ol.ìti it\ l
(6) 'Te(hroÌo8) rrfrrirì\ thr d.miraÌ1t eÌri{jÌre oi Sr otrtÌr,1!ith h!nL!ì | iìfìl i
nre5tÌrentiÌr ie(oid lle..'rlìt)lcrt 5!Ìoü, \!)r I'rizr L-e!ture,1r)Elr l)o).tLaSÌÈel
hp]"iÌÌ!o!Ìrei\oÌìing

' a,?iLdt.Ìd!l! 1aii ÌìlLì ì,xrL.\rtÌrrnÈ1üÌI.!iii,irr1Ìr:,1?.lDiirn! ìi rÌrii'fr.if'\l'jrLi'L

ftrhlliÌrrii,,iiirìmrL.r.rrni!\t'ri:r.,ir,inILÌL,tfr\rfi.!L <q rÌì ! :. |5ri:aúirì:rrì:\\ir.I
514 .. r., ':. .

measurcd peÌ c'ìpila

(7) Ifrhc saviÌÌ8s rate faÌls fomrnc.lly, whât hãplens towcliare as

.onmnption ìn theSôLo( St{an modeÌ?

(3) U5ethc aÌÌaÌytìcaì looÌs acquÌed in thìs chaptcr lo arÌaÌysclhc ìDtrodu.tion oIa
wellarc s-rÍeüì nnancedthrouglì tiÌatìonoIì the lorÌ8 rün pcÌIdnÌâÌìcc ol the
econoJny. Does jt mattertrhether lunìp srm or proportio. aì laaes are

Problems and questioni íoÍ discussion

QUESIÌON A. ln tÌìc solow nnxlel, asÍune thc ccononìl' is lnitiaÌly in a steacìy Íalc 1n

whìchthcÌe 1s no groi{th ofoutpÌrt pcÌ capita AliinÌeIlheÌei!:ì$ddenfalli thc

g(Nth ra le ol tlÌe poPuÌation atÌd Ì1 remaiÌÌs ai !h e treÌ\' ìower SrowtÌr
Ìate Descrlbe
rlhat lÌappcns to ou!Èrt ilÌowth and lo the grorÌth of living sta dards Ìn the economv
an{ì !!h},. Now â\sunre tÌìere labour augmenting technicrl PÍrgressIhow 'loes that
js

altectthc grcwth oí lhe economyir rcspo se lo rtall in thepopulatjon growth

QtrLS llo\ B. Con sicler an ec.,no my Ìlhìch experierì ces civil waÌ tkN wiÌl l h is lfÏecl
theshort run pcrfonn.rcc ofthcecononì-v? Describethe stcadJ state to $'lr ìch the
econoÌny Ìetutìs afterthcend ofthe civil$aÌ Are tlìere anvlong rn effi'cls oícivilsaÌ
thal nravalfecL llÌe economvnrany veârs aíteÌ thF 'iviì wârendc'Ì? lÌlint:LlisclLsthc
eflcct of civiÌ r'aÌ on human capltaÌ ) JBackgrcLìnd rca.ling:lìor the long run effectsol
.ivjìwals Ghobarah, Huth, an.l RusselL (2003).1
see

QULs I ION C. In an econo nìy characterized b,v a CÔbb

DouiiÌts prod uctnu hrncl ion
and exogenous Ìabur augmerting technical prc8ress' labouf\ s1ìarc olincoÍìe is 700/0

and thc .lepreciatlon Ìate is 3olo Per annum Ìhceconomyìtintsteadl strtewithGDI

gro$(h aL4% peryear and $'Ìth a capitaì outpulratioof2lúr'tuÌesavingrateandlhe
marginaì trodu.t olcapitaì. At tiÌÌrc r the \!1'ìÌìg Ìate in thìs econoÌrìr'' increases to a ne$
corÌstant ìe!e1, \{lth tlÌe ouLconÌe lhat the economy conveÌge1tu the Goìden Rule ícad\
stitc. ivhat thc new savingsratc, capital oúlputrâtio' andmâÌsinal product ol
1s

capjlaì?Use diagraìns Ì{ith tinte on the ho.izontaìaris to sketchthe palh ofth€

capl[a] output rall(), the marginaÌpm.luct of Ìabour, and ofcoÌNunpljon Per eff€'tì!e

QUESÌÌON D. Us€ thc models Lhcussed Ìn lhi! chapter to expÌorc lhe Possiblc
inÌplicationt f(n groÍ'th in oLrlfut ând ìÌì output per capita ir,\uÍraìia ofthe dala
presenlcd ìn lis. 13.20.'?r Usìngthe right hancìscalc' the clÌart shoi!'sthe trerÌd Ìi the
feÌt11it-r Ìate (the ivcrage Ììumber ofclÌlÌdÌen born ïô i rvÔmen in heÌ htetlme) McanÚeiì
agirinsl OreleitscaÌc aÌe shown (r) the ralc aiwhicb girls Í.ìy on lo thelìnal year

rr w.JÌr!tÌaietuÌt.ìstoveDorvÌi(kttrgeneÌoudvPÍrvidnrgllrirdìta TÌle50ur"rntrthedâtaare:PJrtir!Ê:
Rr\rrveBankorÂuÌraÌú, AunÌatrfuìtctn.ÌiLsrari5li.s l9ó1 96;1uÍnÌlim ÌlureruolSliliriit\"l ab'Ì
_
rion:
Forlc rInÈlnìl1t97 2(rl)l FeLti!iiy: ÂrÍLalian lluÌèau.I5taiitìL\''BiÌ1hs Au$rJjr'ÍC'l ro 3_lo1i)l l'h''
Ken'ra'. rrd \l.Leod (2ol)0).
 515

F?niLe pl!.rp:Li.! hLe

r!lrt\.ale,IÈÌaÈ.Ì.rLÈ

Figure 13.20 :.r tr Í[ !r.,ì ;.d t!,, : : d!!!' i,].: pi,1. Ì:!Ì c r r$: : i

l!erÌ I2ì (Í \ecofdiÌv cducatn)n and irl thr leÌnale püújcìpatiorÌ rate itÌ ure Laborr

Tãble 13.4 aLrP J. .. r r li,r Í!!.1 r :lìÊ rz-'.h Fl-"pJir .

f,rilìr5Í r l!!r5 a..:!ú21LL:r,.ral! = ralr

:1. rilÌr CDt

(ìl- LSTION I Thc daia 1n (lDf per cirpit.r reLati!e to ihc LL l5

the TabÌe 13.1\hor! tÌre
r\ erege a.ljrblc.l orfurchrsjngÌrorLeÌtarlLvnrthereirionsoltheaire.hÌìepubli..rÌi
AustÌia nÌ 199''i a.112002 TheIlIz5ilcÌiaeÍtetrqualt!1íl0nÌ{.1Ì\err.\otctl]rl
the \ane fuÌchâsi.g fower paritv ú trÍ:d ftrÌ rll tÌre resiortr ìlithúÌ tì countrt. lÌ!\ ftr
{ concÌ5c .tc5.rlfLlon ôl rÌrc datx ÌrÌ6cnlcd i. TabÌÈ 1:1. +. 5ho\! hoÌ! thr corÌcefti !J
aÌ)í)Ìute ând.ondllionxl ..nr ogcn...an hc u\ed Ìo ditcu$ the e!ohúntrr oi lì\ iÌrs
sr:f{]rÌ.1\ | Ìh.i. r\Lô.ô1inlri.\
516 ,: ':
.. APPÉNDtX

oitÌìe non
Ìhc aim of Lhi âPlì.ndir n to pÌere't dn
intrìdtrrn'f i'i sonìe
'orìmo tused'oÌ''Élìi'
ard re.1ÌniqÌr.s in thÊ rraLtÍs ofc'ononìic 8r'{tlr

Propêrties oí production íun(tions

11. -,. ' .I ì
, t" , ,, "
" "^,,,''
njDftIlLÌcLionlÌctrâlsnÌ|ìe.]jnlooutlrrlts'ÌÌì.!.lcrLolìakl|..gÌlÍhoÌ{ercI.jtìl.ltenuscillÌÌ
":;..", , ,, , ,,,"', \ th'o'
rLuì'Lidr in
;,;i.i;;"' 'Í.\t 'onln'Ì''v úscd rí!ìr'rion
;il'iï;iì, (lolb '('norri' s'nvtrì
.rrÌìrtlrÈ ","pndu(rnDt'nì'tlon
LÌnr8l,n
';;i;:'.";;" nrtechú'aL'$urrnn'ronihefnrdu'ri'n tu"ú'ì'whnìì
aF 5tr'rnrtr
'.ìi;'":;
l'Ìl(!lLrctionl
i1i Ii0 = 0,\nìi.lrÌìe.nstlÌaLi!rlutidÍee$entill

1
l ''
.aPiÌn!crnbrÌ{rltf iÌrdlflr'eniwâ!s:
(1.J.1'
l'(ll = l((K ll:MrK

l|dlhJrthl..[(inir].lt]ÌePhductÌontl].ctionin!.s0\dimìÌnsìììÌ1i]lelul[LofâpitalindÌe

(ll lhr so.rììed'l.rrlr'onditnnÚ l

(,rÌir, ,/ rr=!
Lhr lÌìi{l! ftotrÌ ihe peÍ|rú'rc oi
rlr.r liÌu - f 1kl : tl. he iÌn p'rtr "' oí
L
'o!diLnÌÌJ js thrt nìe) r' !Ì I tÌrat i {e'd} í'ii
'"' .;ï",ì,1',;;- ,,'" :.,,',.;i.5 o! trÌc sotúr sÌ'|an rnrdcÌ 5

tÌ1( r'od!'tion rúìcrnr r

ì.:,,'4,.', ', " "'t, (j nh!ÌÈas tÌìÈ otÌjÊr tf' úLer !rth' rÌradtr conrrition\ ÌúLe !ur
".':,';;'
:ì:ì.";i "i ., \tcadv Jiat'c n'fth
J at it n trLrr!- s

',";" "* u'",,,', '''rc iìì€rc is iÌ leist!'e \t'adv rnre L1ìi5ltlrb€conÉ tL(arr!n't
" ',i,,ì.,.,,ì,
.j:'."
.t
''-''n! ilÌ'$tÌr âi e iJlL'ìt€d nì (:hr!i'i I l 1
ì't"
"ì.ot.t,- -,ttgtt*
Rdurnsio scâle and ÍetuÍnsto a ÍãctoÍ
tunú la'Ì! olten \eem ur N Èn tÌì'u3iì
l lìe f iíl€rcr.e beiweú Íehtrn\
nr t'r lr aftl re to r
'onlrrr. 'g
' nttdìPrr'anÍ.rÌ1r ú (1rÈ ro dì€ ern''t
-",,
;,,:,;à:,ì;.,'....l,".,'"",\ir'
,;. dÉÌinsuúhrLrr' Ìn
." ., ' " 'n
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:.R.th.rihm]$lÌÌnÌSiheln]di(nLdi(irnüb.ltL'i.]lLe|]ìtn'.ÍÌJiesrÌloú].bÈtol$lDlilútJ{e.(l\
-". .ìi',. ,.', ,". ..," "' *" l{nÌtt6 rrtüis ('r5
(Ìê'r Lhú$'nrdrrnNtrÌn\eotrpnarÌL'LnÌrIrL
,.",'',ìsrr -'nìs' k itÉre i anì"4Èn'r\ rÌoÌlth oÍdti!1ÌrÌo!o'rtlìerr'\
,ì,,ìì;;;,,,;,,,
 511

I
Figure í1.21 ;.n l

rra,rÈt,i.r.LerìtrL r\ltrrrii!rL r.:|r!,!:r ,., ftli. \rr . r:...nr.rìjr

n:,tL r,Ír , r,
r. rirt' r!1..,,!.ir,Ít!.,)rrrrlr, rrtr.jiìrr i lrir\r1trÈ.\,Dtlrrl.ì-:.|,".,.,",,",,.,;
Ì!ì::.i
.Ìri\ ,:lir: iir,.È.j ílr:4rrL,:rr:!lrllr!r,rr!.r-!IL.r \\,1 tl.tr!ìLr!.irrt,|:!!lr...n.rÈrlÌrf

r|,rfn lrri t,lÌ err! fr.( IL t.u:ir.Lr :L I j..ÍL

..:,a!,rli.liÚ!rL:re,r Lìì rr..nrDr Llr.,r.rÌ.|,r lrrsi;:ri! :iÌjrdLl

'Ìrri,,ÌÌÌ,,r!.rllr.r!!ÌLÌr.,ì:ìrrr,ììjLrfith.hjrrr,rA,rr,",,,,,,,,,.,.,i,,,,,,.,.,,,:l,,,,,,
r!.,ÌLLrlilili:.,0rj.Ì:jrtrnìfrr\Nrt,,!ir.qrtì!r nr.raL.tr f!!r t\urrrrLrÌ| rrr,rirrrr Ìr,
rtrlrrÌ{r rrir\r!L,r rlril rÌL r.i. rr tr !.j ì!trìi prr,.,,,I r.,UiL.
. rt, Ìt\ i'r,.r.i,,1 ,.r_r r,
).rriÌrlr,:ìiL(rsrrL.irrltr r.,5rrLL!|trr..ir.rÌl!\ilÌrfLrll

',1 ì.i-lrr\..re ìrr.rrrr|rr;tj.L.jir .rj.ir!rÌr\! !tr.Ll,nrq L:)tzeLl .:Jr i) .tr.rb!,

' t|rilt.r lÈ\ Lrì 1,r i! ilÌ: .L rr.Lr !,.tÌ,r. ,í,t,.,.,,,.rir1,.rrnra ,, j.
_1. Ì)it\
ìlfrÌLirr.rrh.firL..rlt,jiLlltrl rl.. r\Ì:!.rrlelttlir\iì. Lrli Ì

.
,.,,.,.,,.,, ,,,",i;;.':,;,.,iì.,ìt,'ì;.il:1l;:i,.tii.,,l,lili..i,ill,ili:i:lì:ilìiJtltllìlil
riÌr.irtlrrlrÌrt\i1,LriÌrt...,:trlri,!.S!n!rìi.rLÌÌltr:,,"t,,tt,,,L.r"ltnr,it.;:t_
ReÌnn3 Ìo (àle ànd hoÌnoqenÊiry
518 -'I r'

êL

FiquÌe !3,22 !oq!in15 LusÍaun.l th€ Íeturns t. t.r . PrÒoÊrty

nultitlt ea.h ol lhe ârBúmúts Ôr lhchnr.úrn lì) v ìrn.n zero.r.{anÌr. lhis 1!Ì1(Ìirnr 1ssâIdnrbe
hoÌn!ileneon J.l de8Ì.È / it.

iir={!rrr ì

Ìrj{!r!if,o.1u(ÌionÌnr.tnDÌÌìenLhe(ase/ Ì(o espo'd\l'lhc(o'slantÌrtÌiÍnstur'ale ': l

n *"r", a.d I < I iô.lerrrôsing rrhtrns to {ale ll rÌc har€ ' r tÌt' L"Ìors
'Ju.,..,'rg."-^.,' l .c . l- i . " " ' " - l '
'{iA.r ior ê ''l '
"lc| '' a( \tbstiÌutanle, rt Lcdt roírmrrlrenl' there 'r exìstma"
r*"1.i-,tryr (illrnt it.aPitalâml i.ü.rr
cÒdìlrinrÌi;ú oi..pilaÌ Ìl Ìrbour ihâr r.suÌi iÌì thc rame llvrl or ÔllPut lÌr lig Ìj 12
we shoN the
i'Ì!rrÌ.rincrc.rin; botl.aPiüland Ìrbourbta l,L.Ì'rofc llìe Ìo'u\ of Ì'lÔints nriíisouhvr s and

de;úding onllF d;S(c ol honlrgeneìÌv Ì orlhe ntrì'tn'r iiì!illbeeithuÌ' LÌre lcft or l' lhcÌiAbt 't
er
plnÌs Ìtthrye{actl}.Ôin.nÌeÌf€Ìra\e.Ò.slantÉrúrn\ni\'ale

ÀiÌdr?/.,\.oÌnn.nltusede\rtìpÌeoir(!nrtaDtrcnÍn\tor'ale0ro'ludi"ìlun'tntìinthis'lìa|ter
irÌheCobb lÌmaÌas prcdtrcÌion lilnctior Íiúì vL( tl - ('ir ',wh0Ì!

ylrK.dl) rr(r"LÉtìt ' din r 'ìKrIr ' dlrrK L

Dinìnishing retuÌns to caPitãl

1hr othÊ' ret nìP.rtnni .on.cpt in Lhir.ÌÌaÌrl€r ( tÌìât ot n,,ri"trlrn'i ff'r'J /' dlint Tlìe conterìl
otrcr,rns to a racLo rrten to the lmìra.t on.utptt oívaryinil one si'glr J"to'vhìlt kce|ing aÌÌÌlìe
Òrlìer one\ co.slaÌÌt. Ì[ relic(ls LÌ]e idtr l1ìal as $t add morc and morc of 'ne
lacto
ufit\ be'oÍÌe and
'l Produ(rbr
]'ss pnxlÌr'nr€ at
Bhjle k0epiÌrg erctthi.g clse uchân3cd tÌre âdaÌtionrl wiLl ìess

the mrli]i'ì FoÌ cÌanìtÌt hiring mo( a.d morc ìâb.uÌ 8ÌìilÊ keePing the ânxnnÌ !f'apiÌll 'on(anÌ
hill pÌodú.e ovi.nxtdìÌìB ân.1.vennìally thc DaÍgin'l N'rkei empl!l€d$ill ÌÌoÌ fr'duc' r!,1hing rr
0ìeÌ: will noÌ bc ênouSli lh-vsi(al .lfitaÌ ìÌr tÌrÈ fliÌÌt nÌ Lhe wor(Ú io usc ard Ìhús b' prodúctiìc\
emploted. siDiÌa.Ltiitlìe softl!.re..iìpany in Ô!1.1rÌLerexâmplc inftea\es tÌìr núnrbrÌ ofc'nìputc''
 . t i:: ].:]:: 5i9

,iÈ leeÌri.A ihe.urnbeÍ ofÌrr)Nranrnìef c..5tanl, il sÊenF pLâunLìlc rlÌJt rhlìouBh Ò.e foAradrnìer
': ghr lse rìore than.ne.on|ll€i in ÌreÌoÌì.r to lrrite ort.Í Jôft{a(, eventrLall} LheÌe willbe tlent}
!nrs0.l con]rrúrÌs lyingaround not bcing lut to .ny pliLÌ.rive úsÈ
:
trom I mathcmrtì.rl point (Í ÌicÌ{ ihi\ .oÍ(sporrìr tu tÌre ..Llô. ol r?r.drtry ot thc pÌo.luction
.rtn Ì. A nÌrftÌor ÌJ.or(rvciithrta.Senr Lr iÌìri tu..idì aLânl poitÏ lìr\.bovrÌhr Sraph ofth.
. r.ti.'ì Ìh( ( iÌ\stratea ir fril l3 2:l f.r 5orÌÊ tÍ.d!.liÕn Lundnrn, I = l ( lt. whcrc Ìvc lecp Ì
.n{a.tafd.nÌ_vvaÌv Ki rhis is i.dicale.l bt}ìitnrglhe Iriodr(tìori1ui.li.nì as t: r(K:7.i lr is eas!
: ieÊthatâsrc in.rease.âf LalitbeconÌcslc$rndlc$pí úÌiveìtrlìe nìâÍ8 n and Lhefírdrclion
-..tnlr Ìales the ürual.on.are nLtc.
:rn,ì?1. Lf{cnoÌ\loolirSanraÌtlìrColl DÒreÌar ru.! nÒrì \re .an eari\'iholv th.t jt rúilìits d iÌnir
:rjrs rrtLrntr to jts fa.toL
i..piril and laboút. ThÈ rìarginal ÌÌolu(Ì\ .rr llÌvcf b) tÌt li^t .rder
r.rlarireslriLÌì respÈ.rrÒeach ta.lô.. Ì. ordeÌ to rÌnú' dnrrJÀriì,1 nJrilif al .ehÍns L. ea.h la.ror se

f., ,,/,, 1ì: l1.l.,1ll

ri. "i,, rt; t1l l2)

ti..e. : i0 Ll, he harc Ì'K - | ard frr .: O, hú.( l'exhibic diminishnrg ÌÌJrilnÌllrcl!íì5 to
nÌÌr fa.toÌ! lÌ.an b. $olvn that d((asi.8 .r ..njtâ.r .eLuins to Írl! ÌnÌdv aiÌìL.nhi.8 tìargi.al
:tu1Ì(Ì\, N]1Ìlr inrrc.rÍÌg úrrnr i! s.nle nì av ÒÍ nìat .. t imt\ dimnriilìú8 reru nì s Lr a lãctor'

nÌensive íorm producriôn Íun.tions

i\ rn rhe s mlleí f.odr.tion rú..úrnt g0rcht. Ìh(r lìta poinc,.ne nÌ.rpitâI, on! Jor libour, and
ì ne l. r . !l|nú. Âs 1t i\ oll€n q uite .umbc^orr( !nd .!t paÍi.uLarlt ürtorìaiivc i(i .Ìie nì È I ô !i{Lalize or

ììanjpulale inloinrtnlr in nan] .limenrio.s, !re Òfte. at0Ìtaver,Ì uscÂìltick.fe{f.esing Lhe 1ãcnÌs
rl!Ìoduction rs úÌjorotrâch !tÌì.r.Tlìe nìorLcômÌro.lt used cxrnÌt! ô..u6Ìrhen he 1i.us onÌhe
!nr!Ì.lcd b! (ipitdl nrÌhe n$rla$ .alg.owlh Nr1€l ârdcohcquenllt ús€ asan ãr8UmcntÌht aìpital
I -" ,. \ ,,,,r,t r. r{,Ò,, Í I

rotÌì.ises \t (iel to L:atlrali. i.l€n!iv0 furf.r(lth( p(nluctjun lunctionr = IrÈ, orrr likras
iÌìenÍ.rrtr.fn,nr|Í.drctnrnluncLion lhctrìfu.rivcnÌ ì |RrdrctioÌ1nìn.iio..eris.f LÌreâsnLmPtion
ric.níânr ÌeturnsÌo \câlei i : !i" : r(r,'r llrhen.el - / (ll, BherÈllk) irl Ìr. (ì1r tr(tu1
tnpeÌt-! to ÉÌÌrnbrÌ is tl tthr sl!È.rrhe inLensn'e lorm Proau.ri.tì lrn.tjon equalsÌhr m.rgirìaÌ

Figure 11.21 a typ.à .ônLàve prôdú.Ìcf Íun.ion w th d m i sh.!r rêtlr.s to.ap ia

520

frodu(t Òl.atil.rl,l,/l( = [(1K l] = fi, Ì!hich r..le thowr t. h'ld urìÌ1ii tlìr ruLc
'hain
'ì
(Ês!a
lül.tt thtot.r ÌnLcrsThr!(nr l5 oltlnnrcd i. drÌning br\n Ìlnrlts if.!rrtrthÌhe'ryiÌ1dn
ÒÍ LÌre id(l.lhono3c.eit). Ìt sLates lhri d nnìction,!lr Ì: .Ì,lish'mo3crcÒ16'ldcSrcÈ/iLrh!

*f
Ìhat i5, lÌrr Ndì .r.Ì thÈ mrÌ8i.rl Èllè.t ol cr.h lr8u e't G'S ;li ) tiiìÚ thc Ì 'lue 'r thr ÚgtrnEri
(Ì I n trrpodnmrl io iììe vrLre.r the turrti..' lritb r fir)PÍì!r'ìirt "eJ6(irri eqúât t!ì nìe degftr
.í h.moseneiL!. LÌr tlìe.$r,Ía fro.lu(rn,. !n.tnr. LÌrishr\ i ìer! nalLÌrrÌ (on ' mi' nìfurl elrÌÌo'
úìe nuf lrer th! nri€!nrl ÌrÍrtl!.t Úl(a.h lâ.t(tr tinrÊr th!.!f'u'r oi thc tenÍ n fÍoflitiÔ'nltu
nni
.!tprÌlÌrúì...j..l.oblintrrtÌtrnrr.s.a[,il].degÌec!fhÒdìog'Ì1cÌl]ir'nelr=Ìl,nrjtholds'Li:'

LÌnrr/r. loÌ r Cn\ prod!.rb! nui.iÍnì (e hrÌÈ:

'i lkK + lrL

ÌrhercNr(1r noÍ dnide b.tl5 dÈsbIL..d.braiÌrrr likr /i Ìnì 'h nìeanrÌlrai LhearcriAetriLti:
tro k€! p[ú tÌre DaÌgnd ti'du(l i
!r lahouÌ rqlaL\ tÌrc nrâ,giÌr,ì |írdrrÌ oi.rfiLal tnn6 'atirrl $'

lncorporâung Ì€.hnoloqi.al proqÌess

lÌì rs mon Beneril iln lhc pr.dlL.lnu nrn.lj.r tlln inc'qÌÌltrJ s'nì€ "nrc Ôl t"lL'!lÔar'
pngrerr jr trÌitrú J\ f /i( /. 1) Ìt b Òilen ulrtuì l. mrkr . tÍft trecist rnunrftìln ab'ul ti '
*0,.:irr ,"t,;.tr t"O,unt,rgi..,l |úgLes útc6 thisntÌl r-v Lun.tÌor a'd\!e hrv! llreadl inÌÌ!du'ed thI"
rlntiÌÌ.t Ioíibilitr.s LhatliirÈlreeÌl.otridekdiÌrÌhe Li'rrnftr
1. 'lll( Lli
(ÌJ 'Hi.ks Ì1.rrÌil .rirrrr âtLilìnúìi.g l€chnolr!l.al tÌ !ilÌ.rs:
i2) 'Srl,Ìr neutÌrl .r.,ìfÌr!l argmrniÌnAre.hnoloBi.a!f!.8rcsr Ì' '11( Ll
'
L3ì llaÍla nerlÌal'!rl.Ìbd a!Ênìentingi(hn.LognillÍ'grÊ5\ !' : rrK'1ll
lÌrrìll.r.rthrí'!ìJbDouillâsti.du.tionfúì.1ntÌthethreerprd6catiÔ'srreidcÌrticaÌ'Ìetu!!'et
tlis j\'.,,l.,;;i"'.
ind€cd tlÌr .are. Ìt is ea\t to s( thât lor thr Cobb DorSl,A .aie l' ''ll KÌì I(ì'r / =
;; .Ì '.:i'(ô1.r ":ìl ("1r; He..È, ii,rc rctt r,=il ' =
rì" "'. tl,"" Lh"",;i.,. "
rh'"",1*.i1i(dti!.s.llhrcoÌrb DmrlLJpnl!.LnDturrti.'arcindrc'idÉ'ri!'

Growth accouíiing and imp€ríect competilion

Solo!Lsedth!t(.hniqLrcÒígrol{thl(.!!.Llngnrc5iLnìalet{ÌrlÌa.iltrfÍrd!'tniÌlilnÍ'lhÌthcSr'
aridrali oÌ(r Ìdrg prnods.t tiÌÌc i..Ì nrund I nÍtrg.orclrtio' hehleen thr rrsnÌual and dìr
':t:
c.onom( Bnú1h l,rìtho{ tul,lrt erfl.ilrrlnr. to tÌì! lnunìftj.. oip!Ìi..r 'omirttÌti'n'
L\ Lhn
hâr.rÌguede\lo\i!clninthtrl..kúratnnnsÒfÈiatenìaninìlÌrle.lly(or4rclirn'eenÌiroÌ' ìeir '
!Í nrrn{ !tfìÌi(irìg in lÌr. il!ôds ÌrarkeÌ H.tu.N€dcrrei5inìtl?.afubi! 'frheSoldrnridral::
rr
tJl.s intor.rou.rltìP.ú..r..tÌrctìÌnìì in the goodsnìarkel
Ì et r5 asurtr'lhal thc pírdu.tnìÌJLr.cll.. i\.hrraclerize.ì b] iÌrr(r\ing !alÈ:
'etuursÌo
t^r
r'ueàieEranÌu ú\irl,lr\ a)Ì'Ì(or 1úi rnde rti.n
 521

l lre !ÌrrÌ.rrr,.r,r.i lÌ,r\, rrf h,

..(iÌÌt,r\l]ìr!(!!irÌ ì. r\ L. rli:. rrl rr r'i nri liÈ ii l. r:rnr,Jr llr \

. *r nr .!tr t.ir ri tÈ r.l -.1 thr !:!r ! , .n re. ! r.i rê

\r,, .i i ,r I .t. r! l
.. rlr.rrh, im !qL itlj lÌrÌi(!L
t L,rL

ì= \rrìl rJ I
llrr8rD( Ìn,r ft.új rr.ìì|rrr,ilf rrtr.j\.
l|t l(
I =.Ìt .irk \,1 I = ìÍi jr = L
rrú l
tr!!r( \ir !r|È,lr!(r. rrr|íìi1.nri. !nr|L\.1(rrrrintLiliì

lÌ.u!È,re1ì,ÌÈ\'n llr.: trrs.trr\ !!t,.jt!\r!!Èiji.rLrrrrjrxr.,rre(ruril,,t.rlf,,r!rrlr.,

lttl.j\ 1lìlrtrr trÌ!r\ ìÌ0irrDirnltir:.ìntrrtìlrjLjr(l,rÍtrjrrf
r.iriiiÌr]f.ir,ih,r. \r
r{hrÌir)'r'1ì
itrÌirtxrì'r'\r' r'!Ìiii uÌte.rÈd ÌrLrL
'r'nr '"i""'",".,',;;,ì:;'-,,,lll.rrrld
',t,,g.,,',.u,',..,u,,,.,.,n,,;.,,,",r,;;:,':,i,:.f,,,tIrt"!Ì*\furn.\tÌLr'rer'rnãrÌ)r"ru'r
,-,",r,,u,,"1.pr.,"i,,,,,,,,,,,,,,.",.,,,,rìl:,:,:..:"'""i1"1,Ìn.rììì:i'rLr
,r,rr!nJ,!r:,\r,,,).r,(rrirn.ru.j,rÌh,.,,,,,:ll-1,'",,gr,.,..r.'",,n,,1,1,n,.,:.i.,,,ii
j Ì, n Ì,,p,.\ Ìi (ì,
,"".,,,.",";,.;,,;,,1.:;:,:lll.,:ifilìillïlllll;:1:ll,::i:li;lll::i.:i1
itrr'r.fl,r rìrliilr Ì:.:ÌÌ!..ir) rr,,!j!.Ì i rì,r

u,,.,,,".,,.,,,ri,,,,",,,..r,,.:i:il.l,ìtï;ii:,il::i;,:l]:illìïi;l:::i
ÌrÌr n Ìfr.il Ir, !ì Ì\, .Ì. t,lif. n! 1,r...,ìr\rrl
tL
nrr'rr r'i' r:r'rrì'rì!r
'ug;.''"ii.,,,', r,",,,.,.,.,,,,,1,;,,..,;:;, i:'i:lÏ" ''"t"" ' \\ I Ì \" irri=thr i!tr,.
'iÌi\ \!ÌL d i,.,..
!1 rì'nrrl "'"""'"
:,,.,,,,,. , ,.,i ,,ì,,.;ì.,,..,,i;,,],'ijl"'"1'r ': u1
..l..,.,.,.i"..,,i,l'r,.,..ìì',.,,.";.:,.;: trre''i!rf ìì.ú!tir' i:r lr.rrÌeriri\
i .,.,, i-.':., ,'.,,,,,'., i '"""'" "' ' 'irit 'ri. Ìrrr\rr)iìÌrr.ì.r
.'.,,:.i,1.,:'..,ìl:, "' "
,,e\,Èa , s i.i
, i,. ,.."i;.
'.,,,,ì,;ì;ì,,]j::ììllil,tì1,,.ï,:,:ìl.i;;i"l:l;.ï:"1:i:lì:ll
,"u. ,,," ,,,,"ì,, ,,, p" , ,,. ì;,ì,,, ri ,:.::ï:i1,..'i :.iilli :i:.:il:._il,t.,ii:,: l:i:::i
,
irl,ìrr!,,!e,r,nr.t.!j!, ",;", 1,-r,r,ìr!.r" lj::lili
,rÌ:.1!Ì: (r.!r,n,,,,:_";.,,,"..,,".ì1.i,,,:.,,;,ï:
tl[.frat,n*d]Él!!iarf .,,,.,, ..,,..;.,t., LlLrrmf rir_.r!r,li i I
ii.,,rr:!tn.Ìi \eirÌfr t,,,u,.t.,,.,,, ttit. u,i,r,.,,tÌi, i tillrÌ,,1ì..ÌrÌ,.r:r,rl,rrr,\
.ììt !\,rÈ,l,Lr.rìrtfr j!'n!r.,ìrlj.,tr!Lijr ri!rtr.,,ll,r.,
rurlrl
L
!Ln

tLl
522 r:: '.' i:'

AppüÁiÌr.tnìg nonìnìeaÌ savnrgs skl!

',
ã Ì.s
.E

z1

Fìgure 11.24 Nwrèr.à LuiÍation ot pro!re$veÌayor ãpproÍ m.1l.f5 ÔÍth€ ror near 5avrqt
pal't
thê Fúndâment. sÔ o!! Ecuàton.l líoton rr.!nd ihc íea.ly n.ìc À'

'lhÌr loLnnrli lôok! .onìllicntcd at tuit ill.nìce buÌ ji cãn br crllaine'l a\ folÌd{s '\ll Ìt savs ( thaL
Ll lre arc iÌúÍe{ed iIÌ lfproìimating th. ralúe oJ nìe nrn'tÌon Í(r) rÌ i
point clorc r1r 1' giv(' bt
Ì +iÌ,1!r.ândotÌìnbIaf.Ìvnoml'li.Lhedista..eolÌlìepointolnÌrerÈstlbnthe|rnÏr'The
..eúrirnis olthr |Úì-Ìn;nìiaÌ ar 8i!cn hl thc dÚnaLivc\ !r the 'rignril rÌrnctbn !\aÌlal€d 'tÌ and
sa,r th't Í'e ârc
rcsctrl.rl ìr-Ì th. f&ìtôri.L of the oÍl$ Ôl th. r.specltuc tÍm' lhus c$cnllaÌÌ] rN! ran
rp!rcllnrÌúÌÊ the hìrúnr tLrl al soDìc lìoinLf clo\( tÒ Ì' bv a rJ'ÌInonÌial of the ldÌovin8 tornÌ:

/ Lrt :.r .rr +.rl .rrr +.,,)'ì'

tonvn!?,.e oún hsjtktt .Ppuri,dti,,. Lvc. simfl. av'amic models Ôll€n lrcscnt anâlvÌicaì chrl
ÌúìgÈs dneÌ! inb€Ienlnô. lì (ariti€s ir thc e!úLnÌn ofinteÌtÍ llhasÌreconìrjnÌea\ingly "nnon
nr use .omp!teÍs lo !únulate tr.. sitional dt radr ic!, 6Pe.iallI iIÌ t trÌttiors {hc( tÌre
imPlicd eq !ations
ir€Nellbq:ond hunìa. intuitoì.lLho{(v.rwe ra(lì r.rnÌ1.nìlvii'alpÌ'scnr'ìtonweh'!c 1Ô arurorri
1DÍcrlìe Èq!.tio.s.Iour 5tíem (loJt t. the srtidtstute. lhis pÍocednÌt ( 'aLLed lür'drizrliot
'',! caD trc quiL€
l!.8 aslc 8.nLt inÌcÍ€stel irL tìaÌlderiaúnÍ liomllìe sLeadl ttnte lo8 ìi'€aizrÌi'rn
rrÌlariins
^s \\( nìalÌ ìllúÍalc ÌlÌj5 nreth.d by {Ìeriling Ìlìe equa rn ntr iìr€ 'oÌ1\crgc"e sPccd oÍ an
wertifi rÍ.n th( rlndrúÌr taL s.lo{ lluâtion rnd use a coblr Dúrglatspc(incaiion toÌ Ìlr' pÍx1Ì(

t, Jl' kll r +r) {Ì-1.1{t

r lì' ìoret.rhni.iÌd.irik rdDu(r

'eadldnedandgcn(üLÍêaherts((:anÌpLreÌl(1rrg'li
 se.r! divide LÌì!5 cxpre$irnì ìrl * ânrl olrialn

(i#:) +-:,u' "-'-",

\tc.l.rìnci {Lch th.tiii' ' ust rTavl.r rp!Írr nìation íslc p'e!io!t
ni Ì +,ì - 0 wc n.s
sectio ) nr linearizcÌhr Don Ìi.Êar ttrings fârt útÌìÌe lundamcntaÌ sokv lluaronJ(" rarcú'dthc
sfu.d) nâte i' aml ol,taiJì

(i^L=\*'ì''
' 4ll l."r L."i'r
, ìlgl r,

Íôril1{ncari IúrthunÌbrritÌnlon\rcnÌìtin

lìt^

ú r ,) (À lrili')" '(1""i L"x|i

!l

rvhi.hwr.ân rÊpln.cnÌtÌìeTa!br!!Ìrr.ximrtionô.dcoU.(ltermsÌoobralrì

rì orii -r ,l
i---:----------, lÌ,)sl oll ì (1r.18)

sin.!t = i^ se.[Ì.ullif LIÌryd and.btrn] ilìeequatn ì ÍÔrth(BrÔh'lhrai(-ÒroutPutnsl

slì(d is gilen
Nhoei btÌìe(c.nsÌantljleadtst.tc.rrhe(o..rìtâr the
'onvtrilÈn'c 'oellìcicrt '
b)r: ll .ìiiir l
ln r(tron 5.2 (r d(riÌe equation 1:1.:J0, Ì\lìL.h LeÌls us tÌìat thr 3a! etoLlr\ 1s J' Ê\ponertial
'urput
dc.ay tu..rion (iÌh f a.anletcÌ l:
t;\: b(i!

where L ì = Lo!lú l!sl. 1\le.âr use Lhis í1(l io derlrc.n ÚtiÌìrtr.g equation Lhal ca! be us€d in
empünal .rk lo (onriJtenLÌ-veltnfil€ Lhr rpccd o! convc4€ncc ironr datr on GÌll' Ìtcquiii'n Ìl Jll
holdrl,eií'een I :0 dnd Irve.m idtegLrÌ! il:

'r#-' , [l'à"'=1"'",
tì.gíìlji - rlj .. lúg íir L. Gí hl
(]3laì
524

\{È cd noN nÌìrtÌi(i (;ú ír.!rtJoLh sirì.s iÌÌ o.deÌ nr eÌiÌni.atc

tÌrt nerd lü a (!nìfairÒ..ou.[tifd
nr.u\ on lhr data !!r€4.Ìì cornt!
cr Gr - Gr ieiri /'ll ll

\{hnlì ire fàn rcÌ\Íite nì LenÚ ot olilut!!Í'rlìita a\

(1.1.50ì

\\-e.rf aDpro\iNrte lh( rerm ì.nolling l, on úr righilrand !dÈ ilÌ( retìÚih€r thar i'rl '1]
,,ì-,ì iir irtt- /, 1ÌrusNr.a'dnidebotÌì5nl6btIÌrhlch('rti€!addinsthcÚüln'drlíi'

''' r'"' '''' ' ' "l

", .,'"' {'; '
" "
, ,, r. r' ... t. ' l' l'" ' '' Ì

ôlt.l
iheÈ'o onrllru'h
...ì',"""t,'"'"-..".,""t.nndlhcÒf"tìmúúquafiÍiL'soll'Íi'u\Ì"iaÌrl6'
,,,.,-
,":.,'--,.,
,rrÌ tli\rreLe tirf È iv:ÌÈnr.
''ï;:;;,;;,i dÈ.h,.ìe equâti('s'tri'rbÌ1io' rht R!nì5r) nìôdcr' a' crie'\ìdì 'rÌir'
Ji-ìi",,ì \,i."-r"".
'i;;;, '''.
**,., whcrr..n;ì€s (h.of.rÌirüiLrri.h Fnodhoìr ÌnufÌì Lo !r!e.rr.l
irtiÒnar.nnúe6
iilìï.;;:ì';';.;,,'" i;,', '"e.r,,r LÌ,r.snülrion orcorrÌint çtri'g\ Lìr arrd'''ìs
r. r.doL(.ize tÌÌeir ronnúntLior'Ìmnr
-ìi.ìì.ì.;;,i;'.,,i',".;;,rì16Niuneednrolìrinìiz'ca'Iìor'rr'/n'ir'.rdì.ìaLis.ìernt.toÌìar!
l"'
., |
i'
, ,';.;:

;;;,;,;.;;,,,,.,,', tt"kiÌ18 inLo""trtrt h'1' her r1rr"È rdr'tr'{irr'irecrÌrre'ÌrÌnnÚ

'i ''

"'1.
rviiìabrrnr
ì.ì Ìnú'hirìewlÌ be rrìe nì' rÌìni\tru€sìÌL'êh.(nn
',.ìn"i,i-... ";*'. "o\ r!s !'ri'!! Ì1nì oro( and rcs nN tÌÌ'n t È5
;;,,;i'';i",ì ;;;; . frj.n r.dr-Ì irì rrLi(s 'rribL
{!ì! l' morow
';'., " ",,.!rì !rnì!rolv d heÌ1( a LdveÍ abiLitv l'
,,l ,ar _'ì*".",t" t(r 'atitii 'n ' '!f
üs nÌ iììe hÌtuÍe lnd jt ir
"",.tl.n-'"n, "'*,.nrFut
,,,.,".,-tìt Ut-vralf('i thc rhtLt â'e nvrilâbÌt n) 'nlv
jJ,,n 'lìoi(s
n..nun' *'r'"' rìob HdrL(r' 'dNn\ÌiÒrìnl
ì' d!Ò
;",,.:ìì*ì;'"";,* u'
"ri"N "o'ndf
,r,,.
","*"
a*r." *r,.r."*umlti'n tüla-r' lnt a ni Í1 conn!ì |tirtì !rllâ! pírr esrsNiiìì inrediàir
",1*"
;", ,^ "r'u" .,
1,,"...',""rr"",
;,",,
,.:,,,."
ïi";;ì;;"ìi;;;"p'*Ì r,nn u"int pron"cÌì!ê dis'u$ed úÌ 5Ècrior T I to rritu d'Ìm
",'n,iuÌ'r'"
Ìlre m.ri nr izalúr Prob Lrnì âs:

It' 'i
''ur'
ir rr '=fLrl
lrÀrrltìl

Nlere lhr so.irl fLrnner n!\irriz6 iÌre dtr"unÌe1inÌr emfoúl sun of trLilin(5 ÍiDr 'uÌuri pdÚd
(hÌ'h n'ilr Lh't rhe a!enL
:,,,ì.;;';ir;;;",1^".,,,*-Latn c asenÌ \übj"" !r lr' ÍÈ5ou("'nn'int
:; \f\êrr Ì,..kirìdÚtonLerii\!..kJitranran120r-r2)
 525

úlilrÉ(tILâL
rrrr!.lrjJrÌì1, !r.,1!istf!r,Èinrffìrl i, brtn.Èn rnrnLn4irfrr â'!\:fL:!\i
ì.rf rLlrrnf..n!tr,ì.tÌrl iJr\trfu\Lhr:r!L Ir]\rnìüilìr!r'(lLrl!r'ÍiÌr!6Ì:ìrrrr!ir0rlÌinrn!i
ì,..,",.:,i",..,,,,.'.t,,',Lirf,,,i:tÌfì i 'i^ \,i1.ÉtÌÌ,LLr(rrÈhrr( !ìfr 'rÍÌn t'tliii'n
.,.,'.rn,",n,-f",,',..Urìrr.!rrilri\\(!rfathrtrrLi'iLiifìirLL!irtrÌ!dÈÌt!llLonu!r'n!LÁfÌi
ii. .,'.L ,.,.",,,'.'.',ì... .u,''L'-t' "r L' Ì"Íiê tÌìÀ nrrr ".rre'Ì trr( 'Írt'ri/àLn)l
'.,i,,' ",.,ur.
rfi,iitrtiirt Lh. irr i.n\tÌr r:L intrr Lnr if 'n!lrr 'L-'i r!ì

i, ii, I ,t

,\rìi,ìì ir l,( ..ÌiÌ Ìtt!'i .i

_}i,,.n,.httirridtr.nn\trriìrll.ltim/r
nr!r.nr\\r tÌrrLett\.1-.,!i!,!ìiÌ,ri rhri)ÌìÈrir"
tÌlrì r i,LnrÌ.IrÌr !rr'.lrrrlrr .il\'

\r.ìr, tr'Lrii I 'L r

\rì.rrt.,Ìr\timrlLìrÍniìflrrrÈrr' )rLL rÌÌlifLrrrrinrÌrtÌr"!ÌÌr|tlrì\lfL!il'il:L 'lÌLhrt

úrilo Lrrtrti, ihr\.mÌ.(..rrr'hirÌ'LÌ'rhe rÌilrl:i :

rrir I ii:, i

ÊÌenrr: tL.Ìrii.gtlì!'t.LÌÌrrilr\riÌrÌrili"tt.r ,fl rì:i únr thrn6rtrdÈ: '!rL'1iiì li!r''br:

.rri.: r "r I
l|' ()
] r' I ]: l .]

"l
r.,r,r Lld: :Irrr,;..rrrt lLin.Ll'riÌìl orl r't11"ìr!t'!lr"
\ trilìr 'Ìnt!ir':i'rìi!i'bllsri
n-",i,,i,u,.t.t..1f"..r.t,.,11.r.,,Èt!lìn,iÌrrtÌt, \(,ti( rh"t t re LtlL' I 'fdlri!ìrr rt(ì' 'rÌr
l!r i, ,,.ittrf if lr ri (,Ìr!ìi 'LL Ìlr fiÌ r\

' Li ' I t I

r r '\ìc..I .ã,irÌ !!t| i

rnrr. \Í r, ri riiÌ inr ì!r hririú rl nìrrtrLn: ÌrrL" nr"rkrt! I

L:-:rr
526 :.

jr nrât hoüerer bc nJelúL lh. roJüinrcu! lnfc fÌam€hu( llc htre ús€d úÌ nìÔí 'Ì tÌì
Ìo ÌliLrn Lô '
.hapt.rrÒd.írwrwillÌ1ccan)asúnrcIrPcciallormotthe!tjlitytur.tjo''lit'r)=nrrrlUsiÌ13tÌ:'
sp0.i6.iti.nwcf.. .oÌÌ r({rite Lhe LullÌ cÒnditìo! as:

!:r ,rr r +,,,

ard âlie! tâlirÌA lôSrotloilì rides wc úiâi.

!.!.-r ìi,gri : li,!.r r ìolrl+/)

Ì. iimpljft LÌr is rÌpÉssion tvr. lÌÍ ther Ì{! iÌrâlL n kc lBo ilI rolimrtÌons li6tlú \ÌLrl] astrmc tÌì::
tsvih.lôgiclÌ d is.out paranì eler r.r tt .elt.iÌfuf ó ! liiÌ r)
J úre
Ì{lìerer - 0r5ììremtuolrd:'
rinìilant l,,ts(Ì r,r r' 4 Ìì!r.!'
!retc(r.e and hcr.e l,,è -r = l,,gil + rì = r ind r

rlr.hìve alL0ad! seen that LÌìe ÌeiÌ hrnd 5ide olÌlÌiJ€\ e$ì.ìr !dn he rhoushÌ ofas a irtc oichang"f!:
thus exprescd c.ntÍìú.us tiÌne.i:
'.

Ìhr Ram\ey rodeLrcfn.es to thr tullÒÌ{ing xlo dvnanì.rl cqu3rlon5

( L.J 5l

1{ecould |eú.nn theranÌc sie a\ rboÌ ( Ì[ t tilc nÌlr a.c.unt Plulati" grc(dl d te'hnolÒili' i
"
frl8Ìlsr|ÌhcrirÈnunvÌ{avrloil\!themorltlft.mhere{h.r(tJvre.andeÌcnni'eLherqujlibrlu'
icv(,1\ Òr.apiÌal,..nnnÌpti.., and onÌpul |Ì'lorttÍaswell astL(l'ehatiouroltlÌe e"nonvonnfd'i:
,1r $€ haìc.lrr.{Ì} notcd dtÌìÒlgh t[is3rtl rd.ltheritÌ(anì that thrrÒ'íúì'L
rÌìcÊqriÌilìÌninì patÌ1
in the r.oroJìrd. n!t ads IaÌnnìaÌ rlilit] nÌr\imlzeÉÌrlÌrn !h..siÌrghoÌv nrt'h lo s'!r' tÌrÈ 'enrlt\ '
theltaÌÌrJ{rÌnì.LrtLllfrcfi.tnì...t..i(.oÌtrelge!.ctotlìe*eadljt.lr lhed-!'aDìicsof"'\er8rni'
to tLr nÈadt rtú( holL.!- is nìô.e ..n4ti.âLed ii... il !roN nr!ollcJ tÌre paÌnmdrÍ Ôl lhr ütrliI
nìrüidr nr rlaiiLon to tÌì.5e ol the ptu.Ìullion nì.(rntì.ìl
Ot)tilnnl nrút!ì i'núPtitrti.rl Ìvhcn {l\'.8.1}!1ni. m..1el\ lilcÌÌìe Ram\e!mo{l.l Fh1'h iÌÌ!r)ÌrÈ:
!,ìnlantìrl .o rtonot .l intcÍrmPoral oftimÌzdidr, e.onúmirt5 .nen !!. Ìht ldgragc of ofl"'i
.rrrrl ìrhn:Ìr is r L,ra..h .t rD3iÌìtering. lhc rdÈa b.Ìrind oPlitiâl .ontÌoL tr a \Èt ol m'tÌtnìrti! i (
pr.(dur(\ úrarrlloÌ\ úr to t!.tr.l ho(r\)st.nìerolL6!!cÍrinìe,!ncn.crúinc"rtriÌri'gã'trrr
;nd.{tôra.tì! '!e ünl,,L! ar eâ.h t.nrtin Ljm0inoÍlrrnr achieìcílnestalÊd 'bj'(Ìive qu\rnr
jtl!5i.riion ii ÌlÌat. LandiÌrBn ú.keloÌ1Ìh( Ìì..ngn!f ÌÌìe rech.ol.8v.!a lahÌe tr)us'!d Lhe lrn !
'l
pbviic5 lhc(ngineerlì.stoúerign.nofiinaÌ5tnrt(g\tÌìatl.uld8u.ni.iÈÈtlì€nÌ..csiÒrLheN$rr:
tre.rf ilrink.l rhc ru.keL ir noÌior ds Lhe nsÌcnì Ôl inrereit llÌÌss\nÈnrìr.hrtu(n'ri7Êdb!rsll':
\arrr rí,irr.\â.rl1r(t ôl.dttdlvrúrt.i. stttr rr.iahÌe5 aF 1rÌirU!s.liÌìes-\ \fumthìrdescrìhrlÌo\ rh'
n itcnì behâvrr.ir.! ponÌl iÌÌ iinìÈan.l rnt..lre ã1fuÌrd thÌ!!th the..ntrcl!arablei Stntt râíiablr:
ìroüld be lhiÌÌilJ like lhrposirdìtr lrlo.Íl .l th0 svnlJì l. the Ììlrn\cl ÌìÒdel'aPil'l i\ ÌììÈ ìai!
viriahle.(:onttuÌlariàbllsa.erariabl.sllJi.rnb.h(Ìl.h.renaLinrlonÌÌinimeiÌÌ.rl.rr'nrnLii
rlìe behr!i!ur.l th0 svrlÈnr.ln lhr Ìo.lct.ase thrr( i..ì!d€ the to\vrÌ outfút.l tÌre prcpulriot
jrnrr'

Iti \ËêBúo,rd!ìÌâ Ì l\1rtnil21il1l..hr.2ntrthe5DlÌrtnÌr

rrrÌ,f\ iìiiln rniL.sÁlfÌroat(.ni ie.Lnin2 6.IEatroira5r xÌ i\lanii llolr rl
 :. ..].::: :.: .. 527

!r trhetÌìer Ò. n.l LÌre landing g€ar i\ oprÍtionrl. h tLr Ramset ünlrl .onsun4Ìi.nì is rhe.ontrol
ÌaÍìâÌrle âs at anr túiÌ1t in Lnne thc !!i.n ÍJÌa.fer.â. fÍÈeLt choo!( hoÍ Ìtr,.h .l .úÍetl dhlrosabLr
in..nìr nÌNld b. dcvútr.lto rotuünption and hoÍ, nrLch tu savúigs. TherÈ a.editleÌentrvidelynrld
m.tholr to rolvcthi\ tlpc oiprlllenr one Farliculadv.eâtaPptu.h is gl!€n btdl,d,,,.fr,rrd,,,n{.
Ìrhi.h h.r noÌ{ beconìeilisi. tdt Òl mrch the!Ìctìcrl nìaúoc!onomics.r':

r2 5tiÌÌ tÌÌe ìren

{LrÍt .haÌÌcn8in8, r('xnr,.r têxtbookor tir. luhjr.t r Sroler, r u.a!, rnd PÌe{.t í1939i
*ood stâÍ r8 f.iri Í,Ìihr.ofiinuous tnìe ?!ìaÌtsjs nclhirfg (2o00i

)
 End ogenous and
14 Schumpeterian Growth

ln thc !r!.! ous .hrfter. \e lLì\e seen hoÌÌ tlìe Solo\ 5r.n ,rodrl ilgnrc.t.d N lh
t(.hfologi..l Lrrlgre\r e\fhnA r sreirt leal ot slÌiìi (c iìrr ì.lc(.slcd i. rihrf jrr
51ud! c.iÌrcÌnic !(tr\th losether. uÌe stercL\ ttrte rÌrrlt\i\. t..sìlir. d!Íìi.ìi.s iì.d
tÌrL ;Ì\s.,ci,tel (.Ìi(eÌ)tr.t con\erlen(e pu e ! ra\ oi i.l(rÌrr(ÌinS nren! oi lhi
Dbslned trriLrrr\ oi the gÌ(^\th !t e(oÌÍ!!ir\ \\ir otrt.ìiÌÌrt \!nìr iJrslÂhl lrLo llìc rolc
ot.lpitrl lonrrtirlr a5 the Ìn€.haÌrirm Ìr\ sÌÌilh r Íxietl i]..umú ilcs h c.l(h ird Ìrort
thr pÌrseuce oiclirÌÌiI15hi.S Ìctrnn\ to ircítr a(cuDi!hticm lnrp,:,s.s n li.rl( on t h!'cÌl.n L

to nhich clÌlnBr\ iI f.Ìic\ or iÌLtjirúiiÌb crn dltecl lroÌrth n Llr.l.fg Ìr.. Lor tÌrt
Solor SurÌ rulel. lhrìrge\ irÌ the irte ol trtr\ur ot oulpul prr.epiti i. th.long Ìur
neâd\ n,ìte colre tìon chdnses iÌi uÌe rate ot erlteno!s 1c.h nolôgi.rÌfhgÌcss. En.logt
Ìrou\ Eo\ th Ìheúr\ prÌrre\ r n!nibeÌ olnÌe(lÌaürns thel.oúld orcr..Ìne LÌiDinishnrg
Ìrtultr to catit.rÌrnd therrÌr\ open up thr to$ibìLi1\ thiÌL .hi.g.s jt toljcr oÌ in tret
erencr! .aÌr atJect thc grfftÌr rete ìn ihe l(!Ì! [ür \t.idI:Lntc. ]h..hare.leÌLsLicdlt
.hani{eiìÌrtolic)oÌpÌefeÌence\crnrltertirelntsiuÌìgír1!Lhrat.oIoutÌrtrtteÌ.atitdi\
Ìlhdt .li\thguìr h e5 x m,{ÌcÌ of erclo:eno!\ tun oÌre !l (\oijc.otrs gu!rÌr
Fiq. 1 1 1 iÌlu5iÌrte\ \e!rrìÌ !r)ÍtlÌ !rthr. d nuLrber oí jt|iLt eÌe alÌead\ iaÌn1Ìiar. Ìlrt
teth Áll: ih(N5 rn e!.nom\ orÌ orÌe sterd] ttrte !ro1!Lh lalh drÌ(N!ÌÌoüt tlÌt perìft].
Thr fath ABDE thol!\ r SoÌos 5rrn tlpe e(onom! sLLÌrircLttÌ k) a th.cÌ( úh d\ I Ìi\t
ìÌì tlìe \r\ üÌStinr\ ertDent raie at tirre i r. 1hi5 È.tr]u.cs i lrxnritioÌì patlì ril to D) a!rirÌ!
\1ììrh Srr\th ir lartert ntÌo$irÌS the tr.n\ìti!n. 1lÌc !:.onoÌn\ ir on r rÌes hiilher le\ d
rteadv ttate gntr\th fath $ith itÌoÌltlì rt tlìÈ oriliniì Ìrlc ttlrc nrÌ! Ìratlì i\ Ì)ri'llel t!
Ìhe old .Der. The trdr ABGII nu\s i Soioü 5urn tt.tc ..on.nrv that É\ftÌience\ dÌ
e\ogenolÌ\ Ì jte iI the r ate ot ieclrrúlosi(rl prosre\! aÌ LlDct,.l!ll(trlnrgthetrantitidr.
the orìtflÌt Ìtr .afitr in rhc e.onomv tsÍn!\ nÌr\ rr lt. a5tcr rrlc.ljneÌÌv. tìre ÌrdtÌr ABf
ce.Ìrot l)e erpLai.ed\Lrhin theSol(tr\ 5Ìrrn nr)del. l| 5 sho\Ì\ tht ca\rolxn ec.n(ÌÌÌ\
nr ithich lhe gn Lth rare rjtt lÌnmedilteLt d lcìrerÚ il n, \\:c n1rÌÌ 5ee how a model
olenll(ìgenou\ Surth Ì)Ìo.ìLÌt\ tlÌi\ !Lìt(olre a! the.,r.s.qtL.n.i. or cxaÌnfÌe, ot r üie
i!Ì tÌÌr \arirÌS\rnrrrnmiÌrr Ìate Ior ror. it i\ iÌúelr\11.9 L. nolc rhat Íhen rnal\5iÌÌS
!Lrt.r. jt ìs ljk€Ì\ to l)e dÌfhLrìLt to di\tiÌrir!islÌ tretÍrcÌr Ìhc f.jr sl.arl) \tate feth ot tÌre
eÌÌdoiren.u\!u\theco.oÌn) (ALÌf rnltlÌetrdrÌ\itilrìfnlh.ithcSoÌ.rr SNa.e.onoÌn\
{bie(ted n) the \rnìe nrock ilDDr. rnlen Ìhe tr!nsitilrrì lo lh. núr stQd\ \trÌt path l.r
tÌÌe5()los sÌral e.onoÌni i\re| !ÌuicÌ(
lI the Ìlr\i prú r)t tÌrj\.h.tter. rle erÌ)LaìÌì thr nerlÌanj.5 of sr{llrhlng ir.Ìì .:x.gcnou\
toenlloi{eDoLL5gro th xnd lhen erflorr thÌee clilierelt|.lìinn(Ìs kn.ra.,dg. sÌriÌÌo\eri
honÌ the rccunrìlation oI ph\ 5icrl caÌritrl, ilrrttnÌeÌrt iÌì l!nriì. ref tiÌ, i.d i. Ìc\cxr.h
5il0 r:':.'i

log Y/r

Ln

qro'rlh
Figure 14.1 GrôÍth pêtln wth ÊroqerÔls and endoqÊ'Ôu5

ÌnodÊ ì
_
an.ì .lcveÌopmetÌt-that mìght drh'e endogenous grot\'ìh Although süch
cconoÌnlc lactors nÌa-v Ìlc i'
tlÌe attriction ofproYicìinghypothesesto suggeslÍ'hich
the contiÌÌuous groirth in ìn'nìg Íandar'Ìs, thct are less conlincnrg in
accou'r:::'
leatrìrcs olthctlorld such as the pattenÌs ofconvcÌgen'e !hat:ìre obseÌvcd
ânÌonS:::
'
groups ofeconoÌÌìics
Ìr thc se.on.t chapter, we irìuo'lu'e Lhe Schunrpeterian âppi{ :'
paÍ ol the
erÌdogenous gros'th siÌnPÌe vcÌsidì of the Hoaitt nrodeÌ of SchuÍìf':'
^
gio!\,lh is scl out, which chara.tÜizes
^ghioÌÌ
inno!.tion as a prccess oI cÌeativc destru':r _

ìi was oescrirt<-r byloseph schumfeter. This approach cmthrsizcs the rolc ol imr"'
cornpetition in mstainingthei r ovation proccss The modeÌ caiÌ bÊ erter decì to i _
'
not ; nly thc .Ìeter mÌranis of the pace of inrova l ion at thc atkl tcch nology tron rr-: _

also of th€ te oÍ gÌowlh ol (ountries who nìa-\r be ablc to catch up

throltgh i'::'
on b" - '
of tcchÌÌologv traníèr, a h ìch l\'âs üúro'Ìuc€d ! n chaptff I 3 ' thc distin'ti
technotogr iransÍer throLtgh inìilatioÌÌ an.ì the creation ol new bluepÌ1Ììts
that a'i:'
thc Í1!ÌticÌ opens up thc fossibÌl iN-- that .lilfercn L kì ds oI PoÌi'ies oÌ inslìtutìoÌ:' -
raise grorlh for countrjcs thtt are catchinia up, as conìparcd tlith
lhose that ar' ::

1 Endogenous growth theory

Ll The ÁKmodel
Ì
The,1K modl:ì is the fnrt()tvpc mocleÌ olerÌdogcrlous Srowth Oncc dìnÌiÌÌishiÌÌ! r':-
to capitaÌârc no lorgeÌ present, ile can ÍePresc.tthe productioÌì function b)

r lhelÌerhèntindìi\se.ti.ntrndúìefr\t.n.rr5uinuÈn'c'bvrc'iionl l'f^ShionJndllo'rì::
 53i

Ìvhere .ì is i .onnint uÌiú reilectt the le!€l ol rc.Ìrnolt)g\ in the ec,)noÌnr a.L1 do.\ ,ot
\rÌ\ r'idr lLnr. lrorLhcfiÌlnrerÌt,seitrbretabr)uÌ.1sunÌrl,r'eerumer..ns{rnLsnli.gs

Ì et u! .or! rclrLrJl to the (üÌrital ac(unuÌrtjr)D cqurtl.n:

( rl J( J],\ r,(
( J_.ì ,jl rÌ 1.2)
(
/(
= i.Ì l

Coìtr!nihjrsithth.cq(rlriìlc.r.ìpcsof irÌuÌeS.now 5Ì{an.rodcl:

Ii=iIiK 1 iìK

r! ir 1ìrc.:r!. oi Llr!. Co!tr LÌmglr\ prod!.tnÌr linrtion

re..hs!i.iÌfr.du.t o. i(Ln.L o. jti\notpoj5ihl.Lor!ÌiLrenr:x])r(isio.lorl

1\Iith thr
a r hn.tjor .I lhc rÌogrn!us !ariiÌlìlr5

S.lolr SÌri n nr.a.ìì

,< Ka
,ihL.h, rthrn \!'itiln Lilie thi\. \lì!r:.lci,rl\ tlÌat r\ thr.n!ilil sLo.k.\fandr, its gÌôr!Lh
.iLL: d..li.cs. lhis \juÍrnothrrrt,ìt oisi!iLÌ8thil ((runs L!.rpitâl rrc nol ct)i1sliÌr1l
:n.l Ìels n,j lhr s.! iÌìlr r.tc dors fol rii:c thr 9rul!lh rxLc oÍ tÌrt .rtjtrl stock ÌreÌ
'heL
ri..nlh llr.ontr,rn,it]tlÌeÌrcr'1(1lp.p'odu.1ion trn.lit)n. jt j\ catl n) 5ee thrt r
ri!h.r sillngs ralr in \r\ tli. !l.trllh ri1r.t 1lì. c,ìÌrilrl st..li rnd oi!(tÌÌú perDrnentl)
L is inrlorlint Lo n!1! 1lÌiìt tlìr .riporì..1on c,rpitil n thc.lKfÌodl'ctllr lürlti(D hâr

,:, b!'rri.tlt .qual to one to proiu.c .nd.!rno!s gírrr1lì. Il il i\ DrÌgjfaÌlv leí thaD

.r. Lhc Dodcl r,!\rrtsnr e\olcÌÌou!!(trrth, aLlr(itÌri1h !.t noÍ..nrrÌgcn.een(l jIitir

ìi,!nalÌ!Â,iÌt.rlh.LìoÌre,ilr.r'th s .|.{plosi\ e, rÌoL .,rnsLent. ThLs mÈrns Lhrt oulÌrtrt
ì(.oÌìc5li ìÌitr in tìÌìite iiÌÌÌe. llÌeprDptnie!olthe,1li Ìrod.l ir.nroNni. lig 11.2
lÌrL: Ìlfcirilrol lhr prod!ctnÌr iunctiür is.pplr€ntr.5 ìs rhc p.Ìnri..nL .if.1l o. gnnrtÌl
r a.hangc in lh( s;ÌrirÌt\ rrte
Th, nrain r.sLLlÌs !ItlìÈ.U( nìodiI irc
1 lhr 1( rxxlel rlltrrt foÌ gr!r!dr nì olÌtput at r Ìnte lletennirÌel bt J.l,i.
I IIjghcÌ srl i.gs J, iì highrr l.1.i.ir..l'rd1ojt..1,,Ììd loÍ1, dctÌr.jaLjo. ÌÌrsitlr cÌ)
atfÊct tÌr. groir(h rntc 1rt ourput.
ILh.rÌìiÌleldoe\nole\hibit.!nlergenccrin.e.oultrie-\nrúirÌ{sitlÌdilìereDt
üriti.l loi ceÌrìtaìÌ!iÌl.oÌriì.ue to dtr cÌgr at iì rate pre(dbed L,\ ir. 1lÌrÌe rre
raLrìes
,ìlso Ì! traxsitjiÌrrÌ .1).rÌnict: the Sulth irt, jumÌrr lntarÌtrDeount \!herÌerer
thrÍ'is.ì (lr!n3e iÌì teÈìeteì r ahre.

4.
532 .t ..:'

Figure 14.2 Ìh€.4( m.de

dJslr'r'ltorì of constanL ÌetüÌn\ 1o

The.1K mo.lel Ìs tÌol a .onÌplcte Ìno'lel becaLrte tht
there are ÌÌo dinÌinjshiÌìg Íeturnsto
-t lirLp,,,a.*t tr."."*tt: it Ìeaves unexplain€d
'!hv
rcquiied of anv modcl ofcn'logcnous
ca|itat. ttor'cver, lt niglitight\ lhe ke-v conrpoÌÌcnt
rr,\. I le- JrL. r "l-_' 'r''r""r'rÔ
l"r'drl d n"l'r"C
ì' ,, ; ' , r'' 1i{ 'r"' r"ir'r"' \'r\\L' ^r"\r J-
, Out.""
',,;
i. *pnn , --'ruìatio n, bv th e accumLrìatio n of h unÌâÌÌ capitaì atÌd bv rescarch
'
"
n ncì dc!elop nlen t acii!ìtY

1.2 Knowledge spillovers and growth models

r,- h l rjr" lr 'l êr '1 dr1 _n \rl $' orrS ' l" I'u\'"1 I'
ì"ì,r'., nì-,i,. ,' i r-
rr" r'e-', r rrr" r" "'
I r rr" ' ^l
' r'' r'
A( tÍpe fürction' Ile
t,' .i^; ì Ir"..,"',,-r pr':ductì':rn tulcLor anct an Production
"'
i,,aid'" n""cla"icar proãud ìon lunction nade'Ìuatei lhc:!ro('th conteat:

unhapfv'o!s€qlen'c tlìaÌ iyolNtÌì nr pÍürrcliviÌy tak's pla( iÌnle

lllhis at)Ìrioach Ìea.Ls to lhc
ut u'" crtitaL !tÒ'k lìri5 adaÌlÌrtior orthe cÒbb
lÌmglas rúDctntr lo
o.I;.ìir .t l]'-*u
ol3roNth itse t'
'
'*t"*in t"1ì"*..,.Ut.," reì\c. lh€ sacÌj6r' ot n satisÍi'lor) crPlanatìoD
"
(ìÌ lhe olher hand, he 1ìncìs the "l('LyPe lÌodüction íuÌctÌon usctul lot nÚdeÌlin8
g,,*l' "i J" "gg*3*" r"vcl but unconllncing $nìen appìletlto ind ividuâl li trns:
!,conoÒi\tJhavetôun!ìÍ(hmod.haltrxctilebccau\colÌh!cml!asisthclgilet'icaPit'ìlacc!and
;ìi"i"," "' .,. 'cn6nì. or srolvtlf an cn\rÌrâst lvìtlì (letp iootstÌtnr e(ÌìoDrÌc thoulht
i,"."rt" t,r"" **-",,-il-v 5atúhins rcÍrìts' UnldtruÌitel)' I;lKlplodlÌctiot runcti'Ìì
nis notÌÌ!ìg nìÌcrestirg nr sa-t abo!l Ìeínrlce âlÌocriiÔn incom! dhLribution
'r
|ÌarÌkcl's contributior n to Íncìâ ay oí leconciling thetú! pÌodtrction tunclions ír
thattlìc.lesirablep(rpertiesofea.h'butfoneoftlìelimitations'arcretained'lheidca

I nkelllt62lÌrÌ!r\Lal.rder('l)edNither'ogenou\\ating\1r)tauRÒderirrÌ936'
 533

isinserÌirr\:th!c.o...r!i\populalrdlrvnÌ.ìn\lìÌns.ta.lÌ!lrlÌiclÌi\.h.ìracteúredb\
ir a obb Dougla5 tr)tÌr.L on irLn.Li.f:

t: =i(l ill

lrlrcrc i(ì5tcad ()l Ì treilg af .x.gcnou! tnÌÌlrl \ tt,fi.lÒr âs ln Llrc S.loÍ' Sjrin nÌodrl,
ll .ìodcllrd rt the drlrr,r,ri oI rggrcgalc .efiLil a..unlLlâLlo. ìn Llrc (r.).om\. \.,1i(r
is
Llril k.or!Ìcd8e erÌter\ thr fnr.luctLon lLúrclì.n lhrou{h Ìibour. hc... ÌcÌrrcsc.(inir lh(
ldci Llri t trinoÍleclse iÌì thc r..nomr h.ìnsìrrcs inro skiÌl rL Lhc nr L.:Ìo lr\ L:l oi Lh. líì iÌnd
1lì.r.Ìr! aulmtrÌt\ labouÌ fÌo.ìucljrirv. Thi\ is ef rìiDrÌrl. oi lhe thenonìcnôn k..Ìr.
âs lci..in! b\ !loirÌF. \!hich talct ÌrÌace thrugh lÌr. e.cumularion ol cafjril.r Thi6, r..
lìnrc iìÌ lhr 1É\eL ol the nnì

,ì ,1'l( r

Ìrh.rf ,, i:
J positir e . on \t.nt. It i\ ar5lÌmed tÌrat cacb nnn \ linonlclse is ! lrLrlic to.d
i. thc 5rn5r tlÌirt it ìs a\aiÌabÌe n) ìÌl other hrm\ Ìn the r(ononÌ! it zerì (ort. \\'e (dÌ
Ìhcrc o( .s3rcgrte icrtr\ dlÌÌirIìt to Set !n exÌrÌetsi(D tirr r(onom\ uiclekt]oÌlLeagr,.{:

(hcr,( li Ìhc iggrrg.t!- crÌ)it.ìL rcro\s ill1ìrrns iìì tlÌe c.ononìr A\ r!.lrir. s.L:n, ú.lr
lnnì 1âkcs r ns sì\ cn Ho\e\er. thr pri!ciiür 1ì,nctioÌì nrr lÌr. c.on.m|as ârfh.,Ì. Ls:

t-Á, rI :( tL/ I =.rLj ('ì Ì ' "tÌ '

Tlre terruÌts oi Llr. l rÌ'i
h...on.nrv s Ìrf.idrct .n tlrncti(!Ì a.e at ntL!$5
nnd t

l:
rl) tor tlÌe Êu. tlÌere rre co.\taÌrr Ìetunú t! \crle rnl diiìlo 5lìi.g tr:LúÌ. ! to.:rfi1rl.
sin.e I is (onitrnt n! the ÌlI!
t2l it)r1hr'c...onrr, lhc carcin.rcesi.! n LrrÌ.s Lo s.iÌle irrl L + ì - 1 ì, 1).
r3l '11Ìr \i4 ol the lnoÌrÌedse rpìlld eb hon catit.ìÌ rc(!nnrht on. ,i, n ill 11.1. rÌì i.c
ülÌethrrretrüratoagg!egatccdlÌitrlaccuÌ!uhtionrre..!rstirtl11ìi- l), i..rcislfg
1,/' 1l!rdinìÌrìthnrgi,r.: 1r
It i! imnr.dl.Lclr.lriìr tlì.iii !Ì. likrlhcsfrcial.aÍ.irr=1,$hrÌekrurledgeriset
(1iÌr.tì\ i. Ìrhto,rioi Lo.irpilil.

r .1,1 (r
.rlitiìl r..rnnulation iÌr tenÌ\ !l thr !((!
hÌ (,tlÌeÌ rrÌcìs ìt theÌÊ.!r,.onsLa.l rtltrnrr nì
nNlatn!Ì ol lÌr(rr ÌÉdgc. th.. cconoÌìr Ls .letcribecl Ì)\ uÌe l( nuìel Ihìj
Llr! eggÌclatr
tul!le5 an elìrÌa.rLio. Òr li.]ogc..trs gnnrlh 1i Ì = ll that is (oÌìt]\ÈÌrt rith the
Ì)re\en.e ot x ne.cl.úri.el Pír.lLL.Li.. tu..1i.. I.r Llr. l rÌn.

ri d,r!Ì Ì l ltqif:r 1lr ! r( lr, :ii,ILn rir ì !, i,ì ln6:

534 :. . "'
MoÌeoveÌ, thcrc aÌe iÌìtercÍjng insiiihts from the küowìedgc spilloveb nÌodel thaL gc
bcyond ìts role ilì provnling a micn)ecodomÌc bated siory for thc possìbili\' ofendogen

. Iiht, it Ìnakcs clear thaL â mocìeÌ ol endogenous te.hnologicaÌ Progie\s docs Ìroi
neccssaÌìÌ-v e tiil gr.t!th. ll 4 < ì, then the econom,t g()ws at a ratc ìn.lÉ
cndoijenous
pcndcnt of t1ìe savjngíirlvcstnrent rate (uìÌlke the.1( modcì) buL its output pcr catit.:
docs grcw (uÌlikc h c soios' Swan nÌrcìel). l o see this, $e tak. l h c Ìl trtÌLrction lun.Lion:
t

I ]1i) ,,,(1Lr irr^t.r i andlootf.n a comnÌon e\potÌential growlh Ìate foÌ outp ú ana (

cipllaì. Thì\ requÍcs ustotakclogs and dillcrcnLiate \!ith respc.l !otnÌe toget:

.!f = [(rí1 À] + d)l.er + lr a),

and thcn tetJr' : lk, to 8et
(1 a),t
11 d),
ír -3& = 1 r+,?H = a ,,lil : (ì
,/l t
'lhegrowth rlte ol outPut pel..ìllír in tlÌe stcadÌ ttateisSt r=,i1rL tandtheÌefcÌ.

'r'II
'lhìs coúrâÍs bothÌlith Lhe Solow S$'ân ÌnodeÌ r'ithoul technoÌogicaÌ progre$, wh.r'
.ír:0ancith€nxnleÌwithlcchnoÌogicilprogress,$'hcrc.$:r'whereÌisc:ogenou\'l'
oúÌ ne$ n$dcl, gro\th ot fer capita output is Llue enlircìy !o technologicaÌ pmgres b!:
rhìs ìs now €ndogenous, jn tìre seDse that it arises lrom Nrowlcdge sÌJillovers associâtÈ':
wìth capital accumuÌrtion. tliNelei, . hì8hÊÌ st\ingíinvcslment lhar€ docs,dt.rl!:
Lhegurthratc. Thì\ will onìybe the câse\!hen, 1ie.iÌrlh.1.(câse.11ÌemodeÌal\
impÌies thit laster populatjon iiufth leads lo la\t€r growth ol ìn'ìn3 sta dards,a'Ìrich i:
not a res!lt thal accords ith the tt-vlizcd lacts otgro$'tlÌ. lhc thÌee cases ar€ contÌant-:
in liij. 14.-1.

. Seconcl, thc kno$ìeditc splììoveN modelraises an inter€sting poììcy ì$ue Sin.e d..:
sion nrakers at tlrc level of lhe iìÌìn take no i..ount of tlÌe inìpact oí lheú in\ estÌncÌ::
thrughout th. economy, tlÌere is a ditlercnce b€t\rc.:
dccjsion5 on trinowlc.tiae araiìabìc
lhc optnìdl amounl oiirn'eímcDtfÌom tlÌ€ p€rspcctive ol1ì n\andftonìthepeLpe.lil:
oI the economl'ar a$hole. so.ìaìplânner looklng lÌom the perspectirc ol lhe econonl
^ lhe eatelralities lhât aúse iÌom..pitaÌ acclrmulation i
at a whoÌe t.kc5 inn) accoLl.t
this context thc actions takcn by â nÌm rÌìay not be ld,.ld ,Pltrdl lrom the $cial poi.:
olvie$.lhismcansthatthcrcaÌeactioÌnavaiÌableÌhatwouL.l!ÌìatriecvcÍtonebettero':
wittrout harrning anyon. lhe Ìeaton the], arc Dot chosen i! becâuse lÌÌns hil to r€co!'
niz." ân aspccl of the declsion pnrces uÌat ls o.lv proPeÌÌ) Ìúenìrìlizcd in the de.itn::_
once \!e adopt thc perpe.livc of the vrci:i plann.r. hr oÌcìer to see Ìo Nhal c{teDt Ìtr::
niaiters .o.sìd$ tìÌe probÌcÌì of how nÌuch to inteÍ ìn capitâL lronì thc fcApecti\:
olÌ)oththrlndhìduaLÊrJÌandtìreÍ)ci.ìlplnnneÌ.Atweha\eseenirìthca.aÌv\i\:
in\enrÌìent bchell{tru irÌ Châptcr 7, hrms pat' a tÌice gnen by the ieal lntffcst Ìat-" n::
 535

1)
Ènd.!.tro!\ innrtl, Ìì = 1r :in soÌo1 duìcL uni{Ìúe
rn\ Snrltlr ralelio\\ibÌe sr.è!df rtrtr. grlr\ ür ritÌì
jr=,rì:l =(ì

't')

,ir
Nnlr\!ÌedS'r sl!Ìtr'Úi I ith ì i Ì
- IlL.,.0
ìr Ìr '\r- '

Figure 14.3 (r.i.1!:j! .'r: j..r tr. l.l':'L: !r''rlì Ìi - l'ii !"!r:rl'' !''i i rr < l

i nntr's.rr Í:r 5!:.rr

(itital \cr i(t5 end .hoote iJìc !pLltirl Ìt\ el ol capilel ,\" lhe! Ì!i5h lo imtltjÌrc't m'h
th;L it nìârún]7.\ tlÌclr tÌolìts Thi\ nriiÌ'\ eqürÌÌi8 lhe mrrsineÌ
ril cnuc trodrlct ircÌn
crL,. unli,rl.iÌlital qltlÌ the (il rrt'rt5t rete Ì(ÌÌr the $ciaL
pldtrÌcr'\
l,,rt"tLu,g
,1" ,1nU.", .rplirÌ 5to'l \!ill Ì)' 'lì1in'' I lìr'e tlrr t!'lrÌ LìiÌÌglÌ'ìÌ
",t Ìe\ tnue
l,.: *p..,"
". it'rllh'ili
Ì^te So n) Ìht (liiIcrerÌ'rl)e1\tccÌ!tht
Ur,,,,i,":, ,, .1,'", u, Ut" t",ìLirÌ1.Ìe!1 'ÌorJr n'cruìru
prn ete an.ì u, g naL r(i tn!': th' ÌrÌesc"c (ìi 'rtcr 'aLjtLct lrcm 'afit'ìl hillìLÌ
j.,rl., nc.,''oclel
tL"t iri'i, -V/ìI'r n.d h(f!e thrttÌÌe nr'iiìlfLrnntiÌ!iÌl'1ì'!\' i
1h i\ prn\ 1!l's l
Ltrcl or caplt,rl sLr,cr rhan I lll rÌÌlrâct('i7Ê tlì' 'ìt('flr!liTtcL "(Ìrotr\ '
rnLiürÌalc iL)r th. go\ lrnÌncül L. iÌÌL rì!l!r' {Lrs
r:ie\ iÒr iÌì1c\tÌìì'nt'

1 3 Human (apital accumulation

ìi,r \aÌ)..11.ÌaL k\ d Ì]]oiÌcÌ\ lìLn{LLL'jÌìB Ìr!rì1irrì Ì)I|nlde r't:n'rLhcj ÌÌcrll
'rÌ)i1iÌciìn iÌ'crr]nLrÌdils Ìnor!'Ird
.uÌi5m b\ irhiclÌ rrtrtrÌs Lo crplLaÌ nil n; ü[
'o'\rant 'corì't1]
,',,.,. \.1 (ÌÌ i qÌ!l hrrrdirÌerìtrl LtlcÌ. lr! ÌÌ'dÈÌÌìrìg ÌnrÌìrrÌr ''ìtjt'11
",r,,..1,nf,"U
,.1,c,,.1 .. Lht nÌ.raì\i rS rÊlliTrtiorl rÌ1t ll ÌìliÌtÌer\
(! t rc LorÌg Ìun l!'
".on,r.tsr,
nomlcper ornrrrrrcol.rr]rc(!Ìonr\' lrirri'll7ìti'r'jtdr'ÀerrnotoJrÌ\t'\therorreÌ!tli11\
rttheÌnr.Ì(,Ìe\.loiihrlii.ldirc!r\c{ÌiÌr(hrÌrlrrÌlÌìrLLdl!ob\tlrc(n)n'rriio'i!tlLÌÌÌ

!
536 .,

lcveÌ Ìnâdc bv Ììanagcrs of mccrss luÌ buslrÌcsscs lhal cnt€rprne\ thai hrvc hjghlv skiÌli:
empÌotccs, divcrsc and meÌitocraLic hlrifg polÌcjcs, and .r luppoúìre coÌÌrorarc cultu::
tend lo ouLpcíorÌ rhcir coìnÌretìlor!.
Ior jDveslmert in huÌnan capitaì lo prorìdc a Dcans for avoiding.lirìinìsìrirg Ìctitr..
to 'capjtal , nr cquarion of the íínÌoirjng torrì ior lhc a..unÌulatnrn of hunran crpitâl :.

alJ:

asdevekÌred bv Robeú Lucâs.r The anrount of human capìtal pcr pcrson â!rilìble to ü::
econoìn_v is ri. the tÌactbn ol1.ìLJour hours !Ìrent in eclucatjon in ord.r to learrÌ re!! sli;.i
that can be use.l in ptucìuctiorÌ Í 1 ü.. and r í a \caÌnrg paÌaDrctcr. Note th.i lor tlì:i
m eÌn) puluce enclogenous itrollth, dre exponeÌÌt on thr st.rck oi hurììan c.pital nìu::
be exactì), one. Ìn other wo s, hunÌan capitaÌrccrnDuÌathn js ììncar iÌì th€ I hunì:;
.atital gnrls in pr)poúion to the exiÍlng íock. ln ihe Solo -Swan model de\!iiÌ::
more re$urce\ to crpital a.cuÌÌÌÌrÌation via a hìiiher savjriis Ìatc raìscs thc lcvcÌ oIoutp..:
peì hea.Ì but not the grNth râte. The Ìerlrlt ]s eu.tlv the sam. in lhc \4RW crtcnsii;
of ihe Solow ÌnodeÌ$hen the share of reÍ)uÌces .le! otecÌ to human capltJl rccurÌìulatnr:
í 1ncÌeased. lD each case, cliÌìinishiÌrg ìetu rr to ac.LnÌuÌalion prcvcnt a pcrÌìinc.:
gu{th effect fÌom occuÌrirrg. B\ .ontÌast ìn the Lucas nrodcì, dcvoling more libour I
human catital accun latìon (a\ comtared with Ì)uhrctnin) raiscs tlÌc grorfth rat. :
human capitaì pemianentl) .nd hence the rate ol gro$th o I fcr .ap i ta o utjìr t.
The iDhritnrn behiDcltlÌe plau\ibllitt ofconstant Ìetums is thal thcrc is ir strong Ìiìr.:
oicl)nanÌìc leeclback Èorn edu.ütidr. Ìt ì\ ceúâinÌv the casc thal sornc kinds oflearnin:
open the wav fd ïìuther leiìrniÌìit ilithout Ìeacìing to cìim in jsh i ng rct! íÌs. W hetlÌer th, i
tèedbücl n Írong enoughto melit the asumptidr otlineaÌilv rcnìains an open questi.Ì:
'llìe iÌÌtenslve production lÌmction coÍesÌrD.lirg to thls modcl r,lll then be
Jìi\en br

(1+ r
/, =..ilri " ri'rrl " ,\Á, tÌ.11

It c ca. assumc that ll,

consliÌìtl tlÌât is ttrat forthe economvas a Ì{ìÌo1e the lracti.Ì:
is
Íiìl s corÌÍaÌÌt, lle can rjmpÌÍ r.rÍit€ tlÌe píxlucti.Ì:
of ìabour hours dcdi.al.d lo rlork
functjon in thc íindard ÁK Íorm b) red€1ìnÌìg.\ = tI " Íor all tiÌne peÌiod! an!:
,, = rlft] ",irlìl.h(rc.n.i.lcrpr€ttobeabrcâ(lmeamrcotcapitalfortheeconom\
that i.cìudcs bolh phlsical and hunÌâ câpital.l his coDhÌnrs lhat \!ith tÌLe human caf
ital acclrmulaLÌon cquatìdr jn lhc ibole foxn, the Ìnodeì is o.c of cndogenou\ ij(^fiÌr:
nrore time spcnl sludying Ìaiscs lhcgroÌlth r:ìte penÌìanentlv. \!c.an sâ) more abouttht
implicatlons ol lhjs model úsing lhc technique! usel jrÌ ChaltLff Ì 3. fron1 tÌie accumuÌr l
tnn e!Ìuatio. nÌ human capjtrl Í'l: can write the growth râtc oi hrmân câpìtal as

St :.íl !l
 531

(Ìii(hi\clrnslrntuÌ1dcÌtlÌeai5rtÌì1, ÌrtriL!r.i!.(Ìr\ta!ìL letnsnürl!)lrttlìl S'lo\

rq!rli.)n l.Ì thÌrÌÌ(\lcL. 1lÌs.qtraii!Ì!ÌLllÌ1, .(ü\eÌ).!r'Ì\ rirnil:r'Lo rhri.iihr strn'1
aÌd 5Lrlorr \r'r. rr\Lil sjth i rol\tarú !'rngcnoutÌ\ Sitcf *\ iÌì!5 relt. e\(ept ihiìL ( e
rÌe iìrirÌg. dL Il'Ìtnt Ìru]!.tio. f L'nciirÌì:

l, s.Ìll'irr,l!, ,, ,rÀ' l +.,l

1\'È|.i. iÌiri.Ìe t)\ t, drd rrrrrllr i.hir iquetlt)n jÌì ttnÌÌs ô lìit!Ir)Ì!Lhratttlir|.iPilaÌler
r1)rlcr iÌnd ÌtenrÌËe to obLii.

t (l l rll
l. r' l

lh!srrtrri5iLÌrfol!dctrn.tÌrIli.lorÌtlÌrrn(nxdì.u5gr)rthIr()Ìrcrt\olllÌ!'lrcì\
rÌìi!ÌcÌ: Lt ÈLl\ u5lhit Ll a itta(l\ ilitre\iriirih.r'.afi lP.Ì"!oÌi..r!nrrtìtr|.o'!trit
ri1!.l1 i\ nrrei5,rI n llrc Ìaii(,I lr Lti bc .!n\liÌnt. OL coulsr' this i5 o.h lhe úÍ I b(,th li
rÌÌi lr !Ìo\ b\ ihr:inrc Ìrtc nÌ iiìr'Ìo.S rin ljrLrcrLÌÈ,rdlÌnnr\ Ìrlril the!r'\tlh rxte
1,llìrLnrrn raÌritrl !r l! n)n e!Ìurtji. l +.ii.
'1o !rLm ut. thÈ Lrtri5 tro(ìeÌplrt Ldct r nìr.hinLsÌr toÌ L.doBin!('s srrsth biÌsc'i (Ìr
r broiLl DÈr{( ni.rÌìil.Ìl rÌ(1 ir ..heÌeÌú ..orrr,Ìnic 'to'1 i\ nr I r! lìre tstur1Ìr Ìxt€ ()l
(rl]r1rt fcr r.rlrr ii i..Ìra\jìS iÌr thc h!Ìe if( n1 Lrll cttjrì! i. td!.iLl'n Ìr Ltiroìlfg tÌ(iÌlr
Ì11ìt.i. beLÌ\er pnrdu.lLltl\ hiLro. lld\r!{'Ì oÌ endogcn(Ìrìj gnrltÌì tornrogc tlÌe
\tÌr!ìg n\\uml)tioÌr r,l .nfsl.!1t retLLÒr\ lo hurìre. .rfúrl r.cunÌrìLari" liìì nÌ!51 h Ltd
L!.i5; gr.rih nìod,l lrr\ r irn!rrÌ iÌrrÈrr5li.S !r!Ìtrlh'ttn!Ì to nreÌ'c lÌ!''ìr!trc\ tl i
ÌruÌ!i..rtjt.ìl [L\ i]..\tcinal t ILlt at trrl i.r' nrr I !nerÌ L.rrl oirì!r 'Ìr' huDLrrì
LxÌritat.Lh.ìrjSheri\IrL'Ì.tlinth.c.orr)Ì]]l.LlrrhiglÌ..rÌÌÌÌ\'nrrfÌ()(1u'11\lrl'flÌj:
jn
n()ti!n o !ÌrjÌÌo\ eÌ: ir'o Ì lrunüÌr .iÌfLtaL r..!nrtrlltir!Ì 5 íÌÌÌttitr'! dis!"r\scd ttüÌì5
ot ihr..n.ctt (ìt to. ll .rtjtri rnd Ìritb noL nnll tt) iLri.i nlltii' 1loü \ dr'l Lht tÌrd!ìg
otidr,ì\h"txÌ!)totlx'.1.oÌÌerir..ji\rnd..ir'.:bihr\nrÌ Ihi''ttli:rtrÌrÌÌ/r L'
lìre ploilL.li(tì iìn.l on 1t, = .\k, !,/r' /ì : LÌre tÌrr' ndi(iìtl: thiìi l'r !'r'h rleÌìl n
rhre.o.onìr.tÌÌtlr\cl.Ic..ÌÌ(Ì|1 Ij!LtlÌunri..tÌritrl i\taluìi\'(!Ì\tifL r'i\ ciìLl!a]
thil. thi cltolerÌt,: ' Ì nrcaf|Ìr5Llrt\ireÚiLÌrrsÌìiltLÍ' 'TlrtÌrÈ'nre!l Lh !tìtenìil
citr(tisqúLte\e|rr.rt!'ronthterìd.qcÌ!o!:'llnrrlrllirn'ffrrrr) Ìh'Drolll isltelLrfl
\.dÌ. rrìil.gc.(u\ !ÍÍÌLh {ÌcÌ)c!Ìd5 nn the liÌì.nÌ Ll ottlr. hulr.rLr irÌritaL i"\rnrtrÌrtion
lÌ().È:\r L lntr({l!.f5 lh. sxtrt ft,L!.tial..iìi 11rÌ S(^e nrÊnt f'r 'l '$ si5lhr 'art iÌì
thc l.ì tlciÌgÊ Ìrilnn(r iÌ(rìÈl t. Llrt tÌtüll Ìhrt tÌÌe :o'ial retÌLm nr lnrr]]if 'rtii'rl
xr.!ÌÌÌrLl.t L)n ii tsrÈrlr th:ì.1!ei.dilidrri.f!'ilr ' j ll,t!Ìerclrr'!\Èi'rsrtÌr\idit's

I 4 Research and development

LhL\ titi.rì F ô1rdeì rn !ÌÌridú.tn!Ì 1.i tht rr)Ìe ot id.r\ tnd L..hrÌlhniiel L'Drr 'ìt on
j'
r\ ihe dÌliu!'. .c(Ìr.nìj. lrnh lb. ÌlÌ. if|Ìoì(ÌÌ ti t!'.hnol1r! .aÌÌÌ.!Lr$ the 5'lon
\Ì!rirÌÌ!ri. Ilii$thelrÍ)..i5,)tLt\1!letIcÌcrltrrle.o.oìÌit1o 'r\' ÌhrrciìrctÌ\!!ipc'Ls
' s(:in rfr 1.,: ij.ì ìf,
538 :' ':

to this: or thc one hand, improlcnreDts 1n productÌvìly afpcaÌ like manna lìonì heavcn
atnoresoürcccostaìr.l01Ìthcolherhand,accesstolhcneslechnoÌr)gyì\universâlsojl
has tlÌe characlcr of a public good that is not excludabìe BoLh aTects are challeng€d in
the g.oÌÌth nìodcÌs that prìt Ìì&D at the centÌe ofaitcttion
Ir.l.oro lri once called lfnovation 'the induÍrial Ìcìigion olthe twenti€tlÌ century'.
The iÌì\,entors lhat push fofl\,ad lhe bouncìaries of huÌnan knowìedge thÍtrìgh thc dis
covert oi ÌÌcsr materìaÌs or goods Ìepresetri onlf on. paÌt ol the drivitrg lorce bchj.d
technological progÌe$. LÌÌìovaljon woÌks through cntÌcprcneuÉ rvho iÌnplenÌent thcse
.Ìis.overies and brìng theÌn succesdulìy to the rÌarkct. R&l) !s about irnovâtion and
firm\ deciicate biìÌìons olciollars Lo jt. NatuÌallt, âs cconomists, we asl the qu€stioÌì tlhat
difleÌence does il nìakc n) tlÌeÌong-tun peÍì)rnan.e otan economv?
The notion thnL innovation as lh. outcoÌÌÌe oi pLrpotcful economic acti\'ity ls rlti
mateÌ\' the enAj.c of econodìic gro$th catr be Íãced back to the work ol Jorcph
Schumpeter, an tuÍrian econonìjí lloÌking tìt HaraÌd, wÌ1tìng in the firÍ haìf ot the
rsenrieth centutv. schuìnpetcrjdcnljnesthe e treprcncurasdrekelagentnÌinnovation
an d .ÌistingÌishcs i\.e mtjorfornìs,"

. deleÌoplng a ne$ routc hy irhich €iÍing tackÌt of prod!ction arc channeìle.i ÌÌto
t1ìe production process;
. .ÌeveÌopiÌìs a ncwp(rcìuct or ìmtuiniithe quaÌìLl olan e\i5tÌÌg product;
. dcvcìoUing a coÌÌlpictcly newprcdu.uon prcce$ lor.n exìstjng p Ìoducti
. irúrodu.ìÌìg aconÌpletelvncw market, ivhere th c Ìe PÌevft)usl)Ì ivas none;
. cha.ging the lndustrlal lancis..pe ol arì indust.\ 1r econolny lhrough tcoÌganlzation
(veÌticaÌ oÌ horizon I aì meÌ8ers) tlÌat ìrrìp ro!Ê pro.l| ctivc cltìcicrr cy.

llut thc cnlÌepÌeneur is a ratheÌ .Ìifferent creirturc tÌonr the bene\ olent so.ial pÌnnter'
lìe so.iaìplannerjstlìe lìclÌtjous agent we lÌaLc úsed n) ìnlestlgate ilhetlÌerthc a.!ion!
ol dcccnlraìized ate tsin !heeconomy actingin lheirown lnterelts produ ce thc sociaìÌì
optiiìal ouLcome, i.e. thc onc the Í)ciaÌpLirner s,ouÌd choose. Whiìe the \ocial planncr
is nìo ìratrd pure\' Lr\' ih c weÌfaÌe ol society, thc cn tÌetren eur Í cìriven bl. proÊts. l h tr!
r

nìnovalion can o y happen il enüepreÌìeurs .4. at Ìeatt tar a Ìinited pei,rd of liÌìe
carÌì prolÌts in tìre arkcl Place. Ir orcìer to undcrstan.l why a frame$ori ol inpedc.t
.omperÌrbn is botlÌpossible and nece$ary in ordÜ to facilitate the tÌoce!s ofiÌÌrovatlot
wc llrnr our atteÌÌtion to lhe natiúe of td.ds.
In somc sense, icleâs arc bodr the irput aìÌd the outPut of innovatl)n. R&D takes eliisl
ing ldcas fÌom the pool oÍ humân loo$leclge, üonì calculus Lo phvsict an.l bidog), .nd
lra.slaret them irúo blucpÌirlts foÌ re$ conÌputers or dNgs. As SchumPeteÌ noticeci ho\i
cvcr, innovation does nol onll generate rer{ prcducts, il mayalso leadtobetterproductj
(the Penttum il is not a .o! prccluct but rather an improvement ufon tlÌe lentluÌÌÌ 3 .
oÌ new marliets (the cnircpÌeneur i!ho \uccessfüllv ÌntÌoduccd conr meÌclaì thotocopierj
oÌ hoìne delivery of pìz7as created a completely ncw matkc0. The ideal that tì)nìì th.
outputoftlÌei novalion ptr)cess howeve. are dìflcrcnL lrom man-v ol the otheì goods r.

' Schurìf(i.r (Ì9:ljr l9úleditiof:661

 539

en.ouÌÌtÌ ur.r.Ì\(1,ìl lLte,ì.dt.Ôn.,ìjstsfuferiolirenrrslo\!c*ingLhepÌopertie\oi

,Ír!iì !tr1 and it/ì!irì/ i/iri
leib'Lu úÌ\cnird
\onrlraLrrrcfersrotÌrtu\.olenerlstiÌÌ8L'leriLzeloÌÌÌiìrgjnilcoÍ
e:tel eiÍort in leaÍrìnts h'q t')
(iìleL!s ln 1;;a rnd si..e thdì crtÌ\ one rììo has ln\ the
!dditilnil (os1 orÌ nn\ onc cÌ\r
diilcÌenlirte cn. terl.Ìm tlìls lrJk \!iilì'ut irÌtoling aÌì!
lri-.,"" ,-, ,u,'*"u' "rr .on rtr rll'tr\' and it i5 the rn âÌÌols nrtrrrc ot o't ÌrrtlÌril
*s,ru.rsLtt"tll"tt,et,ln,iün1cÌìhuÌÌLr'L' llict\1'\tgo(trlsloucnco(tnteli'e!'ry'lu\
ittcrret,oLtercrurrrltcurdrnaLÍÌL.l,tcooli.ìiÌ!ìcrto.i3hr,nÌ\rseDithescaddirion.Ll
toüÌre\oLtr.esrt!n.srtrnrìr:inrÌ'ostandl!rnfÌt\ÈÌrtt(Ìrllnrìro\t'Í'unÌ\1rn('s
;"',l.';t,"-a.. !l!ìneÌ lÍÌu5''al'LrìÌi\ÒrrtÌìrotlÌcÌ lìrnd'ÌÌr'uicolthcmath
",,r"t'..,f'n*",(ioesfr)t(oDcrlanìirgnLn'onnordoÚjttre\cÌrÌlnulr'm!sìngtlì'
5!nìc nìa1ììerÌìiLlcrL nrctÌrod5
LÌLLltlxr.lens1ìltr$LLÌtÍronÌinrÌo\itiLüìredllfercÌrtir'Ìriother!'lensIcctìrtDisl!rrs'
LJc Ìr!t L' pro{l!(tire
otin eulsrge lherrr as birrrÌrrnÌls. tlrat it directio's Ìlìat
'aÌr oI \!hat i.gÌldjcnt\ t(]
]rlrlovation rsuÌLs nr hlue}Ìi.tlì on ]Ìo1l to ]ruìLtl 1hÉ Lnlen |]ln.
anÌ'xk
futintheÌitest \lDS nre.li.i.e Oi(or$eo'(e'bluctÌiÌìtbe'oìesadihble(n!n fndu'1s Ì)!süì orÌ il ÌJr\
i't.L,,u..te,,t"nas,r.anttrr\toustitn'dnìaÌLe1 lhejr
.,,t (c brrc gcÌrerl. cLrLrg (ornPanies that pn{lu't dnrg\ 1lìat lrc clÌcÌnn'll\
".iu",*
l.Ì:ÌìLìraÌ nr úreir Ììon r:Ìnous Ì)randed 'ou\i'! Ì1'!ìce
iden5 ilth'conteri
'IìÌxìo\rtioÌ1
,-,t,t't."r'lheviÌrÉerchrdnbÌe:ncenliüncürolrtai'apitetÌlthaií'jlÌ
",",-trtt
,,.,,'''1
ut,ctrrrr'úÌ tbe maÌl.rL nrr bÌueprtrú5 1'1'Ì1ts rlÌd! hrÌlìs
to Lanr
,,r in p"rf".,
"ÌatL",
i'. '' ' I'
",
,'iìi'",'tiÌ','Ì,,,,1".t,,"t" lLtcntsLheinrrl'lner''rbrrìrÌrrore'o\rrLì]eìrcons
lldÌus\

ifrl all in'o\iìllorr 1toüld noÌr '1htr\ ib!!c

"","_",r,i",'"ur,,.utgln.tco'tLtttlttLult'ÔrLü{tlrcnÌauirrl'ostollrl)drt'nÌgotrr
lìill isl thet (Ììld írì go out Òl l[ri]ness
i"rSlu^r.o,tpri.l"g",,ÌtenìâÌlLtl(Ìi'ìea!iseütnrÌedb\lheiiìlrìtÌsi'pr'lert$oli'Ìeiìs
n.'. ne gurLrnited tlÌÍmsh in idrq(lte ltsal 51\t'm tlìÂt lrore'ts
"r,,ìì,,'t "t,, "'"t
11ìc retL|n5 lo inn.\'ation thíruslì ÌraÌlnt\'

'''''. I '4 r' L

0,,,a,,., oìr ind those cnìpl'r?11

iI r'st!Icb Lhi\ i5 r \ er1 nrlúrtìl Âe'Ì
"ì" "ÌÌì0,,,r'-
- cu'rnrtrìcnt i'ith
trLe sLarú,rtt soÌoLr srar rrrrl*.rt to rn i:corÌoniL.
ì,,," u,^,' """"
";;,;r;i'-' '';;'.,.,.",' \\'t dcnotc b) /l thc rotaì Ìrunn)er !l Ì!ork'Á emfÌ!'cd ìf tlÌe
;;,;i;.,,;; .rr,.. rrr'the IoÍkcA that usc tÌrc Ìrruttrint\ t' 'oniuÌ'1rorÌ I'jtrì
' \' \\ie iÌlí) dcnot'1r\ /: Ìhc n!Ìnber
0,,ìsil"ì.r0,,"i".u','",al)oü!tof'(x1(tceÊfrÌ!o(
iri *.rrt.t l&l) Thcsc rI' tÌÌe Í\errcber! 1!lì' iÌì'Ìersr lÌìe sl({l ot ln'ir
".pf.,t-r ", lhc\crcrt'bLLrctrirrLstlÌiÌr\ÌillhelitÊÌo'lre
ì1.,*",',i"'-ì,*].,,r,,.ushinÌro\ltr'n
trseclj. prodttction b\ \to (els nÌ tht Iìnal ilo"s \"Ìor
1!e uat. (lobb Do!gÌii pr"Ì!'1i{!Ì ltrnctì'n lor íiÌÌalSoodil

(11.9)

!!!!i !!!
 li nolv íands f(Ì ide:ìs' NlÌich ìs Ììot !r cxogcDous co tant' bul isisrather n'
wherc
!ÌÌodeÌ IolaÌ labour iÌr tlìc economv ât tnìe I gircn bl
'"ììt'"t."-uol**
r, - rl r ri, lhrt is, thc sunr ol llìe labouÌ emtlo,vecl ìn the ÌÌranlúa'luÌnÌg se'tor
"uìc
sector produc!ì!
pì.au.i,tg ,r'" r,'"r o*püt aÌìd th€ labour emploved in thc rcsearch
ìDvolved i'
i.*"*Aì"" ur,.p.t.,' Ìot.1Ìabour gtr)*'s at: coütant ratc
'
and lalroLrr

R&D gu{s at thc Ìatc,,/

rut irtrat cur l\c say amüt thc rccunìu]ation equâtion f{)r idcarì One iiencraÌspccìlìcr

(r,1.1r)

i.leas accumulate proportlonâ11,v to the Ììumber oÍwolkcs Il cmplo\ e!:

i{hich !avs thnt
stocN ol ideâ\ lor som€ of lÌc
*SO p-p-,'-"ì to lhe
'urrent "11' 'onstint ior tÌri
'" ".U ,:. ,.", * ,.y thitÌN thioüiih thc lÌllpoú'ìnce of the parametrry
f,,"""",t,-t "ncl
rccunNÌâtìon cquation.

fionì thcearliermodeÌs, wckno$'thrl it4 I'thrÌearcco

stantrcturÌstothc
ll) í)urce of cncìogcnou s gu{lh TlÌis lersìon
a.cunnn atio. of idcas anl:l th i\ wìll be a
ii.,
r''t, rF' r',r, "rr'rrr'll
(2) Iori) .r. I, past knoslelgce\erts aPositiye c\ternalit-v on nrture ìnnovntion
o,1.,. 'dIrn 'L'\rr- ' rr'1,'' L'
".r b) .rl
n\,,1\ eLLitì c\cJÍLlL(rt
on I he accurÌLrlatioÌ:
(4) Ior r .: 0, tÌFrc i\ a n egatile cxtemaìitt o í cLì rrc nt N n oÌvledge
c morc ire lnos thc morc
of lutrücknoNìedgc lt scens rath$ unllkcly th at th
diificult it wiÌlbe to innovatc
todìc cà\(
(5) lÌÌ,/'l,thereareiI]creasingreluÍüslotiÌoi!ledge Ìhis coÍcsponds
p(rcess alÌl b'
wherc th€ more iÉ lrrow lhe more a'cclerâtc'l thc innotatìon
assumtÌic''
i\ .lcaÌ that we obt.ln conrPl€tcÌ-v .ìificrent renrlls 'ìepudnÌg on what
I
lhoe two iÌslunÌtions lhat have bL"'
about r aÌe mn.le in our anal,\'sls 'rc 'ommonlv
mãdeintìreliteÌature:f=1ancì0':r'-ÌLetusÍìrslassumctlÌnt'7:1lntlÌiscarÉr"
.ccunnnation c.ÌuatnÌì ior idcas 1s sìnPlr- gnen b-v

i, - r.a,Lf. (r+ L:

otìdcat
wherci{ecnn nott.ìivi{Ìe bolh sidcsby'1, t{) obtaiÌì lhe groÍ'lh ralc

;r = rrl t+1:

have nÌrea.lv seerì ilhcn ile dìscussc'Ì thc SoloN Swar

Ìnocjcl aiuÌ cÌog"'
!ut ile
tha! the iyowth rate ol o:::
tc.hnologìca1 p(rgrcss thaltlÌis trodii'tion ILÌnctlon implies
asslìmptl(!Ì that 1r =
pLLtlvill c"cluri ihe grosth rate o I i.ìers. lhis JÌreans that under thc
sector' Thi\ :r:'
ilc econrmv gnxs raster the rnoÌe pcoPle arc eqtoled in the rcseaÌch

I Lhi\tr.f .!tÌirr.olü1rn.d( dÈvrnrÌrËJLì-rrrnlÍLonìrÌ(1'q(r)'

 541

\c!Ìr!thrrjrÌÌÌJ|r5i!lÉerlr.ri. !i rrrÌ!)r\mnÉtlrrtl: gÌnr'!,i.rIj.hcóe!rn\dÌ

nÌtlìrlrborrnirc!ÌìÌpl!\cliJì R\l)l.aiÌslotxltÌ(Ái\eSrLrrlh n outftrl.
.\ rrB!e!i bl ( hrrlr\Jone! lhL 'L.tâlrl.ìble Lnr]rÌjcrtion\ oi lÌr. i{ônìr' nro(ìel jl terÌ!r
()i tlÌÊ ÍrLe eiiÈ.: .Jn Ì)e ÈliLììirìiLrd br rtÌ.ÌLj.g iÌre a!\uI]ìtli1:). thit ,, = I r'1th tlÌe
r!!ÌÌìptionuÌai 0,r' L r' if Lh !.r\. Llrc gÌ(nrLh ük olid.i5 Ìiill b. gjrcn b\

r -.1'rIi I+1.J

It a tìilrD.r( i]nn\tlÌ frtlÌ {in: il Lh..quLÌlbÌium jt iÌnPljrs ihâ1.(r = ir = 'rr. bxt ìÌl
orlleÌ l(trj t!t)e(on\t.rÌtrtthr,'qLLiìLÌì LunrwereelltlÌrr.ìl ./i..l r nìÌreronrtiiÌrt
Tlìi\ nÌÌ)Ìiei tlirt,rtì j, Lhii l!.thrlâlÌrxÌl(Ì.ÈirllohctÌi.jnnL\rÌìoD.tsÍn\\ii
rhr \ame rair rj I \\'e rlvr l.orr Llral lh!\ lnlÌÌe\

i 1.1. Ì1r

lllrcmalitthrr!lditir!ral arnrÌìrIii,r. thil lhr Ì-.Ì(Ì!)I1ion 1:) hoÌÌier\crÌÌl)l!\.tl r1I i

Ìhr R,\Il \crt'Ìr rrÌd tÌÌe ÌÌÌaÌìuir.Lrr .S \r'.nn r1. t .on\liì.1 it r' ll i.ÌÌt)r tlLri Ìrrl /ì.
Í hjch jr a. e\!!rÌÌ!rtÌ\ Si\ en ii.sLrnl dctendÌÌrg !n i!'r L lit) rÌr.1 in!!i!riìtiou |oll.l
5ub\iitutiÌrg iÌì tlìr ri)(r r rq!.rtì.. ..tì r!rrra.giÌri< \. .btii.

1..ÌÌ!r!n !turih if I ri R.rì.r tr(trli1 rr nÌodiLìid rl l(!re\ i\ tlr. Í oÌt dÌi\ erÌ Ì)l PrrfrL
ÌalÌ(!r !u\11Ì. rr. .ì rd t rr c\Lr'nt tt) \l]i(lÌ t]Ì( t.rìilll\ ot jir,ìs prô11! lÌom the r][',rdl
c\i\:iÌrts lnnrL(.1!i Lrijclf th.e.orÌ!Ì!\. i lfl.lÌ\o:tlrr.lii.LoirÌrert\errLr\r.1nr.
itÌ\:lìrirlriiiÌr,ì1.o l1l!'(ì.rrrh\trt.rrilì,ìt.ìiLLr'ÌsirÌtlÌiiÌiri.. uÌriltiÌrlÌLrììrIsl
1.(1ÌÌ!tit\.r|\i-!ii 5.i r 1\..ÌrrlLÌitürll.,lhi: s!LL.uÌthlcl5.rL$i)n()t-\rhrrll!rlr trÌl

TIit:inüi i. tLÌrlLì \r.,rL nI int (DÈ \ r d.' \ rd rìtr tÌÌt hÌrÌlrl.nlf Ï)illl)\ er! rÌÌ,nl(r.
1\herÌÌLeiìlLornÌLr.ifdo,.r!.(ÌrrseÌÌerirllo.o l.rÌrni!:LfInS(\s Lnthi\.r\t.11ÌIDrL!h
Ìrtdr(lÌ.rDrl lr\.l]|ìirLi.ttrLt\tiÌr1lÌ(|'iri.LL!Qì\c.ihr'.ì!(hL'.jÌriÈ: tl LÊirrrllig
\ÌriÌl(r rL lhìÌ !rlr i.r i.irLìrrli:tltlr trÌitJi.Iir,r'Lo: mrlÌr3iì!'lncrÌú\ ì\!nÌìftiof
Ìe!ÌrirrlnrrerÌlrS.nlr!\S1:,ath,rt1ìrÌrLir,ìtlri1's.ìurÌitJr\Lri,1i \lxte gr.rilr i1.
rÌrtÌÌrr!!rÌLÌn\. \:1,:!r!.5|ottrlrti.rÌ3!r\\thì:Io\itL\t,Sf(r\t[]ntn LlÌrita(lDl)i,ìLii
tÌrre lrrL it\ +,iid dctr f d5 .n Ürr rtrersih.J tlìc r.LrtrÌri t! 1lÌ!',ri.rtnrtrl:itiorÌ !t ilr.\
\iJ(lÌ.J1!ì.ln i,iiL lrrm)d3Ì()t3h\tI risr.lL).thetulrI d.rsIje.ritlÌlÌor trc
\tru.i!rÊ1rl.rÌllirk(r..orrirr.rIÌral10thrrllnriÌLi!r()lr(\.,!t.rt()lheÌ)r!uftiüìo
bluet)riÌrt\.i.! lì,r1\d,rh,'....urÌnriÌÌrph)mrol .thcÌt.errrIs.r1nÌt):ihetc!ÌÌLrn\'l
ÌhrirrlÌiriirìiiri5L.d\.hLLiÌttreraÌ(siirÌ\.niieLcLtnÌtlÌ!iol ôlrlfg\c.:i(tì
s42

2 SchumpeteÍian gÍowth models

Schun4ìetcls concept ol crcatì1,e clertNctir!Ì .altures the du:ì1 n.tur€ ol tcchnologi..:
p.ogr€ss:irÌ lcÌmJ of'creatio.', entrepretÌe!rs lrlrr.luce nelv ÌrÌolucts or prc.$ses 1u tÌr.
hope tlÌa i th cl rlilì enjoy tclì PoraÌ) DÌonopob p Ì onts a\ they captu re nìarÌict s I n .loi!: -
í), thev.' nakc old techrÌoÌogjes or pÍ(hrcts obsolPiP rhi!ì\tlrellê\tnr.ïi.n'r.fÊÌÌe(li
b) SchuÌr4ri1cr. The lcìeâ ol modeÌÌirg hnovilìon as 'veÌticaL' iÌì the sensc thar it txl.,
tìre tonr'ì ol a qúaljq irrìpro\dÌent rather tharÌ 'h(nizontaÌ' {the iÌÍrodu.tlon ol a nÉ:
vaüety olgood) aìl(Ms Scl nUetels basic insÌglì ! th at new tood ! or techÌìiqucs punr o:::
ol.lonestob. ornralized iiì an endogerous gro(th nn el TheÌìostfrnìoussuchnÌod.
basedonqualil-vimfro\ir]ginnovati{rLisduc(oPhiÌlflleAi{hionandl'jctcrHowitt.'l
rhì5 section, l\c shall set oul a rnÌple lersion ot lhe Athidr Howitt modcl and erpla:
how it providcs the basis lor a Ìich arav of i cstìgatnÌs nìto aspe.ts oI SftNth àÌ::

The motivatÌon t{)r to nÌake a LcmPorarv nÌonopoÌ}' profL by steali . :

nmoval(Ìr 1s

maÌ.h on othcr prcducers. As note.Ì itr tlÌ€ dis.rtsslon ol the e\cludabiÌì!v prrpe.i\ :
lnnovatidÌs, this rc!Ìulre! thaL tÌre ìnno\atioÌì íoÌ new coDÌbiÌÌation, iÌì SchuìÌretÉ: '
woÌLlr) cannot lmme.liatel-t be cotied bt ar ìmilal.Ì FormaÌPrt€nts arc on. method
prÌectìng thr tcmforaÌ)- rÌÌonoPoì!Pr)Êts oithccntÌepreneur. tr.d€ sc.rcls are ânothi
an.l beìnt the 1ì6t mo!er inio a maìl(et is ü thüd.
Eeiìre iúrodrcìng Aghi,rd and Ìl{trlitt'\ sirÌìplifted \ ebnÌÌ ol their nìodcì of ScÌrüÌì'
peteÌia groNlh, we can pr.^'ìde a liÌÌk behfcc. the Sold! SìlirÌÌ nìodcì ol 3u':
i{ith eaogenous LechnologÌcaì trogress arÌd a schuÌnPeterian Ìrrodel lÌÌthcSoliN 5r..
moclel, $e.an compare dìflcrcnt iteacìv siatc grcwth fatht turditt€rent rJlcs ol .xo!.:
ous te.lÌnoÌogìcaÌ prcgress, Ì. As ire hale s.cn it ChaFeÌ 1:1, gi\en thc sari.g\ Lt:.
popuÌâtioÌÌ grosÌh Ìate, and deÌrreclati(Ìr iÌì thc cc.nomv. a hislÌeÌ Lrte of lcchn{.
progress irìplics a loÌler lcvcl of capitaÌ per eltìcjcncl unit ol ÌaÌrour on the stcndv 5t.,:.
gÍnvth palh (see ligure\ Ì3 l0 aD.Ì 1:1.I 1). Ìhls alloirs u\ t() .lerìve a do$IÌÌlrard_sl.iri.-
r-d r'h,tl- s-',rl l\' ,,lP- iL ' ' l pff cel::.
'
oi te.hnoìogìcâÌ pÍri+ess, tlhich úr tluì defincs the
iartldr rate of output
in tlìc slcady state. ÌlÌìs do$'ni{ad noplÌÌg linc ìs shoÌln nr lig. 1+.4:nd labcllcd i:.
'soiow S\!a. sLeadl natc rclall()nsìrìp'.
Ncxl, a Schumteteriân clcment i5 itrüodu.€d b-\' nro.lelìing the.leterniÌÌants ol r. tr .
''r '.Òr lj --
\-
^o.l
whcrc ì Í the probability lhat eachrnlt lpent on R&D viel.Ìs a mccessh' Ì |nìor.tlo.
is the extent to whi.h cach iÌmovrtion nrises thc Pnxluctn itl PaÌameier. ancl ,/ is R,\
irttnsit). AtterÌtion tlÌcn tuÌnstotÌÌe economlcdcleÌmlnants olq, each olwhi.h is taÌi..
ro be exogenous b) thc cntÌetreneur. RliD intcÌr5ìtl, 4, i\ a functi(tr of the discouni.:

rForicomüch.r\ir.brìtmenL,s(r\{hofrndH,nrtLì9!3lFo1i!ìloreriDdmor.ac($i1,1Ì)rL.!,:
tion, ree ruhnìr Jnd Horit (2005r
 543

iLr:!rlt \1i1. rìh.rlì ì

!.Ìrur:.Lrrr! :l,)rìiil)

Filure14.4Ern.:i:r'r:d.1_ i:..rll:.1_!'r!"r_r!'::

\rluen .\Ì)c(t.d rclurrÌ5 indlrliÌ (LtP...l foi LncÌ\ on / xÌ\l', ncBrindl onr Lhtrerl
nÈrrjl riìre, Ì)()5ìii\'.1\ on i. .llitrL rrr Étiì. !'rrc\ tnit Ihir I ten t'r th(rÌ!lÌ1 oi 'ì\ rrr
1..ìi(r1o otthe\j7.t)lfoliÌìllal mrrl.t\n)Ijnno\ìtor5 rn!i'fL11\iitÌrlL(!rrliietreroi
lÌreÉroLl!Ìnr{.lliì\Ìhet\t.rì1.rplrdu.lnLìrli.t.tÌ!pcLLtn!ìindÌrl\i$tÌÌtlx'tr(Ì)ertt
'ight\ or] no\ irÌì1r1itL.rÌ\ rr. fr)tr.lrd iorlì inriÌrii(Ììr

rJ t ,j. ..1 i !,!nÌrt:rl.I Ì)úLe'trrìÌ|rt.Ìrtl r!htr rl rn'Ì:t!rì

!in.ctlrrÍiÌLcoiii.hnoll)sniltr)!rtsi Ì.dtÌì..dr.rÌii.ÍÌrì'lìLntLrÜr'(1eÌreÌìdst)nr Ìtt'

lìi!cì \r..n.ìÌtlúnrfnriÌr LrrlrrcÌ! i.ndi lhi\1)(trìtit'l\ \jofrLìreL'1ioÌLlÌllrsÌaÌ)el Lì
tr. Sch!üttÌerI.leLioÌrthilr'i.liS lI + (lÌrllrcneii!sl'l1f!Ì(!\11ìt:ìth llìL'c"rÌ! \
\ .ha .t!'r i7c!ì bt iÌ gÌostlÌ riLl( rn r:.
\\:e rÌ.ri .oÌìtldcr Lrr) Ìr.Li.\ e\l\'r'inrerÌt\ fr\t. r. i'(ÌrìsciÌìtlr'sr\iÌì!!ÌritioiÌnd
\i..nd. iLrì ìtr!\ cnr.Ìrt Ìr 1lì!' i€t!r.\ to ììf'1'ìtnÌl dut 1o I ri\r n \ (ìr i LÌ thÈr!' i\
,rnj...eLì5!'Lnthesrll.gr:t.i.Lht...inlnrl Lhr\ \hìi15 LIe \'lo( 5linLirrc'u \Jrd\'
lhL\ Ìr!:l.r ut crplrrl Ì]erÈilricrÌ(\ rLnjÌ.rs i ih' \tinirrd Sr)LoÌr SÌlarÌ
nìo'ìtÌ rjLh
rLôg;Dofs tt'rnÌnlogl'rÌ l)Io!r'$ ÌrhL'ÌÌ nr L'tÌÌr l!rnìÌrt\ nroÌe LÌ\L) a'titlLi
\i! th!
i.flrrtiin li.Ê 5.1ìúnTtterì cqttrtio|. lhte|..'.t)rrÌ) nÌol+toiner:L'a'ì\ nrLr'ËrnfLÌl
ll5liÌ"ÌrliÌìio
|rLhÌì\idhl aPontl(rtht"rlÌrtìiL otlì''inlzatpolntÌli'riE
;h. s(ilÒ\! sNdÌ mü].j. thi Ìì,ìtr thet hìrlìrÌ srlnÌ! ir( u"\ r ÌrrrÌìrÌrÈnlÌ\ ÌìitslìiI
ì' r\tfrl Ìhel. i\ r liÌlL ':'l
irrrtllrnL! ftis i|LrÌrttìÌl! lr n()t. iÌ!ntll lhi ni r
'r!:il
Llri5llnliftrm(àpiÌelÌrtrtiiì.,'.(\!.iltt)lÌ\L)aÌìdtiiRSl)L'SurLh!\\urrg'stt'bl
tÚtcL !J\ \ÍrnÌ\i\t
Lhc SrlÌÌrnrÌrrteÌ rr'itl!n\hì!. ,r rcÊÍ'5sLo. irarì.\L)rÌ. i!'h r\ Llrc LìÌrl
R()Ìncr 1\;l dii.u5n1l iir ( llÌ.rrL.r 1-l1!lllo\ er'riLlmatr tht !iirc'L c(ÌrtribuiioLì rI 'rÌ)it.ìl
LngÌ.\lhhl iSrÌ.r ngtÌreia.lLhrtÌ)lrL.ijitc!n lhÌiri"ir\jr1ÌìcRlil)LhatitnimuÌaiii
ln thr scc.rd.rfcrjÌÌreDt rrc arnLnrc tlÌiìl R&D lJ!.omi\ nore llrLillrl lhl! thitt5
Lht s(LìÌLmfettr ljÌì. trÌr a 5. At r Iisrlt Ììlil) lnt€nijlr ri\'! Ihi'lÌ rrj'er tlr!' ÌrÌe !l
Lc.h noLo .-sl.eÌ |ro!r'cÍ ìn!lthl (.(!Ìorrrrxli!ni t. tì Ìrtr stcal\ slxtt lrolfrjl
eq!illbrúÌll

2
SM

,--SclÌu Ì)ctfi r elJtiof trìÌr (loÌ\,\l

\ I ô\ \\ J.:1 ìiËh \)

soloir Sirin:stead) staterelatjols]rip(ld{tr

Figure Í4.5 P! .! êÍper ment5 ina -.nLi!qÊiú!! !r!wtlì rse r 5aÌr i!5, r!e n froil!.i!! oi R&D

to thc nonh{cÍ of toìrú Z irt poinL ì. SinìjìaÌlv. bette. protectiorÌ ol iÌÌlo\atnÌì ft..:
inìtators througb, f(r e\üÌÌÌplc, nìorc cUcctne eniì)rceÌüent ol property riilhts, 5Ìr':
the s.hunrpct.r ìÌne upwtìrds and riìisc5 the slead) Íiìte groivth raie. Conrerseh. :r:.
S.humpctrr ljne 1s ihilted doM bl a hìghcÌ iÌ1teìest rüte as thi\ depresses the pÍc\':::
valrc ol cxfccle.Ì pr)Êts lrom thc ìnno\.arjoD. Bv ìeclu.iÌìt the entrePreÌÌe!ls €ripr'.l::
ponls, i..reased pulüt marlict conrpctllior js pÌe.ljctecl to have the sanÌe ciepress :
clíccr on inDovation ar stcaL\ jl lc groNLh.
TonrolefÌoÌnabtuldüinìcnorklordis.ursi.g5chunÌl)eteriangÍníthnioueirÌrlì.
th. fn).cs of creati!e cleÍr .1lon ilrcll is modeììecì requires Ìrecìivnrg iI more drÌ:.
ho jnnovatnD tales ltacc. lhc tundâÌìcntaÌ ÌeÌatl(Ìúhjl) tìrat ive neecl to ìntr({hrrr
a Ír .aÌÌe.l re5ea(h arbitragc co..Ìilìon i. $rhich tìre maÌtinaÌ .oÍ ol RliD i\ e.Ìuate,j
the erpectecl nÌargirÌaL berìclLl. In ol(1o lo show hoÌv to cleÌìve the arl)itraije condit:
ìn a wav that can be €.sil_r grasped, Aghion an.1ÌkNitt p(^ icìe a 5tritped cÌoiïI \ er!:
ol their ba\ic nÌodel. ln tlìls sjnrpìiliriÌ nrodel, theÌe i\ no capitaÌ. TheÌe aÌe tiro goL.:
in the econonÌv: fin.l Boods end inlcrÌcdiate goocl\. IlnovrtÌD onÌ) takes tÌaG :
tÌÌe iÌúennediate goods sccloÌ. The n.âl good, v, is pÍnhced urirg the lnteÌmed:..:.
goodonÌvíi.e. olabourjs jn rhc Ìruluction olthehnaì goodl and as !ÌuaÌ::
used
improveÌÌÌentsi iÌìtcÍncdiategoodsteliefÌace.tìrjiraì\esthe.ulpuloIlÌnaÌgoo.ls T.-
piodu.tioÌì ìuìctnÌì for lì.al goo.ls it rhrrcl(Ìe wrìtteÌÌ as:

Ìlhere rT is uÌe iÌúenÌìedi.tlr good and 4 is n conslaJìt less Lhan onc I is the produ.ti\':
paÌa Ìeter rnd irr this rÌìodel, jl rclÌ.cls the qüalÌlv oI lhc i.lcrrncdlale good. qurl::
impú!enent ol tlÌe iúernÌcdiatc good drc lo nnonllon wilÌ raisc l. 1he l€v.s1un: ^nv -
ti{)n neces\ürt for the nÌodcÌ ot cndogcnoús L./ìri.d1 ,rÌ{/lis to producc endogcn,:ì.
jro 1, Í that each ntrÌo!.rtion rais$ thc qunÌlll oÍ Orc ìntcrnìcdiitc Sood fronì ì ti)
 545

lÌrt.rrari.Ìr gú'1r
_
R5{l)
LLTLTL =Ìr I :i r"
'. '=, tÌr"', nunl'
=11ì , - L I
i\i
l

l.r\LrLLi lr -L
^
i =Jr]+.1
PRODÜCIIO\ 1\
I
L

conÍPr ttl Í\ t fRÍ\GE

! ": ":":l'1'=' ,

FiguÍe 145 5. Ê ìal

nÌrrÌr _ - 1 iÌÌd 1r i( tÌìt iÌrno\ rtion:

'11h

Ì, =_ l

LlLrl \rt h're;tir1 io Lrr Ìrr('!trÌ\

Lo
(h(ìe 1ìre !o1nrÌú re1trnì'' it\tuÌìfÌjoÌì
lhi\ r!
,:,',,,,.:;"*",,,,,,,-',^..1.::,,.111.'ilìl_l.l:'::,,,"i,,,,r:nrrLc,oneur,Lrrr,rrr,LL
Ilì. rJr(irtctlorì lunLlj(!Ì

i,.,.,r" , rtrr trtlÌtÌ tt-l I rr

.n
trtìa

j,xì!\ itei hlÌ5 .ì DÍ,Ì,,,ror\ n,Ì t"fi" !

",'"Lrro\i!lc\ r '":ìl;i.;. ;ì,,,,.ì,,,,, ", u-" u," u,,*,.,,
b\ lh..1htl pú]lLirs Llg Ì 1'
.i, rÌ.drs .1 lÌt rro(ìtl Ìit L.{rtÌrrÌ jiL .Ìrr fert!d aÌr.ì núÌr! to nìe\iÌÌÌi7c thrii
r,ch ìrüf i!rreÌ in ihii r(''"'r '' ": l"' 1:::.::'; ìi,.,:'ì"." ,, n",. u,r]]-'."",n",,
.nnnLtrìr,i!n rÌ Ì1ìc ,,(ìo :,:':l l.r lll::l:j,::,,",,ìi ,ì"",", _ u," -,",",.,,.,"
*-,"" i 'i'""'
::l:iliÌÏ:ilÏi::ilf,:;':'ì::j:lli::l:l'll: ìì'"
"ì''ìì ""''n '
-:t,"i::ì,ili:l:,ilL;l:ï'l,'i'lilìiil;lìïil1
ìil:ìì,,ìïì;;';ì,';,;i,' ";. 1,,..lrri5!r'c\! i
lÌ\D dePdrtÌ\ oÌì llrt frlhrDiÌil\

,,..ììì:l:"'I'i:':iil::ì,il::l'i"ìil,il,-::"1'lì"';:'ii;:'l'lllil:::ì;l'!;';'i
546 r'::r:

units ol iabour ln R&D l€adt to n qualiq' imp()venÌcnt with probabiÌity \4' AÌtlÌough
a

ÍlccesstuI InnovatoÌhasa monopol,vìnüÌe pro.l .tion of the high eÍ cÌu alit-v Intennedìate
good, thcrc ìs â so-caued conÌpelÌlive 1ìingc ol producers l{bo can prodrrce tlÌe toae!
q!Êìity venrcn ol lhe goo.Ì Thc pÌesenc€ oÍ the competitive lringe limits the Pri'c the
in novator can charge. Ì hc unit coí of the co mpetitÌve fringe is h ighe' becaute
they h ave
nol inrìovatt.Ì and they can Ìrroduce good ," ât I cost of r (pronourccd 'ti') unils ot
labour, ivhcre Ì :, ìas.onrpaiedlotheonctuÌitofìabourrequire'lbythcnrmthnlhas
i ìovated. JIrìre coÍdisadYantagc oftìre conìpetitivc fritÌiìe is vcry large' i c Ì > il, then
thc Ìnoropollst is ablc ír chaÌiie tlÌc monopoly pricc and the exlcnt olcoÌÌrPetition
pìar''s

no de. ln or.teÌ to Ìule tbls out, l! ìs asunred that Ì -. * LÌ lhis case, lhe nadinìum
prìcc that the in ovatiÌ can chiugc is l : nl this prìce, the competitilc lringe h'Ìll not
pÌefcr to receivc the wigcÌ w The pi)Êt
;roduce thc lntexnc.Ììate gooci bccau'e thcl
iòr a successlut innovator is equaÌ lo total rcvenuc minus tolaì coÍ and ìs highcr' the
lÌigheÌ Í Ì:
,- = Pln 1rn
- (Ì 1lÌr',.
lhc t o key cquations dre í()r th€ cìcaÌiÌÌs olthe labouÌ markc! and thc rcsearch aÌbit
üile con.lition. Labonr ìnârkct clearirg i\':s $a'hàvc seen:

L=nt+q
Wc now havc aU tÌìc intredients for the r€scaÌch arbjtrage conditl(Ìì:

w ,\aÍ
: À'' (Ì 1)1!'r'

SubsiitrúiÌìg í()r I/ì us nrg thc labo! r m aìtet clcarüÌg cquati(trÌ ilivcs:

.qfi-i u
I
-rq:L ìr(Ì I)

'lÌìÌs.ÌeteÍninestheamoun!ollabourdevotedloR&Dil]Lhelteadys!âteThegrorthot
productivitt, in th€ stcrd)' íate will bc cqual to

Ì - r4tr 1)

Ín words, p(xhìcti\.Ìty accodiug to lhc ìn'remcntal sizeol theiÜÌovation ie'

tlilìg(^!
:. 1, thc aìnounl olresources devo[cd to Ri*l),4' and the Prcbability dÌat ÌÌ&D de]ivers
an iÌÌÌìovalion, À. tly nrbslìtutinil tbc steadl slate equalion fü í, $'c crn see thc set of
detenÌÌinants ol thc gtlvth Ìate:

r.,=Ì:ìtr lltr )+r)l

 547

Gu\th irÌ outp!r tÍ ifiLn i. tìri\ e(!noÌrr! ì5 P. ÌrnentL! lÌi.{hc,, the hightÌ i\ the
1,\r, thr bjgger i\ thr n.Ì.mentaìtLe ot ilr(
pÍ)b.rbilit! thit l\L) d!' lr ! rs rÌr iIìo!.tion
inDo\atiüÌ.,th(lir{rrisLÌr.sjzrotthtiabouÌlorcc,L,rndtlì.l gcrj\\'TheioÌÈi)1
the Êrst tso 1a.1o.s 5.Ì.ar
Ìlowerer tlìr idLn Lhi( iÌ lergÈÌ hbo!i 10r.. pÜ 5c oÌ r Ìrrirer nLLttr.r oÍ Tì.\D $ orÌieb
crniÌì.rrisrtlÌcri['o FnrrrLh i(Ìe\ er does rìDt a.rordrLjth dÌt li.1sr1]ìL: Ll\ cfi)ld ìÌrcreate
iìr uÌe n!rnb.r !J Ntl) rr.,rli!',s ln the U5ì sincc ihc 195ü Ìrar not bccr accoÌnÌraìried b)
a (h.nse nì thr riìÌc.i IrÒdrr.rj!it! Sro$Ìh \ghlona.dÌloritl5hoiçhúttheìÌuulrl
ot SllÌunÌpeleriif irl|'fLÌr .in he aÌodihed to (ì Dri.ate tÌiis \o .ellcLÌ scrÌe eite(t u hìln
ÌetaìrrìÌì8 ihr iril!r( .I..d.gcnour Rlowth. I rs( ol ail tlìe) frlcnd tÌre \nDple rlnÌlr
n) rlld! lor tlÌ. criilcn.. .l Ììânr \ rrictir5 ol Lhr itLenrìedìltc goo.Ì The) theÌÌ i'ril!(
thdt ure nuÌìbrÌ oi riìri.lics tÌolilerates as th( r.ônoÌn\' 8rÒ!s n.tÌ ÜraÌ ir \te!!l:' st.d'
gÌ(^vtÌÌ,ertratÌ&l)illPuli5diÍLÌaúeclt)\b.idgspr!'idìlrossill!aÌittie5írthatth.(is
.oìeÌrtnrahipiÌrtlÍ'slciì(ltsl tÉÌ)et\te(ÌìtllcsiTcoithelrbour ot.ea.dthetsrorth oÍ
Ìrr u.ti\itl lhis plrd!rrsi Ììoditìed equaiioo Íor\lead\ nalr-qftrLtì1:

.{ l,\. - tr 1\ Ll

ln lrhi(h ttÌe iir. oi lhc lâbôoÌ ii)rre plat5 n. r.lr but iIÌ lthidr tÌre oth€r d.tcnÌLn
I
int\ remriÌr irÌ pli.c, l'oll.ic\ thal irlìÌrj.gc orì lht ìe\Èlr.h idrjhì8e ell!itjo. so i\ Ì{)
LncÌe{\e tlìe íÌârr oI l(sourrr! de\ oted lo R&I) 1trÌl Ìaì\e thc !,oNth tute ìrì tlììs mÔdÈÌ
Ìl jt intere\tiÌì8lo.orltrl5l rhis r!dt oI !'llm nalLnt ! s.ill cife.t lrith thc iìlfr)ach
frôltore.l tr] Chrrks lonc5 iÌnd diÍusí'd i. n'.tlon 1.1 .bot.. Jonet !ìcÌ1ilì!'5 RoÌnelt
nro(]tl ot RiiD tiis€d cndt)g( nou\ SÍn!tlì:s|r.il.aÌÌ1, iì pisl knoltlels€ rrÍ1s a toslti\ e
r.x1.nrÌitl oÌr lìírr! irÌÌìi)l.Llt)n blìt rel!rns L. R&D are..l co!r\trrÌt (i.( l) - ,i - 1
r\rÌìcrc i! tire e\tiorÌ(nt !rÌ thc t\i\tinÊ sto.k o hlrtcfìì!Ìts in thc r(curlÌrliLio. c.ÌuatitÌl
'l
tor lLlcâs:.Ì, = r-ì;'ril, ilÌcrr thc gÍrtth ol orlÌrtrt fÈÌ \!oÍNcr in tht n€âdl 5ÌaLc 1!iÌÌ bel

ri
nherÉ r i\ tlìc populêllon gftr\tÌÌ rair. hiimeatrthrÌ11ìrgÌ(tr\tlÌrilrolltriniittrnd.rds
dÈtencl\ !ltiÌn.tcl-! of thr gÍtrrtlÌ ritc ôI It&Tl iroilcÍs, ilhi(lì irÌ 1! r. .ieÌrencl\ on th.
totuLtidÌ!r!\tlhraLr,,r,rfhirhi\.rog.:.otrd),gi\en ln.ther sord5,. onet5 {Ìrproiì.h
..Ìail\ re\ eújrÌ! ko.r rn(logtnor\ i,r lllocloËcnou\gnúdr
Àghi(Ìr dÌìd Hor']l( pro\ Ldt ílnr ctidcn.e fÌ(rn th. L SA nÌ the PosL r\'xr teritxl t!
suggen ürìt tlÌ. dilr ls moÌc.!n\inrnl 1!L1h tÌre predi.tlon ol tÌreil eÌldogc.ou\ Surlh
mode! uÌ!t plodu.lh ilI gÌolLth \lì.rld t,e.li rhe Ìrtio oi l{lD exÌ)endjlrLr,: 10 GÌll rí ú1
the Ì!deLlth.nwLlrlh.trcLtiltidrkonr.l.r.e!rÌnod(llhrlt!ocl!rtj!1-vgnúthnrluLd
tÌacli the SroÌr'11Ì rnlc oÍ ll\D lro.lers L/ì).
l:nraLÌv, \!r luIrì 1o thc,(n. oi \ iÌÌ thr S.httmteteúaÌÌ rÌÌ,rdci. The lÌillÌcÍ is \, the hilheÍ
i\ tììe cost dinìdriì.legc (rl Lhe non i ìo\iLingcoÌÌrP(t1iÍcfriÌrsehÌtlìc nLcÌmedirir
goodt lectori]nd.5 wc hrlc tÉeÌì. tlÌis rnisc5 thc Ì)rolìts bÌ ân ünÌ!!alor a.d heÌ(e
Ls r$o(iatell üitlì i h .rhcl gft \tir irtr. \ .iì. b. ÌnteÌptLrd es an irnÉrsc mcasue ol

Irri\.\Ì,rrrrd,.ìirÈJerni.\!,,i,r..n!LllLnL,LtlIo(lìr.rrNÌ1](ìlr-i,ili,Ìj
548

pn)du.t lnarkct conipctilir)n 1n thc inLeÌmediatc goo.is sector: in a Ììore conÌpct:: :

c.onomy, \ 1rìll be cioscÌ tu onc and the ÌrìonoPoly pn1ìts avaiÌnbÌc to a n'.c.:'
ìnnolator arc lorver. Ìhis captures Schunpetefs ìnsìght tlÌ:t stí]ngcr frxÌud m:-::
co mpetitiof nr av bl! nt lb e úcentivc ftÌ lnnovallo n Ì kNever, Sch u nìpeteÌ also n ri":
lhe ptu i Ìovatìon rolc of the conrpcljtn'e Ínrgglc to be the 1ìrst to ìnnolate \\. :--
ncxt ti) proÍiditg an inlÌocìucticu lo lhe deb.rtc about the Ìolc .onrpetìtidÌ plir i

2.1 Product market cornpetition and Schumpeterian growth

A broadì) held vie(' is that thcre wat a causal connection between the âbscrìcc ofcor:!_ '
itileforccs in the romntüÌisl ccoronìies and their llrnited aÌrilitt to dllcÌof inno\:': '
produ.ts an.ì proccstes. .^ notrble e\ceptlon rlherc ìrorh innolatioÌÌ and conPeti:
llere prcsent w.s in lhe lPacc Ìace lvith thc uSA in hich the sovìet Ljnion made i :
stanti.l lÌìnolrticÌÌs. Yet thc !iÌnlle modcÌ scl out in thc prcvl(Ns section prc'Ìicts tlì::
more cornpetiti!€ ploduct market is asvr.ia lc.] witlÌ Ìcss innolatioÌÌ and Ìower gror:l
A od cÌl jng lr.ìmchlrk 1ìas ÌccentÌv emcrgcd thât rcconcjìerdie b.si. SchumPeti l
mechìÌÌìsnìolcÌertitcde\tN.llonwìthorìril]luiti!ÌìthalcoÌìPetitidÌisgoodn)r!r!::
but that too mu.h competition cân ch Ìpc. ìnno!ation.r: It 1s asnrnìcd lhat ther' ' :
leadingcdgr technolog-v in cach sector.ìt a gìobal levcÌ. lhr econonÌv l\c ate concc:::
witlÌ is dn ide.ì up inh threc difteÌent kinds oí sectors ac.oÌ.llng to $'hclhcì the !":
betsiÌìs thc period Ì!lth teclÌnology at the irontjer, onc ícp behn ortwosletslith':::
ÌÌnÌovatlon 15 aL$,a-Ís 'ttep bv-step', which means that a ilnÌ can onl)'upgra.Ìe its ti:'
noÌoitt b,v one \tep as a ìesult ol innolatloÌÌ aclìvitv:thclc is.o ìeap froilsing luit a! l
tÌÌe c.sc i. the \implc S.Ìtrunpcreian ÌÌÌodcÌ, it is assurÌìcd that in e:ì.h sc.lor ther( '
conÌpetlliveiÌirÌgeolllDÌ!thatca.pÍÍhrcclhenrtèinÌi'dlatcgoocÌatahighcrcostb\: '
tactor r' l. The othcÌ kev assrmptìon about lhe (ompctitÌ\'c lrnrge is tlÌat lr aÌl e\'::
tìonticr secti)b it i5 iìssunred !o he abÌe to kccf up with thc prcvaìÌitrg quâlì1-ï le\ci :
ifiÌìionestepbchindsector.alìrnrinÌovalcs,thisiÌr.rcascsjtstrxhì.tifitlb\_.'::
the pÍoductivit), ol the tì1Ììgc aÌÍr increases br'' _, The irrnotaloI tnÌpl)' ben.tìIs fÌo!:
cost advantage (bccause \ r' I ). By colÌkasl,
ìn a frorÌtj$ sccloÌ. il a 1ìrn iÌürovatÉ:
prodLrc rivìt) Ìiscs b)' -. but th at of th e tìirÌgc do.t not Ìhc l]r odcl â$ume! tha t thegÌr:'
techÌlology trontiÜ moles as Ioll.Nt:

1': rA'
'
r,here,1 isthc IÌontier levcì of pÍxhrctivÌ(,v an d _' > Ì
innorrte, tbc qualit-v ol lhe intenÌÌedintc goo.ìÌrrod!l.cd ^llcrlÌÌmshavehadthcchan!.
b-Í the con+etitirc Írlnge i::.
i!ìth tÌìat ol lhe 5ector lÍ ìnÌÌoratiolÌ Ììas occurred (i.c. b-r r:ì. but can LJe no hì8heÌ tÌr '
r,'
Ìoot at ÌroÌ! coÌìPetition aflccls jnno\auon Íor ll ns ìn the diflercfl kind.
Let us
5ectob. lt Ìs a*unied that technolos-Í sÌriìL)veÌs iÌr tlìc cconomv meatÌ thal lt
j!.
posiÌ)Le lor ÍrciÌ! tu ía-Í more thân hlo steps behiÌrd thc üontleÌ This nìcans tr.
rr rn ìrÌÌ{ il lri\llof Alnrof .i r i20oÌ). lt tr pÍ.nJted i. :tAhi.n in{ì ÌÌN\'iii (nÌiÌrr.drng
 549

ilìc( 5n.ln.!.nL \..f rì.Ìsif

rfu| helÌirú \ectl:iú 1..:.ga{Éin iÌur(rltiuÌ \jÌl.f
Ll\lr
LhfrrlllìirrL.nrrLi.rlÌrrLfg,r{LthrirfuchDol(,irlb}thrnrr\Lmunto$it)LtoloÌrc\trp
dLrri.t thr p..io.1 \Ìli1Ì.flio.j\thÉÌeiorel!.u\e.loÌì{hr.rc\tcÌrÌ)ehir arú Èontirr
51cl..s. lillc 1.k( LÌr..,n!. 51rf hthi.d tectoú hAt, UÌis ìs c{Ìrtr rlent ú) tÌre litlÌatitÌì ne
d 5.r6n:d eb.\.: Llìc r.ÌrLr.s Lo irn!\ atirÌr Ì!iLl t)e lÌj3lìc'. thc hLghd jt \ Ì)Écau\e $eilrr
.onìlcLllion mm lhc.orÌ|. Ìit !e lrinire ihislÈr (ot1\l iÌlloh s tht iÌrno\ rtor t() (lÌrrtc r
hirh.Í prl.r ind Lhc(iorc rÌriìkr h ghtÌ tr ontt at a renrlt oÍ inolxLjng.
ll!1\rhnl o jc.Lor5illh!.lorlieÌlAtihetÌo.tirr,.rLì n.olxtriÌnotoÌÌÌ\ ttroducel nt
l!Ìfrr rosL (h.. Llrc..nrf( 1iÌn r n jnge but rlt! nnpll]fL s qtLxljl) Ìelìti\ e t. tlÌe .!rnpct
iti\ciri.grblLh(ÍnrLor.l.lhclÌ(ntìeÌ5e(t(tr,rniÌìn.ÁitoÌrtr..ì5n)gijIrlrLÌÌÌirxÌo!il
ti!Ìlln qrLll. iÌ d cir,.rÌriì!is..ntrredNithtlÌe.Ìrf5tcfbchÌnd(i\e.llp.rlti.!Lar,a.
liÌìg Js thr. iìd\ i.lagf r.nrlnn(rrtj(nìiÌ.rsreÌÍ{rgh,Lh!Lnno\rtt)rnÌlhrr'Iontlcrs(:
t.ü.irn.nibÌishi['.ì!ofr]rnronot.Ì\iÌruÌÊ!e(toln.d.hâÌËetherutopolp,lcL'rl
.\n irÌcrca:c ìrÌ..)nrpctltlorì, i.c. a f.ìll úÌ \, relu(es thc trt)íit\ ot u Ênrì th,rt dlr!- .ol
ìÌnÌ!\ ât..ìnrl b\ 1lidüìiLìt {hc gat Ì)etlleen tre dÌd posl in.(^atioÌÌpr.1ìt5..fhiì...s
the iÌÌcentir r t! irnÌor rtc s! Lìi l(, ci.afe the..nrtetition lhLs.Ì)tir!Ìi\nola!,ìilibÌci.
the onr \teLr LrelÌiÌxl se.nrrs b.lâú\e lhe conÌretìtiÌ e iri.{. L\ ehQt t rPot(nt.ì ))tiablc
tlrrre, Ì!hi.h trtr.nti nn iLÌroút(Ì norn rhirljtÌS thr nro.(Ì!)h I)rice. ln thr PÌ.s!.ct
.trconÌlìetiti\rtrirÌ.1flr\s.onU!lÌtj(ìrniÌluÌrtesin.oQli(!rÌ))rai\ifgLhcfr.cürt

To nuÌÌÌìr.Lrirc. tlÌc i piì.t o r.hlnge ìÌr pulrì.t,ìi,kct.onÌf ttitil:]n .n ]nnol atnlr

anLl Ërtr\tÌÌ i\ rÌìrt)i!!o!\

. 1oÍiro.l.Ì s(t(Ìs.lhii.\cìt)e(onÌPcl Llon cllcctd.ÌnlnnL.b€.au\trÌor.

.onìprlirio. nrikr! m.r ntÌr!cti\. tlìc raÌ,.t oi D(Ìropoli lÌi.ing thrt I o!ld IÒllnr
a s!|.|.risILrì in..1alirin.

. ì:!r \e.lor\ iÌúirL! tlÌe te.hfolo!! nontìtr, tlÌ.r. i5 no chrn(. to (s.ifc lhe
c(Ìntetitìre trìrÌgÈ.ìnd un(lf strLh circ!nÌ\i.rnccs. ÌÌore coxrpr'1lli.. LÌaÌnltDr
i..(^rti(!Ìì)\ lo'rriÌÌÂth. su.ce$tuIiÌÌrorrtoÍs ÌìeÌlup
'11Ì!'r ir inL$.slLng rnÌriÌiral nrpPo, L nrr lht c\itteÌì.r ol boür uÌe\t .ilr.Ì5 in rn âna
Lliis,rl lhf pitcflj.g acltrìtie\ oi LÌllislr llÌm\ AShioÌì !'L rl (20()-i !ie 1ìÍÌ l$cl ditr
trorìr tlì!'(lK on frtenr\ xr a nìernrrc.i in.orxtl(lr dÌd o. Llrc tri.e co\i nÌarglf r\ rn
iÌl!r'rs!' m.a! L c.fthLrxtentolroÌìrPcLlLio.i.lhrÌno(Lu.lnrerliet \\'h.nthisn'litL.n
r

:b I i5 pl.Llrd u\Lng r {,ÌrLÌdratì. e:L nrrL,)Ì 1r\ìrÌ.h ìÌltr\5 .Ì e n(D ÌiÌrÈrr I.Ìili..triÌrl
ih.oLrl..nrr'i\a:!howni.ti! ll.: Lh.{Ìrl.Ì5ugge\t1|il lhcÌdrti(ÌìllÌipi5Ìi\crcl
j.r.. el ÌôÌr lcr cÌr !t .omtetltì.Ì1. j..n'ii!d .onÌrttitjol ìs ir!)cjdte!l siÌh nÌo 1 i..rr a
Liof. rÌhcÌcr! rt hi:Ìr lei rl\ ()l (.!Ìrp.titit)n. in!rÊarel ronrl.tirioÌr (]luptrÌ\ i...\ rtio.
I his srrggcsLt thnt xt Ìor Ìer el\ ol.omÌrctrti,)n. the ts.iìpc .t)DtetitnÌr' !lir.L f,c\ riL5

r.|tll(o!trLÈL|:tnL'jÌlll.l.]ÌlÌrjliÌjl]L]j.rr:jr:!L]i!.|L.'ú+
tLlelI[.t:lb?Ìrnd5i.:]!lnLÌ]l.írnlÍrl!ì:L.t|t.:!f:JnidllìiL]!.ltt?Ili..i
r:ìrlraL.hürtri..ìr!11Ì. rrri, rrtLr:ì.:i.L..iLhìfrrlt.. t\lnilrÌh!Llìr.'ìrt hrÌ rrri]r:tx
' r! ì'f r ú.rL rür:, Drr, .ir.Ìr r,ì,,a,r \ r.r r,,:f
550 ::

!rcÉàsing Ptodrìcl rÌarkeÌ conpetition

+

an'l LIK írÍÉ

Figure l4.T lhe re.1Ònrhip h_èlw'ên nnÔvarÚn 'onìpettun

\.\",,., I i .\ " Jr'w' l\'lrr r' rr'rer'

jnno!'ãtìoIr
rrd don]ìÌÌatcs
'..','.,,,rclatiorls;ìf LJclwecn-rconlpctition
inverse
rar'rr^i
'IIu, r' 'II ''uI'^'-ì 'prr ^' r'rrrd
1 r,' ,, r" r
" ,:". ..,..;' . Ì'
:;;t;;, oppoúunities' and on rhe other hand tìros' oPpoÌtünitics
trrr c'::
,;i;;,;; t'-, s;ek to tiìke adlrnrase of thenÌ rhis rn tuÍr wllrartere'onon_::
'"';,,'",',,"
"';'"'"
,,",ut""".;,-t**t. tftc eniÌ ol lhe plannìng cra i!ì thc ftÍmcÌ comnÌunií
opporruÌÌt1
i,ì,,""ì"i",J."*."*,ope and the formersovict unioÌr offèrsi aunique lP'rnrl;"4
. ,', n r' r " ' rr" r"1 \"' r' -
" ,',. n ". " ''r'_" r'rÚ"'r' rr''ìu 'L'
. ,'r.. ^".|l...|'|n
LiuÌì Ìcre1 datâ íor oler 'l r '
.".,ìi,."t "'" *,"",," innovation an'ì gi(n\Ìh LJsürg
'....*".'.,"....."".".*es'lhelcisthcchanceolobserr'ìni.lÌoi!dilíeÌelìtclrmleljt:.
(r is' 11 !
;'-;;;;;ty-rì' 1**ition e'onomies, an ìnveÌsc u rcrationship ìs loLrnd
" gencÌates nore growth at firìì Ìel'cì Ls
,",,'lft t.t**"r,, u*, *",,se rivâlN
,

2.2 Convergence clubs and technology transfer

nìodcl\ intÌoduced in thc iì;'
(Ìrc of the fotüble lcatlrcs oI the cncloge o!t5 gro$'th
\ll ri J
,,,,, '.."_
1,eri r'r' prì p'-
:.,',.;," ' ' ",' '\"r" '
meartstlÌatalthoushrhe srtr'r:
."'iìi'."",.-*"""* na!bcenfourd rn thcclata: thÌsries tìre Ìonc run (rc'ordins :
ìi"i"i"""i,t --.ìi *..arla nÌaÍ dilicÌ acrn( 'oìÌìr thein sârìc Ìate in thclolrg nti
nâtc), countrlei at
il".r"r".oin-'tr,,r ir." ,teadI ilrow
;;'' i;;;;; raL" oi g.o,"trr.r' in rh' $)ruw ss'rn mo'rer' hr chap(tr ::
"xog"nous te'hnolo$ tranrii
r'. i,ìtúd!ce.l the idca tlìat convergencc coül'ì take place thÌough

Ìi a.ÌrjÌL .! Ì.ìu. , lnd \!xbÌiar\r (2(r0ll

 55i

.i rs
' '
.:,
1,1 'tt'
: '
a1
a =, ,'
:-
\rrìL-'er.t..frÌÌrtilor\

Figure 14.8

rs n.iÌ!i tlìÍ,u!ìr !rìLiirrl a(cu.rulrti.'f. À! rÈ shril \r' nr tlr' 5(Ìrì'ìfÈttrian m(ì(]'L

(of\ cÌgen.r LiÌie\ frrcr thÌ(ü!h terhÌì.ìoË) úinsItÌ 'rnd tlÌe siÌÌne lr'rnìtlt'Ìl ls tr\e'11'
r\f hln tÌÌe f.ci otiÈ.lln()Ì.{\ tÌrn\!tr end th. pit:c.i lnnoliLlojr àt Lhc tÌoÌìt r'l
,t,, .rt"Ìsnn ,,, ttrc S.t,,uÌÌp.lcri.uÌ modei to I ÌÌNLtl r!u rtÌ\ 5ri1i'g rLl'trrt tl)r tht:
pr(l .tj.!Ì thi L sn{1ilì te\ !..1eÌSr Lo be clrÌsi\rtrú h LtÌÌ drc fÌe\c"e (ìì c'LlosenolÁ
lrorrh. lhc LìrÍi. 1ìtulLioÌì \lrmr h.Ìì tht ii(r 'i \'clnÌ'l'gi'rl 5!riÌlotis !!!u'i'i
ì(r.ss (ÌuÌtÌif! ie. Lr\ L.Ìr!\ntLnE n.lllntrl rrjth i le\'l or te'hnoÌogt inrnlr Ìhe
roÌld iÌ,ntitr.ìn rì(rr {1f ú Lhe llo.LrcÌ lerrl llrr fonÌi l! thri lin!\'Llio' ir ior
Itrn isso.latel rrLth tÌÌe lrúhirÌg.trt ol lht !Ì.b.1
lc'hn'Ì{iil! lÌ(Ìrijcr but 'r 50 \ itlÌ LhÉ
;Ì)i!i1! oi counLrl.\ Ìhrt iÌ,r nÌ\ d! tÌÌt íÌ..tier 1o al'ft Ìeiìdi'g edlc ttclÌ'oìotsit\
lr
l(!ÌS ,rs tbere i\ lnn.\ rljt,. nÌ r lertl((liÌ rouÌì1r\ ' ils c'(trÌorì\ iÌr thc llng rtri r'ill ìre

.hiLr.LrÌiztl b! ÌrÌodu.lirlÌ\ rL r ..ÌÌ\lent ti. 'l Ur' IÌr!lrirÌ Ìt\ L l: tÌrìl m'rn\ thlt rn
rÌrel.ngrÌr,Êínftirl\ilìrsrnrrn\tÌr.raLr'ìÌrrhi'bihrtÊ(hn(noEllí)ntitlisad\àf'jnS
rrr rcororr\ rt Lir rÚ LLìoo\atirrn do(\ noÌ ronlr]!t Lt) thi gÌd\th att ol thc i!:rntier'
Lìre il.ntier
The \.mc ÍÌrt o Ì:ctor\ .Ìr ilifrtlttl i! .ìtiÈ.ÌÌ narÌ1s ot iÌìÌìt^ rtion trrsid'
âs oi iIìft\ aiion rl tìlt iro.litr ( g ÌJlofcrtr rigÌrt\ proLeLlio' 'uú Lhe nLì'rotcono Ìi!
,ìì\ir1ì.meuÌ thc ÌerL irr1.Ì.t rnl.l
I sìrìrÌrÌr \er\io. r)ttltr'nìr{Lt Í.Ìi\i.tbeloll'nnÌ!nar' Li\r5mmtdtlrerÌlrt\rnrÌrl
l!.hrr,ì.lerìr.a hr ÌnaÌrl .ournric: úÌci.ilulrhi(h1hde'ì'cnrtrÌl \e(tols frodt'Lnq
LÌ1furIìì..ìÌate !.oôü\. 1Ìtr'r. Lr r tc.hìrologr Ìea.Lr''
j! iiÌ'lr \e'Ì()Ì L! rìrl'e trc Ìnod'Ìr\
.nrìpLc r\ t!\slbir' ìt i\ iÌ\nunc(1 tÌrú iì \trcccs5i(Ì irrno\riio' i'Ll's tÌre fro'ìu(tl\lt\
le\ al , igbt uÌJ io lhrt ot thc lúrrLÈÌ H..cc tlÌr.tÊiL.{L: tu1ücti\itr
Ìc\el in rnl
'!rÚl
( ÌÌr s: rrrn lt cLor'5 rloi Drodu(tj!il\
lr\ d,: Ènd\ ,rn lhe probiìbÌÌiÌr lhrt irl no\.ìtiri' rÌ
rtÌrìai.s.ìttltr'l!.t!stingler. Ôlt!Ìr.ÔuÌriÌ\' lìcl)rüÌLÌcli\ltlt'lrattr!Ìi5tberttun':
.li=i, l,: I Li.1,,
ÌÌÌÌ!)1rtir!Ì. Ì' l\tÌ\'ercrigL ÌrL{lItrÌi\it! !' thl lotrÌltrt
nhere ii ,\ Lht ÌrlobrbrÌ11\ nl
iltlner iirLl 1i5lhcltrtli.StlS(Ìr\eÌo frr).LLi.Lnit\ \\ihtn LhcÌe is i hjglÌr'I lÌ(nrì
hrÌir.rl in.(rati.nlrltlÌ!.ouÌtÌt m(ìres..LL)r\ií:rtiiì'lÌtillic! snì'c the\ \tiìÌhÀr'
5t2

ìntrovated recenllr' He cc rrctage pr(xluclnìt-Í is closer

to the woÌÌcl íonticr lIì I:
'
thc lypotiesis trìat backwârdness Ìs an ach'antaiae is captureci b! the íact ìÌr::
morlcl,
plâce iÌì a sectoÌ, it takes l(xhrclnity út to the letcl oí
tir'
,"rr",, 1."lr\.,i.n
"r'".U"t.". Lr." Ltlgg"r üÌc gaP to llÌe fronucÌ' thc laÌger ìs thc 5ize ol an i'no\ .ìtit ::
r,,,,rri"'.
"fcs
,,"."", O*,.*"à ,he itìÌÌ't on ilroi{th Ìt is arnlmcd that the Íronticr
Ìer'Ì :
".U, uctì\'ilv
trcd ilÍtls at tìre fate 1 = rrr sothat
li =1, r Í1 FÌ

Dr_.]nidÌnia tbc fiIs! e\pres\ion LrÍ ì. aÌld reaÍaÌÌgi'3' n'c get

,rt' u,r*i-
"!,,-"*li--,i",
Ì, rvith rhe rcsuÌtlhatthc ec''Ì]oìnr.
coìr\cÌgei ì
r!.tnttrclungtun'o, .r'

1Ì +rl

iÍthe probabiLit,v ol innolation /r' ls posilì\'e and to ';

Oilf = 0 ln thc latter cdii
íaiinatcs i\sÚrÌd conÌpr1\iÌr:
,,*pì'ïr"t *pt. u*' '-t sroN rt alìrnd the eclrnomv
I
. r"t ut'".n,.otni"t in ìlhich ìnnovalntÌ occurs {i c' i -_' 0) âÌìd a lel rv1t1Ì such Por'
dlÌacteriz'd t-'L
i.silrution, ttraL i.'rnuarion doc5 nor iaNc pLa't c' /r 0)
(i wouì'l b€
converÍiinilto the sanì
tlro so c:lÌtt conergorcc cÌubs lÌì one cLub''ouuÌrjcswouldbe
lrowthrilcolÌìvnìgst:Iì.Ìrrdsan':li'uÌcìattÜthclwouÌdroÌpalticipatei'rBro1\Ìrl
gro!ps lÌr a Iullv sÌreciúi':
i*"* ',""u,"" ""i", theretore 'li'eÌgr betìlcetÌ lhe t\lo jn
/, ì, tl -,l.rn,e ol a re\earch
irbitr'ge condìtion thc sanìr wa\ ns i{r ha\ i
"';;:Ì,'; "
,itt.,.'*Uu)tr.'", t ^.- illg to thc trade oli bets'ccn thc e\Pc'ted
brnelìts and cori:
". ÌroLicv detcrmillãnÌi
ui"ngrgins u, uttot"tinn aclivitics This r! tht wa,v in \Ìhìch thc
to the lonlergcnc!
ol innoìttlon re<1 LtroLLiah 1o tür down Nhether ir countrtbeLongs
cllrb orn'ìrethcr it í'jìÌ íegÌìa(c
lo nrnrmrriTe, 8l(Nth ìn i laiagirÌg countì! !\'iìÌ Lrc hiiaher
.lhehigherìsthclúbiÌ)ilil,volúnro\'ìtìÔnth're slLch iüro\atiof takes the Ìc!e1oÍ
i'lÌlgher thc nÌorc íarolrÌablc
i',.,r.''.,t,,' .u ,. u*'*,rid lrcÌÌ1lcr' thi\probrbilir\'
iu lÌr'o!n1ior' \\c Ìetrrrn to the
are thc msrltuttonal contlilions iÌì lhe couúL!
.ÌLìesli{!Ì oI whal thesc arc in the nert scction
. thcbiSgeÌthcsiz(oftlrca\eragtì xnatiüÌ lhisclepcn'ì\oIì lhegapbeth'centbe
countì.i^natl"trnntic,.largergalÌal5$Ìhc5izeolthervcÌagei'rno\alioìr'
. whlch ('iìÌ lcpcnl o'
thc taner lhe iïowth olthc internationaì pro(lu'tìvìt) horìtier'
thc lâctois that lrcmote ìnno!.1iotr

r,, \Èe,nÌÈxiÌÌrLe,!.tn.. l.L\|hnnÌafa Honiìi(n!tÌÌ'trmrs21r)rl

 553

'An)counhvinirhjchinnovationtotalicad\a,ÌlagroffìÌ[tiertechnok)ia]exÌnsrliÌÌ
evenhraÌlv conrerge lo the same g(Ívth Ìarc ar the lÌontler; a colub v Lürable to
i ìovrtewiÌÌnotgrowaraìÌ.TheÌnodeÌ rhcÌcÍorcÌrredìctstheeristenceol
corÌvertence cÌLrbs ir gÌoifth ratc!.

2.3 Appropriate institutions and economic growth

The SchumpcLcrìan grctr\'th modcì ran bc cnrìched furthcÌ by incolÌoraLing lhc i.sights
oitheRlrssianbonrccorÌonÌi.hjslorjanAÌc{and€rGcrschcnkrcn,whotâughLârHaNar.Ì
nom 19.+8. (,cÌschcnkron anal_v-scd tlìc dcvcloprncnL ol the f.ìÌo$'eÌ colrnrÌìes ol
GÊÌmant, Ru*ia, Irao(.c, ltal,!, Auírla, and llulgnria. He argue.Ì that the Ìate comeÌs
ír lìr.ÌustrjaliTation NcÍe ablc lo grow nroÌc ,apldlv than the inltiat()rs by makìng use ot
ditíeÌcrt inrlilLllioÌìs. He broughl logrlhcr thrce argumeni5, tÌ{o olrvhich have aìÌeadl
b.rn i.thduccd in the prevlous sc.tlon:
' Lhc llrst ìs lhat countries iffid.lhc lc.hooÌogI fronlìcr can catch up ÌrI iÌn estiÌÌg
rcsourccs ir inrÌovation,
. tlìe secon.l, i\ that catcìring up ì5 easieÌ, the laÌijeÌ is the gâp to thc ironlil:r, arìd
.lhclhirdlslbitútanÌr/irÌstitutlofsarc.onducilclocatchupa\conÌraredwith
lnnolaLiod al thc lrorÌtier alld lhnt ìnstirulionaì inrovatn)n is promoted by the
'LcrsioÌr bclw.cn the prornlsc ot ccononrl. dcrcÌopnrent ò achieved ei\ewhere, and
thcrcalittof Íagnâncy. Such a tcnsio. motivatci instìtrìtl()nal iÌìnovntlon arÌ1:1
plomotrs lo.alLy apprcpri!te substilulìon Ior tÌrc absent preconclitiotrs of gro$th."

I o sNet.h hor\'Cers.herÌlroÌÌ's arÌalrsÌs can bc brought ìnnr the 5(huÌnp€t€rian grorlh

{:LiÌÌework. it is usetìL to irúrlrdurr thc disIinction bcrireen 'nnitatioÌÌ'ând 'iÌÌlo!irtion'.
lÌnitation retìers nr the proce\s of adopllng ìcadlng edge inno!âtlorÌ\ iÌì thc'backNad'
.ount4 .nd 'ilÌÌov.tiLÌr' r€fers lo 1lìc lrontìcr. !!c hâ!e alreadt en.ountered this dislinc-
ii,Ìì iÌì the discussion .Jf ïÌontier, onc sLcp-bchind an.l tllo Íeps behind scctors abotc.
lnd€ed, we hâve \eerì t1ìat ilÌc snÌìc'inslilulion' i\ preclicteci to h.ve . dillcrcnl cIlc.l
!n ì Ìovrtnnr depedclirÌS orÌ $hcth$ lhc sc.lor is on the teclÌrÌ.Jloity irontier or ls o.c
iiep b€lÌind: üìore inten\e lÌoduct maÍkct compclilìon boosts iÌnìo\âtion for lronljff
ir.toÌs but depie\se! it lor one step b.hlnd lcctors. Sonre ol the counúies tlìat trpcrl
rnced the nÌoÍ nüpre$ile bursts of.atch up Ârctrrth in the recond lÌalf l]l the tr€ÌÌtii'th
century suclÌ as JalÌuÌ an.l (orea were charicterìzcd b-Í poììcle\ tlÌat sÌrleÌcied iÌüuÍry
{orÌ iÌìterrÌâtlorÌi1 coÍÌÌretition conÌlìin€d within.cntilcs to encourate Êrm\ to Ììcrease
iÌÌeil Íüre ole\poú nÌarÌ(ets:hrins in scctors nt thc trontleÌ dnNÌd l)e conhonted wlth
nÌt€n\e.o fetitiorÌ but protecticÌÌ sÌìould b. a1ïordcd lothose.atchnìsup.lhe Losìcof
iÌÌe ârg!ÌÌìe t set out iI section 2.1 is that irs . se.tor g.ls.lose tr) the ríorld iechxology
Íontier, the i poÌtance r)f irÌt€rÌs€ product markct conuctiti(D ìncreales ()rÌe $ay to
ieÍ this erÌìpi.icall), is to ure grcwt1ì râ te d a t. fioÍì a larilc n Ìì ber ol countì ies, ín \lhiclÌ
r r

iÌÌe dista!(e to tÍrÌÌtiel cân be güuiled by t1ìt ratio oI Lh.iÌ (lDt per capìta to that nÌ
iÌÌe UlA at the orúset olthe pern :LrÌ,i:lto nlrd a proxl toÌ lhe extent ofptuduct uÌarlet
.oÌrpetitidÌ. Acemoglu. Aghi{lr, arìd Zllibotti use a nÌcasLLrc of a countÌy\ openne$ to
FÉìÌÌDr (Ì98/1. (,È..hcnl xÌ Jnrnthd.Ís nitemÈntoIlìtr.rgu.Ì.i i\ (jrn!lrrnr Ì(Ìea,2

)
554

lra easaProx,vÍorthcc\tettolconÌretitioÌìTh€-vnÌrcìt1ìatforcourtiicsthateÌe'1i:
gr oÌlth l lotrcver' l L be"
m i1Ìc ír.,n rler, oPenncst d o's no t âlfe' t their
distan ce lro '
to ttre írontier'rs
of 1Ìì.rcâ\ìng ìnÌpoÌtance, the closcr a countrvgets
lhe scnse t1Ìal a\ lon: a::
To rhìs point, backwairÌrre$ has becn arÌ a't\'ntage iIÌ
lrrtituL."tri..p"tti.ur"rcourúryaÌecondLrcì\etoR&Llb(radÌ-rinte4rretedt{)iiri:'
jÌììtation, catclÌnt is casicr the Larger is lhe ilal ni the lrontìer' Hosevcr if it ìs tlÌi :'
resotrrces iequiÌed l.t undeÌtaking R&D dcPenl on
tlÌe abiìitt ol entrct'ri '
that thc
uP As dìso\scd ìr{ lhalt': '
to borroa to fin.nce il, ba.ksardnets can hJÌnper catch
Ìo$er úitial sealth (i e bl bâckllaidnes\ i1''
the !bilitr to boÍow $'ilÌ Lìc Ìecìu.cd Ì)!-'
Ìights of creditor' rr
Lrrl"."f. in,,i ",,-ìs (c g bv weak eÌìlorcenrcnt of the
':
"ro iìnPllcs thal tìr€r' :
$iU rìake banlt\ lcs n'ilÌing to eÌtcncì loant This 'onsidcraticÌì
bc a positn,c jnteractlon b€lween the l€vel ol
1rün'ial clevcìoprncnt oÍ a countr\ ei:i
rt also highììghts hor'írnÌc loüns ol stâtc intervcntion
lÌL'lu'
tct"ioirr.ct*r.an"x Clina ' :
ibc de of cent l pianning !. the lncluslÌializ'tiÔn oltlìc So\ie1UrÌiof arÌd
,Jlnstitutirnalcleietopnienls(hasthccmcÌgerÌ'cofthcGeÌmiDLìniver\ilbanki:
U,.trLr",*., ,n" .'*tecnth ccnt!ry and of thc lnteijrated lnan'ÌaÌ and
Ut
lür"::
iorexaÌÌìPleì halebecn associatedirith fi': :
*'ut"tt-iott" fa",*,s! and.haeboìs,
-
.lal.t.,PttyÌÌnigati.tgLìteprobÌeÌnsollimiteilr"'sstofinarcelorimllatiotì'
and iÌrcasurcs (f tht frrìar:-
,r 1tl.iüÍr\ peÌfornÌdn'c
""ì'ipr,,."i "'à," "si!rs and \{aver ínÌd evidcnce'Ìatathal lìnJnciti irìstitülìrnls | '
structurc iÌÌ .oluÌÚies, Carlill
dele1opnÌenr'r'r l!Ì l{NrÍ r'
oìtt"*" i'"t" t tor counüics rt differcnt stase' ol
"-'i,,a I mr? .on cen I tated banking st-Íem is PosititeÌ) reìated I'ith gn :
po cap l ta m ontiics,
Íìe âdlaÌÌ'cd courìties' /eJi conce!ìlr":' l
ln bank cìepcnclent industrìcs ìl-v 'ontrast' in
iattd i
o""atnr,,*"'tt o*'at""ter LÌa sprÌer'l' oi accoun l i n ii iIúoÌnÌat ìon arc asocln t!fÌ::
on ellujt! lìnance
Ìrìiaher;ron'Lh and lì\D in ìnLlustrìcs that rrc 'lepcnderÌt
innovatioÌÌ, !t i\ likell' that ìnnovation is r:
ir.l a,si"cttt " L,ct*ec' iÌÌÌìratioÌÌ and
imitalion in bank dcpendcnt onet
lmponant iÌr equÌty dcPendcnt ilÌd(ttlics aÌìd
bc cap uì ed b) \ ri:
ìnc aoti,,.tion rt"Úu""n im itatio n ând in ovatilrn activitìcs câ n
'-
I

sector asi
rhe pi(nliì.Ln,ity c!ÌuatioÌÌforthe iÌrtermcdialc goods

À,=,r'i'L,-.a,,
the 1ìrst term (lincc dìis Ì': '
where pn).lul:l1\'it-v Sro th via nÌÌitnll{Ìì ìs caplulecl by
proctucìivity bv nakìng Lrse of the prc eri$ng tcchDology lìonliet 'nd
\ii lnno\ i::
fa'lor _ -
iry tr.e s".,,ra t"rtn (tin- this raises !r uctilit-v
at th€ local lcveÌ bv the
sefa rateÌ)- bcftne j c' th' f
th is erp esslo n Ìrrir gs togetlÌ€r lh e í!o procrstes discusscd
r '
r'âs the prüab!ìlty oi nnii'r::
,,ril.r/i;rpn.e$Ì!here,l, - /'1Ì+(l rrìIr r whererr
::'
occuringind tne puie Ír,orrdlii,r Procels içìrere /. : -"1' Ì heturc' e assurnc
^s
lhe lroniier p()grcsses at the rate 1 so rhat

l, = '4r !11 I -Y)

and as beioredcnne r, - lr, ifhi.h gìles

,,= r I '14+-"r l'

I :r (:rrLinìndIIJY'Ìrlrl0lì
ÂLemoglü ìShi.r,indziÌibtiii i2OO2r
 :: ':.' 555

'lhis tlÌát líhen the r.onoÌn) 1s fâÌ beloa the frontier so that r, Ì ìr ciose to zeÌo,
sa)'s
lhc distan.e to lrontieÌ .lefen d\ Ìnaìnì_v on nÌìtalnrn (rr, whereas Ì{hen the economy ìs
closc 1o the Èontier í) th at d, rìscìoietoonc,Lhcrclaúeìmpoúanceofinnolatn)n(:.)

Lt is tlÌen cleâr that il rhe instltutlons that tost.r 1mìtatì()n diiler tionr those that fos
lcr innol'ation, irAtìtrúÌonrl change s'iìÌ be ncccssary as the econonr)Ì appr)aches the
ftontiff. we have reen, one example of drc scnsitivity ol institutnDs to the leveì of
cconorÌììc^\deveÌq!Ìeni is lhe hvpothesis drat srrongeì prxluct market competitìon is
morc importaÌÌt cLose n) lhe fÌontleÌ. It h as aì$ bee n argued thrt $heÌeas secondary edu
.alion is irÌÌportant nÌ imitatìon, tertiâÌy e.Ìucatìon ì\ esientlâl lor irÌtuvatnÌÌ, which
takes on greater impoÌtance wheÌr countÌies conre cl6e to the tìontler. lÌi ChapteÌ 13
\!c discussed the rrgum e n I tìrat e.llìcatidr speeiÌs up technoÌo8v dlltu sion atrd notedthe
evide ce that the interaction betweer the Ìev.ì o l educatloÌ ancl the technoloSy glp is !
signiÊcant cìeteÌmìnant of the pace at which ìaggiì19 countúes c:ìtch up to the lìontier.
Thi! insight Í taken onc stef furtheÌ 1fìtcan be ettabÌished thatso e types of eciu cation
arethe liey t()pusìring Lhc lechnologv f(Ìrlier oulnarcìs and others to crtchhÌg up. SonÌe
.:..r r 1dr rapid preliminaÌy emplÌlcaÌcvid.nce nr sìppoÌt ofthn h),pothe\is coiÌìes lrom pârel data on
TFP gro$th in nìnetecn OF.CD couniries í(Ì the periocl i960 2000: a higher lraction ol
the populati{D with tcrtiary educâti{)n ìras a it()nijeretïect irÌ riisiÌìg grolvth, the lowcr
is the clistrnce oi the couÌr lÌ ) fÌom the tecÌuoìog-v iìolìtieÌ.'zo
': l(nLcf cDl The Ìiterarrne on \iarictìes ol capitaÌím suggest! that there are.onìplcnìcrlnriLics
bet$een nnancirl,labour market, and tÌaining/e.lucation iistitLrtions, rvhich nccd lo bc
Ìespected lfeconomicr arc Lo feÌtbm effectively. M()reo!€rtherr ari'diffcrcnt pa(lcírs oI
complementaÌlties a.ross the ()ECD econonìet. Llberal ÌÌìarkct cconomìcs, such as llre
USA oÌ the llK, Nork wclÌ a'irh education institutions thât produce gcncml skìlìs, nilh
deregulated Ìahour nìnÌkcls rhat prnÌote iob mobillry and s,llh irancial maÌkcts that
tíìce fi Ìstotalerapidãdrantageofne$pDntableoppoÍÌrrjticsandaìÌo('f(Ìhighrík
.::iLì\ sritin! Ìa.ìical inrovaLÌon. Bv ro.úast, coor.Lirated maÌket economi$ (c.9. (icrmany, sÍ'eden,
an.l the NeLhedands) Ìrroduce â labolrr foÌce rrith vo.ational and coÌnPaìry tÌrecìnc
rkills, in whjch empìoÍccs hare repÌesentatìon withiÌì firnÌs, thcrc aÌc eìl devekÌrecì
welfare states ro nìakc such tpecilic lnlestments saler, and a frna.cial systcm that prc
!ides'faticnl'caltitaÌ 1o ronrpanjes. Th e .omtaÌatile :ì d lantagc ot lhcsc cconomies is iD
incÌeìnenial inno\'ã!ior and in the pnrcLuctnrr olhigh qualìty goods and ricrrìccs, i{hich
rcquiÌe weÌl lraincd and cÌpcrience.Ì irorkeÌs.':1

3 Conclusions
ÌÌi spite ol the Ìich iDslghts it pnivlcles, the Solo! SÍ'an tìodcl rcmains silenl on tÌÌe
lìndaÌneÌÌtaÌ questi()n of what lies behnìd the steadt risc lr livjng slandalììs obse^'e.Ì
iòrrnan) countÌies oveÌ th e past ter! cenhriies. This puzzle fucls lhc scarch Íor nìodcls ol

yardenbnsi.hê, r.d veghÍ (20r,1i

liÌ rn r\In\iii,,r ^gln',,
.t tlìr vdi.ti.\.r(.Ìtiitr n.r hÌpih.\i!, Í.e HrlLa.dS.sli.e iZ001l

j
 canditlateÌncchanisnìshavebctn ftrr:
-
cndosenous Srowtb. AnunìberolPlausible
to ,:ePilaÌ lr{'n scttinsilr ard hence ofÉÌr ':
ìi',ì.ìì,ì.ì,""""* n*''"tshüÌs ret!trÌs
1, ,.r'^ ' . -_r' ; ":
r
. u i nien.ted kÌÌo$'iccìilc \pilÌotc rs t o t1ìc econo nÌy at a s'h oLc as a con 5eq iren(
cap ital ;Ìccu mulatioÌr,
. PÍÍlüctìvitv gì oNth through hüman capjtrlr"unÌüÌation 'rnd
. rrre gencrrtlon or ner'liilher productilit-vblucprintt tlìr)ugh R&D acti!'ìt) '

Ì. eâch cnte, ìn ronuast io lhe Solot! SNan rÌìoclel' a Poli(y or institutional ':::
the case of knoÍ'ìedg' rpill '
,"rr,,"",rft u,gncr Per capitâ !ìDl']i'rowlh lÌì
i;::ì,;;#';;;";i,';:ïvrigsrurvetmorr iiratrintrìccascorhunrancapltar'jr:
'"',n.ì"
stucìvins: aild in tlre case of R&D it !
O,,,O"tlion or time sfeÌrt spcciar a'sÌtn:!:
"ïì,-."^'" ì;";,.":""r or pcopr.\';rkin* ìn the r{&D scctor' rlrccndosenous
:; ;;":'";; ',',"" !r
:;;";;; ;," ;.....ürâtion po'es that ìs ÌÌceded to Produce
'; -.' .ri Ê', |.""r'il '.
,,,,",,, r J P -Lu -r' 'E'oL i '
"'l
". ",,.;
'R^r!to,
,' ,'" ''' rr" .'
1".,,' ;"",'",o" '1"'' '' "'' exìstefce or â rvedge bet\\'cen private and
ÍrcinÌ-rctur::'
ì
i-,"1. u* u,i" tl" r't"L) edücation oÌ Ra L)
ì1'"':..,;i a; t'"vides a rationarc ror surrsi'r1es' e s ror
'''.;""; '"',;;; ' r'."' I'rJ -r'- "
. ",., ' .r'\rr'
-,; '
do rÌoL ac'o with thc e:':l
i ì,",i."t"'' ** oreclrciic'ns oÍ non convcrgence
""ì.
icallìÌr.hìg5olcross-coüntrvconvergen'eolgrowthÍatcslrrthcp'ÍdccrdeÌr:'
-ï : t''lrr" P'1 - J'r 'o'i
"^-
i:",:; .. a"'P ì
'-o, J"ì
ì:;,J-;;,""", "4." '\^- 'd'r'
,,j., "-' ';:'"'
,;, ,..
l\ lrrL)iLl!.trr{ tlr' rÚn!'lt ullìl-l) to rt'lu'
nnxlcÌ pro!ìdcs 'ì un' '
ï,.," ì", "'ï,'.13 u-'ucr tccmolosies' th' sclìunpcterjen a'rn'it! in tÌìe ìoDn Ôi:'
i'ïi"",ì.''t. tì"."t.* t"wrÌ the dcterÌirìants ol i.nolativc
."ì"à ". lt rrcco unts ÍoÌ ih c e{istence oi coÌÌ\'erscÌ1cc Ìi:
' '
strÌÌdrrd-s sh{i:
'rÌso
'"'.'"'lnL'0,,."t" "qualion I'ill not rxÌ)erieÌì'c ilroirürg Ìiving
..,ì,'i,,"t u-, u" ""iutn{)!ale
ì;ì;'i;;; i;;,;" ",,," '",rcrÌeLitironÌ rech'orosl trânícr ìrn úÌ toir'tLì thc ÌoÌr' '
L,. s - 'l rr'r'r"' o' l l
''. ' 'l\'r'
l-r( ... | 1rr''r ''tu " r l \' _' r' 'Ì

'; ,,,: , ,".,

.",.;, .',.-",'"'" LàÌL :
'ut
ï'ïì.;;";;.: ;'; rart' anct institutrons that esralJrrsh the ..ne oI '
'"t 'nLeresL
{Ììd hence 10 gí\Lth llìe rrrle of Írnc iÌÌstitülions ìs mf '
.otrducil'c to úÌro\'âtìo!ì
(oÌnPctition losters rnnolation rÌ"Ìer so ccir'LiÌ:
ì,,i*ì", ,.*",*"," n'"nu't markct ìs drawÌì ben\ ri
\rok broüdr)., o.ce the distinclion
,ì",ì.ì, i,.,iì,r,J",,,ì ,,,,ocr otbers.
 557

inì tntil!Ì !1 tronticÌ rt.hnLìlt)g\ rnd in.(\'atiof rt thr hontier. it i\ Lllel\ tÌrat Ílne
ln 5t Lutlon\ r ill tre rÌÌoÍ \tr tcd lor n)rteÌinij .rt.h LÌÌr r!ÌriÌit otheA s jlL be ÌÌe!e$ar v nrr
Llì. d.lchpÌììeÌìt.t Ìrrr b,ur|Ìint\.

QUESTTONS

(11 lrorsi..!tt n!t!,.,tÌÌer tii ìn.r)gÌ ls di Llbelnr Ìrú1L,ccd. ard theL r Larqcr or
L_!

5malL.r (lìar. .l (;DP rìrnÌ l\. d.\.trd n) lt, lìflL) theL thc L..g Ìrúr gÌ.wth ratc is
en.ÌoScn.u\ir .tr tf r f Ìl.f (ll
(2) l\'hirt ji ihr li\tnr.tj.Ìr hetreeD e\oijen.\r\ anrìerúoS!nrrLs!nr'Ìh Jnôd. il lì.is
rrÌdr)8errlrrj grrflÌr ÌÈrÌujÌr a rìjllerent rìehlition ott ì! ì.rti\ natc.Ìtr...on..r1'
tlìriì re !Ìrr r e rised nr tlÌe Solol 5sdnnuleli'
(3) WehÀÈstr hoÍ th.r Ì(dr.dclse,r6aslhcfrct.t\peíÌe!do!!rrü,!!r,ntlì
nuìcÌs rnd h.rL.hinq.\ to lbc S.l(ú1 tr.an nr)(leÌlirÌS hd!Ìe c! ( !rr erd i,)
endoscnour grnrlh i|..g. LinorLìc!ìgc sprlÌDr cÌs).staÌtjÌì8 hourthe !o.r \r,rn ú,,dll
dÈscrllrLLìintbcfr.riÒtrs.|aÌrlcr..!ÌrrorlhLiliotJÌrtrdditl()nir is$rrltiinìs(n.1
iÌre:ilìr..ú Ücd in thii chiìptol thit {I p!)duce r rìiü{ rlth rf.L.Sinors lr.lrlh?
(4) (inc.trit[].trlra!cl!irint.rnitiona...rdrodit\.r.!Ìd]onerpe(tjt\1ìn!ÌL.tn:l
br thr srfrr ln à r,ürtrliil
(5) alhoose tÌrÌee rnodÈli ror erel irÌ ihli (lì.rpter rÌì.LLìntrisl lht nÈ.hrnAni thrdruh
shi(h ther rnr\ expÌalr (Ì!\ (o!Ììtr ),lreteroSefr it! in long Ìun ÈronoÌnir

(6) (onsi.l.rLhcdaLaifllg l:.9IÌoDlrrecentL\lLìlFÌì.lr.rÌi\frill0{)5),Íìrich

ihurri lhc.lislrìbuti.n.i.hiÌdreo oltrjÌnat r(ho() ì!.Ìrh.aÌct()trLtcidLng
tch.oÌirdillcÌ!nlr.gionsoithew!ìÌ(ì.ah,Ì^rrrìr()lÚì.dr,)dclsrÌ11ÌoLìucedjÌrthj!
chilto rr.1r\lllain horr i1Ìrr ould r\Ì)rrt the rli\tr jh(úi.. ôl tÚ .aÌ-nt.ì ('DI'aDd
i.rS íúr !c(D.dr . gdrth rate t.(Nbt regxÌrotthL lror L1

(:hl I r:Ìs.lr,

FiguÌe 14,9 P:!?.irqÈ. r _i.r:. !. trqEil -lr:ì .i:t:-.r. _!r.r.,i,:t, r!.r 2lrcl
558 '
(7) l)oe\ únemtlo) Íìent rìaLter loÌe"n'Ìnic 8ro\th?
nìÒdel! ÔÍerdogcnor6 econ'mì' govth cxplain Ìegn'ìal
dilìcren'cs nr
(s) Cao R&l)
spiLlo\ eÚ?
lons nÌn e(onomic peüornÌlf'c? C;Ìn geograph) affect knowÌedge
{9) CJ.lhe lÌLq)can coÌonlz.lidÌ Òi AÍj 'a and Ì alin]\drcÌica hclp expl!1r
de\ elopnrs ruld?
hetcrcSenei\: iÌ1the lons rún ec'noIÌìi' PeÍìrúdìcc oftÌr(
lllinl:TlìinÌÒi therfÍect rrJ irÍjtrtions 8 fÍrpeú!
e rìglÌt! oÌìec'n'rnìjcsrc$'Lhì

(10)'NÍofopoiyprcntsarenccessar-!topro!idcrrrìnccÌÌtì!cldúrnoraiiorÌ';
i. the Púdrct nìarlcl n iÌ sprir t() inno!'ÌtìoÌÌ ''\rc thlt two
'(bnìltÌition
.u t,"Oi. t,t. t tx fìaln úsnÌg lhe Sc h (nipetc rian growilr úod( l'
. r,t"n,
".ts
(11) ly DeccntÌ'r woÌÌd Hctlth OrganizatlÔd rePorle'l thalin^lrica 81r)ol
20í)'1, the
Ncre rcccivlig it'
1i a5 ycar old\ \\'iür AJÌ)S ilho needccl rnliretro!ìúl tlìÚapv
; h ouÌd pharnrc( ulìcaÌ .onÌPa dies be !liowccì to c ntoÌce fatents
fo Al DS drugs?

il hed,Ìtan rcpoÍcd in\\ HO (2005) '3 b\ 5'lrc8rcss RrpoÌt:

r!$s.who nìt/3b-v5/ProSressÍeport05/cn/ )
(12) ADtj-Slotralizrtn)n acti!ists argue lhai c'onrtnles Ììccd to bc localizcd add enìtowcr
nì the long run' (See lor
sniaLilocnL invcstors in oÌdcr Ì'r Ìrnrmolc huìiÌlileliaLe
.ra rpÌe, Kortcn (2001ì I Do ]ou agÌec? L\€ thc SchúmPet'rìrD 'rodels intrc'luced
iÌÌ this clìaPÌer ro aÌgtrc íor or aEainst this \t'tcmeÌÌt

Problêmt and que5tions foÍ dÈcussjon

growtÌi wìlh \plìlovers lntroduced in
QUISTÌON A. aonslderthc modcìofc'onomì(
ur i'Ìentì'aL
i;dion 1.2 oithi5 chapter' tlpliin ilhy we nteclto ha\e nìan'v 1ìíms wìth
nÍÍltrctio. tnIlction Do-votr lìnd the Íun'iional form of the lìr Jproduction
jìnd tì]e lür ctiof al ìorm ot thc cconoìn} wi'ìe
irrìc lì{Ìi ÍcaÌìst lc l trflain l Ì) } ou
pÌodtrctìoÌr flìnction rcaÌinìcl t-{planÌ Atnrm' tLât !hÉ e'onorÌn'
1th ìr = 1
'".p"r.*"t * ul*-l*""d ìncrea'e iÌì I to I n"$lbe ìts clfect Can thls modcl eÌpìaìn
.rJr, n*".og.t"i1-ï? Docsthis nodcì1mpl,v un'orditionalorconditlonal
-".,.t
(ìUllS LION ll. l.manycountrresmtxÌtc)trrÌ)'ìnmigritÌonis'5igniicentphenorntuon'
pâ5t hnÌf ceÌìtLtry ln
rìlte t +.r stros's ttre groirth oÍthe ürbân Pop!lalion ovcÌ tÌìe
China.
RliL) intlodu'€d ìn
Consi.ler lhe cliect oI Ìurâl to urban ÌnlgtatioÌÌ on the nrodel ol
section l..l ofthis chap!cr' !oLt nÌayi'ish lo nÌakc the Íronii \in\tìfring
d\suÌnftions
that lhe econoÌÌr-v consists oi trto \€cLds,
(uat ind urban' i{hich manufactLlrc goods
tÌÌe nìig rainÌr n bv isher
rnd rdcr s rcsPe. tivelt lìurtiÌc r morc assLi me t1ìat !s h
'lrÍ'c
r!aile5.hÌitjaiÌ!h'ri{esj.botblherLrrâl:ìnduÌl)ânstc(Ísarethesamebutasthe
*"g* inthc urban secloÌ ìn'rcase $'1ÌÌlt tlÌosc in thc nÚ'ìÌ5tctor
"..,,"-r'".p"n,rt
reÌnaìn !nchangecl. Dcsciibe the Ìong nÚì grú'tlì lathoÍ
lhi\ c'onoÌÌr'v
rcconÌìcn'ls lheusc
QLILSfIO\C.'ÌÌìítraÌWcste ÌKenln th€\4i'ì\tr\ ol AiiricultiÌre
oìh!brl(Ì\e€dsrndfertili/crtuinc!eâscmâizc-\ieÌc]s !ìr ìt recoÌnnìc
n'htlr n is ba5td on
lIÌ2000'
.vi.Ìen.c lronr e\pcÌuìenlÂl lanìsthal teÌtiljTcr nìbíantiall-v increascs vi'ld
íanÌìcÌs jrrst +50/0
hoilev.r, ac.or.ìing L{) a sütr ev ('c condtr'ted in a râfdonÌ sampÌe oI
 559

Ìable14.1 lrÍLi.ï !.tJi:.::r'.rlr r al _à

i. Lhe ) edr b€turl.'

oI iâÌÌners had e! er usid l( íiÌizer. tìnd iLrlL l5rÌ'i hacl uscd íeÌtilìzeÍ
(DÌrn.. Krener. dr lÌ!bjrìso. (20051 i
Lr5ing the corÌceÌ)t\ dÌs.rLsscd ìÌr tlìis.hatLer (e S Leamini{ lpillo!.r' íxial.ipllâÌ.
hnarì..ialtÌerel(Ìlnent)dcs.rlbe)o!rifLrrLrj(tr\(úrhrn)leüpeoflcu\eìtitiliTLr'en
tlìo(,{lì irhat a.leir Ììot..lialto ìÌ!pr)lc (r)nonìì( LrrnsÌrerlt) \\hituethe
ìnpll..iìLlon\ olthi\ o!i..!ìc i(Ì tÌÌe plr5lc.t !l ÌorÌil ÍrL n econonÌ]. grnrtlÌl Larì -rou
uÌinL o frlic) t(uls to ììllf!iil. tÌris lroÌrl.ml
(IJllllOìì D. (.o.\nìer tÌre iollorÌLnS !LÌotnl .n loDÌl(rt'Ììer i2!0]l
\lrLtrir, lrber(rjlL\i\. rii!Ì rtraiì\.i Hl\'.oÒnrnn iÌr 1íi.a lilÌ j trlllion ÌÈotlc c"h leâr
ÌLÌt
!l.rútllol tnenr iflr\ iÌÌ.(ìdrerLÌfrÌrjrj LlLe.l rÊ\nriIÉ rSniJr\t tÌrese dÌ\rrirs are
rì6Ììrr.1!Lt Ieeaen trÌ ÌÌrcÌ. ij a !trilÌJr! n!arLh oire\trr.h antl i!\ cl.fÌìÈni lt&Dr! ì
\ì.cnÌ.sa.dLÌerÌr.rntjnÌdi5ra\r\Ìr.nìirllrniiertjÌi3|ofr.rNrlrle\ (riÌÌÌ'12-rl'rtr:'
lÌr.$.dlro orrdrÌr' \cllì1!'-5rrid1!9i.trÌì l:r.rcrLfÌÍrlic. Lìi\cr\rj indtnl\ 1't
tlÌorc rlere !ìre.ihúÌLt dlr.lqriì b\ .Ôllner.i ni tunÌ:.Êrhr iL Ì: Ìì\ Ìo Ìrfil t of 'rÌ dÌ\fij's
Ì

irh!!rifì Lrli.lrllElob.l rerltÌÌ RLLr lt l'rt2r.su[]eÌÌrl.. rl ÌrÌj\rt.lrlü\tÌr,Ìut'l

ÌlìalLr$tiÌrnjl)rr.!ntlr!!\l-rent.ndìÊni!\\Ì)c.iLì.1!Ìrrrìr.o!ntÌiri
( onsiLlcr the S.lnrnÌ]rcl(!an troÌrlh ÌnodeL,ìÌìd 1iÌÌÈ heìlLh r! ero!('otrs to tlÌr
nÌodcÌ !)l!.u$uÌeeiJ..to the Lr.k olrrÌ\ arÌ.ed h(iÌlLh.iìrr rn tht gr.trrth t!o_rfe'1i oi
rlo!riJìromrecorÌorÌÌt.NoÍtndolc.iiÈhe!LuÌ1,\a$unÌifglhatitisf'ÍibÌelor.ìt
Ìern pirL .I rhe R&D Èlior'1.i thi\.ou.1r\ to Ì)t locus..1oÌì lrcellh ll.ìr'\!llÌth1\ (hingc
tlÌedj\.r6iLonabo\el(i,rLhcgorerÌìmc.tlì.'hÌhrorrghi€.{trlahorroriJìrtjlutìonrl
chrng!'? rriÌurte tlÌr irìf.,tin(e 01 t..b n! Ìt)Sica I tr'anslelr iÍom aÌ)Ír.ìd ior tht\e
,tr\ n..nrr c..noÌÌrl.:.
 PART FIVE

Micro-Foundations and
Political Economy
 New Keynesian
Í5 Microfoundations

In tl(. 1Íelrtietll ..ntrn\ nÌiìrÌoe.orìoìi(\ Ìrns lÌeq!(nrÌ\ tìc icenr oi her'r il'brtes
beÌÌ\er. idro(rtc5 .I ruÌ nrì{'ntaLlÌ (ljtleÌenl P.ÌtÌ)e.li\e\ rfd ÌnetlÌodoLosil5 L' UÌ'
.uÌÌerú PcÌj((ì. rliJìntrsh (liiiiicÌÌces r.DdijÌ lÌr. mìddlc ilÌorLn'ì oi ronrenlr: !\ trr
bÌoa.Ler. lhcÌe i\ iì!,ccmeÌrt Ìlìit r nrllsiâctorl üicroe.Ônonìj' nodrl 5h(rÌd
alÌor tor
rrìge anil trL.t Ìi8ldl1jt!, nilìLl(Ì ÌrÈ bnsed on ottLmiri'! L)ehe\ io!r bI nicrr iÌgents
i..l Ìlr,ú ìn(Lúi!hrl bcha\ì(Nr sÌÌrld !ìtittr riì1l.naL cxfc(t'l(i"r''1') iunnrrrlTt tlÌ.
i!.ituesthrl!ha.n.LfrL7cnrLirì5tÌerÌÌrnrodeÌs!5cdlorÌrìx'rupoÌi!\rrriÌIr1\rr...:
. irìf.rlectLt ll.libÌe I ig!1enl irrlce\ .rsio.iated Ìt Lh iÌnpertecijo'! nÌ L'rbouÌ rndirÌ

' ratioÌÌal inttìiÈ poÌxl1ÌÌti iTirs brhr\icrr olaÌÌrg"t\j

. núio.âle\P..Lrtron\.
lhe aim ol rhl\ clÌ.f1rÌ i\ to:cl out a tLnilìed lrenrer ork to sho$ u b'rc the nìrinnrriìnl
\rrr (e\ÌÌcsln. mr.ro nr(!ìel Ì!lth nÌicnrl(trunlntL'Ì1\ 'omes tronì Ìll Ììost cÍ 1ììit booli'
\ ! h ; usrd i \trippcd dr\\ n fracÍ) rìo.leL tr1lhl\ ÌliÌnl: I e tì1\ e choí:' ttì priontìr' lht
rbilit) oi ihr molleL rÒ better mat(h 1Ìrc \t) lizr{Ì ia(t\ o\ er tht deslrabiÌìil o srtisillni{
tÌÌc Ìaquilrrnì.nt\ tor Iu]Ìl inionrL.r.Ll oplimlTLng bchr!irnrÌ llthouslÌ tÔr tÌÌe nr'\t
f,rrL, the irntÌL.ations oi the modeL ihil re Ii\ '
r\edL'tlÌcbooliìrcÌnLiiì'(itlÌlhri\e
,,1 i Ìnn(Ío11.de!i \rrt Ke\ nr\rrÌr nÌrnleì \. highLight ìrÌ ihir clÌ'rfLer lrnì'
in4)oitrnt
liri.s nÌÌeI. LhL\ 1\ roL Ír. Ui ìlÍ) lhoü tlìil Lhr \ür Ketn6iln model l5 stilÌ lfrÌer
:if;tÌLìcti.n jÌÌÌlJorLinli!!es renrjn uìrres.nt'{l
Kclnrsiin (rÌrtrìi.r LÌcr eloÌrc.liÌr Lhe 19-l1ri i\ d rfiction 1o th' nabiLlil oithe 'ìc'
jn
.lìs5i.rl e.o.omlc\ ol Lbt intÚ 1trr pcÌj( to !\Ìn!ijr the GreaÌ Dcfie$icÌì rh!'h
trÌÌcnrtÌ{r\nr.ntnrtlÌctrKrnlinotlÌcr.(irurtllcs€ìrilncdàbole2li''ih)rsc!'raL\'ar
,rrcl uneinprolir ent .rrs cÌtrrl-t Ln\ olu.trrt lh.neo.li\\i'rlo!thodo\\hel'ltìratÌiith
,. rlcctÌv.onìtÈtltì\ I liÌb(trt rÌrd trodücl Ìn!rki 1s, tÌerijbÌÈ prirc\ drÌd Ì!aS6 $'ouÌ!l acl e\
r:, Let cka, irrg rLec rrnlsÌr\.n.1s !uld t!irÌrnr.1' i olunt'rr\ uneÌiplolDrelì1: li rr8ü'd
ilril the .onsL5ierú J!fljcrtìorì .l (.xìrletiti\'c nìjcÌo lould'tlfn5 lÌ'ì11 no oth'Ì corì'1tr
iÌnn.Ke\ncsLooÌrijsucrritììthl!\ìeÌ!i.hi51çl'(;di'rì/lr''lr'ar!ungtlÌ'1$enr'ilh
ln
.. mfrtitivr' ÌìeÌLeis n.LÌ 1ÌeÌiblc triccs' theÌt' .ouÌd b' in\ olrLnterl uneÌÌplo-!ÌnerÌt
.,lLLliiblLur. Ker nes ircnt to soÌìe LtÌìgLht úr tlx (;r'ÌtÍìll r''l lo bàÍ'hi\ ui'oir\Ìndit
::nn\(npcÍ c.:t..Ìl]LÌ'lilLon, lthrch ,rkcs ítr1ìürhrt ir'ni'âl Lhr ÌÈ'€nlrÚe o
(heternì
\rÍ Ke!Ìì.sli. ti) I.i!'Ì nr rìì.tr]tÌ' thit Sener,rÌll itrcortoÌrir lnÌ)eÌl"tÌ) 'onìlÉtltitc
:Ììi.:Ìonru.letions

À
564

\\ihÌlc tìre (;.,rdrdl I/r(r,'l,bâs hdd ân cnornrNs subsequent nnfa(.l on nìrcroccononÌi'

anrllsjs, its maior ftÌce has been oÌì thc need to un deì stancl .Sgrcgale deniand as Lhe l€!
lactor !. rhe short and cdiuìÌmnìn dtivúÌil oulpuianclenÌployment aÌ!ay lronr ecÌri
Ìibrium. Ìn tlvo impoÌtant ila\ s, tlÌe L'o'lhas beeÌì less succe$íir1:Êrsl' Kev ess
'relì''d/
tosltior) that âggrcgâte dcÌnand couÌd detenÌÌlrc.{,i/i,,nt, oullNt
and erìPlovÌr]€nl
and thus c\tÌ.ìirÌ PcbìstenL invoÌuntary uneÌÌDìo!Ìent i\ no(I lalien less scrlous\' ,\s
has becn the posì1io. nì thìs book, equiljbìnun output rnl emplo-vìnent âr( lodâ-Ì seef
laÌgely as supplt sidc t heno men a determ in ed bt th e stì Lrctur.l .h aÌacteri!tics o t pÍxhrc I
and ÌiboLrr mrrkets-rÌtlÌough muLtiplc e.Ìuilibrla an.ì hvstercsis mechanisms Ìrturid'
Rrte\ through 1\'hich aggrcgrate deman.l calÌ Ìnntrence the nìcdiuìn nìIÌ cqLtjìil)Ìium'
ancì ! rnnge oì constant i.nati()n.'quiljbìia cÌìaÌacterize thc oltn economÍ Second'
KeyneJs nìjcrcloü.dations olcompetìtile ìnarkcls $'ith tÌe{iblc PÌices arÌd lçages are nol
seen as adcquate cvcn to cxlÌain whv aggÌegdÌr demand \lÍtrLld keep outprlt away lroÌì
cquiÌibrlum ìn thr sÌroÍt run
On the .ontÌdry, ì1 is now i!'i.1el) acccp lcd tha t ÌI LheÌe are per lcc0t conÌp€t I live Prod ü' l
an.l labour m rrkets with prl.e Íl exibilitl , an.ìilthcrcì\ coIÌÌplctc
jtnÌnÌâtion rndÌtìtional
c.Ìrectâtiorì5, outPul ancl enìploymeÌÌt l\ iÌl ne\ erdc\'ìate tìonÌcquilibìnun WcshalLreicr
to rhìt asthc neo.lassicaÌ bc n ch Ìnarli nìodcl (\CÌ l\ Íì The liÌrìilation olthe NCBM is noL
jt
a theoretical one gilen its asmmlrticÌú, is ftrÌ-v cohereÌìt. !!s trÌrle!ÌÌ Ìs tbât it fails
ro fredict some of thc nÌon iÌìtoúant cmtiricâi tacts about n]acrceconomÌc hehâviour'
Whatarc lhese st)'lÌ7cd fa.lsl

(1) lirst ar.Ì lorcmost, o(1lfut and lmpìo\ nìenl eppeaÌ io d(!lale tÌoÌn thcir
equllibÌnuÌÌ !alue\ lor coìrsicierablc PeÌ1ods oI tlnÌe lt is usclulto cìecomtosethis
fundâmentaì c ÌnPiricnì pr ol)LenÌ ifh thre€ paÌts:

. l'helniu.l inÌractoIanilcreasc in aggregite.Ìenì.ìnd ison outÌ)utand

cmtloynÌc.t not on pÌìce\ and i\'eges (as shouÌd h:ìpprn (IitÌr corÌÌpetitltt:

. ..\ÌÌ inìtiâÌdenìand slìock mavbe ampÌìliecìLry subscqueìúchingcs ìn

.onsu nÌÍioÌÌ an.l poss ibll i nvestmcn t at irÌconr r! ch anSe
. ÌntÌrtion onÌ) respond! sLol\'ly .tisequilihÌnrm \itrrntions: jt.]ìspLâvs'i'eÈa'
1o

Thi! is what we hile Í) tìr..ptuk.l irÌ tlÌc ineìtìaÌ(n ba.ls'ald Ì(rcliilÌg lihiìÌ1Ìn
\'hK " .l-
(2) In addition, there irc tlvo sttlizcd lacts about the chaÌacter oI cquìlibrirìm:

. 5onÌe paÌtof equìlibÌnìIn urcmtìoytnent is nrvoÌLìntary.

.'heÌenÌâybcnNltipìcc.ÌuiliÌrÌi!moulputrndcÌrPlolnÌetrirrìtcl
'lhe chaLÌengc it constructing a Ne$' Kcyne\ian macro ÌnodeÌ his bccn to see $hclhcÌ
it ls torsibLe to a.count for these fa.ts Ì\'hjìt mâintaiDi.g the asÍunptÌon that irÌdi!'iduel
aijcnrsbeha!e and í(ÌnÌ th cit beÌieÈ .rtio nallv aientraì1o nìeetiÌÌ3thischalleni{ehas bccn
tlc rìcw that prìccs atÌd i!'ages aie set bv ltnls (rnd pcrhaPs aho bv unionsl Ìather thân
reÍnling ironì ir lvaìÍasian f()cess ol markct cÌearlng lhrough ile\ilJle prlccs âncl Ì!agcs'
'1hc domlnani NcÍ'Kelncsirn apprcaclì has l)een thal prl.c \ettìrg Êrms, an.l PerÌìaps
üase\f1ti.su.i().\rÌa\\!Dedtt)rìpfriìl(tLndrÌco..ìitirn5ollÌferJect(dnpctrlro..
n)rerinìpl( aiLÌll. f.rLarr.ì m)n(ÌÌrLi5Ls lhLsexfÌrL.t\hl .rtLfateÌÍ1e +rLo\JrìfnL
rrtlÌerllrin|Ìi.r\Ì.Ì1)ftìnìchrnBesiLl.ggÌcgxrc(ìcmrr..\ldllio.rlain'!rL,iii)rì:iÌ.
ìÌriu:Lu..d lhiL SriL' rrr \Ì.1r rdju{ÌìrÌrt oi ÌrÌiil r..Ì s atsÈ:. lhu\ lhe Ì(t} rrnrrÌÌÌrtio,l
!l tllr .r..lesi].rl hrÌrchmrÌli Dolrl. inil LhcÌ. i. ftÌte.t .onìfrtiii(tì dÌtl !iÌ1..1 t
il{ibll tr].$ rnrl rú!r\. r\ Ìcjt.Ìrd. H,rtr.11'Ì tlrc!\\ut(úhr\!h.ittoe\pl.rnÌlri.ìs.lt
r ÌÌ] pricrrs ind r rg.\ rtìju\l \l,rr Ì) lÌ rcs|o.n: to (Ìj\cquilitrriunì i.d h(n\ itrerlill i ìili_
tir!Ì i! | odr..LÌ r'nì:Ìln\ .ontÌ(^er\irl. 1\'c í't oul 11\r) Ì!r.lr (1.hxl€!ì apProiì.h15: Lhr
\er (.rn.siin 'jhiÌll.s.uÌtandthr51i.k! Ìr n)Drti(Ìì |lÌil it;.trne. lhÈir5iunìPLlof
oiìrnf.rl..Ll\.ônrt!lrtj\tD.rÌ\ct\lL\.itr.\Ldcrtr:rn)t,NÌìdeLi.trn)ruÌtcrlsL....oi
iÌì\!luÌÌtiìrt rl..Dtlo\rrr.t Tìie rì.]ìÌìsL,.rnr \e\ Kt\ni\ i. trodtÌìÌ(orfÒ,irinS rn
iÌìkrc\i rìtc Ìris!1l ÌroÌrttri\ f.lj(\ NÌi f,oliiÌcs thÉ tirrììrrroÌÌi l(Ì ÌJÒLi.\ mrlilrg Ìn
!cÌÌtirl Lìrnl\ iì ìd 9.1 rÌ.mr.l\ in ÌÌÌrtr\ ..,ttÌrtÌLÈr.
Ii i\ rúr n..rÌrLL'd tìat mr.r. n!!L!15 shotrlLÌ bc aÌrch(ìrrd i. ÌnicÌ.ír!nd.Ll.fs ritll
.Ì)tilriz fg igL'nts Ì!ho ha\e !rti(!Lr iìfr'.tali.ÌÌrrrdlìr'r.cthat!r.lrDorLl\!houÌl
Dr iÌlrü nr L. Lhr I u..$ (Ì jtiqui j.. Lsir.uLLl Ì,e prenL.rr(Ì tÌÌat prlrnlr âitÌìt\ trle
(

iÌúLì r..Òr.t Llr! iulurÉ ÌeÌ!!Ì\e ,rl lnlrl rÌÌdleL nlÌ. ì .h(!tri!! I r(iÌ rcti.ÌÌ\r lhi\
Ìruro,l.Ì(,{l .hrÌr.furiri\ uirtun:,,,.rltd \e\ l(rtÌri:i. Ìnl!LÊL\ l1 l!h.re\erd!LLo
tIr..ìfL ]Ì-ì!li(Ìr.ftr..ÌÌrÌni\t\.. nglÌ(Ì!tlÌr'rl.o.li\!L.rlirllìrrLlrr.:lìt'l\elrìlsiii'
ir.rd Ll.n. Thr \cÌÌÌnÌrL.rrti.li .rb.LLL Ì.ìÌi(Ìrü .\P..LiÌiônt Ì,1 l.hn \ÍutÌì Ír\ fr bl slrral
irì!(rai.\iLÌth\t.itel.1rì.1Í'\Ì!hrth!ÌÌlerrìlÌrÚrtlt)naLcÌPi.1r1i(Ìrr
| .rJ.r t..rf r ,: ll rl\ rr.l)LL Lr.rl .l:ri.n.:i.!r.r. L!!ri(i. r! Jrifre lrr i\Ì!lh.5i\ Lr lL
tlr.\rr!.!!rrLr \t,Ì.!tr!rtri:rr|r.a.Ìi,!r\r,:Ìltri.rr.Let.irrúri.L_e.r\ lÌÌtrn..r. LÌrr
lr!Dthòr!,tirrtitlrrÌ:,rr..n!Ì1 {tier-Ìl \1,ì.|.1r\L.rrrirrrD.:.rìrìrr!LtLú1!rrÈ'LltrNr\
(t,jr..ìÌri. llllÌ,!rtlr.itr.r.t!r'! Lh*iìLrrrrs êÌ
Ìririr!Ì!\iril,rnnLlreD(trìelLiÌÌ3o.Ìlr.t.rtrÌrrri5t)iL(ìrtalr\rteto:!,ìpi\h\
RnbrÌt L!.ri. li.f i\rÌ1.ìnd. !Ìrd lirú,iÌ ÌrrtÍoit. i.r().!\t otlr.r' Ì\ÌiorPf l.d tlo
. qr..!Lit)..r 1\'r lLr\c LÌlnÌrse!l lnrli(1\()lf.l .1 .rcdiÌ)ililr,r.d lht
Irc.ì\(ÌitillrliI(Ìrr|ttblrn!irì(1n!ÌetrÌnrn:rtì!'nìl'ìttrirlLrìl\'Ìrrlrteri51úbxÌÌd
rLILhrrÌÌi!rolfÌf.nii()n\Lìl.L\t1!LirrfL\i.ìÌÌ!tr\Lrl ,.n'n (!ì rrt nfil trÌ)ert.r1jo.r.
.a.ìdiÌiLÌrii.l]rL h{tiN.tÌrr:n.r\\i\otraii.üllr\N.trtioÌr\i.LÌto,i!l .rrdhllLtl
LrìriI\trerrlìÈr.na..r1onri.i.thrÍr.ti11L!ÌÌir1\h.rt.rsLìbÌrslì!'dthtn\rrÌailo.\ot
iL .crr(ÌÌ ÌÌ!!rLì.rnr. thrl b.ì\ ÍrqlrL l,) nrrt!ÌÌ tìr irrlLÌÌraÌ ti.l; Lìl rrìr!tu(.o.().rlL

\ 1tr.(ìrÌ!trÌ1rl riìLui. o lhj\ !Ì)fr!iì.h j\ tÌrrt r!Èni! er'rÌnrÌ5 nhÌ! to !l)tirrl 7.: iLì
.1.ìDtÌr. iÌr r brLi n.\s.\cLr tn{rBlì. r ìrtlo)ct\ rlrnoic Ltì mÌrlL\ lcÍ lrl!rr \ |!'r'tr t
tt)rì!r!Ìilrrìì.nLl! n thc I u.r\ tird Lio. Lt th.rt ilìi rLrÌieDÌLr,'il ('h\tirit\ or ih.,rÌ
!!fÌ)L\l)1.ìÌ!iL1i.r|,)Ì1.!ltrnriirÌ)f.,IiSitj.g\n!(l\'r !ÌrLsmerÌìjÌhât.(Ìrnrrn.''i(ì\
.ho(rt l,ril\.i I l( i.1rÌ. e11d.oÌr{itrÌPLlnf cr.lì Ì)iri.n ,1|d \ iÌÌrÈi ìr.11 ro tho.l\ b! Ìr s
nc!rÌtr\!riÌrÊLh.i,\tr|Ì)LÌotLrLÌ,!'lJIr(!rÌÌrLri\.ü.lrrLÌrt\er(.1fcsjüÌ!ÌJfroiì.h.
hurirÌ.\(\rhsi(,ìoÌÌrrÌl\.iraiLd.7.LÌì\ilu!ilirtiur5ihrttlÌcrqtLiÌLÌ)úÌÌÌìrÌrdir'

I L!r., ìr I . ira ,
:q:l r:r ! r:,.ì I Ìrrr' r irsl
566

ln rcnl business c-v(le ITìBC) nÌodcÌs it is tecbnoìo3-\ slìocks that drive busnress 'r "'
ThescmocìeÌsrepÌesenta!iewofbusi.esc!cÌcslhatiscÌuìti'distjnctfìoÌrÌ1hcnÌaiütÍ"'
Ne$,Kcyne\ian one:$,|crrâ5 ctclicaÌbeha\iour ntracìitioÌÌaìl-Íthought olas Ìetresrn:::_
dÌincIlÌcieÌÌt phenomcn(Ìr overlìcatìng in lhe b(Ínn.nd undeNtilization otresoü:''
úr thc (trNgh the i{LlC pÌenìnÌpuon ì\ t1Ìal qcÌes ÌelLc.l lht optinìizjng decisloÌr'
je
atenls o nr creasc and {Ìccrease thcl r ÍrtP1v o i Ìab(mr iÌì rcsFn to t€ch n oÌ{)il} sÌr ' ':
(

ÌllÌich al teÌ tlÌcÌr otpon u rr !tie\ to produce D.!Ìlìterlillèrenc.sofenÌphasìs astothc '! ::

olthedlsturtraÌÌ.cttothceconoÌÌÌvandtheNatnn)ck\arcpropa3ated,lhcRB'itrndLi::
has inÍlurnced lht nÌalnst!eanÌ iÌÌ l1!o ila-vs: nrst, iÌì hlghìightiÌÌ8 thc ìmPonan"
modclli.g hor,lhe eqLrjìÌbÌium levcì ol outpút is determi.cd. Altho!gh New
(c-!'r':'
moc]eÌs are con.cÌned s'ith ter\istcnl Llepârtutes iroÍì equllibÌiunÌ duc lo ULìctua(ioÌr::
ri+rega c .ìenÌ, íì {Ì. tÌre} also aülysc supplv shock\ and ln.oÌnÌat€ thc detemrioenÌi
(

the evolLúion of the equiljbìnün lercl of outptrt an.l eÌnp lo-v''m ent
Secon.l, RìlC cconomìsts ìra!€ dclelop€d a new ÌÌìclho'Ì ol t1Ìeorcllcal and crì!
icat iÌìrcstiiaatioÌì tnor'rì as ll-vn.rn]ic Stochis!ic G eÌr€ra1 l](luilìlrrnr nì modeÌliÌrg IDSC
Súce rcaì bu\incss ctclc! relate to lltrctlration\ ol the cqLtiìibrium lcvcì ol output n:
models pn)vide a natural Í'a-v of úrtcgÌatidg g(^{ih and butiÌress cvcle an'ìlysis T::'
ìntÌoducc urcertaìntt in lbt fonn oI randonì sbocks iÌÌ th' trxhrction flÌn(tion' Thi
âÌe lÌiithly sttlizrd geÌÌcral equilibrl(rÌn nÌodcls that âre .omPle\ and hrve to b' íL\:
:
bv ÌruÌÌrcÌicaÌ mcthotls The proccduÌe i\ to !\e rììi'n'co'oìnic elidcl'e froÌn oÌ:::
stu.lies lo prctidc estúnâtes nn thc underl]'!ng techlÌoÌogl and prrlcrrnce parenret':'
Usnìg theie valLles íÌ the paramctcÌs, the mo(lel l\ th" caìibÌated and catÌ bc u\ec
pror idc pÌeciictiont tìbotú the i€t variabl-Ès in the rÌìodcì ând hoÌì thc! co raÍr'', l{h '
are compared !!ith nÌacÌoecotromlc data froÌì the econom-Í Sìnce thc microe'on'r::
nnrndeljon\ .rc weÌl spccjlied. nrcl models are ritâble lo r con.lu( ting s'eÌfar€ arìah
\::
Ìlr thc two dcca.les slnce these cnrì) DSCI nro.lels \rerc {Ìcvelqied' lhe metlÌod'li''
jntrodu'!!: :
h!s bccn used incÌeasifglv btua,:lly and Ne*'\c-vÌlesian fealLúcs have b€cn
tlÌeÌÌr. The ÌÌÌrlho.tolo8l hr\ prcvcd uretul ln a range ol sclli'gs and is nos'rìppÌicd ::
cenlral banks lo coÌnplcme!rt nÌorc rÌacììtionaì ecoÌrolÌÌctrì. nro.lelLing t'chniclucs' I :
€Ìamtle, tlÌe Ban\ of hnialand has deleÌopcd a ne\\ nìacro ÌìodeÌ (NI'lì\Íl lhat ilrc'Ìf
ratcs nrarÌl oI Lhe lÌi.cipìet of DSG! modclììng. A\ conÌPnÌc.i irith its c\iititÌil nì'd-
tlÌc NNíN1 is íìorc t1ìeorciicallt cohcrent bul trnhke the D5GÊ nrodeis uscd in ac'rdci::_
setti.gs, üìe Llank ollngìan.l s u\es prâgnÌatic Ìì o.li1ìcation5 1o betteÌ Ìnat.h the d) 'e:Ì
i.s jn tìre rl.tn. This rcìates bouÌ to the incorporrtnlr oliÌÌerliiì i. beìraliout in üre N\lì l
and to a iess .onÌnetc sPe.lficatio. of tìre natrrí 'ìr \hrÌ l\ rh:f i\ rhe 'âsc ìn acâdtÌ:l
D5!ìf models.' Ìt ìemalns t{) be seen hor! thc NMM iliÌl be uscd in practicc bv the Lli''
ol FDgìand\ i\lonetary lÌ)hcy comnìrttee
'lh. ÍÌoÍ Irn.hÌÌÌcntal contriLrutìon ol thc Ì ucas tÌd.lition in nrac.oe.onomìcs iì:
bccn nr erÌìphasize thc re.ÌuireÌÌÌeÌrl lor nr.rcccorromic Ìnodcls lo have l\cll spe'iii:
loún.lationsinnricroc1:oìn)micbehaviour'AsthedúcusntÌaboLúlheBatÌNotIngÌan''
nc modeÌ nìakes clcar, this ìs eâsii'r 1o aclÌie!'c ìn aca.ìenric nÌodcls than thosc on irhi'
poììcÌ ÍÌakers nrun lcìt.

'ttr,i.rerrn,1J1.ÈÍiil.dì\(Ìn\i(',.ith.llrnkolln{ì.fa\modÈlsseêragifr2l)0:lì
 567

IÌr the Ìemrj.tÌe ,i, Lh s.h.ÌtLcÌ, Ìvr Ìrull n)gether ur |ìi.ri)ioundali.I]s or a \crr
lie\ne\ian nü.nÈco.,rnr. ir( rl. 1\notelL abo\e. Ì!e br:in bt pro!ìdlngi fcn.l.ss.iÌ
berÌ.1ÌÌÌÌuL rÌÌ(trìtl \ rtlr rrÌr fh thr \eN Ke) Ìk\iaÌr rìrodel is.o1Ìrpiìrrd. 5c.li,nr I Í ts oriL
r \unnnaÌy (Ìt the aÌsüDr,.1 tÌr\ ei(Ìre.i iÌr the rest (n the rhrpler.

'1 Summary of the argument

Thcchnra(terjttj.\.ILÌrr\fÌ!Ke\netiâimrtÊÌÌìrât1!elÌa\ru\rdi.Lhr.ilic.rhêftcó
ol thr booÌi xÌe xs I.lloÌr\:
(1r TheÌeit jn\(nu.t.ur rLfrnrÌrÌr)vnìerÌtirÌrquiLilrriL'm.
Ì2r 5ufplrsnElertuÉi!tdrer.onoLìì)d.(ifÌriÌlc.qeLlibÌ!umulenÌnotnleut.
i3]AggÌegxteden]a.tÌdìt].]is.ânlÌr1ttorúputiÌrt]r
thi\ Ìì.â.r thii LL 5 tjrLLpLlr an.t cnÌn(ì) m€nt LìÌher tlì.n iriìgcs i.LÌfÌ1.!s Lhal
n,sÌÌ)fd n Liâllr 1. sLLrh sÌr..Ì\.
i1r.\irirrrsrteleiÌÌrnlnr({l\nì,rtbiiÌnìtlilìcdlhr.trghtht(Ì)trrtiuÌoithruultPllcÌ
i.e. (onnrn4)tiuÌ rertrÌ(1-\ to.lìiur,ics ln o! LprLt. olhcÌ (hrnrelr tlÌro!!lì triìì.h
!Ìrplìtìcatiuì (irn occxÌ rrc:ú o!l i. { lhiÌfL!'r: l ggrcsite cLenÌ.ì ni sho|.ks nriìriln)
tie !Ltìn4)uÌell iÌÌ tlÌe \er l(fr nisln. Dod.i lo Lhe e\tent ihlt uÌ. pr!P,rn of o
lrNseÌrnlli aÌ)Le n) lend dxl bolrorr is larg....rtrÌr dn!ltÌÌe) râtionalLt iÌnLl.lfatc
tlÌe rer|oÌrie oi t1Ìe ceÌìtÌil tr.rÌìk to iÌggr.gelc d.nre.d duli.
r5l lÌr.i.rrLl.,r i.firio.illohsthedi\equillÌrÌjruì i....rLLfutcitheÌrbo!eorbelor
cqrLiÌ brlu.ì Lô p.,5 5Ì

r6lThelertiìÌLÈnli\nìnlar:Ll.oliìrìgi.L1g(,ld$thcc.orinÌÌbi.kLÒqtriiLlìrLtrÌntr\
rLnr: a ìea(tioÌÌ huÌrtir!Ì to .lÌiriÌgc Lhf LnLrr$t Ì.Ìte irÌ respoÌ1sc Lo ln lerjo..
agsÌesrte denruÌ!1. dnd rrpplt sho.Ìs
r.r \1uÌLlpl{.cqtrllihÌ a nrirr'Ìjttbe.ause olr rrilti(!ìs i.lab.urÌrÌodt!ti\ ii\ or r lh.
.lijt .irI o d. ìind i1 hialr r.d loÌ! outÌrut.
8ì l he ]reAinence !t outtxt.,ri\ ir onì .quiÌlbrirLiÌ mar jisell alic.l Llr. strtti\ \de.
rn!ì hent c!uiliÌrrirìÌn xÌrer]ÌlìLo) m..1. l his is li.(\rÌr r\ h\ sirr!'5ij
(.ìI lì!. nLÌodLtrLio.oi.onsiÌcÌaiÌ(!ìrtlÌairlircts.irkcrs'ulLlii\!thÉrt[uÌ
r..iumtlionafdl!.srLn,:u.hertainÌe5rnÌa)leiìilolhcc\ittenceoiriÌ!eol
.qúilibrirLrÌ cmf Ìô_rnrL..t Ìate\
ln rnrìi.Ì .hatLc.i cÌc.rr.nLs.I mjcroeconomj. Ì)ehiì\ jorLr r'. r: LntÌodu.ed turtÌlnÌ
plf,mod.lsol.o. nrfL onxndilrritnre tJeha\i!ur'bas.rÌorÌnti(DaÌÌ)thr\nrroi
Ìroús.holds if d llÌnr! rrcr. 5ct o,-rt i. l:Ìratter ;. r!heÌr. Ìrf iÌl:ô iÌitLche.l hoit tÌre rri(h
orLnLÌL:d nr.dcls rouÌd iÌlir.:L ric IJ eu\c rïe rlí) detr offd rf ,)DtjmiziÌìg nÌolle! oi
..ntÌil hinli h.hI .!r e5 lhc basi\ f(Ì tlk ccrÌtral Ì)rnliì rcirtLo. inr(horÌ. SnriÌ!rLÌ
rrc skcl.h.d 1lì1. r.l. oi.)plimLTi.S brhr\iouÌ b) rlile Í't1rÉ as thc ba\jr n, the l\1
.11r!c rnd.I ÌÌi.. lctÌÍs lor thc lJ cule Tire t.rsl oi dr s.haft!Ì l! lL) Lntexiìte the
nìi.,.cro..rÌ . rodrfo.cf L! lnio a \e$ K€) Ììe:iaÌì Ì!o.Lel. Llr 5 5..Lio. rtrnrmar jrer the
568

ar!!nÌcnlt that bchinclthc rlnt cìraÌacteristi.s ljsted al)o\ e and thc,v are (ìirt::'
Lie
cletail lf the ÌenÌaúÌdcr ol th. .Ì1apLd. Thi\ iÌltÌoduct(!) nunnÌary' l]ray be sl r:
tho\r (nro treler to go st ight 1o thc equdtìons. AìtÊÌnativeÌ], tlÌosc s'ho pÌet:
nÌi) rcndtìrislection ancìskDthc rcsLolthe.haÌrttr'
Ìt i\ usrlul to b€girì wìtÌr a ben.hma!l( modeÌ in i'h1!h ÌnaÌkets iuc(.onìflete i!:.:
petitivr againn \rhi.h lhe Neh,Ì(c-\'.caan a\!l]mflìon5 are then compaÌcd \\ t ...
uÌeÌÌeoclalsjcrÌ benchÌnaÌlnÌodcÌ: N( B\l. llÌc Jirsl tteÌr is nìmoi:lelthc LÍo ke\ d.i
oì housclìol.Ì\: to nrptl) Labour.nd lo connìmc. Household! ârr modcìÌed a\ Ì: :
connìnÌpll.n end liìbour nìppl! dc.l!ionr $ rs lo ma\imize uÌeir irÌtcrlcÌìforiil i::
Thet aÍ iìsstrmedto dcrn e utilit! froÌr .onnrnÌpllot and fnln l€isurl, Í'ììect t! :
get cons(ralnt. The büdget.onnrai.l sfecìtìes ÌlìaL ().nìmPtiorÌ pl(]s s.Ìting lì .: -
peÌiúarcr{lurÌtoincoDefronìcnìpl.}mentindinleÌestìÌrccÌnconLhr:iÌPrtr:'
wealth. lhchou\eholdlaÌ(esasgilrnthcwealthllhrsaccuuNl.tedi.Lhetaittlìi::
eit rate.nd lÌre priccs it face\ nÌ thc mi!l(et\ tlr Ìiìbour and Sood\,I c. lht real .Si
tIaÌrLes us lo.leÌive oplimal con$nìpLion aDd Ìnhr Ì nìttÌ\ liehaliour oler tìn.: : :
tìre Ì)tìsi. paÌaDreters oI the nÌodcl BctÌ)re plo.L:cdi.g fuúlÌer ì'i. un: thir aPprr':
sìuv lÌor'a siÌntÌe rraÌbusnìess cJ.lc mo.leL cin bt.onttìucted, ìÌÌ Nbi.h eDDlo\
_::
t
.Lci \ì{nÌs ar!' ôlttnnizif g ch oices b\ ho tseh o Ìds ill Lh c irce ot teclÌÌìoÌogl and l)rti': :
t d
{
ÌÌr tÌÌe NCBI\4 we illLÌodLrce,r 5nìPljíi.ation 1lr elìow the optimaì connuìpÌii' :
lal)our sLrptll decisions to be trcntcd setar.Ìcl,r. A coÌnuÌìll uscd sFcl1ìc il:]r: Ìtl
the (orÌsltnrpti{!Ì fÌ,.cti(ÌÌ i\ choscn an.l tlÌe uLllil) ÌnarÌnlzation píntenÌ i\ 5. '
'rr.r...ir.llrr"
morlel iiìÌír nn)$n in ahr])ter 7ì, i.c. houjehoÌds .:hoo\e nr lieef clnsuÌÌttion (on'::
oler timc rïhen tlìc ÌerÌ ìÌÍerlst rnl. i\ ecÌx.l to rhÊ dÌscoruÌt rütc lI tlrc lntert\: , lri
e\ceeds Lhr dì\couÌÌl rate uÌen lctr\'ff connünpt on js ctroseìr this
perÌ.rl lhan ìlÌÈ j_

\iÌì.e i1 i5 rloúÌNhllc n) Ilistponr .o.nnnption iÌÌrd cnjo) higheÌ coÌÌ$mÌrtio. ì!ì

Llìclibours!pph.urveisdrrllrd turÌ tÌÌe !amchousch(ndutìiit!ÌÌÌani'ìiTation l:

l.nÌ, búr Lo alLo$ flrr a tÌact.rbll ]ab.(Ì 5trppl:-.urtc. Lhc conÍìnTtion dc.l5ion i\ siì::
lì.d.Iabournìppl)i\ato\iti\,ciun.lionoluÌer'âgc rÈUe.tirgthedinúiìi1-tolitorl
1Jìr \CBl\Í prod!l:(io. talcs pÌa.c L1t.ÌeÌ peúe.t .oÌìPctition ÌlitlÌ tlÌe resúlL tìrat tlrt r.
irnii.: ú e!Ìurt to (hc nrdrsiniìl ProdLt.L ol Llbour. hc siÌÌPlincation oì collsLant Ì!Lì
pnnlu.tivlt! is nìidc throughorLl Lh. chatter, i.d thls imdie5 that tlÌ€ l.rboLrr deÌn.,:
.rL^ c, whlch is ilso the dlerigc ind ÌìeÌgnial pr,rdrL.l o hbouÌ cuì\e,1shorì7oftxl.:::
cq{ril Lr) Ìabo!r prodtrcti\ it!. Lì-!.omÌri.ing the prodLr.lion \ccnÌ Ì!ìüì houschoÌd hb.
sutplv,theequilib.iuniiÌÌthclaboútmaìì(eti5dc(cnÌincd Thi5 tna doÌ!n thc unjL -
nrrl(Êt cle.ring lclcÌ oì enìplolmc.l and the rc.Ì(Iagc, n'h jch can be clirecllv comtr:: l
irith the eq!ilibrirrm undrr lrnpffIccl comÌìetition
The nÌodclLlnq oí hounìrold brha\iour brlfgs out â seco.cì toÌrt ol .onrPaÌL\ ::
sith tlÌe Nc(, Kelne\iÌì nìodLì, lbe Íte ol consunrttion smoothitrs in thc /.t .trn:
Throrirhoul thl! chapier llc tollol! LÌre connno. lÌa.lict a.Ì{Dted lor c.ÌÌ!cficfcr l
Ne$ KelrÌesi.n Ììo.ltLs oi omllti.g ìn\eÍnÌe.t úorn lhc It cuwe TlÌÍ.llo\!s tr! i
co.cerÌtrat. o. hos tlÌe jfclrL5ion of conlunÌpLlon !nìoothitg rftect\ uÌe modcl T,:.
 569

nìi.ÌoÌ!(..ìxtiL)11s i): Ln\t\lÌnrÌ!t b(l[\ iourn'i !.1 r]rL ln (:haÌrter:. LlÌc /-\ 1i!'rs L. goorl\
L

nreÌLiel e!ÌuiÌiÌrÌúìÌ. rhrÌe dÊnLuÌd.o.rP,5!\.onsanÌ,tir!Ì.rnn i si..rNd !'Ì.gcn(ú

(ÌntfnrÌìt. rhi.lì iÌìrLudc\ !.\ ìÌnürt .\]rcÌriliLtLrc. llÌe (.rÌ\umfLl.. s.rooLh ng
nr.LÌÈl ìar\ thrr.onrrnrftjol ihlr pcriid i:rqli l...nnunÌ)tì(Ìr nrrt pc'od flu! r
conÌnücn1Ìhat dÈten(ì! regrti\tL\ rnih{ .. inÌ(Jcsìrrterh!llLirÌ.lt1ì.ij5.ot.Ì tr'
.o.\ra.Ll. A\ r'c h!\t Í.r., ihe t(old .1rn4r.Lr..l drÌrs (üt rÌÌen tlÌf irÌtlr.jL Ìiì1. l1
.rÌL[l Ll) rÌrr rli\ftirÌìr Ìarr The.t\ Ìi. ol..nn]rìllio. !Ìrr)tÌÌlÌ! ÌÌÌc.ns Lhnl Llr. /l
.rrÌr c i..ludc\ th! exÌrecÌeiÌ lutLÌrr \ rLrìr\ ot o!ttÌri r.(11\t)gel.nj dtrÌÌan!:L lhls is.iÌlLÌl
th.tuÌrúÌd lt!t.ingI!.uÌrc:ÌtirìÌrieir,ìli!1hr\( ll\landnedrLllrr(tlral Liihíi1'ghl
l.1o ih. r"o\ lc\.c\Lrn rro(ìtl, it intriu..5 i nìr.lrirl:Ìn thrrì3h u hi.h brLs n.s!.\.lc\

ll.Í'.\.,. nlhcNa.ÌiìÍ.âlgrci|telürlirìdarrdnLncethelJfli\irrllLnrilcdÌoLt
b!..nrL;. .rirk{.t!.Ìú! i.itr.ti\ uÌd thrrr nrr iìo irì|.r Ìe.tlr!r\, ihr !.onÒnìt l! rh\ a\ \ ìt
.!!llLìrlrLnì ()rL1Ìrit. lhrÌoÌ.ottheI\r!r\.i\1!lìrLhtÌerliÌrteri\lrnl( irncft!ÌuLÌib
rnìnÌo!lpuL i rlllir\o!.f.u\derrd jrnÌ)Lir\ th.LhlgheÌ (onsLìnÌPt on rìfcn.litue
ÌÌNn bc .'.l\Ìd.(l i.' Lo br n.-r drmxn(l up t! rq iliblirLD outÌrú rnd this.(qu Ì.\ a l,11 er
t.rlirì1rn'\1 r,rr.. h.rr.1 thitüri\ÌraÌrl)enii\tllr.üghlhecttt(toriìcr.el Ììofc\ nÌ)
Ìrl\ oi.hlrìitr's n Lhr !rlr. lc\.1 l)uìBhi iìbiìrt Lrl .\.c; dtnlrnd. r. .u! !ÌanÌne ot !
rLliÌr JtS(g.lc d. nìr.(1. lh. fÌile le\ eltrLL\ ìnn a..oft]Lnt to thr l-\|.r1tr c, thL\ Ìt.ÌrìiÌer I
l,r\!r rciLjìnl1:'csL,eL.l...Drfenr!fulorth.iil i.d.Dìn!l .\t.ìLli.LÌr.lÌ fcle!ÉÌÌri5e!
ÌrÌe r.irl lÌ1!rn.v 5'LfÌrlì lnd Ìhi\ Ì(r\e.. tLrÈ jÌrtirf st retc.
Ì.(iìn+rl.t.th!'dcs.rILlnf(ÍtheN(lLì\1 iti\|c.c:rìn t.di5.rL5s nLlxti(!r aÌrd tlÌ.
Dr.nrt.LrlNi..l\lhoLtfrLLrlrrlrìte!uilibliurÌì,lhcÌtaÌenonr!rLÌunlrhLllÌrcu ri:
,,Ì!L\ tÌÌerÈnìrrll']hilips.u{! \Ìcle\rrt llÌtÌììonttaÌ\ rnLcislr.r.IoÌ.\er\ \nnÌJL(l
nrt oÌ)tiÌÌÌìrirÌ!.entril birìk sinrÌrl\ ÌÌa. to scl inlÌ.ti(). tq!ll ír ìl\ Li,Scl Tht \(lLl\{ i\
.-mrÌÌa.ìrel nr r lì!riznnii /!.uÌ\c!ttlÌennbiiizl.gjÌrtert5tIil!',b\.Ìicrtlc!lIlÌiliif\
:!nr!tthe!ni!t!r.qulibrLurìuntmlrlo\Ìììinf iLt arÌd bt r h.rlTott!Ì ì1,1 r!r\ciL
rrlct ìÌúÌriidl i\ri l! li.l). I. tt(tilrÌ:. rl s!'L .(lthet.lÌL.L .ns lÌrrt deli\tr ilìcn'

I]!\ ints \tt rf th s lrcn.hiÌirl' tÌ(trle1. ìt i5 thcrì Po:riLrLe to brifg j. tbe nrrliÈri1io.'
rrrtdrereqrireiloddi\cr'lh.Ncl\Ì\t\n.jiiLrnÌod.Ì.\\'eirrúodu.r'frÍìuctâÌ(].]b!ur
ÌrrÌ\rt únfrrle.ti.n\ irÌ lh!'!iirtle\t srÌ jrÌ thi .D ,'t a |ro.oÌrôl\ Ìrrìlu(er.trìll il
Ìt!ÍÌr)Ì\ urÌn]j]. ,\\ !nr.ìL tl nì\ nr:\úìtr proÈ1\ inrl jt ìt arnrnìr!l Lhrt lIe urì(ÌÌ !r.r\
.r:ze5thrLìtilitt.litrnxÌììh.Ìs.\'hirhitrÌÌ!deL['d]fera.tL]11Ìcslìcre)attl lol
r)tr\eholli rti!\ e lhr(.,rìom] ir Ìn,).LtLk!ìl\ (cìn]t.i\iÌr{ r rnìírb!'r.I\c.rLì$, cr(lÌni
.Ìri.ÌÌ Ìrr)!l!G\,r !liil!Ìlnijil,al tnìdu(i r\lLìthrPf.nsl\ilrrtt|ru.i..i.rÌratin!lirr
.!.nìr.lÍ!r-\er tlìr rr3. ind Llrdr ÌÌre Ììn! clÌoo\r5 lhc tri(e. lÌoÌrr't.r. !lf!c the lìnrl i
-h.ieolit\rrhlir!'pLi.ciìi.il\eDtÌo\ut!ìtirÌilcsrrt(!d.nìPlolnr.nt(ri$rllirj
:lrr ai+)rnlrr\thcurro.5tttjÌjl\tLÌn(ti!n,ilÌ!unl.nmrì\tttlr nLor..t)tr.thoÍtlÌt
.ì:.É ìs iet I henmi]liin! it5]!i!c dt.itn!Ì. I liÈ o!t.o,Ì1 ,)lnÌrÌ rnl !Jìjo.lLJrì1 trNr !Ì\t
.L\e(trtrslÌtì\eirt\\r!r5iÌ1dfl.t\i\rÌrÌirerettirÌ!.u,rcbeÌt^\thÈi!$iìEr:i=nrrgúr!L
:,)dLtrt oi hbd!r.Ì \. i( ri.h lr ln€ \(-N\l e!ui\ iì c.i .t the fricc sr'LLlfg.urr É iI tlrt
r

:.r l\e\rÌerjrn rrrodell and i lQgi.rttnrB (uNt.rbo\c thc ne,\]Jsic,ì liì]r.LLr strftl\
rr É: trerre eq!iLibriLrrrÌ .nÌpLoì mcrt i\ Ìd\ er tlrtrÌ I I thr \(-!\i !nd jí 1rc Lik. tht ÌerÌ

À
570' ...:."
wageat equiÌlbriunÌ cmpìoymentin theNe$ Keyncsjan nrodcì, thcrc arc hous.holds that
rvouìcìbe $ilLlngio supplv ìabouÌ ât tlÌe equilibriúm Ìcal wagc. Hcncc lhcrc i5 irrrlÌrúr,1
unÒ plq,ntnL i eqLilìbtiur?. TlÌis is remlt numb€r 1.
The gap be Ì€en lhc e.ÌuilibúuÌÌì eÌììployÌÌì€nt rale in lhc Nea'Kcyncsìan nrodel ancl
tìre NCBM depeÌìds on !r!o Ì(ey Parameier\, l\,lÌìch aÌe delÌncd as reaì tlage pushluÌre\s
and real $aiie rigidity. \'Ve use the teÍn ÍÌil ndie frsftful,?esi 1{r Ìclcr to lhc dìspaÌit\
beti{een the wâge and price setiing cuNes at the Ìabour marÌcrcìcaring (or hatlual'
unenrpìoyment rate. lhis dlsparit,v relÌects the lactors Lhat push thc pÌicc seLting cur\ t
bckN the marglÌÌâl product ollabouÌ curve aÌÌd the wagc-scltjng clttr c abo\t the labour
s!rpp\'cuÌve. Ìt i\ ir.rcascd by a Ìess competitile produc! markct IoÌ FÌo rcaÍmsr nost
súaìghtnÌwa 1v, a highcr nraik up b)' fiÌnÌs redu.cs lhc Prìcc-dcLcrmined real waiie. Or
Ìhc othcr hancl, the lowcl eìaÍicitv of cìerÌÌaÌìd that lies behind Lhe hìgheÌ maÌk up leìd-i
unjons to set a higiì€rwagc sìnce the perceived ilnpacl on cmdoyment ofa given wairÉ
in c Ìcase n ìorveÌ. l his bch a!úur pushes the Ìr.ge sclli n g rcaì wage up. Th e upwtrcl \hiii
o t !hc wage settinil .! rvc and ihe downwa íìilt ol the | Ìicc-sc llì ng cuNe Ìeslrlt in Lo$ er

cquiljbriunr empÌoynÌenl. Ìn our simPie riodel, thcrc is a monoPoly unìon tu it is no:

possÌbìc 1o incìea\eunion po er.IÌ(tÍever, inâ dch$modclttith unioD baÌgairirg, rea.
wagc puslì tul ne$ ríouÌd also ì n cÌease with union bargai oing powc Ì. /ìcd? wdrr riSilih ii
the slopc oI the Ìrai{e settlfg cuNe and 1s a tunction ot Lhc disutiìily of work parameter
lhc ÌnlcÌcsting reluLt is that it ìs tìre ìnteraction ol lhis tcaLuÌc ol indìvidual behavlcÌÌ:
íthc disurìlii_Í of work) and inrpeúect conÌretition thal ha5lhc ctlcct of$ntenlnii ilÌe gaf
bclr\,een equìlibúún ernpìo)nrent in the New Keln$ian modcì and the NCBM \!her
rhc djsuiilìty ol ivork is high--r. This is iesuÌt ÌìuInbct z: Sultlly sideÍaaturcs oÍ tht tto oni
deteMìinc cquiIibt ion trc ìltIotnttní.
The NeÌr Keynesian fcaluìe that it ìs output riìthcr lhan prjccs lhaL Ìetpond ibt t.
aggregaLe demand \hocks rcqunes the pÌesence ol lmpcícrt compcljlion ìn lhe p(r.]uci
nrarkct. ft ìt usetìL to sÌìor'first iìrat rÍitìr peúect conÌpetition, thcrc wilÌ bc no resP(lr.
in output to a chiìnge iÌì aggÌegate demand irhen prÌccs are h€ld flxed. 1ÌoÍìl maximizil
tion undeÌpeÍectco ìpclilì()n Ìequììes thatprice b€ eqLrnÌ to mirrginal coí.lI prjces ana
ivages are hel.l co Íant and theÌe is a fall iu d€nìand, 1ìr'ls Í'iÌl not aìtcl output sjÌ1cc
neltheÌ piice nor nìargill al cost has changed. (Ol.oursc thn highlÌ8hts tlìc odditv oI tìl.
asumpti{Ìì that priccs cannot falì to cleaÌ the markct in a situalion ot pcrtccL compÈ
titÌ)n.) ÌkNever, oÌÌcc wc move t{) iìÌperlect coÌÌÌpetìtion, hold priccs Êxcd, and lakÊ :
fau in aggreilate denaDd as an exanple, thetr:! proÊt-nìaximizüÌg lìrrn ltilÌ cul its ouqru:
ir Ìire with the falÌ in dcmancl. At this lereÌ ol output, its behavìour is optimal gne.
the hred pÌice: high€r ou t p ut coul.Ì not be í)ld (ro rÌìarilinâ I rev€nu e \tould be zerol ar.
lirwer output wou ld enta il lh e l()ss of prchts on the Ìnargxìal unit s,r1d. I his is result nu m
beÌ 3: Á$, $arc ,erlì,nd s/? o.ks slijlt autPut itt thc tco onry alraf lì., 1ê.t ìÌibtìünt.lhisuenl!.
thuL it is autput ttttuÌ e ry\o)\ tnt rnthtt tha wdtts q .Ì ttíte\ Lhu! rcspan.l i ilittÌly t, stl.i:

We tLtrn nor, to thc question ofthe magnitud€ of thc eflect ol a chanile in exogcnou.
âggr€gate deÌÌì.ÌÌd on ouLltut. We have ju\t seeì that ìn the NCllM, the eltèct is zcn
In the NeÍ,Keyncsian nrodeÌ, there are thÌee possible outc,rÌÌìes of a ÌÌegati\e aggregat.
derÌìand sIìock: oulprll c(Ìrld iaÌl one f(r orìe with tlÌe lall nì dernând or it could l.ll tìl
 : :: , . ::. :.. 571

.$hcrirfalìsoneloronewith.ìlallÌÌrcxogcnousaggregatcdcÌnandthìsiscoÌÌsistclìl
with.odsunìplìon snroothlng i.e. corìsumtLìon ì5 not a lLrrclion of current incomc so
it docs noL.hangr when aggregate demafd and jnconìe does.
. $herÌ it falls by morc, lhe demand úock is amfìined atÌd this is associated with
tlÌe traditional 1ìolIiplier proce$. Ìn order lor the rìultiplier to dppcar i. a nrodel ilith
con\uÌììptiorl smoothing,ll is recessary to assuÌne lhat $me proponion ofhouseholcls
are prev€nted frorÌì optimally rÌoothiÌìil their consuÌnptidÌ becnusc Lhcy are unable
t{) borrow and they do not hare accurnrlatcd assets. l\e explo.cd Lhis in.letail in
chapter T.
. When lìlÌs by les, thc dcmanLl shock i5 datrpene.l. This.is thc.asc with the
1t
toNrÌ.Ì ìookìrs 15 cune iÌúroduced aÌ)ove, nÌ wlÌlch ouiput tlÌi! püiod dePends o
clipccled outt t next period. lhc sa) thÍ rvoÌks iÌì the New Ì(€yncsian ÌnodeÌ is that
!\'bcn ashockhasocenecì, fonlardìooking hou5elÌoÌds anticÌratethat thcccntÌalbatrk
will in!crvene t() stabiÌize the €conomy b) cutting t1Ìc inteÌe\t rate. Sincc a ìoweÌ ìnter€st
ratc lÌÌcans thal holrtehokh prelcr higher curent relalile kr irtur€.onsrúnPtioD, thev
$,ilÌrcspond kr the neiiatìve c:len]andshockby raising.ltrent corÌsumplìon an.lthls wlll
h€lp to dampe n the impact ol thc shock on output. l hc centÌal bâ nk, lrì lurn, anticipates
tÌìis bchavìourby households and does notcutthe intcrestÌâte by as much as itotherwìsc
\\'ouÌd. lhc outconre i\ that cyclcs arc nntre nuted as the forward looÌìng behavlour ol
houscholds and the centÌal bank rcinf{Ìce each othÜ
;\Í trrri:' Thì\ i! renrlt numbcr .l: ; t!tuiuk' .le ìa dsln.ksdt..lt PliÍì&l tht oufh the oletutidt af tht
r ultjplitt, i.e. ú sumptìon rcsPands la.hat$es itt auíPü1. t\&ïrc{dtt .lcmutLl shocks Dtdy dls.)
tr! tldrtpt t(l in th( i:.tew Keyrtsio, motlel ta ttt. at?nt thtt the lttilnrtm aí hoLLstholds ablc to
knLl dntl t)ot tw isÌtllge e otsh anl they tultio dllv antí.!út€ tltt ttsPonse oítlE 1nídlbonk
ú d[st(\dtt IünÌntl shocks.
The Neiï (etnesian rJrodciseeks to proÍidc nricrúouÌìdalions lorthc slltggíh respoÌÌsc
olirages anci piic€s to discquiÌibrnrnì.ln thc sú!tPed doltn New Ì(evncsian mo.leL us€d
ln tìre bulli ofthis book jnflatìon 1ÌÌ€rtia is sìnrpll asnrnìcd in the ÌrhilÌlps .u Ne: infÌâtìof
deten.ls on last pcrÌod\ i n Íl atidì plLrs a luncti on ol the o utlÌrt ilâp r\ nìajoÌ chtlLeng€ to
\e$'Keyne!iân ma.rocconomic\ isto 1ìndaPÌopeÌ aÌÌ.Ìysiroftìre PhiÌiips cuNe ba\ed oÌì
retional expe.tations nnd ottìnÌizi 8 bchatiour. The rcÌc!ânce ol tlÌis problem is clear
rlhen we consid€r tÌìal lhc a.l hoc ìncllÌaì PhiÌìii^ curvc Pre.lict\ idcflicaì beh:!!ioür
ior the econoÌny in thc fa.c of t ân ìnÍlallon shocl.nd (,) an announccd chanile in
the núÌatiotr t:ìrget. ÌÌì an cconomy tr'ith foí!'ard ì(Íìking agents, we rÌould cxpect that
rhe.ÌeijÌee ofcredibility oI lhe central bnnk I'ould influcncc lhe diflerencc bctireen tlÌe
pÌedìctecìpâth ofthe econom,v foÌÌo"ing ú?) oÌ íú).
There h.ìve b€en tlso rcccnt atte ptsto filllhi5gaÌJ:thcNci{Ke)' e\ian ÌihiìlìPs CuNe
\KlC) :ì!Ìd the 5tÌcky lnlo Ìation PhiÌlips CuÌre (SÌP(l) LlÌrlike tÌìe backward ìooking
.r ìnertiâl lhillips curvc, both iÌÌcorporalc lul\'ìational agents witlÌ forl'ad Itx)kltÌg
|ehaviour. 1Ìì both modcls theÌetòie, thc crcdìbiìiti' of ccntÌaì bank alìnouncenrents
rifects the beha!ìoul ol thc e.ononÌy.
hr the \t(Pai, the Ì)hillips cuÌve is.l€rilcd Ircnì a modeÌ of pÌice settitÌg knoM as the
l-aÌvo model, where it is assuÌne.lthatÊrnìs.annot adÌustthcìr frlce atwill rathcl,onÌy
r randomperc€ntaÂc ol lìrnìs can set tlÌeir pri(c cach Period. Kno{ingthi\, Í'lÌcn the} get

.l
572

the.ha.ceto lhriÌpricc, nnrìstakc acco nt ol exPected futu rc ch aDges in th e outl':::

set
gap snìcc these (,oul.ì altct theÍ dcsÌrcd púce lhis produccs lhe $ calÌed NKIC ::
whicÌÌ ÌrìflatioÌìthìs peúod is equallo n tunction otthe (urrent ouq tiidpandcxpe'i::
tutlrc lnflation. lheÌe is no role for last perirrd s intÌation, d$flte nictiy prjce\ rj:
NKÌ'jC proli.1es a Ìì ic(Ío u..Ìetl |hiÌtips curve bascd on ritiolÌaì extect:ìticÌns an'ìsolli
the crcdÌbllitt probìeìn: af annourccd reductiorì in üÌe iÌúLâtlon taÌ8et r\IilÌ p(rduce :::
lnnnedinle Ìeciuction in innatioÌì and no chârgc in output htcreas ân inÍlaln)n JÌÌrr:'
lviÌlproduce a onc'peÌlod dc!ìation oÍorltput lronì ecÌuilibrium' An announ'cdlt$eri ::
ofthe inllatjor trrgct.t()es not allect tiìc output gap and sinÌplv reduces erpccled nrti::'
nrflâtion: the r€suÌl ìs ân ìmìÌediâtc rcduction in inÍÌation and no changc in o!tl'r:
l' ,.,, r! .. " r1 1" ln l 'a r'ior ol
.i',lJiE 'rn - rì 'ri .dr, l ' arl'frr
a.]ìust thcì bclow equilìbriltm The follo'ljng p€ r: :
r outlÌú. Th e .eÍ1lt 1s a tìlllf outÌrú
rhe econonr-v i\ back at equìliÌrÌnnn bccause thc con sÌìock has gone ând lhc ÌúLarl
I
outconÌe thc pÌevious perlo.Ì ha! no Ìaíinii e1ìccl oD eith$ grcup ol f,rrns So \rh
rhe NKlc has the nìeÌlt of beinS âble to di\tilÌgLrish between announced .haniie\ iÌì i"
inflatiorltargetândlnilationshocksandhenceisabletutakcintoaccountthccredibiÌ'
,.'. òr'lrJ o I olj rn-l "' ,t," r'l lr''n '
a.count lor a one pcrìrxl dellati(!Ì olìÌrfati(!Ì Èonr target:prlccs âÌe stickl but núÌilI -

The seconLl tnodcÌ Ìep1â..s the assrrmptl{Ìì that pÌices arc stick! bv thc atnunpti '
rhat iÌúormâtnnÌ is sllckv i. the sensc lhat iÌìiormaiion rbolú a chânge ln monil:'
poÌìc), for cxanÌplc, .Ìi fhìscs slo\íly through the cconont l hìs Ìrr{LÌces a l']hilìÌx ]:u"
!n rvhicÌr ìnUatioÌÌ (his Perio.l is equai 1ll a irnclj.m of the currcnt output gall and ::::
expectalion lomìcd ìast pcrì{nl ol t1Ìis pcÌi{ 's innatìon trrgct As in tlÌe NKI'jC aÌl dI:::
ha\e rationâl edlrcctatidÌs Because it js Lhe tlJwrce ol núorrnation th'rt prcvaiì! hi '
the SÌ|C pre.licts both tlÌat ccnúâl banl dedibilit)' afiects tlÌe rcsPon\e ol thc econo:_
to a .hange 1r thc innation laÌget iìnd also thrt thc adilótÌnent back to e!uilìbritrn r'
ì)e assocjate.l with ì n ilation lebistercc AprcPonion ol finn5 havc fuìÌnÌformation a: :
the rest are uniÌìlonÌed bulaÌÌhaveratìonalelpcclatlon! Ì11\'cassumetlÌltthcceni::
baÌìksÌììlttt{)aloÍ'etúíÌ.tjontaÌgetbulonÌ}thclnf(tmedfirmsaÌeaÌtreofthis tÌ:'
what happen\ ìs that the tdl) üúìrÌÌrcd oìres adiust their priccs in lìre Ìlith lhe r'
târgel bLrt the iesl do not. lìrìt Ìeaves ilìflatìon 'too hiiah' ivitlÌ thc lmpììcation lhrÌ i: '
cerÌtral baÌ1li sets lhe ìntercst ìate \o tlÌat outfut ìs belolv ecÌuilibrium' DepetÌdìrìg on i::'
speedoÍinÍannrtlon.ììtÏusion,theecononDadjuslseitìrerne\tpcrjodoìo!ernrunrr_
of pcriods to tÌÌ€ nc$ eq!iììbÌúm with bf atl(tÌ it laÌgct and outpul at c'ÌuilibrìuÌì
'Ìhc SÍIrc is betlcr able than the \lQrc to malch tlìc sl)Ì1ze.i lacts about inllation lnc-:
but n queÍìon nÌaÌk ÌenÌains oveÌ the source ol iÌìflaLÌon stìcknÌess: í'hy doe\ it foL f:
hxns ro be bettcr int(ÌnÌeìl and rlhât is thc sense 1Ìì I'hich fiÌa\ operaling ln the.ont:
of.crtrâl banks Í'ith rno.etaÌ-Ì rules arc inadeqLraLcl) itfornìed? Both the NK|l i':
thc SII'C producc ìemlt 5 on the b.sis ot mìcrcfoundatl()ns nÌìd ratlonal expe.tat: '
,lthoúgh cÌueÍlon ìnarks Ìcnrain over lÌot! satisfaclory an account is fhvicled oi Ì"
origìn ofinfl,rtjon pebistcnce. Renìlt 5: /j?.turk oíÍntldtiú rllo\rs úe nistqujlibt r':
í-.. aLttPuí !íthú t\b.r( ot betow ctluilìbtitttt &rp.t'sat When coÌrìbiÌrcd l!ìth the slÌi(
Nl(Ìjl., the moncLnÌ-v'. policl rute of the oplimlznÌg.cnÚaì bank as sct oul in (lhapl': :
 573

tÌoda.c\Ìcstrl16:/l.,nr'//l,i,'(.tr!.1i,\r/r..(r,rdrrtlÌr'lr)rqrilil]'nrrrrL !inìjd'.d.ri
lhr nnrL lhrcr' Ì.\L'lL! rr.liìrc t1:) ih( Po5s ìrll L! tlì.1 $rLlÌibÌ rrnì r'.cmtÌ01nrr:.1 is n.rL
uÌri!Ìut. T\ o \Lnr|lt crirrÌpi.! . r itlr c. Lo prÌ i!]e rÊiulL :: ,r1.i/)1. (trilirft rrr) rriit
1,f.!r/!,/ Ì drir.tr!i! !i inlÌrir fìr,rr( i!1üt l], dú]j1 l {rlì.,rpLidrlri!:lidrril,)r oll?!r
'rìrl'.
In the tiAl, jl Ls !inrll\ iisu rLd t riÌ il l.r'a(.('!.!ri..iutlr I fr..iu.ÌLr iLl i\ lnÌr end rih.n
oulÌrtrt Ls hL{h 1)ú1lL.li\ itt i\ lÌi!lì li íhij js lhr rlse, tltrìì 3i!( n i t.s Ll!,.11 nop.d lLiìÂ(
srrri.g.utrr th.r!.ri b.onÈ.qui jbÍi!nr iìr l!\ a.ti1irrÌ!hcr.Lh.rl.ÍrrrgrnLLlng
r.Ìlltrgcs.LÌurlLoLhr.ik,rrtri.r:cttIr.(r!iìtr Ìrl.ìn.o.drLÌuLllbrirLmâlhghr.Lirll!
rrlr.Ì. lh. lhilh Ì!n!. ÍÌtirÌr rf.l r'igc 5 c!Ì rlio thc rhlglì) tri.r selti.! rrgc ìI thir
situxtio.Ìrtu1rliÌh(.in.rin.,ú\.orLlil{rLslu.li.Ìh.l(nracltrLl\e!ÌuLlihÌLumsin(e
\mrlÌ ÌlrrLrILio.! i. i]il(rcg.tr irÌi.d Ì!llì Ìri úìsuilìfifnr nì drjr.t thr ef.n(!!\ nr dìe
Ìr glr.mtÌôrnr..l c!r iLiLrriuÌìr.,\ |.ìril ilrcs! t.ÌÌrrS.5 i Lhc,l1\rj.it\.tLldne.d\rriÉ\
rriÌhtÌr.l.r'(lÒii.tì\ìt\.L'oiuÌtir irìir,ì.lji'. (nlilrl L.rnlrrârÌrrÌieinhr.r(tnit\
5lo( lhirrrìll rìrìd,:ntrtrttiì.ti\.(lrJìr.t\iitishiShen.l.uÌ.Der\rrÉhn!LiÌÌgit
h.Ìd (1r 1ìnd j!F91j!'rs bÈ!a!\e irÌ.üLÌrlìrnt 1ìLrns lÌâ\ i lÌi orÌcrb(!)ii\ Tiri. russelt\ thrt
tlìc c istì.it\'1rl d.nì.rnl ir ltr\ rt L!rr'r.l \ tl iÌln \1.!. \r,*r and Ìn(ìicrte\ that tlìe /)J
.!r\cj\!pr.ìInnopinsrjil.ltioürprrdurlìrì()l\.oLìsli.tr.ÌìorereÌ,ÌtÌ\dlt.tÌrutible
tlÌirt.onlpriitioÌìtrithe\j.tlÌ!nrfFlirrsslÌìlüÌsfÌfr.faftj\jt\i\1.ÍdrÌlL\1ce\rbr,
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i\nÌoÌr\eÌrsjiret!11ÌerrÌ!j)rtiti\!tlÌÍiLo in.rüÌbc.l! lhenthr1'rÌ\'illbr!lorrÌrri
\ÌtÌiìÌrS I hr LÌ!!it,ilit\ (,t rìultiILe e!uilib'li .r sr: o.Lt i. lìrc l(ÌnÌtÌ (r5e.
,\n irier uÌri ÌÌò rttra(itd.!Ìì\ìirriìblc .|l(:t l. nracÌoe.(!Í!!i(\ i! tlÌiri ihrr. l5
r! ìÌrtrÌr.ti,!Ì tretr eerÌ tÌrr a(tu:L r+,lo!Ììrr f1 l.\ r in.l e!ÌtrLliÌ,ri|ÌÌeÌÌrL,lt)nìini. \\r
lrr\erlie!l\rn(ourúirr(lrhiii!ielinCJìrfiiÌ.1.r'hr,.:(tra\thrtrxr!,ìti\.i!!cSi1.
ìrrÌÌar( 5[xi. ilkt Fr!]t to trlt(!r!rd iini nrflot,|..t rn.l rai\e\ L!tr8 t.!n u ri f Lot
mcnt rrÌr rrdu.r urr etir.til rÌìe\r ,rl ilìf u.i nrI o!.(1 i. bol!liÌÌ3 dorn lritc Prcss(LÌ..
l!c (onselluer(e it l ri\r iI cquilibriu.r rLnL'nìpl.!nrtnl ie tlÌe drnìr.i 5h.rÌ ttl
ìure\defuriorrtirÌrorÌtlÌeiÌÌ)l\ jidr oi LÌrc,:rnn.nrt. in thi\ !hrptrr Ì\c d(\.1.f il1,lh.r
rÌre rr!ìel ntru\i.g orÌ thr irchil i!ur.1insid. r: irld orLLsi(ìer \ iÌr tlÌe ]rbo!I nìi]r k. t l.lnl
ìu.e!l nr (:hd|fuÌ 1 hÌ thir nr{lrl. tlÌc r | !n .Lrrrs o.l\ aÌrìut it\ r]ìrnÌbcls ltho in
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-urt.t rm|lo\ Ìlent Ìe\ rL Lqui!il)ril, Ìrr lnìplil ÌÌÌ.Ìrt hr\ rÌr.rcnnecLtrllÌed irni r'ìlln1rL
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,r4,tl,ri!/r,íitrl/,r,rrríjri/il,ii!,rÌr!,i1'drÌrrrorr./ilJijhuL,Ì,j\/Ìr\ro.ii\.
liÌrrlLr. c iÌrtÍ{l!re i!inr$\ ..r15ìdÜnli1:)nj Ll] lÌrc u\arl !\sur4ÌioÌr thit \ork.rj
rLiri\ e !tiLit\ tu! ((Ìrm!4)tiLÌr rnd iro.ì l( iì, 'r. h.hr.soitherrinrr\i.ìÌ!!r]rrÌrl 5
:h.rt \ lÌex \ orleA rre SriiiÌrts r,' k,ìn is lri! r ,r r.q. ir .t)nÌr.ìraÌ)Le !rrp\ tlÌ.lloÌr t
.,jrÌ.!rÌÌ i\ t! rì,r\1nire ther rÈrL iÌr..ürc brr I LlrcI i r' lrthl! r ll)rer 11.L!e 1lÌen thiÍ
,tilit\ Le\el i\ redurell Ìhìt intÍ)l]!.!s ir Llrìl ìÌno 1r. lf(i lttÌc.(e QÌìt\ rlÌtn uÌ(\
.rr$ihe,r\(!ne llÌe..rbeljrrdÌc!i\tìiitrirr$ÍllLÌì!. Ì\€l)e..nrertllto\err
iì!UÈ !l eÌÌrpL!\ÌÌrdÌt Le\rÌ\ hÌtlrisriÌrqc.Lr.i\ì'iÌìL.inÌrL.h.1t|en!l\oDlLn\ nr(h
workeÌs necd t{) be compensatcd as a resuÌl of t'iìÌìP(\ 'ônri'leÌ'tìÔns lhe IVS colncÌ':
\{jth the l,J cuÌ!e, \'Yhich implÌcs thlt infÌation is .onstant llence 1\'c have resuLl 9: :
ntú.t\uttìo aÍ nrlsnknüt)tl\ Íhat úlÍuL a*üt' útìlity othet tha (ottsnnqtion 4 l lei\L''
sLLch ds l'u/mess, t aytedlto4tu Se oí cttttiÌihriL"ü tktpl.,fne\t ra tcs

2 The neoclassical benchmark model (NCBM)

Wc set out Ìn this scctioÌÌ a rcry simpìe nnxleL with pcrle.t compcljtìoÌÌ and feri':l
iÌÌloÌmatior. lvhât ìs .Ìistinciivc about thc NCì]M ls lhe asrurÌÌptjo' tìrat product 'r; :
labouÌ nÌa rkcts aÌe pc I íectÌi- conr Petiti!e a n d clear inÍantaneou sly I'i lh Perfe'11,v fle\i' '

2.1 Preliminary: household utility maximization

lhíruiihout this châpter the rational bchâvìour oi houselÌolds Ìs ìmpoÍanl ftÍ t$o r::
!ons: houschokl\ dccnìe lÌow nìuch labour to Ípplv an.l hoÍÌ mltch to conÍtme r::'
pcrìo.I. Thr lÁt cìe.lsion is cenlral nr the analtsis oflabouÌ Íiarkcts and the sccond to:''
dcrnatio otthel.\cune.\{cstaÌtb-vsclliniioutagcneÌal Ìodclinwhi'hhou\ehr:
cÌìoote .onsumption an.l elnployìnent c^ch Period Lo ìnaxúnizc their ltiljl-v íìn'tr:'
iÌrreúemporalìy. Wc ihen slÌoa'holv to get simpìcl (but snÌÌllar Ìesults) bv u5irì9 "'
oosirÌg con nrn4Íio n inteltcnìÈtrall!'and anothei fff c nìpÌt)!nr
m odel tor 1:h
'hoosnìg "
In the moÌe general nìod€L thc hou\€hol.l at / m.xlnrizes il
t,. ,,

where ri., t15utilì!y tuonì corìsunÌÍion, r(ri isdis(ltiliq fÌonÌworli,ãndristbcdlscoi: :

rate. lÌìis js nrtrjccl to thc budget connraint e.ìch pcrÌod

an.Ì ú, is household ireaÌth at 1lì.: ttaÌt ol t. Ìt is assumcd !hat the househoÌcl re'cl1'
lnteÌeltrr,Ìl'ÌonV'attheerÌdoft l,sothatìtcouÌìts.sÌncomenil íttrÌ Ú'lìst::'
sa!ings thc ou5e1Ìold nr alie\ 1ÌÌ r, ;In d thercfo re ., is tú.ì1 in.o nìc, eanÌed pÌus unea ÍIr
h
":
r!,!.+,,,v,,lesssa\.ing!(Ú,,'lr.l
To nÌâxìmize UÌ il is sìmplest to substitutc lht bu.liiet .onst rai. t ìnto U,

Ur irilLri.r ' 4 'r,. íúÌ-, ,1,,)) r'(e,ll

I j r I
I

At l. thc ldlo$ing lari.ìbles arc gnen to lhc household: ìli, (lhe accunntlale'] reslLl ':
savnìits dccisl{Ìis i. lheprst), andn,, , ând rÌ L i whichâr€ nìnÌkcttri.€s can b€ sec::
^s
 575

thr h.úr€h.Lri lì,r! L') .Ìr(r\e !]r1jiÌrl \.rLucr .f current n.d hrlurr ÊÌnPll:rr.rent Ìi\.1\.
arÌtl\.ilìhL.rLl!ÌitLrrrln'rlf!l\.ú. i'Lr. r''.iiÌìsLcrdoi., ri L rLrd.i !, Ì.
\\r: be:ll \iiLh Llrr !,t.i5i{Ìl iÌr.trt r!rÍcrìL ernÌ)L!!LÌl!'nlr r, iLLiL c(!ìle: in 1t) the Èrsl
Íl!itr,hi(iet 5. thf rrrtL, Èr.onditlr!ris
ÌÌ5 s

rr1.1lrìtÌr!'.ml)Ln)ÌÌtrìÌ1.!LlsaÌeLil.lrjir31\crbl ni .ir, r, Ì,1;, .rhrr!:rt. =

rr a Ì. = + ll!e:. (qúilioÌrt nnLr tÌIt..ìll.tirerú 5lì.xL!l bc i"rea(l i' aÌì\
j:
|1ÌÌ.!i !nLll lht rÌrÌlliLìal tÌl!!liLlt\ ii 'nÌrl!\rì!'nt L ' r:r 'LÌudl io ÌreÌcnÌrl uLlìLtl
r)i
..nnunPiio. frr\ idt.l lìr ' Lr

TtrnìiÌì! ì. thÉ (h!i.r o nlxt Ìrtriod s ]terLtlÌ ìL' , ! nÌargjIrL li\r i' Ú r "mt! oli
o .uÌreÌÌt .1r.(unÌÍilrÌ.Ln(l i..Ìe!ic5 ntrt Ì)lri.tr] s.r!r!rnrttion Lr! I - 'i ' lhu! tlre
iì.'rschoLd iriìl oÌ)tinÌìre 5(.Ìr rÌrìt:

L!luÌr.!rÌn!ìfljo.lttÈlsi1'sLÌniL"r!!trerÌbl rr, .' r r-- I I ir, i, r 'ì Thes!'

r.r Lhc.Ì.1\ri.iÌl .o.{Ìnr!iiof smL\ìtlìlfq equàtions SìÌr.' lhe irL ' tr "nditions
eÌrlill .!tì4Ìirilio. xcÍ)r\ Nr ln{Ìs. tlÌct rÌt tÌirrìrtl6 .t L!l.r elNrli'n\
ln LlrcÌ..\toi Llrl!.irtÌ)terrrllrilÌtrÊqLrntÌ\ fr1rrL. ar r I innrth'nnLolti'geipli'iL
trirì.1iofaÌl()Irn5 l..L)nL!r!i\i:Ì!.ì.in!i:r..r!Ìnrnr(Jbtha\jotutrrqÌicftl\!5r'LhÈn)Ìio\r
irÌË !iillll t!rÌ.ii...i

r!hiÌf ir " (l iìnd I ìri.ir I i.ld5 iluúe sinrlÌt ÌrnrlLs r.d iÌÌÌ]rlle\ ilì'L

(15.lUl

I r , A note on ihe real business cycle approa(h

\\'hit (onnì.n lt) l((tÌì(5Lin rÌ)pí[cÌ]ts is thrÌ trrÌpjo\DÌ.fr chrÌr8'! aÌe nÌn e!
Lr
(iusc.] !\ clìifgc\ iÌr .ì83r.gelÉ !l.iìa.d lÌriÌ ButnÌ(ss ( \.lc rlìE(-l modeÌ\ rinr l(l
r\phln eÌÌrpln-tÌn.nt flu.LtriLro.i .s tlre (orÍLÌucn(t !I otiiÌnil ho!'ch'ld rr\ponses
'i,rrr'ÌrÌ.riL,!ì\:r!(,,::niiLr...i\.lirìr! ÉLitrr_i\"1r:r'fÍrNÌl'_
ii nlrrlÌ:.n.,,t.in., .,, ,,:-!i, ìj i1ìÌ

' rr!Ìl riinl.trèf nlìdrr rdr rtfÌlr.i.trrÌ!s

576

tote.hooìo$ orprclcrence sho.ksl ratheÌthan ns.onsequenres oi.hangcs ìn asilregilt

deDì:Lnd. r\t tìre sa!ÌÌc lìne RBC tlÌcoÌisls irant to bc ebìe lo shoir th.t cmpÌo-vment ir.d
outp!t moveìnents arc P(^itiveLf coÍclated
UsirÌg lhe two erplicit lorn\ lor l.r ancì f ier lÌom above, ire Êrst .o.Ínìct a sinìPlc
Rer lì,si.csr (l!c1e íRBCI molel. in (,hlch thc hortschold nÌariÌnizcs

,- r\r d r/ r l+|r\Ì r, . ìt

\{heÌì this is suli\tituled ìnto thc (LllitI iìn.{ion lt'e get

Lr) \
\
',.1
I

hÌn tlÌis ottimìz.tio., $e caÌÌ dcrl!.c the foLlorçing lÌrst (tr.ler .ondltlons:

(l:.1l
(15 L.Z

(15.I l
d5l1

(t-i 131 is mbnitutcd lntt,

.,
I
1
l'',i u'' ,r
lhi\ Í drÌ €rnpÌo-v Ìnent sÌrìoot ÌìiJr 3' cqurtidÌ: Ììíct iÌÌx (, Lllit-\' m arinÌiza tioÌì siìIs th rt ìt
Ìì âltr ienre to kcct em o)ment al thcsaÍÌel€veÌotrr tlmc As.aìrbeteentlÌ$cnÌttilr)
 577

ÌÉanrn\ rrlr\ iL .ìrr p.rr to r.r l hrrcLrr t()r Let\ hâÌdt Ln the Ire\cÌìt Ìelatjre t. th. lrtun
I et i Ìü!li rÌ r hr !..ìpl|\Ì!dÌrrÌri!lúd{Ìi.c:
iìlrìr ..! .l:i\ir.Ì.Lsic€\!ÌÌrÌile!ldrh(rlÌrrnÌregrtireÌ)Ì( LÌ.tirrtvsÌr(!Ì.rrlr.ll
itato.rrLÌi.:nÌ.rliÌrtr)rt.rlÌìÌriheredÌrdgt ln h (,r\phnrr\Êh.lil\.hôôn. . r'.rL
leÍ. N.rc t(n rhil l:]!tÌ\rt tillr. b.th tie.au\e cDtlorDeni hat derljneLì rfd h.1ern
oi thÉ fcgrt 1. p'rd!.1ì\jt\ nÍxl: \ rrrt, = \ rgr + \ 1rr,\. rr1h.r' \ li lnÌr.rL
frìdu.l\ L_\r HiLì.couqrúaÌìderÌtlo)mr.Lrx fo\irnel\ coÌrclat(ì,ân.lLhcdr.ifr
i. emlìo!.r!.t \.1rÌ optimirirg ÌetÌxÌr.e to n rr.hnoÌog) \ho.l
fLirr. : r, \dc.lirÌeìÌrr.ìrÌclnÌeaÌr)rúnrs.rcÌ.ìlÌerÍ!L,nrrÌLÌding!hlÌj..rfltrl
tr!ÌÍ.Lli Lt oÍ i .lÌiìlse nr l,ÌeiereÌ(e5 tl)r Érr)grnou\ demaÌìd ilclu.liÌrg {.r crfDcnl
rxltt.(Ìi(tLr,'. Ci!cÌÌ the Ìr(\tibìlit\ oilendnrS r!.Ì boÌ ror ìÌrts, it Ììo\ DrdÌGr m(!e tÉ.!È tr)
lrorlil!sshid.th(r!rrentÌrerj({lrnllrr er ne\it€ri.!1. horoÌliÌÌS !nncrtprìj(trì
L(J .o1.Ì .urÌrÌÌt roltrìÌÌÌptl!Ì. .13anr lrìtÌrut r.d cÌnl|)\ nìent are c(trÌrlatecl ll)eLau\e

1.11,. -\,,:.ìrith..nltrntfr(üu.ti\it\l.a.rìagaìÌìtÌÌr!ie(lnÌenÌerÌÌ)lo)me.ri5
ir .ILlnrizjn! rr\porÌ\e thi5 tiÌne to a ttteren.,,\hocL
\s rr ÌÌr)t(l jrÌ tÌÌr ì.rÌo(ìtr.nr\ rection oÌ th !.ìrrtter. RD(: rn({leÌt thai 5tÌct5 terh
nolo$ sho.l\ !nl tÌÌrÌr frotr!et11!Ì ihrlugh.{ÌuiÌibrnuiì c!(lt\ l!])rrrlìÌìS \ia the
n lrrLcmporal r!LLtìtrúi(Ìr ,)l !db(ü r ha\ e .ol t.Ìlornrcd l)aitnulLrl! \ elÌ rml)iri(rlÌ\.

\!nr nal ritillitie\ and impeúectiont nr ìraÌliers hx\c Ì)eerÌ iÌrtro(L!(el ìÌr nÌan\ lrteÌ
RLllt\piÌrrcxlrl\Cì\eniheLilritrti.n\.t\t!.ÊxndtlÌeenulr,\isnlthi\L,oolonuÌe
!ìr' oi irS!r!!iìte !E!ÌìÌìd n SerÌcrati.S lN\iÌìe$ .l (le ilurtLr.ìtiorÌs irnd e!uirll). on tlÌe
roLr ll1 rìtÌretàÌ\ to!i.) Ln rile.iinHtÌrr le\cl( lacttrìt) intlÌe \hot to mcdil'Ìr nuÌ \(
!lo not üle hrúÌÌeÌ dìe Rl(. ettÍ)âch

2.2 Simplifyìng household optimization

\\e (rn \nllìhi hou5eholLì (Ì)tinìratnÌr b\ norÌtnÌE tri1ì tÌtlr nìririLc drôd(Ìs Lh.
Êr\t ÍiLl L)r u\rd I he rtr .r'Ê dcrÌinS ü iuÌ (onnüÌl)tioÌì d..l5jo.s i.{1 thr icco.(1 rÌith
eÌÌrPlotrrìuú !le(i\ì(trìt.

2 2 I A simple household intertemporal consumption mod€l

ni ll!Ìrer nirlÊs liLÌr.(r mfltt LÌ.cLsion\. I.:tÈa.l it
ln th \ \ünlìle xr.lel tlÌe l!)useho1l
trcaijin.orrÌer\d\endÌ!ìnú\ì ireslr, r r, Ih!hou\úhoÌd.(\\

r, r, rr Úr ú, Ìlrl

lb.lrt.rdÍ.o.ditlr!Ì!\t)eiorcÌrrL., r,. t r, r', r, r.Ì!hi.hnorrbesth.simdr

,,' ,;'-111-,',
s78

s,hlch úìflìesirì lt)iis

r.'l

orusinSthehrstordcraPpÌoxlnration nrsll r Ì) :Ì
,,,

'lhu! ilr the coÌìsunÌplìon Ínoolh1ng inodel, as ile hav€ sccn in Chapte' 7, :

ìate
'onnüpLir
equaÌ: ::
rünaiÌÌs corstant o\'er time l\'lìcn the rcal iÌìtcr'st Ìate and arc
cqual to.' I stren I : r, ihc
jnt€rprctation ìs stÌaigh!Ídwiìrd: ìL. -: I' therc 15' j:
'liscoLrnt

irlcentivc to savc tdlay lo get a h!8her lnconìe tom{Ìrot\'r'hich is Iot ouí\'c!8hed

bl tÌ:'
rarc at fl'hich future uliìity is discountcd' hencc LrrA '1 < lost,'Ì Ìl js also useflrl to no::
a 1%) iÌÌcrcase in t iÌÌ4rìie\ a j'l0 falÌ iIÌ.,' we i\'iÌl use this e'Ìuatìon
in the /'l bsl:.h!:'

2 A simple household employment choice môdêl

2.2
heloii
\ow we {ìevelop a \imple nÌodcl olhoLrsehol.l lãbouÌ $pÌrlv decìsion\' Starlins as

trom Ìi. ur1ÌitvlunctÌon Ll - L1llr.l rl4ll r +trri..+,1 fi!i+,!+ ' ,Ì!'cca simÌrÌiil

(l5.rr

'(c): 2

rft i\ rssunÌed lhat.r > 1;tlÌis cuarantccs mbscq(rentÌy an cqulìibrìljÌn with thc r':
_
durn cmtlotment raLc." 1.) So houschoÌd\ ma{ìnÌize:

".:(., +)'+(" 'i-'). tl5.22l

Ìì1,' (ìfr Ì vt)

'r=wÌer+t
Subsiltutìng the budget coÌÌíÌâint iÌÌto tìre rìtiÌit-v Iunúnü implies

.',"iì
,(' '
-"1,(',*'",, - riú, , iúi+, ' I
r'"i.
)
* (1s.2,1)
 519

Tìre Ìne1únlâti{lr (ì\ c: r i! innp:c sin.c.Í't .at trÌie ea.h pc.i.d stfaÌrteÌ!: lor eÌ.nrpl(
., cÌÌl\,ìppca.5 nthriifnir.iand + trÌt1ietun bra.ktt.ThrbthelÌouÍ1Ìdd.hoorc5
.i rt) maaimize r rr. r-.\hi(htrììflics
( 15.251

likcÍlÍ..r =.r!. r i.{Ì n, on. ,\s Ì!c sÌìill Í'L nthene\t\..ti,r,r,Lhsqtrahonii

thr ÌaÌrorLr s(rÌrd! nlìedLLl. f'. lt \al s tlìil iI lhc Ícel a,age i5 n, tbr aiÌou.t oI labouÌ !
lÌoLrsr.hold r!llì ch.o\r' Lo srrttl) r!iLl br ,
Ìr.
r\ hnt arc Lhc inìfli.rli..! lr)r .orÌnurìrr bchiti.Lr? Ìn t!(t tlÌis modd Ls Dot x 5en\ibLe
oÌlc 1o L1r. 1ocxinrif. .o.{nrPtioÌÌ brhiìli.rLr otcr time ii lrorroNing an.l lendnÌ8 rrc
pennillrd. lh s .:i. b. sc.n bv nÌr\jiìizifg o!$ Ì!, : üe 8.t ;,lF = 1 + ]+ tlÌls
s,rt:. salc c\1Ì1'lÌri.S lI/, 'raÌ (onnrnÌcclcryLhlngil,, /. Hoi'tveÌ thi\ i\ h.ìftll'
usetirl.rdri.r \o rr!' 5Ììill r6c thir nÍx:Lrl prinìarìlv for en4)Lo\ÌÌr!'nL dccirnnrl drÌd onll
look irt ilnplìcitioÌr5 lor.o.sunÌ)tidÌ lrlÌcÌì satinA end bo(o,tiÌrir erc .ot tenDitted

Using thc !ÌcncraìforÌr of r rl

For ilrture refeí'.c( (. NiìÌ nrrke use ol thc JÌor. geDeral lornì of rirì üÌtÌo.lu.cd I
e!urtioiÌ i15.Ì0). 1hi: 5

(15.24ìi

Thiú nos nì r.ì.h pcr od fln lhìt \ìÌnpLe fo b.Í.r'i.9. Ììô lcndjfg modeLlÌhr hoLtrchold

1il-l

Thìtj pLics thr fAt oÌdeÌ.ondìtìoÌì:

(15.28r

IÌr tact $e nÌaLL nornì. lt i.rk Ìn ÌoS Lincar IoÌÌrs, !r th.i

r,1ir = i)gr i. llL(s. Ir5.19r

lhis nroÌ!\ tìre drrdrnt.Í liboür thÉ ho!Í1ìold i iÌl .hoo\e to 5rftìI oÌ the Ir s.hcdoÌe,
tr.!:=l')!,, ! ; Ì,rsr'.

2.3 Output and employment equilibrìum:the labour market diagram

\\i..onìmc...llLth LÌre Ìrbour marÌict LÌiaglìm üìcnúì Ln Ii3. 15.1. ln lhi!.hatter it
\rilÌ oilcn bc.ltrÌeÌ nr Lliscu$ ihr lebour marÌ(et diagrâÌì üith .. .ÌÌrp o-Ìnrent, on the
lÌorizo.lal ixl5 rrtheÌ tÌrrn tÌÌe ltvcl ol otrtlut, r,.
'LhcLrfÍ'eÌdnoÌringÌineinIi!. l5.l is lhe jn.Ìi\iclÌì.lleb.ur nìppll iunctlon,I\ \\t
hiÌ!,cscc.inrheÌart\LLÌrscctirÌrtlìallhjtj\gnenb!.r ,i ìr,r.ltisr1\orLscirtltr)seethe
Figure l5,l Labo!. nrppy and demaro

derivarìon oftherj.urve geometri..llv usìng it illerence curves. Ìronì theìastsectioÌÌ

the Ìn dì ltcÌence .! rvc corÌeilxÌ iÌìgtoaulÌlitvle!eltisgivcnbyre:=r'orìitting
the I súbscrittr. Ì1ìesc âÌe the U s1ì.pcd indjffereÌice cur!es: 1lÌc hiilhct at ilcliltèrencc
cuNc thc higherth€ lclcl ofutlÌity siiÌce lìoldnrg. (hours ol €nÌpÌo-vÌÌ c ntl con\tant, ar
irLreasc ìn r, the hoürly Ìeal aage, incrcascs utilitJ. To see wh,v thc j.djfference c!rv€s
ire u slìatc.l, we totally ditlerentiat€ 1rf + : t. to ilet edti' I 1t,id .r'd. = 0 or
l1i -, . Tì'"r "," ..' nAi see thiìt tlìc sìope ,)f rÌ,e i,ìdllfer...c clüve i' zero lvhln
i)e Lr, ì.e. wheÌÌ !\'c aÌe (D the t\ c!rvci 1çìrtn r,. > Ìt,lte.ìre to thc right ofthe I\ (!rvc
and t h c j n.lilteiencc c urve is then ! p!\'ard sìotúrs; lìnallt Ìlhen .€ < r' wc aÍe to the lelt
oi (hc Ãi .uwe and thc ìncìitìere ce.Lrnc l! lhen .lown$a sloping.
uccau5e the Libour market 1\ perlecllv conrfetitl\'e, worlers can chooie n) \upplt iì\
m an t h our ol $orN âs the) wisÌì ât th. giÍc n ÌeaÌ lvage. Since they nìaxirì i7c utììity, th€
choicc ofr ir at the highertutility level possible given the reaÌ !vâile; heIl.c Ìt Í'iÌl be rvhere
thc bott(nn ol aÌì indiffererce cur!e is jLÌsl lou.hlng the hoúzotÌial liÌìe rcfrcscntjng a
givcn reaì ilage. 1hc li schecLuÌe trrces ouL lhe cholce ol. corespondiÌìg (o incÌeaslni{
\.alúes ol Ìr. Ure iss(rme that IJ is incrcaslfg with D'. that is that â hiSher rcaì r'agc leads
rrcÌÌeÍs to choosc (o sufpÌ-v more 1,rbou r iat íDe itage oi couÉe tlÌe anoo.l ol labour
\uptÌìed Íops risi.gsìnce tlÌe worker's lÌou6 per.lav are Ìimited, but tre assunìch.rc that
rhis point 1s not r.a.hecÌ)
The downward-sìotnrs line hÌ liit. Ì5.1, ii lhe maÌiiln al pÍrcìuct ofÌàbour, ìl/r/. Lrn.leÌ
teÌfectcorÌÌpetitlon lrnn5 prccluce!pio thc Ìroint aiwhì.h thepicelat $hichlhcl.at
seÌl a unit oloutpuL i\ equrÌto the coÍ oI labour Ìree.Ìe.l k) Ìrnrduce it, nanÌe\' L'vrt.ldl
wheÌe W i\ t1ìc nonìinal houÌÌ) ro\t ol labouÌ and drii,ï),is the nrìmber ol lÌours nccdc(Ì
to pÍxhì(€ onc rnorc unit ol outÌtrú. l) tú?c/dl' Qrice e.Ìuals marginal (ost) únpìici
, : rt,1l' ./)i.1r (the rerL waile equaÌs n'Íll). The üílt ìs meamre.l on ihe verticaÌ
axis toitether Nilh p, and decliÌìiÌìil marginal pr)ductivìt) ìmpÌies that r),rrú falh as .
ilcreases. Ior ftrluÌe Ìetèrence, rÌote that il labour pÌoducti\Ììt-v i5 c(trstant, iì\ âssumed in
much ofthe rcÍ oÍ rhìrciÌapter!nd inthcboot, the ì,Íla is uat.
At an) givcn rcaìirâge theprolìt\ a frnn makes arc ìoNer tÌran the nraxlÌunÌ po\siblc al
tÌÌat rerlrÌagc (rrcr errylotment is abov. or bclow thc cmPlovment ìevel\lhiclÌ equ.1c5
i.Írl í) x'. HcÌÌcc a'r cau (ìrâ$ iso proht.uÍvcs (thc ciÌtrlvaìcDt of indlfference ctnes lor
 581

llÌm\lnuÌiÌrt n.(r!LnStroht\.r5r' iiÌÌ5nndatdÌ!gl\.Dn.tlÌcscnÌclangentialtollr.

horlzont.rl lirr r!'Ìr.sc.li.g tlìdt lcaln ìge (!ee IiS. 15. ì r.
The eqlilìbrirLÌì Ls rhcÌt ilìe .\l/'/. rn.ì tlrt Ii (.oss. Ic. dt (rì...l Al r, \orlrr\ 1r ll
.h(rne to suppl) .ìe.lh Lhe rÌÌr.ufL t)f enÌrÌolrììelì1 lhrt err4rlol.r ÌLiÌl clÌoo\r 1o
deDürÌd. l Ìrìs Ìceds to l\!o iÌìtori.r rl .o.hr(s 1rìtlì ìì.Ìr Ke) Ììesiiìn nrr.r) ren'Ìtsl
ilì AttlÌj\equiÌib,ium,trncÌntÌo\nìrntl\entìÌell\olu.lrI] .\ll trorllÌr aÌe nrpPl!irrg
the lÌÌÌriu.t oi hbtúÌ lhe\ choosr L. \up|l] itttÌecxi\tnÌErei Í'egcr..\\:eíìl]ltin
\e(tiorì I hol! Lhc Lnl(Íluctnnì oÍ inrteúections if lalur,rÌìd !fttrLr.t nÌ!rlets.an
a((o!ni Ior i.rolunraÌ\ unenìPl.-l ment nI e!uilibrLuÌn
i2) \s.rnbe5een,ÌlreequllLìrlúmì!uniq(r.\\iedÌ(u\s n sc.úrÌ: thr foribìLitvtlìit
lh.Ìr aÌe nultipL( cquilibr a in tlìr c.ononì1. AgaiÌì thi\ j\ ò!i.iilcd n ith the rolc oi
inìfcÌlccti(ra iÌÌ lì biìrÌ i.L1Ìx{hrci nrarl(15.
\\'r'(.o..luLÌÊ this nrbse.tion bv ÌÌalillg Lhc rrgunìeìÌi h.rc erlier lo rcÌrLe to the NcN
f.e\ Ììcsien nrodel ol nrbsÊq!rnL !tcti(!Ì\. ind csÌrtcjrÌll thc nert se.llon l3l (Ìr enÌplor
nrentquillb,juD llAt. tlÌ..!//'l ì.heduc itÌ.]\ lo liÊ..nrtrretl 1!llh tÌre Ìrj'\ s.hrd
ulÈ !rd.r lnrtcrfect (oÌÌrpetìl!... \\irit( 1lìL'Ir|l rclÌ(drLlc iÌr tenÌr5 Ô llre ÌrÌi.e lc!'1,
r Ì1' ,?. di Atnune tlÌc pírdtr.tì!ìtl o Ìibour i\ consta.t antl .q(riì r{) unitr sl:] lhrr
lt th I llcn.ef - ll'trrlhcmÌIequr.L\crtKe\n(sLantectionstrcl!ìLÌÌÌoÍk1!Lth
a nNlll :ccLoÌrl ÌnolieL. irÌ \!lìl.h tlìe pric(' lc\ eÌ nr re.toÌ i it /ri âIìd lìre l!r!e k\ cÌ 11
Tlìe reLiìtirc pÌiLc Ìr\ el iÌì i i5 f, = f'']]. if d lht lectoral reaLüag. is f' = I\ 'Ì', r'llh f
lÌre aSSrrgiLc tÌL.t ÌevtL. ln tlÌ. Ncr ì(efnl:sir. model, PÌi!e \ettcr5 !.l/ii irÌ tlìr (leLi('r
Lo$ !i i (rrrlloÌÌrrrlìt ÌnÀilnLTetn!Ì so thrltvÌriciìll-!l) - i1 irlf ÍlrÈIl f 'anÌ)e
ilrterÌ)Ieteil ns â maÌii up lhi\iitheDthr5..1t)raÌr/is.hedule J. the Nllllll rnargjnal
.osÌ trì.iÌìir iÌìpljeslj rr.inrìaenr.ll .onÌrrìe t1ììs a'1tiÌ thr scct(ÌrLrf schc'lule
un.ltÌ iÌnpc'ic.L !oDtetìtion.
T() e\pr$s tììc a\ ;chrlLuLc if r üa\ \!c nrrÌÌ be rlrl. n) (onrfrÌe to thr rrti \rhed
jt
trlc uÌÌiier nìÌrcrlcct coupetìliot. ÌÌe uic the lorm r .. = ,.1_. ', nnÌrllifg r! !ioe!

Taüìt loq5 â.d esgresrtlnà thc \ector.l \rt \chedulú !!e !€L

r,,rtr = N Ìt L, !.tr \ \- Ì,)!ri = ,igìll'/. ir 5.31ll

LbiÌrStlìe sam( 1o thef! \(hedL1Ìi!

,,;rr' r r!L.rr -l',!! i. 1rì '}-t,,q,"=,,.,' r I I'i!r ls3ll

rììcre tÌÌe nìfrrs.riÌrl. !, ÌrighlilhL5 üre larÌ thiL lhit Í th. ìebrNr !ptÌI tLÌnatioÌì 5ln'c
Lhe e\ eirle oi rclattr È trice\ rÌnr:L be c!ua1 to .nc (arÌ!l il5 log t!u.l lo 7t!ol, Ì.rf
(l'
l,quiÌiÌnìLun enÌPlot Ììtnt ìt (ìefrnrd b! r,r'' ! ", nh1.| in lhe ÌJerlcrtÌ) conÌreijtilr
j
reí, j! l,)! UlÌ .A !

0 ,,r IÍ1L ,!r'- l'Ìs r i. l liAr

' 1,r,. = !, 1,,:,,
 ros.:)l r ì l)

Figure 15,2 È!u ib. úm emp oynrÉ.t t nder peÍÍe.Ì LÒnrpet ron

'lhisirshowninlìjg.l5.2.NotethnLlheenÌplol'm.ntratelncÌea\estoanìaxiìÌLìmollirl
naturalnumbersalheulÒge 0andtheÌea1r'agcincreatestoanÌaximunìollinüturai
nürìbers, sirÌce labouÌ productiÍilt ú assunìed lobc l. Here tlÌe log Àrl richedule 1s eqÌral
to zcrc sÌre labour productì!.ìl-v is I and thcrc is no P()fit maÌk up and it is shown as
thc hoÌizontaÌ dâsìred linc .olncìdent Nith thc hoÌizontaÌ axis. lhe loB úf s.hecìuÌ€ {Ìllc
labouì5upplv.uNe)isupwardrloPingwith.otíantteÌmollogcjândsloPcof' 11hr
cquiììbÌilìnÌcnìplolmentralcl.A.).isSir€ÌÌbtthcinteÌtectidÌoll,rB1trandloA,tÍ2.\i
can be reen l.sr;\rì : 0. Ìn nahúaì numb€r\, thc.nrfìovìnent râte, ci!' < Ì sìnce d : 1.
i.c. becau\€ thcrc is a distr tiÌit)' o t labouÍ.

2.4 The lS curve

lÌom our snÌÌplc con\uÌÌrption snÌoolhjng rnodel .bovc, consunrpti()n i\ negatllcÌ\
rcÌatc.ì to tlÌe úìtcrcst Ìate:

r.g., : r,,sr,*, ]i., r

ln r,lth oLher rnicroioundcd nrodels, iÌìvcslÌìcnl is ignoÌe.] here (. dis.ussioD oI

LirÌe
Diicro b.s.d nmleÌs ol inicslmcnt can be found lrì a.haPlcÌ 71. The IS cu e Íats lhxt
rìggreÂ.1cdcÌnand Ìoqtiscqual lor, Ìog.+J,J ÌoAd,$,hcrc d ú non connunption dcmaDd
lor ex.nìt c g.veÍnncf l cxpcn dituÌe; JÌ is thc clas llci h o l t s itìr Ìespect to i. HcrÌcc rhc
l!.ÌÌrv. can be illitten

osr,, - -,1)g., , -ì loarl

: r,, Ì,ig d, + J. r!,8.:,,, ïl,i ,l
:r"r,,Ad'+(Ìog)ì Ì rìros.,, rl r).
;(f.
 543

Sincc fullÌrr QÌLrbÌ!s h r' Lo bÊ tr)refast at l, ilìe Il c!rt. is

r,!Ìi .rì ,.rd, ar l)!!r -.'1.!,i.

-
'
It $iLÌpÌo\ e conrenjent t. !\fÌri\ ihú rehli(ÌLÌÌ]p iÌÌ tc.ms ot.:x.È* denrand, r where

L,,gr,
= Ì( rr', Ìo!ì'. tì5.36ì

a.diÌsLlrual,lr isLh!.iq!ilibrirLmìoclolrtrtÌrul,j.€ llrrespoÌìdi.Â1oLÌrr(rÌtìÒtmc.l

rir(,... Golììg bJ.k nr ihÈ 1€Íìl.ologr jntrÌÌlucd jn (llÌapter:1. thc $ .aiÌcd stabiÌì7i.S
rit. ol lrìl!.rcsl al r, Ì., i\ d.Ìln.d r! r|c ÌeaÌ rrtc ot irÌter€n ]!h.h cquiÌLcs rggrc{rtt
dcnìend Â1 I t! !IrLil lìrìunì o(rLtrl

5!btÍ..ilng lhl: c!r ition Ìonr Lh|, n)Ìnr oiÌÌr. Lt c!r e.botc gilcs the c\ce$ clenÌrnl
lônì Òiíhcl\.LrÍ..s

Ì!g!, /, (,AÌ, ,', ( 15..jE I

;',
lh!s Iir thrÍ .qrLiìtlons iÌÌ.: ..Dmon t. tlìe r\(lLì\l iìn{Ì r \eit Kelnetjan odcl, lrì
Ì!hiclÌtlÌcr.is.oniL,rìÌptìonsÌnoothÌniihrthe\llÌl\{l{llhiullÌnti)nnrtiiÌr,pelfr.tlr.c
tÌe\ibiliit ,ìnd miional rÌÌìLclatl.fs. a Lie\ Ìeiìlt 1\ tlìit

'::jr, =Ã.Ìr,Aì, =0
ln othcÌ1ro rthee.on(Ìn!j!rltr si.r'qtLiìbritrnr.hÌthiN( LJ\l a. inLÌ€areirÌrlircl
it.drma..Ì.a.ÌÍ)tcalseuÌl(ft'.sri.ÒuqrtrtortmÌrtornr..t LhúntÌo$\dire(tLtiroÌn
Lh. enrÌ) !i\ r)f the Ì{Ìrü rrdrl.t irì rlìirh ll r rs sÌr.rÌl ilÌiìLn th Ììtn!r!Ìe\Ì)e(t.rijo.:,
rr.rl(eÌ\ iriÌÌaÌl!e)t mÌÌrl). . i.d l,mstn rrì t. \\c\hrll \ee nrltllhoir
iggÌtgâte Llemancl ìt brouÍht irÌ1! linc 1!l1lr thc cLÌuiliL,riL!Ì l!'tcl of (rúfut 1ìÌel b! th.
srrttÌr:idr Ìt hr\ d iiÌÌrÌt.rÌÌt irrÌpl .nlion .r 1lre /l (urÌ r i. thc \(.I]\Í. 5uLrnjtL'ting
,,!r,:ar,,iÌ =0 j.to the l-\ .!r\ c, r:r lr|)!1. r ; ri r\,imfÌìt\tlÌatif
thc r_aB\1. Lhe Ij.un e rrdure\ nr thL hÒri7.f lal Ii.e

ì, 'j 11i.1(lr

llÌl\ i\ sht]Ì,Ìì ln Lig. Ì:3sÌeJÌe(irtheir(ttlrn]n LhÈNl:Bì!1, r{!Í'!ai( dcnrindj:

Lh
irrulir i.1 or llìr. Ì.rrl o nrrLtui eÌÍì rmpl!\ !Èrú: ll ilDfl\ LlttennirÌes t ìc ÌciÌ i.toed
ritc Hcn.c, .r Lh. glrr.n.qu:Ìibrnu! li!eL.t Lr!1frrt, higher !8!reg.tr d(minrì nÌ
({.nrplii,o.ìg.r.rinìr,rL.ìÌrenditrür.jrnÌJLii\rlìith. ÌcrÌiÌnert\iirtrsirl.clÌr.highn
rcal .Lc(iL rnÌ(isi.qr!((l1o.r(rr'.ì.utÌri!rte(.Ìl:ÌnrllLL)ne\ltnlìtLrrt\o.sLoiÌl.r
!o\ cr.N..l r\fcid Lr,c lo rlrr.
'1o shor' 1i)1! isgrc!.1r dcDafLÌ it bnm!lrt nnnÌcdia1.l1 Lnnr liÌÌe nith Éq!ilib'1'Ìì
oltpr i. ir ls f...\si ! tl] i.rlrkÌc lhe DoÌìev maÌlet jrì Lh. Ììo.ÌeÌ. 1\e rinlnle th.l th.
r.ll gol{.rì nr( nl hij i 7.r. i.llil i(). lJr{et. Thl\ Ìe(lLiire\ ii i. n.ld lhc n()mirÌrLrrrürrt suffll
:

constaÌÌt.!\renoi!sho(rth.tpeúel:tl)ílc\iblcfricesandrâtionalerpectatbnscnnrrcthüt
,, rr , ,f." th;l lt'g Ì. - lìÌosa.-Ì =0 Rationel erpectâtjoÌÌs Ìmply thal
".",*t
i, u'.ì,-,"-: o. a ,,,rr, - iíÌ' \,) Ìì sav loAÌ' : 0' p€rrect
prìce llclibilirv trÌrpÌie5

iiru, i.tr-. tn",,,"ut n olrclttes rr)pL'5Ì1rr upto '

rs lìi! nì cchan isnÌ oler'1cs tlìrough
deÌnancìand suPPÌy of mone-ï, tÌÌe lI1ctrÌ!c
cquatlon
_ _in,..g,-*
tÌÌe
thc LÀl cun'c h's had a ratlrcr nÌndo$'elisten'c
-".tt.r,bis boot cân set lhe real lnter6t rare at illÌat-
tt""" nÍ'retary authoriljes
r'\'Í
"".";;";'" in.'t *"n"t'"",",1thc
n' ha\e noted elscwhcre thl5'Ìo€s not do as'a) $'irh'the
"ì"'ì"*, "e 1rr order ro dcìiler their choscn reaì Ìatc of inter€st' tlrc
i,ì"". oì,i'"', n.**,hâr
ppl,v slfpoús the rcal denrand n)r rnonq
authoÌitjcs have to ensure lhe nral ìoney
Ìcq!ircs that ir' rekr n) the
,, U,,i-."i". ,n" 0,,* n"ribilitr- nle'hanÍnr iI] rhe NCBM
..*n.'ìt a"t..,n'c, since thc lisc m l arfe'ts thc ìntercst rnIc lrt redu'ìnsthe
Ìeal deÌnaÌrd ÍoÌ
",,tl"
nÌÌìc!
'1he tIí clrÍ!e is gitcn bY

! rL', r,r:rr,,--l ,i. ( 15.,11)

ilhcreljstlÌcreal.letnanclíoÌÌÌÌone!,irtnlisthcrÌomnì'lintercstrate'âIldr!1he
sav"\r with a
;:;ì';;;\:;; ",",,",, rì.e cuÌÌenr Ì,ominâÌ mo'ìcv suptrv is kno\fn to rre'nncrest rates aÌe
."r.,rUf"U,- *p"ctc'l inllrtion is zcìo an{ì tlìc real an'lÌÌomnìal
uì"rt,.",. ".S*,
tn,t-"*t,n" i:liscussìon lcss does cilangetbe logic
' 'ot
perlcct prì ce tìcxibill !'v k€cps l!ìA Ìi 0
'lums-ïbut
4,"" ì^" . *" ,n" .*| anism tÌÌrough whi'h
tr i,ì''
"t,n". n" p".c lelel P rìscs iÌÌn€diatelv to ki'fr thc labouÌ nÌarlet in eq(l
ì,
' on thelr labour suppll
itL,,.'r, ot.. .,Ì, u*,i.Ìarg1Ììaì product cuNc aÌÌd houscholds
lot puslÌes the intercst
.-,,,r". u ,'*t *O n.Ìrt * lalÌs, the c{cess 'lenn'cì nÚne-v

ìrì".,0^ro' ,i,ts- taÌìs ;o!h thc Ìisc ir I ancl the ìaÌl in ÌoAÌ r€duce lhe dcìnand
""'' ('1 hi'h Poìrìlloerr - 01't|cnili\
iornoney.sLrppoeLhatrhasrotÌiseD)cttr)/sr
Ì.sr muÍ Iìse further' This Pft)ccss contúÌtlct
,illr tru" iltot 1,,g" t o But 1ì > 0' thcn l'j
in
,.',.'0,.r, : u tl thc Ìc is PeÌìrcL |Ii'e tÌeriibi Ìit! lh en h ú pro'ess happens
t

".iti,l=
i,iÌ'.p" tì,lì"n"""" ncnce the ílcxibilìt-v ol rhe prlce levcl kecps thc lâbooÌ
nÌnrket ìn

crluilibrtm urd ensurcs that ercess agsÌ€gat€ deìÌìând 1s eliÌni atd

2.5 Íhe Phillips curve and the MR

âssunìed bcfore' tle assunìe lhe nìone-
N-hat deteíìincs tlÌc rate of iÌúLntl!n? As s'e h'ì!c
lar) authoÌitieswaÌrtto ÌnÌn1ÌÌÌi7ethc loss írur'lioÌ1:

'i .ri'' .'r'

l l5 .12l

Sincc rr = 0 any\fal llì th€ NCìII'Í ttÌc authoúties need nrer!l'! to sct Ì' = curte -r' tht
ther' no'sh'ìrt_rurÌr ÌihillÌps ijr
p",f*t pt"" tÌe{ibilit-\'nreans t1ìar is
""tt"".".t
irr" NC;Urrr riu*,f,"* 1, ex.e\s derÌian'l ÌÌ tkNcveÌ' it is \tilL lNe that ir = nr aÌÌd
'n)
tÌÌis deÈncs tlìc \ erlic.ìl l{mg run |billìps curvc in thc
N(lllÌ\Í SiÌì'c thc lhillits cün e i!
 Figure 15.3 /.!,,Vll ind rllc.uí'es n lh. NCiM

\.cÍicaì,lhc authorities do not tàce â tracie otïbetween 1aÌÌd Í n I . lnste.rcl ilÌey sinpl)
,,,r,1...Jo .,..,r , Lr. r,i..i. .lr rl \,L\4srI\'. rrr I

l,hiÌìÌpscúrcat/ l|:ìncla ho.izonta I nÌoretaÌ)' NÌe Ìire, rVÀ, at; Ír.11Ìisi\úìown

in tìig. 15.3.
]\ ÊnaÌ queÍion is: how do the authoritjes set n : -r 1l tÌìe) no longer coÌìtroÌ t1ìe
ìrÌtclcÍ rate,', sirÌce, : We Ìetrún to the aM cuÌve. ÌÌì equilibrnrm,' rt .nd I - rf
a.d lìcn.. the / M.ìrÌve ^?mri\t he

(1s.43)
h
it í knoÌ{n thal Í' : ÍÌ, ratioDal cxpc.tnliont imfìy that nÈ = Ír. SuÌrpose
ancì \ince
thatÀ.:,s, ror,l"I="1 1so!ha!íi=nl L.lhìslrÌÌrÌiesthatthereaìnronevsuppÌ)
ir .\rr. rr lr\ ' rr r' r.rr-
'll-
cqual to lhc groí'th rate of the noÌniÌìalnìoney mppl!. lhus in thc N(llìM thc monctary
aulhorilÍcan coftrol therate olirúlation costle\slv via the Browth ofth€ nonìinaÌnìoney
supply.
IiDal\', in addiÌÌon to poirÍs I and 2 above, we carÌ notc thc lolÌoi\'irìg furthcr poirÍs
,ì ll ofdìfference wilh thc \eì! Ì(etnesìan Íìode1. Ìn the NCBM,

(l) dcmand slÌilìs clÌange pÌice\ aÌ trotoutputj

(2) demar.l shlits rÌe nol aÌrìplilìcd: lhcrc is I Lìo'h.roÌ\'di.g oul oI'tl'sho.lis via lhc
reiìÌ irterest rate:

13) inflalion ls aÌirays equal tu târget iÌúÌâtion.

546 ! '':":

3 Equilibrium output and involuntary unemployment

ln thìs section ire sÌìow ho$, il ì!e nrove fÌom conrlctitive to impeícct prxhìct a'd
laboui mar|et s, equiÌibr! um output and cm ploynÌcf I Ìì a-Í be a$o.ia ted wl I h dìe p.escn 'Ê
of invoÌuntary unemplotment. We assunre 1ìrst thal lhcre aìe N \)mmctric sectoÌ! in thc
c.on omy, each sect(Ì pro.Ìuciug a dilíc rc ntìated product The cleÌnând Io r outÌrú, 1'r' and
emplo)ment (labolü productìvity is ünilyl, .i, is gìÍct by â co stant clasticìty denìnn'

)'i : dr=l' 'rÁrN

where1] js the eÌaslicit) of dcÌìand and,1 is agiiÌegatc dcnìand Note that sìncepi is tÌr.
relativc prìce ofgood i. demand foÍ i is AIN i{hen pr 1.
TlÌerc are a trunrber of dilfcrcnt modeÌs of price setting an.ì wage settÌng behaviol:
under orìc f()nn or another oÍ imPeúect competition thal e .an.ìrâÍ' on A commo'
aptroach assutnesn monopolyp(ntucerin cach sector (diflcrentlated producttà la DìrLr
stigÌitzl a nd tunÌetim es in.d dÌ1io n a monopol-v unior (IÌÌn. chaÌd Kivotakj). This ht\ 1r'
witlÌ the microfoundations ol lhe lhilLips cuN e, which wllì occufy section 6 siÂcc lìr'
reÍ ofthc chaptermakes Ìrsc oI theuniors'age settingnÌodeì, ire ha\e pLrl lhe derivalio:
and anal,vs ir ol tlìc cfnclen.)' agc nÌodeÌ o t ttaiie s€tting ln lhe appe dixsoast()irnp(n'
the flolr ofthe argume t.

3.1 The monopoly pÍoducer, monopoly union model

ln this modcÌ, lhe uÌìon choo!e\themoneywagc in scct(tri W,andthupr uc€rlhç:
.hooses the prì.e level /ì. Ìbwever, sincc the unìon inkÌtsted in r4rr - tvirPtlÌe ufl"
js
actually choorcs Ìt,. jusl as the produ.$ chooses rri (lhcrc ìJ no dilfercncc ìn the ii::
rcsult, but il i5 simplcr to úe Ìt, and/or/, a\ thc djrccl lnstrunre t) Lvsr thousl tr:'
unl()n choo5cs n, and the hìrn clÌooscsl, gilen 1tr, lhc union neecis to kno $h:ìtI rr:'
fi n will scl ftn an! given wr. So we nnÌtaÌh thc irm choosìn8PÌ glven rr"
The iÍÌì nraxiiÌÌizes itt ptulìts:

Il : ri)]Ì ric,

Ílbiecttuth€dcmancicLlrvcr,=.,:1,;'r,1/N,ÍithatÌl f] 'r'1/N' Ì''p,'r,1rrN HÈ.:'

lt
,,1'
' f I\ " / t\'/
!
'Ì his is lhc nrm\ pricc-settnÌ8 c!rve.
We assuÌne the !njon marimizes thc utiìity of the r€prcscntatn'e emPloycc ìn si-
i, as in lhe Blanch.í]-Klyotaki Ìììodcl UÌ = Ìt'c' .rei'1'' tlhìch was nÌtroduccd in :: '
:lhi\rdrer{ittoasnea5ubSrÌÌcprÌt{.tèqunibrurìifthegrn'el)ehêen rionandirnr lhiJi:
j:r\Ì)Lruied irì ChtrnnÌ l6
 547

frelnÌrs \rctjo.. 2.1.2.; Tht enìPl.-1ee f!ts i Ìrosltil e Írìghl rI corÌ5!ÌìÌ]tioÌì. r'.,
a.dÌei\!re r. ..1!heÌe!\iÌì2 L2.theteisur(..ÌìtorÌcÌrllres ',.: 2 nìr)regerÌel.ljtl
l\ r$üÌrrrd hÚc bl Ìetkúrì! 2 Í !lh ls! .oL1Ìd rqualLt hale dr!Ìt t ris i. lhe \'il\'i)
'
SuÌ\titLúirìglhccntÌo)mentdcnìrndliuÌctiür., -]) rl ìIjthp' ..riLr jÌrto U, 1iÌ'

,Lrtr ì{l=1 rl l) ,L rtre ntE

19r ir , u "t r'i ! 'lì Ì Í. 'l,n'

alr',
iÌ 5. +5l
l

rcnrcmÌ)erlÌ!tlÌa1. = f 'l lhisitlheithurììo. strasr s.rtr.g(urt(

rutri.s the LÌi..- end Í nge setli.ll.u ÈshÌo.{I_linearIoÌÌn:

1', r)
(l5.171
(''',)

o nDd tlÌc cqu!Ìibúu! lor th. tconom! âs a i!hoi!', $c tusi 1eÌe tlÌe i\'.'rge\ o1 'rgl,
,irn,.dÌtlÌ.p:r, RcnìtrtrÌ)eliromtheN( ul\4thatl'ì:r = N
Ì! ,)r.f andliktri!e'"r1l
=
\ I rìst. n.L1r,!n =\ !:,,gn Hcn.É

,,., -'" (r-l ,'.,, il5..181

L r=t-1-lirl 1l
Í 1 ,.

B\ ir1ì.itl,)n

t,!f 0

sjn..lhe $ ern!c r.latj!e ÌrÌne rÌutt be equiìÌ t. unìt) '\ndther'(hÌe

= .-(Ël ..(';')
=,,.i ''"-ì ' ,.q. r15.5Ìl

: 1r" ì,Sl,ini&1.ÌrìrrliLrLr ì:'rrìr.nLl!rrrÌrl)thittÌrr. (t!1..rìr'LútaLnrr!ìÉr(iÌr\ir{ìn

Figure 15,4 Equ Lhi únr empoym.nt !! tll
ìo! l

Figurel5.5 Eqli orrrnrríp.vneÌ mà vr;.re

pú51Í!1nc5! àff !i s'àqe:q dtY

'Ìhc lr)AÌrr5 and ÌogwÌ"r s.hcduìes ar€ lÌÌúÍÌatecìirì Iiil. Ì5 '1 F.quiÌibriLrm cnÌno)mcnt
.:)(.jsgìlerÌbltìrexìtersc.tjonotth€lnAPrtan.lÌogYÌ1rschc.ÌuÌesascarbcseeDHcn.r

,.s''.=Ì.g(+)
,,"." :' ,
,,,.
l, 1r,, ')']
_
-*["(*).]
We can uo$, conrpare eluilibrlúm etÌ4to)' ent ln this nìped€ct .oÌnpetitiorl
NeÌÌ Xc-vnesirn nrodel (ecÌuati.,n 15.52) ÌlitlÌ equilibrium cmpkÌrÌÌent in the NCI\Í
(equnLÌon 15.32).lnIìg.15.5 $e havc nqÌrrelsed tlìe Ìogs in frutolwÌ1J ei. clc.to ìal.
the diagram riorc readabÌe.
l. .' [\ pl ll J , u. . r\'..' h.l
intcrscction of loA lttt and log l rnd r;)r represents zcro jtvoÌuntar) cquiÌlbriLrr)
!ncmploïrÌÌerÌt, since.i\r ir the unlq(tc equiÌibrnun enìploymcntÌate chosenbvhou5e
holds. B) co trast ât.r\(. rvitÌÌ Ì.rg L1' = l1,A housrholds I'otrl.l hàve llkrd Io hat.
choscrì cmpÌ{))mcnl al the jnter\ection =, (which íÌows cmPlovnretÌt choicer a:
of }t-lr
ea( h ì.vclotlr) and th r'\ line.
 589

( onrtir'irÌ! elujlihÌL!.r .nrplot.ìrììt betÌ\eÉ. ihe N(:!\Í a..Ì th. \.1! lir\nrsi.ìn

r,...f = l;,,,r..,
:,,.:,. ,,1,r.1,(É)'] 115.511

1
(.,,
ìl
Ar..ìn b. Í.f ií)ÌÌ liS. 14.5 aÌrd thr rbo\c cqurLlon. n:..\( ir1.Í0.\e\ reÌrti\r nl
' \' ', ' I

lÌtolc'ln\rÌetÌlbo gr.il ]nrlo(in.c iÌì undrr\tü irÌqthrjrnol|ÌrÌi .omfo.rnLlf

cqlL libliLrnÌ!nrnìtl)\Dr(fL !\L.sÌral rrleÍnrihehLirsì(//rú:ì(f!\rrIl,Ìf\ixnrltr)thc
n.oni i\,r,// n rlí,ri(i,/ir l

lcr r
rllr.ìii -l . -l l
,(r,r/riili,
1,.'" l,,r r)' - Id,.rirí;.,1(i,iin / rìr.rl rlrlíl!s/rlirlr.!i
IÌr Lhc dn{'iÌ at)(rr. Ìerl rr!r ri!idlt\ j\ tr\i tlìe iÌì\cre !t thr rl.fe.l rhr
ÌL
t\t.hedrrlr'ind kri rrlepinrlLr]leíir thrrrÌtiraldi\trnceÌ)eoreen,/rnd/' 1\rr
5hrllre!hrl.rr.(.,rlrìBrrì-riilil\fLr\\rcúti.rln)leirÌretr jrÌ! tlÌe rlìust!ÌoÌt .t tÌre
e..nom! hirk f. iquiLibrìLrnì iÌlthe lir.i !l r \lì({1.

3.2 Extensions
I2 I Eiasticity of demand
ln Llrc 5 nì!lÈ lLúlel tet out ìÌì thir \e.Ì:o.. lh( dctcDÌnrNt 1)l Ìeal r efc ttrnìIuÌ..$ i(
th(.l.sti.jt\ ol!,rnrr.(ì. \ aÌli.lhcdì\t.l Ii d!.nìr.(1 n.Ìcrí,!tr6hiuln(jLh]nrLgÌl
L1!..ìr'.hlni!Ìì\ tÌrr nirltl ltri er oi Lirnrr a.dô ú.i,r.r.r1.
_ \( l Ìnri i..i.:rser. llÌe nAl rs rrtrcstnte.l r Lstrill\ hr e d(nrn rÌd rhrlt nI tlrr. /\ .rLr!( ird
: lJ\Í th.5f.nrdb\tlÌeu|rrrd'ÌrÌtlolthtÌlJ lr{.dlsLif.crt(JN!..r.atls.rid(rl.gLhcgif
h!trrr..iquiLibriLrnÌintÌìc\( B\trndiÌrrf.r'l(rirÌrnrflormr.li.thc\ll K.rn!riin
l't.rLÌc
I2 2 Bertrand competition rather than monopoly
L.r \iÌnfLirii\ \É xs\LLnrL: LÌrL:,r i,. Lrro ÌlÍìi Ìr eir.lÌ:c.ror. lhrrc.Í no lìrell c.\t\ (ú
plod!.tnÌr.laÌrouÌ iilÌri.fl\ i.Lo'oi|'drl!(titÌr.rÌdl,rbd|pÍrlu(ti\jt\i\eq!rlnl
lrfir.rc:(hhlrr B.rLÌ. r.L.,rnìf.L Li..iL:\!ÌlÈrtiltr,r|.hlìrnÌs.ijrfri(rrx!Lihe\tÌÌll
Í t tlÌcir fi.e5 rt tÌrc \iiÌ. .r.nr( | nr L lal rÌtiilrir..ìÌ] rr\plnd to LlÌc otlÌeÌ. ÌÌr dÌr t.n)r
L
590 " 'r :r'

both frrm\ produce thc sanÌe pioducl: thus il lìInì I rets a lower price rhan l] (assuÌnin:
thegoodsârcgenuiÌÌeÌyklentical)11s'jììiaettlÌcrvh{teìÌ,Íketdenìand WeíÌalÌscethi:
rbc onÌv'Nash equilibrjum'is $4Ìc.c boih firm5 in sect(tr i sct thc srme pÌi.e, namel
P, = 11,, i.e. púce is s€t cquaÌ to marginaÌ cosi To see thls, $pposc this iïrs not lhe ':

t; it wolrl.l then piy6 lo piice

'r
maryìnaLll
aniÌ huì A scl a price above Ì'f i, sat 11, + set â

bcloi{ ItJ lj but that coulcìnot bc a Nash equlìiìÌtum, since it wouì.]theÌì pa!ì to \:
a ÍjìÌ sliJthtÌï lower price in order to lake t1ìc cntìÌe market tìrl nor $()uld cÌ(heÌ nnl
sct a fÌice bclow rvi si.ce thtt !!ouÌd mean:ì prjce ÌreÌov nÌarginal coÍ atld ÍÌouìd reÍ:':
inalo$. Henccboth scl fi: I'Vi
It theÌe 1\ Llcrt!and conrpetltion in the prcdu.L nrarÌet instcad ot nronopolr'' triciÌr:
thcrcaÌe rÌo supcÌ norÌìal pÍrÈts so t he pic ing cquation i!

whìch impÌi€s that l,)g1'r5 = o, instcad or n,g rJrj : r,,A (+) as ab."" i" t1É Ìn'-'p'
producer .asc. Ìl $e norv equatc lt,sL!r\ ogwL$, I't'have equiÌibrium tìÌplo-rnr"
Í'irh a nÌonopolv union aÌtd B€rlland colÌÌpclìtiim in thc product nÌarkctl

*.)^= -'-1,(li)l (BeÌtÌand .o m petiti,: .

l Ìris conÌparcs nith eqúiÌ1bú!m emÌrìo)rÌÌenl aith a nxnìopoìv unìon aÌÌd nìonopoh '

r,,rr';*: t (mo opoll pÍrlui::

,o*
l,(,r)']
rÌÌd r,iLh the NCill\Í itÌ rvhlch there dre no Ìnarket impcíectl()ns l eithcr lhe Ìâbor'-

torjc;\'i: l. ì,,go

lhis comparilon shows tbat cquilibúrÍì cnìpÌ{ÌnÌent is rcduced b-v the prcsc.ce .: : '
impcúe.ti(nÌ in theltbour ÌìaÌket (i.€. thc monopolv urÌlon)4..Ì agairÌ bfrnonopf
thc pÌo.Ìuct Ìâ rkct (as .ompaÌcd wìth Bertlan.l co petitiof).Tbe nriftlroln nÌrn!ì:
to tsc[rând cornpctitioÌrcduces real wagc pushtuÌÌÌess bt thc lactoÌ *

3.23 Replacement rãtes

Real i\'agc puíúìlncst arxl hcncc Ore gap bct
een e.Ìuilibúum Lrncmfìolment iÌ: :
New Kcyneriân modeÌ a d in thc NCBNÍ is iÌr.reate.l by theprescn.c ot uneÌìplot.:-:
bencl(s.1\ie rssirlÌrc thât houschoìds Ìeceive l ptì h(ru fd hours fü whìch the\ ari r:
to clalm unenÌployÌìent benelìt. Lrropping thc subscÌipt i, the utilit)' tu n ction i\ nt:':

L =wf rtl rjb

 ''ri. rr\in / i \rl rr.r'. 'ro r 'Jh, .ru, .r . .r.

u: 1.1./N + iÌ Ìr rrt1,Nl, : (1! "Á/N)".

Í1 r )lr r\ , 'r l\ "

l\ 0
-
rj idinc lhrouch b! (Ìt 'r;,/N), multìpì) iDg by Lr and using t : s, Ì (ì1t\'eget
1.1 ,)w + b, I r/4r." r 0

,, ":1!*., ]L"-
tl l,tI
I ith Beúrand pÌicúrL

,, :, =,, ,:1L
,t 1*. ,t
r"- 7
,

.)^ l:(,,i,)l-
iÌ,
rheÌei.,rclJ > 0inÌpÌiesareductionine)(.s1ÌÌcecr\' - (lj)

r.e"i* "A")"=1*(?,)
;Ir..(,;, ï_,) {ls..Jl)

.:ìonl]l The pre\ence ofunenrplotnÌcrL bcncjits doc5 rÌot altcr Ìcal wagc rigidity, which rcmajns
equ:ll to but ìncÌcascs rcal lragc plrshftllness, as can bc sccn by comparlng lhc abovc
= wlth thccquation labcììcd (Bcrtrand coÌÌìpctjtion).
É\pre$n)n

3 2.4 Coordinated wâge-bârgãining

CalmfoÍs DÌi1Íìll
ÌÌì Ch,rpter.:1, we set oula simpìcr.cl5lon otÌhc laÌÌìous CaÌmlors-DrilfiÌl nìodcÌq tÌÌat prc-
dicts that economies a'illÌ cithff hìghll. ccnüaÌized or hlghly dcccrtraÌÌzcd wagc sctting
strr.tiúes have knv equiÌÌbrjuÌÌ urcmplotment, whercas thosc wÌlh 'iÌìt€rmediate' or
iÌìduÍr) le\ eì wage sclling Ììa\.c higÌr cquÌìibrìüm LrncnÌptot,nÌclìl. Hcrc $'e slÌor\'how
th€ renrlt can be.Ìerir-cd from thc nri.ro Ìnodel that !l'e halc bccn üsing in this chapt€r.
15.6/l
! crÌ,ìf.Brrd DrithrL Ír9BBl.

)
592

The ânalvsì\ lo.uses of the tule ottÌre nünrberofsccl(Ì\' r\, foreach oí1rr '
r union wnge settcr atrd on tìre elislici\' of denÌand lor sectorai outÌnú Ìr l: :
thaL N and Jr are illdePendent lo sinìdifl the algebra, Ne a\s!mc that' -
l
in se.tor i
'naaiÌni7cs

$'hcÌe yi\ asgregalc clema.d This inrplies

I Ì\ I Ì\ Ì
' \,. ,.

'' '\ " '

"
wcsinÌrii!'Lhìsb-v.lìlidingtìrroüghblll';'ll'i'Nrìan'1delìIìing',f: -

'''
s,,t/ r .r"l=[.ir r.,,]1,'i

ln oÌ.ìer to cvalualc the rcston\iv.ne$ ol outÌNt to nlages in sector i, r ' '

bri.g iÌÌ thc CentraìBank s monetary toli.t NÌe (ChalteÌ 5) \{c s'rite thrr:':

Í nr = -i(t' Ì'.1

l,: - K,r.llcreK-v,

Retlrf lngtor,,,w€have

1j,,if ll ltigf I ilÌiA- 1 ,ílúg| loql Ìì I

'r" l' lÀr' ;lÌ,,gtr

wc.an showrLr tÌì.l ir rr.]q ..\andthdetìire

i1
a N'r
-Ì'(1#f , '."'
^! ";;'r
r, s,fr , - ..i,l- q,!! 1) -,d.:1,ü,i
-1,' i)1.::l
,i,,rn t' I
 593

:ir =l 1. ^,' oì)

ì''r:tìl
"(, i'
' 'li+
::J renìenìberingthat-. = 1,/.Ì,1 (1Ì.ìÌn Chapter5), wchalcwilh BcÌlra.df ricinii,

(15.661

':'c rssumc rhat o =ì: ,l (i.e. ihe nope of the PlÌillips culvc ls cquaì lo onc ard rhc
.ighr in infarlon lrÌ lhc ccnúaìbanÌ'\ l.xs frmction is e!ual to oÌìc), wc havc

i.(Na)rl,;#] (1j 6lt

,: iÌr. numbcr of sc.tors, N, incìea\es, e.ÌuilibÌiunÌ enÌplo)'mcnl Iaìls and âs the elastì
-:it oI dcrnand Ìn.rcascs, cquiìihÌ1um emtloyDÌerÌt rìses. thc 'nunìbcÌ of sect.nJ etïect
-rphrrcs lhc cxlcrÌt to r,hìch h'age setteÌr ìÌltenalize thc irìpal:L oI the i{âge the),5ei on
:1e cconom,v Í'idc prjcc ìclel, taÌinia accountoltlÌ€ be|avjotrr ot the central bank: this i5
lì :i ilcclcd in 1lìc tffm (,,,.. The 'eìasticjt) of.lenÌând' ctfc.L captuÌes the efièct on product
:inìaod nt scclornl lcvcìota Ììse in the lvage ancl hcncc oÍ sccl(Ìaìt ces.
lhc simplcst r,a_"'' ol rcla lì ng lhir Ìenìlt (equation Ì5.67) to lhe CaÌmtars Dritìllh!nìp
:hap(d rclationslÌlp is Lo astuÌne that tlÌe eÌasti.it-\'oi dcnìand Ìemains lairly conÍant
.\ the numbcr of sectors riscs initialì). Thls prcciuc.s thc rcsult lhai as !!e So iìom ÌÌag!
:rtting taking place ìn a .cntÌalize.Ì way with one scctor onìy, i.e. N = 1 and iÌìcrease
:he nurÌìber ol s€.tors, lììe equiì1bÌtum empÌotnÌcnl rate Íaìls. ÌÌowevei otÌce thcrc ari'
rrÌa ny sectors, the elaÍÌcl tl of demand 1íilÌ begln to risc as tìre müÌÌLrer ot sectors ìncrcascs
aì fther. Ì h€ cla Íicity cÍIcct will eventuaÌÌy ouí{ci8h Lh c 'number ol sectors' eflcc t a n d
-quilibriÌrm cnìpÌoynìcnl wjìÌ Ììse rs .lecentraLizition increase\ (see llg. 15.6).

cooÍdinatcd Í'agcbargaining aÌ1d centÌal bank prcferences

\ rather surprìsiÌìg rcÍìlt lhal .omes fìoìn this ÌÌrodcl is lhat wìth a ÌÌnited numbcr oI
\e.tors.ÌÌd therelore relalivcly cooì.Ìúrated wag€ bargnining, the higher the weìilht on
1 r .g Il
iÌúlationiiÌthe central ba.k's utìlil)' functioìr, the Ììighcr Ìs lhc.quìhhìn ÌenÌplo),ment

Figure 15.6 Eq! br!nìÈmpovrcÌ ih.

594 : : :'f::.:.:

rate in thc econonry.rÌ lhir is parado\ical: one Ìnighl after alÌ have expe'lcd ir::: _
-:
higher thc seighl that the central banl attachecìto cÍ4'ry'tc'r, the higher wouÌc
cqaìÌibrium emplo-vmenl Ìate lo see tlÌis re Ìt a1l !\'c neecÌ to do is to lool agdì' '
:

".(nr):-{Lrt]!]l*;+
'lhc pÌefercnce of lhe cenünl batrkfor ìoiv innaÌion relatite t() eÌnploymentj' !:
'
tÌriscquatiorbyr.Hence,hoÌdìniirandNconíant,a inÜcareinrlìcadstoan:' '
1.,,". iSrppor"-,r ,1 arcix:1tlÌenani crca'eoll h Ì nÌplies !h"t
uÈ
5/6Ì\'hcÌeasbcf{)r€lhenìcreasc itwas'{/5 ) L 1 LheeffectolanitÌcreasein rll:Ìr' :
by 1/(N 1) so ttÌe smâÌ1€r is N (i e the giealcr the coordìnation oÍ age baf!': -
the blgger irilì be thc incr€asc in cf as a Ìesull of an ircrcase iu rlj lhe resuÌt h:':'
ihe reaÍ)nnìg ofthe union: *'hcn N is small, thcuìridì kuo$sthat itsila3e d"i::
_

n ary resÌÌr: -
altectcconoÌÌÌv iridcìntìationand, iÌì1(ün,thls ill eÌicit a 'ontÌactio '

rhe c€.!ìaÌ bankr thus the nìorc ìnlÌâtìon a!ersc is the centÌal bânk,lhe nÌorc
rçì:
wll1be lheunion and hence, thchiSherwiÌl be cquìÌibrium enÌíor-ment

+ Disequilibrium (l): demand shocks and

output response
The laÍsection slÌo ecì 1Ì,r!l'imperfccl compclition could expÌâin ìnvolunla' '"
plo)'nìent in cquilib r ium. Ì hc n ext th rce se.tion t attempt to explairÌ lthy th' rÊ "
p€rlìaps prolonged-peÌiods ot .1i\equilibriurn. Agair impcÍectÌy co'nPetitn ' l
;nd Ìabour nìaÌì.ets are central to the cxPlanation The basic fÌamework oì an; '
be thc 3 equatio nnxlel, as in the rcsl of tlÌc book; but hcre the locus is orr
:" l

Lreha\.iour of lìrnìs and hoüseÌroìds, as $eÌÌas thaL.ríthe ilovcrnm€nt

l)itequilibrium is cau\ed bl'shocks. we sÌìaÌl con centrate thÌoushoLrl on thc ': '
aa.c -J nJr' \1ô r. Id rr'.' rlô \' al r'lr'_r I

to dÌsequiÌibtiurn. Ìn sectiorìs'1 atrd 5 this slos a.ijuÍIncnL is tàken as 3D'!:

se.lìon we sce that imperfect coìnpetitÌon is ne.cssaÌv lor the ad\ers€ dcnÌan!ì "
bcreÍlectedinar€ductioniÌÌoutputln(ìlenexlscction,x'eastunder\tratconi:
ini(ial cìenan.l dÌoct n ampliled (the multiplìcr) oÌ dtnÌpencd (tlÌ€ folsa l:
.úrlel. And Ìn section 6, comDcting explenations for the s1o 1\' adjusinÌent ofilli::
scl out lt1Ìc Ne$ Kevnesiân lhlìl ìp\ curvc ând the Sljcky l orma lìon PtÌillìps cu:: ''
ot lhe threc sectiorìs Ìespond 1(] empÍical obser!'alìons: that a demand sho(l :i ' '
a change Ìrì outÈrl before prÌ.et charge (section '1)i that thc dcìnând shoc'
amtliÊedrìahoüscholtlbehaliour(sectior5);andthatintlationonÌyadiutti:::
nonlyirÌrcÌnÌìscn)equiÌìbrj!rm (lectionli)
wh) thcn 1s Ìnarket stÍrcturc necessary to expÌain the outpul responsc lo :' :' - '
shocÌt? lÌì lhe NCBM, an incrcase in âggregate dcnìand 1s iÌnlncdiately eliÌìin'j:':
l

rÌ LheIulÌm'delslÌrwnìgü5Ìclrlti\\et.!tìn\oski.eandl!rftt(2ti0Ìr)
 595

rrrcÌrriate atrtriDili. irÌ(rei\e nÌ pri.r\. \Ít)Ì.o\ cr orÌtrLL ;Ìfd crìrplci\ Ì!rrÌt Ìtrì.Ìjf rt
!ir e!ujlìÌ)num lcr(ls. llÌis dor\ Ì\)t rr.oftl N LÌr cmtiri.il r\fteÌr.e. An i.cÌcrn: in
-.'!r.8iìie deD.Ìnd nouìrll) lercl\ Ìì t t() an i..(ns!. in o!tput rnl en4rÌ{)vmtnr end
rìh nrt)jequ!.1Ì\ LÒ prit iÌ(reajet. l
\\ ( llÌor in thLs t..liüÌ:
lrìjr. 1lÌ!t.Ì.c.c!s.Í1 clr ititrÌ nr (ìutfrú Lo ln.rcaÍ ln rcspon\e to ar in.Ìtes. tn
tlrls!fu deDrnd 1!llhout r prior ri\e in prL.r i5 lÌr c abÍ f.r lri p.rie(t coüÌretit .n.
\i.rrrl. thal, LI ÌrrÌs ir( !pelújirs undeÌ co.diL ons ol i.ìt)cri!..t..lnfetitirlr. outÌrür
Ìll irÍrea-\eundc, r,ange oic!ì!litiiÌtr, erc. i PÌ .ÌiiÌr ircd
\ote tlìrt drc rrndlrlrjrs anurÌ)tì(rì !f tÌrLs iì.11 Llrc frìt:c.ti.n is Ur!t frice\ u!
i\!dorrtrn\ Ìrr{,Lhii iÌÌÌatioÌÌ !lj!5ti tÌ{úÌl L. LlinÌltrilLÌrrlrrnì L jj frÌ beiÌÌil !ÌSue.l
lrìtirnprrtecL.omÌr.t tit!ÌLÌÌ it\elir\i.lil\dj\rqrLiìihr únr:rri(h lmp(rlc.tronryeti ü,
arLL\ tÌerible Ìralcj irÌd Ì)Ìi(er ì!l,l! contjftrous.quillbrium is nr!.h âs rirh teÌlÉ.t

4I Output under peÍfect competition and fixed prices

Ìhe hrl fr)]rosition ìitlÌ.rrrrr erÌ)eIle(tcoÌnf.LltLo.rnd..nstrntfri..sirirÌ.rcrseiÌÌ
!.enl'nd her n. L: Ír.1 !n !!tÌtrú. ÌÌr Ii!. I5 I thc \amc haìi! es\umfrions arc nìidr.bout
\r((Ì\anr1sr.l.ÌilnilurdtruÌctì(Ì\ati.rÌìclastí,.tio..fhctuar.\sc.lo'\aÌÌdilÌf
ithte.Lr)raÌd.nrindhìrtrtjoÌìitp .1 \'r IlürfôrrrÌcxsiunrcrhrrcr.lr Í,.1.ri5 pcüc.tl\
LonÌ)eliti\. lhirràrellnn!\iÌìea(lì\e.n)r.rrlrLÌ. rLs.r.rl ÌìrgL.rLnrbcr. lssumr
1)LÌt|Lú i\ d 5l.iÌr! {i i È. rìilL) an!Ìril the nrD\ ir I t(,r liÌ mr, rnd that rggrcgâ1. dc.riì.d is

re\LrÌt ncqrLllib,iuÌÌr,|l =V{-=Ìtl'IIfrrr nhcrÈ Ì1'l LrthejnitLalnr.nr}lrig.in

l
rnd Ìtri'f ôutprLl,\Íí /rl

FiguÌe 15.7 P. i..t.rn !:t . .fil r. rril

I r'Ì"\..rfl,r I r. r.Li,,.
596''' :'

No$.th€rcì'àna.lvcIsedcmandshock|aijg.cgatedenìandla]ìstìon]j:
the.lcmand cuÌvc shifls inwards Llv asnúttion, fl and t4i remaln tìrco '- :
rni\ js tue in all scctors so that P docs nol changc)' Thus neithcr reÌati\ c !r::'
"tu

rcaL ÌúC crrve have slìi[ted Hence the individLral

nrn has no incentive tL : 'rrÚr

rt \ : ' r'
beÌcÌ\'lo. ll lt clid ír, ptice x'oukt bc greatcr tlÌa' maÌgirÌaì cost so that
cxprnd output. lhus, abse!Ìt pÌior price i'ìcÌeascs, outpul reÌÌÌajns 1ìricd Lr:::' -'ï'
(nnpctìtition iÌÌ the fa1:e of adreÌse dcnÌand thl''ts

4.2 Output under imperÍect competition and fixed prices

'lr) resolve thn problem $e ncc.l to more to impcrÍèct conÌpetitÌon (scc F:- '
now adopt the assu!Ììptions ol the last scction: the flun has a nìonfi
r'iLh 'th
!Ìargjnal revcnue cqudr ::
gooci ìl produces. ít is !nìtiilÌy in €quiÌibriltm
ln,r, i."l i.r'{n = v,l r'. *ìth a Price oí rj) ll' Thi : '
pÍ)lìt marinr izirg elativc
Ì

trcnÌ to áÌ AsaboreÌ\i:' :
adrersc.ìeman d slì ock and ! ggÌeg:ìtc dtnÌan'ì lalls r1o
to p!Ì)íi ::-
l,]r/1, rcmains conÍa t as does llÌe líc/f schedLrìc
whal happcns

l; thc nes, tituali{trì irith rcduced dedand' but t{ith ilre reiath'e
pri'e I -
can seu is /!' At that :: :
the ìa{inNm llunntity ol Soods thal tÌÌe ith lìrm
consumeÉ!\'ill iroL lt i1tlill aÌway\ pa\ tl ':
prePtred k) bü,\' mo'c NlorcoYer'
arleastfr \incethcÌÌarginrlrcalprol_rtonlhelas( goodsoklivillbeth€di\i::::- _

tf,1Ìrandthc reâl l,Íal .uÌve

of Ì':
ThLls it ì\'jlì pay tÌìc iNr to reducc its outPul bv thc
fulL
'mount
ltc h've n!':: !
in ciemand at consttnl relativc priccs undcr the assurnplions
rhe dcmaÌìd cuivcs arc d{)wnÌ\'a sÌoPirÌil, and the leal It'-
tf : curvc ì\ not
sìoping,this ÍenrÌLìtgcneÍaL1y tÌue lOneinalpointlsthaltheus!rÌ
doit' :
..rginor reuo.,c.ut t,)r thc lÌ dcmand curvc has no meanjng ii lr\' "
<r
Ìnstca.Ì tlÌi' correct rnarg ralrcteruc'u!vcisnoÍ'IheIìxedpÌicelotI ': '
re\enue tìr lìre PI B!tabovefi thelìrìncan selìrÌo1hin3'so lhe maI:::
lì.n is
.lrops at orrce to zcro. Hence thc corrcct maÌgürâl rcrenue s'heclulc
itdìc lr:
" -

Llinc, ì'{lll

P, =i
/,i

Figure 15,8 AdvÉEe dÈìnano nìo.k !th

rmperf.Lt.omFellìon did Í rea pn.e5
 591

5 Disêquilibrium (2): Amplification and the dampening oÍ

demand shocks
l.olìoi lfg Lh(lisLsr..Ll!. 1lì.õnNÌrti(Ìiolprúeftprì.canditagÉ1ìeribili is.Lropprd
n boLlr Lh s ..d th. ..\L s(.lio.i aÌìd it i\ as\runel ilìiìt a.hr.ge nr asgÌesrte denìand
trarì5lit(i dirr.Lh lnLo i .orÌ6|o.dnrg.ÌÌarÌSe irÌ oúlPrl A! Ìrt ha\e ieen ìÌr tlÌe l.Í
sr..Llo. 1lìls llqriÌ(i soÌr. tÌlgÌÈe ot i!Ìl)erlelt.onìprLllion htÌt tÌÌat üill be,r ba.k
!rorLnderumtti.n jrlìll.lLrrilLbethelo(!sotiÌÌt.I(sLi.stclioÌrli. llÌi\\e.tioÌìisk5llr{:
qucslio.:.{lrc. Ân idr ( ric clogeÌr.u\ dexu tlÌi,.k,l!LtseliectorÌrSBrrS,rtcdLtrend
lrnr lort]n!.LrlL =Jl o,nnrfÌiÍied ,iì -..tlr!rdrnrpcncd ú _-,11 Ìr|c'!'r 5igg..grle
nrÌIand aÌrd.l s rìos. forLs LÌdÌrndl
oÌÌe ol (hr b.n k.o\i. .l Ke\ne5jdÌ rrglnÌent\ 5 Lhe mlrLtil)lier.tlc.t hr.l t.l
on i!!r.s.(i ainrifd,:,1 i. nÌtirÌ chdÌ8e jrì eÌoqc..trs deÌÌÌaulL riLl bc ìn.f,'iÍaÌ br'
tlìe nÌrlt4ni.r 1Ìì lls stirìdid f(nm. 1l r ,l .1 ÍlìcÌr r it ottÌìu1, ( thr f,otcn5jt)
to.!nsuÌÌr., ritl 0 : . .- I r.d..l eÌosrnols dcnìr.d. \r l-l I .r ihde
I LL r Ìiithcor!ltlpli.r.ThLbtlÌrelle.toin.adlereclenÌànd\h.rlils.iì'ltirr,
!! tlÌr Ìrrultipli!Ì. lhis iusunrcnl, tran\posed iÌìto d(!lallLlr\ lrlxr rr.onìc,r = I r! r,
i\ de\ rLopen irÌ sr.riorì -i.2.
\Clì\{ tui 1ro ÌedÍÌrs.lirsl, thc t.t)n.nr\ ìs
llÌe xNltidi(I ciJc.l lìas ,ro ÌrÌace nr the
.ìl\d\\nìÈq!iliblnrnÌ.s.rr!'srtltoi$rired pri.. n.xlbjLit\ rdÌ.ssr'nìftion LlnÌÌie(L
r. NÉ$ Ì\r\ ÌÌeti.ìn È..n!mi.sl \t(Ìeo\ eÌ. uÌe tlÌeor! ol tlìe con\!.ìfLio. íuÌrctìoD ret
,)utnrtheN(lLÌ\1irr!ue:igiìi.rL thee\iittn(eolnrÌultiÌrlierelircl. I i lì,)ureh(ìl!l(rn
Ì1erd lorAurlptidr or er lo.! tÈÌiodt oi inÌre \ ji :i\ ing ar Lr!Ì orrlfg,therÌr\er.ìÂc
.L)nnNÌ)ti(Ìì nro!ll lep(nd .n liretúìe ernriÌr!: .on{ÌDrptiüì sÌrôuÌ.1 nornr!Ll) bc
..n5tr11t to r!r\iÌnjre utiliLt, r.d LÌrarÌ!e5 iil .on5(tnrftì(Ìr slìorLld r!Ìlc!t úÌteren il.
r

.roreDent\rehtiÌrtÒil\5!b..lj!É!li\(o!rÌtrntc hÌ\ cdrÌ t)l:c( f b! lhe.orÌnrnìplio.

\Ì..thnÌgrct!rtiülil:.Ì! lf\c.tlt!Ì2,Ì(,!( l.i.r r Ì' /r Lhi\aÌÌ)úiì.h45jtc
.oted!oe\ì)acltolri.dnr,rfsLrcrnüntì1hìcün.H)Ìrotheii\.(fdtÌthtrt!rrì4ìti,r.soi
trrjectnÌrsightiìni..nk5sl.f.Ìi trülbollüllr]S,rcl\erreerogcn(ü!Lt!Ì!nnsho.k\
..ir xltert roÌbrmptidÌ i.i ih..xtent tllrt tllr\ .hinËrennrÌilil5oiljictinÌeìÌ(ünc
\Í(\'nrg nì the N4 l(e\Ììrsii. nl)rÌd. rt òl lrüi tht o]rtirnjTi.g lnterttm}'rirl .oi
tÌre \rr K(tnetirn !inrrììÌìlinn
'LLirÌrtn!r dÌah\i\ i\ irÌ.!rP.,rLcLl. lve t.rlt r\ !ìr..
irrt Ln the ia(e rl rn r!!IigeLc dcnlrÌú nn,.l. i .hxÌìBt irÌ th( Ì.rl ntereit iúr l,'t
Llre centrat brnl rìnnot h.ì\Ì xn jmnrecLittc lltc.t of ì:!rt{ati d. ìrn.i !) aj io oil5!'1
thÉ \Ìrocl brnrre .utlÌri is iI c.led. lltnG thr \h..li riÌl rtl!'.( iggtgrie de!Ìrni lrrLl
iLjÌÌ ú Ì)e rÌ!ÌrlìÌìrd !r dJnrfcft!Ì? lÌÌt |ÌH rp!r.l.h nltlei pr''i{'.:tli g(!trl stnr! ìrì i
\c1!Ke\n$irÌrü.rldiiì1!ri.hiniLúrìrd!n:sorll,arknì]!h.hthertcarÌL)edisi
luiiitirilD brt\\ e.n düììi rd ifLl equìLiL,rnÌÌìì o!tlrtt. Ir r!.h i riodd lhe c(tìr!ÌÌption
. ì(!ìthiÌÌts aÌrphir.h jÌnIllf5 tht ìÌ)\erre !lanÌplirì.etio!r. Lì!t ii.lr.iumflL.n 15 r(Ìrn.ìnt
ìr thc ia(e !l r l"lL iÌÌ.1 thrrl l! .o danÌt,enìÌrs ÈìtlìÜ.
staÌtiÌÌir lÌ,iÌÌ r :irnlhr o..: . m.rt rt(eìt rorli on the -) (irll.d ()Ì\'rÌd L(!ìLiÌr! l5
-:.r c" nìEEen\.ìn àdrliiio.aldâÌnftniÌrts tt:t(t. lh.iârgutr\llrlorrsgllr:.thcÌagged
\lrjÌt[.ì(]\l..|!,1]i!,\r..-nr..ìlLi
 .I

598 '':::
ctïecl ofiÌìicÌenrates las.ìilcussed
jn Chapter5l theconÍrÌrìplnnÌiunction'an bcit'ri::'

a'
1,.\Irl,.rn 'r' 'lllp'' l' hll r"r.' o Irl\r"up nr'\ "
t. r'; i,rrÈ' r"' r'\'rd \r li'F r''\"r 41êr '' l

lhuslhe adterse shocN Ìs dampencd

ming Perfcct foresiilht aÌÌíl Ìational expcctalions' ând Íartìnii
üom thc \iÌ:i :
A\
eltè'15 cìomÌnates del':::
mo.leÌ (2.1.1 i.levcloped 1ÌÌ the NCBM s€'lúÌì, Ì{'hi'h ofthcsc
on thc abilill ol holrseh oÌcl s to sprca'l co nÍunptlon
lia sa\'ì n g\ an d boÚoiriÌìg

5.1 Dampening: the forward-looking ÍJ curve

Inthi5nrbsection,ú'cshowhoÍ'ho!scholdsmay(ÌaÌnpcnttÌeimpactofrdvcr€dcn:::
,fr*"r. ,n't t,".onsuÌIption snroothing and ratlonaÌ cxpectãtìons tlou_seh: :
"t,."t tìm e with loÌ! irleÌesúate! i' o:::
cân work outthat thc cenlÌal bank ÌLìll respo n'l over
to rclurr lhe ecoDom-v to eqÜÌllbÌíìnì' llence theÌe
s'lìl b€ higher clpendìture j' ::'
flrturc and ìt thc retìrc pâys households t()incÌeâsc expcndiÌlrc
noÌL

Ìn nhat fttÌotls $'i'b;\icallr_ use t1Ìc lhe nn!ìel in 2l l lvith con4ìcte botroìlins:' :
lhe d'rìpening ârgur:_
l€ndìng an.l peíect íoreslght Hot!ev$' nì o er to conrpare
witht;am;lificrtionúnultlpÌier)argunìe'titwlllbcslmPlffnottowor|inlog5:
tue if the assun4ìL'!:i
imfì1e\ thatthc Íesuìtt i. sÌiat l(nl1r(6 are onlv approxÌmrteÌ-ï
.!!'r"'l,rl rÔ'l
lendlng ând perlecl kÌcs!!r::
Consümption behaviortr wnh con]plete boroüing and l
givcu l-vc, r, Ì ,
L{,i r) Iun/l :'r+Ár''r =Ir l' Similarlt-''' Ì f! I
cq!41 jon'
Hcnce, rctunìil]g to !he connrmltion4moolhnìg
ilt (1' :
rÌ 11, = /i+r '\r I o r)
''l|inc rr'I a' 'r" l

do Lhis dcIne,'r I b)'

L I=). r.,, dÌr I

and \ubtracl e.Ìualìon (15 70) tuln (ì 5.69);

(1: "
ri Ì' Ì dirr 'ì.1
thc ftt\Larcì l()oNì nia /5 cuÌve' snrce cLr a ent exce$ dcm and dtlÌ : :
=1 ,. TlÌis
1çìrere rì ìs

on nexl period s ercts dcnandvla co'nìmpli()r] snroothing'

'
we u; thc doublc Ì:g struclltre of the nÌonetary PoÌicy chapter' Thus Í'e reqlú'
pÌe\iotrs eqüattun as:

-1r=Ìr, dl,'Ì, ,:i,l

 s99

rÌ.Lio..dn be \ Ìifien

11.! 681 1.Ìírr,rjl ll5.73)

,. .leÌ.ân.Ì s1ìock b! ,\iÌd. rt t = 0 .l irÌ(Ìed\ei lÌonì,li tcì-.lì Llenne \l = ,t, il \\'e can .fÌate \l o i
.orre\ponding.hüire nU j lÌonr ri to rì i betoÌe l/ì jrr:rcascs
-. \ilÌbe i,ÌcÌee\e.Ì
:rq ir!Ì 1lìe 5inÌrlr tr .1, = r! rl, drt t
: ..'1I]rini]fus del)cndi iod atÌer lLr in.Írase\ t() I l

ìd\rÁe.]em"rìrì
i:i,Ìiì.
Hou\eholcÌs
:::. rÊn r.tes iÌ) odeÌ
:.'i)rn.litu.e in rh.
. L: honori ing iìr{1
\l : 10 .li ,(i.\ r Ì\ ,r =,1f,
\or, trÌ(in!.hant.s on Urth ti.Ìes oi cq!itiln (15.l:lt. ÌÌe hâ\ e:
-\ÌI= \Ìr 'r\ri ì -\'!r l"ì
'r|. nnÌra.r.:ilc.t ol \.1 i5 uÌlj tjmfÌ_1. \!L = \.Ì lh. drniÌrenjrg ct c.( cürìes e5 a
,.nrltoithesinruÌL.rnr!uslìr -- 0 i lrous\:hoÌds Lìcljrle thürÌ Ìi5es rs iì r|s!lt ol the
id!erse rho.k, \,l.Hrreisüh\ rrhonillìouschoÌds slÌo!td erte.tì 1o in.rca\r:it. in
r 01, -0LlìiìtimplicsririheteÌiodlilìllì ps.unc(ir.iÌ=r'+.ÌrìrÌril-, - -f.
\o tlÌr llentraÌ llankrillrelucerr to.nstLrcLlri(r:0incìrderroretln.;Loitstarset
\ àLur ; Tlrls rÌÌeàn\ tlÌit rÌ \'iÌl j..(nsc, LhrL! if.rc.snril Ì, Ì)e(au5e oI .onsrnÌptior

lhe que\t .f is, lÌon do lrtrLehoÌds eL t Dr. 0 r!ôrk Òut, !tirÌS ÌrrjdreÌ e{f.crelì.!r\,
the elfuctol \ I on,\1,I rÌ i\ !i! eÌr br th. i.tos.rr.n ollhr nÌorÌrta^. ÌuÌe Ìinc, i/iì, ind
the Ì'jhjllifs.rrc for i,. I liLrl. \\'e nrâll i\strrìr nLhiss!..1i.!ÌuÌaturelhjÌlits.rrnri\
bi.lÌ!d l(Fking.s,)r, -Ì nÌ Sin..i jtu.k..n..housrlÌoLll\(rnuteÌhcp$io.l
I l)hillìttruÌrr, -r -r r,,r,toerfrcsr; LnL.,nìsÒ ri lorrinÌ)llcit\ âr{nrc:r (l
llÌeD -r : ,ÌrLr and tlìe.e Ìr

|(_: i2 = : iì I = iì !.r rÌÌ

ns un'el llc rrrllt thc morÌetaÌr ÌroÌjcv r!Ìc, 11/ì. ni

I15.;t l

i, +-rl
\ojr take (lìx.gcs on both sidei

(15. ìr l
1iìi-t\Ì =nlri
6oo

aÌÌd usi g lr. : \l

^Ì!
(n +'illrr : dl^rÌ - \'11
tr,: ,,ï-,-
ïinaÌÌy, aiaair usiÌr8lÌo = \Ìl + À.4 $e cansce thctu1l cílecl ofl"l on
^Ì':
lÌo = l1l + r'r = t'i - ,r'r + :e
(, _-,.)-- (#;)
.. (;ïi).,
tlìc elfcct ol \A on -\a! is danìPeÌìcd:

o'/ \ I
\,4 ' \2 r ,i

lìrìs pr{c5s ileomelÌic'ìLÌ-ï' ÌÌÌ lrig 15 9' s'c hÚl

not'
Ìt ma! alí) bcuscÍLrÌto Ìool<
't Ì ü'ìth!': '
iìrnn"*tr,,,".","",t,,Ìonlunctiontakesthelorm-io= 'tl' ^l'ìe
rl r':I
,,,o1:or r''-l-r-'Ii ' lrr'n'I'' \"'
,,.;'"4, rr ,.', curvc Ì \, ' -" 'L'
t1Ìa ! socs throush ;Ì - nr n l'1 on the
votical I
li uÀ t. nn,r,tp'
"'.io, "
i-". it"..'" *r'." .onsumltion snnxÍlì irg r Ì rs detern Ìed at tlÌc nÌtcre'-'r :'
:

iio
"'i
-.t'nrt' .,Ne :
rircnì abovc, thc rattcr is Í': Ír + d\ 1 r 2'1r ' lÌd
""nìi'"
sn""" u' the dasÌìc{Ì lìnc pass lng lhroLrgh thc s!Ìnc poinr
on lhe r
'-
'",1
hlnLü" "i"g"nr
r'r'r'l lr'r"'r''"<r"
. i, ' (in absoLute
'"'t '
tenÌsl than !\'ithoLrt cofnurìi:
s;o.k. the initÌal oulÌru! gap Ìs snìãller
smoothìng,5o I hrt danìpeÌÌirìg has occüÌred

Figure 15.9 lìe Í.rúaÍr ool n! /J't'/' àrd thP dàmpen nq'Í a'l'Ír;nd 5'r'l
 60t
r2 Amplifi(ation: liquidity constrained consumption
and the multiplier
, ..:rr ,,,rJ., ,...^ .nd. pi,.r\..
:ll
'i_ rÌrìr'p ir ,i,,r, n,,d\ , \:rl,r,.r
,,,.r1
tilt. it. tr ,,".
|"" ''e':rurth.
.onsuÌnption, thu\
,,,,-'
depressirìg deman.t. .L.he*
,o,.,, ;i,,,ì .,,.,,,,,,.,
,.:"i
::Ìe.lÌârtsÌn:
u'" ,rr."t"- ,*. i" irr"
"*r"",.
1r cul irr dcmanct.ut, orìtput and iÌrcomc.
ïhis atìriedas mu.h to the ì.rst sLrbsc.rjonj
^ id thctast sectiuì,,!e drnrodstÌated
and
tl tntt ui rcd iÌrflexjbletrices and wigcs
rn the \hort nrn and ìnì pe, r"., ,,o,nn",,,,o1ït '"q
.-" ,,r,niio, \., r,. nr'. 1d.,,
I ","": r,,,r
'r-Ííp/ r tJ t.r tÌr, ..,r,. 'r, \. r.ri,.t,o .,rt ,r. F1,r,t ,. \/!w
thcmuÌripÌi€rÌÌììrrotbc.ìlrLhâtgreal.fhcquesLronsare:howir!'risconsisterÌt\rith
,,.
|5 ii
':,".';,
ì1".'.\,BV.LtJ ., I,_.r,.,.r..o..t-\,,t\to,
\,o j.\..,,,,d ....u.,,..i.,,.,-. n...",.,,,.
\..1 ,íl ,.u.of.
I hat thcre is a probÌcoÌ tor hoLrsehold Ìiìtnrratìty
is erid€nt tuom rhe nx)del ìn 2.1. Ì.
"rr' 1.,, .dl ,.,1
, I,a , 1",-, rw...^hr. r,r,, rlrvh,l
,.;"'"'... ,.,,i1,,c ,,,r,-, .,i ,,.
''rd\. ' itwr",.'i, .,t -.rr,,I d q .nr ,.r uo r,r.. . tr ,..r..
nìotiratiÌrgrhc n*rtipÌicris
, |t.\. )
ro ass.rÌìe rhar somc proportion orhouschoìiis r has rciiher
' l, ""- ., , :r.r,,\ ,i... ,F, ,., Lr
"r
I \., r.cltÌÌjs j5 ., rLJ r, r.t, !.,
asn'mptìons oI thc NCB\,Í that rrc drop.
A$unrc iìlÌ incomet aÌe equâÌ, a .t thaÌ irririalt] there
is Do .hanJÌe in ,1.: then tlre
o' r.o,\.n i i,-,r ,.u_,,,,. ,;,,,,.r:. . . ,:,.
uncooÍÌained househot.ìs is (t !)r,sothiìr

1,o = rto iì JJ.ì r,1.1

rir=h to/,í1 oì
I _l rrii{t ,1.
5jÌrce thc consrnrÌptjoÌÌ oI the unconÍraioe.l (snÌrothirìs) hous€hoÌ.1! is

l'o /oi/(l ,l = fÌ Atitl "t dlt t t,)

t. ,1oiiit rl: r, r) d0.5 /,1

^i/i(r
602

r-o :.!ì I /s).

'líf
. r' II L|r3. Ir4 \{\d\.rrrÌ oll' Ì \'rlir'. .

lA :..ìo '{o. dld in the dampeniniicase, ile can âganì relate AA tu l\4, by usi|:
=,ìi, .'l,, .r1l\. ,\oì : d^r\ j
^swc
^A
r,. .ioi (t -l 1,. r,i (l !) .r(i5 ,)

ÀA/(1 !l : dla.

Now take charÌSes on bolh sidcs ofÌo = ÌÌ ,lr r aland

ÀÌo -\x, lA,'tl rl (1i -

ThisequatioÌenablcsus lolookal 0reiìnpacteïÌ€ctolachangein.1urÌd€rtlÌoassumf
rions. TìÌe Iìrst !ssurÌìcs lhal a Ìs con JtaÌÌt TlÌis is the a\suÌÌÌptiorÌ tlìât the boÍotli.:
savìng houselÌolds do not tat. jnto accountthe elfect on1Ì viì nÌonetary poliq explo,.:
in the pÍevious mbscc!Ìon,5. L The resrìlt is the starÌda.d Keln€siân multiplier

-\1r 0 =) l-Yo: lÁ,111 'l (ls.:

ríheÌe the Ìnultiplicr !s l/(1 d).r,/í1 rl,ríhiclÌisgreàteÌthanone,'iice0!*.

\1 ! lr l,l \\r= \l /l .ì

5.3 comparing dampening and amplification

The secon.l assurÌìptio. is !hc corìtrart onc, thal the cÍlcct on -yL vÌa monctary poÌlc1 :,
tâlien irto account: this lvill cnablc us lo coq)arc thc aDplit_vÌng and the dampcdii::
etilcts togeth€r.Just as bclorc, lo workout \Ìr thrcugh ralional cxpc.tations, wc usc 1r-
rhillÌÁcu^eandth€ccrlraÌbank\moÌìclartrulc to1ìndlÌ, intermsof l!:
tÌ+^,).uÌ-oÀao
Noi!

= lÌr + -l,i.1(1 r)
^Ìo

/\1,:
,.u
' 20 i1 J
 r: . 603

Noie the dampcnlnÂ:AÌÌ ha!tlÌe opposite \ig. to /\,1 Andhence

1Ìo =
í1 1j (;';':) {15.79)

'lhe critjcaÌ .Ìuestio| is noÌ,v I'lÌether or not (. +-i)rr(2. +-,)(i r)

: 1 lt
(t' _r),i (2.
+-/)(l rì -' t, thcn the net elïect n amplityjrÌs; il < 1 tìre ner cltccl
is dampening; an.Ì f = l . it ls ncu tral. l lìe con.lition is Írâightldwad:
i

(jH)t,''1.' r'+':-' rri : 2 +' it\

(rs.80)

SiJìcc 1/(2+-rli,) ' O5 a suflìci.nl condilìon lor irnrplilcntlon islhat! j 0.5.^n)

JlaltcniiÌil of the ìfX cuNc (with slopc ^, = redu.cs arnpìilcation. irÌ.re.se in r'l
"'r) ^n
rcduces anìplifrcâti(m hccãuic.J mcasurcs lhc inflatìon avcrsion ol lhc (.crÌtrirÌ bank: lor
a 8ìïen f:!11 in nÌ, the ccnlraì bank will inrrcas€ rr ÍibslantìaÌly. So thc initiil fiìlÌ in ,l
i'ilÌ be .oÌtsl.lerab\' danrpc. cd b) an incrcasc iÌì xr lf,l is high. Similarl)'il o is high, the
|hillip\ curves are steep io agaìn lhc VÍ,! is llâ1. lor thc saürc rcason a5 aÌrovc, thc.enüirl
bank will react rtr)nglv ro thc inÌtial Ialì in .4 ard dampcning iriÌl bc cnhanccd.

5.4 Summary
lhÌs sectionhas provnlecìtwo cÌuiie difteÌent \ew Keynesi:n perspecti|es on theirÌpact
i'ftcct of exogenous clemand shocks on a#Ìegate deÌÌÌând. lhe standard multiplier
app roaclÌ, ba sed orÌ some degreeol li!uiclit) conniaint oiÌ hous€lÌolds, implics in r mpll
fi.atioÌì ofthe erogetrour demancl úock. The fdward 1.,o1Ìn915 .urve, alÌo\\ÌiÌìg borlrn
ing, inÌpÌies dampenlÌÌij asÌatidÌâl lÌousehokls tale account ol the expansiona ry impact
of cÌìdogcrÌous m.rnetaÌy poÌ1cy on tìture con nÌption and hcncc via coÌìsunÌption
sÌrìoothingo presentcontumptiotr.
llÌ 5.3 thes€ two apprcache! were put togetheÌ to get ân ideâ of the net iÌnpact ol
cxogcÌìoLrs denÌand change on asgregâte cleman.ì. An iÌìcrease i1Ì d, the slope of the
l'jhiÌlips .urve, implles an iDcreaie in rel:ìtjve dampennìil: the re.sorl lor this i\ that the
Jnain clfc.t ol rÌÌ iÌÌcrease in. is it\ iDitial etïect oftÌanslatirìg Ì0 iÌìto a fall in iÌìlÌâtion ol
ir ir .1-\ xr . I he biijiier the idtial decline ú iúl atiorÌ th€ 1.ìriter \\Ìi1Ì be the iÌÌcre.\e in
r, as a rcsu Ìt ol nìonetary policy trlins to rri\e nr bacÌ( to n r . Ând the larger the irÌcrease in
\r lhcbi8gcr(i.e. closertozeÍ, rviÌl beÌo. Soa0 is moreclanÌpened. nì rreduces
dampcr ìng: this is becruse the loosei is rÍDetaì y poÌicv ihe les\ will ^deüense
b€ the iise nì a Ì (the
nì o I c( ary aulhorities being less concenÌed to retlun rpromptÌy to Ír). nnall),, tÌìe
^nd,
blggcr ls the r\'eiglÌt ol cÌedìt coDnraÌÌecl h ouseh oklr, |. the greâter the ÌnultlrlieÌ elïects.
1s hc discLrssed in ClÌapter 7, an aÌtemative Ìoute to procluce aÌÌÌplilìcrtion in a tnodel
in whìclÌ irìveÍrÌÌent a\ lveÌl rs connìmpü)n ì\ m()delÌed i\ the presence of ÊnancÌÌii
.onsLralìÌts on firÌns, which implies that tbÌ Í)me pìolDúldr ol frnÌr, thejr abilitv n)
mltìcmcnt ÌÌìvestmerÌt pÌaDs depends on casìr Ílowan.ìhence oìÌ crrrentáctivity

1
604

o Disequilibrium (3): Sustained disequilibrium and

microÍoundations oÍ Phillips curves
The anal-rsìs ot nbtained dlsc.ÌullìbÌnìm, ilith rationaÌ expectations and aliìm : --
aijent!, is thc.c.tìepiece of thc Net! Keytre\ian apprcach locusing tlÌe tìnal!sls t ::
on aD acl!erse dcmand nrocN, a necetsaÌÌ condition lot the sìrock tu úaníât€ inlo ì'.
equììibú output is that wagcs aniÌ trices are not pcícctly flexlble;and a second..:.
sâÌ-v condition, glvcn imt)erfcc! lragc anLl price íleribìlilt, is some tnÌm ol moÌÌof.
oljgopolisti. conìpctition lse.lion 1). Ír an appendjx,lle setoutthemeuu coÍ tÌrc..
pÌìce (ir lvige Íi.tinert, whlch shows ilhv à nnirlÌ cost of a.Ìjustinii prices ortoai.' -:
in the cortedt ot lmpeüect.onrpelitjoìr entail largc macr)economic effects
\\rhat is still nissing hol\'cvcr ìs a mo.lel ol Nage and prìce ÍickÌtess, grouna.:
rarl()nal erpectalions, ìnâxìmizìng ageDts ârd impcftct competitidÌ, $'lÌich sÌror t.
i!'agej ard pdccs adjust ovcr (inìe to disequilibrium: in other $orl:ls a propcÌ n::-:
'. J r'dv \ol.r. I.lr \i.4'rúrr r i\f ii I lr'r.-Pó l

Iar in thel)ookthc ô_ I'l-- i,ÍÀ nÌodcl hat been Lrased o. nraxìmìziìrg behalicÌtr bJ lht.:
clary authorities as cmbocìied in lhc IíÃ, and inlroduct.i in sectnn 5 1 ma\rni :.-
bchavktrúbyhouschoìds nì thc /.!. Butwe ht\e assLrÌìedthmughouttÌìat, €ithcr nr: ' -
uncxplained reason lhe.e is lnflation lne.tia $ thet tÌ1e lhìÌÌ\rs curve taNcs thÊ : -
- \,,. 'l I I i.r'r\ro,l.\ r'. I r'. p ,' "
f ith nr': Í , lhciustihcationtoÌdoìngtlÌisisenìplÌicaÌ:nÍlatnÌìinertia,Í-:
There are t$'o conÌnÌÌents rcquiÌednt propernricÌololrdatidrs 1ìr the Ì)hilllps.-.
h:t,Ì!eÌÌeedioshowhoÌ!dccÌsionsnra.ÌebvirdividuaìpricettieLimplyn :'
ihere Ì!€ takc cxpeclecì infla Ììon âs given. TlÌis is donc in the hrst \ubsection. 5.. .
rve need to de!.cÌof a .ati,rnaì cÌpectatl()n\ bascd thcory oI ÍÈ. This is purnred L. : .
f{tld!1ÌÌg subscctiontirÌ s'hlch wc set out two proposcd apProach esr the Nei! Krl rr.' :
lhilLips cun c base.t on stickl ptices and the SticN)'lnturmation lhiìÌDs clN e.

6.1 The microfoundations of the inertial Phillips curve:

n:Í 1- Ql
Wc can fu,ide nÌi.rofoundâtbns tòrthe fhiÌlips cune, n = n Ì + dÌ as lollcnrs l: .
sc.llon .l and equation (15..17)

,,,,f \. t) ì/
ând a$unÌirg Ìcr( ran d pricingto sìÌÌìplitt lhc cxposition:

Ìogrr los
'ri

""p,
:
"*
( r4) * 1" rl r'*",.
 .=,."(Ë) +r, r)Ìog.,

Ì,rcP, (' 1)llrs-fi oc É,1

ìnd il1.ìbour pÍxhìctn,ìt) ìs constant, we can swìtch fronì emplo)'mcot lo outpút

l.,Al, : I' lll.Ft., ì,,c),.i.

llA I'i : los I l' II log/Ì ltjgr.l.

irÌsettingl,i,tlÌetLr' tìn ha!tonìaNcanassun4ÍionaboutlogPr,i.e.
.gr, = Ì(i" rr + (r |[ì(igr, Ìos],.] (1s.E1)

5u'nÌring olcr N sc.tors, r'i. havc

N rf
r,rAri:rr,!11'+t" rt lr '!1"s.", r,'e1"]
. t,rs.1, Ìoe/ íd lliÌogt Ìoglll
rgP ogP = ìogtr: losf r+io ll[l,iAt l)al

": "" t" r)L,,sr (r s.82)

H€ncc, lhc nccpcr is thc Í'agc rettirg cuNe (i.e. the grcalcr it
' 1) or equiwlelÌtly,
tlÌc 1oÌ\'ü is rcaÌ r'agc rlgidiL,! (ince RUiR= 1/'i' Ì)) lhc greater wilÌ Ì)e the elfect
!i djÍ'quilibrjLr,Ìr on iúÌation. To thls poirt, theÌeforc, thc Philìipr cu^e has nÌicro
irundJtÌons. So, ln analvslrÌg sustaine.t.lÍe.Ìuiììl)úuÌn rcÍrìling, lor eranrple, tìoÌÌÌiìn
Èriog.nous deÌÌrand sÌìo.k, i\'hcÌc wc ha\ e gotto amountsto lhis, scctìon'l extlaits wh! d
ncgativc dcÌÌÌand sììock translarcs jìrto Ì < 0. Section 5 scts oul rhe arguments tar hot!
a. cxogcnousdcürand sÌrock it anrtììhe.l or cìanÌpen€d to product the r.tdemand nÌocl
a.d hcn.c a (ì!vcn a ; : i + nÌ nnNs how disequillbrirtm graduaÌlv Ìecìuces the
inlalionra!c.hthck.oìcdgeolthii,themonet.LryaulhoritieschoosehowtunÌod
i\'r rhÌough the rsc ot rhc monetaÌy ruÌe. Ìlolever, r,c halc so far sinÌt) asnuned
that nr : Ì I. Th$c arc ts,o pdtems rvith thì\: Êrst as r,c sald rbove, tÌre nrodeÌ laclis
ioNardìooliing Ìriffo[oundatjons on tìre paìt ol wage and pricc ictteÌs. Secoì].I, the
.rcdibìlilroÍLhcnìonctarlarlhoÌitieshasìroroÌeinthespccdwilhwhichthcec(rnÌnv
rLtníìs lo cquilibriLlm.
lhis polnl is cÌarifcd if wc comtaÌe tiro sìtuatiorÌs: onc ìn hi.h rhe economv is
alicctcdhv in in fãLlof sho.t an.Ì the otheÌ ú s'hiciÌ the.en{ralbink annources a Lrver

)
606::.r :l
i,ìllatnü targcl. \!itlÌ lhe 1nÊÌtiâl fhiìlìPs curvc, the econorÌÌv responds to ea.h cvenÌ :::
thc same wav: the cellÍal bankrlises lhe interest ratc iD oÍcÌerth.t ! < 0 an.l the €co!]":
adlurts do\!n the t:Ílì to ecluitibrninì. Howevcr, il the centrâl bank has credibiÌlt\ ' r"
ivouìcìexpe.ltÌreietobcâdilïeren.cÌntheÌesponseoflheeccÌÌomtLothetwosÌluatit)i:l
Nirh a credibìc centr.l banÌ(, ân aonouncecl reduction in the inflalion taÌiiet $'ould ÌÉ:' :
price and $ragc setters to a.lirútt1ìeir cxpect:ìtions ofinflation dowrìr'ãds a d ihc
'enir'
bank rvould bc able to achiele t1ì€ rcduction ln ìntlatiim to targcl ai a sÌnallcr otrtl::
coí than wouìd centraì banli th.ìt Ìacked credlb il ì ly ìror ciedibiljt-v lo nÌatter' p r i'e :' r: _
a

lvagc setters ÌÌrL$l be loú!aì.Ì lookins PuttiÌìg lhcsc two poiús Iogclher: the inabÌÌ::
ol !hr ìnodel lo take...ount oltlìr rcacti{ÌÌ ol price setteÌs to thc crc.hbiiitv (or not
monctarv poÌl(v is xnsatitfactd); and the wav r' rrLê rr'1ì r':'ïiÕns iftu â"ouDt Ì\
_

basc the lhìÌliprcuÌve on expLicit fortlarcì tookjngbehavi(trtr byprice setters.

Rccent d€vclopmeÌrls in m.Jd€lÌlng tÌÌ€ lrhillits curv€.lm lr) providc a ìnn:
optìmìzation based modeì that.iìn both allos' sustaúreci disequilibìium and a
()jt I '
r
jj
thc c rc.]ìbilitt, o I monel a v policy wc eraminc 6l the \o câ llcd Nci{ Ke} nesla n lhill: a

currc (\(lC), i{hich ha5 been ÌlidcÌ-v adoPied in the liieraturc (c.g CÌrrida ct al l9'ì_
r{
Ìt is base'l on a nÌnleL of s laggeì e'l Prìcc lettiÌìg dcvcìote'ì b)' calvo we iheÌÌ look d i :
âlt€rratjve approach bascd on stic(y inÍdnÌtìuof

6.2 The New Keynesian Phillips curve (NKPC)

The stan.l. dcrh'ation ol thc NKIC is írnÌeìdrat lcngthv llv.ullìng sonÌe coÌ":
Ls

ho$,cvcr, there Ìs a nNch sìmpìer derilatn)n tlìat ÌÌìakcs tìre irÌtuition behürd thc \l

6 2.1 Deriving the NKPc

Calro asuÌncs lhat a random PeÌcentagc, ,j, ol lìrÌìs gct t() 5et their prÌce 1n the .uri!'
pcÌiocÌ. Ìl Ìos lÌ js the log of the attregalc pÌ1ce levcl i. .,4..Ì Ìogli thc log olthe prl"
_'

ln t hl those llrms !!ho can.lo í)

logr. ,losPi+i1 JlloAI', r 1lì:

si.ce (1 J)ol hrns stllìchariie the sanrc tüce as ln thc latt periúl
ThlscaÌÌbcr. ÌittenGinceÍ,:l,rBf, Ìogl'r Ì.;. =k,Ali lo;_lì ,l

\{hat iÌú1atìon rate $,iìÌ llre nÌms thiìt.an Ìetet their prlccs i. t choosel Gi!'ct nÌpt!:' :

.onÌ)etitionlhevirilÌr'^Ìrttoralsethcjrrclatlvepri.!iflosr'OandÌeciuceitlll.!1
Thu\ (iìthcÍknewthc-ï couì.1aÌ\o reÌ't lhclÌ pii.e Ììett prrjod as(elÌìthev_ rloúìd cll
nl : -, F d oaa,. Hoiele! the pricc lhc) set noí! has ltr lâst untìl thev 8€1 a .harr:
ìesettlÌeirfrice.lhrrc is a (l dl.h.ÌìcctÌre)wi1lb€lrnalrlcrr)ÌesettheÌprlccÌni
âi1 ,ì'] chance nì I r 2. an.l $ on.ln addìtion tlÌet .irr. Ìcss ahout tlÌe iLrturc be...:
oltlÌe discount lactor Ì <1.Thu\tÌì.lalLachì\âLueoilloharjngtherightpticeiÌ:
i- (_aÌr.D l,rljtr ir rÚr\Jrune.(:ÌiÌiaa.r.ÌL iì9':r9)
 1:. :. . .. ::::.: . 5o7

. I'p,I.Ioa ri t..r\rrË I Ë.rt .r.õ ,r I . r 2 Fi,.\, í

chosen Ìi has to be t1Ìe coÌ.eci rate lor thc currenl p$iod plus the correct râte tòr I + 1
rleishted bv (l dlf.pÌusthecorectÌatctorr,2wcÌglìtcdb,v(Ì rÌ)'zçLr, aircl yr on.

Íi : [(Í, + ô LriA-y,]+ (1 òlf.iE,ÍÌ+r dÀ nìg-1.+Ìl

.1t t;12,r'ztt,,-,r.1"r, ÌoqÌ, ,l+ l
rnd n. : óÍi impÌi€s

. n, =,t (Í. + d Ì(,sÌ,) + (l .ÌJu(rirÍ, I + ol1 osÌr r)

+(l Jl'zrl(r,ÍÌ+r - (Ei l(ig1i-r) - . .

\ertwetakc Lìrc cxpectation ofprice setteb at i ab.)utthe 5anÌe Ìelatìon iìr Í + ] Ìnultjpìy
both sides lhrough b) í1
dlf.:

i1 ,)uI.Í, r:r[(1 ,ì)r)lr,Í, i +nÃÌì,]Ar, L)

+ tÌ ,))rr(I,-, ) dL,l.A1, r,l .

and srìÌÍractthjs irom th€ pr€vlous cquationto get

NKI'C:-, I dg
l{rgai + r:,r',Ír+r. (1s.Es)

I his i\ the NKIC. Notc nrsr that drr erfcctcd lfllarjon teÌm Íelâtes ìrot to tìÌe eÌpecte.l
Ì alue ol curent irÍlation but to next perio.l in the star.lar.l lnertìaì
s inflatioÌì. Secon.l
lhiLlips cuNe, the coetlcicnton Ìrsr is. I HeÌe ìtis.òlíl òl Ìlò = 0.5. the
='
1nÌpâct ol logl on Í 1s rhe same in the NKPC as in the standa lhjllipicurve.Il,ì.:0.5.
then the inpact of ÌogÌ on Í ii muted bv thc tact drat a Ìimitecl nunÌÌrer ol ÍìÌms can
rdiÌrsttheÌ price each fcrìod. As t goes n) 1,ltriccibecone more and mo.e Uexible:ò : 1
rorespon.l\ to peìfecl lexibìlit) and there i5 i medjate adjustment sìnce ÌosÌ muí go
nìler()ilinflâtìoni\r.hcnôn inlinìre

6lz DerivinqtÌnr+,
LÌoppiÌìs ihe expectations opeÌatds loÌ conlcnìcnce, p ce setteb know the fttìowlng

,ij
Í, i=r i, ni -0
-ÌloAÌ/,-u,
rnd the Ltìo$lng Ì\lR eq!ütion

iirc assume tlÌât n/ =0.

I
604

SoirÌeichperl{).ll+iltecaDeÌirÌnìateÌot:Ì',intheNKICandIrÂpaÌÌoíeq!:.:
f(ÌI i. Ìhls Ìmtlies

',r - ^ô-^11
a
ò1", '-r ì

o - ,r: oòldr^ri1 Il - I
ilì n

rlhich ÌÌrcans that eithcì -,+i - 0. ìi > 0 oÌ n!+,' l as l - - Ìlwe mle olt thls'-_
tl
possiblÌily then

lrir i={lïi''o :'

The impìÌcatìon ol thi5 ìt that thc djsc.ÌuiÌibriLrm only lastt one period: this ìs bri:
(a\nmi.g there is a one Ìreriod lag belore nìtcrcst tales have anl elfe.t) l.Aa,,
a renìlt ol the adversc thock, rnd tbcrcf.ìe Í0 l.rô_iì IrlogÌ0+Lfn, lnfic::
EonÌ : 0 íú : l.ròrr1 ijl{,gr!<0 uulnrPeriodÌ,!t,AÌL :0:ÍÌ-n' AndthÉì'
is tnreìrì aìÌlutuÌe pcrbtlt.

6.2 3 Critique of the NKPC

lhe NKÍ,C oilers .n clegant solutìon to the problcms Posed by the standnrd i!.-
fhillips curve. The NKPC i\ a lon\'ard'looklng Ì']hilllp5 cun e derived lronÌ mlcmn':::
tions rvi rh rationa l .xpectatiorÌs. lvlorcoler it can l akc ì n ro account the credibll Ltr . :
ccnkâl banl to usr ils m(nÌetiry rulcr an-v chângr in (hc inflatl()n târget IÌext pcnf;
bc iÌìmc.ÌiateÌ-v reflc.tcd in currerlt c.pectatioÌ\ about ncxt ltrjo.Ì's irÍÌâtion reL.
Ho e!eÌ, it lìils signaÌ\ to predi.l a Í6taüÌed discqullibrìum, becau\e it dors..: l
dicrinflatìrÌÌiÌìertia.InÍeâd,thedÌscquihbÌnunÌastsorrcpcÌiodThenjÌÌflrtio.Íi:-:
to the tâÌiaet te\cland output riÌuÍì5 b equìÌibrium Ìhconìy$'a) irwhiclÌ.susr:-
dìscqullibrnrnì is allowecl irÌ thc NKl'j(l nro.lel is through Lhc incoÌporation of an l
.otrcìatecÌ eÍoÍ ln !ìre oiiginal slìoct, an ad hoc pro.cdurc s'hìch iioe\ .Ìuit€ .iln n': :
cÌcgance ofthenìodel.

6.3 The Sticky lnformation Phillips curve (SIPC)

The NKIC brings bacÌ( r.tional cÌÌrcctatÍÌtr into lhc jnflationaÌ-Í fr)cess, b!t it i.:
outtlÌe bâby (lhe eìnpiical la.l otlnflatnm itr€rtia) ÌLhlhcbath{ateÌolnon iâtiorìl
An inpoÍanl rcent clevcloprÌcntb,v N'Íankiw ind Rcis n.gucs thal thìs ìj a cons.qÌ,:_
of b.rsing lhc mlcúe.onomì.s ot stlcÌ(! plices.ri Lnstcad the-Í aÌgue tìÌat ni!ìt li
rett€rs onl! brle deltìycd airxftÌrtss ol up to daLc jnlormalìon about mouetâl p.
Ma li!!andReiscaÌlthrlihiìlifscuNebasedonthlsassurnpliottheStickyItúor ::
lhillips cur!c (slrC).
i' r\'ÍJn!.n\ r.d ÌLÈtr (2ílì02
 :.:i, 609

ÌÌì the Mâ nkjw Rei\ ri)ÌmuÌati()n, the SÌlC ìs Í)m ewhat conìple! math€ÌnatlcâlÌv. Ì his
rcÍrlts in part 1ÌonÌ the asrlrmptlon that rnonetar) poli.t i! based on the Srowth of the
nÌolÌe)'supply ratlÌer than the irrtere\t rate base.l ìÌuÌetart Írle, and in pârt froÌÌÌ the
asÍrÌìptionthatâ given prÌnÌtion,j otpÌice setteÌs accÌuireup to date iúòinìâtidÌ eaclÌ
period. W€ de!elop irstead a siDple nnrcìel using the iú€reÍ râte based nÌonetai,v nrÌe
and assu in$ that, whìle the prÌÍÌtion ò olpììce setieA ic!Ìuiie up to date iÌúìonÌÌatiorÌ
e.ch period, the remairiÌrg (l ô) Ìeceivethat inft)imatlotroÌÌe period later.

6.3I Deriving the SIPC

We 1eâv€ asicle lor a moDrent the questlon of jibt $lÌrt iÌúorinatioo is only acquircd by
the proportnÌÌ J oi pÌìce setteìs each peÌi{xl. Renrember th.t ]\'hcthcr a 1ìrm has lull or
only lhnited ìntòÌmathn, aììnÌmsuse ratiimaÌ expectation!. 5C) evcryoÌìc knot\5tlìat

n,=ó"-lt +i r),-ll (1s.87)

ls iìr the pÌerious sccrìon, nhen a hÌm sets its price it will $'ant to raisc its rclaliÍc
trice ilhen ÌosÌ : 0 and vjce veNa. EÌpÌe$ed nr tenns of inÍÌitìon, thosc wilh tull
Lnf{nnratìon iriÌl choosc rhc ìnflation Ìate nlj : Í, + alog}, süÌ.c thc} arc assLrmcd lo
know oÌ be able to worÌi oul n. an.l l)sÌ.. An.l tìrose wiih liÌnitcd inloúnalion wìlì set
-!Ì =8, tl",+" oÂÌ,1 H c n ce, aìl paúies know the equation:

ÍÌ - jíÍ, +. .sÌ,1 + i] ,tl(ÃÌ Inr ! orÌ rl.s1,l

ll t.,gr,+i, ,,,

Of cou6e those lvìth Ì1mÌed irÌforÌn.ìtion wìll rot rìcc$saÌily lnow Í/ aiÌd ÌogÌÌ. How
eveÌ, usinB ratidlaÌ eÌpectatidrs they ca ü deduc€

I ri + t
,-nl t

r Ì,rgxr Lì
-fr
This nÌearÌs thattÌreSIIC talestlÌ€ forÌÌÌ:

(1s.8E)
-=,d,,t,'*,-l,-,
\le need diiïerence witlÌ thc NÌ(l']C ln lhc NKP(: í. =
to highÌight rhe critical
ô,t/ I óì LosÌ, ì)Ë'n, ,
Ìn the SIIC, the Ã,r, L tenn i5 repÌaccd by Ár LÌ, ÌÌr otheÌ
nods, Ìf rlagc and pÌlcc sclr$s aÌr ÌatnDal ìn aD NKIC world ]t is díUrull to scc how
lnflation ineÌtia can comc about, siDce Ì,_.Í, I depends on expectalioiìs aL r aboul &r/.
lnJlation. But in a. SÌìra í'orld the most op to dare ìntonnrticnÌ that I I pff ccnt oÍ
'J)
rÌsmalhâvcìnlorminglhcirvìc{saboutÍ,ali l ieIi ÌÍ,. nìay plausibì}'jncl!'dc
last lactors that
jnflucn.c ir

,/
610 :

6.3.2 Deriving Er rÍi

TolìÌìdoutt. r-, thostwithlúnitedinformatioDnoirsirìplylÌ:!etousclhci'Í,C .. _

-,t,,gr' lhisimtlìeswithrationaìexpectatnms
"' "J
E, rÌ. = Ã. r-1 -,Ã, L loAÌi : E. ÌÍl
sìncerr I losÌ. = 0. (Ìhc onl-v!ÌualilìcatbÌÌ lo lhis ìs dratthose withlimitcd ìni(Ìr: '
mai notknowtìreup to-dalcvaìueol^ t\'c assumc thi5 is notthecâse )
GolÌìit bacÌi lo the e.dlcr cquation iar n,. this ca. nowhe tnnply ÌeÌlrittcn as thç :
hrldrÌÌation ì'jhillips.ur!'c

n.iÌ together $rlth theltR

Í' : Íi _ì
l'gxl

th€sc two e.ÌurtioÌìs deteÌmile -, and loAl.

An €dampÌe of liiÌÌil cd infoÌmatiorÌ: thc intÌati()n tàrg€t

A sÌnple rasc js wlÌerc lhosc 1th liÌrited jnI(ÌÌnati()n cìo not kiÌo1\'lhat ir hri :.
kNeied in Ìreriocì1. Àssurìc in t l the c.onomy was itr a lulliniormaLion equil:.
lvithÍi, =nlratpoinrt.Assume,ìlsotharI' LÍa:n/ Ì. rhen thc SII'C iI pi: :
goes through Ìosr 0 ând n = iL,. âs is shoirn in llg. 15.10. Ìhe neí' ttl goes thi :
' r'l Ir.' . .'r'
l. Ir I u" I

Ì(isa LJe.omes negativcand r Íalls í)me ofthc al ìrct]{cen -/ r ând -1 . linaÌl! iÌr :
tlÌe ecorom_Í n1oles lo ils nca, e!Ìuililrrium al polnl a' irith Ì(ig1. Ì O nnd r'
(assumlng this Ìenìal.s 0rc neÌ{taÌi{et).
'Ìwo ronse.Ìuen.€s slìould be noiecl. firsl, disinllalion
1s costÌv irÌ uÌis ipprox.rl

contrasrÍllth the NKÌrC atproach. Bxtnotc lhaL an adlebe demând íìockÌs iììÍ Ìr:.
diatclt' ÌrveAed unÌcss lhere is an iÌÌlormnlìonaì lag. Second, orce thosc *'ith Ìi-
informalioD ha\e ündcrslood the nÌfl.ìtion latgcL has faìlen the-v inÌÌnedjnlcÌl :r
thcir bcha!i()uÌ. Ìhus b-\ conúatt with thc ba.k('ards looking PhiÌl\x curvl:, .r: :
bânk.rcdibìÌitv ÌÌÌattcrs lìcre.

Fìgure'15.10 Ìhe 5t.ky l ornrdior Plìl ps.úrve

.h-nqe I rìtaron tòr!.Ì
 ::: :. , .::..:j I ': 6ll

6.3 3 A better compârison between the SIPC and the NKPC

ll is not reaÌly appr)priatc to conìpare the SIIC alth a one period delav i. informatioÌÌ
asslmilitior to the \KPC, be.ause the \KlC asnnnes tìreÌe is a dìstributÌon o!er time
irì th€ ibility of IìÌnrs to r€set theil prices. The apprÌÌiare conìparison cnrails a]lowjlg
iniornÌâtion to.hffusc nìore slorlly iÌì the slI,C. \,Vhen we rllow tor morc than.ì one
pcriod hgin ìnf(rmatlon assi ìlitioÌÌ thn h as 0r e eltect of sì01Ìì ng {Ìoar tlÌ€ ad j! stÌÌreni
oi the €conomv back to €quilibriunÌ, Nith the rcsolt that it is bcLtcÌ ablc to predict t1Ìe
phenonÌenon of infl atìoÌÌ persistence or Ììeúìa.
ÌoilhútÌatetÌìis'cnowassuÌn€thattlÌeshaÌetIofnmsacquireimmcdiatcNnoÌÌledite
tro peúixÌs ard aìÌ lì.ms a1ì€r four
ol the reductiim in nr . J2 atÌer one pelio.l, ôì alter

ln peú( 1 thesllc is

Ì
'il

íLi.9l
lhat is, th€ nÌâre ôr bcììc\.c Lhar ír : -l an.l hüve chinSed their piice üppropÌlately,
trhìI. (r òr)stilt beìicvc i! isnr = ní
ln period 2 the SÌPc h

_- _! ,,ò. r-,,,
/rr0+tó)!.5_l

ij.cc d, now have 1ìrll intÌÌmxtion and (1 ó21 ÍiÌì belìeye that nr = ÍJ . Ì.ikciritc ìn
:.'Lod 3

-ÀJ

rnd onlv i n pc Ì iod .1$'lÌen there is ful1üÌlorrDâtion is the sllic (nr Íi.loBrr 0).lhus
:n each peÌiodthc SiPCgets steeperr€fl€.tinitt1ìe iÌÌcr€asing proportion ofthos€ l\'ith full
:!frÌmation. This ls slÌoÍÌÌ in liig. 15.1Ì.
\fter Ír has rlscn froÌÌÌ Í; to
"1 the,rí cuÌve is deri\ed flrnì the nìnìimizâtion ol
: )rÌ1': + r:ltÌ nl I. subÌe(t to tìÌe sÌÌ,c Ì - Í.1 (.'ô./1 ilÌogÌfor 0 ! i i 1. HerÌce

Í Íj: r, oga t 5.91)

..as Ìt iJlcrcascs, theMÃ cune becomes ÍÌatter.Thìs is aÌÍr shonn nr lìii. l5.l l. Hence we
:.t a cìoscr approximatnrn to iúÌâtnÌÌ ineúìa i. theSI|C apprcach.

a.l4 Critique oí the SIPC

re SÌPC peíorÌÌs better thrn the NICC in inÌpoúant respe.ts. Gitically it e\plairs
!fÌatìon persislcrrceaÌÌd hence ÍÌÍaiÌÌed di\equìÌibriunÌ more pÌausiblv than the NKPC,
:ì iihoui lnvoking ad hoc a!s!nÌptloÌìs. Atthe same time it aÌlows centÌal bank cÌedibiÌity
r Íte 1n Ìeducing tÌìe coÍli e\s of a.ljiìstÌnent, an.l it nÌeets the re.ÌrìireDeÌrts ol Ìati()naì

I
Figurel5,ll 5Pa riÒrnat.r | 1:!!ôri.!er

jni(trìnational drLr.,r:
hchavi{)urand cxpect.tjons. What is lcss clceÌ is the niturc oI
HeÌe there arc lrro poinls. Iü5t, we nÌghl like tu NnoN wh.theÌ lìÌms in\'cst in ::::
nratioÌÌ: it $'oúl.l be attractive at any ralc to Ìino!! rÌhy soÌìc nìnr\ ha!e iì..cs! t. a.
lnftÌmatloÌÌ than otlÌers it not vja sonÌi' Ionn ol erprndìlurc' but if Í), Ihl somr .-
ind not othcrs? But secon.l, an.l perlÌap5 nrore ilÌÌportarl, ('hât are tlÌe iiÌlormri:
dclLclencies? lf lbev co.ccrn the tarilets ot the nìonel.I,v authorìtie\, $e nright ir':
most 1ìÍns to gain irll jnlormatl(!Ì so,r.cr oÌ Ìater' So ii largcts selcÌ(!ì changc th. :
app()a(h mÌght not havc enough Lìite to cxplai thc conti.trinia teriltencc oi int .

7 Multiple equilibÍia
Ìnrhe r€mainiÌrgthr€csrctbn\ ofihechaflcrwe trrrnto s,ÌìcvcNdiífeÌentidras Ì:.
section thc asunrpÌio. that theie i\ a unìque e!!ilibrium rntc oí ouLÌÌrt, )'r' is droìrf.:
thls scctjon two rÌìodcls $ìth mÌe Ìhnn one (erolenous) cq(rìlibtiun are devcÌ.ÌrÉ:
sectiof 8, ae ask ìlhclheÌ aiigÌeil.te dcmand c:ìn itsell shiil Lhc cqujìlbriu (hlsr.f.'
And in scctl{Ìì 9, nìotlnii aivav lrorn lhc underl}ing iìs\urnplio. that hous€holc' :
tlìeir unionr ar€ irÌtcrc\ted Ítely 1n corsumption.nd leisúrc, it js thown hos .o.:.
ior lalnress nia\ SencÌate muLtiple equiÌìbÌja.
Work on nNltlple cqullìbÌia has not rcached â staile ìn r\'hlch ant laÌticuÌrr nr,::-
have bcconre nand.rd. Uie slÌalt ther€forc set out iÌì uÌ1s \ectio. a slmlÌistlc nui.l
ilìunriìlcs the nÌâin idcrs behiÌxl multidc c.Ìuilibria. Before derivi.g the mxleL Ìi:rr
cmatì.aÌly with rmìlìple \ectüs 1t lnal bc utenü to let it olt iÌì tcnìs oí fJ drìc
sclcdulcs, a\ sÌ]own i. Ili{. 15.12.
lnfig.15.12,r!€havetheunr?luplÌardd.plngi!!sesetting.urvc Howeveì,Ìhr'. :

sclling cu e is quÌlc dìtïereÌÌt. r\s belorc tle a$unìe tlÌât l' L1',rl (nreìe ì i! La:
prodúctn,ity. A neN asuìnptidÌ,lÌoÍ,cvff, !s ìnacìeàl)outlabour producli!il):whelÌ li
oÍcconomic activnl ere hish econorÌìv n'ide, tÌrere is a hi3h level of prodúclnitl. '11
thctaicloi!,ld! prod(ctivit!: \ieci1ìcallv, irhen the econo!\ ì!idelevcloicmtl()tÌr:i
ìsabovc.Mìabouiproductìvìt)ìrishighii{henthee.onoritt!ideÌer.lolcmtÌd.::
 613

\.ì'r"., FiguÍe 15.12 . L.: .: I r:,, f, Ì.r L. l, .

níi:rÈ'i : .j r, fr'.:,I. i .!

i\ LrrLor r,r lib.!r Ì)ìt!Ì1..1 r L\ .ì, \ Llr. hr tlrar fâÌr o th. 1)..c jfrtirÌt.LiÌ\c rbrÍ.
r,rthÉrrrÌrii. i!Ì)li(ìirr tÌl.L.i!.ÌLrì!i5lireÌrbyI'= 11 ,\r, Ìi jì .\,i Jn ür.ì1
l)rrt.:tÌr.l)'.!rtttirrg.Lrúhrlorr.,,tlÌrìiâlrrtrlcjxÌn.(lbrt.cnÌtjrÌ!i\Sj\cnh)
| - l1'.\,, l\ |=,,r lrLrsLhifri.i\citrn!ì.aÌrìg..rLr.hisLrÚ!\cSÌÌÌrÌìai\
_lh.
nÌ(n\n . ij. LrÌge L L. irLLÌ rLLr.rpliÌri rl) c\Ì)Lrj. Ìrìt)cyrlrcillibÒr r| 1trtu!ti\irr.
lÌÌ tÌìc .Li.d,ìIr] lircrrÌ, LÌr. 1\ \ .u 1r irÌrtbe.r\ tlìc lJ cul ! o.r.. n hi.lÌ ÊÌer rhc
!ÌÌl(lllrcqir llÌrri!ÌÌ lÌr lìig. l5.Ìl,Lhr!.irrttlÌrreiÌrfur\r(tÌ(!ìr..ìtf' f,i.rrii,--

71 lvlicroe(o nom ics

l ihit nLÌrí,.ì,,rì rr\lrrr tL)r ihr rì1lL!ilì!\rrdLb.ilrri\tlirÌÌÌaÌni.rL)r..n()nri.
L,r\:\ Lói.g f. itpr, rrI jirì,i1trÌ n) rbxt lf !.i: ,lr l.
lhcnÌnr nìr\1fi /È.

ir 1,,, Ì r,

i.ii)jr.t tr) tÌr. d.,ìrrÌ!. .rÌ\r i =l''1\ iìr,l .,,,,r \o Lr.ìr 11 lJ r1\
:1 rr 1'. ì \ HtrÌLr

'1,.1, .., r,. 'r \ 'i,, .\ . f r r o

l, ,,.;, t,,
h \ \lh.Lìr|!Ì!i.i \LL .r.Lr \!..
tlliL.!,,rq\.lLrÌth\lìL\.LiÌi.ii\.r.t$rÌrdI.rúr!rÌÌatt I- Ir]J 0.frrbitlrr
: rìrÌs (, Lhr Ì,,r ir 'r ..Ì:.tì,,115:
614

Logl'r\ir ,,"''
ìHi,r 1l
rl

loriLr''t l :r,,. ]L! Ìl

lh. iih Ìrn ôn as beforc Ìnarìmiz€s

ür', ior'l';'

tr : ü'irl)ì l.{rN laboLú pÍ)du.livjtv is.\, but ) dcPcn.l\ on :::

suhject t.,
cmplolrÌìerlr:ì - ìrahenr > e ) = ìr wh.t | .' \\r.n. r$triiel.::'
:lït' I r't"
rr s' rìl'l'i rir-r-
ÌD nÌa{imìznrg í15.931$bicct (15.9'rl, lht ìÌ ividuaÌuni()ntak€sÌrerasSÌr.
Lo
ì cìepends on /,jp?,{dt| en4rÌo-tment oveÍ Íhnh rlìe ÌÌnlon hrs no .ont'ol i: '

S!bnltúirg (Ì5.911into (15 93), the unlo!r b,\ to malimize

r'l "ì(.)u rrÁ,'Nl .rtr rì(.l r !lj rNrl-.

which impÌies ior a nìaxìÌìtrm lir lict, jusl at beforc)l

'" fi"r'
ro tlÌal lhe$age scltúsrealwagc schechle L!Ì'i beconìes

t,,s-",''J = L.g t'ì + i" ttÌ,,r..

TlÌereforc there arc riro equilibriurn vahes oi e a( h'hich Ìr,s Lti Ìogn'r'\:

,l
\ '/
aììd thcse aÌe nÌoÍ'n in Fig. 15.13.

7.2 l,4ultiple equilibria and shifting demand elêsticities:a sketch

lhcrc aÌe niarÌv rcalon\ for nÌrÌ1ipìc e.Ìuilibrìn jn dìa.ro nrodels \{e givc one h'::
e\rnìpÌc. I-ike thr pn)du.tilitt erirmplc tìris one nÌso asslrmes that a key pnre.reter:
 615

l.s-

Figure 15.13 t.lL: p..nrD.r,,-rr:.f r t,ri

}!uÊroL.! rl tÌ? Ên..i I a:,q -È.iF r..L..ijril
rt I i?rÈ t i. Ì,-. .,f: ri ! :j
l, x, r,

enteb thefri.c 5( ttirÌ8 equatìo. is inlÌucn..:d bl th! lr!r i of iS8regrte e( onomic âctj\ Lri .
At Ìreii)Ìe lriLh nÌonoÌrolistÌc tÌ1ci.g, s \ = Li,/ 1r'rr ì. ln tlÌe ]iÍ \ubrectl)n il wr!
{\srnne.l lÌrlL I I .r IIere wÊ r$unrc thr{ I' rril,r rllili'l l Hrnce
rì ,rl-- i
(15!7)
', ìllrl

\\h\ sftr]d tìre elaslì.it\ otdcnÌan.Lrìr\ üiÌh rggÌegate economicactirllr?r\ lh(.1

aruhronÌaiÌìreaso.rlrst,llÌrilìrcatoientÌ\oine.olÌ)ernÌt1air.ltÌrL6rhcrÌc{li(rÌr
telrÌÌ eLasticit\ of drnrnndr is lik.l! to be lo\' *hen e..nonìì. acti|itv i5 Ìrú.I hi! mcrn5
tlÌat hn!r riÌrâdr i. lh! nì.rket nÌit leel Let\ ÌLoniÉd rlrÌú higheÌ mark !Ìr! o..oiL5
irÌ.ì peü)d of l01ç e.lh it\. Lì! .orÌtr.ìn. lÌislÌ rconoÌni. r.tjljiv jr a good riÌìe 1o cntcÌ i
nurlrt ar .urr.nrc.s m.r be tìndiÌìg it lÌa nr nnd \uptÌìeL. SecorÌd lend thi\ rols i.
tlÌe WÌro\ile LÌirc.Lion orÌ proht nÌâr!ìÌrsl, ronrpetition rith exi\tiÌìg nìÌrtlieÌ\ ú ÌiliÊÌl
to tre high Ì!hrf ..onDmi. n.tirit\ is |rs: (ustorìe!\ crn sÌrÌr !rür!1. lligh economic
!cti!1t\ tdules.omt(litiln bctíccn nrppliÈA, \nÌce b!\iÌìenes h$e 1ìlL!ÍleÌ b.oÌ$.
I hrt L. c í..1s go in opposite dire.tiLÌrs. an.ìdÌel rü! peúe(d\ (dÌ!eÌ ea(h oth€r
out.ltthe\..Ìo rhcasnlüptionllÌat ìr is.onltnnijs \erÌ\lbLe ll L,u sine \ses dre !ue sensitiYe
t() thr threaì t)I c.1r! than to irÌtnì.1clrìrpetitir)n. ihen rr rÌÌtì\ bepr)c\cli(rl:maÌgì.\
Ìlillbehjgherhìr.niciiritti\ll]stlÌiìrÌÌÌhena.Ìì\ìt)i\hislÌ.aDdthefr'!\cheLtulÈrLjÌÌ
be !pwadr \lofing. b!5irÌerses.rre nÌore \ensitn.Ê to iÌrterrrl conÌÌreÌitioI ÌÌre. n) the
thrert otentÌ\', rlr.n ìi rliLL be.ourÌter.l.lical inaigiÌú Ì!iÌl be Ìt^!eÌ Íhen activit\ j!Ìo1r
tharÌ s he. aclLr.iLl. is hi!h, tìrÌd thr rrr\ ÍhecluÌÊ wiÌl be dorirldrt ìoping. ÌÌr L|€ ÌnLter
caseiti\IotdLllL.ulLloÍ,eth.ìttlÌere$ilLonl\beonee!ÌuiÌiÌnnuÌrtherj'!,chr{ÌoÌcL\
de.lirÌhÌS anLì tbr r 1'\ s.hell!le is irÌ.re.sìÌìil 1\'e focus het on tÌre rÉÌìriti\it) t. cnrÌl
.âse. iÌì Ìrhich tbc !r'i s.hr,:Lulc is rj:irÌg. CLrar l\, thi\ couÌd be atÍ).ìriecl n'ith fo cqui
libÌia.rt!LÌii.e.1fLrj;ihrar'sibo\.Dr'lÌo$4eÌ.thi\iipÌet unÌilieÌ\ilrr"b!.onrcs
Íeep rt tulÌ emtlorm( nir r !nìque eqriLibrjLun (r nruÌtiÌrlee!ÌuiÌibÌìa. rLhi.h Ls Lhc.i!.
.on\iderecl heÌr. S'rppos. tlÌere is slrìÈ lereÌ ot nggÌe:rie ec(rr(ììii ectj\ ir! hn)\ rd b_r
thea,{irÌegrtetmfÌ.ìnÌcrìtÌ.teìltslÌi.lÌtheliÌieÌLhoo.ìole.ÌÌrnxÌtsrorj!.,t,lloLhiìÌ
poirn iÌÌenìbe.L huslrcss.r lì.!r bcen rL,le n) mai.iajn a high fÌoíir mxÌglf lÌor! ,i. s,l
tlì.rtrr'i i\ ÌrN.IÌo.ì LhüÌoniÌr.! bentsÌrerceircrtlattÉÌdema..Ìcur.íhighìrIiIthrl
6t6

Figure 15.14 Ú! ti..ÍrÊ.yn3nt.q' irra

r ãrr I r.Í d-êÍrd.d vi e5 !!th i.orcNat: è.i!1v

rai\erÌoirtmarilins.asthêlirouÌcliÌÌvitcne\!€ntry'ThrìsÌtr\rjscttotak€accoruÌir': '
ìncÌeüs€d risk of c.Lrv. liìagi.e ìr.orìscquencc that the Ìt|i schcduìe can bc dÌas!ì:'
lig.15.1.+

7.3 Choice of equilibria, coordinated aggregate demand, and

monetarY PolicY
The ain tuDoscoltÌìis scctlt!Ì o ho\r, s'lth iÌnPerf€ct .o nÌretil j' Ì:
1Ìns been to sÌr

i\ posslble to hatc nÌorc than one cqtrilibrnrdì leveÌ ol o!írút ancì erÌìpìolnrent l: :
a Ke)'ncsìarÌ pcrrtectivc thì\ posslbiljtv 1\ ìntcreitirs be.aúse the equjìibÌ1lnÌÌ thi:
clÌoscn deperÌds oìr dgiïcga te .ìerÌì.nd ln thc gc n oal .olrte:il oI lhe ìo.us olLhe t)ooI
ÌÌlorctaì! nrl.r as central io nÌacro poìicy aking. it i\ iroÍh astLng briefly hetlÌrÌ :r:
ctìüscs Prnrlerns ntr rììo.ctar-Ì po1i.]'
Ilríore looking.Ììrectl,v at ìnoÌÌetary tr)lict, Í'c miSht ask sììnt lìre lhillìps cunt ':
level ol ootput oÌ eÌnpÌo-vÌnent -
Sram loolis likc il theÌc is moÌe than one eq!ilÌbritrm
answcÌlsÍraighti(r\Lard,btrttna\bcabltstrprlsiÌrgât1ìÌ!t^ssholÌnirÌIig.ì5'l5tÌ:i'
.rc thÌee ÌorÌg-ruÌr \eÍti.aÌ lhiÌlilx.uNes (oÍcsPondlng to tlÌc lhrce eq!ilìLrrium LeÌ :
oÍcmtlolnìcnt: ii Ì!c nrc actuaÌÌv at anv oltlìl: LhÌcc, the rate oflfflaLion $ill bc conji:
sinc.rÌ'i s,"\ ateach r)f thote .mpÌo-vmentiÌ1cs
!tÌ erch cxpccted ratt of irúlation theÌe is a sìngle erÌre(tatio.s augnÌentcd ìrh1!r l
.ure: uÌe surtìúe is Lhe dlp.È tlìct tale Wc hale .lÌaì!n ti\t here, corrcsl)l)ncli: :
to Íf:ÍÌ a.d rr ;r. Note t1Ìal Lhe) go through erch tertìcâl lhill4x con' '
thc same l.!d ol iÌìÍlalion as tlÌrt cÌpected: so, ÍoÌ cxaurÌte, thc Íf :.r ctrrlc f '
th(DSlÌ thc LhÌee long run \erticnì lhilLips curvcs at ir \!c alo tnoÌ\ thel
âlling to thc lelt of r'i. Ìisúrg to thc tiSht of ei/ rislng betseen rr and ft. and ÍiÌÌi'_
hrtÌleerÌ.rr and.r lhis erpÌains the nÌapc ol lht short Nn cxpcctâtidÌ\ l'jhLÌÌl
clÌrves: Ìlhcn intÌâtion is risnìil tlìc cuì\e lÌas 1o hc abo\e its €xpcclcd \ahre irnd I i-:

A5srì c.owthat iì ìs comDÌon knowlcclse acrolsboth hou\eliolds and lhe ceÌìtralb:!:'

thai tlÌerc âre tÌlo cquilibÌilìnÌ lcrcìs of outpul and cnrtìovnielÌt, l'f : rfl urd r: = '
Then thc qucstl(rÌ is hìrether tlÌoÍ cLÌuiÌiÌrria a rc ! uffoÌtable bf â g8Ícgâtc cleÌna nd TÌr: l
is epertincfl queÍiof rlnceiflÌlruschoìd\ (oordìnalc theiÌ beLielsonl'l and itthet rrìg:r!'
 617

Figure15.15 Ph t!.rlr:i L.:tr.rrú ir.rnr.Ìr.rrmÊnt ri35

irÌ ronJ!nÌ|tir)n rÌìo()lhin!, tlÌ. r.onsLrrÌ+Ìi(Ìr ÌviÌl be Ìratd on Ìrenndnent incomt oi

r. ftis reiÍ[el]Ìe loa5s!rÌ1c lh.t ü1..crìtr.Ll trrnLiÍilllreÈrtlr to r. lrltlÌouijh!fcrrtrrc
tlÌat Équire5 in âd.liLloÌ1to t1ìr niÌìd.rd lo$ tilrcti(trì uÌat urr GrtÌdÌ ÌraÌrl( ha\ !o Iar
Lreen rsnuìecÌ ro tak. n: its obi..ti\.1. \ir! tlür, ir rhe rerl ìÌrteren irte thdr the cÉ.rÌal

'''I'l
'I
real iÌìteÌest rrlr,s.t hl ihr zrÍr nonìiÌÌll i tere( rate LÌrrÌd (\ee Chrpter 5r llutiti5Ìrot
itnpLau\itrÌe thrl < i rn thit .isr. tlÌc onL! rqujlil,rnrnÌ rolld bÈ o e ìÌr ÌÌhi.h the
'
cerúral Ìranl( cooÌdi.alcd on ì.:
TheccntÌrlhânkDÌlght.l.o!ÌselÌrìreluÌeor)aÌrouluÌeIe1Èrrìnr.uÌtsolther(Ì!!rÌi
belìet !f h.trsclrôltl5 a\ nr thr .orr((t .quilibrirnn (ì|tÌÌrt. lior irÌnrn(c thr certiü t)rnk
mightbelir\.lhiÌL lÍil\È1 , i !rthrtr .ìj.t[]trrìillÌtstrit.hthÈtrelìÈlsetol
holsehol{Ìs lor'r li!t re dre n.is irÌ irnnred irì r'lìì(h little rorlhiìi br€rì done..\nollÌer
fo\\jbiÌjt! Ls 1Ììil Ìh( ccntrirl Lrrnk brliÈ\cs uÌat r.1 j:i thr !nnluc.qul lbriÌrrÌ. .\s ..n bc
sÊe. fÌom lh. |hillifi .un e liaÊr ]]. irÌ!r.r\es ìÌr ort!ut aborc t: rr,uld .L ìnnÍ.r th!.
_ .ilrr i cenrr'âÌ ba.k s b(liclr, !rÌle\ tlÌàt iÌìrrÈr\r p!nÌe(t output abc,' c 1:'r ior thc ì .tl,ìr orl
Ìlould \raÌr to lnll ln ,ìn\ .a*., this i\ i riclÌ ÊeÌd n)r resriÍ.h ii in ...cp(rd lhcoÍ!,:rí
nNÌtjtlr cqLLiÌ brli .arÌ br de\ tLoprl.

lÌ L iri
8 Hysteresis
Ir thi5 \eclron ri. cÌimine tlÌe rr!!nÌüÍ that tlicÌe i\ r !niq!. cmpllt mlnt an.l o!tput
e!u1lil)riinì eLenron. p.ijÌÌ iÌì tjnÌe b!itlÌrtititrl!Ììctjonoitlìthjnlrl ol!nenìplot
: i i.1: nÌerÌt. 'r ÌÌr ( hitLr'r.1.1!e irÌtrodu.r.L
.r nunÌtJer oi cLilleÌrÌÌ nì..h.ìniììs throurh slÌi.lì

. 'ìiÌllf\ peLi\tence oÌ h!!Lc(s 5.o!ld .p.rit.:. tor eraÌ4)Le trhln unrnrplorüüÍ iÌì..e,ìst\,
ÍrÌe w)rlicN Ì.:miì n uìÌer]rploretl ior ltÌrser theÌì othrL rrÍl r]]lr Ì)ios.eri\el] L(tre
\kill5 .cÌlrirh.nrploreb llrre no jrÌ.entirr to c(ÌúirÌlr to tirirÌ orkeb r[) aÌe
:iilrd!trlÈ\.irrì!ÌrrfÌni.iÌ F.,:n.f.r ìrLrd: rn:r.I Nlin.Ìr:rt 115!Lrr| i.nr.r*iiúìrr
i, !.1r. FriL r!\[ !lÍrr].Ìr !f-rr irridrr\ r.jrg i d.irhr.rr !i! \ rl rl ;j frÌrS|,rtr.r I L,r. dÌr:
ìì. Lht\ i|q|j.'tr.ÌÌür.itlr?Ìlj!.|l!r.Ììr'lÍ,]Ì.Ì]ìrr]l.|]i
618 ".

uneÌnployc.]. Il thcv hÌÌd iL veÌÌ h:rd to hnd iobs Lhev mav irÌ consequen'c d(4r oul
ofthe labooÌ nÌarkct. Supposc empLoy€rs ret eflì.ic. c-a s'aiies'zo b-v releÌetrceto the likeÌi'
hood of gettinil â n other iob rlitlÌin a gircn period oíiìme;then, as unenÌp1o,vcd work'rr
drcp out of the labournìârtel, Ír the probabilit)' r'ill rise that sonìeone lvho ìs curentÌ\
cìnpioycd lviÌl gel a ne{' iob quicklt if lhey become uDetnplotcd there is Ìcss conìpc
ritl(ÌÌ arou..Ì for iob\. 1lÌot s'iìl cause cmpÌo-vers to raise wages aL the c!rrcnL ìev€1 oi
cmplor_nìcnt: tlÌe wrìì schcdule ríilL shitl up, .nd lh. ecÌullibrilrm Ìate of emfìornÌenl
wjìì iÌÌ colì se.Ìuen.c decliIÌc
On this argunÌeÌì1, a.lecÌlnc in aiai{regale cìeÍìand will Ìeducc thc e'Ìuilibrium rate oi
cmtloynìcnt. CoNeìselt an jncretse irÌ aSSregatc dcmard may brinia ba'k these djs
couÌaged woÌÌrers lnt{) tlÌe labouÍ nÌarkcL Ír that (hev activell scek iobs and increas€
competitll ion tor ernPÌovnÌ€nI
\{e look in this scction al anoiheÌ reason for hl'sLÊrcsis, the so_callecl insider oütsid'!
mo.]el. Ìhis ìs potcntìally a daniaerous model for ihc econonÌ}, sìnce unlìke the argu
ÌÌrcnt aLrotc, ìt n:ìy onÌ,v \{ort ln a downwad directìon. Declines in deÌnaod Ìnay r€du'€
cquilìlÌnìm cmpLo) Ìnent; in.rcase.ì d eIn a nd Ìna-v not incÌeasecqu!ìibrnrnì cmtloymcnt'
produci!Ìg a ratchetlng.l.J$IIn!'aÌds ef f€ct.
ln both this ar.l the nett sc.ljon {Iairnc* and n Range of lquiììbrìa), it ìs simPler l'
t]sc a ì1near Ììocìel otprcduct and ìabour maÌkets than the 1og lÌncar rÌÌodcÌ useclso ler'
wc ret this out iÌÌ 8 l with the union utìlily irnctio' Ll : xiei in sect(Ì ir in lhn and llrÈ
rcÌt sectior l$o diíleÌent n]odihcations of the utìlilt lunction are made but dre reí oi
thc model it unchangel Ìt is show in whlt follows that wìth Lt : n'i'r' thc nÌiel hai
the Íândard tropc{ies of a uni.Ìue €quilibürÌÌì lfdcpendent ot lhe history of aggregatÈ

8.1 Linear model of product and labour markets

'the produ.l demârd curve iÌÌ thc ith lector is no\r

/, = 1,1\ ,/t?, 1) (ì s.9s

(Note thal lhis nünr ti) tl, r'1.) lcllrand pÌicing (ì Ê each of lel) or
We shaÌl as\uÍìe
nroÌe pro{ìucers in cach sector scls Price eqrGìto nÌa.ginal cost)' tnd thallabour produc
tivity is unjtv. IleÌìc. in each sccloÌ

Pi=v'
and the dc mancì cu lve for labour Ìn tector iis

= À/N tlw' ll
'r
l-.r. .," õ lÈtlir r{1 r';.1 .r:ol Ì\r 'r'
u = ljrr€r
:"5eerh.,Ì)pêndixn,ilÌnrÌ4pl.Í11Ìihe1..Ìtsnol.fnLÌen.vnages.ltirrgh)6nnr'
 619

nìÌ)ìect lô libo!r !Lrmâ.d. ClÌoosnìil rr, nr nraxünizr tii iirl,N ,ìt!i l)r nnÌ)Ìies

rn rq!ilibriunr is benrrr

!,1,' Ì

8.2 The insider-outsider model

Ì. (.i,)n is (on(enre.ìorlv ibo!t ls .urr€ntl)- enÌ|lo) e.ì mcmbcrs: tor
this nì.l(leLrL. tÌre
eÌanpì( uÌÌi(ÌÌ Ì)oÌjrr ma) be ni.trtelt b) rÌrosc rü,r arf eÌìplo)rdj or thc u.ion rÌÌa!
bt foÌdrcd b! thosr Í'ho aie erÌ4no!eclr or it nìa! bc i hnt fLrms rÌegotjare lrirh rhosc Nlìo
arc.nrploled. Slrftosc.uÍrnt Énrplovmenr rn i is eÍr Hcn.c asnrxring ar bclt)rc thal
lhc u.ion.1Ì!o\es r tÌ\illne\erchoosea.ombìrìi(on ìr,.rrirÌ$hnh.i:..iorcr
a.oÌnbtrÌatnÌìlìr,.iirtrì\!hi.hl,_>!,,.Onlviiei-.,rwillitnì.LriÌnjre i,,Th(l5Lhc

Li - ír' fr -' ri
I ., j.)

Ìi i!e d\sumÉ drat lhc rest ol the nrÍìel ìr a\ if 8.I, llr c uf ton n'ill set ÌlirBes d\ tuÌlorÌs

Ìr,i = Ìi ri f, .d
u, I r/ r,r ., ' r.r

,\scâ!bese.fi. ig.15.1li,r i\giie.h!i.l(rse(tioÌÌoitheveÌticallilei =.Íìn.dlhr

lirbour.leÌna.L1r!N(.. : 1,N ,/ir, I lhu5úÌisleiìnedb\,.)=.1,\ Ìri!., ttt
nd ,i Lrrlçhcn.1 .1t,an.]r:n,, j\i.rplj.itLvdeÊìÌedÌ)r.r=lr \' Ìiinf Ì'
,\ndti=1lrh..1 1,
Nol! nìagjnc lh( .(onomÌ i\ inÌLirllÍ n rquilibriLrrÌi rt i1 ..1 iritìr 1 =.1r 'there
ìs iherÌ dn rLh..Ác dcm!Ì \ln)clJLhi.h rrdu.es -ì to lr. l]r(h \edoÌ i rhcn molrs to
1rr.rr,ì). lhì5is.orine!u]ÌìbÌnnnrnc.r,'J 1-.r,,ì SupÌ)osetheÌej\atositircslÌoct
1.) denìa.cÌ to lakc it to /lr Then. rhc iLlr uÌÌiorÌ i\ ont! jltere5te.Ì in ra 5i.g ( rirtlÌer
th.n tìlLdling.Ìì|lo\rrelt tt) jDoeaí: aborc f.,ì So jI\tea.l of mo\,ing uf r,rì1,r r..
thr r(ononìr nrolcs \rÌticalÌ] up r,Ì1'1r'oì 1lÌu! i1.dÌ0r js the ìrgr (ÌLlilibriLrnÌ jrÌ ihe
cc.trrcnnv: a.! ittcnÌpt to eÌpan.Ì d.:mi.d iLrúlìer Ìead\ n) ìrr1' .r I -. i,r'\
rr \,, rnr.Ììi,!L.xLd\nrìrìr tLÌ!3ririlllL[dLrcrr]n!!i.rrer ircsiri
620

Figure 15.16 I : 'r i. .Ltj il_ rr!.1

So nÌtlÌis i.lldrr orLt\Ller trôdtÌ, ilìirc \rÌri(hrlrnaÌ.rÌe!uilibriumenrplrtÌìent

\ (li.ÌúÌÊ nr iggÌrgi1r (lelìind ftrÌÌr dorrì (lLÌiiiL| L1.r cnÌrlo\ nÌrnLi btrt a nrLìs'LÌurÌrt
ìf.Ìrarc d!rs r1.t r(\1oÌ. th. oÌL!lnaL Le\ ll

9 Fairness and a range of equilibria

\ ,xther dirft'Ìent rtpn)e(h .rtrltifÌt rqLrillbÌì.1 \l( ms tÌom ìÌrÌrod'1'LnË the !o"clt oi
l1:)

'rirnr\\'irt()tnlfll]\.tLÌtji L! ittnrtir!Ì\' . (ìitc!s5 .! nri.Ìoi'LrrndiìLL'n\ o" Ìrri'Ìotc()

.omi(r Ìrc h:x r trrrn crreirLl Ln nnÌtr\ ü heL .r()Jl c.ononrirt\ i.Llc iì5 nnc (ú tlÌf Lolrch
iL.ne\ ol ralioneÌiit. Lhri ìÌ]dn ldtraÌ\ !re..n.cnrtd iìbrrut their ÌerL irr.onrer !ndÍhet
câ. be Lrought 1rìtlÌ ihL Ìn ir.l Lhc rÌÌÌ({rnl .l leìt!Ir Lhil tìr€) ÌÌa\t. LJLLI 1|ere it:1 Ông
rr LdrÌ(e botb honÌ pslrhoLlgi.el Ìt'eardì ..i lÌorÌÌ diì! L. tLr\ (n\er'iìLl'f ot h \ P'()
tÌrbehrt(.thrtLrosl.Iu\,ìÌLi.hehiilhimt.ÌlarÌcctob.iÌrSlÌerted iilílr'' Anl
lrÌrllc
rllmat Lrr lali jI Ì(\t iìncìÌ\,ì'. Lh.l L\ !eL!ionrL Ìrt olllÌc \\1)rkthle L.Ììì nr'1' obttn itl'n
lusseit\ lhet nüÌ\ trrÌrp5.r.!l,eìÌÌ)LDtr.!he.orÌn'.on.rÌ.ed.e\rni'gtred iirhrt
\eeihrllhc-rareLrrìfgL!irtcdÌ.:\sNeÌÌthin()Lherlirnlir.nìIl!reei lilhcÌjÌrtlrrsanr
nrnl or c s.Í het 5p(!nliìlh , Llìat the\ rn',ì.Ìt (on.rì'.cd LLi r\.i.1Ì).nìg prLd l*\ 1lÌi'
r \inriLar gnrLrÌr ot sorÌicb eLsrÍìr.re tharÌ 1lr hr Ìraìl.L.,r'ri'Ìro..ìjn! rÌÌÌ.!nL nrorttlÌir'
rheu Lh. L.jurti.r'.l.loirrgÍ1)Ì\c1\otnì.('.orÌ\Èqu....11ìr.tlìepIis{1Ìcoi!ioirì.{
betÌrr t|.f r gr{ìt !l !Lnìihr r..}ier' hÌ tlì( rtftÌ\[]i. Ìic !tr\cnt tlìe Êiiì. cnc\ ÍrAe
D()rlel ol lrist \etÌiÌì! ln I hì.h .on\ideraiuì! oÌ :ainrt\ pr.\ ldr rhÉ DÍ)ti\,rtiÒ' l(Ì on'
rÌas\oi\u.bmo!l(15.1ìrriÊlsunìiìrnúrls.ft\i(lelthrr'rlthtcÌnliri(JlL\'ir'(e(Ìr
tÌÌr.oli nI eLnei..fsL!l.r.rllons L. \ dS! \r1ìinS
lÌìrprtnìrt \ lllìrtÌ(ar ll{r!0r ilirdror.h(n\ilriti)|colbchlir\rr.n. l1a.ìn)r

rr L,ÈlitniLf,,,:rnr,!rri..l!LiÌLi:r(l rrrri!,rl.rrìr\ì.51r! d?ÌiÌ!r'L:rrrrjiÉ\rd1ll!tL ì:

\r!L).nii:.1\l.liirl'llt!ì..lrii. lr'rrlfrr È!1Ì'rrL!rr. LllLrÌtr.1:i:rt lf;.rlrrr:l'' rIr_L
i,,;idrF ,. .Lr,t,lL.ì.rIi ìÌ,r!1..!! 11,,,, !!,j:..r.i fì itL)n:L..rr r ì tr:hr rrr-J. ."lrr'1ú
 621

Figure 15,17 irr.liÊr ì. !err:.r,.i\r:h

9.1 The Bhaskar fairness model

No$irr(lsfthemollflolliÌtosetoultÌrrtÌh.\k.rÌrrsument.trft.qrLjrr\dreDìo.ìill.alil!Ì

(ìÌeÌe,j af.sitive conttrnt. _lhccriti(al5econd reÌnr rheL i5 nddiltto the utiÌilJ ]uncti.Ìr,
is
.j(Ìrr ! r. is lhr trìinieí teÌm. Ìn pirtiNlaÌ. i. line Í irh Llrc dis.!$jdr ab.\a:, this sa\5:
Ì!hen rÌoÌkÜ! iìre gettiDg rt l.asl iìs hiilh a ÌÌage as comtarablc !r!ut)s. ihejr o.Ìrcon.enr
is to nìariÌìizc theìÌ ÌerÌ j..omc, LÌlt it tìrev gettjfg â lonrr Ì\'age. i.e. it | . rÌ tlÌrn
theiÌ utiÌj1r ìclel ìt Ìeduce{Ì b! iJií, rrt. Trpi.aÌ shaf.r oI lhc jrxulterence cuNrs .re
n(ni'n in ia.t.t l;.The.ofLlnuousiÌ ìllertn.ÈcuÌl.csâssrLnÌ!ilÌereis oteÌÌ.65Lcrm.
'lhatìr.oúLctatrorethcÌ horiTont.ìt liÌÌe Butwhenrr,. ( bcloí tlie h(ÌizontaÌti.r.
UÌe indiiÍ!.( o.e cuÌre n01! s1!iL.ÌÌcs to the .lotted ÌÌnc. Th s is bc.n!!e (.ÌnÌreÌrsarion is
rÌeeded L. Ìrile uÌr n)r LhÈ fr\'ch.lo8icaL con ol the trnlaimcss.
\\earsúDrcthatdlltecr({stÌ.ctltÌìeithbeha\ei.ieÌìti.aÌÌvThcnsin.eli Ì1I.theftral
ÌÌase = Ì nnd ìs nì(trÌ. in Iig l5ÌSirtther"'5.he.tuìe.Thcslolrolca.hn iiJercn.c
(uìrelh.:(Iore(hrn{e\rsrhrcrLnc.!t\theìrr"hoÌi7o.LalÌinc.,a.hiÌxtilrer€nce.urrc
rh. Ìinc (hrn ir har bcÌo$ the Ìinc.
hds n 5Lc.pcÍ slot)e abole
'lherlhúnioÌìchooresrhúfonLonÉ.ìclÌ.lemeÌìclcurvcrt)Ìcâ.hLhelÌislÌe\tnÌdìfteÍ:rcr
cLìn e. Lt lo no$ drat has bccn stri]ighiir)r!âÌ(]r ú Ìs rrhcÌc thc d,:Ìr.uÌd cuÌye is râ.g( nt
to thc h gÌrcn iÌrìití.Ìrn.c .rÍ!c. llhere .ìenrand is r.:N Ìor!, ,rs .t .1 ,. N thÈ. rh(( is
Do trìt.rì ,rbout thi\ ftrÌnrúli sirc.lor l{ff en.ugh dcmind rhc denÌanct cúÌrc r. ll b.
tangentLâÌ L. tlìr'laìnre5r'faÍ ol lhr indüleÌence cuic, i.c.lhc piìrr rlÌeÌe ((rr\Ld.ÌaLions
ol lajme* ârc inclLded rrl fq(riìlly 1rhen.ìe.raÌr.ìjrrcl) ]rtgh.\ar.1r N rÌre(1.iÌand
.uÌre $ jlÌbc taiÌlentiaÌnr the n.f-inilÌei\'5ÈcÌìon oirhr: in.liilcrriÌfe cüre.Ìrri.
luta\ d.mJnd i\trogÌÈrsú clrlf cr!.ìsed{bo\ e 1o. N jt.rcnru.ll\ reichÉ\Iprjrl sr rlÌ
.ìs i ÌÌhen d!:m.rÌú i5 l L. ,r Atd LÌrc.le Ìa.dcunejtstll LinscntiaL to rhe f.Ìjrncsr pal1
oi the indi Í!(n.e er\e (ir l buL Ìr.ralse r = Ìr = l, th. tid if.renre crNÈ j\ xr a k nt
atthetoi.l 1henoÌrÈo Lhclnd lfcrence curÈ is equâl lothcdenÌrD.lcurch.loNtlÌe
rr|i lire, brrl i\ irÌerter rhilr rhil ÒftlÌe demân.1 cur.r! âbo!( ti. ft cürÌ holrc\ o bc rk.rLÌ
seer thet thc.hoi(eol| =r'-Im.ì\imizr!tbcu.Lons!tilit\.Sì(erhci,agcÍrriÌÌ!
 ,i'= ,t

figurê 15.18 Fàrn.s . Ìhe uÌ ty irn{Ì ón: à ranqc oi eíipl.vment equ rbf n

rcaÌ wage is lhe *rÌìc as Lhe pice \etting reâl \L.ge at d this is ân equjìÌbrúm lor thc

As cìeÌnand increascs, fd instanceto.4z,lN, w, 'ìr= l remains tlÌe optì m um ivage fo r

the union, even though as can be sccn rt b the dcmand cune is tangcnlìaÌ to neithcÌ
tecbr of thc ln.liffercnce curve (nrl Nhich iust to(r.hcs lhe demand cún'c: the tìirncss
ílower) pan olthe iÌìdiffeÌence cu ,e has â tÌatter slopc than the .]emârd ruÌle, and thc
non faìrncss (ufp€r)paÌthas a highersloPe But lrìs also an e.ÌuiliìrÌiuÌn oI lhe econ.ìml
sìnce herc Loo the bargaiDed Ìeal \ragc ls e!Ìual to the prÌcc-sct Ìeal wage
ContúÌrc increâsìng demand untiÌl/N:.1r1N ,\tthispoint,. the ncw demând
crìrve is langentiâl to rhe uPper p.rt ol the itÌclilferen.€ cúNe, but not the Ìoslcr llatter
paú. Hcrc agaitÌ wc are in eLÌuilibrilnl. Ììr tìct w€irre ir cquihbìnìm at nÌl Lhe toÌÌt\
Ì)etween d, rlhiclÌ nìaÌks the st:ìú oi lhe Ìtnge ol elnpÌoynrcnt e.Ìuilibriâ and ., whi.h

'Ìhc wrr\ c!e lhcÌeiare has tlìrec s.8ments. Ìhe rrppcr and l(Ner segmcnls aÌe not
equilibrìa, hut ea.h fonrt on the horÌzot tâl 5egmelÍ is. lnlcÌcsti.3 question is there
lore:s'hat ìi the lcngth olthe Ìa ^n
ilc oI.quiÌibria, the highcsl cquiìibÌturÌÌ en]plo,\/meni
Ì:Lte and !he Ì{níeÍ?
'lo a nÍler this qucsti{ü we neeLl to dcÌive the three \egnìen( 1rr1'rsche.lule mathcnìati
.ill,v lheunionmaxinrlzesLl: nie, Iiw, B'lsubjectto€, l,/N ,/(i!, il tÌÌ€labouÌ
deÌÌran.Ìeqration,ihenÌ!,.:wandÌtmaximize!UJ-tr.rsubicc!1oci=.4rrN,/(Ìt. I
Ì\'hcn s,, : . It ls s jnrple\t to sol\,e this in thÌee stag€s.
l,lrsr, rle cln t\'oÌk out irÌnÌediâtelv tlìc segmelrtâbole 1t Ì. In lhis segrÌÌelÌt , is tot
rcÌcvant í $e harc tÌ1e same problcrn ai in 8.1 lthe \imple basic modcl) As $esaÌ\'1hcrt.
ìn this segmentthc IVS jchedule is
 623

Th.sec.n.lselDc.tr'É.tcrilti\tìraLlDthrl{,ltbeltrrr =Ì thrúr.)ijrniraLjon((rrdlio!

tlL)
i,, =iI\ Ìì tri iI rl ,j-., rrÌL .ì 0

n h j.h xrpÌ cs l(Ì tÌr. lor er pfft.itÌr! Ì15 sch(.lule:

1\'r fon tüüì n) rh. l)iÌizô.lil \egnr..t Ih. !ppeÌ a.LÌ loner
Ì)!jfls .i tÌris r.rÌi{e oi
eq(llibria !a. rÌ()Ìr hc ra\jÌr rr..ted !(L ÌetrfprrfoìÌìrjsLh.liÌnjLi.gl(trvÈ\LtoiÌúo.
thr Ì lrhtutjri i nopiÌrg Í:g.ìÉÌÌt, rhrrÌrr = r, 1. e.(.(,

l=
Th. lo$eÌfoiÌÌt j\ Llì. liD Ltn! lÌjshesl fliÌrt on thÈ ÌeiÌ utrr d\ slot n{ \ernr..l, trhen

1-r Ìi i=.ì ,r i.

'hu\ ÌrL hr\e th. jirìtìc irÌd ìÌtr1Ìj1ilr r.!suìL lhrtuìrra.gcoirnÌÌrtor.nnteqrjì bri.i

,anre.fl ,i i\cq!,ìln)rh.urÌirueeq'r tjbÌiumrmflo\nre.triLriÌrthcbistcnÌodcl !n

ntLiìtl Llcj\nr.dfL.thci!ihoitie!..niÌ\Ìce5f.qÂresrtc(Ì.:.riìndl)crrr.lni,rnd.i.
(iU!)uli..rearjn{rhrr.ì1.Ò irúhú)f .rlo
ÌÌr1 liÌr. lerr!r!.r)ojc\d.rn.j!ìli\nreLl.d
Lo a(hicrr 1hr h glì rrtìì(,r thiÌì rlÌÉ ltri iÌrd oi Llìr. r,Ìrsr iirh...lÌÌomy is iÌi,,erred h, il
11t!iiir. dcnÌa.iÌ sÌìn( lr

10 Conclusions
nnr.i.nüte(ìmnrm.| oiLh.lrlrnne.r. Ì!(tolor r.JìQttìrrl h.re
SrctioÌr Ì set\nLLL
lhr\c.oLì([dj.{ reDrrls,Lrc rì]il trr jer ij the !r.rt si!Ì.ih(rrt Ìr,slrlr\ ()r rÌrc \t\!
(e\.t! in rptÌ.iÌ.h. TÌìr axrl\rj\ i. ilÌjs.lr.fter oiiÉÌ\ af irÌteÌÌrtLitiorÌ.a Ì!h! e
íÌiSIi .ìpert.r.ltil 1ìu.i!rti.11s {o bÉ !ÌoÌc rÈrtraiÌìrLÌ Llìiìn ìÌr iht lijt. tìro Lnstjíl
ti'rrrÌ dla rlqrD.iir !Ì. rr]t\ d|r: 1lìr. jrÌ.r en.cd .r(cei .l Ìro!jehot.l\ L! (reltrr âni tlÌe
ürìr:g.f.c oJ nr 1r,ì(ì 1..)ljÌrs cÈ.r.i brnts. \\re|:Nrsrrn rlÌrÌcrf tbeaDL lLrâr !

.üÌtrrÌhanlIrjÌl..iìrrl!n,ìÌ)ilirclhri(o.()nr1 ir u.e\ sLiÌriljrirÌg b.lìLìrì(üÌhrtÌo!jÉ

624::
away Èonr bubbÌe phcnomena, which mavbe irelled in morc h ìghly .level.Jped l.:..

The idca that markcls wìlì not autoÌÌìalically Produce th. slâbiìizjng iÌÌteresl ri::
exaÍìple, bccause of inlornratidr ilurcs (.ìiscrìssed tìrthff in Chapter 8), ÌÌìcan' :i
ir a írle Íor macro€.o.omic policy. lhc (te plaled bl n loittard ìooknìg oplLr:::
cenüal birnk ìn coordlnaling private seclotexpectatiolls is qltjtc coÌÌsisteÌÌt !tith fit...
.liagrÌosis ot rlhv nìacroeconomi. polic-\' is needed lhc sccond therÌe ol tÌrc..::
aìí) echo€s KcyneJs nnal)sì\: once thc Nen KeyrÌesi.n miffo[outdations arc fL:
tìace the rl:ìclance ol lltrctlrations in nggregate deÍì.nd as a souÌ.e of tÌ!ctLratr
-
ând persìslcrce of urcmPìo)ìÌe t gaiÌrs conslderablv Ln importance llucluet.:
.Ìemand.an dÌ1ve b! sì ness .-vcles, âdjuíÌìent tracktoequiÌlbrjum ma) be prolra.iç-'
muÌt\Íe equjììbÌia duc to entÌy behâviour, hlneresis, or to taiÌtesJ consideralio.:
that the c.onomv can get stxcl with high Lì erÌìplo-tmc.t llithout associaleLì :'

Iìnally (,c Ìnighi ask: are theÌe lLurdanrentrl dilfercnccs tith the n.ocÌitsi... :

âptiorch or oìrlv ÌÌÌinor (mesl Her€ thc an$!€r is: it aÌl depend\' The .:)1Ì l ntr!:. :

IÈÌence! bc$\'cen the Ncw Kevnelian âplìoach ind Rtlll theoÌy aÌe the Nc(' KÈr::
issumptiors olimperic.LconrpetitioÌÌ andwrgeâlld prlccslìckine$ Other('iscth.,
rueoltÌì.nrodelsisinlttinciplesiÍìilar.LventlìeelnphasisofRBCÌnodclso.f::
úvit-v nÌocLs can be .aíìed ìDto Nes' Kc-Ínesian nÌodcls Bul in tenn\ of praclic.l :
makirÌg Ìhc tiro approachesaÍe larirpart REC theorl, bv astum rS perftc1coml.
ancì !Ìorlcìling clcli\ as e.luiÌibiiu phcnonÌena inÌplics .o ntnruous optlnliìú\.
nìles out a stabiÌL.tjon Ite lo! nÌacroc.onomic po1i.v.

PROBLEÍúS

QUISllON A. AsuÌÌrc h oureh okl! 1i\'c lo r t opeliods,pernrds0and I TheirulL::

gi!eÌÌ b)':

h. t)- 1 I b.
u t. a.i t". r +r,l,' ,,ì .ci )
In peiod r-),1hcl can choosc to sale Srì ând lhis incÌcrser th eir iÌicoÌne lr pctiod
i1 ! rì51 hc reaÌi!.gc ÌJr pcÌiod iì\ ,i.

(d) A$unÌeÌf. = wÌ = i and,' /,. li) ì:nrd i,.rì.er.€, ílll ShoÍ'thrt.t0 : O \\ Ì:

lir :a 5 * 14andexpìartrìre5i8ns'
í11) Nowlet , - ìi. whcÌt .ìi is (eroseno unv given ) labou r Prod!.tn'it-v in terif-'
,\istrme ì0 - À :. I rnd ìr : 1: Go I'c.an thinl of th€re benìg a onc_pcÌjr{ì .
pfoductiritt shocknr peÌiod 1).1fr = ,, hoi{ does this rlìectconsumption a:l
cÌìplovDÌent lf both peÌìodt ând thc lclel of sa\'ìniis itÌpertud 1.
( ) WlÌiìt il,\i :,\ ard Ì r (Assume tlÌat both ìs arc Lnown in a.t\ ance.)
i'7) AssuÌneÌf0 r'j:landil
^i rl,1(l+rJ:.1.FìDCìrr,.r..0..Ì.wlÌalislhe\!.:
Jo jÍ(ì) 1> l alìd(ìì) i - 11
 : 625

qllS llON B.In cach inrllútÌv,;. thc uliÌlty iìncti(nr ol a Í'orkcr is Ìr,., AÌÌirorkcrsüÌ i
rre jrlhc /th unìon and the unn)n maxirnize\ Ì!,r,. The unio. scts a nìonopoìy (,ag€, ÌrÌ
Lnlhcithi chbtÌI r'lìose denr an.l .u Nc is given b) 1.,: A/, (jrl,2)pi. $heÌc,,1Ìs
iggrcgat! demandãnd, i\ the nunrbcroíìdenticaÌ indusLrics.

{j) l h€re is BeÌtrand comÌretìtio. i. llÌc iÌÌdrìstÌy s.) tharrr = 11,i,/.\ Ìlhere ì Ìs ìabour
productilllv. (So r,ì : tj.l DeriÍc the ith unnrr's nagc bargaiÌìüìg cuNc 5hosrirÌg
lhe $age ì riìÌ set â\ a timcrirrr olcmplo)nrent iD thc ilh jnduÍr).
1ii) StìÌl aisunìiÌìg BeÌtÌand .oÌÌÌpetltidì, Ì{hatìs thr equilibrjum emptornìent rate ìn
the econonìyl Ihsr {tocs it châ geilì increises?
liii) I
^ssunÌe.\:
Ì\'ell ^ndnowasumcLhcrcisamonopoìvÌrroduccrlnea(hin.Ìusrry,as
as amonopol) LüììoÌr:deÌú c thc rnion\ wase baÌsainins cur\e an.ìthe
cq!iljbrium cmployment ìate.
QLr151ÌON C. In Lhc J equatìon ÌnodcÌ, Ìr is e\cess deìÌand jn pcÌiod L r is the rate ot
inlrrest, i\ is th. rnt€ oljlreÌett which implies Ì: 0. and ihe targú irÍÌati.Jn rate 1s 7.ro.
I he econonrr ii dcscribe.l bv

1r= Írr I ,i)

rr=nr i lÌr

l.pcrìod1= 1.Í L 0.a Ì=0an.lr r:/\^ssume rj 0.

1 I e ;r : 2 (iül.rion íìocL). Iin.l thc lalucs of Í, I and, Ì irr peÌl(xls
^ssu
I 1.. .. 5. F.xplaintlÌe econoDricintuÌLion b.hÌnd _rourderivatlons.
1ii) NowassLrnìeth,rtÍ0:OandtharthcreisaDaiigÌegate.leman.lshockjnr Lìl
ÌeUeclcd in aÌÌ irÌcrease in /s lrom /r Otorjo=2.(d)lxpÌaìnwhyadcnandshock
incÌeascst (r) Fir.Ìthc\ialucsol í,Ì and ? I in peijocìs I : I .... 5 Againcxplain
the cconomic intuition behjnd torLr d.ri!dtidrs.

QLTESTÌON lr. Norr assnÌc a lorsriìrd ÌookìrÌg/s cu (4 I fs) as lvell as

rhe ììhiìììps culveâncìì,fi uscd in qucstion C. A$unre tÌÌatr L = ,j = 0. ro rlÌnt

\onaslLrmc nninUation shocli in periL{10,

)
 jn
Househoìdscanatrkoui,oncethc] knowlhe2llo jnflatjonshock I - O lhatiheCB
wìll râisc rr and hcnce rcducerr. \\oÌk out (he enacl ctfect ofthÌs on aú ând cxpÌâin the

ìntuition hehind vour dcúvttion.

' ÀPPENDIX: EFtICIENCY WAGEs

l!e no{ ...sidcr a qtrifu dirÍererhr.l Òr settint *age!: it Ìs âsrnerlÌltâi t'n! \ll thÈ rtgcs !r Lheir

enrpL!ìv((\.rpotcniiaL.nÌÌt.Iecs lfalinnirnL.fositilrÌ's€trvag6 trhvshouldÍÌ{anltorttantgc

au'c ire minurun at 'rrrich ìl (if hire lrbolr úonÌ iÌre nrark'Ì? the anÍld ir iììal lor fìanI hÌnb
sn8r setrirS í.rìd Lelr.Íd 5.ÌtüB m.re gerÚalll) is a Ìe-t inltnr!!ìì t in mniÌÍâ ning | Ìrt!l
qrililìtd
rrLi coopcrrr ve wxrt! rce ua.agemert Ìr\ tb.oll rerÊr to tlÌc fr] emj of nr tlÍation nnenüor' Ia'd
Íâgú rè bl cmfl.!€!5 o a'ldrc$ th'se pnntcrr, lhn n !li(' reÌeÍcd t' as
r(úilmúLt UrÌror s€r
tfn.ieÌ1.! rage\ctling lh.6íÌ chooJcs Lhe w.ll. üìrÌ b .Í''i"r 1ÌÌ t!r' s Ôl ils 'ontrjbúrnm t(i s'ÌvìÌr8
rììÊ lìÌm'r pítrLenÌJ.leto( tre nro!irÌ dÈraiLrÌho\'thì\iJd.rre r{e \lÌ'll iniLiaLllron!d€1hoÌ\
ellr'Len'l
iragc sctiL.gdìffc( lun Nhat (r hive doÌ1c bcío'e
wâs duivtd lÍ' Ìn PÌoit Ììaaimizjng behrvi'nÍ
'l:o Ìlì is
lr.nÌt, " e haÌ ( h ad n prÌ.e se tlit18 e! uation tÌìât
ly,4nrsanrla,rage srnlngcq!!h.ndeÌn!d ftonÌthcrtiLity nÌlìinìl7in! Lrchali'tr! olr't"r LhÌÌ!ith
n+ *uno t* tt'it fi dìi \d l.tr pr ì..s .nd Nr86 Íì ls ('Ìks ni ih€ l'lld\ iÌìil wâvr thr ltm
"il.. ^r,-"
ni{imi;r!pÍnil\{irlìrerP(.lb.thtotÌrcf.icearat'lhro'BeÀsbli'trcthÊpÌi'c'istl]erchlivepì'c
0r |Jrrì;ndth!Ìtagr';slheierlw.BelLlj:ÌfiPlìi.rhenÌDc)Ì\rgejnrh!naìtÔírrlariveloth! res!(t
areragtp'lce Lrvel,n Lrrc corxìÌÌ lheJir5t! er'onljtrÒn 1lìatÌcsrìt\ lronÌm'rrnìi2in!Ìrnh
L.Ìh(ir;l.elc'el (holdt,g Lh0 1rìil. ..nstart) is tÌr.f it' ÍlÌr'J lhc irsrÒider'o'dirnrnÌlrôr
'4rnli"
ÌrnrlÍ l.oDr na\imiznìil with rsfect t. Ìlr. \tage ílìÒÌdjng thc f i'e le{l (onÍanll is the $"r{? Í1rnf
1{ilh LìliÌr monofôLtlÌic .g and Ì(Íú..1PÌi.L'g, th! pri'e setljng quarion\ th't tnìergc tÌlnì the
dral m.rinrizrÌio. I'o.cdur€ lDaanniring rrìÌn resjrc't toloïh the (lltjve PÍi'e an' iÌìe Led Ì\ageJ ar'
identi.aÌtolhcpÌi;srÌrnìge.Ìuation5derilrlibÔveLlÌÍelathepú!rlìellrm'hrrllesrirPÌ!P!dl'nal
to rhe Êa! (.ge ir thc rirm (or s(i.r, w l. lhe .ar( Òr se.türl nìÔpoL-r pÌi'iÌìg, thc Prce settìÌril
cqlitionist -r,iÌì llrir)jfliÍmk!{.t.r)i $]nh BeÍÌrd pri'ìfg, th' pÌjce s€ttin3 eiualnrnir
rnplyp,:",'.rIotÌrrcmtriÌìlrueinthc..ntextolrneeLlìci.ÌÌ!lÌ\ajlenìolcl
Thclilr€í€nccbfs\enr núrlr{nluni.n and (ri.ien(v w.llc seLLjng b! rÌì' níÌ alpd^ i' thtìra8È
s€ttiÌr3 qralior T. thir!.int. trnilr bas€d \nilc settiÌÌ8 iÌìpìied a(n8! Jerling equltiÒ'
olthc nÍm
u, : r.i. r, rn" sc.lu.âl (al1!age is â nnr.Li{ìÌ ol tìre Ènlfl'vment dLe iÌr thc Í-'tor' ÌloÌ\ev€"
"n"r"l-r,
ohcn llÌms rel:n etílienc-ì lv.ilc, iÌret i( ol 50 mu.lì i'tere\t'd irr the 'eaL NrBr iÌre-t sct fÚ lheir
eÌìflo,rc$ is Njth lÌÒw rhc ÌlaAe tbel slt.onrf es ìriih alemgc \vages rÒÍ eDPÌo)ees el\$vhrre ln thc
ê.ân. r TherersltnLhâtitnrÌrerehÌivcÌlaÂetrirrlhalisr r rcÌetan t lì! n!Ìirârnrn ('miimeDt
andÌ.te;ìiiôn.lloBhightlìrrelatitew.il..€€tl\totJeluse.urcÌÌÌe!ÒâkolnotÌ!ari'n itcruilnìenl'iÌ1d
r€tc.Ìjon deprndr rertxru.h on th( Íare olÌhr o\e.âlLlabour tìaÍket' ltlhe Òve'aLLemploÍnìent ÌaÌr '
ì!Ìcryhigh,rh(ntriÌt$lllneedtob.lìighrloÌ\!LLhl{ÁurÌìpl'-vD0ntitìvillbeea\yfún'rkrnr
Ìcoeanriìrdtor*ersc'.]rcrcilÌlÌevrlìlnkthclrrneâlrü)kBuiilthrLrlniuímaikctisdelresrd(l'Ìt
.l iÌr€n tìnrrslrilÌ ticl sê.!Ìc tl!tiÌreIhìll roÌ l.se Norlcr andwill bcible l' recNitth€woÌlcÉ tlìe-t
\rant(itn l(NeÌ rclaii!€(n!cs Th!\atlr.n in the sÍnfle iì.r1cLsÌhat Ì!eshall lcÌUÒ1, th0tldrie"l
wâgr srtiingeqÌ.tdn l !etheLrmwÌ.rÌf ll.r.
Ìhn diLÌiÌo(e in the l.nì ot Ìhr \vage setÌnrg eqratìon Ì{lÌen we nÚve Ironr L'ion nr Érnì wãgt
srtí.ghâs ar rÌìPÍari imPlnrton f.. Lhecquilib.iumcmplovnìenLÌâtr' tìut nÒt l'rúrc!úiÌ bÌium
(âì (âgc AsheloLc tÌìÈequilib nn Íenrâin\ Ìniltd'tennined lì! lÌrÈ fri'e \'tting eqrrti!n
'eâLrÌril'
Fô. erantÌe, a$uDrc 1tÊ hâv( tu.n ôfoliÍi( Pr.e settìÌÌilnr ea'h s€cldso

L!
!lLe (]B

''l

Figure 15,19 Eií.. r.v Nr;,1. sÊLt Ìj

irÌeiÈ.1Ìroih!\Ìfueierrirì3r!nr,(ìuÌlÌünnnÌeqúircsLharÌelatnefr.Èsrr(rNrltoti!.

lr!

Ln otl]0r rf.,d!. Lrt\,((Ìn. Lìl 1lr\ rage iÈlLi.N ri((i fl.fr rlir ti(r ltttiÌÌ8.qulúlr Liererìines
tlÌ( rqriljbilunr.eâ rrUr. lhrirnnrrìinlii l5.l!:rlr((JJÌi!e!ÌrrÌiB(urÌr!!DfrÌtc(rânda.d
nì,,.!)rd\ !n.iÌrg aÌe ih.rf .
\!ÈtÌ,nLr!Ì!ir)lheÊqLLiliÌrÌiuíLr rÌrL,ÌrÌ.nt Ì1t0. Ì\'ilh rrrrrrlúge !etr ng tr r.,fuif r(riliL)

tl
ÌiI.,=nl

,,.=1=.\! l
lhji nìeani Lhrt ii drr rquiLibriLLnr r.al iag{..ilr !ÌÌrn!.r Ì r[ì., thr rq!ilibÌirLm emtt.!mdìr mr. rill
nÌt xith.ÍJ.,.r.r \r3r \rttìÌrg tlrÌr i! n. Ldr!er Lírrr rhr ndB. lltrjn! rqurtÌon noÌr til€r thÊ nnì

[quiLhnrfrrrqrÌrrsl]rat,elrfÌ,úrNr\Jrr\nilt.i llthatrlai..rrÌìe.r\È.iÌrrrSrlcÌrliÌr0r.h
hÌDr{rldbeiÜorrorlr.LdrLherrÈ.rA.l.ÌrlH!n!!,f Ìr I }..[o]..nle.'e..(,1.i!rr$rnr
628 , ::. ,ii.i.

'lhisÌnÊansÌlÌJi.hang(5inúrcfúrmetcrÒfrììetÌi.rseLtinl!qualjdrhrveroellecL'nlÌìeÈquilibÌiu ì
cnrpì.vnìcnlrâie lÌ1;rrerrvotls, inthrriri.ienc) lrJgÊmodel tlìeÊquiliLÌiunìÈDllqnÌenirat0bixed
(tr ú is in thc nìÒ"Pl} uniÒ' nrolcll t! thc
lu;ell by iÌì€{rg( setrin!.1,r'e Lhc Éal \vâ8c is li\€d
Ì. Ì__i8. I 5 M, tlÌ( lo\!er shNs Ììì e $agr sctti ng eqtrrtÌo' wiüì wr,iR Ô' thr
ì,,1* r"',i',A -,* LìareÌ
rerricaLarlslrrccqrlriLtunemplllnìÈntíteÌ5dÍ)wrbllheinÌtÍc'tionoJthcÌriltr':ÌÌL'euiÌlÌ
LÌÌe S.nÍ!ertuiiibrnrnrinthrt..noDliralìnrÌlieloNer!'r'lândatrnitììeutP(rÌraneLintÌt
', 1i
ry inlrodÌi(i.g et1ì.ren.) Ìlage settìrB,.ne rolÌÌlion ir fr"lderl Ì! the frodu'nviiv Puz" dn
errd in ahi|ter 1. IjnrltÌ efll.ieÌÌ(! üage srÌlj'g, oÌÌll ine t4/S 'tr! n ielcÌlrt tÔ Lhc d'ieml ni
natnrn ol lquìlibÌnn emfl.-vrlnÌ A.hangr i' frodu'ln'il) hàs no ell€ct on tne WS
'uÍ!€Núh
hen.e, iÌr dìn DroacÌ,.n ciÌ,iljbÌnnr emtÌovú.n1. Ìì.n!ert!' thc rcJÌ I'age niFs ÌÍ'lroÍio'itel-t

' lÌrtÌ!'eli.ì!r.vsagrnÌnlrL.fí.dúcln'it!BrÔhthiÍfÈ't\ÌralÌ\igesbuÌn!tLrquilibrnnf

Efi i.iency wages and motivation

ì.J.,rÌerustu rtor{Ìire.ta.altrì\ofctri.ienclÌ{igesetliÌìgÌnthissulÍectionwrâ$1ÚìcthiÌelJici'nrl
wagesdtnìgis.onnrined\virìmorolJ.ìtfri.cielling lneachottlìrÌlìrcecâs6 n'Ln âiirnì 'j 'e terti!t I
lhe bAi. stÍtlLrre.lthc Irnìfs pÌorìem ì\ lnrilar 1hr lÌtr hõ lo
(ÌÌo'se lhr pri'e
.ri
'"-"i,-.u
lclrlt a.dÌh( ('age lc\.Ì s, to nìariiìizt frnlLs

Thir ìs tÌ{. .onnÍaint\: dnt, is beto( tììereis i .'nìt.titior'Òr nrar(ctÌru'tLLr ron\lÍaiú

nìbi!'.1 to
rhatdcÈÌìdsorthe|ri(rlti.gmodeÌ\'earcrsinSÌntÌìe'âreofthrnìÔ"Pl-rinr'1hi\ì!dÌefÚduct

TÒthisponì1.Lh0s(Ò.dconskâinttâ(cab!LhelìnnsarthrpÚdüctnÌrnm'tnrncon\ttuni'':)'/r'
\vheÌcrjslahourpodrrtiÌriI cthlf nnnütÌrÌr.Ì rhG conJtrai't jn th! plohtobl{tÌ!' r' get

-r = l,l, n',1, r '\

(Ìr(È moú.úi,nì. re.nfnnert...{l rel€nti!n â.e irtrrdu.e.l. lhiÌr3s r'e not so !nìpl€ be(tr!Je the
'' ''.1{
lve brgrì r'ith motirali{ìì.  r'ôrkeÌ's Ptudúcti! ìÌv . ÔN rnÌt'lee ì\
.lelcrdi on how moÌnated Lhc
ronorlhardrnlrlfe.lncÌ!,ôrasitissonìeLinÌ6crÌrÍescdtoe\edelÌirtloÌ\inrpli'it)Ì\Èa$uìrc
0rattlrÒ1úttrtoJnìe$orlo,ÌabourPaüLLctivitl,iseqrrlirìlìnÒÍherNrtniÌionUrh'tdctermìÌtrl
Ì1oÌr?The a$unniion mrde in ntlì r)f th€ etlì.Ìcf.t NrSr lircrâr!Ìe is thrÌ rt de|€nds on 1Ììe nagcrl(
en,fLotc.isB.tlinginÌÌìêllrnronìfr.edloN|atheornìr\'ÒtrÌdbelilclvl'.?eLel\rwlÌcÍeieonw,ltr'
*'here,r Ls tle rverr3c fage clJeÌlheie lt allrde|emlr o. Lhe slâfu !tÌlìe laìrourm'rl'r and lrolr Ìdrg
ii$ould rìlie kr ntrd. iob otls de thi! car lre nLnìúln7ed b] thr e(on'nrl wid! enìll'-lnÌcnÌ Ìiie '
'Ìhcl1Ìilher sniiìr,tlrenorc5ârnliedthc( ìPl.ttc\villhPsìihihr'uÍenLlúm andtheLo(rrÌs' Lhe
po!(r rhe strfu ol lhe cxtcnìallabonr frarkel rl! the nor ratiíled tÌre $Ìplotee' Ihr 'r!rnìfln!Ì
th(r Ì\ LÌrat.\, = ì1h, rn, rl: andth.tan in.relsciÌì | rtr hi\ d foritn'ecttc(lon -\ al
his:.€satn!.rLectorrJ
 629

Ì\Jhr nì.r ll rÌÌtlr)r :.i r\l)!hL nÌ úr! Mri, l he.r Jr ( rrr. .rpl.nriionj ]d úì ji e [1,. Ìr.jt .Lrr ! !m
r{.,l,i'r.íiÍÀ,/,Jì]ir ()neitaf\\.hi)l!sirillrtllnaLi.n,dÈi.rihedÌJÌÁliuÌoJr\a{rÊ.!.rrr,tì..:rtrÌ
eÍeirrÌÌÌitrnu,.l\ t! d:r enrtl.r.. ia\i.3nrlÌrÌt.ll: rh s tiíÌ r.eaL! dLr \rlìrift0 nrtNagr \rtirr
thÈlÈ\rl !thu li,irt n,f ,ll fl De: s. ÌriLl írÌJ!rl Ìntlir.1bIlL.rlii.gÌrrÍÌ
!/ìdtr, -ni!liiz I ririrrrr,ìú,,r/ lhcre..nd ellJ(jn.Ìion is btr{d o. |!.er rìLj...l Llhr\nru ifd
it ÌeLlei.n rnlrÍ.hrlr .r nr L. rÌ!Ìr tÌe.ire, .. rlrr Ìrrl,ÌliÌI !Ì th. lìrrì r. D.n ror lÌon hrd its
rmtlorees nÌr r!Ìlj.! all rlì. rÌrÌ. r ü ú (nr\{ $h .tì \!rL(È trrrr shirtiÌrg rhen ir riüa nLrrntr
J (orrL) diiìi5irÌì!rr ind ah!e.rhi.i.tind dÌiÌrit.otG
8Èl .AÌrrtrLioqoìthardaL renjrhrt
trrN. nould rlren Ìr r! Fn)blÉ.r 1.. rlì.lirf Â$rnì€ rhe JtrD getr i.t nìJrilr jÌom tiÌìe k rinr.
ah.!iÌrürtriÌd nd ì(l!rlÚìÌrLoree!arÈ1r.rl{jnS.lhrlüm reaímsar l. .rrs: lar!rnplokri\.au.slrr
shirking.tÌÌrrn.ree!rt\iir.lla.lonal:€nrirl{in!(,unrhcitrl)rnrÌrra.tne,rhehí'nrcfrnrpa_Ì
rÌÌflo_rÊe\ al'r1c whrr Llrer (!rll .rpr!Ì t. grt clser'ìì.Ìr. 11'Ì!r rÌr(Ì r!rld grt.lierrlreÉ ditJ.r!Ìs !D
th.ou.jl1erì3rr.trd.frÌrÈf raL lÌtr rlÌ.rfthri rL.!ld nJ]denì|Ìi\í rrÌlr,ÌlÌr\on I relaLirer.tr..
lithrcnr!.!e(rtrnÌl\ he içrÈr\ !.1 l.lvnrL)loL,\ened\lr r{ing rlìÈf tr,, trrllr(d r.lre high re ari\.
t!,rr t.gne hÈrrlì(i!ìprrtrirrein.efLnrr.nrÌhhtÌd;ilrhe rhjnl:5 ri5 krh nì.riìtbcobjcn,..l rhen
r..rrbr l(nrer if rclrfÌ. nrn\
Ì.ìr!v.r\r. .rb.Lhihr!nr!,úìrneÌrc..ikr nii\

ÌÌre tirìr hrr Ìo mdinr 7r il5 Ìt0 rÌll.(t t. ( L5 I tl I iÌd ro (li.llt2r. lr \lrti .nt the pr.È ierri.g
eLlrati.. bÌ liitrÌrnriâLing Ìiih (Ír.rt nr I holdiÌrg tr .n.sranL Afd ir n.Ìk\ our tlÌ( Ìrige ierrjf!
0qriljt)Ìr hf.Ìúi0rntirrir! rlLrh (if.rr i! n [oldiÌ]g I .o.nã.r srhstiLLLn:t nDt rl: Ì112ì.ml
Ìhrn (lf 1Íi 1ì .tu rÌ5.100) g rÈil

a)./i,,n4 r( t,!t ÍÌtrr-,.trJ/i., Ìi) d.Ìi\r thr pnrc \Ètting cq!rtnD ÌLÉ djl Êr..tiâre l: la:ìrb\ I
holrlngn.1,,trt,rrt\otcthâLrâ.d.a.È.Ì,,i]r.,Ìr!ÌothcnÌnfi(l(ijionmlin!lhisinrtie\

,r Ììx, ,.r Ì,i l.llr r o

,, :iÌ-
\lrrlÌi\prr.nel_rthe.ritnilnrnnrItdnr0mo..rlÌtÌi.È\eLii.!È!lrli.rìtr =Ìr ,i ! |. )
er.Ètrt of dr \r !1ì rl ,ì is .. l,xÌ!rÌ u!!r.fu\
r

lr./n,irri r,rì ilÍ nritr{!ìÌúrrir, Ì. dr r(rlìrrlrgrterrtngequainnrc.lilLÉrÈ.riart(ìiÌllJl:

trÌtLÌe\Ir!.tr.r h.ldin!! únjirnt.ÌLt, slrÈld..in.jnÌiÌtr.r\) rr r( tlrri nirìÌÌìzing - jteluL\ rl.r r

p r l5t-
630

Ì Ìr rrì r,! l ri

- Lt1 ,,\

:-'..*1

Thi! (o.(iLLi.. \1i rÌi!i.rLlt lt.n'e!l br i,,Ì.r" in!l \1r! Lhar dÌr .ld'L !:nnt Èspr!i nl
'iLi 'Ì 'rLth
relrtn. ÌagÈ! mrÍ ÌrÈ Èq!trIt1) 1 lbeiÌrhLrLi.dijrr \inìflr: rl rintL'mìÌnirrrr un t Lilìou "n;
ri ì \. ürÊr.Ì!( nanl io !! .. i!rÌ|\ n3 tr untrl r l!:i ir!Ì.rte i' rtg!\ Ìr'(a\es r bL Ì'ri' ÌÍ the
ir(n'aie iÌr Ìrr3(! i..Ìc.i.\ r hr n!r., tr.jl llLÌNr..it! ri]Ì iall. Íì it 5lÚrld rat !r gr or in'rer\in!
riqer, iL \:ii.\ br Les.1{46 ai0 t0) high
lÌ{tL.r.r,tLLati.ÌrrlSl05r!l!r\..ldrlr!!.h }:tt[rrrAÈírtnì3'iratiftrr(|rÌfdereÌlÌ)d!)
iar'1.r.!\rnjÌiÌrtolÌr.Lrrrti,jrllnknÌlr ttrrrrf('d!)1|l!ilìi!"tirnrlnnìl"rrr r'

hrÌJdrìÌìigÌrt , r ììrÉ:1tr..,r.iif, .et trr n('rÈâjr5rtiftr ÌÌÊ'É I i | '1f'$Ììrl(nrrm

is rhu.f,re I ,Ì . lhls trr.rÌtr ÊÍ' :

,, :"
l

,L,i]! I
a' .r rL

Li,h ll Ì,, ,,:I

,nlr!. 1r =
15.Ì0:

\oirÌlÌri/nn1r. r.!(iÈti.gtlr\nâg!!rfinr!ì.dfLi(\fiìgequ4tÌtn!i':thelì:n (

Ìhl; illuslrtrs.LerLLr tlÌ(d er.Ìrr(lreú\rerth.Ìrfli.1nn!tlLLn'irtr!!\rttirr!'ndÈrr'irÌlrnrre

çÈlliì! i,, iÌÌ eqlrLiLÌiunr ÈmlÌiiÌtrÊ.l r(l,tl..rtLnlil_.:Ìr.!nrtl!?\'rÌ+'lr\rL'lrrìtnjd Ìhe
r.ÌÌr\Ìi,.t ig rq rÚ!rs .r rrrur \rag. !rttnÌ! r Ì :ìr!rorrr! irri.È !ÉriÌr3 r:r

" =;ì,

Ì.thertti!ir..1Ìüg.rtr:rrirrr:1riÈLrrgÈL!rtir!Ìa(Li:ìrnr!tlx!!tlbrlúm'nl)t\rr'rirl!b\
tlrltrlÌ..,LLlhirm!!ì.ÌLifn).!rrlriLi I rir\ìLl LrÌìriLrljlrL tilrirÌrì'rrÒr rehrlri Ll!..
nliti!.ìlLl iln(rl rihÈrrerttr..:l,ri!r.hl \ i..ri r:hrr!ì1tre tri.(Ì!(trf i r ìLstb! rr!il
t.!,Ì L. È,lrj lLrii:n, L rl)r.itrbÈlriÌ! rrntr!rl.r lqr.úrì.rli L0SrlhrÌrr fli'\LhãL' Ì ' nl
:liitilree!ì!ilÌbnrÌì!'ìtL.rÌnr.rr1:?Lr.rtrrrrifrdL.itLr\ilrenllriniÌr!(lr"irÌr hr mtìbli t
 631

|.i.ê lrtnDg qrati.i tlÌrÌr u\e\ úìe eq! liìrr rm.mtl.rnìÈnL Íaie (nrh to (ldcni.Ê Lh.l.vrl oi rhc

11n
,r Ì,\:1.1,)l

urnìr rragÈ iett f8.rÍ tlìcnonof.l\ fn.. !Èfti'S rlftrtnn al.DÈ der(rrÌiÌÌ6Ìhr

Ìil

iÌìen. \rLnjtutlnA rhirr(iÌlt intLr the\ragÈ 5eftin3ri]lltnr., the Éqrilibriu ì efrJrlofm.nt rrLe j5 deLÈr

..
" ilrrl', t
'r',,

EÍfkiency waqes and reÌent on

l\'fÌr.\rl0ahrll..qtÌrÍÌththrrrtnâtnnr.ajeÌh.rth.rtÌf..rjcj.ann.rrbeÈ\ra
fÌLirltlv..nlÌheì aÌe nd.rn(ldrlLÌeÌarÊdthe..nì.oi.rrrÍ.1Í\iÌhthrrtte.ti.n.a5Èindtcír!thr
'dnNrhnnÌr
quii rat!'nlm Ìhr Ìì,nì a! í.l hL n . cmpl.rlcs lÉa\e iÌr. ÉrÍ1.,i!h prÌill it srnìi!. no.ne ú rì.traì
lhellnì{!ft!tunrjntan.rtt,!tii\orÌ(prÌti.!Larle\eÌ.r,andrh.r(ntr.rmplo\ÌÌrnrâr. I )
l.d.nrreqliÌr\,1:.nÈr'rÈ.nrir\ ]s!nÌr nì dL tinre bei.! úìat 4 i ú.rrr\r.nLrrhirrdl!!ìthÊ
n1Ìlcrat!Ìrnfu!(rÌÌÌr\agÊ rhe llnì.li.N ÌrrlÌrÌrrtrLrtng.ricrharrre.nn;idernÌrrlÌ.Ì!cd llnc
r1Ì.üdrijrÍúnìfLi.r,!rllL.dr.t1r€rl ,11úÌrL!hilì.r.iinolì.bl.mtriÌnrgnÈrrÉ.r!G,rlr(r(r!r(o\tt!Ì
(liúÌ3\o.lhr..sli,lìittLc!ìp.Ìi.n.È.1cDIL.1rerrh!qrÌrÌidrnnÌrpr.j1ì.\liìlli:ner,É.ruii\ÌiÌl
lrrì. t!.(rluire úìÊ i {ilÌ\,,rrLltlÌr nnn \ill hàre úr |À' io tlìir. Sin.rtrÌ lrnrjxon tìnn jF. lt. i ( lli ik
.nL!.1\.ì!r Ìn r taÌricuiâ.lirrrr, rt r: tlÌr lìqì trÌ11r.r ihÈ rr.r{Èr r'ÌÚ ÌriÌÌ lJr! rì. ruDn!..\r
Ì\'e asn, Ìr tlÌr r.Í.Ll,ai. nitt..h.r! rr!nut i\. 5i..ê t. .ÉÌrÌÈLÌ! L! rk r.lurÌrl t!Ìrrflac. th.
rml-rlo_rÊesnlì,, hìLrquit. úre..iLr. LÌrf rií rJl!iÌrgí)i5nlr,.ÌlLhÉlirrìlrisIhirrrhLrL,IüÌiÌÌi
dÌurf úìÉfrnillL)tLìÌ.t.rLi.na 1.11 \ìÌ]=ri.lh.tLÌrl..iioÌtrrinngAre.r/i\rÌLúnirÍ
llrr lìÌm thÊÌêL.rc hd\.in iÌr.eÌrrn e r Md!.e.t 1\.Ìrnni!rf trboLr. \r rsuÌI? thrr{ie]Ìfds f!jiii!(lÌ
Ò.Ì1.Í.nüregàLrÈl)i!Ìthrr(,n.D_rrirleeÌìlrlranÌrüt|rr..rr\,1 -ir I LtÌrLúrh.r.rll

a..11ì. hÍn mLiÌntzei fr)hÌi rt

r:rt rL. l+altr r. r

=1, '.1 Lr I ilrn I I Ii l

Ì)il.rÈfti,,lirÌg{ith,êit.rtt!l.lnndiÌì!N..f!L:.iinplir\r!r.lrtlÌthr{rì€li.ÉiasÌrcntr.ìtL.i
nrc tri.e s.tinÌ! qrLirjtì. ii

f,=É"rr -r".,
632 ,

ÌlheÌÈ tr (Ì r4(h /r clr i\ th. unit.on .l labonÌ Ìn.ludin! th! lrdinLng oI neìr tu'rui$ bcnÌ'
nr de'n'. Ìh( Ìrâge eqnrtion Ìrc liínÌe.tiâre íÌ5.Ìr2l !ilh Ì.sp(.itu tr h.ldingf, ro.nanl ^sÌti\tìsr
Lo s0c hlnì rhe r ight bi.d sirlc of ll5.ll2) thrt tÌìn n út inìe âs miniDizin3 Ìhc u'ir cod ol l'irlÌtr!
ir il rí1bt/n,rl)Ì\ith'esPc.iloq'.Dift.Ì(.tiâLi.gthirtcflnsiürÌespr.tl!Ìigjles

l+-lh rL, +,- ],ll! :,

lotÌtr.rhi5e{ÌraÌirnrinl.at.ô8nizàblcü.BesÊüing(!uation,Ì{0nccdnrgite4lÍriln'rlaÍrnclitìL'l

./l*,rr, .l = 'r 4

hcÌrt is thcnndeÍl-Ìing !uit !atc ìÌ1ÌlÌ( econom) llrssay\Ìhrtir(ei'tr'Ìelntivrl.r'(thnÌloi

Ìne Ìrt1ÈÍ âr Ìh( crpe.led rilúe ot ÌlÌe Ì{ige il ân rrÌpÌ.lee l.r!c! Ìlr. rinni redn(!r tÌ!- q! I ntu 4lv â
suLìrtrnúìng iÌ5.1 ls) i.10 (Ìs II lr f lirlu.cs

/l ,,\

I hir has thr pr.|erlirs ìr( \ianÌ

{11
'lhrhjghÈ, nthcr ìfl.tmenr Íale jnthec(!n.m!,th.hiAherÌr'rwlÌ.rtube
(21 i. !l r r i" '.
(.r) lhe hiSherl. (ihe !nritivil-t't thr !nn rate lo r', i trv lh0lo{rÌ rs r','$'
'ìr'

Eflj.ienry wôg€s ând recruitmenl

Ìothi\pliÌÍtrehak.\nnne.lÌÌÌôühÈllrm.rnrNruira\mrr\n(Ìremlb-\e.s.rÍr\in6âtÌhrF i
wrgc. l\ú Íe. Lìtmc.l ú nornÌall! a dilticulÌ Pr..eÍ, in ÌÌìi.h rhe llrm ha\ nr.omleL€ alliÌtri 'tÌrer
inÌrr..!eL tÌre rrÌr hiÍes itìr.'.G. irthâi the trof!Íionofnsl'acan(i6llìat ll'an
^Frli\ti..\!,nìptnu
lilldeÈn.15porÌirelt.nÌi(.eLativ0Íri+il.llebrnd.qlatiteLtont[rrl!i!''lLheLabournìiíkeL lhr
.úmlreÌ.t!a.inclesth!inìÍ'illhivr!rLÌlb€equrLr!rt5qúit!atcÌim6rtsenflo-rnrcni l : r.' l-et/ìbr
úìeper.(ÌúâiteoLú..!!ieslìllrltJ)feshires,u,íH /,f = /r4(.5ÔÌrÊasuDìctlÌJt 11 ]Jln" r I

not.h.Òre !rnIJlliLs!r..r(iÈr it simPly Ír dv .Ôsl t1rì lruch n leÌnrr ot a hiBh n'latn'e {n8r to dr
^sturì!.oÌrnirìÌnfli.ittth.rttÌìequitrateti\roníânl\\ri(.1Ì!lnaNoridnrÌ{lìi.húì€1ìnnrrrl
yrÌlìe..unt!4ìrítôthir iÌÌbea.o\tÌlÌ(liÍìrìurlb!dÍisarenúlotuúìll(a\a'an'ie\\'!( eedh
a$l!ìe thrÌrÌfs..sL is nrbnanlìrl oÌÌÌcFli\ethelìmrÒLrldnotrLorv.boutunllll€dr[arcierTht
liilúretonÌ((t.Ídermr!i.deedlrnlÌ!ì.ângeoÌLìoi(ììtlal.lamagcsn(l(ÌinAÌ.rs.lÌ.pnt.Ìdr th'
râr\Ìcr oi cl{onrer to orh er tìnn5, is well $ rtÌ rìlhtfÒíúd ldj oi ptu6i w e shaLl .âll thir ! '5 'tr Ìt L

ir LÌlll) r. be tÌ.poÍiÒ.al tollÌ( \rage ll the lìÌmlÌas tô u5r.mpl!!(s nr make !P toÌ tLr dânrâAe it hr\
ni(ured .\n.i ìrc 1$unrÊ thal. - 1 tLr indìcâlrtÌìar lhe 1ìÌnÌ Ì!!!li Bain on lhe a.13iÌÌ lÌ'nì hjrjnglrtrâ

l\Jc rÌ(ro,r ìn â lro\iti!n Lo ltÌrlrtÌlÌ(.on olan alcrJAe !nit ol lab.uÌ.8n(r tlìe !ÚbrbilìÌvllrai a'
emplof( nìa! quitard tlre Po$ibilir! iììal LÌre PoritnÌr nìa-t n.t bc Iìllld

s',1Ì , i /r1f /r' ?lql Ì!,.1t triÌr rìt rl

htÌÌrri6rL€rnÌlÌ ,, /Ìtr,iìt..ì4 n thÈ teì.cnrrBe. desii!.1j.br., hlld, rranreL-r th! PÌoPÔ nr
of rlÌose \ih. dotrÌ (!ir iL .rÌ and rhÉ nr)poÍn!ì .l tho{ rlho lo rllit wh. arc ÌçÌ.(.n br '0ì
 633

rruuils /,ti lhutiÌr(rìrsrL.ruLthe..Írtr.rürÌ(mflr)\DÉfL llÌr jcr..d (nn t\ LhÈ lojt

LtÉi
r.rl(Ìr . !.Èll.d râ.iD.ies rlÌr Ììlp.tr Ò. !t t|.ie Ì!Ìr! qrÌr rò. a( troÌ.ored b\ .ír (ruit,
t ít) Dult Ìrljcrl rt rh(..!r.Iaf !!i e.tri!in.r. rL I
rhislimen.aiiln.ie,rÌth.1Ê,n nBÌiÌrtri.È \rttmgequ,r,,Ì Ìtnr.!ldL)l(l€arenirlhh.rnrto
í i. LÌr ! !a! ìilÌnrirrttìÈÌLaSrjrrÌrr!Éq!irn!]h,dri.Ì.nti!ti.!tl;.tÌi)r,Lh;ó!e.rúrtr.

Ì r /,r-,I /ìr Ì, iil ,11'!l i

À!iiira u,ìr nralnrtrnir.L1.tÌrt tr! 1r,a.d rcisunr !ndr. rhaL

r, ,l!
5rhn rÌrÌin! ln it j Ì lsr.ri\rr

/ra21 )l 1t,I
B,rtlÌthri.1utÌÌ0rndrÌr!nnrìat\iriLjiÌ\bÊúr.rthcÈ.íìrr(rtrmlrerefLrÍÌe\É!s.lQrÌ\e.an
sLmrrrizÈúÌ,túplrLie!oithÊrraA.5rtntr!.!rrerÌih0re.tuirirrÌt..j0as.llrn\\
ÌÌr( ÌrÌghÈr \ tlÌr.nìJt.Ì utnr rnre in iÌÌr r!.n.nì\ thr hither rL. I lÌ.6 to he.
i2ì
lhÈl LBlÌü ii ) ftÌLr \ens ri!Ìt) otihe hiri.!r.úr hr rlr,rhr nnrÈ.Ìili|rri ì

EÍcien.y wãges-whãt is the evidên.è?

llirm i hlr L,ocf nrJdr tLì Lei 51ìi!úo .rrLi Sr lljiz \ \hi.k .! rìpl nn nr iljr clrrÊ..È .l.ttì
.(,tr\r'âAÈ5Ì\hil\tnr.rnìt]r.dt.rrlcn..haib(trnrund.rhÊLtrrrirn.eri.ilir!\t(ììjknrr.
âAeô lÌr..lll alltr,t tne relâtÌrn\hi! bexlr(Ìr rJbrr ind ri!r! hr\
ÌÌüjLtrd Uut0r iu|tfr ítr re r. e
.: Ìa nrr$ ...! d.nrt;(!rs r! oÌÌhitizÊd b) ttrnol 1n r\.ruplr ot úìÊ lì.i t\pr (n irudÌ r! LrÌ ,\La.
ljlìrie..Ì Ìrr!r\ârr !rl,itìtrrÈ nì.1ÌriuiÌr l.r ÈÌi.rriruelt.( irÒ r Ì\!rt0r\ ] (nj.B(Ì.oD|aÌÈi r.jUr\
inir\t L..dnÌo|jtharrrrÌrlì.Ìr \ÈsJrd.!D|a.vrhtr.d. Jhe dÈaj\ihirÌÌr.ale. njnrnchtiesh.!r
srr!!30r !f.È.ti\rir)nr.rÌt.Ì rtìaf d.nìintrI0jr n.rÌnprnr.rr.Êdn!rÌnar(ru5e rh!,r!rtr(Ì rÌ.h enì

Jlrì\ Ìrrrlu.lng id(ÌÌi.alf(úr. j\rhãr r r!ntrl lre t.dÌ.i(f f.5hatir) !iilliÌzgÌ.u.r\rlÌrtÌrrsci

,
ìrrf i.!roore DÊ.Ìì.ÌÌi\m h.!.!r!.irhÉ ÌrÈitu nüir..irt rt \rorkd\ b! nìJÌtrjto\ Kr!{:A.Ìilund
uÌ.hrr nÌorerrìr.lltr!É1 d.Ì (.ÌD drlì|.rt rÌri5 hrt.Lh.rjr .jrrl tt Ìri5 fÒi.nrl! to ex.lu(Ì( riÌÌrÌ
.tplì.alnÌr turthe nrÒarÍ {rAÈ Êitr rrlroiir.l
ìhh!r{h tÌr( 5lÌìtlr. \ri!litznFdel r.ippQti.!,jr\rDpiri.r relÈ\if.rha\bÊÊ.it!.Ínj.lrl.RÈ.fnr
itün.r r\iÌìg n,n0 .rftertrr trnrt Lâb. rrtrÌ rxtejja,úÌj hIÊ 5uAAeÍr( thrL Llrerrr!L\ ol litnrr\
\!roÌ tÌre.ÌrcrinrennLl (üe r| Ìir.Ìrr(riurltrhrr,,n.\tÌn 0rrrr.!rn(\ q!È5
Ìi,ìLr; nr tlÌ.ú rare..trc r.r (Ì,r irÌ tL recÉisi,;,, L.(iuse jl Ìri l(trr!)1.Ì,.r.Jidthrrlrtd\.rri
Ìtalr C.$tar:!Dr | ÌriÊ6 {irh \.rlrÌ: .lsêrrÌrr I \rem ru ne nrporÌrnt tf ìtf(rrng n,traL j\ Ìr.i
cÊiled b\ n.ilra rt ÌarÌ C.rmthe anLl le.rtâ. iltìtl7) iLsn rc|lÌr nrpÌ,orL l.. rìLrhnârôrs rÌri

r' {n.hL.LiirLL, rr,]lroì

I l.rerÌ.tú. ai ìr)Lr I rnd r. jL.rri i qrrì .\l!) lrlir.r i Leee
634

f..trs or rhe cifc.t o! or Él€nllÌÌ: lfnì\ fl'ar tÌrL lls Òl lìÌn 4re'iíic hnnrân 'apilal hh'n
ìrage5
ext0ri!..Êd won(e$ quit;lÌnoÍ as Dnìrh âs thrl leaÌ th( 'rÁl ol htrnìg a"l tlaiÌri'g rPl"emertt
u\iÌÌ]1 sútr'ey tvüÈn'e Ío r s{rdnlì
|t]785). '\gcÌl an.l Lnndborll i200:r) cx.nri.€ thc samr lueíion
ius,rrLiry a periorr olprclonge.l Ìc(e$ion(ilì Ìo( niflation lh!! lifd thaÌ !!âge cuts dlmostr'vÊ'
ltitlì
u..-,*r.,ã lr.nt '-,r.t r,"canr, il a.thnÌA. duc (onceincd ìbÔ!t relntive ivag6 C'nsistor nÌbÍi'dâtul
rtLclenf) *'age Otories, rel rlro loúnd Ìhar uncnrlì'lDìcnÌ ises a'd rcduces
'JtuÍ

: APPENDIX: MENU_CO5T PRìCING TllEORlÉ5

ln thr tÍÊsentainrn ol iÌìe NlÌ'a in \r.tion 6. ÌlÌc iocu\ Ías d'n!ing â lrhillÌfs irÒnr i npdeL
'n '!rt
'lr'1"'
'lrr't
rerling. LÌr rbÊ moìÌr (rÌ âpforrl, Lhe to.us is or lìnDing d'ri' lhc
aüo'coDoÌìj' iÌnflicatìlns
Ì!.rÌlustiÌ4 rlìeir PÌi.e rh't CaÌto dos is Lo mo{Ìel the ín as úri'g
'.hpr;Íís rarr r smâLl.ôí
jrt(i,rsrÌ \!hât hilpcns itthcÍ€ ir I dÍ'rÈfancrles\ecnÌlÌe acl&úfrlcean' tììe
a. a.liusrnrenrron
;|üm,'ltrj.. Ìltst0rdvìngthc..(ofrot 'ercitingPÌneJiÌrnr!r)' ifd'onbiÌring it Ì{itlì LheÌ ìd'm crtr
:'trfgc,l.g'"sr,.pt"r., tf." NKP(: ir de'n''d i' thi\ Í-'Lion, Ne nrow lÌoÌr a ncnn "sl modÈl
ÌJF
' ' ' '' Ìr''
j., , " ' 'l '
;,.,",,,.,,
". ^, ,ri, "
" '

ÌlÌi5 reódÌ, rt orGntr.tu.n tht cilro modeLin tÌrÈ maìÌ1Ìcri

Ìhe m!.u.ort âffÌla.h drsi8.€d to eljrlâiÌr Ìrh-r Pi'( âdlúíÌn!nt5 nrav Lìc inlLequcnL' Ìr3eÍ its
G
úrÌl restnúinls t.Ìld..lttochangcrrri'esonnLr'usaLinlrntaLr'
(tre'tini iÌì lart
.anrJr..ì thrn.r
the.!n.lpiÌrlng ntN n!rìu\ lLsnanìÈ jDìPljes rhàitÌrÈ'ost ol!hangìÌ1i:lPn'Ès mr-v n'tnÌ lâ't lrL
(úsnìãll(o!soi(lìa'sin3!ic'sa"ourtrÔ'rh$loNarljrLÌdentol
'j"lye." '1,',.ri,'*q"""'ô.
pf.ú anl ti.Lon3cd depJnrie\ oJ!mfLovnLr'r lroú eqtrilibÌnrnìl
' c"ln,"si"lng*i âtÌÌÌc..re oldn an$!rÍ ro thúqrtíi'n 1*5haÌÌ !d our iir 1!'rvsiÌÌlle
"L-.'-"rt" ol thenìenu(!í
modrl nìe bn\i. nìe.hd.iÓ Arrl rve adofr â slitshll,r dití(rcnl apPro'ch Lomt(h
Ì{hl trris d. nol l{Ber c'ninÌloun} inrtcid (h! li rm\ do
liLeÌaÌÌiÍÊrs bv asliing set
"L 'hange 't
púcsrrrert.rrmtoirr,or<iDgr,ï\!ager!Ìii.Sisthilthe'ortrÍ'haÌ18nì8\lagesi\nìÔ'eev t'trharlìaL
i'io,"ngi.3Ì,,i.". inaÍgd,;i.gpÌo.($hasroLeenÌuúi'to'úhichlakestìncandÌcsluÍ'es weuse üe
. J nìtÌrr !nionnÌniLrnrr.Lìon and cnì|lol!ìe't '1crìâ'd curtr tlìan in e'rLier\€'ti'Ìn be'âusc 'an
Bet neàfu r an.1 nÍÍÈ conif
Íehensiblc 5olutÌons
'lr iih lDiornaxnnLTú l, = I. aÌldrtla'es'linearrlrmandcur\c

0s.r2r)

wlÌere,i ì\ n Òr' súpPiv, rr is thr Í€allvâ3t in se'toÌ and n€ iÌ! no lÔngcrÌ!Ò'kin8

Lhc reâl no.t-t i n
Ìogs .\rbrfo.elv. asúDìc llerÚand Pn.ing anil lah'uÌ oJ pnll'titìt! I
strtPo\' ú chân3'srwill it ta!
die rnior to rarcsorlatco. nol? \\r a$únre t]Ì. .ott !t . renegoÌiati'nì each ir'r Sìn'!nnìrú \((l'r
fâ.e rni caÌ.onditiürr ir is flauiibìe thatcithe' it \!ill lavalLunions nolto rr'egolirte or LÌr€ rrcre'
Ì5 fttrnLrquiliúúnì rnion\ nrkeePthtiÍ1{r8c6{ed (oÌ rtlf.n úndcÌÌvhâLconlÌtiÒ'5
ÌìDraÌÌ
the i\tÌil
(asr)?Thi!is.iÌi.gtltqueÍion:6 rÌre stnÌÈila oinxÈdsâSrsn !r êqrilibÌnnn1 Ìhcnrelhod
'alled\rstì
foÌpírriÌ1ilÌlìl5issiÍ,fÌe WcJsk ilallollrer!nidr5ar€kc'pnÌgrììÈirlvâ3eJli{ed'do(silfayn(tÔajt'r
nìi;p / lÍil;an$v!rn no,.ndsi..erllunnrnsa( in i.teÌÌtÌ( 1l ctrcúmna n"s, itnìernJrlìatitdoeJnotlar
a.tunnnìLoaltcriÌreiÌ\ige1o.he.k$hetherthirjrY)(ehalctìrìtoJlnrlontdretrtiliÌvnrturn'ì
ge; Ìl ir Íollo\s ilì th! oihe. r lior5 nnd trictpr iLs w.il( 6\€d rív iÌ Âei5 Lr'i;tlÌ{r lind ont ús útiliÌv i!
ìictrnses t[torrrlmal 'rageinihc neÌr ci(u míaÌ1( c\ Gat lirJ.);'nd li'nÌl!s(un'leÌ lthal'onr]itDns
('Êe ÌL
c _r Ut., lrr,. Notc tlìal itüjll aÌNaI\ 3et ât leól r\ mrch utilil) ftom 'lÌoosi'g iÌ5 oÌI mal L

sraiior rrom equilirrriLur, !;., mbt cqÌLaÌ u,1 iÌ eqtrìlìLrúrm' Njlh trr,t : LÌ' ontsnte eqnÌlib'irm
'.c
:r Thr ke! .Lisinrl Èp.r .t ìenu..n\arÊìkrÌl'I'n'Ì'ltniÌ!35l1fllMr'kiÍr( 98s1
 635

1n!lth0 q!ÈÌni srrhrLh,.,ìr.erts.rerrrilirr ll, rn.\il,l.riAe!..rìfeúatÈiLhe..n. hal8aif ng,

trlìirlr i\ nr.nrÌr.i bÌ ii.
li i,(Sif trÌtlÌ l,i lirrc.ÌL !.jfni àÌr {ttinij úìe lanìe crl rigr 1r Ì1. l'ì. rnd \iÌr.r Ll: l)
lúiÌB. ra.(Ìpn!iÌÌt.\0hIe! lf I l) | r L.LningÌhnÌrrqutrtÌfnrÌ5.Ì2!rnÌ|licithit

I5 lllr

\e1t.ÌrÈldrirt Ii.,,. hr iih rnrÌÌ.h!oir\ r tonrìiniz! rir, nrnir(Ìr).rL!,,ti!,ì Ì lj l lÌ .llÌD \ rll:

ir+tir=r ,r LÍr=i'i.r.

,, ,,)
,,,,= ,, | , L 15. L2:i

l hr.ondjrn!ì i., ktÊtif g Ìri!es llled is úrer!1.r.

,. (?)'-
lri,,..f,r\.\l(lì!nliÌErò.\iìlrrinrgAkg.rencnììndãimri{r.lht,rnÌÌ!Ìi\nÌ!4.1.Ìrd.
n) Ì!. nr.a!\. tri!.r t! l,r Ì.\dl L. liq I j 20. lj' rr ii tlre 15 ìin. úrL L. Ì = , ìr I 1Ìì is rnL'
!!ad.àLi. \i\re haÌÈ!h.Ìn.rÌr,\e rhÈn rr iraLilsÊ!úiLibÌiL!Ì 1.;LÌcni'ì.

t,.,. = '2., I 1,, ., , !,

l\e.rn a !.nr.Ìrúìat LÌre i.t. ni l,'r.. elLLrl!)tht.l lr rhrr ì1= 'r

FiguÍe 15.20 ìlerl .ís .d rl- r.l r .

5:t6 ,

'Lirus as .rr bÈ rccri in fÌÊ 15 20.1tìe tirlr! !r'l rhêf 'Ì = O LÔ!'he\ 'r $hú 'r rr i'd
quldr'ric
JLr rirsagair lÌì ract rlì., intlilitthotr
Ll.rl 0t3a reietÌüÌ8 Ì{ages' ìis\'rmrti'eilhcr5ide
,r 0 r{1r" ' Lr,'.r : ar'lì an'l Ìli5 n âGÚ rlre \vlre"Ì : 2!:
,,r,, : , i" ":n.r 'ast
1" . \)1i1r ü1
",".1r",
(:J4rrr"1t 2r - 1r,r"1 s?ìi'l 4r4
\o;s€.]fnú8 ììdÌ!theÌr]L,ts.t,,iÌi'hnhNagerrÌtFÈt:rL4.t LrÍ rì5rjúlLtÌhcredi'rl
,1i!t."ìre Ìrd'.en l;.;nl lii, UrnLilrììe'1s'Ìi'eÌrbÌ'Ìr í'Í\ rr'n o!ÌÌìeieltnìl
â{js Ne thtn
'' 'â'
LÍ'lL5tmmclÌi'
scc rrtloearctrL,vrtrsol,J.tt â.d,ìr'nt\Ìli.h (r
- irrr, Lli'l 5in'eilirr'Ì
üther sile rr n : ! ClÈaiÌ-v d5 a. túÌs jrn ihilt tÌrÈ 'l liÌÌe riown iitrrâtrls d!'''
i." ., "*...-ut ,' "*, 'nr frlls to\rnlr l And't(!!Íelhú'' 0lvr(ìnsertÌrilân-ìrhâ'ge
,,, . ,-- u t",LL l.o Ì!âges lrriÌìA Íe5d 5' lot lrrprisiÌ13lv a rj5r nÌ ÌlìÈ
'osÌ 'l{r!(
\cLljnS
^',o
. ,Lr'q l: r" "'
1'
o"rr"'lur"L'',,-t.it^rt",e)uni.núBÌrÌÌlìer€rr'lr{oDìriÌrlÍ'bLrniswilhúThÉlìrtfi'ÌrLcnìÁ
úì! nrÒre Lr! lv il
Utlrolrdvirrg. rtc rorgo re nnÌr €{pc(lr â 'l'(line in 'il3n'gat€ lr â'd to irtrrr
rr'.ru'-"ì""g..anuiJn".rniethe.on.rr€sein'gNâ3(s''r'isrlfe'r!'ostrrhile(trr' |iÌri5the
,n Lr I ., I'S I r"ii;
"
,, '4''
r\jd€ dir(!unLìÌ1il) (.on!d€!

r\ -, ì

lfI ì l r,r),itpâtsÌ!resetÌr,reesator.È ll l i Ti''l rhen{rilcsandpÌi!esi€n'nì un'hnrAed LlÌcse

otr lhrsrhet[coÍtcantìpÌainÌr's"ab]v €ll
-r.,,1,r1.",.,,.,-",r,"t. *iiiretun Lo l attreoì(Ì
rrhv â mor.1ârr!dil-a i(h as

,, =r r: wLLh:, i tn !:=0uniíüJnlliur''i 'rrJl l:l

w.úld br aso(irtÈtl\rillì Jiald \'ages rnd I'icei

ii'"t".'".,p-nr."n,o""nL;)ih.F6tÌrnìonúrÍvt'Lì'lirÌì'rccolirÌer'toÌi'5tân'(iíabl!

rlìen it b(.ômc\ (.njirlÚaÌrll more.ÔmLìl.r t.1roÍl' ort tlìc iÌnfLi'aÌnnr

l'r( rile a'd pn'È 'levclql
nEtrts. Ì. ornrolüote, thr mrn u .on .rrPírach n â $Í olìinntu thfoÍr: nìar! tc'nonris6
lr'li've lL
," ', .-lr
,I' / r r'l
'^ r!,' "'i
ìÌrtÒPhiUip5.unrrdn.1he..Êt!r.t.Nemr.Ì! roLl'Ìs
 l

16 Political Economy

O.. ÌhrtÌ. iÌr thi\ Ìrook is thâL rìa.roc.onoÌnics mu\t Ìre Ì)uìlt.n nri.Ìo.co..nìic
.ll ì btrndalioo!. 1lÌat Ì)Ìerìiss ,cqu rcs Llriì( re looÌ( di the behari(NÌ oi in.Ìjvjdual â.Ln15.
\\ic hiìlc speÌrt tiine rniìrslrij hon houselÌolct\, uìri(!Ì\, ancì hìrìt take d(isl.ns. llut
rclit \.ch litue \Ì)xce ha5 Ìr(rn dcvolrd to anaÌv5iÌìg ihe deci\nD nraÌing oI rh. golcr.
rÌcnl.L)cspitethegreâti,Ìporla.ccofgo\tnDnentpoli!\cle!Ín)niinthisboôli inf5-
cal, nÌlÌÌet.rr\, rnd \uttl! j dc toli.! Ì!e h! \ e either sjrnph ldtte.t rt thc .., !.t!., ( rJ
r

ol dittcrent poÌiv clrol.c5 in lcrüÌs oi rclno ic outconÌes, or lrÌotaÌrl\ iÌì tÌre !hrÌr1cr on
nronctar! poÌì(\'l r$unìcd th.1 1Ìrc gorcrÌnnent oÌ centirl brnl jt maxinizi.g i trtiliL_t
fun.tion nÌ Ì!hi.h LL scrks t.ì liccp o!iput lrÌd nrilation at clo5e t(ì theìÌ ìe5fe.rj!c targclt
a\flssibLe loìDruch. rhiÌl.hiÌ01!.r,Í'(ns\!r]Ìedthrtthesc ernnÌent)t taÌget loÌ oulpur
\!as equiliÌ)rirn! (rttLrL ind thal it rrantcd . loÍ rate ol iÌúlâtiüÌ: n(lÌ a go\ enrme.t \
beh.r!iorÌ ìs .onrjncnL \!i1h i sÌrstilÌìab]r.q!iljbiru! ti.e strble núÌatntri ÌLirh ÉxÌrecra
tion\ tulfiLle.]l. To(,a, d (hr lnd ol tlÌ. rÌìonetarr toli(t (hrfter. I e irised the.Ìue\tion ol
rlÌiìt \!oxLd hrpten it Lhc forcÍlrìclìt h.d ârÌoutlÌìtt.ìrletibor e eq!iLitrrnun Thi5jeril5
t! the Ì)ì(Ì)lem oI linì!. irì.onsiÍln.\. in nÌonrtaÌ\ Ìro]nt iÌÌ shi.h nì(h a Soreìunent
mSSr\tt Ìhat jr can d. \ cÍ irÍÌitior .rt t.ìrgrt sjih outprt abo!c tlÌ( crl!ilibrjLm. Íhnh
Í jrnÌro$il)Ìe. Thr olrl.ornr is o!1put .t rquilibÌnrnÌ \!ith inlÌltìon abore t.ìr!et. j.e. aD
jrúLtnÌ bins. Thc..ftnìn bctlicüì i]n o!!ranÌliitio!s lorenÌìent irnd one thrt ditn\
to leeÌ) iiúlntj(rr .lo(L: t,) tirgct 1!llh oiiqìut .lose to equilibriLrnì hrlps io e\pl.rirÌ sorie
flÌaLtse\ìnnr\littrtio.âla,i.r.grnrc.isrhiilÌir\ebeerÌirìtr l!crd jI rrccÌÌt rrrrs rch r\
iÌ errendent crnL[l banks.
'lofuÌn'elhcÍ:l!s(LcsIiìrtlìrrrrquiÍ.s.ìtlÌeorlolsoÌÈrnnì€ìÌtiÌìtlÌe\.uìesalthdtÌ!r
lrr!e ! thr(Ìv,)flh.lÌm.)roi uni,Ìr brhiì !i,ìrr. ldeall! ü(Ìì.r.lto lrt insidetlÌe L)Lacl bor
otsovrnrmÊ.1. This i,ì\!l\es uÌìd.rstarÌdirÌE r otiIS trelLr!iour. politicrL frúìes, (orÌìti(Ìr
Ìtr'ildinij, nnd!) o.. \n iÌÌÌportânt iiteiì1Lrre lÌat !le\eloped irÌ e(ononÌj.s o\eì the ìd\t
tÌ!eDtvleaì\,ilhjrhisusuirli!'rliÉrr€dtLìrstr/ilir,r/(rrrrnrnlì!hi(hseelsn)ÌnodeÌ
politjcrÌ l)ehar Lour l( r'o!ld bc. lreit erailtseÌatl{lr to (LaiÌ! thrt r cttrerÉnt iheoì ol
i.Ìo!errtrDeIt nn.l tl iL .s rÌor r\ists b!t ÍÌnr imfortaxt neps lÌrre beerÌ mrde. ln thi\
(hrpter Ì!e rhalÌ 5ct o(rL Í!n. oí 1lÌosr llÌat.Lre lut relerrnt to nÌr(ÍrecononÌic\.
LÌ one ìnÌÚÌtrf1 irar, 1lÌe nud\..,1politilrl .]ecìtnrÌ xrrlnÌS i\ dilterent hÌD de.j
si(Ìr malìng hv houicholds ,ìnn tunÌ\ lÌr ÌìoÌiÌìcal de.iriinr rna(i g just a\ j. co.
nrr]+únú t)ehi\lotrÌ or l.bo!r suLìpl) drcjsiorÌ\, Ì!e staf honi tÌre a\\rünptl{)n thrt the
a(t(tr 1\ maxjDLTjf{.r1 objectj\e lLuÌctj{nÌ. Thu\ Ììouseluld\ me\imi7e e utrlirr ir.r
tidr, and i. sctl nS !ri.es, hiriÌÌg Labour. or mxÌiLng iÌrvenmÉ.t cÌecÌsion\. lÌÌnrs ma{-
ilnire tn)ntt. !uL Llì!'. is ! ke\ dilierence:1I genÊÌaÌ, nr donrg Í), houiÊhoÌd\ i\strDc

,)
lhat the)'do ìrot nce.l to late accounl of tÌÌl rcactl{Ìr ol othcÌ âiaents to llìeìr o\rn
acrion\: thc assunÌplio olì whìch tÌìis is ba\ed ls that they arc smaÌl enough to trNc
cxtem.l .o..ÌitioÌìs as tircn lÌìltical ackÌs, hoÍ'ever' tr€irlÍ ahlays have !o tâke úÌto
â..ount rhc reactions ol otìrer act.Ìs (Íoters, politìcâÌ opponcnts' r!a8e sctteb, €tc )
Ì,.n ltì(al acloN beha\ e r rÌ,rle.ri.d//1. Ì hli m eaÌÌs th at ganÌe thco ry becoÌÌÌes a central tooì

PoÌitic.l ccorom-v js a rJpidÌ-v e\pânding held' irith nÌajor jmllications IoÌ ìna'roeco
nonric\ and in order to uÌìdcnlan.lthc poììtica I ccon omy Lit€ralurc ÍrnÌe ündertândi'rg
ol rhe Ìr.r\i. methlrds ofnÌodcIt ganre thcoÌ-Ì i!nccessaÌy Ihis chatieris organlzed so as
seÌectÌÌÊ a numbeÌ ofthc moninìpoÌ
to frcvi.lent ìntroductioÌÌlopolitical cconorn!'b,v
tan! appli.aLion\ to mâcrocconoìnics lrì doìtÌgso, s'e e\pl.itÌ some of the kcl con'cptt
üscdingamctheorY.l
Although poÌitical cconom-\ .ioe\ nol -Íet provide a cohercnt model ol politics or go!

€rinrert, it has produced a laÌge numbcÌ ol uscful .nd nrggcstne nÌodcls ot polillceÌ
bcharidr. ln tìris.haltter (Ic set oui somc of thc mode\ Ìrìoí rcìevtnt to !he tlÌemc5 of
thls hook. I hty.of cr ntrü arces:

(l I MoÌÌetalv ancl FscaÌPolicvi{hen golerLn]cnts hav€ ân otrtplìt tarilcl gÌeateÌtlìat l?

Thls pro\'ì.ìes a deePer iìrrxlvsis oi the fioblcnr ol ti c lncontistenry introducc'Ì iÌL
Chaptff 5.
(2i lhe analysis of thc interactjot bet\Lecn the govctnnrent or ccntÌaÌ batk ancì\Lagc
scrreÌ!,r,lìcre$aitcsettersdonotl(nos' hetherthcnronet.rÍpoì1q ÌnaNcÌ úto!gh'.
a'ith rn oLúfut target etlual to t. or 't!eak" Í'jLh a higher lâÌget leveÌ ot acti\'i1-ï'
lbir irÌtro.luces tÌrc an;rÌysis ol SaÌrìcs wltlÌ iiÌcomtlete ilúonìati(!Ì. in faÌticulat
s
jgnaÌ1ing games.

(31 Votlngbehrl.iouÌ andgovernÌnenI Polic! h ú ÌrÍh úÌtroduce\ tlÌe idca ol the polit
L

ical business c-vcle'ard a.ì.1Ìe$e\ the qüestlon olh(rv vo!ì ng belÌaviou I could 'ÍIcct
thc taÌ rate sc1 bYtlìc govertrÌÌenl.
i.ll Inte epcn.lencc ln Lrolicy makúÌg b.ls'"en hlo goveÍnnenls. Thit cles'lots uÌc
anal]. \is i.tÌolucc.l irÌ ChapleÌ i2 $'lìcn rle rnolcd âr{r! fìorn lhe a!\lrnption ol
a snrall oPen econonÌv to consider tlìc lrteraclio. between pollca nÌâkeó in two

The .hapter begins by shos,jng hos'thc lroblcm of tnÌe iÌrconsistcnc,v c.rr be ÌePre
sented in a gânìe bctlleen thc go\enüìcnl and Nagc setteb. ÌÌh.rc lìre Soverrìnrent is
knoivntoha\e.ìtargctleveloIoutÌÌúhigherthinthccquilibium'icyr>l'. Râtjoìriìl
beha!iouron the paÌlol$'agc sctter arìd thcgoverlÌmcnlÌeadstotlÌcourcome ofan ìnlla
Ìì bias. Hoi{€ver, Í'e ÍÌaìl sce that, oncc $'e alLowfor lhepos\ibilltl' thât the iÌÌtcraction
bet$'€ür Lbe iiorernmerÌt andttage settcÁ lakes plicc rcleatedl), ìÌ Ìs posìble thalllage
setter5 iÌe abÌe to dnciplÌnc the go!er.mcnt !nd cnstrre tìrat thc goveÌnment scls oui
put ai cquillbriLun.lve íÌnìl lheÌefìre scc tìre ( Ôn(litions uncìer whi.h an oleramblliorìr
80\erllment has an incentive lo beha\c a! Lf ìt! targcl is/r
:r'f
llÌea|etr{hohr!edo|.l..|lse{gJmttÌjeDN(iln.triì]ìle
r.Èrnrorlll.d tri iÌrn.lrrÌtrrbel.r. fornÌrLnÌü Samr\ l.d Ninr {Ì'iLibrÚ.
 639

An inrrjlulionil Ítrúio. ri) rhc probliÌì ol tìme ìÌrcon\iste.cv is loÍ ihe ilo\ern
rÌìent tr) hand n\ cr de(i5i(rr makLng in .ìonetary polìcy t{) an ìndep..dcit .rntraL t)anÌ(
ÌÌi1lÌ r,i:r. Bul rllÌat it tìre goremnìcnt leeps conüol ot hr.aì poÌ .t,? thi\ Leacl\ ut
' I | . ' .r .:. r' ')
contÍrl o\o ll5cil polic! ar.l a.orÌral badi tÌìrt coltrols moDclar poli. rnct \et\
l' ."..
LÌ sectio. .l
a dilterenr isue is Ìiiscd b'| the to\ribitit\ that r{igr Ílrcrs are unine
n! to Ìlheth.r centÌrÌbrnli Ìcalì! js louSh íwith lr =r. ) oÌ not íi,irh I I > r,rl This
Llìc
pÍìteD Í'ilh Ìn.on\iiete informarion .irn be dnallsed a\ a tignaÌÌifg giìmc int rlÌr
looL oi attír1i,rn is oÌr fin. i.g (iônì thr circlrmstance\ Lnr.ìer rÌhich a ircil .enrraL
brnÌt has lhc n..ntire t. fúAur: r s.lcallcd foohÌg stratesv rnd bchrrc 15 ìl it \!er€

Se.tior I looks at the cftc.r oI rol n{ on goyerlnrnt behavl{)L! ThÌcc Ìrodcls are
pÌese.t.d: llrst, ÌrlÌat haÌrlte.s iiLhcrc arc l.ft,ìnd úglrtpaúiian crndìdrres i. en (ì..tioÌÌ,
1!heÌe lh.lcft..ndiclate jt k.o1r. to IilooriÌì enÌ)ll)! nÌenttargerabove equiltÌrrium.nd
the nght bcÌoÌr equìllbÌjtrÌìl Sc.und, ..n non paÌiìran but poller hungrr caidldatrs
ure tlrc cìc.loral pr)cets oftoÌlunisLlcal l ? tor e\dDrple, ir í í)nerimer suggcsrcd l hit
iÌrclrnrbcnl go\cnÌlents i\.iÌl dclib.raLcÌr boon the econonÌv beír.e an elecrio. in o.dcr
to ÌaiÍ:11ìct clÌânces of Ìc-cl..1io.. lhdtr,.:LrÌvorjl8theorvreÌlura.vtìrjrgaboúLlhc
tr\ rxrcs lhnt rcÍers silÌ ru(bsÍuÌlr bc alìlr to iÌlpose on iì go\ enrneÌìtl
Thc lniÌ srcti.Ìr ol thc chattÚ dciìs NitlÌ uÌr irÌteiepenlence jI t.Ìicr miking
hch\,cc. irro go\ennìe.ls: i.c. thc lamc irÌ tlÌÍ cr\e is betlteen tÌÌ() So\eDmcnts. A5
rt s;i(, n ChdpteÌ 12, LI ÌÌrlh gor$.rncnts pl.ce a fo\itir e \!Lrìe orÌ hìijheÌ outltuL bút i
ncgalilr one on hiBheÌ Solcrnnrcf L spcndln! 1ÌJe(.rLìse it Ì.rises theiÌ bu.lget .ìehcitr, thÊ
ln Lcrdcplndence in Ìelcls oÍ orLlful bchlccrÌ tlÌe íro thrt rúte\ ìrori tra.le nìeans rhat
bollì gain lrouÌ hjgher gorcnnr.nL c{pcndiiure br the other. We sletched olÌt Ìur thi\
ganìcnÌiShlbeÌeítvedirìiìsÌrflcin!lrChapterl:1rÌtlÌis.h.ìfte.1!enrcÍho$i{rmÊ
thcoq'.4n1ÌelÌru\undcÁLindarifg(.oidifÊreüttrr\siÌÌrÌhichih€iÌÌtetuc Ìr beti{een
llro ration.rl go\ erÌrme.ts.an b. rcsolrcd.
Ihc trc.lment ol grúrc rÌr.orr i. Lh s .hapter is LiÌìitcd ,nd s€le.ti\ e. but it câ. t)e
lnllo(,cdsilhouttrlr)ÌÌnos,lcdgr.Bt.rnúnÌgour!li\.u\si!noìÌô!rìr(oÌìomicexanÌter
thal Nr lÌa\e erpÌoÌed c\r( f s i!ch al rcad! .tirììe iÌ(oxsiÍen.l arÌd iÌìte efenden.era.d
.rÌ!hi.lÌ the econonrL.: i. ÌrLi( ion lìn5 Ìr.cn pr!\icLe(ì, it is ponible to irúrrhÌcc anumbeÌ
o kcvg.ÌÌre theor\ con.:cpts and Ììclhods iÌì a Ìu\ tÌÌati\ rehtirel) e!\jl! abn)rì)e.ì. \\,hr.
Simctlìeorvi\t[rght,il(L5ui]lÌlbcgnìswjthJtrÌrlrrrorJ!Ì(^eSrnìesmchrsthcirnrotrs
l']rl5()n(rs'Dilennna gaÌr( dis.rrsscd io Ch,ìpteÌ 11. Ilo$'ereÌ. jtr ur15 chxpteÌ lrc b.gi.
Ni(h th€ nÍÌÌetaÌr poÌl.r .raÌrpÌc il] n hi.h the i{or enment aucl wage rÊtteÌr arc thc
flarüs ir t1ìe Same. ÌÌr th 5 gnnrc, 1ìrc pliì\ ei5 n!ì!e s/ro?li.rllì,. Lateì o. i. thc tjripLcÌ,
1.. c..ouÌìteÌ probLÉms fnÌìl.hlhcllavcrsn!trerirDult.uÌeounv.Theeranrtìcinror.
h.r' rcturrÌÌrìl.tiÌrs lamiliar c.ononìi. Lìroblen\ ìÌr terms ol i{ame theoN cxn tÌo\, dc Ior
emorcs\'!tenÌrti!aÌrclsalislri.Ãnn.lJsis.Iìea!ìeÌs\!horaDtxnrlÌeÌintr)LÌ(tlof(o1lìc
uscolganÌetheo h ecorìomi.s matrlirni to reâd RobeÌt (libbon\ s erceÌÌcnthook cd,ìre
tht t far .\ppti.t1 F0ü." Ì\'5.:
640

1 Monetary policy and time inconsistency: the pÍoblem

oÍ overambitious goveÍnments

1.1 Time inconsistency in a game tree

Wcbcgin $'ith thr tlme iÌÌconsislcn.yprÌtelÌÌ. lhiswas intrxluc€d inChaplcÌ butjÌot
5,

inanc.ÌtlicitÌvganÌc-lheoreticíorÌì.ÌtÌna)beusclltlnÌdreìeadertoretiscse.tioÌrs61
rrÌd6.2oltheÌÌìonclaqt)olicychaplctbefore.onLinuiDgB)'takitÌgâprobhÌnthat$e
h.ì!cn.allsede\tcnsh'el)alrcidv.lhcìnüoduclionlogametheoreticmcthodsis iacle
eâsler. lhe le:- coÌìtrìhutioÌì of garnc theor) Ìncthods Ìs n) ìmpo\e a .lcar dÌscitÌÌre on
tlÌerationalit),ofdc.ìsioÌr aklngbvagents at.lÌstages l ÌeÌe we anal]'sc th c Pnnte .rs
:ì gânÌc lhat ìt pl.ìycd oter timc in 1lìc seìrse uÌat lhc llaveÌs mo\ e sequcnliaìl-v When a
garÌÌ€ Ìs analvse.lis bcing Ì)k,vcd o!.cÌ liÌne ii is.allcd a gaÌne iI ertenslvc Io Ì. To bri!Ìg
out thc slrategic.spccls, we prt thc tRrblen in a tinrtìined loun ür this cbapter' Wc
sirììplift gÌcatÌ) b) assunrnìil that 1lìc goveÍnncnt has onÌ-v tÌlo L€v€ls oí output it cin
choose: cilher l!, eqLriììbÌ1unÌ outpul, or )'r , dì€ go|crnmeìrt'\ târget olrtpur' where u c
at\rune thnt rhe taritet is aboretlÌe cquilibÌiuD Ìevcl h is is irhat de1ìnes thc govennnent
as'overambitl{)Lú'. SimiÌail) ìlagr scltcrr, l1is,.an onl-v.hoo\e t\vo cxpccled rate\ ol
intÌatioiì: 20.1, ancl.1%. lherelerantgnmctÌeeis shoirt inliia 161
\'\ie nssLrnre NaSe sclleÌs llvsl havc tìre nrÍ nìovc and cân choose jusl one ot tÌ\'o
elpeclcd rates oliniÌalioìr, Ír 2'loor,1%.InthcknoNledgeofrílÌat lvl has.hoserÌ. the
governnr.:.t (c) has tht secorÌd ÌÌrovc anLì can choosc.ilheì I = rr, orÌ r'r : r. These
possiblìitìes aÌe s1Ìosn Ln the di.gram.
1,,Ì rca.leb NlÌlj irc trnlüÌÌrilìir (,llh c\teu\it € Ioflìr games, the diagranì is Ìcad a\ fol
loN\r lhc s.Ìu!r€ boxcs inclic.ìte I'lìjch Pla-Ìer, lv.! or G, make\ a move whcr the game
gris1oth^tbox.foríuLurereferen.cthchoxesaie(isuaìÌ)'.iìlcdd(irn,rod.s Lhcgame
starli et lÌre top bo:i or (Ìeci\ion nodc, r,lLh ll'J haf ing thc irrsL move Thet\!oÌiÌrcsgoìnt
do$n ÍÌom the 1,1.! b.a irÌr:licrtc thc lNo choic€s opc. Lo l'15, Íi: l% or;r 2ir,. Ìl l1r
.hooses nr +'ri', thc garne movcs dotln the ieft lìa.d ìine lo the Ìett halÌd G d.cition

tr (;

1lÌ
FiguÍê l6.l r,È n..rr5i._.r | Ì. èràr!
l-l
 641

rÌode. G noN rÌìo\e5 d .rn.hoosc cllhcr), li oÌ ) : Ir -- r" is íÌonn bl thc ti'o

m lìÌìr5.onìiÌì! do n1ÌonìtheLef11ìafddccisioooodc.ÌtWichooses-r 2%, thr g.rìr'
nìorrs d!$n tlì. risht hdÍlliÌìr to tlìc righl ha.d ai dccisì(n node. a rÌo$ nìorcs iìnd.af
.ìil.in.hoose eitherl .r.orr r':1 is sÌro]ln b! the tilo lnÌe\ coÌÌriÌrg r:lo\!n lÍom
th€ ÍiglÌt h.nd decìsjon node.]\11ü ri has Ììovcd LÌì c ganre end\. A5 (dn be seen tlìere arr

loLr possible p.ìir\ oì (hoiceJ (2 r'!, r,l, (2qrf,,rr l, ll riì,l',.ì, xn.ì(10'n.l'r l. I hÉ p.ì! olis 1o thr
ti!o ph\ eb are nrxrn unllenÌerth e..h oi thr l,Ìr lìnal mol er b\ the go\ennÌÌent, Ìliih
:.. uÌepd] orì to Ì!.Se setters nÌo$n abolc lhal lo tÌr( gorcÌìrnreÌrt.
for siÌnpli(it), it ir rsnuìied tlì.t thr n'agc scttcrs âÌe ìnteÌested onl) irÌ shethcr - is
.. 1ì. elurL to Ír or rÌot. Il it Í, iheÍ pai oiÍ ls l; ii ro1. Lh.:iÌ tal olt i! zero. \\'e u5c a snìplr
rÌÌilii]tr.une:Í nr+), r,.,\susLLnÌ, nfaLìon is â\ expected. onLl í'lìc. oLlll(rl is
at eluilibrilìnÌ:n Í!Ìlhen)'f..lhusrvJgcl5âtav(ìlfolrlr.!ntlÌccoÌrbnalionr
/ . t,'.i tLJ rn
an.l i.10/i, r'r r since; :. .! in botlì thrÍ cisc5.
\'\.enoi!turntotheÌravollsoithtSo!(úìnì(nt. hctâÌ otìtoL nrnìsiroÍn iL5ordoot
trefeÌencc\ o\eì rhe n)uÌÌro$ìbLe outcoÌnes. Ìhr ord$ofpìeteÌexres ÌorÌr bcs( (oNoÌst it
ir! =29i,.i =r'r,, \"-t:2alt.\, ).1, Í-r .l'li,.f -r.), (.r .t'],o. t, lrì.RcílccLing
rbi\ oÌder oi treferencet rve a$!rììe tlÌc pat olls to (; are .1, :1. 2. .ìnd I rcsprclivclJ. To
n rl "r
;=iiwhent.=1..a$umetÌlr\fhen,r,r'insLcadotl.uÌat.rdd!atcr...lagetoiÌrt
LoÍ.i.e.;:rr ),j r'.:ri+I lhislmpìcsthalÌheiìúÌatiLrnratciÌrlhclourolrtcome\
is l!1) (Nhrr -f = 291 an.]r : r l. ?r/o (Nhcn ;r = 2ol, rnd t' .1,,1 llri) hi'ht. nr = .1%
r

n.dr:lft,an.Ì5.ri,(rheirr .|li,rrìdt, r,r r \ow, uÌe kr! iÌsÍlmttlon about (15

prctrrc.ts i5 thlt wher jrflatìdì is lorr', G allachcs littÌe irnporl.n.c to x dÌghtÌ) hi8he.
rat(otlnllelion:thrÌeÍoÌ.LtirjlÌbeprep.rrcdio5ctr,t,re\eniflhc.oslis:lÌ)ÌathertÌratl
2'l0infa|.n.H..crGtÌrtcrri-, 2tr.Í 39i r':r,'rt.ì1-r 2rii Í=2\,. ) =!t\
Llul Nhcn i.nation ir higlr, G i\ nÌu.h nrorl .on.cÌ.c.Iabout raislng the rate oi lÌúlatiür
i!'rrÌrcr. Hcn.cGtÌclcÉ ai : 4"/.. n +'\,,, r,.i t,, t-t 1)1, n = 591,. r' :rr ì.
1

Ho\! ls th., ganre ítved? \\e begiÌr bt iÌroilng h(\! the golcr.mc.t $ouÌd Lilie thc
gam. to Ír)rli oul an.] lhen clelrcÌÌ\triÌlc Íúy this ú not n soìLllio.. CÌearÌv ìt is iÌì thc
govcrÌÌnìcnL\ lnrcÌesl ftrÌ IlJ to \et ir 21rì sürct tÌren c grts a te-r oif oi :l or lj b!
.o.tl.sl, lI lllt scts Í' = 10,i,, l; lrts. pat oií o Ì oì 2.50 r,e nìight imagine I ciüì\
golcrnnrcnlsallnqlothca,agelettÈr\bclorrlhcwegesetteÌsh.t(Ììold'lí\ouchooÍ'
Ír 21rÌ, $r guarinlcr tìrât ile wiLl choo\e ).. 1hÌs s i. our nÌ.ir'st b..attst we e !l tl)
Ì\'itÌrafa\.oiot3.Andjlisjn)ourhÌt€Íenbe.ausc-rouend!p\!ithrr=Íorala)olì
ol I , Ì!hi.h is thr: btsl Ì$trll I(Ì lou.'
Sho(rldlhcq'egcscll.sbcllevetlÌisproÌnis.lllìcii$!eÌ]srÌo..sNi'hatcalÌcadvseeu
lnCÌìaftff5 ur tc[jng o Lú rhe ganÌe iÌÌ its c)itcrÌ\itc b Ì,ÌLeíÌallros'scclhcsanreloiaic
nr Ì!ort and also stc nroÌ. gtnÊirllt \Ìh) thc ginÌr'Io Ìati!u\€luliorn.elvsi.gwhether
promlscs alc cir.dLÌte or noL. Iìr thi! case. tlì. golrnr Ììcnt \ trlnise is not i .Ìcdjbìe (Ììe,
al ìcesl il lh. r'egc sctlcrs belieÌ e tlÌe goÌ enxrìent is ratìonaÌ. lì!tjon.ìl bi'Ìra\ l.rrÌ here
nìciìns Lhc IoÌ1.Í'i.g: irlìcn il come\ to tlÌe iloÌ €rÌnx'n fs tlÌrn t() nÌot c, tlÌc g.!cÌnment
wlll nìakc lhc .hoicc Lhal marinrìze\ it! lìay oìl it thal tojnt. To see lÌht thc pronrj\c
is nol crcdiÌrlc r6i.g th. lools .l the erterÌsile illrÌì., r'c begin bv mpposirÌit thc s,agc
scllcrs.hooscif=2'h. llrcn lÌre go\ enÌnent 1ìnds iiscÌi Ln the riSlú lÌind drcislon nodc
l'rrl
542 ,:: :

thc govenìmcnt if ll ìs Ìation.l r'ì1ì choosc / = fr ' l1Ìirs tlìc G'J proÌÌìisc to choose
helìe!ês aì is ratioÌ1a1
.f - r.1l Wiclìooses nr = 2olo is nol credible lt Wç
Gìlen t1ìa1 G\ pronìise í not credibìe, what shoukl wâse scllcÌs do? Ìfthey aÌ' Ìatiollil
(a n d th ey beÌicve C ìs ratÌ)nal), thc-ï wlll see t h at choosing Ír = 2vô irÌplles will choosc
ír '; As câr bc
r /Ì, lo thaL thet pa) olïlrom Í' = 2olo is 0. wrat ifthc!.hoose - '1%?
secn lunthc diagrâm, G wiÌt tlÌenchootel' l?, since CÌ pâl-otltu!Ì)' )rr is2whilc
-
its pay olflionì )' : t,r'ìs 1 il -r 4%, so x'agc setters cân guarantee tlÌât G tliìÌch'rosc
I f,. jaivlnglhenÌâ pay otÌof1 il the-Ì choose Ít : 4%. Hc nce if rationaÌ tlage setters
belicvc the govc irìnenl is ratnnÌal, th cv wiÌ1 scl rr = '10l., and G Í'ill set I 1'.' (This is of

cou rscexactly th e saÌÌìc aÌgument put iDto morc explicitgaÌÌrc lheoÌy lòrm that we havc
alread-r made Ìn Châptcr 5 ivheÌÌ showinil hos'sage letters \{oul{ì behavel!'ith ÌatioÌìal

lbc golernmcnt's problem tlÌnl ii cannoL cÌedibÌy .olnnr il iLreÌl t.r a lcvel of o!tpul
is
itÌ advãnce ofwage sett c 15 .lecicling lheir ilÍlation expe.taljots.lfit (ould' theÌe Ìlould
be no pr.nteÍì.l!wolld comnit itscìt to/ r"il;t:2% Wage setters warulcì then be
of a cÌedibÌc (or blndnìg) comtnitÌncnt'
treparcd to set n' = 2% an.ì, by thc delìr]ition
the govcüÌnent wouÌd thcn set I {hÌ thc cxaìÌple 1ì€rc' lvl_ ìs iú1iflffent bet*'ccn
f,
r! - 2,/oandÌ! =.+%intheca\eofaL,indúScommitmeÌìtbecnusenehar€as medthaL
alÌ tlÌat matters to them is üratinfÌiuon expecta!!ons aÌe tu1lìÌlcd (aìr'ìhelÌcc that)' tr;
ìnpra.tìcewemi8htplauribl)' r\nìnc lhat l1:S has aileaÍ 'r slighlpÌeferencc l'n the 1oÍ'cI
rate oi jnflatiorr and wouìd thus choosc 2%l Note that il!\'c Ioll(N this Í1ggeíioÌì and
mbstÌlute a palr-off to tvs of 1.5 (inslea.ìol Ì) ld the outcomc of Ír 2Lri'l':l.this
does not altèct lhctilnc-irrconslstelÌcy outconìc in the absenccolabìndiIÌgconrmitmenl'
'Iìmc nrconsislenct prcblems âre Íc'ÌuentÌl' cncountered ìrÌ ccononÌics and prcbabl-v''
in rcaì life nÌ!Ìc generaìl-v as weÌ1. Wc crn talic anotheÌ etampìc to iÌhútra(c SupPosc
thât cntÌepreneur Á ÍìaÌer an itrv€stment in machìneÌy !!ith ir zcro second hand !a1uc
tÌìat can onÌi bc uted pro lÌtabÌy $ith s oÌker 8\ paÌticuìar skills ln that câ sc th c prcfits
are I0 an.1Á lriÌl undertakc the iÌìvestÌìent il hc cat ÌnÌ th€ prctìls with tl so lhat both
get5- eassurÌethatboLh aÌe betti'r o ff with 5 Lhan i!ìthorú tlÌc lnvettrìelÌt ButorÌce
(an
Á has mrcìe thc inveímcnt, B is iÌì a stronia bargaìnìng posliion to gct, say. E sÌncc ,1
do nothiÌÌil clsc irith thc machinerÍ Howeler, it I onlv Sets 2, lcl us atsuÌÌìc lhat that
docs not covcr Lhe costs ofthe itÌvestmcnt HerÌcc Bhasaproblem ottiÌneÍÌconsittenq
LhÌcss she can comnÌlt in adlance not lo bargaìÌÌ 8 altcÌ the irn eÍlÌìcnt has been Ìna'1e'
.4 r'iìÌ not akc the inrcslment aÌÌd ti tlill be Ìlorsc olI. In the comÌncrcìal worÌd il nrav
be possìble for; and li 1o w ie a colÌlra.t daung llìaL both .1 aÌìd Ii s'iìì Ìeceivc 5 lronÌ
tlìc t ransactio. , bui sü ch contÌacts nì.y Ìre ditìcuÌt to cn f.n ce legally Ìro r ì n úance lj Ìnay
noL $orl tìlly cooperatiteì) unless slÌc rccenes 8. bul Lhitìnayb€dílculttoprovcjn
couÌt.ln üntcase. with gove rnmeÌÌt .h o i.e ofmorÌctary loì1cy, conüa.Ls wouLd uÍrallv
bc meaniÌìitlcss. Giver an jnabiÌity to prccoÌnmit, tinìc nrcon\istency can be â nìaioÌ

1.1 1 Summing up
Bl.irorkiÌÌil backirards Lhrcugh the gamc tÌee, it is cÌcar lhat if lvi chooses Ír' - 2iÌ)
lhe govenìncnt s,ill choose I : ),/ r. )'r. OnLv il th€ \!agc setteis choosc Íf : '1'lo .an
thct be lur€ that üÌe govenrment wiÌÌ scl.f = t. \'Vc havc therelore shown thit thc
 643

ito!ernrÌcrÌ1 cr..or .onÌnììt cÌedihÌI ro an irúÌatì(Ìr raÌgcL .I21h. rve \tralt Ìook.t tÌ!rf
uÌei{ovehì'Ììrnt.u írl\. jttpÍìteÌì lÌ.visitjn8 Í)me oíthc idcas discu$e.]in ath.pteÌ 5l
.ìfter irlrodu.iÌÌt I liÌLlr Ììine 3ame thcory'.

1.2 lntroducing some game theory

_lhc
\!a]. ouÌ 5i,ÌÌple e\l(,fsi\r fox gdme rlas 5oL\ed ilrs b) rhc nìcttÌocl or td.tüüll
n?drr.tldr. ft is âplìlicabÌe to cxtcnsi\e gaÌnes (rilh.r iìDite numbcr ot morr5. It mea.s {hat
vou Íaú Ìlith dc.ision n(rdcs ilÌr c trores iI o!rÌ g.Ìrìel it $hjch, irheLclcr.hoice is nradc,
lhc 8.ìxÌe ends. the5e aÌr Llìc tí,o c bores. Ior rir.h ol rhe\e .lecÌsio. nodes hlhich a.c
o (l:n .ülle.l t.rrnr,l decirion nodcsl, the opLinìnl choice or the pìalcr al t1ì.rt ponrt wilÌ
bc crident: llrc pla)'eÌ aL â L|l irÌ.ìl !i."cì\ior .ode .an \ee rhe Ìrav oiÍs of ea.h choicc.
lh!satthel.Ilh.ìndternrlnald€.i\nÌrmo(lc,OclÌlro\esl=r.becausctheprì\otfof2
i . r 'r p I I ,,1-.1,.
.n e\tensi rc gi me diag ram to slìos hoir the ganìt is \olvect. to Ìeprescn L this choice bv r
thicleÌ li.c-hcre bv a thlclicr daslÌed Ljìre, âs.an be seen iÌÌ lig. I6.2 on lhcI l. choic.
lirÌe tìom thc Ìclt lÌa.d rcünnì.1de(i\nrr nodr ol c. Nor! iì)Ìt(^L rhc samc pÍìcecìuÌÈ
lor alÌ the olhcr tenÌi.al d.cislon rulet: jn our..ìsr th.ìt is simtlv rhr right hdn.ì c
ÌÌlrde. \rh.:rc (J s choiceol,r ],r irUr"1ir"O,ot r,f. r\g.rjrÌ rhij chojc. s nÌ.ìrtectbva

Hdvlnitdon. thì\ l(Ì aÌl {hc lcxnnrdl clecis(rr nod.s, r'€n1ore bacÌi upthcganÌeto the
perNÌtimilc deci\n)n nodcs. 1lÌere it onÌv onc in our ganÌe. t{S \ lInial dc.ìsion xocte.
\'!hat ailìbr tlÌe pav oÍ ftonÌ orclÌ choice r r rlì s de.i\ion ÌÌode? Thì\ is casr lo c.rlcuhte
rr brl)l! be.auserlc kno* wharc's nÌor e Ì!i11L,e tì)r ea.h ol l,ts\ possibledeci\io.r. \'isü.1h, uìe
fav.ll to ca.h ot Ìr5\ choi.es i\ seen bv go rÌg do\Ìn th.È relerant .tatrcd linr to the
ta) oÍtsattlÌeen.lolir. husifl\'Jchoo5esir-.11to,ihcp.L) olt otl ís.cn bl goirÌS
cìownthcdanÌedliner,=1,..5lr11.i$ilLchooscnr.l'rio\cr;i 2olô \iDcc Lhcpnv oti
n) l1/5 ot Lhc lltter Í 0. So no( dÍ.\! I drdre.l Ìinc on thc nr +%choireÌiìre.'lhccam.

/
: i !ri!

/
ii
:\uillr
[f Lr\.
\,
\
0

I
Figure 16.2 Bà.|{a.a ndu.tôn
 garn e unul
is nor! \olved: thc ítution nr oves doiln th t .ìaíÌed Ìi t es tìonr LÌr e start ol tÌÌe
its cn.t. fiìis pâth, nr '+7ô th€n l' = r]|, is called the nt Pú|| ol tlft {]me B\
'qÚilihriolrtclrmc tìrat nÌa\ iÌnlz€s
exanrlninij the pai* of pn) olls, it ls ob!nrusthat this iJ not ilÌc
thcjoiúr;t1ììtvotr'lJandG:$ith):lÌan.lnr-2q,'thegoveüÌn€rìljsbett'rofland
x/ill
tlÌcwage scttersno ivorsc off !ut lhe gânrctree denronstrateswhynìch an out'ome
nol be obscÌved i. dris game.
Game tlìeoÌ! Aocs a lil!le bit lurlher iÌì cxplaini.g 'xactlystr! ìt is ra1!onaL lor tlrj ând
Grobehavcìnthcwar_thcv.lo ltu5e5thc.ouceptotasubf.' el(flctetl ilibrütttt(\(ìIiL)
.{Í1b8âÌÌrc. at leaÍ i thc absencc olunceÌtaiÌìtv a! we are assumirÌs heÌe, i\ the
grÌnc
\\'hicì1stârlt at â dccisiorì no.ìe. lÌr ouÌ 3ânìe there arc thÌee subganÌes' naÌtúÌS from
e:ìch

ol th e thrcc .ÌecisÌ on rodcs Thus lhe 8ân]c itsell is aì$ cl'r\sìlicd as â ÍrbgarÌe
'lhen,rtionola.SUI'Ìbâsicall]'meansthatipÌnvcrl)eh'vcsÌatiLÌrâll-v''atea'holihnt
plaÍer's dccision poiÌús (ìresPecth'e of I'hether thcv are olì lhe eqLrjììbrium Path)
lo
;e;ne an saiPE Ì!c need tlìe corÌceÌrtola pla-rer's slrareii) r\nrategv is lhe choiccap1a-Ícr
wiÌÌ Ìnake at each of its d ccìsìon no.Ìes $rc iriLl p ú1 a stÌate8f in curlybÌackets {Ì Sincc

Ì41has oÌìÌ-\ one decisiorì nocie i1 has oÌrly tlÌe ti!'o possibÌc stìateiljcs {ni = '1vD} and

1Í!:2ol,ì.ItisnroìeconìPlìcatedt(ÌCslnce(;hâsLwodecjsjonnodcseachioìÌo\!lng
tìonì e.lilfcrcnt choìce ot L1J:tlÌüs a (, strnteg\ ì\'iÌl lake tlÌe loìlowing toÌm {iI nr -
ill]lr'

then t = tr, anclil;Ì 2q" th€nl = 1-'Ì riìdentÌlj lhere trtru possible c slrategics'
'rc
Tt\e;quililriLntõtctrLültlrateg,voiwJisolcourse{nr=+%},âÌrcltlÌalofc{ilnr-'1'h
thcn t. = f. andiínÌ 2'Ìì thenr:/rÌ
'lhe requireìn€í)t ol ân SGt! is that,lor aìÌ th€ Ínrgaìne! (or decision nocles' iltherc is
nouncerta!.t))ìna3aÌÌìc,theplaycÌwhosctlrrììri{Ì'rnrrÍr'etthestartoftlÌcsubraÌÌìe
choscn
!Ìnlstha\,e a Ìatio. âÌ stral cgy tronì then on gìv€ÌÌ (jf neces\a{')the othcr plaver's
Írateiat fionr then on.r ln our ilanre it is Iar nìorc sinÌrìe tt lhe í\'o núriiarncs which
stn rr with aj .lecision dodcs, nonìbsc.Ìuent stÌategics h ave tlr bc
taliellitÌlo accourtìÌÌthc
i0tìonal choice sj.ce t1Ìe)'are temìinaÌ nodts. At thc strbiltme (lhe ÌlhoÌe gâÌÌÌc) lvhich
Íarls at rvs's decislon n,r.ìe, I1/S has to tate accounl of G\ chosen Íralcg-Ì ftom then
ô. 'rh,,s the cÌashccì LiÌÌcs ìn lis Ì6 2 capture e-\â.tLv lhe iclea ol SGI stralcgie\, and tlÌe
mcLhod olbaclil\a indu.tion riÌì agrÌnc ofthis \o'l)guarântccs arSGl']I The crjtìcal
ji
point ol an 5C|l tlÌnt both pla-vcn aÌe rati{!rrl 6'hcneler it is their turn lo DìoYc; and

ihis iÌr.ludc\ assuÌnitÌg lhat the olher fla)'cr wiÌl behate tinÌilarÌy 1 e aÌso Ìationalì!' at
subse!ucnl movcs
In a gadìethat is íinitc (i.. ìD Ìlhich there ìs atì\ÊrlnLrmher r)lnìovesì aÌÌd ln which
ther€
Ìnethod otback$ard jn'tuction iÌnPlics lhat
is nouÌÌ.cÌÌaüú,v, $Ìving lhe iianÌc !$ìng thc
thc Ít!tion 1\ an SG|1. lt an equiLlbriurÌ is an SGlL' Ì1 rurle\ out non c'edibìe comÌìit
Ìnents or pn)miscs (or inrlcc.l thre.ls)I ttÌat ls its critical lmtoú'ìn'c in Samc theorv a'd
the re.so. it is so u\elui jn un.ìersta.dirg whl tinÌe iÌrconsistenc,v tribl€ms Ìnat arite
brtÌleerì luìÌr ra1ìonal PÌaYeb

r \\c.JrÌr llhi\tÌ.1rtu'nrrLlJ andg.rrtrlÌt Ì.iíL úd.rbrihrnÌiiegirs'tlLx\Ü5'ìa'd8 '\ nntulJ

sLâ1r\rd itÌr.flr){r'llld.rtthesL.i.teì.hírbgr.ìê.1Ì{hrh rrÌrÌi\eLhr\iÌtJnore'\r !etr'iil oritl
lrcih.nntegir\,tì ifd /] ÌesÌre.tL(lI ìt dìe íaúot üre ith { )Sldrc Then Íì rtd or, ar' I \('L'l nLrt g) l]]ii
iiJf.lrnÌriÍ Í rxrÌì nÌb!ì.re, itNhi( rr.l his nì. niúúÌ nÌrv', ',iilr'l!oliiÌralnlrt'g! ni túb3Ìrrr i!(er
.i iì;and!n.\ê.a aicd.hnrDlrrÌ.iriÍììirh rj haslh(irr i'L Ì)!P
 645

rzl SumminguP

.ììi.,,,,ì" rll^-"'thcir roiÌrt!LliÍ ii rll nner\ed

'n.,,

Using game theory methods to

look at solutions to the
..
time-inconsistencY Problem
JRiNettrr\ foLic\l
Lbt llilr' iÌr'1r'sisterìL\ lrobl'm ot
Ìhen JÌc thÌt. l!1!d {1uÌjoÌìi l(ì i' inl trútrÌ ' Ìo
I ht lìsÌ ir'
\llthr. úì1.11e iÌlÌiÌjng thr ìÌiìl!I( ot l!ìr !nmr 'r 'Ìr!:rtÌÌcr

ltlit Ì+rr(
'l' j =l I i' sttr LÌrg trì 8 \\ ft)rr'\' LÌf trr \
i];:ì1.,"', in a nrre rnstrLur
'o|rL '
'hiÌrtr !L!ìegit$ Ìj](Ììct.ì11
':''.';i
. ] .,ï,.ì;;'i.:. ',. .;. . .."". \!r Jil. \rh.ìl hiÌl)l)!ÌÌi it Lh. !.1tn]nn.Ìn
lll;::i:",;;ì;;,"",r',r.ÌÌ,,ì.,.rúLi{\r"ìii"1,:iiì::ii:'ì,:i,".,,,,",",",,,,,
h.!r.(Ì!Ìr rr.a.hiiÌo'LìrÌ\!rrrrhathrri|!rir-",i"n,ì,i.,,,""u,,,,,,u","',','u,.

'f., n rÍ i1i kÌ! : lÌl.L ü elr \etLtrtniLl lrLtrÌ

,rÌÌrllbúnìlr\rlÊ.'lÌler rì!júü'1er'tri:ìiÌrL
l:.]ì,,i'.i,:'.',ì;;ìt \\''\Ìì.ri{ìÌr'idrirtiìr'nrÌdiljoìi
'rlt'rÌìf(r'i'i'Ìd'\iìsr:erttlit'Ìr!rijÌrrt!nrir\jrL'cÌ.\rsirl
'1,::,;,;.,;*ìì;tl't''"",,"""""''rrr-r"'c
Ìr(lcr n lli(1r tìÌì! L\Ll"ÌÌÌL' \'lll Lr'criì

ìì,.;,j,,";,;j".,,',,'uf,,os,\,h, rìr!.r'tr'!\ilt:;i":ii::,ï,llï,ïì^;'i1",:ii:,

ri:iiìi:i::ïìï1.:ìil:ïl'l:l:ìì:ìlïÏjl'ïiiÏ:ìllti:i:l:,ï.ÍlÍl::lll'l:lt:
u"" " ,'
r:l:j' :'ll,ll:ì;lÏ:i:li:ïi:l;l::.1ï illlì: ìì lìì'i"''ìi j; ìì"' 'i"nr' n((nì
r
rìar rrb'rh'l t r'| I t.',rsrr
"
1
' '"
ì''LiLirÌ'l
ìl:l ; ll ,ì":;,i ;'"ì.
,ììi"rs h''e
'r
.1,,.: ìì:i,;,1ìì.:;,;,, ...n,,,,, n,,
",,',".,.,,,,1.1ì]':ìïì,ïlJ'iï'i:ii:ììïìj:]l:i'ï,1
_,: l. rÌl ì'sc\:ÌÌrlnt 5iÌr'r lhÊ) brtc n'trì I

,.tì:':.,, r't('rL'ltÍr' i: trì'':üiri'ct .t Í'(tr(u ì'

'
';, ":""'t"
j.4 Multiperiod games: endogenous enforcement and punishment

'ì ìr. iÌÌ lhi oÌrr lr'riod !:!Ìì' i\ tin'ìlr

646

inletionbid\.\on'1\'etlmLoe\inìjne\1ììath'ppors lÌc'this.(imei\r'ptaird'(-an
rÌìc wrgc settcr 'elÌlorce Soodl)eha!L.tIo'tÌÌegore!rnrì'JìrllrptothisL!r't'stha\c
iìrglÌed thet ü lr'5 À]d!i t1Ì41 tht golctrÌncnt is $cal'. rr 'annli cscrPe
lron tlìc LjnÌe
j'íÌation l)Lrs lhis n (eÍeinÌ\ tflr' iitlìc geÌÌÌi'
lnconslsLencr prorlcm: thffc \ill Ìrc rn
last, o,rc p"r:icnt io, in hc1 i tre.lcleün ntd nunìÌrcr ol pÜiodsl But il nra-\'bc
iniL'
porsìLnc lor thc wrgc setter Lo enio r.É :! t)elÌi\ lolÌr or1 Lhe 3oç( mnrerìl arú ftÌ th(
"1
go\ernmentt.ben.htÌ)\.s.atiiÌgftoÌÌrtLmeifconsiÍin'-\ \o long 'ìs lhc ìIÌ'tacti'n
(t enoLtgh l\cco!ld
brLweer Ì1/5.rncìr, crrrìei on i.hniLd\ afrì \.ìluc\ húur' outcomÚ
eqúrÌl\ r,clllmegirrc lhis gime being flì-tccL Ì)etr'cn ll _\ and ! 'rntral bn'k
ìvhcrethr
..nrÌrl benÌi i5 knolln ì)\ tbc 1td!e sctÌer 1' be Ícnk
Ìmtr!ìnc thal at tht 5taÌt oi taclr Ìrerjod. Ìri scts ir rqúaÌ eiÌlìcÌ to Ìr r)r to
nriì nrì11

thcn;sc15rr{ìurlroeltlrÜr,oÌl'r:r,'G\u1iììrv1ìì'clioni\thepre:"ttrlrtcoiiiìc
disc(ulL.d !m ol lhe uÌilllJ ÍÌon thlt G get\ irr câ'h pcriod i ilthich is l/
.' r ' i rüÌcre
rhc.li\|.ouIt 14.ìtir i! i \!. rxn Ì!Íite ai s utiÌìt) is:
iLi Ìl

5iÌnihrli, Ì1J s utiÌitl ìuì.tn!Ì ì5 lÌrt dlsco!n1c'l {nì oÍ the rttjÌ1t\ iloir J
I\ gets cacÌì

pcrlod;norn rhe.onÌbirìiìlLon ;: autl1, Befotu xnrl-çslnttÌÌ' tcFrl({Ì gaIìc w' n:'atL

ji hi\ I arÌaÌlred
ln IiB lô.:l th. orÌc period grnÌe bctÌ\ ecn 115 n''l l;: i!
íh UÌc san€ we
's
l,,r,,re.ntron",r,n,ìln,rtl.n.\\icnorsclllJ'5la\1)llIroÌnÌ)Lallngr'=''iìll'5iratber
thaÌì li i.e.Ll:t\trictÌ]Pr!'ltrsrnotrtcomÈolcrl(rilìÌ)riumout!utaÌrdlütnüliÌlronlo'Ì1e
ol eqÌiillbÌtunr outtut.lnd hith lnllrtion' As is tloÌì ÌurÌn ng tÌÌIough tbr bd(l(a
'ÌcaÌout'onre úÌ thc oue pcrnxl gìtre: 1lÌne
i!rdu.lì.n !.{.Ì.i5( rg!!Ì, Lhi\ hi5 .o eift:ct oÌr Lhc
tncons jìeÌì.r f Í\'aiÌ5
rrsu.",rotittr"t rt,e crLtn\i\t gaÌÌÌc in liq Ì6 :ì ir rcltdted n'1eÌìÌrìtcÌr '\s re shaÌl
thc timf.ln(on5itten.!trotrlcnr crf
see. nos b('dt:rlt ü illì bl Ìl l'bcing prcÌrar'd nr \ei rl
tqu.Lltr)-,re.hP.ÌÌ({lsolon:is(;c!rÌ1i!rLÌestÒsclle!rtiÌtulr'LlutilL'vtrÍltlequrl
n;!11!r'ilÌrL!ú$r(trf=rFiubie!lrLerúl\.SoÌllnonhas'rninttr$lir(olrft tlng
si;hl;írthrt ji i;.oÌÌtlnuesto.o(rp!'râtt 1Jì!'ir(^rsaÌcl:r'l','ìe!(hfÌiod'

Fìgure 16.3 Ì11i.ri:Ì. !,'] ri_t'.ì!ìr.rrif )'

2
 641

r\t the ol .rch ÌrÊrio.] I it is u\elLìl tr) dclfc Lwo p.)ssjble ,trittoÌjcs'of nìoves in
itiÌl
ca.lì previ{rb lt(.iol ol the grrìc i.r. Èonr 0 L. I ì. rn rhe ÊLt, c ha! coopcrated nr
cach periocì br n.ltins t, = t.. (alÌ this tvÌre ot history ajr_ 1stândirg hÌ a; tÌ.s il$a\l
'| -l \". LI
hlnor\ r,r rIoÌ al has delected IÌom tlìe agÌeem.r.r of al le.Í o e occarof). ll S tÌas the

. lvJl dl: li tÌre hìsLoÍv,rt the \tart ol pcÍiod l ì\ cu, ret rI ;j. irÌ ouÌer s1)rds ii ar hr\
coofrrated \r laÌ then contìn ue .oo pcÍ.LtiÌrg br se[inlia Ì.r'( ipt.tectrate ot j.]tiÌrioÌì
in the.urenr fcrìod.

' ltsirì: Il lhc hi\t(n.i i( thc starr ol pern).Ì r js arl), Ít -l ;,r, i.e. jt clcr ú tìils nr
ket it! sÌde ol the bar{Jin, 1lÌen punì\h c b! ntin! Íl - tu. As cen br \eerÌ. ihi\
jnvollcs luni\hìÌrg l; ìrì rir.h lLúure period, sirÌcc .!Ìce C rer\
lr rìr.: h story ot the
game isalì!a)\CD.

o has thc .ìÌo$iÌrg \tÌitcg1l

! a,Írr:lil;C.sc|, r., i.e. iI{; h âs .o! peirie.l .on tlnuounl , (hcn it should malntain
the cooperatlon rather than.lci.cl nnd be pÉnna.entlv purishcd lor doiÌìg í).
. Girl, ll a,D, setl,: =,rf if ni Íts. lnd se|., - l.r jtn: ir. Whltthn Javs is rlìa(,
gilcn G is rÌo1í bei.g punislÌel eveÌ\ ÌreÌ Ìod, c 5Ìrould lun d! $lÌaterer mrÌimtzcs fts
o.c-pcriod ta\ oIl.

Árerhcsc ÍrateBie\ âga.ìr thcoreti.e!uiÌìÌ)ÌiunìlThcelttnÌrrlarccquilibriLÌmc(rr.ctt

thit oi a nìÌrgamc püifct c!!ilibúLÌm rS(,trr.ì, sin.c rhr gimc is in e\ren\ì\,e ioÌnl
ìreÌÊ is
\!Ìth.oÌìplcteiÌúoÌmario.. Lhisrcquire\u\t{)nron rÌrârea.h tÌaÍcr\si teir\ ir(ÌnìmaÌ
ìn eâ.h 5rLÌrg.rÌne given tììc iulLr( Írite8r olihe oLhÈÌ pÌareÌ.lìoÌtunaLclv, se onL! lÌa\ e r
ÌlDLLcd nuÌìber ot mbgerÌì.s ro.onsider becaurc alì Ìra\t h stoÌics d !nÌ inio orÌe oitlto
i irtrtlng
50.onsider h 5\ rtÌatcar rlÁt lÌ.rearetilr)mbgamestoco.sidcf.ij)tlthelÌist.tr!.t
ganrc ir G1), l1/-\ linorçs Llìit ilir srt\ ri Ír th!. G Nilì ksfond rlllh rr Ìr ar ca. be
seen trom c,rìj il W:! Í(s il its, C ÌliÌl Ìe5pon(l wjLh ),i : lf Clcirl) i1'5 lloer best
bv choosirÌg lettiÌìg a pat oil ol 1 rather than 0. H.:.ce I1Sirr is optimil tor 11S Sì\en
CD. lii) lf tlÌe mbgaDc !tans (i1lÌ ca. h.\ kno$ tÌrrt rlhitcvcr .ro!r. it nÌalies a; wiìÌ ret
!i = 1,.. lf 1rlÌich case ll ls,rptrnirl to choo\e il = nr sjrrc Lhal itÌres ItS rì pa) oit oi 1.5
l, r'
oÌrhmal gjvcn c'-\ 5tretcgt'.
,,J t- . I. I

a; liÌroiçs iriÌl sct ri Íts iÌì each fulLrr!. pr:Ì od, so rhit C rloe! n(tr{has no
th.t 115
iepeÌctrsslon\tJe\ondLlrccurrrniperi()d.lÌen.(j! 1,r ts oprimiìl. íiil a,, and Íj =:,/
Aiaain(;knon\thrtlr-!r,illsrtif-Írinea.hlulrLrcpcrio.l.$ÌlhdrC.loesno$,lris
no ÌeÌrcÌ.rissiods be\ ond th! .urÌent perìo.1. Fc.(.c fr = l: ls optxndl. (ijì) t;C and i: -
tu ír\ìri.h Ll I $jjÌ (!rlv choose bv.ì(cidentl. G optlmiscs b,! settirÌS 1,. : )... ij!ì a;a-' idd
rl=;!. LlÌepa) oflto.ontiÌnre.lcoopeÌatjo.,i.r r,, r,,I is tlÌe prÈseDt raÌue o 3 jn th!
cunerlâ.dea(hliìturcp.riodÌsirÌcetÌÌeouLeomc\!llÌxil;ranctl,=l.rnrhisand
648

all nrbsclÌuerÌt p$j(trìtl. lrhiclÌ s.!Ìual to 3' I I ij l

l,,,ir.r !,,1.r r'.r[1 li+,i]i l=Ìr'iír'r, 'l

Ìhr Ììx\ oli iÌJnì dri.ction, L.e r', I is + ln the.!ÌÌ"t Ì)eriod btrt !irÌ'c t\erl
{li\Lq('tnt hislnÌl sil bcC./r'L.tarlÌ[LLürt]t'ri'rl ìr 'i "nrÊüìlbc1.' r rqLthr
ter f(Jio.ì fa)' ôliol2. llcÌÌ.r tht Ìrd\ iil nuÌr d.lcctiLÌì
is'1 2 j' I I ì :

!, iÌrt ,,, ;; ,t-l , .,, ,, 'i rjr 'i'+

lh!i LÌra\ 51o.(ÌÌrrriìlc ro l.ng rs

:l Ì j-'l 2;. I ,i )r-'Ì2 itú lr

llÈn.r,úr!illtrltlx'!o\er.mtnttonìeiÌ1tiìiLrI rrrì'*1hÊ(li\"rrtnltr(torslerlilr
141 Summìng uP
Àlth.rLghirÌlhcorÌltcrit)dsrrÌeLrr'Lrr.cnthl.leÌ.rnìbLtil\Ì\!'\1'Ì'ìlentin(1tlìlrtitgÉ
\etirr;nnÍliìlLont,i!Ìt:ÌLll\.thi\.n.beo\Üi(!Ìr.iithtSrÌrìrlricÌreitrd ndeiìÌìlLdl
hÌ fiìÌlÌ{1.ìr. tht rrigc tetlrÌ .rtr rd!!e tlr': gr^eI'iìtÌri trì ÍL
'trtÌtrrt 'L 'qullibriuÌn
rnl
irÌ r.5lì.Ìtrr 1n intÌ.r1iÒ. eÌPr.trtii!ìs sct Ìr)r b\ thr rresÊ reti'Ì h! rhre'rifnlf! tlÌiit
!kl,,cri1!Ì b! lhe !!\'eü!Ìr..t rill br tunisirlì irÌ iÌll \nÌ\i!Lu(fL teriú]5 hl tÌtr'1!ise
!cLLrÌÌrLr{lngil :,r.1\i'ha\t\h.Í\.t[n(;aÌìl]\\'srtraiÈÂi'\'l ri Ì,rricnrbgaÌne
j' (ur this Ì(ÌLÌlr'd Lht
P.rir.Ì ii th.re is :Li licieLrL rtishl Òn luirrr. lÈriods. '{inrÌ)Ìt
(lis.!urÌt ie.tL)rto br' i I l

2 Fiscal and monetary policy conflicts

\fe lrri. r$urìrid \ü itI ln thij .helltÌ tlìiÌ t|e !.tr r'r'mtnt lìns ble]r
m(Ìriiir\ iÌrS

t.li!l lô.h(Ì,n'.!.tÌui oÌ trrÌplo\mcnti|ÔldeÌtlr.o.h.ltlÌ('r1rr)lnúlillon ÌìidÌI

jÌrg thi tLDe lÌ.,rnrjtten.\ tr!blim hrr lr!'c. ìrÌrLl:(1 Ln ttnn\' irr'rr o (lrleSttiIS
'//i'/
aurlÌ!riLl nìr nì.nltaÌ\ toÌi!\ nr ilrcntr I llh r nr..grÌ (oÌlrìlil'r'nt to iÌlÌlntio' â{hL
uÌirllÌi.lheiü.Ì.ÌneLìL lrìtrÌritLlthe!olrrrÌÌlrnL 1ÌriÌìj'llr]LínoiÊt'iìliìtLtn'ri1ll
(-ruli not llrr s(^trrnrrrnt tirrìdl ute lì\.nl f.Ìi!l L' coultir \Ìhetcler ÌìrfnstrÌc! ihf
cerLtr,ì!brnlü.'.loilcro(,u1'.1m.ÌÌetiÌ\ÌroLi(tl\incciti\di;llrrtlltt)nÌÌ'ìSintgo\
rnÌÌr.nl Ì)eìÌÌ! t,tt!red to reliÌìqrLlnr r!ÌÌtnrl ot ht.il polj.\ ' \ lÌal .onrcq!{r'L s mìtshl

lh. ennr rrd.tend\.rilLraLL! 1). thc tiÌni.gottlk n'L1i.g otnuìrlêÌl xnii h\'il ft)li(l
llr( sinÌrLe\i .xrÌnPLr oi nÌoLì.rir h(rl .().rlnl l5 lrhtÌe tÌÌe 1ì!.iìÌ eutlrtritl iiì\ r;r
i\i.1,,Ìt\telsdlhiÌritarsri.(LLlur.rrìlto\rìrrnLlrl!Ì Í) 1i Í.li! lo ÌnirÌ nriTc thÈ
lr\ liLlt)n ol orrLÌrut lr!m it\ t.rricLl
 649

$lÌere I1: l\ theg.\ crÌnnerr's Ìôss finì(rion iti\ ÌüÌimjzÌng i los\ jìnrctioÌÌ r.theÌ rhrn
rÌì.rximiTinS a utilitÍ iuÌctir)n. And rh€n!nr.1ar\ aLúlÌoÌit\ (aB) s.oncerncdt!nÌinimiTc
lb li (he clevir(ion of lfllatiorÌ iÌ(rì ls rarget oí7cro iÌútati{)nl

,\! uÍtaÌ rhr ltrilÌjps.un,e js

in this jrnrne I'c rcú to specii! rhe irbtÌumenrs oi the nscâl .nt Ìnon
1n acÌ.lj1ion
€tar\ aulhorjtiei. \tc rs5ume rhir a, u\es r lìs.rl inlriumenL /, dìich ìiÌsrs iggÌesrte
lemand/, rnd CË Lrses ihe ratc o interert,, rlhichloÍer\ it. A sjmÌrLenx).ìelôiauresate

FinaÌl!,rrte rcLlrr\ chooic Í'r rati(trìrÌl!. rn teÌna oi the ordÜ ot rno!e!, ltï .l\rvs
movcs tìrst.\\'..an then c.nsdei two mein posibittier: G Ììoies second toloÌled
lr\ ar, or \Ì.c vcrs! Both ganìes rÌe ítçrd b\ bacÌ(Ìraftl tfdu.rion to arrj!'e rt

21 Sequence 1: CBfollows G
úirg backÌÌad Lndu.tion, ire..nsidrr IìAt rtrc (!\ .hoi(e ot L BcâÌ id nÌirÌd that t1.!
and a; ha\ e alÌeadr Ìrì. e.l, so rhâL ct, lnol!\ ;r end l beinre choo\ing r to miÌìimiz. jrs

"r = 1.r:
r 1,tr = 1;f +í r ,\,.11

=t -L t r'. (169ì
\otcthrtthj5 iÌìplietfr)raÌl ralursoi/, thitÍ oL t r :, : 0. Hci.c ;r - 0an.l
(16.I0)

NowClÌatn).hoosel to nrtntnÌize ). t,'lr HoÌleÌertitnotdilir.uìl roseetharrhcrc

is nothiÌÌg G.an do u\i.At Lo.hrnse r,:

i.l ),1 :) = í , y,.t, ,.1 :.1 .t,1 yttl = t.L, 1tl il6.lll
Si..ctheCSnrolrslartjlsDìfÌ!r.ìise'bfiçh.te\erjsnece$aÌvtoÌic.pl, r..
hisisanaìnroÍc]l$raÌp.tureolmoncLnNÊscatirÌteÌacrion:lh(go!emmcnLcaÌÌ
srt fsc.lpolic) ãsit1jle5,b(l rhì\lelct\theaÀtoririseÌ toen\Ltre rhell rrrÌÌaiÌsequaÌú
), ard thus thal - renÌajrs cqrLiÌ to zetu. As i'c h,rÌ e Ìlrirten t; s ohjc. le íuctjon. G is
inditieÌert ai Lo the lerd oi I il .lÌ(ues. \\c .outd jx$e\ ÊÌ rúgmcnt C s objrÌ.l içcs b!
iddìrs r targcLlclel ofgorcÍ nenterper{i lure

t,_i" y,t \t Í, . í 1r.12 )

Thc go!ernmcnt ÍiLÌchoosr I /r tomi.inrizet..

2.2 Sequence 2: Gfollows CR

lí, hoÌvevcr, l; rÌìorcs a1Ìer alB, thetr thc labÌes arc tuÌned .\galn using b'ìckwad irÌdur_
Lion, c nìinimiz€s (t 1,'.Ì:r,7 ' r'Ìì':, i1ivc.,.Thn ilnpÌlcs

(16.13)

Ìn olher words, l; wlll n(t! alwa,vs set frs.aì Poli.y so as to enÍrrc / : )'r dB caÌÌ do
,lnraLlu l,r :i,.rlr':.- l t r'-\'"h l;
. .l/ r ..1 , I r'r'i. {l
r' l i,t r'\ l- F I I
'' 'lF
an incrcas€d r mìiiht hãve on/ and heÌÌce n
ni:
ln lhí p,rrtlculartf sìnÌne casc, -.. f{)r thc tolìosirÌg reasonr
iÌoln the abovc,
t', > Ír if lr :- lr. Butli = Í': if
ìs nnite; so
- ír +ir ),.ÌlenceEÍ nr + ),t "i
onlyrr : r nakesll: o' "r , Y' .t',
Wc can makc rF tìnilcbv.h.ÌÌgìng (;'s oblecti\e fu.ctir)n so tlÌat the go\ernment' too,
hâs some Ìúlalìon avcrsìon, ,. as Ìn.ìicatcd b! tlìe iJrcl$idr ol thc teuì íÍr in its loss
hÌì.tlon. We th c rclorc atsunle thal G nÌini izes

r., - (f rrlr + ;" v1 r 1,Í)2 + 'J t"t +í r lì') (r 6.1,1)

(Í 1 tÍJ+t \rt +l ,',

=n, =,r*,.r'', (1C,.151

Now, nr has to bc chosen such thdrf = /. and ghen that/ Í - t,, Ír'hrs lo satislythc
tallos,lng:

,,-v: tl=,-,,=i (y' yò (1ó.16)

We carì thcrcnÌe scc thât t{Ìlh thls nìorc realiÍic govcnrment objcctjve lunctÌon, the
inÍlationbias15ÊnlLc:Í- --t =3' lyt /.1 ììut thc govenDÌent is now constraine'ì
Lo retl f., aÌthoLrgh ìt can tru nÌ) wlÌâteÍc r tìre certral bãnk does l\'iih Lhe iÌÌtereí
Ìaie

2.3 Summing uP
AtÌst.o.cluslonisth!tilthcgoveuÌnÌuliJtucreatcanin.lependentccntÌalbank ith
irll pow.rs o!€r moretarv poìicy, the gorctnnÌenl cin ahlays sabotagc ils obiectiÌcs ilit
nÌovcs atteÌ the ccntral bank. Does tÌìis Ììcan that lhc tìnrlng of ovcs should bc bullt
js
nÌto thc gÌaut of in.Ìepelìdcnce t{) a cenlraì ban|? 1hls unnecessary' sjnce it is lairl,v
ctear ir fractlc€ lhât cenúnl banks can mole much lancr !n changing thc lnterest ralc
tlÌâ n goveÌnnÌent s can iÌì.hanginiithe lìscal ntn.e Gov$nnrentshavc long drâ$'ÌÌ out
budgclar)'prc.esscs nr 31] thrortgh, which nonnall] takc place t{) an ann!6Ì timetablc'
 65Í

( tntÌaìbn.ks c,ìn u{alÌ\ D(^ e !ÌulcÌ(Ì\ iridrLn;Ì nronlh oÌ ìrs.50 a moÌe nrcisurcd !lrN
6lhaLi.dcpcnden.eoithecentralbanÌ($jlÌhcsrLll.icnttoiÌnfo5caÌrnrrâLr:o infnl onl
eten lho(L{h tlÌ. goreDDreìrt ìnai.taiìr5 .ontrol oí ilr.rÌ foÌjcv. It Ls ìlír impodafL lo
nol.r Llìnl Llrcaa!ÌÌeanrÌ\\eLlheÌemadethcrs\unrpL .n.ruciaÌrr)thcLinnifconsislcl1.!
rr\ull\ lhaL rhr Sor e.rrnelt 5 taÌtet it r Ìe\ cloloLrLfur abo\ r thc cquiÌlbrjrLm irr ÌÌa\ c
rÌgr(Ìl in Chiìptir 6. üre Ìe.Ìuirement nr remii. $ìlcnt Lj.c. ro stt l!.:xì Ìr.licv
^s so as ti)
m..1 lhc .on\tÌrirÌt oi tÌre iÌrterteÌniroral budg.1 r.nstrainLl rìal r!ÈÌl cntü Lhc aor'( rì
nrcttrs rrLllitÌ lLrn(ti(Ìr. Both the ture Do.tlrr_r loÌic\ ge.rr! r.d drc Il\.aÌ môn.lary
intoa.L or1 i.nìes tlr.rt $e hâ!e a.rÌ\re.l errxiì thaL rjtheÌ the centÌaì banli or Lhc go!
crnnrrn L sds objectire\ that eÌe i)rlonrittent ( LlìalargetÌniletjor(ut.ome.\!tÌettrn
i. s.clio. .1 to lÌon nÌch behavir)ur ceÌr be rali!faÌl7eLl ar a con\equent ol the trÈ*ure
oÍ!ot$r orì politniuÌ\ \etkirg rÉeLe(tion.

3 *Reputation: lntroduction to games of

incomplete information
Games oI Ln..nrllclc or.r\rlnnìrlrìc ì.IornìLrti.!Ì a( nm.ngst lhc nrott imfo(ent lo.
toliticxÌ r.jen.c inLl (rorì,:!rìi.s. n panirrLlir tlÌc gnnìrs oi inlcÌr\t rrc rlhcÌr onr rcloÌ
Ìrck\ Ìiro1rìcrlgc iboul th! prrfcr(iÌc$ or t1.pr.il.rÌ!r1Ìrc, r.Lor. and \!htre drc ìrrttÌ.a.
Í:nd r slgniìÌ to {hr lonÌÌeÌ tlÌiìt .ontiins irÌlorÌn.rti.iÌÌ úrcrÌrats Ìrincadi.g) aború hcÌ
trcft:,.n..s or hcr l!p. lhe\earl.allc(lsignill!ÌgB.nìrs.tur nsrânceisx(:e.LrrlBânÌi
Loulh oÌ jrrik on lniirtioÌr'l \otÈ t1ì.1 tlìL 1!p!'oi Lll ls 5inìflv rDlnÍlicd Ìn the !tÌc.gth
o iL5 f.rlc..n.c lü ltr$ nd.ìti!ÌÌ rulitì\'c to en4ìlorrÌc.l Ír rLc ce. cithÊÌ trÌÌi ab(trú
lhcL_ÍfroliplilcrortlÌitpLiìlrf5prci$r.n..s1nthcl8grÌìc.thÊu.certâlnqidthe
l!ig. s!.LLcr, 115, ìs or.r the lornì oÍ llìc a-r's objr..li!. llúrctjon rnd hen.e itr Ìrav oll\
ú.rn diilc.lJrl out.ome\ ot tlÌc SanÌc.
'llrr rfiì! thit . signalLirÌg fanÌc rlorks l5 (a5icn 1o c\flejn urnrg !!h!t hds Ì)e(onÌe a
.li\si. rxi,rÌIrlc, tlÌc so .!Llecl brcr qul.hc'târÌc. \!!'L:Ìfleln Lhât gaÌn€ 1iÌtt and theÌì
( lrLrr lo.pplr ih! insi$lÌt\ to t1Ìe.enúiIb.Ììk RanÌc !\ch.:gLnb],rettjngouÌtheinìtÌe
sl{nnlli.ggirÌÌribrrrquj.lìer.ìndír.trrholritisplalcdThsrÌkfftu\n)ìntÌodurÉtlÌr
kct.o..rpt\ wr íÌàlL tlÌex Êo b.cl ind lool.ìt thr pri..itì.r bthjn.Ì the equjìÌbrilìn
s.lrLlio.hl ú tlì. linìe.
S('ÌÌrosc Lh.rr iÍ- tro rcnrr5. lhr firn.,:1or nÌ.rl Ìrc.nc oi l\ro rvÌrer rn gh lIì,
r!.aÌ rLr l). tlÌc 5r..!Ì.1 rì(tor knors ,:,nlt thc prubiìbililJ, t, Lhrt rÌrr nÌ\t a.t,)Ì j! t.ugh
hc qa.rr.onrlÍs l)1 .l x]o\es l.lthouslÌ tlÌc 1ìÍ is rcallr â nrollclli.g tÌick').

. N,iolc I Ìn lhr tìrn nlore ìÌaturp clÌoo\es the tlpr o Lhc frl â.n)r, on â fuÌcì\
randonr basis to! Bh rlith prc br tJili f ÌrerlÍithpr!bibilit\.1 I lhr!scoI'.iLú,c'
5 l(iÍ iì dcvi.e to get tÌÌe Seme BoiÌìil anl to ìÌ ìcdte thlt tl\.. ìo .c ij rÌogc.orL5 lo lb(

a.l.rs i. thr nÌldel. I he ieconl tìcítr loes rÌot lin!s Ì!hi.h ll p( hiÌ5 bc.. .hosc., ..ìt
Lhal thrrc h.s been a | (lìance thüt tlÌe t:-t)e i\ n[rsh.

- ìr11r \ tJi. t:i, rrr..dl,nìi

 . Uovc 2. The lìrst actd ha\ a choicc betiveeÌì ti'o a.lìons, and the se.ond act.rr is
inlorn]cd ol this chol.e. T1Ìis choicc can be seeÌÌ ns !cnding a signaÌ or nìessagc lo the
second a.kÌi irÌ consc.Ìuence, thc iìÌst âctor is somcLimcs caÌle.l the SelÌder and the
lecond acn)Ì the Rc.cì!er.1lÌ€ signnl nrav be ciesigncd cilhcÌ t() Ìeveal the S€ndcfs tvPe:
forìrÌslance, a tLì!gh Sencler nÌight rnake ach.Jicc tlÌal rcvcaled ihe Ìvastough ()r ii ìnay
be desjgnc.Ì tu hide hcr type, by s€rrdìng the \a
c choicc es the other tvp€ wouìd send;
thus a icak Seltder rnight send thc sanre me\sagc as a t(rgh sencìer, thus cngaglnia iìÌ

.NÍole 3. lhc Ìeceivcr lhen Ìeacts to thc message ând ch,roscs hcti{een two aclions
Thegamethcn en.l!.

3.1 The beer-quiche game

\^'., 1.:ll rl l.'-rr'';md rral' ll-"F'1rlòr'
"
p'(lVì 1 ou in which clliÌÌkers are tittìni3
ÌouaÌeeithcraÌough'(f)oÌa'wl 3o ìnto a ba r

saitilÌ$ to plck a ÊglÌt with a wilnp, $üÌlc wantilÌg to aÍoìd nilhtinS â tough We shall
rcleÌ to the drinkeb:s the public or Ì'], and tÌeat I as thouiih he weÌe â slngÌc acnÌ.1(trì
can choosc (rlrcrherto ordeÌ a beer or. quìche.lvhdt you ordcÌ is obseNed by thc tubÌic
Toughs prclcr heeì, Ì!ìrrìps PÌefer lluichcs NeitlÌer toughs nor irìmlrs lrant lo fight A
uteflrt w.y ol dra(irÌg thc ertensive Samc is jn Fi8 16.4.
Nat!ie(N)Ìnove\Êrsl(shownattheccntieolthrdiagraÌrl,andchoosesl$'l(htrÌra
biÌitt p and l1rirlthprobabììitv I l). 1his ìs not obscn'cdbv thepublicÌlho o.ìvknorís
thattlÌerc!sa/rcha cclhattheo ereris l ough. lve thcÌì rÌì ovc to either r\nÌolcoÌ lt\'
Thet.in choosetoordcÌD(beer)oÌ !/ {n quicìre). 1Ììe ordcr lo r bceÌ oÌ qui( he is obscÌvecì
br.' |, thc Ìruhlici LJlt l' doe\ not know whether t1ìe ordü as ma.1e Ìrl a tough oÌ by a
$imp\\Iho is nr nÌicknìg a t()ugh.
Supposc bcer ú \ías odeÌed. Then il thc nei{ entrant is l, thc ganre moves troÌÌì f\
de.ision.ode ìettto i I de.isn)n node (tol left). Ììth€ ÌÌes'crÌtanL is W, the 3anÌ€ nìorcs
tìoÍì Ì1; \ dccì5idì ÌÌodc lelt nr a l' d€.is io. node (bottonÌ li'f0 r' knoNs on\ eithcr t h at
he is al one olthe two l'decisioÌÌ nodes on the Ìe1Ì. No!Ì $Ie Ììccd ro intr).iuce â bì1 nìoÌt

0
0

2,

0 I

2
Figure 16.4 Ìhe b.e q!.h. qõmê 0

' (:h,,rr.ì(Éps1li)rì;)
 653

Same thcoN ienninoÌ.g\ I n hln .r plirver rf in rhis .âs{t hn5 a m.\e brt doer not k.orr
ìltrìch ot trro (or posjbÌ1 rno() d..isiorÌ nod6 hc is at, Llìos. lr\io decjri(D nodcs arc
sìid t(r consLll!te rn nrfnrrrdtirrì J.t ,\n ìÌìlormaLton scl is sÌ1or!Ìì on in e\rensil r gnnÌc
liasram rs a iimg darhd llrc linkins the reÌela.( dccis on nod.s. t thir crse. si..( bcr.
nasoÌddcd,/,jsrtthelctl ni.rfatio!set Bfd.:lLnirjof.iinpÌi'|er1iòthenrorc nnd
..i5rÌr.l; it is taÌl ot the NLe\ ol tlìr giìnì. that ihe tiavcr alq'ars koows il lÌe cl.e\ or docs not
lÌar€ thc more ,rt dnv parLlculnÍ nÌo .Ènr of thr ganìc thr pliìvrr iìNav\ knon Ì!hi.h
irúormrtlon srt lìe jr arj btLl. oI.ourse, iiUre in Ior nìntion scL hns nìore than one dc.tsiorl
r( ehedocsnltlnownhi.hdc.\ionÌÌodeheisar.So,i,/iassjgn.rlled.tlind\hjmsclt
ür the righl hiÌìd iÌúoÌmeljo!ì sct Ì!itlÌorìt lnr(tr\'ing rnr.:tÌrc. hi. Ìs ai the tq) oi bolronì
leciiir)n rndc ,\t e!ch ÌniornreLioo set, the pubÌ1.:Lhcn.hoosc5 cilh. r to hght i/ r, oÌ n.L
to lìght ir| 1lÌegüÌecÌrd5r'irhlhcnìpp!)oÌIb.ingtÌìatolrhcsrndcÍllort1l.en.l
the borr.rì prìr olrthrrô lhcpublic.
O.rtnaÌponÌtneedsLob(nìn.lcbeforeÍeiecÍ'ÌratsrrârcgjcsLhcplaversnÌjNlrru\e.A
pÌareril nnirÌlonnatn)f scL isnotgir.narÌvìnt.)rÌaLio.ahourrçhi.hdc.isi(ÌrrÌ( ehe
i\ rl. lhatdoesn'tmea.lIathc.an'tnÌrliem.reorÌ.isí,nsibÌc:túcssrs.LÌdeed,irethalÌ
rÈe lhal in t1ìi\ t\ te.I galnc, thr plìÌ e. àr an lnhrmrtio. \cr has Lo ilo his beÍ to ríoìk
our lhc probrbilitv Ìhât lìc is it on! .lecision nodc raÌhcÌ rhân tlrc olhcÍ. WorhrÌS out
tht tFbabilitje\ of s'lrcrc on. i5 ìn.n irÌldrnahon srt ú centÌal t.r flari.g tlÌese Sames
Lct ús ilrl1r r i.tr thr (tubjc.tl\,o prdr.rbilitr thaÌ I w1Ìl a$ig. nr btirg er rh. rq) de(isi.nl
nodc i. lhr lett iÌüì)rmrLion sct and hen.e 1 I attheÌrÌ(nrrbiÌ1tvofh.iÌrgir üìc botto|ì
lcll dccision node. And .oÍcspond|Ì8l! / dÌd I r, at the trnrabLlitLls oI b(ing.ìt the
Lof iod botnnn deci5jo. rìodcs rcspc.ti\ elt olthe ÌÌght ini{r matio. !.rt. Rc.ìcnìbrr tlÌat
/'dors not lxoir these t.ob.bìllti(s in ,ìd\!nce but ÌI\ to worÌ! the.ì t)ut. /i ând r ..rÌ bc
sc(.nirÌtiir. 16.1.
lhr texn ty'r,rLrln ìJ.rrris.oirÌedtodescribethetesinìatio.tÌÌhrreatÌilcrÍ'iththc
nro!. h.s nhre thxn onc dc.isiiìì rÌodt. IÌ!t il .an alro be used t(ì.le\cÌibt tlr. sitrLâLl.n
Nhffr.r pLa)eÌ $ilh lh( nrÒ!( h.\ iuÍ one decì\nD node jt i\ then ustraÌÌÌ,.iìÌcd a
sittsktüÌ nìfunüttnrt srt. \! th lhis r'ücr dehrÌiii(D, the \et ol I fÌr\ er\ 1Il(Ìmâti.n scts
5 Lhc sri ol pointt Ìn a gimi. ÍlnÌc thc pl.\eÌ has the nrne: ilìe tÌareÌ Ìnrow\ .\i.llt
rnrcr. lÌc is ìÌr the gânìr iIclsatasirÌSleionlIn)ÌDratirÌr\et,otheÌhìreheÌ.owslhc
lnlonnation set he is rL ÌrL, t rì!t .t whi.h.il üre.lecisìoD nodei ÌiIÌ(ed b\ danrcd Ì f.s h.

.\. ]
1 31.1 Possible solutions: pooling and separating equilibria
\{. ciiÌmiÌre t$o Ír1! ollossibl. sohtions. The nÌ\t ar€ tooling or nrjmL.lilng cquilibrn.
llr! olr\ i!us poril)iÌú!lrcl( is lhit itÌlill frv 1!imÌrr totreten.ltheraÌe t(rgh brordcrirì!
a hcft .iÌthcl UÌru a qtri.iì!.. l( stlnìs l rc.ìslrÌabÌÉ jcìea ior them n) do rlris i. th. \ü1\t
1

lhal th(v tr.Ìrld liÌ(e to r\ o d i lFht oi.ouAe,tìrtreitatradeofii.vol!(lÌrc.i!scth.\'

(IôuÌd preler nr halt {Ìr1i.h. lhiÌl beer. U!1!e\cÌ. il it cÌoer n.t hrrc Lhc d(s rcd rlie.t
al ol aroldÌrÌS .ì iglrt, tÌr. f .ìps $rill ÌÌot p!bue this ttrategv. GrÌne thcôn, truyìdc\ tlìe
L..ls }or \\ \tenati.aÌÌ_Í n,ì.1t si ! tlìe liileÌenr rÌ.ÌÌcntr ther cntcr lhc dc.ision nÌ!tiÌrs
fÌo.css.letus sre rrhcLh( rtlÌe ÍiInps rÌÌiDicliìngrhcbchavjotrrolrlr\:1o!!:hs is.onsjsteDi
Í'ilhÌalionrlbehariorro all.on.rrnea loeÌami.utÌrcfooljfgc.tuiÌbrlum,\1rr$!nÌe
thât both l(Ììghs .Ììd i{imp\ order bcct aÌÌd tìsk wlÌcthcr the tubÌi( lvilli('act in Íìch r
'- ,l.rl . r,. 'i 'r''l{rl 1.m_

31.2 Poo'ing: wìmps and toughs both order beeí

Ìt r'ìll tay ÌviÍìps lo oÍler beer, dcspite thelr prctercnce tar !Ìuiche, ií th. public does
not llght beer drinker :ìÌìd docs fght quichc ciìlcr\. This can be seen lrom the fa)' ofis:
11' gcl s 2 fìÌln drìrki ng beer and I o t nghtirg bu t onl-Í 1 tum eatiÌìg q uich e and 1ìghting.
It ì{oLLld obviousl-v'' not pây a rrimp lo o erbecrlÍlh.tublicdidn't1ìgÌìlquicheeaters
siÌÌc€ thcwlmp pi(Ích !Ìuiche, âIrd/or ilthe PubÌlcdid lghtbeerdÌnìkers-in ahich(.sc.
it would al$ pa!-' lhe wirnp to odcr .Ìuiche s!.cc he NouLì hâve to iìght whate\er hc
o ercd. Thu! the lulì tet ol Íratcgìe5 ol tlÌe pìalcÌs ìn this poteniiaì cqullìbrnrnÌ is as
ìollol{s: both sendcÌs o er b€cr; in.l the public nghB.Ìuiche e.ters bul does not fight
Lreer drinker. lt is calle.l a pooling cquiÌibri!m bccause botÌÌ rypes takc lhe \anÌe actjon
i.€. both lou8hs and aiÌÌÌps act tough hy ordcrjngbeeÌ.
So n'c nee.l to chc.k uÌÌder I'lÌnt .on.tiiions it wouìd be Ìdtional for / not to 1ì8ht bcer
.lúÌìkcrs but tu Èghl qÌuiche eâters. The criti.aì point nr renÌember in i{orlirÌg through
rllÌether n ÍnutloÌÌ Ìs an equilibrlurì oÌ not is lhat cach actoÌ works out irhetlÌ€r hjs or
her stratc$ n rationaì on the assumftìon tlÌnt lhc olher actoÌs stick to lheir str.tl]gics
In other \!oÌ.lr w€ assurÌe that it js com ìoo knoirìedge to d1l thc acloÁ thdt thr ncs'
entr:rt (ì... the person $ho enters lhe bai) is pooÌìng on beei, and thcn an( il so, is it
iational toÌ Ptu behnvein mciÌ a Í'ey lhatit pa)'rboLh r ancl 11 toord$beer?
'Ìhüs P n eecìs to ast givcn Lhatboth toughs aD.ÌilimP\ ordcrbeeÌ, should I ight
h nÌrseLl:

or not? Since I linotls everyone ordc* beer,l'j.an casìlv calculdie thal lhc pd)abiLit,v, I'
thrt thc peson r!ho has o er€d bccÌ is a tough ls lhc same a\ the probabilitv üÌ ilenerâl
thiìt someone is a lough. Irlnìelr'' r. An.l ure probãhìlil-Í that $meonc who hat ordcrl:d
b€er ls a irimp is thc sauÌe as the probabiÌit] irÌ gcncral that Í!ÌÌeolÌ€ is a \!ìmt, naÌnelJ
1 p. ln otheÌ \Lords the \iitn.Ll 'bccr'gne\ no addÌllo.el inntmation to I about tlÌe
\€ndc.'s type tlÌan lhe knollledgc Ìhat ther€ is alJ probabilitv thât a tough has entered
the bar. Thüs the prrÌtic\ erp€.ted fa-v'' oll lìom Tror nghlìng a beeÌ clriokcr is:

lr prv ol r,.nì.oÌ6!lÌtúÌ3 a bÊÊr dÌiÌìlinìs T l1l

ii p) rra!.rttuÌ.roÌighrinsaheei dÌjtriÌì! 11 (Ul =Jr.

lhc pubÌ1c'5 exp€clcd pa) oflfronì lìghling a beer drink.r l!:

f par.lrirnnr lìAhL nila herÌ drnúinA T (0J

!Ll f) piror'rr.nì6ghtnr8rbeeÍd,inkingl1ri2):2'i1 fì
'lhcrctoÌeitpays1'.ott()ÊShtrberrsignallìng\erÍleÌilf>21Ì floÌP:2i 3 11ìc
ií)lujtion here is slÌa jghtfoNai: thc g.eeteÌ the likelihood p ihal lhc sjgnaÌÌer is l. tlìt
lcss it pavs l'tu figbl.
WhaL about frghting a quictÌe eâtcr? No the pubLic is iÌì â morc dilncuÌt position
Lrc.ar$rjfeverr-lrncílckstuthepooliogslÌateglthereíÌouldbcnrqricheeater\'lhi5
leads tu a \ er) in] por lânt questior Ì iÌì pool i ng e.ÌuiliÌrÌia HoN is thc p ubl ic k) interprr l
 655

so .aÌÌcddllìlrilil,r!tr, ,./!iLirr,.) for the Ìrubìi. ro dc.i(Ìe rlhi1 it I'ouÌd do in reÌrtrbe

lo.ic{luiLiL,rlLÌnbdrâ!io!r.ithasto.ìniilnÍÌìepÌobabjìLt!.rlliL/, nr\!lÌeuÌeÌirit
a nLÌrp or,ì t(tr'sh 1!h. i: bch.!irÌ8 ìrÌ tlÌi\ \Ìav. Büt !inc jt is iÌrâLionnÌ ior either a winìt)
or e lotLgh to oÍìeÌ r qujchr nì the polling equiÌibrlunr. jt j! sLrnplv rLr.li.arlÌos I r$ign5

stagtt t Ìat tlÌere i\ no ÌarionalgÌound Ior assigoil]g one pÍrbdtiit

l.cL us ns\urììe lat ìÌrjs
iltrather tlÌaD anorhcr, arÌd .ìsl iÌrsterd tr h{t I Í'orrld halc to bc Ior ii to be rarjoraÌ nÌ
thc publi. to ÊSht r qui(.hr ..t€r. lhe Èublìc't .xltccrr(Ì tr) oU I.onr lìghtirÌg r !uiche

t lìat ollÍ!!Ìnlhan!r.lnr.he ÊiL .g/ illl

(1 ,,r frt.lllÌ.nìÌìirhÌifgaqrnl!r.rÌi!8h'Í21 2 1 r
i5:
^t.rir\tüìii,dretubli.srÌp€.te!:Lprt'ollt!Ì.ornghtinga.lui.hcQt.Ì
r p.\ olihon n.rlìijht nijrlui.hc (atjrÌS I Íl)
+ il rì ltar o ! r.on.ot h8lunr!. qnÌ.h( (únÌ! Ì1 illl : /,.
'llìeÌerare the eaterif2 i.) r:rotr'2,3.
túblrr will1ìilht r q!i(he
lhrìr!Ìongisl -2.':Jrnll$LonilrsthrpubÌi.a*ignrapÌobabiÌlrlonquichrralc.i
L,enìil ímgh oir .- 2,'ll, it r jlL pr! tlÌe publjc nott(J hght beeì dÌinÌier s a.dt,) 1ìgh1 qui.hc
e{teú Ilen.c it lriÌl .túanÌl} pa} r nmsh t{) oÌdÍ bceÌ, jÌ s what the rough frclcrs i.d
he .loes n.L harc (o lì!lÌt. Ancl it ÌlilÌ alÍ) Ìrav thc rllnrt tr) o eÌ beeÌ becausc iv.l.Ìlng
:
.l
!.1Ì hghti.g j\ ir.ÌtÌr more t! thr Ìrirnp tlún ha!ing ro drjnk trÊeÌ rrtheÌ tha. eet qui.hc: r
Ìrr\ otl oÌ 2nÂilnstiprÌ olttÌonÌertjlsquichrrD.Ìhr\ingnrn:htoll.Thútooljrg
equilÌÌrÌitrÌr is slìoÌrnirÌ lìg 1{j.5.
Thc ìo.g diìiÌrcd lirÌes strtr! tlÌe rhoilr\ thrt a.t{!\ m!lie dt erch deciinD tonrt (,
inhÌmalLonscttlìc1 rerch. lhu!IandÌ1 both Lhoose lrj rtf'\ irbtequent ilnrDraììo.
\et (after rl it.hooÍ's ì!/: note tlÌât it hr\ to nrrÌ(e the \ure clú]ce dt each lkci5ìoÌì no.ìe
ir jt\ Lnlormalion 5.t sirÌ(e jt c!nnot clittirÌlui\h between the il nilhuÌdeci5ì(Ìr nodet.
Ìfeirlrcr 7 or hr (r.rc ra!dil\t theìÌ \tÌdtegie\l n).hoo\e í. f choo\e\ / at the 5ub!Ê.1úe.t
!.ÍoÌÌìetlon sLi. LÌ ea(h innÌÌÌlatioÌì trt. rve hâr c âÌÍ) put ìn the pÍìrrbiLitiet r$jgned
bv the r.{or irho nìo!e\ rt that iÌrflrmrtirn se1 Lo Ììr€ dìilÉÌeÌrt cìeci5ìo. ÌrocÌc5 ir the

Ì
)
Figure 16.5 rÊ n-"e rL .h! !. r.. ..! nr.l 2

j
 I

3 2
l I

I
2 z

Ìrcbeerq!.h.!-rr à !êÊarain!
Fiqure t6,6 2 3

eqllbrlnrr 0

inloDÌiìtion whethcr or notthe inlormatir)n set is on thc cquiljbÌiuìÌ pâth rUlhough

set,
ire have nor -Íer liiokcd at the formal.ritcrìa for r.ìtionâl bchaviouÌ in thi\ sort otgame,
butitispr€llycìeaÌthal !hnpooiiÌÌ3 equÌlibrnun $ill satisfythcm.

3.1.3 Separating equilibrium:toughs order beeÍ wimps order quiches?

Nor' ìcr u5 Ìooli al a cìilïerent polcntiaÌ e!uilibÌiurÌ, $hìch Ì!e \hiÌl scc does not Íiìnd
up lo the Ìe!uirüncnt ol ration aì bch aviour. HcÌe are the stÌategies: Ìt tough, o erbeff;
ii wìmt, o er quiche: public: lt beeÌ is o crcd, d(m't 1ìghti if qrichc ìs oÌ.ìeied, hghll
issÌgn pÍ)babllil-r r - 1toabccÌo erer bcìng a tough; assign probabiljtv r - 1toa
qLliche oiderrr bcjng i \'\'1Ì]r!.
Thn is ho$n as a lpotcnliaì) separatiÌìg cqujìlbÌtum because thc dilfeìent tvpes ol
act.ns choose diltererÌt actions. The sendels choice signaÌ\ ni l, whcthcr Lhe lencìer is a
7 or a W. lhús the siilnnl \cltaÌâteJ ÚÌe ú!o types. This c:ìÌì b€ sccn in Iig l6 6 llul
Lhi\isn'tann.lualequiÌlbriumbccauser.ìtionnlplaveÌswon)tuseitWccansee$lÌ)as
ÍolliNt. Ìfl']rcccive\ t1ìe signal ,, P nrbt nssign a prúabiììtv I = l to th. scndcrbenìil â
Lough arÌd to bcìng ai?\ lot lcIL decision nodc ltl'Ìeceneithe slgnal4, /']Ììtrst â$igni
Ìr(trabiLit-ï Ì p=ltolhcscnderbeiÌÌ3.rs'iJnlandtobeintatl'\bottcrnright.leci\iLnl
node. Ihus il4 ir sisnalìcd. I'knorís the scf.ÌcÌ Í a irìmp ancl tlÌereforc fights, irith a
pay olloi2 as oppoÍ'd to 0lÌom not lì8hting. tsut the wlmp Ìlould theÌì bc ìnatìondl t!
sigrÌal4 sincc Ì,V\pa)'otl it then 1:if n'sigraÌled r, I wtrìì.ì asnune tlÌat thcs.ndeÌ wât
a T, would (hcrcítre not 1ìght, Í) lV\ pay otlÍ'ouid bc 2 fÌom o erinil bccr.

I1.4 Summing up
Ìn game\ ollncompìete irÌlormatÌon, two cÌifì€rent kilÌds ot5cts olslrrtegìes arise:1)ooì_
ing', iÌr wlÌich bolh tlpes iakc thc sanìe actìorr, e.!. act tough, a.d'scParatirs', in lvhich
thettpe\ a.t dlllcÌentlt, e.gt,rughs act toush and Ni psa.tlnahinrPlikefashi.Ìì.L.sjng
the diagram, jl is po$ible 1o cxnnìlnc cach possibiÌit) to scc it rntìonaìllâÌers Ì!o!ld puÈ
iue it. Whcn rlr conÌe to appÌy lhc5c inslghts to a ganÌi'bcllçccn the central bank and
wage sctlc6, $e shaÌl bc cspc.ìaìll inteÌened in thc pooling cquilibtium jn which üimps
nÌlÌìic thc hchavl{Nr of louglìs. This occuL ìlhrn the probabiÌìly ol a llPe benÌ8 torilh
it high enough. A5 we slÌalÌ scc jn !hc centraL banl c.se, il Í'agc sctLcrs bclieve that thc
Lrobabillt,v oliLbeiÌÌg tough is hiijh cnough, the-! don't need 1o
('orr!about$eak(entr.l
banks si!Ìcc lhc weak (entril bank Í'ill beha\e as though it is tough.
 657

l.l 5 Pêrfect Bayesian Equilibrium: conditions for equilibrium strateqìes

in signalling games
\\:e hâ!c il.e!dy i.ÌnÌnì.11) beerÌ ihn\ìijh thc.!nrlitions for üre rtÌaregi$ i,ì a sigrÌallilg
grmc Lo lì! rn eq ÌlibriunÌ. He.e ile denrc in.l dis.ust uÌe condihons (hat ÌÌ.ed to be
srti\lìcd. Lip tu nol'sri. h.r\e !sed ihe concc|1 ol.ìn SUÌ,1to \et oLú the.Ònditiortr nÌ
r sel ol stl.tegies l(r bc nn eclriLjbrnn 5er or .i.q!iLibrtuÌÌr' strategie\. lut SG|L..{i onÌ\
Ì tu'Ìll sohe ilanrer i. the dbseD(e ol unccíaÌnr)- âbolt llhere plavcÌt ârc ìn rhe Same,
lhal is r,lÌed aÌÌ irl(rÌ,ÌÌìrtiorÌ sets Iìale onlt one decision lode. Thi\ ir bc.arLsc in Saifìl
o.ì) chc.ks o. thc .ati.ÌÌaL behü\ìour oI pli\rr\ iI tlÌeir nxive staú! oll a slbgrnÌe
Btrt subgirÌei ,,4 srat froxr rjlrsletdr Ìniortrì.rion sets. 50 SCtL ì\ Ìn)t g..ffatll \ eÌ!
usc uÌ úì discursing Lhr r.ìtionâlitv (ú a ltÌavcr (su.lÌ as l,) \!ho\e rno\e Dc!$ srarls a
!ubÂanìr..\r u e \lrâÌl :cc,.Lfeúe(t Bd\ etian l.quilibri!nÌ (l,Lllj tolldÌt the ba!1. i.lrLlioLì
:41n'Sh oÍan5L|L.am.ì_rc.dÌl)la\erÌnustbehalcritiorÌìllratea.hpoiltinthegânrcrrhcr€
hc has a nxn e. BtrL in 5C|l h!\ to be augm.nLcd to deil Iiihtlìe laü tlrrr the ltÌrvcr Ìrìav
nol linoÌ! i!|jch (lcrision poili he i5 ai Ílìcn Ì( ìs lÌis ÌIove. lheIrDLe\pÌxinshor!lotakr
tlìis un(eÌtrirrr ]f lo n.(orürt.
'11Ìere dt elscnLiall\
tlÌree con.liiìons n)r a lìcrfect Slrcsiin l!!ilibrilìm:

{il AÌ er.h ifon sirrslet(rrì irnnìrrtio. se1, uÌe fh)€Ì lrith ihe nrolr músL assign
prolÌ:ìÌ)iÌitier t. bcìn8 !fthe dillÈÌenr.Ìc.Lsion nLÌ].Ès rt rh.rt nÌldnatnD ret. Thcsc fi(tr
abilìties aft: a5s!nÌcd to Ìre c(rÌno. ÌnoNlcdgc to rll t1ì. p]r!ers.
lhus in thc s n4rle Same abore, rh.rc iìrr 1\!o iÌúìrnÌ.rti.nr seis sith nroÌt tha. ofc
decirt)n .odc. 1, hr\ n) thcÌenÌÊ r*ign vilues to I .nd t.ì I. llÌete \rÌLrer arc thcn
(omnro. linodcdge thar js, tfe Í:ndcÌ knoÌrs thenÌ. l, lno$s tiÌrt the 5en.1er Ì.oNs
them. lhc scndcr lnowt that I k.oirs Llr n( thr:en(ler krÌo\!s tlÌenÌ, etc
(21 tii\ eÌì the\e pntribititics, Nhrnc!€r a pld\ eÌ har the mo\ e, thar phr.r nrLL5t mÒ! c
rali,rnalh. Spe(ihcallv. 1lìc pliìvrls nratcBr troD then oD mu5t t)e optimal gtrrn thc Írb
5cqucnt nratetie\ of lhc othÜ plal crisl. LÌ eltect. drìr ìj ihe erteÌìri{)n to no.-singÌcLon
inlormntiln set\ oi thc 5(iÌilr rcq!Ícmcnt tlÌrt tld\ eb sÌrrld l)ehave ratjonaÌlï lrhrn
clcr the) have the nroic ai thc staú ol erch mbgame or sinijÌenÌr inlorÌitio. scl. lÌÌ
lcíÌìs of the beeÌ qtriclìc Sinrr I h.\ to choo5e ÌaLioDelÌ\'l aÌr.Ì ,Í et re.h ol his t\\ri
i.torÌniticnÌ set\, gn tn lìls prcbabilì1f rssi8rnDent\ of r rnd /)i a.d tÌrc rc.{]cr / or ll hirs
to.ho!\e iìtìd râÌlv bc l\lccn , and í liren ure kf.Íle.Ìge oll s rtrât.:gr. /,doc\ not h,ì!€
to Lnkr.tcolnìt olthc sc,ldrr's sÌrbscrl!ent \tÌategi ii'hen he nÌn er sin.c thc 5cndrr doc\
no( hav. rnv mbiequcft mc\ cs.
(3ì ThefÌobabilÌtiesha\en)Ììechose.rrLlonilllasiaraspossibLeRirenthesrÌategies
ol tire plaiÊÌs. n lhr beer quiche game (and llÌ. SinÌcs ol inconÌplete irrf(Ìmatl()n in
tlÌ! rest ol the chatirrì thi\ r!edns: u5e voüÌ .onnnon scns€ in .ssitnins prtrabiÌitic\.
Here \ lrtr! thìs rlorNs iÌì the l)eÉÌ !Ìui.he giìnrc: takr l) s .ssìlrÌÌìent ol,. Ir í,e âÌc in a
: Ìr' poolÌrg e!Ìuilihrium orÌ beeÌ, tìre ten.ìcfs sLrntcg! to \igril beer \.r!\ nothiÌrg ab.ur Llì.
sender \ tì te;sô P shorl(ìa$ìijn e tntrabLlirv I f. 1f bf .ontran ì!e !Ìe ir a separerìng
ÈqriliÌ)ÌnnÌr,llhlsiitrdÌlinijbeeì,thcD/,shouldassiln.ìprotr.rbjlit,,ol,:lrhn(lhc
sendei i5 r. BLú l there is r toolì.g equjÌiìrr u on tre<r, tlÌen li lÌas nothiìrg to go on i.
irssjgniÌìS /,. lhâL ls the p{)nrr ol'a\ lar âs toss ble irÌ conditidÌ (3r.
658

AtrotheÌ wa-ï ol wri!ing (3) isr 'Whcnerer poslibìe u5e ìla-vcs'1mle in asìgnirg
possi_

biìiti€s.'ÌÌÌcìecd this is lvÌìy tìre equiljbütrrì Ìs caÌìc'Ì a le c(.t Bd),.\id' L!Ìuilibtium r\s
ÌÌeadeÌs \\IlÌo
rle havc juÍ sai.l, Ba,lcs\ rüle basically iÌr'oh es ! sì ng your 'ommon scnse
want to knol\ more shorÌÌd coüull an elemÊnt'ry pÍÌrablìl!) te\tbook An ÌÌnPoúanL
clemeDl in B.ycl\ nrÌc is u pdatiÌìg p r!or PrcbabilltÌ ct on thc rcceìptoÍ
ntwi ornation'
ln a pool inil equìÌibriunÌ, th c signal giles no newinloÌmliiolr aboutthe sender'stvpe' so
lbrnrnì tcìl tlÌ€ rcceiver the lendc fs tvPe: so in t1Ìc sctaÌaii n 3
r = But a s€paÌating equ il
i. s

cquìlibrìum wl!h T signallÌng beer, the Ìeccilt by I oíthe signaÌ 'becf

should ìead | !o
ü;date tlìe prioÌ Pr.,bibiÌitylr ihât thc seÌÌdcr is l lo the poslcrjor Probability r = 1

31.6 Pooling on g:a perverse PBE ând the lntuitive Criterion

that
Í,la sibìe tlÌough thesc thrce condilions ma) seern' it turns out thal sorÌÌe eqúilibria
satLfy (l) to (3) aÌe far from convlncnlil. lhe Proì)leDì al"âv! con'crn\ assìgniÌìg Pn)b
ihilìties lo dccÌsìon nocles in olf cquilibriuìn inftnÍLatirrn set\ inloünatioÌì sets that
üÌ
rhe ganìe Ìvo.'t Ìeach it thc Plal rationalì) ConsideÌ the pooìinil cquiÌibrium
Plalers
hìch both torghs .n.l wi nìPs ordcr .Ìuic| cs Ìhisislhos'n nr lig l'j 7
In thjs e.ÌiìiLlÌr!jun, both kNghs an.ì Nlnìn order q!ichc; f thercft)re ass!gns '
proÌl
ability p = , to a qllche ordeÍer bcÌng toughi it l(ììows that | $iìÌ tationnlly trot I'ght
of tlÌc gânÌe to teÌÌ dìc pubÌic tthrt
rÌ .ÌuiclÌc oÌdercÌ. Bú therc is nothing iÌì the histoÌ-v
it should assign t()â bccr o rrcr being a tough Ìlthe publicâssÌgnsa pd)
f;Lrabiììty back
atrititl,less tlan Z;'-l to ttra! event, then it Pa-vs ? l() hght abeer ordcrcr' Noa conÌc
ratìonnlitv of roughs and l\'iÌnP\ orderi g quiclÌes Ìt cÌearly pays a wìmp to do
so
t() th;
1.Ìrìichc withoutâ f,ght) ralhe!tÌìân erlngbecr (beer iìnd a1ìglÌt) voreovet'a!cnnbe
o
s;en ÍÌom thc ngurc, ìt pa-rs a tcÌrgh to do to too: the tolrgh gets 2 trom thc 'quichc' no
hght'optioÌÌ, and onÌy 1íi()m th€ 'beeÌ, 1ìght' I llcrn ativr '
HenGthe lhree.rìteÌia trÌ a feícct Bâlcsia Lqtr1ìiLÌiunì are clea'ly satislì cd:

(Ìl rand r aÌe both asslgned b-Í l arÌd their\aÌues ari''ommon knoilledgc: /' - p an'1

t -.2i3.
(21 G iverÌ th $e probabilì lies, it is rall(Ììal lorr nolto tìght ìl!Ìuiche is odercd but t'r
ighiifthe ordcr is forbeer' ÍÌate8]. it ls Ìational f'Ì
eithcr T or
'
L!'to oderq!i.he ^fdknoú'ìnglD\

2
1

I
1

Figure 16,7 Poo .9 cn t: a pel.r5r eq! bflrl 0

2n.lih. rlú t!.4Í leron
 659

(.ll /!!rre(tl).ì$lgf!iprDbilìi itroir f!irenthituÌesÈndef\rtrates\irtoÌr(!)Ìon

olderjrÌ!quichtiafdsinrrrrhasroÍitionrlrernÌìto.onnraìÌrlrj5(hoitoirhÉ
.an.!rúìrt€ntll i$lÂf r --2 .1.
()rÌtlì.!otheì hrndLlìfrrsul( sib5uld.lirrst\on1)rs\iirniÌÌirareL!ti\el) hightrtlbiÌ
t! nr r beer o(lerÊÌ bri. iì rrinrp 1iz. ì I ì 1, l. liÌÌÌplr !\iÌril tlÌe r\srìmÌ)t](!r5 oi the
moddtherei5noÍrroI(ÌlliÌlrìjrìgrLh!àn) ktnÌült(uglr or riÌÌrÌ) nrÌrld o erbútÌ.
So the pub]n \ {sÌ{nÌìci oi a h sÌr ptubiìbilit\ n) a s jinp doirÌ! ro is t)e.le.tÌ! .onsirtent
L

Ìrith ihe hi5Ì(r\ ol Lhf.irnoÌc. r\t nÌi.{lÌt no elheÌe$ r5k Ì!lìriher it i\ nÌot Ìatn)raL t{)!
tlÌe rirnÌ) or the L.(gh Lo d. $ rlrf lhoullÌ it i!Ì't ratilrLìl lü either. Cho rnd Kìe|\
í1e8: I de\ eloÌre.Ì thc ln l rLililr ( rll.rloiì tr:i decicLe. \\ih.1th€! saft r as: ii 1srÌ I tlÌe wnnp
$ould alÌ!a\ 5 r!(r.c. lì l5 |i! oli irhilcrcr tlìr pxÌ)Li. dft ii lÌc ordc(Ìl lrc.r.on+Ì[ed t()
tlÌe Ì)d\ ott gilen tlrc cq!L lib'i!nì Ír.tcg1 ol tlÌr pul,li( iúm oricrin! !uj(lÌe iherÌ tlie
l)!bLir should is\ig. a Trro pr.,Lìibìlitr tothe rlnnp oútriÌìg berr unles\tlÌe \rme rr\
rL\o tÌue oithc l.trglr. \s.anLrcncnirÌthclìA!Ìr,tlietoushrlilldob.rtcÍrtr.Lerirì!bÈeril
theÌrubìiL do.!.oL fghtí3111Ìanoftcringqui!lÌÊ ]uÌouta1ìghtL:r N!tthrsiÌnplor\
1!(rsÉ or.leÌi.g b{:cr Í1ìr1lÌcr tlÌ. p!blic Ê!lÌt\ irlr or rÌot (2lih.rd.Ítrin! !l!i.he ÌÌiuÌo!t
r nght i3l. TlrrÌcLn: on ilÌ€ ìrÌtuiti\c (.ritcrion. the f!bli. !lÌ!ÌLd.ss.rn z op.obrbilit\
to the iriÌÌÌr oÌd.rlng btÉr. ln th.l ciìse the qui.lÌr Ìxxntrìg É! ulli bÍnr nÌ .olli pses.

I17 Summìng up
Llrr rquilllìrium.on(ett nÌ ! S!nÌe Ì!itlÌ úrc.nÌrlete irÌloÍniìtioÌì 1lÌat patuLlels the
n1Ìrginrc prrle.t equjliì)rirnn í:(i|L iÌr the (ompÌete jrÌlonn.ìtion ganÌe js tlÌe l)erie.t
llircs i. Lq!iLibriurn il)llÌ:). I he thÌee (ol(Ljiiont tor ! Ì,lL a.r n,pplur{ntrd lìt tlìr so
.aÌl(d ürtuiiire liÌiteri(Ìr t{) nüe ort jrnÌ)lau\iÌrÌe tooliÌrg e.luilibrii 1nì thr b.rr qui.hr
ganx., thrilÌÌplirusibLrÌrooLnrS equjlibriunÌ js ìitr Ìrodi to!ghs and Ìrinr ps 1o ordcÍ qui.hcl.

j 2 A simple (entral bank reputation signalling game

\\ e now de!eì()p a snntle gaüÌe lìetÌÌeerì the.erÌtral t)irnk ind rf i:tc Í t tcÌs along sinr llaÌ
LirÌes t! tlìe beeÌ !xi.he geÌne. l\rase ietteA iÌ1Jì clo noi lnoÌ! r'h.tbrr th. .cnÍil bJ.L
iLl'ri!1ìÌrrlÌill.,r\lealtiÌlrl,.nl\thattheÉi5r|rìbrbiLiitolftÌa1( /lìs / ind I I
t1ìii ( ll is lr'. hÌ ure 5imÌrÌe \igndÌlnÌt SanÌe ÌrÌetÌrted ir this \LrbÍ'.ti!Ìr thr nÌürs,]rL

i1) NitÌrre rÀ l m$r\ nLt xn.ì cÌrlose\ the i) te ot (lr, so t1ìirt Ll] kn!$J \lhetlìÉr it is l
or ll Lrut lr'-\.Loe\ not.
{21 (lll Ìnro Lng(h.Lh$irs/.rr\rLh...ro\csLì\.hoo\irgejlheÌalÌLghí/IìoÌl.ow
íll ÌeveÌofouqÌrl nÌrrrlodl.0 ..rrÌs( / m.r(.hot)sc x dÌfttre.t le\.el ol outÌrlrt nl
lt. i\!e ríumc Lhal r\ J Ìri5 alrrndr Ììolcd at tÌrr 5rrrt.I fcÌjt{Ì l. hut rt arilì o.lr
nr( elÌl'jschoi..oIrlpc(_Lrd nlâLl.nlfpcrj.d I i.lbcmoÌc\ofhisti.r1.drìod.l
ot tìÌe ìr€\r subrc.Llon ) H or / ln .:ift:.l l'r lcs n s gniÌ üret l\'t lheD raÌics lnt.
accormtircho.5in{crpf.lcd nlaLlonir rhenaíoIp$iod2

ih,. r! ìilÌer!.r!.1:hË!r,!r.!, ú!r.xÌ: tÌì?rt\iì: \rtnx,ri. \ i.\ÈÍ Ìir3ú

660,:
2
0 0

I 2
l I

0
l 1

2 I
0

Figurê í6.8 a5mpeCB sqna nq!-nìe

(3) lyj l:h ooses eapccted inllaLion ìn Pernrd 2 ai eltlÌer high (l) oÌìow (/), knoi{iìrg and
!sìng lhe siilraÌglven by (-'Ë in ìtschoÌ.c ofoutput in pcrlod I

ThesenrovesaÌeshoirnlnfig.lÓ8Thep.y-ofít{)ü â re í raìgh ti(ÍwaÍl wca*uìne

rhat a tough .enü.] banli, r, l\'iÌl ahlav\ choose outÌÌú in pffiod 2 tu engnrcer l(N
ÌnflatlorÌ; so tÌÌat Wj gets r p.r_ olt oI1 lìonì choosing / üÌÌd zcro Ircnr choosing l, iltÌÌ€
l--Bi\inlaclTilikewisc,Ili,rnìftand0lÍÌrrllÍC-B1s11'I8etsahìghestPayolfoI'1whetÌ
T chooscs L in period I tÌÌrs gLriranteeiÌÌti losl ÌnUatio iÌì perìod 1,ancìI'Yi chooses/at
the starl olpeúod 2 Lhus eÌìabLÌrìg I to choosc dre appropriatc lclcìofoutput to cnsure
kN iÌÌÍlntion Ìì perio.12. \ot.1hiL ire cìoÌÌ't cxÌrìlcitly moclel thc ccntral baìÌk s choice ot
output in peiúl 2 iD thi\ simpÌc teNi(!Ì of thc slgnalÌhÌil g.rn., brú lhis will bc done iìr
theÌìcxl sübsection.Ì.ìker\'iscl gcts2withla.dr; oÌwitlÌH andl: andoríithH aniÌ]Ì
The s,cak certral bank, I1', gets.+ tlitìr 11 and I íthe bed .Jl all Norlds f(Í W)i 2 r'ilh I
and li and0with I and /i. uÌc I'ill asrunÌ€ thâr 11'gets2+Ì fionr H rn.], \ïhcrc 1
Ìniy bc positive, ncgati\ e, or zcro. This will ilÌdced tuÌn out to be of inìPoÌtance: and rle
eÌplainthesitnihcancedndsignolÌbeÌo{.Wc5haìlnolvÌool.ìtthcPossibìepoolingot
separaLÌng equilibria in this nìodcl.

3.2.1 Pooling on i: i.e. both weak and tough centràl bânks signal low output
The criticaì thing io rcmeniber in evalrallni{ equllÌbrÌa, is lhat ìt is connnon kno Ìe.liie
to ail thc tìaver\ l\,hl.h ecÌuilibriunÌ ìs beúril played. What ae ìrale to do is then n)
test if thc tu4roÌted cquiÌibrnrnì is indccd a lÌ1. Wc 1ìÍsl (.tk out, tìr non slnglct(tÌ
info!Ìalion *'hal prob.ìbiliti.s lV.S aDCl Cl sÌroüld asigt to the diltìr.n1 nodet
sets,
usiÌìg Bayesian .easo n ing all give. thc Pu4roÍed cquilibriúm ÍÌategies r\nd wc lhen
testthar LherÌÌo!eslrìplied b) theÍralcgies arerationalal cach inf{ÌmatidÌset oI lhc tto

lrÌ this case, tlÌât is reìatively eiì\y: thc only itÌlormirtion scls Lhrr hale more tlÌnn one
decislon node (i.e. arc non silìgleton) arctlhen WJ hasthc nrolc alter CB's sisnal lherc
arc${osu.h iúòrÌÌratn)n set\:the one LhatfoìÌl)ssa hwoutpuL LtjgnaÌand theonc that
iollows a high outpüt H signaL.
 661

.1 z
1 l

2+1
l ì

2 1
o

Figure t6,9 isr!Ì_ rìq!r;nr:pir q.r I

(i.sldcr ure ìnlorìrrjiD \et oi lt:! iíierl nes hcc. sigo.lled. IhepooÌj.gc!uilibÌìrnì
i\ \hoiln j Iig. 16..r. Ci! cn rhrL rçc arc hÌ ! Ì)ooltfg cqrLitibrjLrrìì on l, ll.J knoxs urar aÃ
lliìÌâh{ivs (h(!^. / rlÌether (lfì is / or t1/. So tr't hes n. nrore irrlonnatL.f on LU otheÌ
ihan ils kn.rìe.]gc llÌnt there i\ al.lìio.e tÌÌar uÈ is 7 ând l1 | cÌÌanc. Lhat Clr js h'.
S. jn 1lìc pooling qrLilìbrirnn on r,llc r Ì retla.c b!1. 4
Thc other non !lfitlen[ lnfoÌn]ition set i\ sct ot I1l aircr H his been
rhr irftrÌmirion
risDrllcd.llere, it t h.s nothì.S djiÌ..1 nr to on sin.c Lhc I15 s,.rs noi e\tectjng lh( sjlnal
ff lf this equilibÌiú.Ì..\srnÌe rr)r rhc nìclneni thtr rh it Ì1J rirl onh sa\.that I tsbct\!eeÌì

\or'lool rltìdralit! ol nro\cs !i\en tÌìrsr ltrüabiltil iìssisnmenrs. I l.!5

ar thc
tc.rivcs the rjgfrl
it can be sccn thit the exteclcd fa!,.Ii to l1'J 1ìom choostf{ tr
L.
isl 1l i1 l Ì 1 l.e.drh.,c\pc.tedpar.finrchoosngli\t ) t1 l\, O I.
I i,ith / ThcticÌe11.tchoosr\ritl. 1 2ândl ilt ,1 2 ThÌsac.ordsq'ilh.onxìoÌrje.sc. l,l5
i iìl .hoose I if tlrc likelih(!trì ol thc ..ntriìl brnÌi being t.ugh, 7 . is hirh Ìeiatì\'e to rhat
.IoIit beiÌrg wrâk, lt, and vile!rsa.
, ng o. \\ i l it pay l lo ch oole l l ll l - l.2, tlÌe . LweÌ i\ cÌeal! vcsr IoÍthentÌìe Ì1/5 \!tlÌ
rhoosc I ind 7's pnÍ oiìwiÌlbe l. \olc lhitsharereÌ Ì15itr Lo.lroosril(_t \ìgnalì.dH.
i Nould itet ar rìì!. nÌrst 2 hf ll,J .lrosf 1). lheÌeioÌe T lriÌl .ola n I p|y t jr rhjs q'L
libriu . \\har ahout the 1!eaÌi.enLÌel Lrinl, t4'? 11_ get\ 2 nlnr s itnallirÌE I ìil, Ì,2.
\Ì"hitdoe\ Ì1/grl .onÌsignalÌÌngHllhsdepend\onlt5\ass:lnnÌcÌìtol,5iÌnÌrh,usjng
Batcsi.n prtrrbilllv doe\ not hclf L1'.! hcre as ire hâ\Ìt .orcd aborc. tht we car trsc lhc
lnluitileaiiterjo.irrdiiclb\e.Ìabolr t\-!(dnÌern)nasl(nloNs: / gcts.l lronr I, rhcbc5t
r .an get lÌonr H is 2r uÌeÌetaÌe it.o!Ìd nerer be ÌatioraÌ [.Ì / lo signr] tI; thcÌctorc bl
lhc lot!iti!e arircrlc!Ì, I1,J nrouìd iisigd I 0. ThLs tmplics lhal llH i\ \ìgnalìd n thjs
cqúlì briunÌ, l1:S rrill il]leÌ that CB is iÌ and $iÌÌ then .hoosc lr. 1lÌc \rlue oI-r is th(n
crlli.al:ìlÌ ' 0, rr' ill signaÌ lj iiÌ . 0. Lt $ilÌ sig.al II; i 1 0, ij'is irÌ.lifrcft:.1.
ll ma\ Lìe tlausiblc t! r$uÌre Ì . 0. this $!uÌ.l bc Lhc.isc tIs,e tlÌouillrr ol Ìrcr od t.s
!horL í.lirtile to rhc rost olthe gamc. lhr reaí)nlng bcÌrind lhis jsi]s ntld\.sr jr fcriod Ì,
11' lìis the po$jbilltv ol cÌeatÌnq e rclìrr.tiiÌ tar hci.g Lough. lt hr doej noL ralic rhat
otpo.tuÌÌit\, Ì1 nriÌl be (conecrlrl.lâs! Ê!!lrj rv.aÌ bl. ÌVJ br ho\!."veÌ long 11,! bclì$.es
thal a li lÌis not .lìinÁed its tìÌe; and lhìs rÌa) bc toÌ e Ìo.g period ot rìme. Hcfcc the
662
0
2

\'r',
r=
o ,.

1
I
L. ,=,, '' t,=t Vt
1,-
\ns L w jl 1'ì/\ ì-..1
il ,^,2'r
; 2 ,a,ai
FiguÌe 16.10 aB5rnpF5!ral nq !l-íre
0

4 \''ll '\'rI r'\r''r'LJ l\ r/ r'

ot r'rn I lr'r' ii ili ru
'È\ "nL/\
.ï.."j,;-l "'-\r'J
'.. 'u" ' "'u',","ì
_'' -\ rl / "'r'_"d Bi\'' I l4 lÌ
'
"'.,t "', ',",.
:, ,;ì; ' ' ú'. '

signaÌlilg il.
"

3.2 2 Other equilibria

llcleriliratclrcrrmstanccscnnthcÌehensepaÌa1ingc.Ìuilìl]IiunwitlÌldlgh.nd'!eãk
ris 16 r0$ros\! poteìtinl
ì".ìì",ir"i. nreir tvpcs Ìrv bebavini' drrfercntlv?
',
I ,,; ,., / ,..,
'"'*t-,
",
,,,
*rLfl,b,Ì!m1ô \ Lr lin''t\,rccJÌrÚ'tthe
' " -,:
n '" f,, l; : :, . ;
as anc.ÌüillbriuÍr itlr > I r2

3 2.3 Summìng uP
lreti'een the ceÌÌtraÌ bânk andwagÈ
in",,*.U,'"* r^-" -' Oc aPplie'ì ro the i!ìreri'iiÒn b.nkis notkno tr rtcraÌiicstht
;ì:;ï;;;; 'i;J:,t.," '"hrcri Lre rvpeorrrre centrar
.ììììi',,,,'" ú* '"nnn '" tooìins cquìrìbrìu ì nì r Ô"úÌ iÌÌ Nhich a '!eak cen tÌal bani
" lssue tÌrat .,ÌP.re\ rcratcs to tìre weisht
oÌÌ curr€ni
ìÌÌ,,ìì,:il-iì*ì, -,". bv rhe de of \
is modclieil lÌÌ the snnie si8naÌling g nc
^" 'mpo,raÌìr
dnd flrruc Periocls' whicÌr
the nelt Ícp ot molinil to an expliclt
t". *u",*,'t ìs U"tnt*.r negatìvc"lhìs suggcÍs
two Pcdod selting lor thc gaÍìc

sìgnalling game
3.3 Explicit two-period central bank reputation
Now$cturntoann)lcsophìni.atedvenionoflhìssìnÌpÌcsignalliDsgaìÌÌc'Thc|ic\
i rr ' r | {Jl r'\'Ír i t
.'.,.,,' ,, ri ' Fl_rai
;". 1", r- r''\ ' I

--,.," ,'u irlrr'

,ì.i1, 'or'i'.\
.', r'' '/i,'"l ^
ì r'r'e'r' .:l
',"';
',, -: '"r inr ' \-\ I'orlr"rJ "
r' Úrr .
 663

AtsLúÌìe ttre rïcik Cï rnaxÌmi7cs

'i\: ,,, (,, j"i) , (,. j":) r Ì6.1-)

l

"'tre* i,,, 1r,z1"l) istlÌeply orirÌon, therìAtptrroaand (r: .r,,2r"j) r.,rtrÌete.

2+a ond.lriih e li e dì\ú(lntfa(torofi.t'hcsLrbicrjft It rc c.stô\\eataa.d Í;r sj!ÌÌplicjt1.,
s e dsunrc the irÌiìrtjon t.ìrget is ren) n) lhc Êorenrment Llllìvcs !tiltv tr!m hjgher ou1
pui an.1 lrorÌÌ iÌúlatjof beiÌÌil !\ close l. zrÍj ar tossjbÌ.: \s discu!\e.t in !.h.preÌ 5, .l
, ì-.. r re]Ìese.ls tht irúÌatjon a\ eLion olthc govenr re.t.ÌccrlrnÌb.nt.Thefa!oUsir),sthar
the Íeak (-'r h.ìs a simpÌr triìde oilìretwccn ourprìt, Í,hjch h,ants dr,rÌl., dldr toJ\í,/r,,
.nd inilerlorÌ, which iL r,.trrld Like t() be as.lo\e nr zer) ar fossiblr.
'lhe nmgh C? bv conlrin rìkÌimizes

u: : "l t-i iì ô. t81

.it\10I
Ìlhich rclc.t\ drrl iLs onlt coDceÌn 5 rlith ün) deriatjof ol irút.ìrj(D ÍÌonr 7r.o.
\\je asuDc th.tthe i.nation.ì!erion oI rhr toush Sovenrment is inlìnit_\, Ìlhich jnrÌrÌ cs
tlÌat itaÌ$,nvs set\ ìnflal on.qualn)zenr.lntlìelanEüdgeofahat(.r5,t1ìetough.c.rral
banÌi i\ .oÌrpletelv non icconÌnodatì.9. ln râ(1ì period the t--,8 ia.cs th€ |hìÌÌits currc

The tlmioB ol molcs and tlÌe iÌúormrtion c.clÌ p[\er ]Ìas rt its dL:.i!torì nolte it a\

t1ì ü:5.iìloses -1 Í'irh no lnosledSe oín'lìdlÌcÍ thr n.t!rl .erÌtraì banÌ 5 lo!!lÌ or
1rcak. brt does ÌJ.r'that theÌe it a ÌrrÈab Ìit!t ol tlÌ. L? beini{ n gh.
í2) Llr choos.!r, , knoÌÌing -f.
i:i ) IV\.:hoos€\ it, kn.]l,lngr,l
ia) ( ? choorcs)r, krÌo$.irS il.
Whrt i\ nrteÌ.sLio! ltir ut ir to j.rcsljgile the .on.ìitiL)ns u.dcr lrhi.h a ÌrooÌirg cq(ll
Ìlbrì!nì eri\t\ jn thls t!1o Ì)cÌiod:rmc. We llÌatÌttrìr go o. ro 5hoNthlturere is a st Ìo.gr r
n.clìtlr e tt) pooÌ the Ìrue teÌirrÌs 1lìcrc ire ú the game. As (c hi!r enÌpha\ìzed, i clì{
i.al asnÌnftn)n made hr gr.re thcoN I he Ì!e rÌc Ìooking ar a fnrticüla. rquitibÌiu.r i5
thnlbotlÌ pla! cN irr con|i.ce.Ì rhal lhit is ure.quilihÌiunr Lrcln.s plaled iÌitcoÌìnìon
knoNltdile Ìretwccn tlÌem. Thu\ Ln thjj..se both Ìr5 aDd ar bclji.r'e jt jt a pooÌ ng rqui
ÌìbrlrLlr\Ìithborhtrpe\pÌeri.grhcslratcgloithetough.:cnLraÌbinkttCAisr.u!h,jrs
súalc31is!er\ siÌrllt. lhebe\tLt.ândoistoe.surcLhâr;, n) U ircannoLa.hi.\e
alrlgherutiliílÌreJrtlüt.TheÌenrr!.itNillrìIllavrchoos.r)randl,ronÌalier -Í, 0
Tbiscindlì!a)5bcichie\edtjn.cni ;l lJ,, ,,- Írri =0 ,r, .Ì,. n:.
Nh.t doet r rrcak C, dol In Dcriod Ì, it\ rrrarcgl is \.ftr simple. 1ìj tre mistaÌicn for.ì
srro.! Clr itnrust sct ÍÌ = 0. an.Ì rhcrci.jre \etl = 1" .j anr' otherrate oti.ilarion irÌ
t.riod I Ìlould ât on.e trehlv its r!|c is \!eüÌr.
664

But pcÌiod 2Í lìre laÍperio.Ìand ús nn^e i5lhe lasl moçc TlÌcrefücìlpalstiÌ€rr-''

'
Lr"le ,. r' l - "' ," r' 'P'r' r\rrr " d t
rhe Ì,hiuips cu econstr.ìi'ìtthal r, Ít f2 /. Thit c the ite.k CB nÌax !ÌÌizc\
/t\
;1Ì, rn r r,l I
i1ô l

r,l'-'r',.'" "!
il rì.:-

NoN \!e nee.l to lìtcl oul ilhal iÌúlation expectatìdÚ

Wi ioDÌs ìn thc two len':'
lnneri{)c1ltìÌeaìrswcrisstraiShlt(Ìs'arcìSÌncelVJÀ'olirsthercisapooliÌÌge!u!ìibrjd':
aìso knoÍ's thât l\'hctlÌer L-B is t t" tough : o tt"tte
I L
"âN ",
-i =tt
CB\1-rpe fromp€rjo'ìI sincebotlì !l pr"'
Iv.Sha! lhercÍ{)rcganìcdnoirìfoÍnation aboLrl
L'u.d:,la' "r '{\rì ' nh"l
-
.:
",; ,i-
nru t1Ìan that ttÌcrc ìs a ,' piobabiÌity cÜ ls tough afd
1

^, lhat",-*
pd)abiìitf
". HeÌìcc
"Iorc
Cl isi{eak
:i
"!=p -',, t i)\ "'t' 1') ,)
( 1tr. l

Thus l1'.r.]Ìoosei Íf :0: lou8h'lB chooseÍr = O: l1Sthcn 'ho.::

botÌÌa ileâk and a

,-t = 1.1 | ) .) : and

I choose\ Íi = 0' $'Ììile I wcak CIi chooses n2 =. 1
a t{)ugb (-Ï

Ir iì ln lact ratx!Ìil Í(Ì a we.ìN lo pLay accordÌng to this poolirìg equilibrlu':

'-'
lhe .nsríer is vct, !o lons ils 1t cloes ÌÌol pa-v the \Lcak
(-lJ lo in the lìrst Pcrir.
'l€icct
ir.",lr,i,n,'grn'"Ì*oa""ntageofusscrtìnsÍi=otogolorahighcÌ)'rÂndthu\choL':'
' n,,.t u P'u'] '_ r'l"|''rr'pa"l'
".,1 . iì '"'-,fdJ"d
r"r' rr '' :'r 'IdII
,,,'",r".,r ,-,," I

rhe vnltre;itheweatri C'B's obiectilc fü'ction to so'

'1o to tÌìc pooÌj::
Iirsr. w€ need locâl.ulate tÌre vâlueto the weak'-AofbehavingaccoLìing
cquilÌbriunr. lìe.alL thc seak CB\ oìrieclì\'e tìfction:

ur - 1,, ;Ìr'+ ò

I . ' lr ul.^.\\,r'J r, ' rlr 'o l rJ\ ' l '

... .-.Jl { | t / lr"
r]1 : 1,/il.rüÌliniithctetogethergnes

(1'd')+ô(ì4 i
ru,' r. I (r" . ;(l)')-r" ;) tr h.:

Thir is tlìc Pa! r)ffto n werN CA thit nÌimÌc\ a tough Cn in period I

 665

!!lì,ìlistlÌeÌ)a\oiljitÌrcÌ!ceÌ(rd.[..t5irÌperio!]1l\\eÌìredrttirisl,onrttoarlihorr
Lr'\_ intcrpr!-t\ UÌe (-al !ho(rsi.g: Í) hls is rÌì olt eq!ilibrjLull r)ìo\e. Ììot fredi.Ìd br
llrrtooìn!c!uililrriLrm.ThistuqLLi.rsrrsLo\pccii!11-\'\ofle!uiliLÌnüÌÌl)eÌ1en.Thcnros1
filrLr.lüÌttrÌìÌetrúrrjrl()rÌ.1\Loassurnctlì.rtilthe(llset\;:.0.the(liirDoÌ.lik.ì!
10 hr rfcal tliuÌ nügh..\nd lndL:cd $c|.in !5e ilÌe LÌtlitl\r (ìiteÌì(!ì ro ruÌ. orrL Lhc
possÌÌrilltl uìat r nrgh a.ij jr.rLld.roosrf,Ì: {): the LÌtuitj\e (lriterir)n sxl\ tlrat I
iÌn ofl rq!iLjbriLÌm Dorc Ìcids llr a loÌrcr pat olt nr the t\pe nalini{ the nnrrc Llìi. lhc
(qu ljbrnrrÌÌpr\ oli,lrrr,.r.rolhÜpÌilcrsrespondÌotlÌrnÌore,tlÌeDÍe.a.r*ignâ7cÌo
!rolribilitÌ t(ì tÌrrì tr t. nralijn.{ thc nlolc i.t led\t it the rrnìe is not tlre ot the orìrcÌ .r
anothrrtrtìel.ThtrjiqúLc(.l. taptli.aLìLciÌrthi\\it!rti(Ìr.orÌthcequiÌibÌjtrmtnth,
lhr toullÌ (-, !a. guara.l(r ,ì nìaxinrÌr.r p!\sibLe irrl oll ot zero Lrl tettjrÌS iÌ = ;, = 0:
(,Ìrc bertlútLr, = :i ,ìrr':andrh.L trìtlìisRrnìe1lÌe.erÌtriLbJnl(rnrÌltrtttet
r,lÌatererle\eloir.b!.lroo5i.AthcippropriiteLr\eloh.1hu\tettirÌSrÌ.{lne.rt\rril\
irrìplie\ | l(nLÊÌ frr oI lo'thc t.us r I /1. Hüìce Ì1J ìliLl tìs\isn., fírbrl,iLit\ (ú i that a
a-lJ 5ettirÌ{ ir : 0 isrrcaÌ
hÌÌ)einil.thcr{riÌií-]JÌ\lÌo.leiÉ.tsÌ\illclu)\e:]rt()!úÌiÌlirejtroL)ìectneturcti(rl
\iÌr(e Ìlhate\cÌ . lr.Ìrosln.ìborr 0 \'ill in\tÌ nì tÌre sage setter tlÌtìi the (entìaÌ benÌi
ji 1re!1. Snrle lrhal.,1o'ìt dor\ lÌas no irìp.ìrt on |eÌi.{l 2 r.Ìhrr thnÌì teLlìÌrs Ì1J tlút it
irirteli).Llrrcrhissi Ì)lr to r.Ànnjze ilr :t,2 -:\ = (..).1 r,2 1-i ,,' r'l').
lhLs impLie\ t,]1 =.1 +1. "f =,r+t, tNolcLheL :1 iirLtlÌ 0,5in.c ir-\.hosc
ii L\ f.!.1 (lÀ norLlLl.hooÍ. : r = 0 r lhis ldrflics i. lur. LÌrnt
iI] uÌe tieÌiet ihxt bolÌr

rtrli Lri iArln doc\ 15 ÍÍLl as po5slbl. ând 1lrls. i\ rlr ha!. 5ccn.
lÌr prÌi({ì I, thc
nrrohe.lchoorjrgril r'*r,, _j BrLl ìo\' l\ \ Ìinoú Ln t.rio.l l lÌrâL lhr(ali
Ìveirt:hen.r -j =;t -l ritÌralr]' ,' .'. ,,:l +t 11=)..
l\ttiÌrg these Ìestrlts to{clhÜ. rc.if rr.Ìk Òut Ìhc ti! .Ii Lt) a {cali aà IÌom dctc.t

riì. , +j,. j{r 1'r,' ir ;i;'l )=,. I +,tì+ ! 'l j' i]ô261

It piìrs not í) dele(t ir Lil ,. Uii oÌ

ltll -.f r ,,:.:^1, .r 14.2 )

Tìri: i! rh.. rô..liiion lor r pooLirÌ.1 erl! ìLi bì nu! OLì\ iouí) thr !.irÌ io i, serl l ll
Lh.
trÌ)rr pooli.g ÊrÍ peÌid i\ tlÌàt ii
n thL 0, ilút i! r il.in r'lÌúhii or nl]t tlìr rtal all
defuct5 Thc i.rÌìrLliÌ tdL\ u\ the SriÌì lrÌÌÌ fooLirÌ: i,tlÌcÍ ihrn dcfr.tint: tlìe irÌtuitiorl
' l r',
$ilÌbe ÌelaLl!.h l.n inllthereilre \ o! .iìì
Srl r Ì)i!!er o!tÈrt !ain iÌì uÌ. \ecorÌd pernrl
So the morc 1..rLliluc the re(oni fÈrion (uÌe bìi{i{eÌ i\ .)1, ihe Êrr,ìter $iLl be }o!r i|iÌr
hom ÌrooÌing ÌeLlì!.r th.n defe.tjrÌ! irÌ tlÌe iìú1 lreri({lt rnd the bjller i\ | tlÌr linler sill
r: Ì)c b.carsc lhc'iige \eiter rilL thiÌrl it the DoÌe Ìikel! tlüt tlie centÌdl banli i\ t(Nth,
a..Ì hcn.. Lh.lffFr r ìÌill Ì)e the \ec!r Ì)eút)d grjn Í()m poolüril iúher uran detecting
\ote thcteÌilÌ.Ìs bL t\!eeÌÌ the cor itn!Ìlorato!lìnSe!l!ìLibrjLunlÌererndìrrthrrirnplc
 So lar we have loote.ì at a 1s'o gaÌì c. We have aÌrcad,v seen that the cìoteÌ to 1 is J,
teÌiúl
tÌìe dls.ount lactor on the sccon'Ì peúod,lhe Ìess likcll'tlìc s'eak (-n lvilÌ bc lo deiect in
tÌìe lìrs1 l)eÌiod. lhc intrìitìon ì5: tìre Ìnorc lmport.rnt thc tutLure is to a weak CB' the nÌcÌc
it l.;iÌl Ìray such a C'B not to defect, büt tobull.l üp its Ícpulatì()n A natÚalsay to thinli
about thúistoassumethal Lhe a-B is iÌÌ cxirtence lor many peÌi(di: e g. imagine a centlaì
bânker ìs in oltìce fot si\ years. So we b!iÌd an N period nìodeì, and this wÌlì connrnì ouÌ
intuitìon that thr Ìonger is thc furuÌe, t1ìe nxì e it pays thc lteak CA to colÌtjnue engüsing
ìn repLltation building bycon!jnuing a pooli.3 nrateg] acrxs Periods
As we hale seeÌì wìth thc pooling sohtion to the two pcÌio.] ganÌe' thc Í'cak g€ls
the resuÌl (r : l. and Í - 0) jn lhe fiÌn period, and 8ai i. additioniÌÌ thc sccond"period
bvbeingabìetosct),2 > t., tìccause -l issc[by l1rj rÌÌcn al] the)' k o1\'is Lhitthere is al
trcbabiÌit-Íthatthc a_B is strong an.l l plhatitisÌ\'cak.WcsìraÌÌc.r1lthÌsrecondperjod

ncs bciwe€n ccntral ba ntt and wagc sctter\ typlcnìly take pLâ.e olcr manl. pcriodt,
(l:ì
Ìather than iun onc or t$Io. 'hc ÌeaÌ b€nclìt to a Ncak CB lìonÌ minìjcknrg a Íro'3
one can bc seen Ì\hcn the incomfìete lnlormation gnrÌrc Lakes place ovcr man)' perÌods
lntlìitivel-y, itp.ys thc$e:k(.Á logo onÍ!nìickirg Ltrìtìlth. PenuttiÌÌÌitc pcÌiod lorlhcn
the wetìk CiJ wìlÌset ): = lf .nd Í = O iÌì each ol the pooling PeÌiods' and lhe a'iditìonaÌ
benetìtJ if lhe Ìaí pcrìod. lhus the Cn\ pav off 1s

LIrÌ l. ldf + ò2r,. !. ò\Ì. dN+rr (16.281

lÍ the Cl stopr nrlnÌicking ât ãny point, from (hen on WJ knotls the Cl] is Ncak Hen'c
nrcachsubscquentperio.litwillaltuaysset;r:,lIFro!ÌÌthcfon,theLlJlorcs 1/21
cã.hpeiiodnraìe$ìltolÍbeing'l Ì l'hus nr p pose, without Ì4r.! k nowìnii Ì!heth cÌ th e Cu
jsweak orÍrong,1t knoi{sthâtther. tliìlbe â poolnrg equilibrÌunì f.ì onÌy two PeÌio'ls'
thc pay ofl to a weak CB wouklb€

Uv:),"-r).+r':r+òrit. lr2ill ' 't\r(/" 1,/2Jl (Ì6.29r

Lvjdentlv, coÌnpaÌlnJttbc last two equations, the.on olgjvnrgup poolìrÌgcarlv i! i Írlng

Ì/2J, higher tlÌa. lhc weak cÏ $'ould like Thusthc
ol ìntlation ralc5, rr/'2i + +JN
rcalbenelìt of bujì.]ing a rcputatntr lia poolnrg corncs nol in tÌre tivo perlod contert bul
ovcÌthe iongff ternÌ.

31.1 Summing up
Ev cxtendiÌìg thc cetrtraÌ bank slgnalliÌìg ganÌe to Inany pcrjods, the insigÌìt [Ìom uÌe
sinìple sii{nalling gaÌne is connÌmecl: s'lÌcn nrore weiillÌt is pltL on the irturc, lhe $e:ìl
ccntraÌba NismorelikelylopooÌonth€lon'inÍÌâtionstralcSloíthet()ughcenlraìbâr .
Thí anallsis âlso highlights the parallcÌs ltith the cp.dre,l .orrPlrn' infòmÌailon garÌie
?

ÌÌr tlÌe coÌnpÌclc infürÌìa[ion game, the gan]e must be repcatcd indehnitely ior tlrc tìme
inconsirtent outcome to ì)e rvoi.led. Nc have seen, in thc incomplete i ornratl(lr
gaìne as soon as tì1e $,cak centÌal ^s
brnk rcvcaìs its type b)'ccarjng t() nÌiÌni. thc nNiah
cc.tÍâÌbânk, Lhe lntlatìon hias retüns.
 661

4 Voters

41 The political business cycler opportunistic politìcians

and electionsi
\Íniiorpírt)lemindtrn..riÌLl.Lh(oryistlÌatjtnÌatÌ)elilì(ultt!ju.li{ethe.oÌnlrl:t...c
o Lhe politjrìuÌ\ Ìvho s1ând toÌclc.LÌo|. Cn erì thai ÌÌe irener.ìLL! have nÌcomtlctc jr lor
l]Ìaiionaboutthe'Ìrfcs.)lpollti.i.s((..1.tlÌeilconÌpeterÌce]beiorethe)t)ecomefoÌitL
.jiÌÌ\, there aie vaÌ Ìoui irars in rlhi.h rlc miirht (tr Dotl di5.or er thejr cornÌretence le\tl.
llispo\sibletlutdre\mighlsììorçldlrcclhiÌììoiÈr.nìple!!tili.rlebrte5(nrrele!1\ion
or nt tlÌe lesidatlDe. srr.Ì1 is 1Ìr!. Hou5r oi Rr preserÌta til rs or tlÌe H(üse ol (ldnrì([t.
li r!. beljeve mc| Èridrn.c ÌrcasÌ,ri.s polìti.rl co Det.n.r. tlÌcn there is Ìb Ìrnnrl€m.
HoÌre!er,itiiunlleerh..iÌsJllisLoprulideernlerÌc!oithr'c.nìpctrn(etoilo\eüÌ'
.\ \€c!rÌd Ì)65ibjlilr s thrL lhc poÌjli..l i)'ÍgÌÌ slkcts lor.orÌÌpeten.e tor la(li oi
itr llÌai ìt tr) çÌ\, rlÌhous| hÍ roìnpcllnft js piìrnte iÌìiornì.1i,rn nr the rÌe1! entÌalt
to uÌe politicâÌ aÌrfa, thr .osÌs n.d rcÌlardi ot lhc poliii.al :\ ltcnr rre ru(h that it
oulcL .Ìrh p !mc.fc rrilh high co.ìpctcnre t.i erì1Ü ln ((.hnl.n t.rnÌs. tlìis i\ an
era rtte ot a.heNe í,lcclio. iìLhorLghl{lmì.Ld\rrscirthls.a5f.HoÍc\cr !nle\s.ìn
aÌlhü Ìr)t of poljh.jrns arr hidi.{ th!. I glÌt5undcra bushc. this do(sÌÌÌ sc.nÌ lil.lr

A thircl Ìro\5ihLlitl. is lhit ! Llcs hi!( i..ess to irlioínn(ion o. llfcs c\..n thouglÌ
\ofur\ clo nol, end Lh. irnilulio.s,r pir(t choi.r ol.andldnLcs rnsurc ronÌpct.ncr.
llthoughtâÌlLc\nìar.orìrtrni.nnd.ontnr.ârÌ.lidatrsnn..scì..tcLl.i.ìcs.c!1i.isml.
Ìrr\ errhelesr 1!aÍanLc.l.
IlerÉ rÌe .onsjdcÌ if alt.rrnÌ rc, nanrcÌr thJt polit .lêns iiiril thclr coDrtcL..cc. lìis
it cìitJeìent írrnr diÌcrl rc'rl.l ion in Llr il ln !rür.lplc ÌroLh a..nrfcrcnl rnd ln.ImÌrclcn1
irolitl.iâncânsc.dllìc5.ìlnciignn iiì5 nlh(.brcrrlui.hcgeÌn.1.\\Icessum.:thâLLhcoflv
h r\ 1r rrhi.h a ! gfaÌ.in
ii!ia thf nìrnsurc\ thit en 1,r.rrúrrr foliti.ien.if raÌt.
bc 5L.nL
.r!.ial .ssrnrpL on n Ìlhirl íollorç\ $ wc higlrljght il h.rc orl!
Thi5 trrn5 oLú n) hc a
brbei.gi.gorcrnnìcnt isipollli.ianiblctositnal|.o.rpcL....rôtto\l1io.t.liL .:iâns

ThenÌ).Ì.ÌNcosrlsa:il]ìplifcd!ffsionoi|erlsoiìn.dLnbcÌlini'slt(rsrserÌ.d.lo
c(rnpctc.c. a.dclrclions to dis.u5s iou r obser\ àtioÌÌs thnt arisc.iLhc. tÌonì lhc rÌì p rlriÌl
I oting ÌÌteÌarrrr oÌ irom rn..rot.oronìi. thtor) :

1Ll HoNclÌalLrnileÌrbeharÉmrtter5rlotÌesrrhi.howinclÌmbent\dolthÉoÌrfositi(rl
d.rsn't nin iire eLecti{)n. the go\ eÌlDÌeìrt ÌorÈs iL'ì IÌr th€ model. thii i becrute onl)
in.unìbcrts crn send sii<nalt.
t2l \!h) \hould ÌalLonal \oLcFrol. nLrosprciir'clJ i.c. LLsin! i.lorÌìali.. lrcm !a5(
driion!l The ânÍi.er. i..odi.g to 1lì. DodLl, is tlìiÌ1 !oLü5 arc rrsi. tÌrc sig.il5 lhar
retrospe(tire data gtr( LÌrcnr Lo pÌcdirt (hc IÌìturt conr!cLrf.c and hcn.c pcrlonìin.c

Ihii Í.ti.n r lr.r..lrrr r rì.11.

{
 (J) lvhv shouì.Ì lotcrs \()te about $üat is hiìÌrFning iuÍ bctoÌe the e1e.lìon and nol
over thc whol€ tlme perìod of oflìce? Ìn tÌÌe nìodcl, thú is b€caÜsc onlv tlÌe ÌÌroÍ Ìecerltl-t
eÌectcd indrnìbcnt cân bc Ìc ele.ted so only pfflonnance tlÌat rcflect! the a.Lions of ar
iÌÌcumbeni Ían.ìint ior Ìe election (l e. ÌecelìL PcÌft)rnÌaÌÌce) matteb We shall see how
.,1 , -llr
"ó.in ! \.. r'ir 'rl- '

(.1) whydogovc'ÌÌments gcncÌate CDÌrgrNth iust bcnÌeeLections (thisplÌcnomenor

ls known as the 'political business ct.le'), !f rationnÌ votcN lnorÌ thjs wìlÌ siÌnpì-v'' lead to
inflation alLeNrids? Ac.o.ding k) t1ìe model tlìc insi{er ì\ t1ìat lt nrav pat 'o''P'l"r
i.clrmbrrì1s to d.r so ilthey can sìianal thcìÌ coÌÌìpetencc this way, d'd ltit docs 'ot pâf
jn
l,?.rrrp.rerr nrcumÌrent\ to nìinìjc theÌn We \hill scc whI this is lhc case b€Ìos' uslng a
signaÌÌinggame.

41.1 Ìhe model

Aslumc Lhere rrc two caÌìdidate te.rns rt the torlhcomi S elcclion, tlÌe goveÌnnÌent or
ì n cumbc nt (C) an d tÌre opfositnnÌ or ch allengcr.
lach cândidn lc team has lsl) meÌn bcrs '
who remain 1Ìì thc team Íor ti{o perìodsi each p.Ìi.xÌ a ne!\'mcmber ioins lhe teaÌÌr and
the older suNiviÌÌg nÌe ber lcales ln Íac íes'ìll onl) be iúcrcsted nì thc govenÌmctt
lcam as hinted al alrerdv, it wìlÌbe assunÌed thal onÌÌ iÌÌcunìÌrcnt toliticjãnr caÌÌ sc'd
''òr Jh i,r;r'' rr'' ll I í ol i:'|\' rr _r óm;
'lhe.ompctenceolâÌnernbcÌ who joins G iÌì p$iod r irrírittcn /r. ThecomPeten'e ol G

in / is wrìlren.r and is tlÌc sum ofthc competerccs {)fthe tÌlo nrcmbers: hcnce
(16.30)

i\'here /,r is lhe competetÌce oí the nÌenÌbcr who joiÌìcd G in üe cútrcnt peÍiod and w1ll
jonÌed
rcmanÌ to the ne.{i PeÌiotl I I, and rr, r is the coÌÌ4rclcnce of thc nìenber rììo
in tlÌe prevjousp€rjo.t atrcl$'ilÌlcale at thc en.l ol I ÌhisisshowÌìinlìig l611
reÌirÌls alnhich an irr.li\,iduêl ioln!tÌìc sovenÌÌÌl€ÌÌl are sìnNÌÌ on the hoúzonlal a\is
'Ihe (ompctence oI goverÌÌnÌcnls at clitì€rcnt periods is sho$t]oÌÌ tlìc veúica1'xis /ri 15
the .oq)cteìrce oI the 1ÌÌdi!.idual $lÌo ioins â 80\erfmcìrt at 0 lÌe .oìrtribrúes lo thÈ
competc.ce lìrÍ oi the goferJrÌìent at 0, .o, and thclr to the cornpetcn.e ol the govenì
nrent nc.t peüod t . .r. lach boìcì liÌìc ÌcpÌesents a goveinmeÌìt Jt lime 0, 1,2, etc '

Figure16.ll G.!ÊrrÍÉrt.cÌnpetef.. n
23
 669

lh. tüjod ol rhe go\'!.ÍnÌÌent beilg thc number ìn the mid.Ìlc ot (hc rllevant boÌd
Ì1nej tlìc boLl liÌìe nroÍ's thdrit i\ .omÌroscd ol trlo ir i!ìdual\ IÌotrì lh. curent ar.l
the trcljo!s peÌiod lor crânÌÌ)le rÌ is measul.d at iì)ÌÌdÌ\: r.t.i rogcthcr the tllo /,s on
the hôld line lal)eÌlcd Ì. ,\tnune roi! rhâL L|e \. De Sovennìe.t is i. oiÊ.e iÌr er.h oi
these tc.iods. Ihe g.rcrrÌnìentat rr he5 onc menúreÌ (rlith comfeLcncc I I we icìentiI)
nremìrcrs slmpÌ\ Ì)\ rlrcil conÌ)etence ÌtvL:l ]ronÌnol!on)ilhohâsloi.(djrÌrúand ill
tta! in the lovenrnrcnt in perl{ tr. This is slìo$.n bv the rerricâl arírí nÌo\ing /r0 úf
lnrnr lhr pern)d 0 gorrxÌlert to thr pcÌiod 1So\emnìent (joLninS rÌì. nìenbeÌ rÌith

hf ne\t dsrlnÌÌrLloI is that t]reÌe arc clc.lionl e\ erv two peÌìods. Th is is also nÌo$!r nr
thc.ÌiiÌgrnnÌ Ìlith el.cr ons l-Ll) rt the end ol h (or jÌrctlltèrentl] rt rÌre sLrÌr.t rjì nnd the
end ol t. üre inìtli.alion ol this ìt thrt thc itoler rÌìelt eLected at l:-10 rcmains ln ofiìce
i.fÜlo.lsIdnd2. llrrstlìeSo\enrmr.lcÌcftednif/0hasconrtetencc. fr r,ÌiÌÌ
iLs lìrst peü)d oí oll.r rr and r, = !
-rr: injisseconclaDdlastpeÌiodr, (unl.ssitis

Obser\ation (11:iso!erdnrcnts losr cÌcctnÌÌr, opposiriors do .ol rliÌì rheD, II the

nbdel, tbc mon úntiorta.r quc5rion is ílÌat hri(Ì rìation \otcÌr ar tlo .an lirther aÌ)oui
the con]Ì).lcn.c ol tlÌe g(nrdr Ìrrf L (hrt tlÌen elect nÌ teÌir{ì\ I end 2 wcissunÌerhar
benÌe thc politi.iar $itÌr (.oortcl.nce /!i hd\ l)ee. in e gor.Ì.m.Ìrt Lr.aml nothiÌÌB is
knollf abo!rt fr. \i)teÌ\ cen Llìcr.lnÍc orìl\ leam abotrt competencc Ionì pcrnÌrìrÌce
ìn oln.c lhr oppositior r.iÌnr al / ?0 is uniÌÌteÌerring to \i)teÌr br.auÍ: noLling cün be
Ìeant abo!t tlìeir jìrture .onìpücr.c iÌonÌ ttre| part felJoÌma.ct it.ìc.rcd is rhe ÌÌert
golrrm(nt. ft js tÌre nrodcl\ is5ln4Íion tlì.lt onÌÌ incumìrent5 can sig.al conpcrnce
thil !rodu.es oÌr\er rtion I Lr.
N.xl Nc nÌ.ìle Írne sÌrccllì. nssuÌnpiiorÌs ìbout i,r:/rr is a Ìxnd(rÌ \ arjxblc tlriw. arom
.,rr'l{. I ,.t ., ,,. ,t 1....
biÌllt I rri]nd /rr, ihigh co.rpcÌcncrl NitlÌ l)hl)abiÌit) ,. Thus i,, i5 i..ìcF.{ìcnL ol
/ri . lhìs ÌìenDr that rhc .r:rÌÌpcttn.c oi .rÌ\ l)oÌfticiaÌr i\ n ependent ot rìrar .I Llrc
olh.r folitìci.trL iÌr the târlr. n nddìti,Ìr it is âsrnrled ürat üre ertected rrltrc oI /rr

ltr, : r//r! tÌ r /rr lì (16.3 r l

\otethatthi5impÌic5th.trr-- :0a cl/r! i 0.

ObseÌvations (2) aüd (:Ì): 'retrospcctivc votirS' ard 'onÌt ÌeceÌ1t pert'ornradc.
matters'Thcs. issuu4rti(Ìrs dÌamari.aÌÌl siDrflii\ tlie arsunÌÌÌ1. \\ e So b!clJo the Liiâ
iliun and Ìook iÌL Lho loter rt the elt.tjo. âL Lhc end oi tr Ìd ir\trnÌr the \oteÌ n) h.:
i'tiinüÌ. Thef.,lorc all nre i5 i.teÌe5ted jr i. asÍ,ssirÌ8 tlìr .onÌf."terÌt ot the in.unl
bentgo\ÊÌ.nrc.1r'Ì!hnhhr\bee.LnoIl.ci.p.riols land0anlperhat\earlierì ii
ÌrlÌrt tlìrt Ìrilì cnable 1Ìrr ro pÌecìict eìr.ut lhr i!rure perfoÍlrn(e ol ihe cuìrcnt go!
enuent (a\srrÌÌrlnt it ir Ìe elc.Ìc.11. Slr. r.o 1ìÌÌd our noihiÌìt !Ìr)ui rhe conrf.,Ìc.c!.
le\el ol r, or rir siÌr.e ther ha\,r not bc(.n ìn !. ernneDt )er. lhe (Dlr nrcnnrff.l
rn\ lutue lca.r ib rt shom nre can llnd t]ut an\tlÌirÌS b\ the eLecti(lr rr rhr: c.d

)
67íJ :

of p€rjod 0 is /i. r1o is tlÌe onìv poÌiticìan (ìnÁe Pe ormancc Ìs observablc befüe thc
eÌection ancl $IÌÌo wiÌl be iÌÌ gotcÌnmeÌÌt after the election il tlìc incurÌbent golemnìenl

RalionâÌ !oiÜs \l)te retrospcdiveÌ-v bccause the LJehaviour olthe ilovernment belorc
the elcctl{!Ì Írpplìes th€ a"ly drdiloble |níonndljon on competence altcr lhe eÌectiorì
A d ralionaÌ rolcN (âccordifg t() thi\ nìodel) are intereÍcd onl-v in ,cl"rf peÌloun.ÌÌ.c
becausc that and on\ that gilcs a gÌìidc n) the rn.,re rcccnt\'ari!ed nìcmbeb of the
iaolerrìÌìent teânì s'ho will peÌitÌl l
ÍiÌlbe a(Ìrnd Ìn
The un.ÌerÌriÌì8 asunÌpti,ro ol tì1e nÌodcl js that /,! or thc cunent govcrnment teatìì
cannol iÌjrectly tcleaÌ lts.orÌìpetence, bút it can \eÌÌd a sig.al tÌonÌ Ì\rììch the \'otcr
nÌav bc abÌe to ÌJìfer i I0\ conÌpetence lctcl lÌ(r!ever, ard thjs ii w1Ìat rnekei it iÌìto en
ijúereíing siiinaìling 3aInc, thc govenìnìcnt is teclÌ]ÌicaÌl-ï caPable ol scÌrding this signaÌ
whethcr rr0 i5 /,H or fr. lhus LheÌe separali.g oÌ a poolirÌ8 cquìÌibriurn ('n
nÌny bc either a

both) jn the gimc. Ìt there is a setaÌ.ti.g e.ÌuitibriunÌ Ì1 \!ìlì pav a conrpelent /r! to scncì
the âppropÌirt€ sìgnrl but ÌÌol a. ìn.onÌpctent r1o Ìn that case the votcr tliU kÌx! lt rrf
is compcteìrt or .oti if /r0 is .oÌnPetent, lhe voter can prcdict the expc.t..Ì value ol lhe
iao\ eÍxn cni if rc-clectecl, n.nìcì-v''

l.r =?ru+1,,i : ttÈ +Lpi = trtt (Ì6.32)

Sincc the lotcr has no basi5 ft)r assig.jng a con]pclcncepÌedi.tion b tlÌe oppositioÌì,
íÌc Niìl votc lo Íe elc.t lhc incuÍìbcDt UJe slÌalÌ shoa sìÌortlv exactÌ-v wht the loter
prclcrs a con]pete t govcrnÌnent. Ìf (contiNrirÌg rlilh this sep.ratìng ecÌuilibrium) /rrl
sign aìs ìrÌcom teterÌce, l hc loter !ot.s ftÌthe opposjllot Thl\ is be.ause À.Ì !rìlthe
iÌrcomtet€ÌÌt incuÍìbclìl is elected as agalnÍ-L.r 0iÍlhe\l)tervotcstoÌtìreoppositi(!Ì
Hoirever, il theÌe 1s ir pooli.S e!uilibrlum it Ì!i1l par'' the lncoÌrìpetcnt rro to ÌÌÌlmìc the
.o nìpetent I i; h eì]ce th c voleÌ wiLÌ havc no bâsls to disl nglrlsh bet$'eer lh e sot erÌxì elrt
j

and otpo\itlon and (IiìÌ thcrenÌe lotc ran.loÌÌrly

Ír oÍleÌ to prr!idc in i.sightiÌÌto observation ('11, j c. th e tenderÌcr'_ iorgove!Ìr'Ììcrì1s nr
cÌpancl o! tp r rt belorc an cÌe.tl(Ìì, it ls necessáry- to sct out how uÌe economl is r\sumed
toN)rl:thr ler5roÌì l abell inì m.Jd el in lÌoduce\ the crucìaÌ as mpiionlhataco pelcnt
gorennn€nt js abl€ 1o rcduce eq!ilìbrjLtm unenÌployÌÌrcnt.

f€rsson Tabellllìir.ld tÌ!o assunrPtjonstothosc(Ichavemade inmodeìtup to this poúrt

FÌst, nr noteclâbolt, tìre) âssunì. lhatth€.orÌÌpclc.ce olthe go\eÍìment has econoÌnic
eìfects: sl)eclnc.rllv, competence adds t{) tÌìe Írppll potentìalolthe ecotonrt so tha( it i\
r,.. ..Thiri\ af lnteÌestinsând slrongassunìptlon: coÌnpete tgovcr.mentsareablctt)
loÍ,cr rhe equiiibrium uneÌnplo,vmcnt rate. l:or c.anrfìe, a conÌpetcrì1 goleÌnnÌeÌìt nra\
bc able to puisüc efíecti\e policics ìn aÌe.rs su.h as cducati(ÌÌ and traifing, conÌprtilìon
polj(n, techllologt transler,.rnd lãbouÌ nÌarkcl rcguÌation, irhichimprolctìre \upplr''sì.ie
oIrhceconorÌì!.Aì.nijeofsu.hpoÌicìesisdiscusscdlnChapteÌ1lhLrslhel'hìÌlipscu^È

",:"1 r,, Lr',+.,t. { laì.31l

 611

Jn thorl,..!ììpeten.Ê âllo\!s a lÌjshrÌ lerel of o(LpÌ,t ÌliuÌo!t addiÌìg nr liritaLjo.. tn p.r

ti.uÌar nolc tlÌat ior lL.

, -i t. ,t) (lô.J.1)
')..
S(Ìr.d, L']rr\íÌÌ ar(Ì lib.ÌLirÌ] Ìnalte x .ÌLtjcrl ellhoush econonlcaÌlv reainablc tiÌ iÌri3
ârumpli.n. tllrt ìril.l, i\ ob\en dl)le ì. r, ir isn.rtob\e dtileuntilthe.cìtfc.iod.5o.
ìril. tolrrs lt lll0 kf.Í',rr the\ $ jll onÌ\, gtt 1o linolr n, .ìlier rhe electÌon in Ìrcrbd 1.
ÌI11)l$s.!uL!l ob5trr.Ì'i]sseÌÌ r\ l,r btnÌ. / 1l) tlÌe! .ould ì!(trli our r,. rtn cc i.
nl 1., ir.-rr.,a.L1 tisâsume.ltherÌnor,-1.Ìtis(e trrL to the nrodel rhat vÒters
.:in onl! iÌÍer comtct.n.. /rì l,r/i( t/r, b\ .bsftlins the le\el ol our|uÌ. I I I thcl hnlr
no wa1' !l irÌleni.g conìpetence djÌectÌ\. \\J. 5hnll s€e belorÌ thit ttÌe r aìue oi rj ill
br lrcattll tr\ \r)trA as a si!rì!Ìol c(rnÌrete.c. F!rÌ!r!eÌ,b<au\ethe\(an'tobí,^c;ìl
lotcls do not Ì$dç Ì!hi lÌrrr a high I ! conres IÌÕnì:
. higlÌ .o|4)eten c. i c lh. rbjlit! olthe goremÌìrni ici r,ì isc .q ! ilibriÌun outÌrú ìtsclI

..t.,
outlÌ'l iÌrolr tlÌe È!ÌuiÌibÌirLiÌ bc.iÌusf ìt trirs to !iijnaÌrhat it 1\ coÌnÌrÈtc.r. I. this
crse, hLgh.r intÌation Ì!11ìh. rhc ..n5(qui nce oì the pÌÈ eÌectnlr boom.

Wr no{ turntor otcÌ\.1. tcrrns oltheir/tdr/j, tììevaÌ. s1ri(.tÌr ioN\'ardlooÌlng. We.ssunÌe

lh.t loteÍs preler hÌshrÌ o!tput .ìn.l freler ililrtio. rÌosc L,) 7cF. Stc.il.nÌlt, in e.clÌ
prrild. thr\.$ouÌd llli. is hiÊh i r ilue at Ì)onìÌrÌe ol

rlÌere l ÌrtÌrcts thc Ì!.i,irÌrl tlÌeÌ t)Lace on outÌnt reÌâtìrc Lt) i.flati.n. Ifthc| hrrc ln ìÌÌlt.
liles and a ctiscoun L e.Lor ol i. ther nÌarnDizr t i i' ilL.i ;:'lt. Fl.1rc\ ft , io. 11ìc rrn
vnÌ\ | e hare tntf. !olrrs crnnot ])Ìedn t ..mpe1r... ifaú IÌom Ln r . iR.:nrcDrlÌ r that
rr = i,r trr. so thel lhr roter at Ej{l ha\.o bari! o. asscssing ti. .r trr.) I hrLs thc ratio
nal \!fur it o.Ìr.on.(irÌed trìth cÌÌ.o\ì.S a glr.Ì.nrc.t Llrat rrill tÌodu.c thc hlghrÍ

-i2

Â! nc hl\ c ilreadr tÉe.,lh. opposilion is coÌÌ4rleteÌr fassn e in thir ganrc i golrrnnìcÌìts

los. rlc.tjons. otpo\jtÌons don i I iÌì therr'1. \'!e oIh n.c.Ì rr).onsi.lcr thc go!(.rnment
whi.hrhoosesì!iÌìpeÌjo(Ì0.nd.iiit\iÌÌsthr..le(tìonrl0,r LnpcÌLo.Ìì.Thcgorcr ncni
it issrlnì.d tr) rrìr\inri7.

irrr i; 2l r ,i 1,,!r .i,2t + 1, 1'l

612

í 16..lrJ)

ll rÌìe incrrmbeÌÌt 1çint r!ìd

if the incurÌil)erì( l{\es. I ìt thc rttjìit\ that a..ruct l()m Lìci'g in ÌìLn\'cr To un'lcÌ
sraucl thc go\€riment s trtititl lLrnctntÌ. il is rÌc.cssal to uÌld$stanc:l thc ke] idca
ìn
the trrÌrc lhat it is costl-! for.ìn iJrconÌpetcnt nì.Ltnrbent i!tr() kr ÌnirrÌic a c(ÌÌÌpctc't
incunìbc.r {c Ír.) b! .hoosiÌÌg i hLiih I, slnLe tlÌìs c.trih d lÌlgh inilatiorì trte r,r) Írom
ilhich 1lìc incrmÌrent lose\ ÌìrmcmÌrer thiÌt the diltcÌence beLNccn th€ conrtetenL ancl
lncorììLrcLcnt i!ÌcrmbejÌl ìie\ nì thc abiÌity oÍ the .onÌretent in'un1l)ent 1o Ìrise eq('ilill
.ium outftrt. i.e.lu raisc outpuÌ without ralsinB úrllallon ÌrÌolhcÌrvofus' lhtcrndidate\
ãÌe nol iL6t potr'cl hrngl U' ' 01, but iÌÌe also ':oncenrrd about policv ort'onìes
crcn il lÌìose polict outcome! atu: ,ur krì.iflÌ ri'tn after thc electio' Thi5 issúnÌ)
rìon nÌal appeiÍ {ÌuestlonaÌ)Le bLú 1t l!Ì Ímrr s'rch a$!mtLron) is 'rìticàÌ ior the

4.1 2 Separãting equilibrium

(\Ìhclc r
,\.orÌÌprlcnt iÌÌ.ümbent, c tr. \ignali fts b! cho.)slnii r hiSh o(úÌrut Ìevrl, )"
sran.l! for'sufeliofl.I/ there it r sctâÌatiÌìg cquiiibrlü Ìì lre'11 asmme tlìcrc arÌd lcst
ì\
ior it Ìntcr the lmfh.iìtl.n i\ ÌlÌnt it.loe'r,r Ìrar' (r' ln'oDÌprtrnt Lncrunb!'nt,I ir' lo
nrlni( tlìls. This is beciuse mìÌnicking l'j \!ouÌd i')rcc I iÌt to icccll too n hìch ratr ol
lnildti.nr Io \ee thi5, it s jnÌxìrtarì1 k) ÌenìcmÌ)er t]\'o thÌng\: thal onÌ) thr 'omletÜrl
incu!úcnl i5 rbh L. reducc e!Ìuilibrl(1Ìn tnrmtìolnÌcnl end tÌiìt \'lrLcÌrr otlng it tÌre end
olionlrobrelvc)Ì,tÌìe,!.ÌorÌoÌoÌrÍÌ\eÍ,.'heploblcnrt{)rttÌc'orìfeteÌÌtif'umbrnl
is tlÌat nn inconìfetent one rould miNic Ìhr Ìe\eloi ouLÌ\tt the (.onÌretent one $ould
oÌrtiÌÌralh \et: il] o er 1r) prere.i thú, tlÌc .oìnlìricn1 one ÌÌ,ìs to \ct a highcr Ìe\e1ol
ouÌpiil if (trcier 1lìatit bcconÌes subôftnìr1ior tÌre iÌì.omleteDt on( lo nrinìi'thìsìrecausc
ìt ÌlouÌd Ìrr)d!.c inÍÌatioÌr that $'.s loo lÌigh igilexl nr'l PÌelerencrs)'
TlÌcotrtloxrrina\eparatlnitequiÌlbrjuDli5lhaÌ1ü1i.hoo5e\theoÌrlinìrÌlereloioutPut
'| Il r'' I \'r' r' '
' jn
I

eqüilibriun rrd il tlÌc.ÌÌlt equìlibrLunÌ. ì1 nìean\ thal ohseNing a riÍ: outp!l bcf{tre
js

elecijo.s (a so .iÌled political busincst c\ clel is a refleclio. oIa irell fu'ctirunÌ8 p'litl'aL
\\ \rcmr conÌpcLcnt SofcrnmerÌts arc aìrÌe to rc.luce eqrillbriuln unenr!lo\'ìneÌlt and vrt
ers arc aìte to idcntiò this con\Ì'lcn.e und cnnrre thc-! eÌc ele.ted lo f(nÌosl lh Dgh
thr nrgluÌ€rÌi, il i\ rÌoÌt ne(ess.rt lo caÌcrlalc botlÌ tlÌc Ìrcnehtt oì Nitìning nt C nr' ancl
lnr.. rndalso lhe coÍsoichoosingl" to sigf al coxìpelcn.c irhi.lÌenabl'!ll ür'ìndlnr
íil il mlDÌics (- i,Lì to \!in tÌÌe elc.lion.
'lhe gaiÌìs flonÌ \'inning tbr c'iÍ. ard l'tl.
Ìn p$iocì 1 t|r: gr)!eÍrnreÌú \!ilÌ scl an optinìaÌ |oli.) fff iLteÌl !ìnce it ha! no ÌÌccd nr
\i8nal anlthnrij Note lhât ì!h.t hÂÌlteris in feÌn 1 hiÌ5 no eilect orì lhe eÌectio' at
 613

ÌheÉ.d! peridl, !1... peÌionranc. i. p.rn{ì Iiavsn.Lhtn:t;Ìtroutthecomf(lrnce

.ú i,r an(]rrr, the Ì)ìÍl.ip.rnts irÌ the Ì)o\r / 12 So\.rnnÌreÌrÌ ts( I :t 1rj.1it. Th. rflüint
nü\iÌÌrftÌ or the !(^ffmrenr ìÌr ter.d t i\ t1ìÌÌÌ)t\ trr. Ìi 2 l\hich 1r nri{ mize\
subjectn))i ,! rir -, -i.rlertiitsrtr!((,nÌrereir.eo Lh. p.ri({tzerr i..urìbeDt
!!!enrm..{ iÌì peìiod Ì and 1\taìrclr toÌ tnruÌntrelr. Í).1 = irl iil. theDlriodzeÌo
r'''l
olthe LridclnÌit)i{n,utnho joÍúintcrt.d ltr lìen.eI.l : /.i,' rl, I,l
l. ícl lhr Èr\t oì{Ìrr c.!ì.lirjtrì, ÌLÊ suÌrslit!ie the constÌaifl tnt! the mari!rân(l nnl
lillÉÌe.liiÌlrÌrjtlìresÌÌ..tto-Ì,shi.hrcsrLlt\jrrrÌ=t,.ThjsisrrurtrtÌerheÌrÌclìircì
coDteLcnLoriÌiconrfclcÌÍjrÌcrÌnÌbent.sn.c.ìÌng(trernmtnlrfllsft;r=t.jtoìÌo1f5
uÌat ercrr.ne lnoss lhiìl rlÌi\ ìr rlÌe cr\e Ír Lhat -1 - t, aÌ he.cu

L 1', +r'i - ri r, -,'i +, l:r., r,l,

_Ììr\alLr€otÍin.Lngi\theÌrl.Ìc iLlì(,,,
/,Ir 1,, tt rr
lìr ìret raÌur.i rirning, honartr, ìs rhe djUdencc hL.Lr1.cr1 tlÌis aDd whal r{olLd
hi!( hrpÌìencd i Lhr oÌ)to\ihof had r!on. In Ìhrt cr\c I = 0, ,f ). , ísiìrc€ I/,. |.
Íh$cuÌenÌrcAüittOdenoterthc.ppoiitnrìla.dr =l] n)r1h!.samrreaí)n\a\ahorL.
\n itlÌeotfosirionlÌrd1ron,rhr'tirr:rlitothedtÌnaredgolcmnìrnti\tbr, l)r2.
Fcn.r. tlÌe neL \ ilLLr !l ÌÌinning Ls

Ìf iri,r .lrlr,.+/'ir l', 2l

lhe cost r )f s igÌÌiÌÌÌiÌÌg

\\'e den.. alt,r Iiìr as the siS.allinil.osl ol\ertingll :I,gilrni,i,. hus it Pr\1r coDtc
terÌt nrctrÌnbcrÌ1, ( nr, to ! gnrl L' i

Ltr lirr rri,q I (. rr i 'lrl

Btrr lhc additidrrl co.rlltiüì 1lÌat is rrquned I(JÌ roLrrs ro i... pl rhis ls à lredììrlc lgniÌÌ
ls lheL tht sisnrlÌer .l,!' is irÌdeel conìtetcnl: narì.l! ìl mun,xrr p:\ rtre n.omÌìcLcnl
in.úÌìÌrrrÌt, 1irr, n) Ììimi. ii. llerÌre, iÌ ÌrulL iìlÍr bc tht ..\t UÌrt itre c.5t !.r ? ir .rt
sigÌraìl n.qr' i\ SÌeatcÌ lhinthe \rLiìe olNinnlf gthc cÌc.tlon. i.r.

.rt .r i lÌ't|i ò1,1!1 l,

Hor i\ (-| . i,rr ral.!lrte!ìl Thc coits Lo th! jiÌcunÌberÌr oi \iij.alli.g i( blnÌe jrr thc
.uÍrnt peúr{Ì 0. ÌxÍore the ele.hon A! f( lÌa\e seen. the ircuÌnbrnL s üÌrrr(nect in
..oDonÌi( ÌreÌnynìe... iÌr t)oth peÌjods 0 iÌLìl 1 LealiÌrs a\nìe \jgr.ÌlifA, I r!uLll \et
:n l)oftimellrib!tir5üÉÌìotedxb.r.ancfle(tiresiNrÌalnrâ\ÌequiÌ.âhiirlÌerrrlueoi
ÌLr ( r iiiì i\1h.tet ollìÌìÌreÌiod0Loi.jncurrbeìrrhonr.hoo\LngiLsoptirìdllercloi
) i, lcss the ÌreÌiod 0 fi! oti nr aìr in.umb..t iroÌn !ho(únrs r \ubottinìrl l.rrl olourÌmr
notlÌeÌÌvoÌdi,l l rl. i\theredu.tion ntlìrperl{dlfar olilÌo.r iln.llirÌ! as Ìrto \rd s (

lo.doptinxlÌrcotÌ nì.rlÌrnic\.Th.diÌtnl'rprr.lffÌomtcÌiod1) or antrÌcüÌnÌ)ent |.!.

r,llh rÌ! \itnall i5 i,rr,f 1'l , 1,2'2.rir1.eoftiÌnaÌf,r- r. th.tloveì)Ìravou
'ir
614

troÌììí.ndLngrr.rbilrer 5igÌrLlt' lrfcìÌ|olloÌr{ L latcrli\l'l'

;.ri irlìì jrthe\rLÌrt oI-iÌequiredbl i'l i()rtüirÌiì: gnalrl

1)'irlì=1,r. i;+1, -; /,r I rlr .L i'i l

lìrr.!r'=r -/ii . r' /ril r".t| s inÌrÌie\

=,'2 ])-) r'i +-" r'1,'u

i",t' r'i r i'rr z r'lô.+2ì

Aicrnbr's.cn,therjsn,rÌllng.o\t!leÌrrndtorÌlÌoslìighLÌre; irrìpli.dhlrnnr.unÌtrent
\ignaiLin.{ 1 l5 rÌu t 1,. b!tL rrc caD etptu\\ it morr Lrn' ttllr thrn this
ì:jr\t slÌr.f Í r ' t,l I -; I I' t. I r'. $e rlr\tiiulc i.lo the rbrÁ..rfÌe$i{!r tÚ t(t:

r-rr' ,,1. o5 ia r' L. rl I'

Sc.r!rd, Ì!È nc.d lo e\rLiìrtL : ì inclt! do thL5 re.L\s!nr. that \rlf 5r1irÍ u;c retnlrll
.rÌre.trtiorÌs. hcl .ìorrìtkn.Í rìretiÌ.rrri Lcr!ÌÌPet.n(.r L11r(ürprtc rt btttthcflÌÍn\
thrt i repiìIi1i.g c.ÌuìÌibi!nr iLratcill j: ÌrcL.g Ìrla\ el tÌlLh tht \ !ttr\' H!'n.r' theÌe i\ i
Irl
.l ,Ìr(n)tìbillllllrali I i,r,nhoriLlihfi,'nrrcsetrnopli.raÌrrinÌrlrnÌR; I
erthnt.ìa-rbe letbclor:,r'llilclh.!rif.unÌbeni5.1:therÌ)tìrÌ!LLetlloi
íirhate\
-,sLnceitdo(!..tfe\ 1,rtcìnrlÌnL.i'r irÌth 5:L'ÌreraÌiÌìStquillbÌiun
HÊ.ce rith a sctaÌatjnS eq!jl britrn.

ri 1 r,tò +,' t '. ii'jì = I ,tlJ i ,i-. Ì r., ir,l

=1,+ " rr ì. /i,jr
r'orr na: crn deire tlÌ(.osL nl \isnrllilì Ior i'1, : /i --:

( r'irr,:05r-i r r. r,q ll'

1rsiú+ r' r'
\.r
-1Ì r, r,,ri

(_l|'lrjr ll5l.:i t' r, r! lr:

1l i
il I
 675

\orL thâ11r. hxr. rL.rk.d orLl Lhc hc..ilts ú.rÌ $ifning n)r rilr dn!ì n, i'r ancllile\li\e
theìÌ ÌesÌrectirc rjg.xlli.g.o5ts Nc .:rr stc Nlrr:1h., lhcÌe it a seprtutitrs equìLibrjL'Ì! jlr
$Ìri.h !r ret\ Ì. = Lr n.il / I \cLs riì \o rs Ìo miÌìLnrj7È ar,Ì .tirtj i.c irr tet\ 1,, = r'!
IlememÌrrÌ lÌrât rh.Ì. er. lrro.oidLLlons i.r i npariìtLng e!Ìu1lìÌ,ÌirnÌ. Iist, that thÉ taiÌl
tuÌ $ lnning L.r,,,r is grcil.r thin .r i.ltraÌ tô Lhc inL.t tlgnrlÌìrS,

11 1)

ancL\rcon!lthìt tjre gair ÌnJm itinnìng n)r i,r ìr le$ uÌarr tlÌ! c!Í of 5ig.iÌll ng,

rlti:l;r

\\e r\ânìirìe tÌÌe IìAt..r itìdì in Ìi8. 16.Ì2 lhe bcncfl 10,,1 ínrm lli.ìriÌrs is the
horizorÌt!L LirÌe Ì1 LIri.ThecottúlsisnalLirÌSi\thequa.l.âLi.Í!.cliona-),'./,{ìwhnh
i\ e!!àL nr zetu ÍherÌ ì ' = r. + i,ts. i.e Ìrh.n tlÌerr s.osig.aÌlìng (lÌtaÌl) itl ìtrnt
oltput Lerel lrrtlreeÌÌi. ,,ra !1) thrlìrslcondnionrfilìbe\eti\htd:itülllPa)r,sicì
!igx!l rtlern!)L(!Ì:a5the\e.onnc.nditi.!ri!also5âtjsÌic.Ì.
l! rÌì.ìp !!t the iecorÌd ((ÌrLjiioÌì 1!c supüi.rpo5f iÌ iir! and C rr. /,, on Ii8. 1ar.l2.
'llÌÍ i\ íÌo$n iÌì Lia. 16 1.1. \ote thit a ir" iir' .rìd Citr./,rl dre iderÌti.rl q!.ìdr.tlc!
ercept tlÌat tlÌe co\i ot \iSÌr{ÌÌìng i\ zero lü riri whrn ) \ = r /,rr rnl loi Ir rlÌen t'r )
1

ln FiS lli 1.ì lle can 5ee thet it silL onLÌ p._!!r 1o signiìiithe 5ìtnrl Í Less th.n1;.loÍ o.h
thenÍjllthegrnrhomÌrinninilo!tÌÌeilhthr..\tolsigneÌÌiÌrg lleÌÌce rs ì!ill sj.{nal,i'
Thi5iitheÌ{\\'est tììu\cherÌrert risn,ìlih,rtrr.annrrÌedr/1rlÌiclÌit 'illju\rnolfi!
|r t{) c(Ì)v. Thutrrrr lliLÌ 5iiaÌììÌr, .ìnd rj itill 5L'( ) ì ) .
Fig. Iii.1.ìhiHhliSlrtsÌheiacttl la5(piì.a1lngcqrrilLìÌiunÌÌruÍl.\isl nthisÌìo{Ìcl.lt
i\gunìenteedtr\üìeia(ttìrrtuÌrbcnrlìtslrc.rNi.ningnÌthrinconìprlrnlln.(rnrbent
xÌc LoÍer tÌran lor tlÌr r(ìnrl)rtent (i.r ll /,r r -- ll i,ri l drrl tlÌat th. .osLs oi sLgnaìÌ1ng
eÌc alwa\\ higheÌ h)r the jn.orr4ìr1rnl I c Cir' /ri I i\ ih\a)\ gI.i1l'f L]riì. artr /,! rl.
Thi5 ji an (ÌÍiniitn re5uÌi ri to tlÌ. rli!'.ln'!'icss oÍ lÌre dtÌìro.r.rtic s)5lcnr. L LÌìplje\

Ì'.. l..r rrrr

Figure'16.'12 a ii,r'r,-.. r.': í.r ! rr lj;r d: qì; !r.it

figüÌe 16.13 a-ir. àril / /r.. e.t.r t f i i! Dê.eit a:. I qià nq..5i

tlìnt (at Ìeast il one Í prcpared to accept thc atsurnptions ol the nÌodeÌ) a separ'âti'ìg
eqrrjìihriumah{âyse)iÌsLsthat€IÌnblesa(orÌpcleftj.ÌInìbctttoNalehimstìllnowÌìto
thc \oteb and h ence to get eLected Ho$ever, Lh ì5 i\ Ììot nc.csaì ìì-Ì the onl,v cquiÌibriun] '

4.1 3 Pooling equilibrium

|..
compcLrnt orÌe? lÍ ír, t1ì.n both a tr. n!.Ì I n1. ÍÌ tìre sarÌìe l. Hcnce the volcr caDrot
rlistinguiü thc coÌnPete.ce olr/0lrom lhe choi.c ofto, and so I'illvote ìrndonìl,v fr)r the
opposltioÌr or loÌ lhe Sovcünnent. lf al tr. knows he cannot slgfal c.nÌpetencc il Pals
him lo choo\e thcli th.1 ls optnüallor hnÌ ard !o accePtthatl tr.nlilìcopy it

C-tr. r,iìÌ choosc optnÌÌaÌ laltres irr Period 0 and thÜclore i.cur no sìgrraÌling coÍs. /iri

hyt ,-lt t2 (r6..18)

\uLrject to lhe lhillips cur\e.onslrâìnt

-,,= I ) J. , l (1ri..191

i1ó.s0ì

and trom tlÌe |hllìipr.u^c

1'í : .Í ol;+.1, + 1,11 :b "-1,

y', 1 1,' ll ar.5 r ì
 / nr. siÌn|l\ co!jLs C t'.'s.hore oir i : ) r". HeÌÌcr

t,ì = t,,Ì = r Íli -1, irì

1!lÌcre)'r'jsLlrc.oÌn.ro.rÍpooÌìngorLlfutle\eÌ.I)oc5iLp.tlnrn)tool,i\opto\r(Ìto
sritiÌrir rn oflimllt.I r:ilrorÌ(thÌsouL,Í,enre.llolt.dttÌepooli.s!aÌLr(otìrj,rvhi.h
;,,i ,r,.. ,t,.
prob.ìÌrilir\ Lh ai tlÌai gircs I nr or bctfg rr eLrcted oúLr{c gh\ tlÌe }ra\ oiI oí settilg thc
optiÌlrÌ,1ri.rl tr ìndib.!Ìdoning thr |onibilit\ o rc-cÌc.(ion.
TcsiiÌìij thc poolnìg equiÌibriLun
,,. ;r I,ii ,.
ai|l r,rr= u 5.ii liì irr I ' 11a,.531

$ hcÌc lÌ is I tr 's optlÌrì.rl r ì and r I iì rir I tr rhe tf tiÌrìon rare irnplird b! r,l
.t

"r,í.r,' :ti i; t, i,r -t -"-t, ,,,, -i \. 1 :t,+ttt, tt,

tÌ6 51)

\o1r Lh at iir ri. /,r tr!llL nrcìea\c r5 !ir ìn.rer\et:rhis is bc.i!5r the lrjBher ir ir!/ Lh. lÌiglÌrÌ
r.iÌl r-n!( ie|rll oÌrli ilÌv: rnd 1lìffciore the hjglì. Ìri -111.r,, Ìreiiirinrtrì.sir-".

(-rL; r,rr 0 5 ir' ,'i r' lar.s-ìj

ÍitlÌiri thr nìLÌìi.kiÌìt cL)st is hlAhrr th.! n(Deconrp.lc.l s( rr.rr hishcrthr1.5\

.ompeteltjsI i/r(.SoitsjlÌti\ I nì( tomirni.a nr.i.dÒnÌr i

0:Ll r/r! : 0: ,rts ,r, r'?=,,iòii, /, - .,ts ,,,,.1

i rSl '11Ì ! aJ lo.g isthr..rrt{ Lr.rÌ...1ìf !er1!een I n( ìnd 1 ìr. ii Dotr'). gÌQL. ih.r. riLl
Lre t)roli.g
.ì .!ujlibriLinr. LÌr 5 r.jüLt i\ n()t es Ì.:assurtLrg .rs thr \eÌ,arrtin: .q', lìbriLrrì
butrtlearrlL nìflie! that in..!rìplluÌr irÌcumÌn nl\ sill not r)Lirni. ìn(uDbc.ls rllÌÒ.ìre
\ rnihrdntlr nì!( (o!Ì)eL..r.

414 Summing up
'11Ìe leA\.i t.ìbelÌiIj Dr.)d.l ot tlrr Ìrolirj.âl brLsirÌer\ cr (le tÌrtret t)n thr tiÌnited iIn)r
nl!tirlr alailnbL!, t. i !r.rs n5 to rlie cornfe1.f.. ot rÌÌr So\ enìÌÌcnt. Ihc! hi]!! no iInÌ
r]LLtirD ât ill nbout thr .orÌÌpeteÌÌ.e .l th. oÌrporitnÌ, ! electLon\ âÌ( düjte!i on th.
tri\jr ot hoÌr tlle \ otcr Lnr.rÌrret the ac1io.\ L.kül t)r rhÊ incunÌrcnr gÒlt I rünedt. \ír)rr
o\ eÌ, thcÌ., is i 1ì\ed fxLLc' ì ni t!ÌnoreÌ ol t.l ii(ian. iÌr ihe ir.onrbri L f.úv d$uÌncd
nr the úrod!.1, yr o.l\ Lh. rÌlo5r re(r.r r.tionj !l the gor cÌnD..r .irrì. ân) iÌri.ÌnrâLt!n
.ilr ÌrFra.lt.it\iutrÌe..nìpcfuÌr(e.tì.1\rr.nÌPete.ig.\ejnmcfl s itrl!. to ÌÈduce {rrt-
Lit)úLuÌ trncnlpL!r Ìncn b!i rn jrcr!ìÌrtkf o r. rouÌ.1ha\ e thc Ln...lj\ r to.luÁe hjAh
L L

J
614

oulfut beiorc en elc.ti{!Ì iÌr in attcnrlt tt) signaÌ c(rnftten(e Ìhc ÌnocleL iIìdi'ate\ thal
. sctrratnìg cquilibr iuÌn dl\te) \ e\l ts but tlìi1 i I tÌre !a p betì! ecÌl 'o nrÌ)eteÌÌl â n '1 ir Ìconì
s
-

js
pctÈnt iÌÌ.ÌrmÌrents noi too gre.1. lìrere ü.\'rlír br â pooLin! rquÌÌibiLrm ln itìrì'h it
pa-rs an irÌ..mtetcnt go\ernÌnent lo set outpul hislÌ, ie nr b€harc in uÌ' sinre
wa! ir5 i

4 2 Partisan partìes, voting, and economic policy

\oN re tuxr enat Íom opp.úunisli. toÌiti.ir.t lri1h diflerent lcvÉÌ\ !l conÌretejìct'
to Ìroìiti.nn5 n'itÌì opt(tirÌg trú1\iÌn trelerrn.t\' llÌc a'dÌ\\is trticaÌll lo(.L6et on lcft
!r;5(6 right poljtic.l larÌìÈs iìfcl So!!nrÌnents There is â Ìrr8e lj('[tue on l]re etle'l ol
p,ìÍrisrnnÌip on ma.oecoÌromic orL1.oÌne\''Lhc b id question i5 whethÜ ÌÈlt E!!c'n
;ìrrì1s aÌe rÌìoÌt lìL€l-ï lo Ìirudrce rcÌiltr elr lÌi.lrhÊÌ inlaLjon ànd cÌnÌrÌolnÌrnt tharÌ rigbt
tolcrnmerÌt5. The Leadins inlljdÌ .ont
iblÌtlr llas DoLrgÌas lliLrb5r Nho 'uguc'Ì \!ìthi' an
oll KclÌÌesirn sfrcl ive theL tÌris \!iì\ inde€d Lht.,rsc ÌÌr tlÌ' orlginrL Ì(c-!ncsia tÍiÌdi
teì
tìorÌ,thcÌe$,isnoruÌiqtreequllìbriÌrnri.theItbourÌnirketStâbl!'inlldticnìllrsbeliclcd
nr b. fon5i\terì1 witlì an-ì futc ot em ornlenl. although the high'Ì Ìhe r'1c 'l elnÌto)
nlent, the hi8h.r the rilc ol i.ílation. I. tlÌe folìcl lenguds!- oi LhÉ tiÌÌÌc' lhere üas x
kÍi.g Lrâde oÍl bet$r.n e ìtÌotrÌÌc.l xnd ifilaÌì(Ìrj Lhe 'ÌorÌ! í1' lhilLiPs 'une'Ìlrs
not\cÌtÌcaLLasintlÌilliÌl\'\orignÌrl.rttre\lìoÍ in ClìxÌ)ttÌ 3) H'n't Ìeít gorenÌILrnLs
u LNld be assoclated nlltÌr Ì)e!ìrnentÌl hiHher i.nation and errìplolment than
rishÌ iror
enìmc.ti. \4ok Ìe.ürt aÌrÌ)riaches'r hi!€ t)eg(úr lÌoÌìì lÌre Prenìis; Ììlt su'h a tradc oil
(arnot erìn ii.e. tlÌil lhe Long rln Philìil)s cürle i! lcrÌìcall \\c crrnÌinc rbt llibbs 5
nodcì drÌd thcn Aleslna\ ÌÌÌrre re.r.l xftQr.h
Hihbs'! ÌÌÌodcl íwìth a non_l trticaÌ PhiìliÌx curve)
hÌ o!, !LnÌrle tcÌrúÌ oI Hltrbs s mo.L!1.1h. Ìett piìrÌ\. il in gorennÌÌrnt marll7cs

()i t i2 2

Ìlhoe r i\ iJì{: úmÌ,h-!ÌìerÌt rnte !Ììd ; is intÌâ(ion \!' rcfoÌt tlÌi\ nrÔdcl nÌ tcrm\ ot
€nrÌrlo\ n\e.1 rather thin r\rtÌrtú beciiü:.' Lhii is.lo\er to thc rÌrnit oí thc !rllitrll dcbaÌe'
I hc Ìight panl. it ìÌì gorer nìr:.t, rÌÌarlnrLT€\

rnr.Ìt criti..ìh oicou6e

ttt _rr.

c the lrft go\eItrÌrrnr att..hct nÌoÌr nìf.rtan.r t. en+ìlo-tmLnt lreftn! tointÌ'ìt onr
rhal th! rjilht go\ er.nrent.
An irxrilcrc.ce.u,lt llith this tl pr .l mrÌiÌìen(ì ìs !pÍr(t\ \Lopnrs lo \ee tÌr!s,
..n\ìlrrlhcinclilirrc.ce(!n.rtutililrlciÉLL /]r :: 2 l'st'ì\ rtthrsameÌe\clo
 619

Figure 16.14 .ir:: fi tsinnì p I ôdÊ

útll lynnilcrer\cincmlr5te\ì(lunLlvbccountcÌbalenccdbl.intn.rei\eir.h\nratrver
lhr!nhì..olrr soloììtertr, -llt. Ior iìLlv. thc nopc.:a. Ìr( dcri!ed tr\ .ÌiU.rcnl itirÌg
lhc indilteÌe.c. rrLrle rr)teÌl\,,11I - r,J. Í dn=0 dr J. , i:.0.Norcthata
nìolcnlerÌt nr rh. s.ioth ersl iDÚ.as$ utilitÌ
ìn tlÌe ol.1 (c\,n.tirn model, rhr Lj| llips .un.r ir .or dcpcndcnt !n rhe expt.trd rar
ol irlfliti(!r, and both left r..Ì Ìjght gorcÍIÌrentr accept rlraÌ Llnkrstlìeiorm

: ,-t + it.

,i.ì,i;i,il
\i.cc lht shÌre ot rhc Ì,hìLlit\ cuì\ É ú (Ìr.slirnt rìì.t equit tu .1, the oÌrriorit posjintrr í,
-. ilih\i lh. Ìcft !oveÌnìr..1 is rlÌeÌe ure rlotc o anlrldleiÌSoreÌnnrenrlindiiÍcllncec!Nei5
cqrL.lto r !d. t1. rì --! - r : ;! : r/ i.,\nlliteÍilerr : rr .l Thists jttLìnrifud
rn ig. 1É' 1 1r dru\ rr ,N ) . --! = lj r. UsirÌB rlÌe l)hilliÌn !uÌre irt ran src rhnt uÌj\

50,i.HbbssÌìr el,lc ISolrrÌnìtnt\ÌÌiÌÌ(hoos.high.rcmtìornrcnri]ndhigher j.íli

tlr)r ÌatcitlÌirrÌrightg.\c ìüIdi:.
i\Íôd$n|rdúrco.o.ìicsn!lcÌÌserdcceftsâni.llilio. rrÌìpiornìexlrÌrde oftjtrrasc
seLlcÌr ha\e Ì,1 rrxl crp€.tation\.,\$umjng thiL go1ÜÌnr]rnls anrl theiÌ n.ÌuscÌs rtu
xnraÌc oi tlÌi\, r e nrould Ììo lolrler rrtect ÌelÌ{. n{ g.rc ìrÌÌcnts to be arÍ)cjarcd Í iLtl
morccÌ!.nijrDaÌra.dìrúhti.,Drr\|ollcie!LhiÌrrl!hrwlnt!o\ennrerÌr5Thtú1id.f.r
hol!.:1'('r s!il!ert\ that lrmr su.h eltect i\ \ isiblr. WÌìiÌl nrÌÃht e\pl.ìiri ìt? The othft nìil or
co.lÌihrltoÍ to uÌir lir..iÌLurÉ is,UesìÌr!.l\:e drrlÌ crttitn \listrÌa s hishl\ irgcnious ar$,
ment. nhi.h a\nrÌ.r rati.!rìl rÌpectrti{)ns b! \!igr í1rLr\ .rnn lLül tnonlc.Ìg.: oI rhi
nn elb!{úennÌe.1.
Alesinâ's modcÌ (rlith a Íertical PÌÌiÌlips cuÌ! e, Ìati(nÂì expccralions of wage
s':tteÌ\ and [1rÌÌ kÌÌowìedgc ot lhc nÌodel b) thc govenrnrcrl]
,\furmoígor.iÌÌrìeÌrtl.úLstro!.riods,1an.i2.thclctsi..l(.iiiÌr.LftheendoifL:ÌLodll
ll the ìelr rrln! partv 1ri.s 1nìaliÌÌÌires

frr !r.. ii )+t)tt2 -2 2

680

irÌ Lhc t\Lo È'r!r.1t In ollì't IIIÌi8ht\!nlglì1rÌrrl'ct itÌÌì!ri!ÌÌircs

LJL rrrÌ iì 2+')rr' ::2 2

rs ÌìÍ,irìbs,ÌÌ.Ì,fti5a!5üì,dioì)cÉLìÌ1'cr'r!ú'ìl:llìillliiliiiìiiilìiìillll'^;,,i"
I he rúì1it\ Iurr.tì.u\ h'rt iÌrt
sì!nÌrll a tilo le
li:ll.liìll ,:;;. ì,;;;.,;t Lr.t tr'"'" u u' ar'"'"..r rÌ\! eriÊ(1s r rr"e de't')rate ìs rsnrnred
" '

i:ilììi,; ,;';ì;l;ì;;rlill"roui rÌìr Ìrii

'iies.r'1'rd iiliïiìì"1;'illl"jil.ìlliiiïìiìlilì
hare ar {'ltr't on
nÌiglÌl cLo úr Ì)rrioLl 0

i,ì, .'.r u,.'..' f' tn \rLhf lr\j

.roÌth'!Ìrlt{r^ctr!ìenr
:l::.,i;";;.;ì .;ai;,'",ììt'errorÌ\rrìt'ì."'.''lienì!'Ìì"\ì
'iü a'id rhe risht 3(\c ìunenr ü'r r'ntr
trp Í*rì
ì'ï:;,Ï;,ì;''ì;; - - Ìr b'th te*rcìs'
.iLi,r'n',"*ut.unU"t)5(ür'Loi1\trììfriÌrt!rÌÌ'Ìrlt{'\trÌ1nìeÌrttLLiillr\ILtrÌ'ri!n'

Li i;i .i l..l lll 2 /ri lr':

"!j

Lltl,Lrftr ri,t! t\ ì Ìlìt trri \c Lr tr ì I

/r .l =o=.j ="i

etrd (ljiier.Ìúirljns b\ ril inrPh$

-: ''

.:':,:
rLroL..LL.L , ll i ttrLr t\ 'l 'ertL LÌr (

''.''',
diit';'nc' b'Ìr\cerì rÌn' cLr'!tÌiuÌL\ iÌr ilÌr r\!Ô
p iods 'oü
,,,,r.*",,ìï \ltiiÌrr rìodtlr $rgc scttcrs Lhi! i5
rtrditil Ìhi\ i\ Ìil''rr drr\es tlrc
:;".':,-";,i ,, ',"tt'"rl
::::i','',.ì';."i,';;,,ì;ì,r',, rÌr'r,rt'no'rrherrLtr!\'ho'i;'!.r 'rrr'hfiÍt\\riÌr(uìtÌÌc
ìhr! !r., oi
oÌr'dtf,nrLi 'rrrcn tLrer cÌro.r:j htri '!ur!'
"ìiïll,i::ì:',;,,;".;;:ì"(mÌrr
 Figure 16,15 r r. !.; ri :..dÈ !! 1. r

Figure 16.16 rÊi,errr r.:al-; r:r:..!:Íi

kno,! ÌllÌich Ì).rÌ\ hr\ rrof rrlìcn Lh.!.lÌ!!ìse ;1. Ìhus ìÌì ferj.\l f, 5irÌt rate retter
r. l. .. I / I i ' .t. ' t. ...
tlìc e.o oD) iriÌl br al ? I n Lh I
ln f .1!.r.rÌÌl Âr sitlÌ Â iÌì Ììotr.r.
'11Ìe (ÌiticaL .ÌoÈrLi.. ls (hL rc oll rLlri1 ìs the !.rlue oi ri ? l.t !\.ìsnrrììe thrt ÌvdSe iettes
bclir\ e thrre 1\ | Ìrrúibilll!iÌ LhiìL ? r!lll(irÌ. Ìhen agrs.ttcr!sri:

| .i Ì t)ì if =lr t, I tI r') it\

snÌ.err:rr.rr -.-L p L i1 fl tr > rr,.ì:is. 1ó.16,\eittÌri\out. 1s.enbc

seer, therÉ js r ún qL r rq!iLibriLrnì eÌÌrplovnent Ìate ... hr the scc(Dd teÌjt{Ì ol.Í r..,
both a leii gol rm Dr( Jrt rnl â rillÌt So\ ennÌr.t n'ill choo\e rr : ... thce Í rgc scrtcÌs
ÌlillcortctÌì,Í:lr,rqu.rltob;i]ndtrre+)ecÌi\eÌ).ThÉtuocfu)se fotitio.ri.fig lô Ìaì
rret,n!Iand/ì. o.Â: l\.Lbo\e. the I ì.ditlrÌence.u\e5 arÈ co.hÌruotrs rnd Ìhc /ì
trìd ilirÌence .u rcs diìnÌ.1.
''
lnoÌÌn. tÌrjr Dcâns thitthe Ì,hiLljp\ (u r i\ r\ tr(N. Ìn f ig. Iô.l6 rf{Ì iL orffcstinìnL$
irúLtiiD ii l? lrif!iÌod !Ìxlerenilntìte-r it ii I h i.\. Ai cân bt \ec. in th. fgu(, i gi n5
b\ thi\pnrcedtrÌc,ilnÌoreitemplrr.iÌ) tuxhLgh!Ì LúilLlr,indiil.Ì.n.r:.u.!.intl, n'ith
: rli eÌÌÌpluvrìenr ri f, lÌ Lo\e\. nÌoriÌril tempoÌrriÌr to r lo\LcÌ ur!Ìlrrlndllrrco|.t.ur\c
i.rt,\Ì )riih cÌntlo\rÌìrnt / rr.
4.2.1 Summing uP
Ì. the Ilibbs's nrolel, lbe assumltion tlÌal lhtie is a lcrnranent tradc off betìrrcn unenì
pÌo-vmeÌìt and lntLrtjon Ììes bchLnd the prcdiction ol the modcl that Ìett ilovcnrÌnent\
.hoote higÌrcr enrplovnrerÌt n.d inÍÌation ralei thn. d. úght got$nmenis
L. the nìodcì, whi.h user the noit statrdard a$uniPtion thatther€ is no la\tiÌìg
úndc olìbehlcen nìflatií)n.ìnd utenÌto,vmtnt, thc rcsult i\ tlÌat Nc sh oukl tor â*ocia te
^lcsi.â
pcrnranentl-v higher üntÌoylÌrcnt s'ith lcll goverjÌmcnts or pexìancndy Ìor'Ü tnÌto!
|ti'. . r' l o '-
librìoÌn eÌ4tolme t rite, $'lÌlch botlÌ colouó ol govenrìneÌìt havc to respecl lnsteüd
dclierìons Íiom equilibÌìunÌ lçilìbe tdtpr,?,'l, ai tJìL: ltaìt olpeÍiods oiolìce iì'd due to
thc l n aÌri Ìitv o l wage sl: tter to f rcdlct iÌÌflal i. n exacl ì) becau\.' irl f a li{)n exLìecl atn!L a r(
set bcn)re tlÌc outconc ol thc cìccüÌì is knoi{Ì. lheÌe i\ â tenrpoÌaÌv elfe'1 by ]llÌich
enrpìovnÌel]1 is boostcd ìtÌ thc lìÉt perlod after n. clecinÌì ot i ìett So\er'ment 'ÌÌd
redúccd nÌ th. l! rst period altÜ an eìectiod oi a righl golernÌÌÌenl'

4.3 Voting:the Meltzer-Richard model and the choice oÍ tax rates

Thu\ far Nc ha\e scen hol! roiing nìiì! atlect macÌ.recorìomic orìtconìcs:
. belcÍc a. eÌ€clio. ìn thc opportu n is tlc 1ÌÌcu dnreÌÌt nì odcl and
' alteÌtheclc.tnnÌif lhepirLlsansovernnreutmodeì
djtleknt and Ììore lLrndanle tal role of votilÌg  'lenÌlr'raq
!Ì-e tro$' ltrÌn to a quite
can be thought ol as a ìedislriÌrntldÌ Ínlggle beli'een !oters. lÍr n{joiit! ol
roters Ì'r â
l, , r\' l' r 'r"
Lhe üch nìinoritv to the kss well oiì nì'Ìioit)'? lhis ìs thÈ bisic i'Ìea belÌìrìd
I iinÌlus
mo.leÌ ol how taries nriSht bc set nÌ a dcmocra.-\" A \iìÌ4JLe scl'ut i\ wherc lheÌe is a
(nìf(ÌnÌ raLc.li conrc tlr,I,lhe prc.erds of$lÌich aÌe u5ed to givc cver\ \ otcr a uat ratc
beneht,l. lhu5 iì!, i5 the gn\s inconÌe oi the ithvoleÌ and ili I N

' ('È',,),'^'
.rÌd diï!)\alrlc jircojÌìe ()Ì c.nÌsunìptn)n) ior th' !'t' r ìs
'rh
I j= l,rlÌ tl+lr
Lvmcnll-\'l{r!irìc.mevotc6iriÌlwrntahìghtaara(csjnccthe)wiÌlpa}littletlìemselve\
jtcome volcrs iliÌÌ
drÌd gcl nroÌe b.Ì.k in tlÌe Íôrm ol Ú. for c{actlI opposjtt ÌeriÌìs higÌr

4.11 Downs's median voter resuÌt

'1o go tuÌtherÍ'c need nr specilt hor'cìectìons.rc oÌ3anize.l .\larnousÌenìltÌ!rcÌalesto

a commorÌ loÍm oíeÌe.llt)n, the pluriliLl or iìÍ paÍ the post svÍcm. Thìt ìs tlÌc
nonnaÌ
 63?

nìethod olorga.iziìrg eìectio.r ìn botÌÌ tlÌe Ì- Ii aÌrclthe Lis,\: 1Ììc câ.djdarc i\'ith the nr(^t
\otes $jrÌ\SucÌr a \\steÌn Ìs ÍÌletirìes (rlled a Ìnajorltarìan s_ÍsLcnr. \\:c 5haìÌ ÌtstÌÌ.t
orìrseLves to t\Ìo cdndidate5 or pàúie\.-.{ d l].irhoseonÌ}goiÌllsiçi.njrALherkclion.
ll(hpiúvlÌasaplattuÌm,ilhi.iriÌrourcr\econsi\tsnìlello a protosl tix rilc.r oÌ tu.
\\e lssrì ìe urat tÌre paìtv tÌrat Sets tlÌe xrst \ote\ ancl is thrrcioft: clc.1d js.ommjrtr.Ì
to imtteDentirg it\ ÌrÌotose.ìtax rate an.1 dìrtributirrg th. pro.crds cqrtiìll across aÌÌ tht
\ t.l\oÌ\r -m lrrÌ Lcrn tn n.
Iir\t, 1!e ldrÌi at loteÌ lÌeftrences ox tares. \{e crÌr or.l.r thc !otcÌs accurding l.r Lìrejr
Ì)ìetdirÌconreÌe\ÊÌ5,fhnrì(^Ìnrhigh,drÌdletu\|rit.thcordÜrslL.t.r...1\wheìe
lÌi5theÌdlestdndr\LìrehighestpretaxnÌconìe.\\'eshallalsoasumclÌrarthÊÌeis(!re
\oter, \Ìhom rle callthe,r.di.r, \oter. )',,. nì(h tÌÌrt th(c arc es Ìnanrtotels i{ith k\rer
iÌrconre\ thaÌì 1,, r\ theÌe rÌe \oteb \!ith lÌjgher iÌì.omcs thrn t,,r.l\re Ìnalie a cÌiticrl
astlrmpti(D íblÌtonetlral i\ hâ l),iìlplau\iLJLeIttrlttlÌchiSh$thcjDcoDeolr\oter.tire
ÌoNer 1ìre ta\ rete tìre roteÌ nÌeaÌÌ\ $!Dts. 50 (sar )uÌe rìcdlan !ol$ rLalrts a tax rate (ú 1i,,,
roteì/wantsetaxÌateolli.aÌrcìlr >l:a ..aI,r Ìal,r''t,, .: ìi\ L l\.
IÌrlns'sralhoÌcnrarkablcthe(reDì\!\!that,atnlÌìingbothltarÌjtsxÌe!neÌ)ìtúer
ies
c!tdinmaxlmiTifgthclr.hrn.esol$nnÌirÌgtÌreeLe.tilrn,!iç.câ.or.ÌeÌthefreieren(es
ol\ol$s in thjs one {ÌlmcnsLonal nrartrÌer. aDd il (onc ll.âl assumttion) a \ote! aLNats
v.rcs IoÌ thc ÌIÌt) wilh lhctkÌxAedtaxr!tecl(treÍ1.i lhattol!Ì s fr€ierrtd tà\ irte so
.rlltd sjrceÌc i otjrg th c I both tàÌties r ilt pro|ose t h c Lâx Ìrte preleried b:" tlÌe nìediin
, ,J... , ìÌ,. .,:. .t....., .. 1

\\ht?ThcenÍ\'o is rÚ_l simde:ìf.1prcpose\ dtaÌralc ibote í,,, r crn \rin b! Foposinil

n lnÍ raLc ot I,i. | (ilÌ gcL all rhe \ otes ilith hÌ.o iesabolc thaÌ otthe nÌecliaÌì \cÍ|.riÌnd
llìc nrcdinn l.lrrs roL!. ris s,eÌ1. s hiÌe I orll Sets tlÌc rolcs oi tÌre \oters $Íh ln.onrcs
Lrclctrr thal oi thc rncdian \ oLL:Ì.IÌe..e r llira Thecon!.cÁ.hoÌdt ilSproposes a tix rntc

]n In.t, r,f cn. Llrlnk ol Lhls rotilg same rs a \iÌìúÌlane(trA nro\e g.rrìrr bcl\!c.n lhe
tl\,o partir5, so lhel Lh. cqLriìibÌnim nìun be ü \.5h cqtrilil)rllu!. rÌ rrÌ. rr 1,,,1 is a

N,r5Ìì c!uiÌ brì('nì: li lhc olhcr paìt! proposes í, it docsn t ta) )ou to ploposc antlìrjDg
diilcl(r1.ln llrc ncxl súbsr.rjoìr, \ve erpLaiÌr tlÌe cüì.ctt oi a N!nÌ eq!il brjrLtr this.a.
b. slilppcd try thosc iÌrìiÌlaÌ Lth the (on.ept.

41.2 The Nash êquilibrium

Lììtil noN ihc Ílan]cs s('har.: bctn conliderils h.vc ell rnvol\ed pklers m.irln:l ln
s!'qucn.c, $ thal o.l! on( tìiveÌ mo\e\ at I tiÌÌÌe. !hcsc gaÌne5 carÌ LJe reprcscnlcd
diigramnìatlcnllt i. gaÌrc 1(:c lorm ai we ha\e chÌìc. lhis ira-Ì ot Ìepre\erÌtitÌg thrnl
is .alÌcd cllcnsivr oín 5()mc gaNer hoìleler whi.b I'c lrjìÌ coÌne dcro\s iÌì ihc ..rt
Írl on assumc 1lìaLflalcr mole tnÌultarÌeoxn\ !olhâLanlonetÌr!eidoesnotknol!
ìal nìoÍcs thc .lh.r plirrn hare made untiÌ atter \Ììi'ha\ nr.\ ed. hÌ tdct, the pli-!(rs
do no{ lilcralh nccd Lo moic ! Lm uÌtrneousL} r aLÌ th.i l! nc.c*at ì\ that uÌet do not
Nrìor! nh.L rÌloçcs lhc olhcr pl!) rB aìe maknrg. A connnon Icarúre oftheie SrnÌe\ i\ tlÌal
plalrrs b.v. iust ofc mo!c. hc_\ arc oJte. Ìetèüed t.ì .s onc-:hot game\. ot course. $e
.af haic giìmcs in Í1ìi.h Ìììaltr mole \imultaneou\lr prr ìod eltolt$iod, but we clo rÌot
.onsi(lü lhcm h.r.

I
 684

ì",ì;"ii;;;,ì,,",,'ì.";Ì)rt'ar.c\'Ir'I" i'!f'1i' /'] he!rÌ1riÌ)oiibÌt!.hr.oj r4 I lÌrrt

'l
!r r'1 fr jnhrìiÌe il ftom thr iÌrltr nl
rÌrer bc 1ì.itc t g. ìIotrÌ rhc set rr
c 'il
'i \' \$o'ì'Llc!ì irith eiÌ'ÌÌ f(tr\ibÌr tlir rìd's iÌ e thÊ
lii i i ;; ,ì= ,,;. rì - 'r
"rr(ì

t'ì^ï:ïì',,;:;';,;ì;i i.Ln'ìrJÌiri\'.{i\e'trìairrrÊ!"ìitscit'gelheIt(ì'grec 'rÌriÍ

noltomrkt.biÌr.ìif!rsrt':ÌÌì'ntoÌlrrhrltLrc!sÌro'ncLboÌjì!ìolAnt"ssrrcoÌrcljìLoLril
ì)otlÌ 1arìLtlJrrfrrtìorìiÌL i\ thiL{ tÌìc Ìriri
dLrìì'ì.nì'uldÌrra\õìÌ'qullibriurÌr'Lhi5
ol mo'r. si\ rÌrLüÌd ruluL': th' hl{hesl Ìrxr o,'
r' \
ï,;,;i';;:,,;;;;"i ' ' .,'o,c. 'iì-
r;,-.*,,-.t.^.,i .iì!ìd\iLr'1trsr' hì: 'rn br \nìÌrÌ\ tu1a\
",ï.1,,

l,' l

- Ihe llÌn ltrr. !ii!\ gircn rr hx\ tldrd 1' \hr rr 'li ìc' Ì lroÌn
d LIr 'r' i) ìust br

' ., tl

l. -r
,,;l,lì'ì"ï;"ì;,;;:;:' Ìlris(trìrdbLì..,neb\ $ÌÌìLrÌ\:g'in!throltshr'rÌrrÌì!sritììc
ii! ìrirÌiìr1!n ì' n \iÌsrÌ
.;il
..;ì,",,ì;;: ì'.;",,,"' "nd 'Ìr'!cri'3 'o lfirL n!1 ì)e nie rh.,1r,..r!sÉ
frn1'rir'ìr '!ÌurrìLrrr!nlr)l
.:,;ì".;,",;r, ""..,uncr in rlrc t.ÌÌolrìÌrg sr.Ìi.n\ r' !ì Ìire
i;,1ì;,. ,;l;: ;;,;iJ\r \irÌ rÌrbr r'j1t'!''\rr\ in Ìrìc Ìi'r Linc n)r r1.ntr' {) ndittrÍ
t' oi s1r\ ÌÌÌr''t r\pr
nÌ11 i0 I in trr ot eür
,1,". ,]ì 'iÌ\e 'bon
,.",i,ìì,ì"i ",".ì',,,.
"'
"liïJ;i;ï,',,;:;'';';li ('tr siÌnüÌta'itou\r\ iìÌrd rrÍ]cÌr'!ìcr('tr\
,octrr' rrra rrtç
,,,,ì"';,'"ì;ì ;i",,; ouìt!t n ând r' r'p'ctj\ '
t üìrerr J fr\rì'Ìerr i5i(r rr.n1
Ìrìcir irr; iti t'! r{ e r(! s pì Lilr trrat rì1eiÌ
;ll'iiì; iï ì;" ,,"" ,,;i,'to 1 iÌntr I rÍ' d'L'drr'\n.frtnrc;;=rr I rÌÌe'({ìrnÒnprr(i
I,]ì, ",.'".'"i,l.t,"tt\rL':=1r í/ : t r urrcre À r\ iì ronnn't ud
i:lìì,::,il;.: ()il'ìi " "'l"u'''"'"'"u
\Lhi'lì i\ 4 = i - l
"'""
tlrc tôLal!ltrrnÌitl 'LìLful

l d r rüì t\'rrt f\'LLrril ìt ,, .r. _.ri\r.rli rÌ.I '''n'iil

ì . Ì ! iro ì.n f Lr' Lerllr rrrr:
 685

rlÌ.pro(edutnrrhndiÌìiti,r'.1ì,the\rdrÊ.ÌuiliÌrriLìnÌ.ìiÌìoNs|Ìtle.ì:n5t,nÌìd.í.r
.nt 1,.11ÌeLe\el.iíthatrÌa\iniret l'\ÌreÌ oll:
)-,]l Ltl )

-Ì 2d l=ll
tlJ

\\hcLÌr(d!tire$Ìenrt,Ìregetl.= I r I Si!(ed-ii l. 2\lìor1thctrìnÌ

ìiuimiriÌrB r rlLÌe ()t d n)r xÌìy \ alue ot 1, ind 1, = l I nu\ \ the pr)1it ÌnaÌnrirnrg
\ iLl!. ot l,lt)r dÌ\ raLue ot,r, I r \iÌ!ÌrÌr !)Llt the\e tll,) eq!itidr\, sh(h n!Ì)Lie\

t l):

ìhrLsi ìihr (ìÌrnr)t NdnÌluopoLr ÌÌúlel. the\,ríì cqr jÌ b,l(nì lin l. i.

.1 l.l The Ít4eltzer-Richard Íesult
L.5lrg thr D.$n\ ÌÌro(Lel .uÍ1 Íill i]ssumiÌrs tlÌ.r1 t r( go\. Ú nrcf L ( lÌ í'1 r .().!ti.l tÌo
l)orl onilli\r,ìfu1.\leLL!r lj.ì,ìÍ1Ìrrr!!rthilLÌr.1)Ì.ir'Ì....st)IlhrrnrLÌia.loteÌhLll
Lìr d.. \jrr. \\:llnt ti\ rrr. 1,, I lÌ thL nÌrliiìn \oL.r Ì-rrcl!,Ìl IÌ rt xstume lhal thc gÌ(Ás
irì.!nìioi\oteri\!Ìüì:eittdLì\thrtaÌr.rtr- if.lh{Ìr:xÌ.no(Ìirin.enttrccllÉcB thr.
ih!'r. j:J rirlhtr nì4)riiirÌ! risLrlt tlÌc nÌcdirìn !or.. r ill rrhrÌ rrnt r ta\ Ìrte otone (t
zrr.. l\ r dÌor thlr re{Lt ìrn r\ lt ..firr(5 r,rthlr dÌimalLcrlÌ) the Ìra\ic inrislrL ot the
m.&1. lut ( e llhÌi ihdÌ r]e!d io lìrirì! irÌ li\irì.{'nt l. rlicLt\.1higher tarei trì Ì)rocL!.r
nì.)rr (ìlini. rÈ!üt\.
!\rnrerlrìÈÌttoiìÌL(]th(tìÌr,rll.r,i,i1ìntlì.Ìrr{Ìlxn\otcÌ.,r.fretrr\,ìÌrjlL.lÌoosr
i r i! trLìÌi|rirr r, . rher( ihc úrdiirr \.1( 5i...mej.equrl to heÌ Ì)on t.'\ irÌ..|rt
i),,rlÌ I rl L,l!s tlÌe t.L\ ririf tirìis lh!'rl rr.rgc ln..nrt ot tÌre rest ot the t ote^, siÌl.r tlìls
\rill Lrc hrr nriuc .i tÌÌ r rrdislrib ir cd in.,:trn!. l]=tlIt,
t \l
(, rrL I +1,-ì', i i r i-\-r,rl=1.,Ì tr+lì=ì, I i'r.
lh!\ìr\illurfurr\ÌÌillÌrtir\r,ìtl,ìsp1]!\lb['iir''r,,rn.l15Ìdr'!\Ì)(tr\iÌ)Leìtr'ì
lhj\ i\ br.iru\e,r l!\r. I r,r, \il liÌiliül iìÌld Sij.: I r rÌa the tÌât Ìrfu Ì)erÌeÊt 50 ìi
Lìrrdi.ìn irÌiiÌn. \ L)rl(n\ ,ì\rr,ìsr r.,ÌÌìr, ìr,i llrrafi t, : I eÌìd it nrellian iÌroÌrre !
,ìborr i,\.i,!! iÌr(Ìne,! \, iLlr,r.l i . !.!i..iilÌ!ta..ìâÌdLÌi\tÌìÌrutiLìnt()tirÌrr!rrrfe
rr!k.trrdnÌ.rete.plehi\r..o.r.\boLürlhcrlcragcthanrìr.\eit: ÌÌeDCe, r '.1
i.drrprrlcrsi. 1:
i l. Ild1r(r ,(i.r,rrri ì.ìr// Ìr!/ll ílijrllfì'1n..Íi,ri Thl\ restrÌt i\ !)mcshat jÌÌÌÌ)ll!\it]lr
b!.iL!\eiiiilnoÌr\thrìÌ(enti\(riir.i:oihishrrti\ition iitrx$rÌet(!)hjgh.peotÌeÍìll
not \tll.ì\ lÌir.d dÌ!it.rle rÌÌok irisuI. iiúteirl. H1rÌ! nr.{Ìd lhi\ hÊ molltÌÌcd'1\'e r$uÌ!i
tlÌai loirr\ orli Ìe$ ii uÌe t.r\ t(i\lrillÌ \Ìrr.ill.llÌl rfr a\srtnrt lÌrtilh\oteÌ hì\rr
I r.l:l::e.r,LLnn iriL i,sl
686

F r'l ' " i "'\'o_ ' \" 'l I

hrll\r'-J 'rr\r\"
ï; 1: ,;:"
U=1t'4t r)+b õcilz

is the trniforn !a\ rate an'l l' the unifonÌl

s1ìck er ìsthe ftrÌnber of ÌÌours tha! iworks' t
s1eÌds roÍ
*.:;ì .u;ì:ì;;,,'n* or consümptìon is .'''.'rr tr - r) dìd ^cii2
'.corìc
iì"..',,,iì"ì',i",t,'"'Iandn,hoi!Ìnan'vhours"ìiliwork?ima{lnizcstheu1iìit-v
iluÌ.tion wilh resPe.lto ', and this implicsthar

i, : itÌ I t)rd = ì'i1 r)iô

is thc
is the hourly ttagc' and thc loweÌ
s1ììch ìÌnDlles lhat i $'orks hader th€ highcr choice or I
iÌÌ the Ììedian
;ï';:i:'"il,*;'":;;ì"',.- :
u""
"i""'""d
ì.11 rl/a so
'oters
ì's prcrerrc'r tnx rale is r.und b-\'
ìïì'.ìnì"'ì..,,", *-*s hoürs
',
sLJsLìturing i()r lhis o iaal !altre ol!'' intheu!iLityirn'tìon

u,,,:),,,(),il iliro)lÌ rl-l Ô(r'il il/il'zi2- (À;(1 il'/z') -l]

r,:r (lr,'"')i'r =r (:(ü"!) ,') =i Ír t)'rr"'

a'tthl,.ìe|nedas'ìi/N,SoìlislheaverageÌeveìolsquarc.]pro.ìuctlvit-v'.lheabo\'c
eqnation.an bc erpresse'l morc simpÌ) as:

r.r,': ('ri'1t il'12") lr'(r rll'rn

Nc no(. nìiÌÌiÌnize Ú.I'ith respcctto t

;i ,r
lru
.,\;, 1l
ìr1l
ih!. ,, i\i or'e s . r, r'" Jr r'1 ü IJn d ''"'." ' -' '1"1,
.."-f ! I 'fìror_t ' \\' rdl
'"": ',. r"o'rc Pi
.t..'' .""
i! the sanÌe as that oi thc avcÌagc votcr' we $'ould
nd cxPect thc nÌedluÌ votcr x'otrÌd
ítr = 0 ts] if rrrr = 0'
-t *t"t' ,,.", .",, ìIrdeed he sccÌÌ to bc tlÌc case' 'ontrast'
""r., possibre larti' Òr t, (since a\ n" decri cs)
;;': ì;;. ;J,' i." ''"\iiìu'n r"' üÌcreascs

4.3.4 Summing uP
OÌÌce *'c allow for the dislÌÌccntivc ellccts
ol taxaiion the lvlcltzer Richârd ÌeÍnt is far
etfecrs adoltcd hcre' th€
ì":;;'r;. t" ttÌe partnuleÌ specification or 'lisÌncelìtile
 647

nraÌinrlrn t.À rate thc nr.diin roltr rlouLd rhoo\e to imlue i5 0 5. hut lhâl is odh in
lhc.âs!' . \11Ìj.ìr the m.diâ. \oL.r hn: ln e\(ettn[allv l(tr\' le\eÌ ot eiúifg.apa.itÌ
BUL thc gcnrral jrnÌrlicari.n ls i. nLcrrsrin8orÌerthen()reneredthcin.omr.distribu
tjof lorfnrd5 tlÌe nÌr cnd, rhc lorrcr rlill Lre the ri/dlir.r eeÌnÌng catâ.iLì' ol tlÌc medirn
\otcr (i.c. rrhtjre to thc iv{:riscl and tlÌerelore tììe rijro the.lÊnÚ.ral .iìlv.hoieD

5 Games between interdependent economies

,\sthetìÌìrÌ5e.tior flhl:.1Ìâptrr,sÈtLìnìn)SeÌìc\bctreengtrcÌ.rr.:.rs . tlÌcmonrl
oi ir]te etendrnl ..onôrÌÌies irÌ ( hrpteÌ 12, 1re rhoÌLed horr rrÌarcgi. ro.sid.r.tion\
.nn eDter nrlt) lh. nnÌ |ì.rcroc!ononÌí polìq Ls ma.ìe. Thi\ srÌrrcgic i.Lfta.ljorì js set
out nrtre tìÌl\ as e giìnÌc jrÌ this cllrpter TheÌú are trlo lro\eìnmrrL!, FoÌìr 1Hl ind
Ìoreiir. lì \\i: nriÌl â:srure tlìnt ìrotlÌ saÌìt ÌncÌrâscs i. ouqÌú 1,r oÌ L: r$pc.lì\cl1ll
t)ut nelther rÌrnL Lo ltcrerse UÌ(ir o\!Ìl ilo\ernrìent eafenditúÌe (; or (;') tÒ n.hii!!.
ìÌìcre!\e.l ouLtrt i i.. th.rt !uLli ÌÌobrn thejÌ Ìrublic \ector .ìeh.Ìt. A sjmlt. LLliì 1!
hrÌìction th.ú e\Ìrr$scs tlÌi\ is

Lir = l"!t nc

li l,qr' ' l;
or H .nd IretÌ)ectireìr.
tlort does tÌÌe ìÌìtcÌdcltcrì(Ìorce t)f thr rii) ccofoÌìic! .oÌìc n? À\ r\. sar! in {lhrp
1!'r 12,il \iÌnplihe\ tìre nr eÌs oI irlerLÌeltenLlcn.c ii rre óstrme Lhal m.nctirl toli._l
is e..otrnldtìtnrB n) drar 1re do rot net.Ì to .ÒnsidcÌ lht jirtcÌÊ\t Ìatr. Th. iggrcgat!
d!nìind eq!dtjors lillÌng (; ând l;' i!ith ),rfdl ' arc Lhcn qjr.. br

heÌr0--r<l.TÌìís

l:l ,,(r l .:(r - í'+.í'

.' =L r(' .rir

J(' 11r(r
 \\ '' \ 't'o',.n
"" ":'l "l:' ' ';i
"'l '' ; il '"
'iJ,\,\.',r' Ìl_" ;:.,. - .,,..,.,.; .".,..1'.
",'..
I hb LdnrLr.'thJ H drrLl I rrclla\
irÌA r c'inìe

:r" ' '.'

",.. rÌegoÍiatc â ÌriÌrdnr8 agrcenì eÌìt bctr'cen
íl I xl €!ì1cÌ or not thc two cotrÌÌ1lìr's 'an
rheÌnselves or noti and c'rn ioÌrorv
chooie anllhen
G rr
,r, -'" .rtcr orthe moves citherlÌ can
" ';;;,ì;t;,,.
:ir*:i::ÌlÌ;:i:,,":lll,ïl::;:ï:ïì1i'::Ì'ì'{j'1IH
aÌrdI m.,ve

possible: H moves first

5.1 No binding agreement
|

''' :..i1- i ";;lir;1";""

I'i,-,'r' "ôirr' '.";li''l;l'; "'l
l,ì j.",'
i rr" '''l^ '' ""u-'\'

; n'
.. 1,", ',': :.:,
, ' :r l:,.1;..11
ì'n '' , ,,,,,,"i ."-""' e"u'.\'
ak rl l' \r'
.; .'
':l ' l,' ''"
" .:
"':'lC' it ,l;,' ;i":,,1"1' ::
lc
"ìl
ÊcoronÌic!. weknowthatf '
r.u1r oI(;'tbrt nÌaxiinizes
.)1 o ('
\!e sìnìpÌ-Ì ind tÌìc vâluc
.G_. To 1ìncìlhc bcst resporlsc
ur $'itÌì rest€ctto G_' holdìng c colìnant

llt4 illoP'l lc + d0 d 0
i)G i)C'
I
- 3Ç tJ(i =.
- C_ = 1/. .(t
Ii3 16 l7 'Ìhis stroüa that O'' ntd'tt"t"nt" tt'us5 lUtt and Ur:)
'Ìhis resuÌt i5 sìloirn in

m:ì: :Ï*";*;t ll,.l**:

-*::::# rïïH[rï!ïï
" 1,.'. " -" ,l;
.. 'i, ,,",:,,.,. .,
.r...," to .to te* tt' Lt"ott lr lÌrough G'-
levels ofc
'_'Ìr'levercholcellnlakesofc'ardtbatÈÌcan
aìir.ÌÌ thal tlri\ iÌl be li's rcsporLsc 1o
sr

,';i;,ì,,,:;;;"';''"orcs;olldHcirr)ot?rrknoï::ïi:::l':'Ìì:"1ï:i:1,ïì:
ï.':"iï":ïi;: iliìiÏ';: C'Ë,ï:Ïì."',,,
i\ Ìretler tor
yrïjliï:.:t;m;;::::n::
n\ G' riscs sjncc a lÌighd
 689

ì
(;1

Fiqure 16.17 l.r-" in: best .

4,,

I'rr

Lt ai,

Figurê 16,18 " .''r..le be !r .à!l!r

tlìiÌt |oiÌrt on
r!.ïÌxúc hìn.lLon. o nLa.imìze jls utilil!. hoÌìe tr'iÌl tlÌcr{:l(ne 'hoosc
Jlonì' doc! dÌ1s
i s tresr rrspoore tunctirrì that 8c15 Lt to lls higììe\i lndilttrc'ce 'un'jndiiiÜcn(e
b! .ÌÌoosiìÌg (; . $ìrlch tlÌ.n iax.rn.lees H a u1iÌit) lcleÌ oi Lii i the 'uÌre
."""rp.",ú,g t,, Urr j"tÌ louches L s l)esl reÌr'n\e lrLnctiüì Beíore going thÌo!gh
tÌÌe
iÌr rhi'h Ìr!1h F ll nro\ e
algebra oi thi Sta.liclberE lca.ìer .asc. \Ì. l'ol
ir rlr'
'are 'n'1

5.2 No binding agreement possible: H and F move sìmultaneously

'lhìs (ds. .an bc anrÌl sc.l as. \rdÌ cqtrilibriuÌÌÌ lfìroth Jl atÌd I ÌÌro1e slmaLtiìntouí!'
arì(Ì ilthcv erch Ì.nor' lhrt thcl ue rnol iÌrg !úììullaneor6l),
ihcl ta'h urd Ìe'rssuün'c
brtürcrns Lht) fcedtochoosc
tbrttlÌcl;n!ì!L:i\oLìliÌnalgì\orthenro\ebltltr'othei
thc nrvcs coÍcstorÌ{ììng t! Nhere llì.ir bcsl Ìesponse i(t'ctions (roÍ lhi\ i! sÌrouÌr in
tlg.16.I9.
ìnfiil l6.19.H\beslÌÈsÌ)ol]set!ÌÌ.lionisLhelo nÌv'rdssÌoPintsline'''=1r' t0 '
lalue oi
tl is constructctt lu iLr:L the siìÌne w.J e\ !'s ì)eÍ reÌronsc txnrlion ì:or câch
po$ìblc
L , Ìhe btst rcsPnsr br ìrom. jt tlÌe G tÌìiL cntblcs IÌ ìo get o'L{) tht hiilhÉn
üith
!r(liltercncecü!;e.ihu!er(bHindìfl(tun.c'u ' 5Lt\ on H s b€sl respÔn\r lLtnction
690

FiguÌ€16.19 N..t..r I Lmttr sÌrlrìÊ' ji'res

'Lhe\iìsheq(!iÌìbÍlLrmú\\hoethrtilobcslÌerpo'\etrtrì'Llon\'LLl A\'inbesr!'n ìtI

(;
rús {,-_ (;ir lìre b.st Ìe\plnse Ì)! lr ii (i'. And !i'r'r ersi irir I: il H !et\ = C" Ìhr
L,cst re$on\e bl f ì: ai\,
Lct rs nor conLparc the :ledr eqLtllil)Iium witlÌ th€ Sta'kclber! c(ÌuiÌìbriuÌn
rììen H
.l t o!lfut i\ lìigheÌ iÌr Lhe St"ÌeÌLrrrg !rn'
nrore\Urt ts\re.iÌnsee.ihcÌel.1 honre
thrt Fl hr5
i(;!, . (;\!l iÌnd lrcn.t, lÌonre \ ulllit) ii hjglìÈr ln thdt 'a\c lbis 5hotr's
irst nÌoreÌ iì(lvantiÌ.l]r. B) .ho(trirg a l.jttr 1lluc ot H frlcrs L t' s'ÌcLt i hisher
'' nÌn lÌ a lìlglrtl
r:lLrÊ.l (; . thus nr soÌne erLL:nt trcc ú.Ling o. f ll 'an be thnl rttnLn\
tho\! thi\ i\
iJr(Ìiller.n!e.ui!e a5 i renrl( oitÌÌi\ lLri nÌorer adra'tage {)
'Llgcbr!i''ììÌl

5.3 Binding agreements

lo$ilìlt tor r.1, s cs lo do bcttell Jn Ii! lô 'l) th' rÌer iÌnli'aÌed i' 15 iiìtlieJ iÌ
/Ì! is tlìc set o
I\ i(
]]olÌ;\ rlith utilit\ hillÌcÌ lh!Ìr {ir': ìor H rnl lrl l(r l lhu!
er'h foirú

'l.drLn.ir?\i'rrqLìiÌrr:ÌrLI!ì(lirelirr\r';r;_rìdtÌlútrú+ÌLoLlrlniÍrì'ì!?lúÌrinxtr'
t. !t;furdt; Ìi .(, 5f,!tr?Í[r1]n.n.!!ì\ìr!\rdìr'Ì!.Oiìrit rr l)! th'
.intra
rrÉ!r(liill)r,rì i1...,Ìr'rrrÈJrqr\'rrl' I i !t !ÌFlli'B
., =,;i l
Ì,,rÈrrr ,rr[,r.'L'Èr!(Ì!jiriLd IIntefii]Irr"riI
-
rr:f ìdr Ìrr nrr
rtJr = r(, ,r(j Nerii\riÈlIiLi itì hxú r\ L I = 'rinr(r_
l"r 'í' rrl' r' \'rl
'f rnr!1 ros'rl' = '! (-i
\jr.. rn. rnrrrìlrtrm r nÌl, r ii-i l\rrrabitt!iiaL

'{ iL .rt 1'.

 Gi
cir

drr dr

Figure 16,20 Cptlr/ ìq irro!nh b id .q rqF.Ír-ni5

H and t.li IÌ ând ì: can rciì.h. bnr.lìng agÌeenrrrr tha( ncj(her Ì!1li
h ghcr utility tì)r borÌr
movc, the! couL.lagÌ.c Ìo br ai a combiration such as CÌ and Ci rÌhich lcârcslhcnÌ both
bcllÜ olì tharÌ at thc NaslÌ equiÌibrium Thc ngrccÌrìent nee.l\ to l)e bjrdjng, hoNcter,
iln.c itÍ,ouLd pa\ ea.Jr.o!ntNto Ìe.]Lr.e thcir own go!emment expenditurc.
lhG i\ the ivpe oI ÌcasoniÌìil that lteds to IornÌalized iÌÌtenrati(lraÌ agÌc.mc.ts, su.h
as biÌìdi!Ìg treatles or rÌìi.nìbebhip ot ÌnLcrnalional irÌstituti{)naì aDargem.nts Íi.h as
lurope:ìn \lonetarÍ Union, $hich jmtoÍi ruÌcs on iembeb. Bur, a\ I\,ÍlI hii tlscli
slÌo!!rÌ, bjrdnrg ruÌ.5 on rÌationalgolemrìcnL5 arc dilhcuÌt to enldce, estecjallv it lhcrc
isârr)ambiguìtÍaboútlherule5thrtarcbcingcn orced. ÌÌúenÌarnÌÌal agÌ eem c nts Ìcnìairì
dillìcult irÌ the arca ol nìi.roecon(rìics.

5: 1 Summing up
ln thjs errnÌple oi intcÌÌìclrcnderÌce ber\leen tllo gorcÍnncntsj sLtting it up as a Same
h ighliithts the wav a ncc ridcr probÌeDÌ dfiects th e o u I comc. lhcrc is a cl.ar i.1\aniase t{)
Lhcgot€ÍÌÌnerìtÌ!ho j!ablc to move liÌ st. Il botìr Ìnuvts nnrlt.ncousl! theÌìtlÌe\, doi{oìse
L h an tlÌe! coulcl .to ìI a h ii d iÌìg dsreement weÌe possiÌrÌe. I his highliithts the tenÌÌÍatìon

1lìal c.ch hâ\ tl) cheâl of anl âtreeDent and hcncc Lhe.liiìcultl $Ìit1Ì !ìesotiatilg Írch
iÍ.ÌìgenÌ€nt\. ft al!r shows t1ìe athactior n)both .orntties oide\ elopüÌg bir.ling tÌearr

6 Conclusions
This .hapter hds íÌìght lo dr\elop a series oi modcls rlith three pu{Íre5 in nrind:
r1l lo live sonrc idi.iì ol what a dtvffsc aÌìd iÌìteÌesting ltcÌd toÌiLtcelcco.onì! is, ìrhite
üt the \aÌnc tinìc.rÌÌphasiziDg how mu.h spdce thÊÌc is toÌ iu Ì th c. dc!.clopnÌent. lt is
still in ìts inla.fv, b!t ma.v Ìcgard it irs oÌìe ofthe Ììo!l cx.ìting and proÌnisjjÌs new
r..l
 'Ìo cxpÌâin a nunÌber oí ihe key game theolv lechnilues that are nccd'd to navigate
\2)
this new lleìd. We have not done this s)'slcmaiìc411)'i bul the readcr sho lÌas peÌ
scÍcred thÌ(Niih thr chal)ter s'llì ha!e .ì rcisonabÌe grasp oI ìnany oi the nnportaìú
tooìstÌìal âÌe needed (o go 1ìrlber'
To set out a numbeÌ ol modcìs tlÌat cnabìe tÌìe r€adct Lo pursuc it 3Ìeater dcPth somc
l-) * , r\ i ' lrl ," ' w r '''

PROBLEIIIS

QU!]5TÌON A. hÌthc Íianre sÌìown ln ïig lÓ21,wagesl:tt$smovcflntanlchoosethc

eripccted rale oliniÌa1ion. TlÌeÌÌ Lhe tovcrnment nÌovcs a.d cho.Ìscs llie actuaì tate oi
iníliiì(!Ì. 1hc Ìlag€ sctleÌJp.ì-t-oÍfis listcd lÌÌst tìÌlowcd by the Sorc mnreÌÌ1'5 Thereìs
comtìete intr)nnation. (ì) Find the !ubganre terle.t rquiljbÌiunì soltrttun Ìo lhis Salnc'
(iilW-h)r.ortl.ÌthegorcrnmeÌÌ1liketobcabìeto.oÌÌÌmittoastratcgfbelorcther{agc
letlcrs had nroled? uhat stÌatc8,v would lht go\ernmcnt conÌrnil ro?
QUES i ION La.h period the iiovünment (C) chooses hs.al Polìcy and the c€nlral
B.
bank tCll) chooscs nronet.I,vpolicf lhe clÌoicrs are Ìnad e sirn ultaneousl-v hritho ut
knolvnìg rhe othcfs choicc) Ii'cal poìic) caÌÌ bccxÌransionary (l) or {N)'
(A) 'cutÌai
\,Íon€tir)' poli.r'' can be lighL (T)or acconnnodaliÌrg lhc fer period utì lit) , ir'{ 'toG
lÌonÌ L is 2 if nÌonetâÌy poljry is T a.iÌ 5 if rnonclar-v Polict-
js A Th€ p$ Period ulilitv tcl
GlromNis0if lan.ì 1il^.Theperteioclutililtkr(lìl'U!:t tromlis2ill'ìÌìd5ifN
And it l5 5 fiom A it I alÌd + fioln A ilN
lheprescntvalucoiG\perpoiodutllilìcsatI - 0Ìs !',s = t;o ]rLr'riill a'dt1Ìe
rri, ,.J.Lr'r'J rl r'.1 rr' J i 1\
pcrlo.Ìutilil) oft LB, GiÌÌpcriod I
(il Ìfthis ganie is plaÍc.l on.e o.ìv (sa! ln I = Ol \!hatwlìÌbet1ìcNanrecìuiÌibtìu!Ì
.hoìces oí G and CLI? (ìi) \\rhai il !L it pliìlcd l0 tìme\? (iiÌ) Strfpose il ìs tla) ed
ìrìdennitell, â\s!mc G s stÌateil] ls 'lf eithcr )'ou or I €ìer pla) ed Ì or I in the pasl' Ì will
al av5playLtìomno on,'andCB'sÍratc$'i5'lfeitlÌer,voaoÌIevl:rlla)'edÌotIür

:l

1.
./l
^,:il
2/
0,.1 0,I
/
/\
/\
,', "l\x
0..1
\ ì,

FiguÌe 16.21 càÍê io Qu€5r.fa

 a
l

\
1

Figure 16.22 rrrreínrQ!Èrt.r a

LhcpiÍ,1ÌÌ1Ìlilha\spÌi\1h.m.orron, o.Í'h.ìtÌdÌue5ol laìerhescst,eL!.{!.si

!r blrme peúertcqrLil Ìrriloxl
(ìl-tSTloN C. ln tlìe tigralli.g !a|ìe dnn!Ìr iÌì fig. t 6 22, a I otrr hr! to .h.{tre $ hetÌrer
nrrol.lâLrnuI.trr()t.llslì.do.s.laLÌNrÍiÌBthecl..tio..ìl ..r t ()s.s \lrÊl\rfi{lalts
cÌars r.(l i: un:!re 1!hethtÌ Ìhr lJL,orr LedcleÌ Ìvill rúr Ìrodcrilc lirLs on rhe ÌÌridclÌe
cÌars.!iclr.lrd ia\ouÌinJÌ Lh. nÌjdrlLe(lar\e5 t\tu \,l kid..rrorrrlìrlhcr t1ìe titrour
Ìcad.rrlllÌsrllÌil]lÌtaxÉrr)n LhcnÌiddLeclai\e\ h\orrin!lo(,tn.oDr gi.ufst\prL
lcrd.r. lhckiderrrÌrteÌrde5iSnrlìnoleratetrìes or'hghri{.s ii.tìì t\JrLsoi
lrâ.1.r.ìiì.dll,sanÌtogcrck.tedjb!inejrherleadoljkf5(oÍ:.11âstg.iìl1rlÌ]clÌ$ilL
trÌrscL hl5 sÌrppoúen in th. tirtÌ ! \l doe!rì lrant Lo scnd Lhc ! giil high .ìnd I
d.c5n'L jrnntto\erÌdth.s gnitlÌnod.
S|Écin.eÌlvthL:!.lrrlet\.1Ìravolô Ì LliÌr(rlr.1s.nì!ít\t)e.aud lìidrerkct!anl.
t\ te.lI nrr roL!.s aS,riÌtrt the l-rhor, .âÌr.lidiLc 5lìr qet\ r pi! oiì,)i0. Lì)th i|ret ol
lÉrcleÌ grt a fi! oiÍ ol0 il iher Ì.í.. ifd ô ii Llrcr Í in,.ìltrr lÌa\ irÌ! sitnrliel rlÌeir
Ì)ÌeleÌre(ttoÌ1.\ and liltlìerÌ.í,,afdliiLlr.rNiÌrrtierlÌiì\irÌ!\i!n.l1.luÌrÌ)olicl
t() nhi.h thcl'erc oppo\erL.
lh. \ otcÍ, \ . l.r)Í! tÌrxr rhrrc i\.ì friorl r pÍn)tìbilt\ / llrit tÌre Ì xbou.leatÌcÌ Ls \1.
(| Shoü thal Ìh.r!...e no \eÌ,rÌatlng.{lrLllLhr i (i I I or lÌrt \ rLLrÈ\ otf rÌ , ìi therc a
pooÌjDgequillbrirLnr ox]íodl1iii) t,n th.: lnLuiL \.LriterilrÌto unit\ r prúi(ukr \ rÌLÌe
oi r. Ln r CouÌd {hr c be r Ì,o(ìljng rqrrllLÌrrl(rnì of Hl!hl ( arÌ \ o! use tlÌe húuiti\ c
(:Ìitenon lo ÌLLlc i( o!tl
(iliL.5lio\I).\snr(Ìutsl.ntltheSorrÌxnrent\ettlis.iÌt.li.1 ând th...nlrilÌraIk
í'Ls dro r.ti,r! polif\ This tinì. hÍ.rl !lln! rrÌr Ì)e enl Ììo!itl\ c rtrÌìbo.l - lr: rfhcft r
hi{h(.raILrol/ ìsn]orerÌfiosionlr\. \ndrurerâÌ\ tnli.r.r.b.rnrf.!iL \.
numbcr.rì 0.\hereahish.r!i]1!roi,r!ìsriiirhteÌmon.trr_\ tttLì (r'srLLlì Ll

lr r /r 05,r ,rll r16.5:l

Lhissirt\ilrrt(lgaÌns!tlo.ÌJointho i nrorr r'Ìt)i.:i!na.\ Ês.al lolio nìr dÌr gi\en

l.rcl!iri I lÌe tighl.r is .ronrtrr\ foÌn\. thr roÌr. oií i\ (;, but tlÌ( hirhrr j! the refu oi
.(1!rnon1ìÍrlÌrolÌú (t...!nferÌltenÌ thetjglrLr'Ì m.!Ìerìr!poll.\ . allÌ rrtiht]
694

1i, ,, : n rìf I sÍ Íi,,

dr tlìis .iì. be rationaliTcd Ln a simiLar n'a!
iìl \ssÌrnrL.(,aÌ Cll.hooselìIdr/sirÌruìtrireou\Ìv.Ìlhat!retheìiidìcqujÌibrlun
rrlucs ol I anr ,x?
i l NoÌ! anrnìr lhrt (i clìoosr\ I ll6t l clÌoosr!,ìi in the ìoÌoÍkdgc o (ì
and then ( \
.h,rice!lt I i.(Ì tÌre {1,!.ìmt Pctjcct e!uiljblnrnÌ 5lriÌL.glcs t)I G aÌú aiIÌ.l5l( in
âd(aÌìtile or dL5edraÌìtage 1,rr G lo lt tlÌe iÍn nrotff?
1ììl 5!pposcLhat(iiLrd( Bcouldnrrleâbi..ÌjngagÌeeDleÌrtthiìtthctrÌouldboth\ti.k
to a romÌn(Ìr !.lrLc o I = rr, Ì!h.rt ! ilttc r1NÌ!i the\ rirrer.n?
(ni rounurldlì.abletoíÌlrr1lìnlI itÌÌillÌcsl i. 1lìci.ÍLeÌ nrri)aullll]s'(stin the
enÍternr tiii) ( an \ or illLrÍIalr I ouÌ !Ììslrr15 on iÌ graPh siih / on tlÌc !crtlcaÌrÌi
rr.n thehori20ntal rÌi\_l
Applications

j
 PerÍormance and Policy
17 in Europe, the USA, and
Japan

irnportânl Ììotivatìon IorrÌitiÌìil ttris book i\ t! pre\ent an i.r.gratcd nÌxìel of shorl

^n nedìum .uÌÌ nacÌoc.onorÌìic\
and thar wo!ld trÈ rsetìÌ nÌ analvsing..conomi. pol
i.\' .ncl Ìrc{oíìance. Thc purpose ol thÌs .hapter i\ t.ì sluí hoiç this c.rÌì be .1o.e. l.
p.úiculaÌ, rhis.hìpteÌl
(11 shows llìit t1Ìe gÌâphi.ai preserÌrrtion oi macro nì.Ìiels develoFd in this boot is
useiiÌÌ lur inal)sìng â r,lde rânge ot teÌformânce ârxlÈ)licv episodcs irÌ
co.tempor.r! economlcs.
l2l provide\ an account ol yrme Ì(ev lcaLures ot what has hafpc.cd iÌÌ tlìe a.lvan.cd
c.ononÌies ìn l!ccnt decrder.
(il ) idenlljìcs m.ìjor poÌlcJ.h.ÌÌges ancìtìreir r.oÌÌoÌnjc eltecrs.
DuÌ1ng LlìÌ\ pern a broad .onsentlL has .m!.rg€d .mc!Ìgst man) poÌjcv nì.Ners arcl
obiencrs in the OFCI) .ountries !s to thc rppropri.te lr,Iììeivork f(Ì thc cond!.t ot
nÌonetaÌr and fiscaÌpoì .v. WhilÍ clisugÌeemcnts rcm.iÌì, t is trevertheÌess rhc cise t1ì.rt
comnron:líÌì di\nnìÜth.ninnÌan)eâÌÌicr(poclìs.tÌÌec.!Ì\erÌ\usÌe\rsonrhc!i!rt
that 1n Lhc ÌÒnir NÌì, monctnrv poln\, does not iÍl( ct thc rcal economv. The conicqucÌìce
1s that monctârv pohcv Ììakcrs slÌouid üjrì to cnlLrrc lh( stabilitr olirúÌrtìon aLa ìo\! rarc,
SuaìcÌingagairxtthe.Ìrngcrs porcd boüì b) inflal io,r and dcJlarion. Moreo\ er, b\, aclivcly
chaDging thc iúerest rirc, thr c€ntrdl bank shouÌd hclp Íeer t1Ìe econoÌn) L(nrard rh!
stabÌe Ln latìon equiìlbrlunr in the lace olsìro -run dist urba n.e\.
ÌÌr terÌìs ol1ì!caÌ toli.!, the consennL c.ntri\ oÌì rhe reqrÌeuÌe.t foÌ govcrrnrìeÌrt
nr.lerjgn lis Êscal nranalreÌÌÌent s\steÌn to cnnrre lorÌit r!rÌ 1ìscal \usrrinabilit! nhit\t
aìÌoí'ing lor \hort tur stabilirrtidr aD.lthe a.hie!enìent ol the tolernm.flì Ír!ctural
objecrn cs. ClÌrìpieb 5 ind 6 set ouftire\e fcâruÍes irì drr.il. ilthoush theÌc is broad .on
senÍL in lh. theoretjcâl literatuÌe abour Ìnonctnrv Lìncl1ìscaL potic), one dcbalr relevant
tu the a.âlrsis oliecenr c.ononìic perform an cc .orÌ(rns tlÌe extent nr whi.h tli.es\irell
tight' m a.nccorom jc toli.v nÌ.r\'lÌave been rcsponsible ior turct)ea. nuggj5ÌÌr€ss. t hi\
ìrSLrm en L rcst\ oÌ Ì tÌre rìistence of yr caÌle(Ì hrsteresb ech.ìnÍms th n)ugh which agijÌe
gate demand policìes ârc tlÌoughft{) aifect Oìc sLìpply \ide otthe eco.omv (i\ descÌibed
irÌ (lhatLff,1 .ÌÌd modclld iÌÌ nrore.leraiÌ tn ClÌâpter 15). We return to (his is\ue ìn
ure next .hapteÌ ivh.rc he tìcldÌe$ the qucs{ion ol n44ty s e folic!, instituti{)n5, and
economi. doxn ìn rh. .cÌÌtert ol the dcbate ìbout UÌe .ìereìnrLnants r)i nÌediun Ìun
unem plo! ment Ìrerlo Ì Ìrance.

)
698

ln tlÌls clÌâfter rc trk. h)uÌ tÌ)ist{ìe\ .Ì! o!I ft!us 1\:c btiìrÌ a1 the oLrttet otthr Ìrr!)(l\
:l
\!ithtlìc\ho:kn)Grü nn\,ltrropc\Ìrlgclte'o'orì) oi'!'iÊ'iLlon
lnLhepcrÌodbcn)rc
Westcr' hrÌofe rs
!nlhr.lion. ü'üÌÌn.\ pli\ ed r Pn'trl r 'le 1Ìì moÌÌctart loÌi(! iì'tuss
Riì1' me'lrar11!Ìr {IRÌilì As i
1lìc le\ .uÌrrnc\ c.ttltn ìÌÌ lht IrÌolìriì' h'hdrÌ{c 'on\c_
o!Ìd ú' boÌders
q,",r." ,**,"t .",0.i,oÌì hrd macÌoc'(!Ì!nric limitì 'rtidÌs lveLl bc\
I hc llÌ\1colliìtsed xnd Lht lL \p"ttÌÌr'rÊnoitìÌe{Ì€'idcrìthmrcrrÌloLicl'toÌrr!'rted
I

i;ì;" .' .Ìer1r'n o1 Lhe rLLr'pcin Ilonttary l nro' (LIrl'r' \\c Ìt)'iL
.il -' o,,"pt.,-",".t.ouÌúry lh'r_ÌÌ( th'rL tÌrìpted oLúoìtÌr' F-Ìì\1 rÌ didrIol
'"r.t'"..',' 'he entcr

tÌllll fur!1ÌirÌ thai dc.adr'

lisÊ.tion2.llerd.ìresstÌrrN.oÈcoÌìoÌnicsoinìr)rÌetiì!v!rrjon lhL:I(lLìisbeglnÌìnìg
tt) $tabllsÌr I tracl r:cord r\ iÌ nÚncLrr! foÌì'!
ìlNcÌ rrd it\ lì'hx\ irrLr! crÌì b' üriì\ ied
it",,"ii*a,-tn^.u-"'ibilLrlioÌÌe\pondiÌìgto"'''rl'ri\ho'l<\hi11in!tlrcF-l-'r'e:Lso
Ircrt to analvsc tttç rerponscs oi 'rcnLbcr to r:otntÌ\ \fL''11ì(
did!Ìbin(rs TÌììs in trrrn
i""ì' i.,n".,"-,u,. "r,"helher lr'!on l' el rlrrÊ\ IoÌ is'rÌlrehilioLr rre r sLìhed
'_i,,r"._,,-t:r,,n",*tf.ttmxnLeoirhe{rSe'onorÌr\\nìrc1!r()i)ite)rnmirÌcd Ìh( l!r!l\
\eÍc e Lrr'nii{Ìì (1e!.rdt lor lÌl. l:5 nronetiìÌl iì!Lhlrjli" tlrc ledÜiÌ l(\cre Ìloa UÌÌlikc

,'-'''''
!hc ÍtulÌ i!ì
"r,r""*oi-tt*t"i,,.rt11..k\'L)ÌLi!nBthe(li't!rrÌrl.5l{Ìcn"h\(ilc(Ìrlrrljdrtl'ìÌrÌ!i\
,,tr-ú,,i"t"". t*,"t, tu" ".!n'lrl i' a \1^lrLr ma'roe('nonri"'rüiLi(!Ì
nr lììe L5 nlter nÌr
tlÌc nid 19905 ol r!'rt!nrÌrL. rat!'i ot lìIo'ìu'LlviÌ) SÍr1lth 'corloÌr nÌrnl'
.ar""." .r ro,"" u".nt , eitr Ì)nn jdtd Lhe r't!Ì'itr\ rllLh r potlÌi\t
nrLipll àniÌ

,,1"r*,1,, ,-". i.U,-'",i \!tÌ'i'katlhcchiÌâ(t'Ì 1)llhebooDrÌldr)lth'{|ÍaÌÌ'c'l

lr(6t nL thetLrrnollÌ1i ne$.cntLLI
se,Jjô..1id.Ìr(s5ctth.Drak1Í''ith'.laÌrr!ìc5ee'onomlnrlhcLrstLinee')Ér15Aitcr
cntcrd r pnnorÌgcLìdÌrnÌr irì
d..:r(l15 ot úìlressn e pcri()Iln!n" tlìe litr ncie e'odorÌì l
1'rrÌrr'l
Ì,r92.ÍonsnìiclÌithrdnotcnlerÂdl)\ 2(l{11 lirrrr lggl groÌlthr\ernscdonÌ)
quitter lL! râlc lÌom tlll ÌÌid ì910s' IÌú1ilr'ÌÌ IclL drtring tht iìrn hail o tÌk' l9!rlrs
.ine
;,,.i"r,rr,,Lfor*Al',rel"tio.ì!rlhÈ\e'onclhaÌf1\ru\'LhetooÌsde\cÌoÌredlnthjsb(rk
lo ìLLunìjnr1r: thr tule oi nÌi.Ìoero!r'nÌl' foli'\ nÌ Lhe
nn!'rtìo'

1 German uniÍication, the collâpse of ERM, and its

aÍtermath
1.1 Background: the ERM and Germany's role in it
r'i\ r Lrc'i8n dccrd( nr! na'írc'ononìl' fol
i\\ 1!. nr!lltce lattrìu the.hrpiÜ. the i990s
ì(tÌìxli(riLntlì.Urìirccì5lale\'lhi5ltasfrriíìnr1lìe'rÍlnlurote llìcÌnondra iìlic
\'
r.!rL ior ÍÍr nìaln ren5tD5: \\ie\l
('enÌÌa'\ Ìras I! fe'! largc5t c'o'onÌ! r! iL f Ì$(d I
kel'n)]tdrtrirt8theÌl)E(\i.L!oÌ:.e.\nì|netaúPol].\rr]etiÌrs.\\c\t(
hú.fean moÌÌcl.Ìr\ PoÌì.l itrs due ír lbe op'rìtion ol th' Lrhenge ililt
I'lü:hdnlsÌn
iLlì\iìotthtluíÌre.n\lontÌalt5-\nrnr:nr'ist1\jcslIuropcIÌ'oLLntúrshadciecti\'Ì\
 : 699

Siven up donìcni( monetarvpoÌicy autotxDÌr bv j(iiriÌrg theIRNi,\fhich wrst{) Ìeadbv

t]Ì€erÌClofthc1!90\tothenÌn]ationola5iÌÌtlec
ol unilìcation on Llì\Í nÌembeÌ .ourlri.Ès oüÌei than ceÌman_Í, t1 ìs therelde ne.e$ar
to e\tÌain brictÌ\ hoir ER\.J rrorkcd and why countrìer Ìolned I. lhis bâclisnürd js alÍl
cssential ft)Ì {br aDal\jis oi LMU i. sc.tion 2. \\Je nraÌÌ see rhar rh€ -l equatn)n ÌnodcÌ
provicler â hclplul lrxme$ork f(Ì dlstingui\hjlg Ì)etweer thc so-called cre.ììbiìitv and
discidi.e cxfÌaniúDs t{D thr dc ol IRM me nrebhlp in luropcan di\irúÌaiìon. \,Vc
then move lo the open econom) Ìrodcl to pÌr doiln rhe wa) ìn rnìlch a decisjdr to tLÌ
the exchangc rat! can enable dirinllaljon.
'Ìhe
trimaN mlrti\ation iìÌ dre tllablish entoltlÌeERMinI9;9bvanunìberot\,\resI
l!ropean co('ntries ira5 to cÌeatc cxchang€ rite Íabilitv becaure lrrcluatiÌìg e-\change
rates weÌe bcì c\Èd to be cìamagrng b the crertioÌr oi a nture lntegralcd and coÌÌrpeti
ti\e lurcPt:a. mìrlet. Although rhc Iuropea lxchange Rate MechaniÍì Ì\'iìs tornìaÌlv
estabÌíhcd as a so caÌìed \\nrÌncúìcsvs{enÌ $ith rÌo couÌìtr} plavingrhc domÌnant role iD
nxnretarv poÌ]c!, jt evoì!e.l inn) â dc lacto as\ nÌn€tiic s\stem ìn which !ìcfilinf (\{e\t
r ì,Í1. Lrnlikc (ìeÌmânt al thc tirìe) was the ket.úÍcÌÌcf (o!ÌÌtr).r 'Ihe (;erman Búndcsbarli e ersed
a! the dominnnt nÌonetar) policv nìnker. ]lÌis !!as tlÌe resrür of a rct ot intcrlo.kint

(1) thr GcíÌan centraÌbank s Ìon g-sla nding reput.tiod lor keepnÌij lnrlation loh',
Ì!h ich pronÌi\ecl gaìns nn otheÌ couotries in terms olânti üúÌatn)n .ÌedjbiÌirv.
(21 the beneht\ Lo othcr.o!ntrie\ trom tvjng theiÌ hands' jn Lcrtrìs of nìonetârv policf
b) 'ha. di n g iìr it to the BundÊnrank.
ovcr' responsibilitt
(3) thc comrÌìoÌì iÌìterest olthe.or,(icrrÌì.n lRlvl co!ntries iÌì ciisnúlati(D ar theLÌ
f riÌìaÍ)' policr objecti!e.
:.lt lrrrp.a: Thus iÌthough the nraiÌr nroliration for cslabÌishinit ÌÌro(, orderlr erchange ratc
'rhr l99(\ aÌrangcmcnts \tenrmed fn)m conccíì5 about lhc dcúimcntal eftect ol exchange retc
ÍlucLual orÌs on tra.le aÌrcìinvestment dc.isiorÌs,lhc c!.cnluil shap€ of the LR\I$ith thc
Bu.d$bank s d.. l{cto ceììtÌal nrÌe, Í,as 1ÌÌe outcomc oÍ macroecono ic imperatives in
thc mcmbcr.ountlies. Speclncallv. lhcsc countrics soughtto achieve low ancl stabÌe ìnlla-
tion a.d ilrre scepticaÌ âbout achievifg this undcr n rcgime ol iutotronnnb monetaÌv
poìÌ.1 11.c. nitlÌ tÌ)atlnia erchange ratcs).
Thc CermdÌ centÌaì ba.k, thc Bu.dcsb.rÌ|, h.d a lodg ÍaÌrdiÌìg reputation íoÌ main,
taining loN iúÌatìon. \/ÍanÌ ol lhc othcr colnúi$ h.d \peÌÌt the 1970s jtrrggljng lo
Ìedtr.c intlatiorÌ and beììe!e.Ì drat bl lliÌìit their€rchange rai.. to rlie DeutschÌnâÌk thct
iroúldpronìote lìÌÌinginflatior. Tiro routes tlÌrouglÌÌ{lÌichthi\ couÌ.Ihappcn wcÌc jdcn
tìhed.'lhc 1ìrst i\ otten releDcd to âs th c 'cred ibility' hl potlìes1s. 8v nxirg the.ìchangc
rate to lhc l)c!tschmark (DM), ìr wes hopÈd to direcily .ffect tlÌe irúÌatnnr expecratio.s
of.lomcsl . Ìr.ge and trice sertcN. ln theorv, this nould allow a painìes rcducLion ìrÌ
iÌrÍlalion as the shoÌt rlür PhilliÌx curvc siÌ11Ì\ doì\,rÌ to reUect a ìoNeÌ expcclcd rarc of

rli.ìin...eÍìbler!.rurt,!.rìrrirÌ\raiLions.lfâ lde a,raLLqÉr b..r ra,,0r,n\,/ n nrn lrr.ydaidrj

L.tèr LrrL(11 /..0aorr,.j,I,u,,,rtrrr lrìn,r l,l. ín1rÌr 2rl03l
 ]rc tÍ '=
2)

),

fiqure 1?.1 aÍ.dlb Ìy vs djs. p lne.ilê.ts !! tlì : morÊt:rv ru e

llclore looking al wh-v lRM ncmbeÉhit ÌÌÌay ha\e bccn :ìttra'tìve to a

couÌÌü) rrith
5 to considcÌ ho$'
an inlation ptr)blcm, let us u\e thc 3 equatnnÌ analtsis ftom ChapteÌ
d1\iníl itlon ;oukl bc rchicle.l in a s
jn81e cÌoted ccononì-t Ì' Fis Ì7 1'ilecanthinkoítlÌe
hithlnflationeconomyaslnitialÌyatpoirtÁ'Ì!ì!h:rninnnritììhìasol40/oìeiÌìíÌatnDis
.{;;ìstantrt 6{1,.líhich 4q,abo\'c thetargetÌalcof2% 1hereason t{)r the Ìn flation bias is
is
cÌear lhe oulputtarget i5 aln)ve thc cLÌuilibÌ1um,lvhich rncan\ thaL tìre constant
innation
equiljbÍntrnwiththe Ìo!!cstÌat€ otintlatlon ìs$'heÌe thegovenrncnt\indìIleren'c
cu c
is;angential n) a short t!!Ì lhilììps cur!'c wìth output a1 f(
(núÌalion bi's ìs ijÌ
'li\cussed
Ìedü'Lì(m in
detaiì 1n Chrpter 5ì. Wc crn sec ìn the dlagranì hoit, in theory, a costless
irÍÌatìon.ould occuÌ:
. Ìllheobìcctne\otthecentraLba.kcoüÌdbe'haniiedsu'hthttlr=fr'thcntÌìe
nÌonetary ruìe line nÌiflsto thelcÍl aud ìnteÌsccls Í: Ír andl' f' atZ âsshoilr'
jê.' IJ..r'rr ''iroF'l ' ,'"rn -
setters and thck is no ÌÌcnia
jn wagc or price s€ttiÌìg, therÌtÌìc I'hiÌÌips curve iunrpi
.lowrì to go lhrÌrgh Poilrl Z.

ThÌs \!ouki 1ca!e rlÌÌcmplol mcntrurcharged (siìÌcc oulfut remaìnt att) and
inlalìon
( e oi 2% Thi\ is th e cate ol â 'costÌess d isìtüÌal ion"
rould drop iÌnm e.liatclv to thc taÌiiet ra

which ,ì ;cd,l .olÌld be brought aboülbv a.hante in institutional aÌrangcmeuts' such

rs maklng tlÌe.cntQÌ bank irdcpendent ofthc goverlxnc't
lloNcr;Í, if thcre is itÍlatioÌì ineÌtia,lhen.lthough thc monet'ry ruÌe 5lÌií1s t{) left' lhe
ccotrom-Í i\ inilìalÌ,v ítrck with being on the ÌihiìÌ4^ clÌrve, |Ci; I = iiì Disìntìation
i\ th€rcIoÌe costìv: unemployment Ìnlist rise in oÌcìer for intÌttion t'r lall l)islrflrtion
jn moncla} poÌjc-a
takes place a1o.gtÌÌe M,ÌÌ linc lÌoÌn Poinl B to pointZ llthcchaiìgc
arúIìgcments suctÌ as making tìre cenlral ÌraI]k in.ìependcnt ot thc golenìmcnt has ihe
etìecl of chafging the Prcfa,"r.a oì thc noÌìctarv pollN maker by !ncreasing the loss
a\sociatrcl tr'ilh 1ú1i1ion being ahove taÌget thcn the n€a itn is not onÌ,v \hitLed to the
Ìelt butbe.omcs tÌatlcr as sÌìown DlsinnatloÌì ìs latter but'morepaiftu'l'becarsc outpul
tìL1s fitrthe. (jnitiâlly to Poinl C] tlÌd uenÌpÌoyment riscs b) nÌorc
on the adjunrneft
prtlì lo tÌre iÌÌll atidr taÌiiet.
 101

lfi.hangc i. nr stitlìtionà Ì . r Ìangement s p,oduccs r costles dìthúlition oÌ â ted!.tion

lÌ thc.osL ol ditúútúìLÌr. thc t.rm 'cr€diÌriÌlll' ú oÍteÌì aplÌ1e.1: the irì5Litrtti(Dal (h.ngc
i\ crcdìbl. and thi\ credìbili1-! r5 ÌeiÌectcd i. lhc a.ÌjustnÌcnt (Í th€ bchaliouì oi privatc
se.tor ãg.:.t'. The üedibilit!' hlpothesìs 5 co.lÌastel ÌriLh the discipli.e hvpotlì.sls:
iÌì th c la llcÌ case, d c h.Ìì8e irl i nstitutionnÌ a, râniiemeÌìts is !jervel .r s . cce$aÌ) iÌì oftff
l,rr dlslnLlrli{lr trì be possiblc FI(^!erer, thcrc jt.o ÌìresumptioÌ thaL lhe behr\iouÍ oI
prir atf scctoÌ agents clÌan8rs s.lhere is no clelm that tlì€ cost5 ofdisifllntio. rre atìecl.d'
.U1Jro(gh the drili tu .r frrcd e\clÌlngr rilc Ìegnne Í1.h rs tire cntry of courÌtrirs lo
the lHl\l ls otten di\cu\sed in !Ìuch ttÌe sanrc tcrms as for a.Ì6ed rc.nomv' the rÌìalvsi5
necds lo hc mocììheti iÌÌ sol]rc Ìe\l)e(ts. irc rhrlL \ec, Lhe tÌ{N1slâs not a s\stcdr ol
^s
.o!ÌÌpìclcÌ-Ì hred er(hrn8c ratcr. Ì[ìt it is úteflÌ] to rssume fired rnLc\ Í) at to highÌìght
tlÌ€ Ì1c\! clcments iÌÌrodu.cd in tlÌe oprn economv. lrì laúìc!lar' lhere is obiiotlnv no
\1Â cun c ftrÌ the countl! ,rnrc it h.rs adofte.ì a 1ìred cxchangr rere: it docs !ìot ha\e
an indcpcnde.t motÌ€t.ìÌt-' Polic\ ant lo.gtÌ So ho\! does c]ìsiÌrnaln)n takc plâ'e? ÌÌl
üìÈ.Lrscncc of 1niÌaticxÌ in.rlia. r colnPlcleÌ-Ì.re(iiblc $!itch to â hrell e{.hangr rate
ruld iesúll ln a dÌop hÌ the lfflatidr ratc to ÊquaÌ that ol tÌre.oun tÌ settirÌg nìonctaN
poÌic\ iÌr tb. \!.sL ('en !nt-. Bl adottÌrg a naecle\cha.ge r!te, thc
r_RN'Icase,
'ountrv
ú acloptìng thÈ G€ÌnÌan inflalion Ìate ns l1! laÌSet ,\s umaÌ, elimlnatìnil trì.tio's 1n the
ecorÌom-t mikcs Ìhe !rr.rlvsjs quite súìplc: theÌe is a .ostLess dí)]] 1n iÌúLatlon to th€
GerÌÌÌan lrìllatioÌr te.
lon'rholtdLsiÌúÌationoccuÌswitlÌìÌÌalìxcderclÌ,rngcìrteiÍengenÌeÌÌtinthepìesencc
.f irút.tio. lnr:Ìlia. rre t.rlc tììt c!\.' Ì!hctc the nomifaÌ eÌ.lìange rate is ocdibÌv lìrcd
but i!herc (hc beh!\io!r oi ]!age atÌd Price sttters doc\ rÌot iÌrnredì.Ltiì-ï adjun to n'
inuatidÌ r.lc rquaÌto thJt iÌ1 lhe k€v crrrenc\ counÚl ]\ pÌar6ibÌe iÌritìaÌ tcendrnr is
ot a countrt ofcÌatnrg ìlitlÌ lcliìte e\.hrniie rates r'!th .onslâÌÌt 1túlalio' abo\€ --i
it is iÌ a nìcdiLtnr lun elliLibriunÌ lrith a constlnt (rl e\change rate so the n'nnjniÌ
cx.harìgeratc is .lepreciating n I acorÌ(ent Ìate:lf'. = n ; IlthenorninaleÌ'hange
raLei5rÌos,fìcrÌagaitatilnpoÌlrnttradifgÌrartuers.lherÌhigher'lonÌi\licintÌation(ill
rftaÌ(en cüÌr tcliLivene \s ls,ith n ; n indahrednomÌndler.haÌìSeralr,''ll]r{)l lhe
c.onoÌrì) nill nr^ e (trúlÌ rlcsl.ìoÌ!n thc rll c!r\c a.d o!tPut end etnpÌo)Ìnent s'iÌl Iatl
ar nn\!n in L i3. l7 2. llÌis ìt ll .ìri\e iÌrflâll)n loÌln ft)r ts'o ft:asons: unoìlÌo)ÌÌr'nr i\
risins, whi.h \!.rk€n! ÌÌrge scLteÌt ìÌr tÌr. Ìrbour nÌarkcl and rcel lvase\ air: Ìjshg tJe'nt6e
oi the real ip!reclatl(!Ì, !rhirh Ìeduccs Lhe nuìe\'Ìlrge iÌì.rcase $lrkcÁ can se'uit' et
an\ 3i\eÌÌ unÜntlo\tneÌú r.1c Oufe ìf lârjon ìt bcÌoir Í_, conrpetitn(nr$ l!ìlL bcilìn
Lo nrÌprove and the ecoÌìomJ tliÌl Inotc bacl tdlaril the l/ìl,r Lune. llcntlralL\,1h'
ccononÌ] íIllÌ bc btcÌr at poj.t l. lÌìt ('llh iÌrllatioÌl (Ìu!L to ; DisiÌìflnllon has Lrcc'
achieled brl at lhe con ol i P$j(trìofhiiih unenìl)lol ment
Letu\ noq'.onTaretÌÌe oplions ì!cìiìij i hjgh núÌaiio. opeÌÌ cconorÌÌ) : I I .o ul'ì lttenì pL
to aclrirrc dlsLntlatloÌ b) rc(rúrirÌ! ffonctal'(onlít itsell th(mglÌ ad'ltlng ! tÌcl
ibÌe e\.hi.g. rate and iiìplcmentiÌìg an i.tlati(rÌ tirgetiiÌg rcginìe Ll! analoiit $ilh
lhe cl.,sed c.onoÌnv, tiÌe .úoplLon ot af cilecti\ e inlrtjorÌ 1iÍgchng re8ÌrÌ': nrav ernnil
i.rtitLrlio.al.hange !u(h.s.L:.tÌal b.rÌi ln.letend.n.c AlteÍìaLl\ÊL) thchigh inlhtion
.ountr! coL,ld dccicÌe to tìe its clcharÌgc rntc to a cinlnLÌ\'$ìth thc.Ìe\iÌed üìllarj(ìr rrtr'
The Lrtter opli.. mdv Ì)e lttra.lile il tlÌc iiol tnnerÌt ha\ dluLrls about ìts.ìbillt! e!en
wiih tlìe lsc oí jir5titutlorÌrÌ .ìanse io succe$tuLll ahÉÌ tlÌc ohjectiles oÍ nr('ìet:Í-t
Figure 17.2'aômp.Ì ì!e d 5 Ìrì ;l cr' Ío loltrn!

pollq. hr ter soltheÌnodcl.thismcan\toshìitandfosriblyalsoaltertheslopeofthe

;ÍÀ Ìlne.ItÌÌra,\' alsobeÌieïc thattherc is nÌorc chaÌì.e olaftecting lÌivate scctirinllatidl
expeclatioÌÌs blceding Ìnonetar) polic) to a bod!-' outtìcìe thc courÌtrv On thc oth€r
ha cl, .ven if the fi{ed ex.henge ralc did .ot piofc lo be a magic bulÌct in t€rnrs ol
shilÌirìg ilenial núLnli{Ìì, hÌgh úúla1!on coLlntries nìa-ï see nÌerÌ1 in't)'iÌrg their hancis'
tw traÌÌãlng ovcr monet:rr) poìic) ìllame ìor lhe '()Ís 'oul'ì be shj[ted to lhote eìlcnrâl
wcaken
a;rangcnrents and thìs co!id lc*enth. political tressurc on the golenìnìcnt to
its antl-inlÌâtion resolve
$ith this bacligrolrnd, 1\'€ ÌctlrÌIl lo tìre liRM Ìt is iÌìpoÌtant to ì]otr that Ìnonetrry'
poÌicl as no t literallv 'hlÌr{ìc.] over' lr) the uurclesbant: thi\ r'oukÌ onlyha\e bccn the
."r" it Lt ttigtt ittno Li,"t .ou n tr ies ha.l ìnlrvc.Ì into a cunenc-v ünlon $ith Gennanyand
"
aloplc.ltlÌe l)M:ìs their cLrrrcnc). Ìn lhìt(orlext itis uscÍuÌtorecaiìthe issuìnptions that
ne€d to be ma.le tìI the adoPtj(m ofn lì\ed c.change ralc ki renìolc âÌl dom$tic
contÌoi
(see chapteÌ 9l: the ecoÌroìÌJ ÌÌlusl be snÌ'ìÌÌ' lhere nn$t be pcrfect
oì nìonetar-v l)oÌicy
crpitiìì moblÌìly, âÌÌdhorÌe and f(teigf go\€Íl]ment boÌìds muÍ bc feÌfect substihrtcs
Ai
the unco\ercd intercst pârit-v con.lition mak.! cleaÌ, Ì!lÌc' intemitlo'al cirpÌlal mobilit)
i\ pcíect, it is lnÌpossible to run â dltleÌent monetarv poìic-Ì illÌilsl retaining a credlbìe
peg: if.i .f-,then anunìinia thc bonds Ircm each count} oI eluaÌ Ìin( i i'
'rc ÌìaÌÌret controls NcÌÉ
ln (he conlcxt ol the Slnillc Iur)pean lvíarkc! p(rgr.ìnìmc, capital
lifle.l ür lumPe ard capital mol)ilit-Í incr€ascdr the âssLrnrptioÌì of pcÌfect lflcÌnational
.apÌtal rÌìobilìt-v bc.oÌnes rnoÌe aPpÌjcabÌe in lhe late 1980s Applvjngthe U/l condilìdr
(;eunan-\
Ìo lhe conlcat ol the tlÌM, an! attemPl n) hold the irÌÌcrcst rate beÌow thaÌ ol
s,oukl lead cither !o r 1os! of re\ervcs b\ thc .e.tÌal b,tk
(sìnce thc ìnonc,v tlrÌrpl,v ìs
erìdojaenoüs trnd€r ftxecl erchâniieralcs)oÌto adevahratio' Ahho!gh the LltÌvi oferatcd
$'ith exchange ratc baÌìds, Ior ìnoÍ coutrtrlc! these Nerc qtrite ,Íow a d aÌliNed â
% h id n)
1l lrctlratio. xro! n{Ì the '.rIì tral bil.tcriì Ìate' o
l o nlv -2 5 Hence, m cmbers

. lâllilrrolirÌe(,ilhCcrnren moncLarypolicl,or
. seeli.ìn c{changc Ìate reaìignÌnent ('ìthìtÌ tlìc s,vsteìn. or

!he lackol.Ìedibiljtv ol th. ncw erchanije irte aÍangements ìn lhe financlal ÌÌÌrrkcÌt
Íìl:ant thât ccntral ba.ks iIÌ lR\'Í coullkics tìequcrrlÌ-v hacìto rnise lhe dodìcstic ilÍl:Ìcst
raie so as to Drevenl lhe excharìse Ìate írom lnoving outsid€ thc agreed ({chaniic rate
 703

Ìable l7.l :r{:;r!èr=t.r:a oìnìeiir.d ní ar on r ríere

r: . l

t)and. A5 Ì!Ê nraÌÌ 5ee. Lhc llNI rÌas r DNch ldtrer lrrrÌgcm( nt lhen thc lc{tbooli 'lrxed
erchangeratÉ'cn5eandinitseerÌvIeaú,nrrnlÌerlisx|ìrntsorÌL:hâdgt,atcsl.Írktla!e.
hr lact theÌe weÌÉ lhÌc. tha\er ot oteratì(Ìn oi ihe lR\1, \! 1lì thc discitlini.g effect
attai.inijgÌeat..ÌiÌnlortafceoreìúnrTo\eeho$tou5cllgl7.2,irctrt.tìrel:rench
economv a5 a. e\anrple. As TrÌ)le l: l sluv\, turì 1979 (o ì!r8l the a\ÊÌage chaniae
iI the nomnraÌ erchangc Ìate itr\ as Sre!t r\ tÌÌe a..uÌruÌitc{Ì trjce difteÌentiìÌ \,ii à
\,i5 Ge Ìrn). A\ nìch, thcrc $ a5 no ciedr Ìerl a ire.ia(ion i. lìÌrncr iÌr tìre Ìir\t PeÌio!|,
n hlch nrean5 thât.ÌjsLnlalion pÌeÍure ü ar ÌlrgrL! absc.l. Fort\cr, ì)Étl!ee. 198.1 rnd
19E7, .omlnaì e\chrngc rrle .hange\ sere cledrLv kss lhan KÍrÌd co pen\ate tor the
ìnLlxrj.r dill!ÌcfLirl: , clÌ ra real rÌrprecjrtj{Ìì ih.rcbl imfo\ing fâÌÌìng outÌtrt rnl
Ìisi.g u.cnrÌìlolm..(, hìri.h tr'lgtered disirúlaiìoÌì itht Ìcfch econom\ uÌoÌtclso!th
r!.staÌongthcllr.rncinììjg. 17.2ì hrthehÌrllphisr'rrl)lol992,nochante\irÌthr
.onrifâÌc\.ha.ge ÌaLc o..trrÌed dnd b] 1991,IürÌc! hadìolLer inilìtiilr thdÌ Crnì.nr.
l)l\ n lr i,rf lri(lh.ln r.lrlrìerl:
I. cxtl.tur rhr rÌu6tlon ol irhetÌrrr IlÌì\,1 rìeÌÌbers Ìr ]r Ìc(Ìu.Éd the ron ol disirÌllilio.,
... afÌrÌoe.h ii to .il.rLletc Lhe !a(Iiii(e rtìiio\ lttÌc c.sl it teÌm! ol urÌeÌnploJ mr| L ol
.cd{.ing ln lrtion. scc aììâtter :ll.r \\'e (tìx !lo tlris t..lhe terl( \ oi di\iÌúl.rti! ÌÌ ìn th.
nrld l07ll! rn.l i. thr l i5L hâlfoithe l9lJí\. 1he renr115 5rLggr\l tÌrrt tR\l nÌenrber\hip d d
..1.ur Lhc LLncÌìflo\'Ìrcrì1.o!toirÉducils núÌation cllh.rr\.(rÌÌtred$jthtlìer.ìÍlirr
fcÌ od.Ìrs..mÌìerdíiLh.()trntriÊ\.rìtli(leuÌrIlÌ\1. lrl!LsnrrrtÌriIÌrblei72l1hrrc
siüil.r:Ìariosir.ftrr(nLcdI(nr!Nnrber!tìluÍÌie.ìfrorLntr'le5insicltdncLortsidctlìc
l.RNl. A..DfeÌLír. ô Lrân.c aÌrcÌ tÌìe LÌK ò iiÌìliìÌrS:sn..il.c Ìrtjo\ ere \!rÌìlar iÌì Ìrin.c
e.dLlr!Ì:Kifca.ht.rlndandi.botÌr(i\eittre)ürd.r.i.Llìc198ü.lR\lrrerìrbershiP
nrrr hrlc hcÌtrLÌ IÌrn.c t. ichler e dìiirúl.ltitÌr Ltrú it did ..1 ,tduce the cott. Dii.ipLirÌ,r.
rarho rhan .rcdL|ilit_1.. n.nrs n) be dre *ÌilanrtldÌ lo' llrc Ì.1. .l lhe ll\1 nr l:!rcpeLìn

I L,::r.r:.rri \..rLtlrr Lirì,r.1.!ilrt.n sLn.i!r. iii lrÌrnì:

jri,ì \rr.dlri,,el.xtr(onridiarÊiÌ.r ì,.ÌtrIrì1,,,rrrì:iL,t,d!dLtiqe
IrÌrr rLL\,r: Íi..!\iirNìn! LNt.rr,nLrdlr\ irÈrì,1 ,Li,llla!.r ìi.r,,fr!!ì,, rrr.ÌÉ:t,Èt):r.d 1.,
?il.l]l.arrll!l]j]ú.L!L..r|!rt.Urüìll.\nr?j|!Ìl]la!|:lr!]!l1.]Nt
Ì.ir:!iiLi, .io \?i..., I trrurfl.\ì?nt6 rr, iriÌ. Lìr llÌÌ .r.rr! \ n, .
'r:

1
104 .

Ìablê 17.2 !à.rif.e rii05íÕ ERM ànd non ERÌú.cúnÌr€! n Ìlre 1970s

lnllâtiondange lfflàiionrhaíge Saati.eÍatìo !à.riíi.eÍrro

r9741

ror(. .:nr i:Êd 1ÍúÍ

.]i\lúÌ:ti,rn. lt ir irterestìng to ote th.t Gc Ìanv thc moncLarl foÌicy maker ir] lhe
r
ERM has thc sanÌe sâ.rilLce.rtio iÌì ea.h pcÌi(trl
I o \unìdìaÌize. it is bccause the Ìnemb$ coontÌies ofthc ÌiRM had dre connÌon goaLoi
reducing innatnn during the 1980s úcfcr back io !ig. ì :i jn Chapter 1 ni see {'hnt had
lÌâppcncd ro nÍÌâtion ln the 1970t tlìal the ERM operalcd a5 an as-Ììnmetric ex.hange
râtc slslcm i{ìth t1ìe llrtÌrdesbanl iìs thc nÌ)nettry poÌlq mnkcÌ The Bunde\banli scl
s
ÌÌÌonclary fohcv lcÌ tÌrc menÌLJers by.onscDt

1.2 German unification

IÌfjng lhe Í) (alled haÌ.1'ph.ìse of thc fRNÍ, when tountri.s comnìitLe.Ì theìn\€lv€s to
,ior rcalignìng their cxchan$e ratcs, thc u.anticipat€d slÌocN oI GcrÌìan Ìeunilìcation
o..uÌÌed. The Lracligrou.cÌ to the .xislcrìcc ol tlvo C€rÌn.Ìì ccolìomìcs in the 1980s can
bc sketchecl\ert' brìcLlv. AttlÌc cnd ot (hc Second $orld $ir, thc dcÍcatt(Ì GeÌman econ
oÌìyrlasdnidedinLokNrzonesoinÌllilnr-ïoccuPation.lhethrccÍ'cslcÌnTonetbecaÌne
rh. Iecìeral tìepublic of Gennan,v irÌ 19.19 and the Russian zonc bccanìc lhe Ceunarì
DeÌnocratic Ìì€pubÌic. The LrÍ !icrÌìnn ccononÌy shiited lrom a war cconomv f(ÍrtlÌìil
kr a centrally planncd ecou,rÌly. ÌÌì wc!l Gennany the ownership ol productjve a$ets
re\ eìtecìto privatcoilneA and thc c.on o nì1 1!as ÌeiÌúe8r.ìted iÌìtothc wcncrn orÌdtracl
inS \vÍem. LlrtÍ'ccn I9.:19 *hcn thc hlo cconomies irere separat.d and I r)Ó ì,2.7 nr1Ì]nÌì

tr.bolfd lng rndú {ú'e-r lh, .rnn.( rndro,trLLLde úì.l1hcrcrrr no1l., .ÍÌlihi ii\ eÍr.a r\!r.úted
N llrrlìv rndibe.nìip LgiLro rnd lJrglxnd.. Ll992i. SdiÌiÍ (.n( u\ìr'r\ r rrut rt Linrited ks+rúe oI lhc
Llll,uÌ'LrÌL(eibinnorfr.a,rrn!èsnrtutrêúnptr.vrrrnnnÌln'tt'enritrlrbl)ì\È.riìerhrgÈtiÌrgurarÍ
!..reÌ it ilìê rÈde{Ìnr\(rr.irr dìê L S]\xnd tÌreTÌratrhrr r::oÌrÌ.dìÈ.t\ Ìednd tÈ..r lnúd.rÌ íit(!!, bo i

!i{1ì,.hÌLeÌejrlírlrn.diÌrÌe/9FoÌÌÌrcIoL'nr,r..llLr..Ì1ÍdLl9B!).ndI.ÌrhÈlrrtrr.s.!IÌriLrrind\lilrÌ
: lÒraniÌrn!entiÌlr )rrti.leaLìor1lÌrcdis.rFir.rnarreiLil)iÌit\cIIdtr.IlIììlIme.Ìbe6nrp,\rcGirÌ)77i
 people letÌ L!Í tur \\'cÍ C(íÍan-Í. llÌc n]agnjtu.Ìe (útlÌe nÌigr.rtionlr'd thc lan Gcrmiìn
golcrrÌnÌüÍ r! (Ìertc n phrsl.aÌ scfarnrion of tìre tÌlo countries b) buildüÌg thc lrrlirÌ
lvill in 1961.'
Llelor€ tlÌ€ Second í!o p:rts of CernÌan-t l{ere ver:"
world war, lilirÌg slandar.i\ nr tÌÌe
jt
similar. lÌì 19E9 u1ìüì thc \talì.nnìc doNn, emeÌijed tlÌrt the average LaÍ CcÍìan re.1
\\,ritc !!i\ oÌÌe thÌd tÌÌat rí wcn Gc.mn.,r ând aveiaije laLro!r pÌod!cti\ìtl iÌÌ rìportirÌil
indunrie\ lras olle si\lh {haL i. Llìc Í'cst. GeÌm.n LcononÌic dr Monetary Union irÌ
t99! .rÌìolnted to thc nbsnrpt on ot thc sÌnalÌer poor region of lan Crrjnaf! (16 mil
llon inhabìtrnts) iÌìto thc laryff rirh onc of the \{esi 162 nÌi]Ìi.trÌ). laÍ Gcr.ìa.v\ lìt)Ll
$as onil ltlô thdt ot th. wc51 l\lonclnN un1(!r meaÌÌt th.t last Gcnnan-v abandoncd
its .urrenc\, th€ Ostmark, i. larour oÍ Lhe DM. lÌÌi\ took placr .1 nn cx.ha.gc ralc oi
lD\4=i OÌ\1 ìve íÌall rcl(rn L. lhc lÌìÌrlicrtnnìs oftlÌe dcsign ol lhc utiof
'ìotctâÌ)
ìLrll lcononÌic lnd NJo.ctatv Lrnion' eDtailel the trilrslÜ lo irasl (ìcrman-Í oi aÌl
'11Ìe

\\eÍ CenÌÌan econonÌlc aod lcgaÌ lnslitLúion!. This h.\ had í rtaching jmpÌ1.alions
lo. uÌe transitidÌ lrom ir planncd 1o a ÌìâÌÌiei ecoÌÌonìy ln Last Gcrmiìtl a\ .omfaÌcd
$jtlÌ its ealtenÌ neiShbouú. lsrasassLrmedb)thepoliti.iinsa.dolhcrpolicvnraÌeÌtjn
\Vest Ce!ììdÌ] thât g..crous lÍ:al ttânsIeìs tìoxÌ tlÌe Ìlcs1.oÌìÌrincdsljth the imnrecìiate
etle.tivÈrÌe$ ol Ìegal .nd i.sLllrúio.aÌ ìnfìa\tructure tra.5 cÍcd trom lfest Cennanv
ÌlouldlÌilea\er:-ripdproccsso caLch up lor l.st GcrÌran) . lÌsi.g the Solo! Swan
nÌodel, raplcl crtch up js prdict.Ll il, bv viúüe ol unliì.ation, Last Germàn) acqrireJ
the \dnÌe steaclt stnt. .haract.ristìes as \\iest Cennanv and lhc lpee.l ot cotrvergetrce
ìt ia\t: 1.e thÉÌe are shirpll d Ììinishirg ÌetunÌ\ to llìc ê..utrìulatn)n ofh! iun.ncl
thlricaÌcapìtat ,\s Ì!c slìiÌl 5cc, Ìhc smootÌì tr.ìnsition to ahìglcÌìraìanced gôlth p.rt1Ì
e\ pÌedìcted bvthe Solol! SwanÌrodclontheteassL,nrPlion\,.Ì!.Ìnottaliepliìcc.
\,\ie\t (lernaÌr !o!ernncÌrt iuÌrpoÍ rt!t( the fortì otl

' dir€ct s!bs ies to f rm\ fr! re\tructlunÌil.nd bÌcaÌinii ut uÌe giânt lnlcrl.i5cs ol lhc
pltrÌìed erononrl,
. subri.Ìits ti)Ì in\estnìerÌt in lasl Gcrnanv,
. irNeÍ!ÌÌent iÌì public inüastNctuìe pÍrìe.ts 1o nrodernire the coÌÌnnunl.alio.s,
üansport. poìver, a.d ialer nÌÌtv 5vderÌìs n.d raise the Ìrte oi return to priraLc

. í).ìal sec!riiysyneÌÌr lo ft^ìde PensicÌÌs

sub!idlcs to lhc iJì li'rc iLhU:est(lennaD
tc.sion prcvjsn)n\ and io pit' unempÌo-vmcnt benelìts.
NÍeanwhìÌe 1n Lan Uermafl, lhc c.o.onrl coLlâpsed. Bt Ì 991, GDI' Ln Ea\t Gennan)
: l, Ìnilliorì
tÌlo thüds oìit\ 191J9 Ìcrcì, industÌial outpxt $as nt onc-lhiÌdollhe 1989leveL, an.l
1va5 at
uneìnpÌo) ment had gonc lronr roughÌy 7cr) to à rate of301ld. ilrl!iq5 awose.ìelre$ion
than everpÌevirrn) obsertcd ür an lÌrdustÌialize.lecononìr. LIJ conrparison, nr the (neat
Depre$ionbetweeul92E.ndÌ9-13üÌdustriaÌortp!tirÌCrnÌaflicllbv40!nan.Ì1nthe
USA b) :ì59i,. The teculiaritl oi lhc last GcÌmaD (ase is 1lÌat Ìrì spilc ol lhc catastrrphic

'lifr\(.L1frr.,(.!íÌurLuiai.rilturdiiúlssnrG..nrnuÌriiiritn'ì,rÈÈtunìandSi rrltrrl) Tlrl 5x

!trtr.è n,;drtJ r.Ì,,'ted eÈ.ÌrD*rÌrn úSnrll.rL ,q7ì
706

úan sleÌs honi thc a est lb put

coLlafse ol iIt econ onÌy l iving tta n daÍls Ì!'cre sús tai cdÌr!
in was tirhìgher
ttts lnto nationrl accorLntirg terlns. dolncstic abÍ)rptìon llatt Cerman)
thrn oüllut. l h ere i\'r\ i hugl tr a'le dc n cit a Ìn(nrn tirÌ8 1o 3rnÌe 75olo o1 l'laÍ Lrffnan
i ts
oi f_a\t CcÌÌnrn GDI in
CDl,aÌrd Í;nllers froin Weslto Last(lermarvnnx\Ìnted to 5Oo/'
199Ì.
$h-v dni Lhe e.ononì,v collapse? The miin reaíÌÌs aÌe:
. especiaìl-v nì lhe úa'leabÌcs sector' Ìvas ìevealc't nr bc
extrenrel\ pooÌ lirÌ
productivih,
eltrcìne.ases oulprúNa5 un\âlcable at a pric' closc lo zerc) Fi
. $'aite rotts hãLl to be p.ìid 1Ìì l)M ât the ex'haÌìgc Ìate of 1:1a! onlficaLi(!Ì' an'l
. wages nì l)N1 $'cnt rl âfter oniication' conÌpoundjng thc ma\sì!'c lo$ oi
competiti!eness ot ljast LìcNian Ìrroducer\'

lÌì term\ ol lbe price ol eaport iioods 'Ìu'ìdruÌrÌed-a rcal

suìnrÌìaÌ-v, rcal wages i.
t"'ã^r+,*.iu,i!Ì oí'100li Althouilb the I:1€rchrnselateaÌLtnilìcalionhas
lie ltauco tor last Geínan)\ lor5 oI coÌnPetitivcne'\' the lorcc of this argu
"'.rro"g"
"rten
me tjsweakenedb!tbcfrclthalsatesÍ'erÌt t a1ìcr unlncationr gn'en lhatthcÌÌjijaì
i' íjmc I
c*.trang" ral".reaL" a aìtequilibrìtm tlal requiÌed i lall
irages it 1\ clcaÌ thal
(hngoi;ertÌrânthcinllialpnrit) musthave bccn at1t'orltopuslì age\lntheotPosle
hnf
dÌÌe;;ion Ì h c unì ll catio D op tinÌis Ls l)elie'ecì tÌr et pro'lu 'tn'Ì q 'onlergelÌ'e rl o ül'Ì
found th1\ prtcìi'tion con!'cnìen1 ancì pmnÌiscd
lr".r vcr" fasr; üte p,,ritic^l optortunists \Ì"est Ge nan
i",t C;","ton' tltoi tt"y."oüì.1 onl-\ Sairì ÍÌom unilìcation The poweÍuì by agrceìtÌil to
trn1ons \ought to elirn;nate coÌÌrpctìtion iÌom cìreap eastcrt ÌrÌod!Ìction
Gernan elnpÌo}ers
in".pto.í'*g"*" * Ìla5t to -\{est :
CcÌmarl wagcs aud the wc5r
k)r raÍ
nrpetitiieness
a\soci:tions dü;ot opPo\c this The pc*iÍcn'e oÍ the Loss ol Ì
'o
(,"""^"t .- ,1."f"r" ,r€ 1ra(ed Lo Polilicrl ancl irìÍìt!tÌonal rraÍü\ raLheÌ thrn thc
technl.al'decisìon about th c exch ins€ rnle parit-v'

1.3 West German PolicY resPonse

loÌ th€ Ì.
\\e trtrn lronr tlÌc story of sììât happened in ìraí Gernrani to tìre consecÌucnces
WtcanuseFig ì73
\\est(lennane.ononn'anclÌndirerll-vforlheÌeslofwcsternÌilüÌre
to pÌcsenl e (yliTed pi.turc ol thc staÍi'g PositloÌÌ of Nest GeüÌany
nì Ì9E9: \\iest I

.ì.;nr,,r! Í'45 chara(t(ized bÌ a cutrent accouÌlt surplus atÌd nable |'d ìos'inUation at
<"n âbore BurÌdcsbâÌrk I'a5 pivotal
a positioÌÌ such nt .4 in ììig l7 3 As i{€ havP
thc
West (ìennan)'
nì rhaniting iÌÌtcttst rnles ior the ÊRM ÌÌìenbcr counLrie\: to analvsc
fuÌction of the
*,e n"",ì rn-.re tl 'tatg" econom-Í'niod.ì üì nìrìch lhe.ì1) rlNe
is iì
"
Cc nan lnteresl rate. he unihcatlon stÌo.k to Wcst Gc ÌatÌ! lake\ thc
L
loÌtrÌ ol aÌrosiln e
aggreg.ìtciÌenÌ.nd nÌ,rcksotheÁl)cúÌ\'e shìIt\ to therighta\ íÌoÍìr
iniLiaÌÌvtheintercst
nrâ$ivc nÌ spcndnìg ìn Eâ5t GenÌÌan)
Lii ."mal'".r ,,".r'ang",l Much oÍ the incrcase
b-"'' conÍmeÉ, !rrìn\, an.l go\ ennncnt splìls back to lvcst Cjerman,v lor\\ieÍ Gcnn0nl
'
tlìc netr me.liuÌn rlr t!Ìuilibrnün ú at poiìú li, at hjgher oulput and emPlo'vmerÌ1' a

i! icquüe'L lo
.1úÌeÌú account.lefi.l!, and at lo('cÌ conìFtitivcness A ìeal apPÌeciatio'
pcÌnit.o.stâIrlrntlatlonatl{Ncr!Ìnempl()}nÌcnt Ììro a'liuÍnìent palhs dft'show' in

lnDrrnsnìnlleqll..Lì .r 5
 707

FiguÌe l7.l r',1.5r aerrèr / õ|.!sr q t. G. Íil

the lidgram, Llrc one lìbeÌleclÌrath I enLiils i nominll appre(iaii(Ìì aD.Ì rs â rcsLLÌühe
n€Ìr equilihÌLunì i\ .ìppr)ached lÌom bclolr thÉ l,RU cuÌ!e. lhe no.rìnal aÌrtrc. atir:!Ì
raises Ìeal Nigcs and rem{)vet Ììre jrllatiÒ.irr! pressuÌe r\sociüted wiih the rightff ìabour
aÌket. Thc s.cond pdtir. ÌabelÌed 2, nroNs the lì\el ef,r1ìrÌÌgerate adìrBtmrnL. rnÌcrl: thr
.eal atpÌrcialion occuA lia a peÌ iod.I lìlgher núÌition thdÌ Ìr \rest ceÌ mant\ rradlng

\{e5t(icÌDrinfwìs \itlrate.l ln a lled clch.rnge ratc nrr.nse!Ìent with lts ìrÌgesr lrad-
irÌg paÌtners ând, ir\ note.l abore, thc ERV h.d €ÌÍÉred its'h.r.l'plÌr!e irirh mcnnrc6
deteÌmincd fol lo rerLjgn. A\ x co.sequcn.c p.tlÌ Ì Nis not tik.ÈrÌ: iì it hr.l been, thc
rìì.rcr)economlc de\elopmeÌrt ol \'Vesrc.n rurope nì thr 1990s nriilht ha\e been !eN
.liliercnt. lo 5.. ì!hv, consider th. .onscqu(.rì.e\ .)l p,rth 2r hislÌer ri<i{Ìegate derÌand
ìD \\icsl !ìcnlinr clÌi\,er outÌÌú â.d cmpÌoyÌÌÌlnt up ind briÌÌgs \!ith ir inUationrN
tressurc (LlÌc econom\ j! rbolc Lhc l/i! .rr\e). lh.rr is also \onÌ€ eÌidence tìrat rÌre
IlÜ cuÁc íritÌld n) dre Ìeti ar rhis riÌìc Ìrc..usr Wcn {ìcrrnan ÌrorleL $eÌe uniriÌl
ìng lo a.ccpt the hjgheÌ ra\er imtosed o. tlÌ.nÌ as lh( 'rcunjlì.ation (harile'.s A\
Ì!e hr\.. sccn ln ClÌapter 1. a Ìi\e i. taxârlor slÌllts Lhc /:,kl to (lc lclt ând era...rtrrte\
the in laLlonary pre$uÌe. A ìi\e iìr i.Ílrtion occuÍrcd n.d lcd th( Llundesbanl to iÌìteÌ
lere a.cordlng to it\ rnonetar! poìic) Ì uk ând raisc rhc i.tcr(\r .iÌl!. h js danperÌel tlie
boonr i. W(n Cexranv ílD \hitts lelr, bc.ausi. wcsl GÜmarìl scts lhc r\orld'iltere\t
Ìat. loÌ (hr irR\/l(ountrjes a5 irclì es.lhcÍ luropriìn countrics tlÌat t.rgeted the D\l).
ThLs had nìportânt c(Ìrrequencer ftrr rhc li\t ol thr lNÌvl, t! Ìrhi.h \!r.€tunr n! the neat

Ìi L:lclìanse irir reaììgnÌÌenl hrd bccn perrÌÌitt€d, lh€n WeÍ CenlarÌv couÌcl hale
rdÈbrcd lo tlÌe slÌocÌ( úa a.oÌnjrâÌ atprcciation ol thc D\i:tlìis would hü\ e.laÌnÌre.e.l
ì.Ílâhonan' pre\sxÌe at nLlìuÍmc.t ro llìc ne\! nìedlLurì nuì equilibrnru Ìlould hrre
talien pÌa.c fronì LrelorL the InLi currc {Pnth 11. \!lÌr \!.rs er.hrlile rate iealignment
ÌuÌe.Ì out? Lt s(rrrìs tlìdt dre odrer ER\,Í nr c Dtrcr .ou rÌirlrs rlrre uÌìsilliÌÌit to counrena.ce
a Ìerâluition olthe DNÍ withnr thr lR\1 Lhis rlcÌrld hil'c i plied â devdÌuation oltheir
cuÌÌtn.lc5 agiìrÌÍ the DI,J. Hali.g ln.urrcd hea!! LlnenÌplovnÌent cost5 1n r.qujriDg a
Ìefuretion for 'antl infhrion cÌedlbiÌlLJ'!1.r .r li\eci e\.hanire raie, the \ ìew ir I numhcÌ
of Lurcl)L:an.lrntr.rL banks ar.Ì go!.mÌìcnt\ \!,r\ uÌat lÌârd trorÌ Ìetutati{)n5 h()uÌd bc it
stakc jIa rcahnment oc.uírÌ1.
 lr,(rll

Figure'17.4 F.í ERn.o!Ì ê: a.d the

B!..r!baf [ à]ter Gal'1Ll

1.4 The collapse of the ERM

lìor a llpl.al non GcrÌÌìin llÌlt1 corurtr,v, the i.irÌaì position in 1989 can bc slìoh1Ì nì
lìig. l7..1. lhc.oorlry js irÌ the phrte ol .ìi\ìrÍlation ís.e poiú.4 ìn ìrig. ì7.i1) Nilh
tnlÌÌrÌit infliìtion.Ììd ('ilh (menlrlovment âbove thc rnediLrnì run equìljbÌium. Whcn the
lundesb.ÌÌkr.ised the interest Ìate. the otheÌ LRI\I .oLrnúies hadto fítìow sutl tn ordcrto
kccp thclr.rchângc rati\ ìvithln the na ÌNbands. lh.dseirrheintercstrarcisslìoÌ\'n
inliig.Ìl..1.sil€itlr'ar.lshiftolthe.ltcurverincccn.hnon{jermânlRMcounrflrakes
thc Gcrman irÍ€resl ralc âs Siven Thì5 cììo\e ouqrut doÍÌì ancl Ìaìsed uncmllovrncnr
luíhcr (palh 1), which as politicaÌly ünpopurar.
'l'hc pos,lion ln h'hi.h tlìe .ountúe5 ìn the ER\{ (apart tÌoÌn ceìmar}) tou.rl rhcnì
srÌtcs ììcs bchjnd onc c{planatlon lor the colÌats. ot the ]jÌÌM in 1992. It ìs oÌrvious ironì
rhc diagram lhat nn cxchange rate depÌecìatìon (talh 2) lor à í) caìlcd rcn,tRM co!ntr]
hould lrÌproÍc its p$lorrnânce Ìeìatì\Ìe to path 1. r\ depreciatjon I'ouÌd rfirct â swilÌ
inìtrorüì.rìt in corrpctltilenesr, whìch aouìd Ícm tlÌe Ììse 1n úncmplornìent. Cilen
ürâr lhc ìnllial posjlion lor tlÌe\e economles nas bclo$ tÌÌe IIìLi currc (tÌìe o!tcome of
the painlulpcriod oldisÌr1ÍÌ.tiürl, theìe was scoÌrc ior this n) be non-inllationirr] 5ÌÌce a
.]epÌeciation cvcnil.olapprovedofddrt bl a rcst l-Ìì\Í ijovenìrncnr appedA ben
ehciaÌ .Ì /Ìrsr, this is ÍicNcd as otre í)uce ol spectrlitnÌÌ nÌ the forcign crchinge maÌker
jtÌ 1992 againí somc ol lhc lRNl rrember cuüeDcics.lf lentimenr in the mnrket take5 the
view that a gorcr.mcnl i\'orld noi be Lnrhâptv ta rr-n ivÌh a dcprccj.ticÌÌ, a sÌrecuÌatirÊ
attackcanbcsucccssÍúì. hisis ü ca\eolsÌreculationdriven bysellluÌfrlljrÌil eÌpectations.i
An ertìanalion aìong these iines has bcen úscd to accolrnL or the succe\srtÌ a acki
oD the pound stffli.g, thc ÌtâLian Ììre, and Lhc SpaÌìish Ìrescta tn 19ir2. (ìre counlrt lhat
lucce$frìÌlv.lc cndcd iLs p.rit) in the la.c oIaLta.k was Iìancc-.onÊnning the dcfrh ot
the lÌeìrch ÌÊsolvc nol lo take rehrge ìn devaìuaLion.
This anaìÍtjs s uggeís Lh ai the 1ìxed e\ch ângc .are arran ge m cn t ot re ERtrÍ r!as s u..css
lul $hjlrt the m.nrìrcrr nrar€d d common poÌìc), goül: the achicverÌÌent ot Ìon inlta|orÌ.
Howe\ er, the asYmmctri. slÌocl of GeÌmân unilìcâtion nreânt ilÌât re iìrreÌcsts oI tlÌe
eÌnber dneÌgcd and IailLrr€ to agÌee on hoh'1he costs ofadiuÍment \houìd bc sìÌared
!ìdennlned rhe rxchangc rate syrtem. As nolcd eìrlìeì, rhc speclìlat1\e atrâcks orÌ tlÌe

'IoL ìrntÈ.êÌúìgrLtrrusÍri.inrjii55úeeê LnlLen!Ír,nrndrf\0Ìrx/lt9!j);!Ìso ìdÀarLdl..ryi\(l9,rlj

 709

ÍÍ llìli1 cuÌr,n. !r rcrc i..iliúted Ì| the ab(titi(rr ol c(rrÌrt\ ôn .et Lil llor{s. ilÌi\
tool plìce j. th. .ontc\l oi th. .hdÌge i. policr aÌrcì inrtiÌutio.rl arrn.g!.Drnls nsso(i
ited $ith tÌrr inrplüìcnLirtion oi tlÌe lìÌìgÌe EuÌ(Ì)ea.I4a (ct I,r)gÌiìnrÌÌìc (1hc so crìLle.t
,-4, tq92 pìogrâmmc laun.h.d irÌ Ì966).
,\ furrllng ft:alrLrc sur u,rdirÌ8 uÌr..Ìlafse olthe FRivI is rhc tLnring Ò th( tr!.r!hti\e
.Llt.'(l\. ()Ie hltothrris is lh.rt the piece ot ncÌ15 thrt sÌrâÌÌit.l oiI Llìc nl Í! ÌillnÌg .tt! (lt
ni the Dari\h lolr n!.lnst tlÌe \l.lastìicht ÌefereÌìdunr en.loÌ5jrg L)anlsh nÌcnÌbrrnì4)
oluÌepnÌ!\d.onÌnoncuÍln.aÌer.Thc1.lÉai\thatthis\oreDranLrh.lthrpoliticrl
.oÍJ d\to.jalcd rt lr in rì.trlÌì!. úte (haÌìge irÌ one ot rhe couDLrjr! was n.n'lotrÊr
bcrlu\e the No !otc siÃfilkd increased uìrceúaiÌrt\ rbout the euÌo trJlc.:1. Hcn.c:lo!
rrnrÌÌenti $otrl{Ì h. sonrcNhlL css .on(eirÌed rtr!üt ax e\clÌaÌrse rate chr.gc. lt .rn br
.ìrRued drnt tÌris op.f cd 1Ìrc r\a\ ior a sÌìeculdti\e rtt.(1.

1.5 The UK economy aÍter the ERIVI

'llì. !.rjt oi 1lÌe |ound rterÌiDg inÌn rhc llR\1 wa\ o.r oi rhr nr.sL 5Ìrf.1i.Ìrlar ( pjsodes
in LÌrc rì!e ol \Ì)ecuÌatioÌ1 \urnur.Ìjfg Ìhc l- R\Í iÌr lhr, atrtunìf oI Ì.r!2, Bc orr {unlirÌ!
Lo Lhc lRll Ì)eúr . it ir Lúetul n) rliet.lr bÌlclv thc I'K\ exteri.f.. n'ith e\a.ict!ol
nì.fctar) poLic\ ti{nnes IiS. I I 5 rho$ Lh.: (liileÌert monetrÌ\'Ìrginrcs i. of.rât .n ir
Lhc L:K sin.c tlÌe eaÌl\ 19i{\.
lnllÌcÌ9;llJ.ÌnonetaìrtoÌj(\r!d\ÌaÌgcìrr..oDmi aiingan.l lnlonr\foÌicr'ralh.r
Llrin nìüìet.r\ poli.r ÌlairieNeda\theinst melttodeeÌirìth thehigb ÌnílarLon ftnlo
ln.{ lhr 1ìr!t oiL \luk iÌì 197.1. IÌì I9:9 \ÍaÌgaÌctThatche. Ì)ecrme lÌime \Íi.i\tcr an.l bcr
.{o!r lÌlìent iÌúÌ ( LÌ.edaIaÌìtì iÌìuahonar! D(Detar) toÌic) ÌeteÌìecltt)xrthe\iediunl
lrnn lijrÌiìn(ial Shateg). Ì!hìch tl)!u\e.l on taÌgetìÌrg the gÍ^\th (ú tlìe nìoÌrev nÌÌn\'.

19iJ 1!'5lti: l!r79 rtsl lt6: la85 r9s rts!l9rl l993lt95lt9tlrr!9204r 204.1

FiguÍe 17-5 F-.Lì I .: I r;i.. LidèÌ | t:rÊii |r Êrdl rÈ. m.r r thÊ l(
710

l,"l

,a,,
l
Ì20

110
\J

ull
t\ .\IÌpre.iatnlr .doPlnrn.tÌi3hL.ì.n0Ìa+
\lrdl!rÌ Icm linã.cirl Slril.S
qdi.t urlrÌ

19i5 19 i7 r,rit lq8ì llrsl 191i5 llr8i 19s9 Ì9rl lq93 l9'r5 Ì9lri Ì999 20iJÌ 201)J

FiguÍê17.6 rÊ ri e!.far!: raie r:h.LrK '!75 20:'-:ÍÊ.n!.!ri.L.tr.cn5 nràiLïi'tLrrr!

r:e rirèa apfr..;l.l

'lhe .leclúìc in itúÌalior was lrlggered bI a rhriJr nÌrfleclatioÌÌ ol lhe pourÌd slcrlüril ir1
ì 9 80 Van-\' econonì lstt ri.r'cd the erch aniie ratL elll reciati.nÌ as a case oì ex'h
ange ii tc
q loÌ an eaplanation oI Lhc mech.rnics oÍ oler\hootingl: thc
oleìsÌrcoting r\ee Chapter
combirÌaLlon ìcircìgn erchangc marÌ(et to thc tightenilrg of mon
ol.ipid Ìea.tlon in the
ctart poÌi!1 coÌnbiÌrtd $'Ilth sÌugginÌ adiústment oi ilagÊ\. lri.r\, i'd outÌÌú on the real
si.lerenrll.dlnarÌoÌìììralandrcrlâppir'.lati{!Ìmú.hìargerthìnc.rpcctedrleeÌrlg'176)'
A5 a corìsc.ÌLìen.., uneq)Ìo-vment nÍn uÌr a\ íÌoifÌr in ì:ig l7.;..\s dìscu$ed i'r Chap
teÌ ll, monc\ sxplrlv tarilet j.g irxs regardcd.\ â f ailulc
jn the UK bccaute ol thc rtnf re
.Ìicttìbir bcha\icÌrr otnrolrc\.aggregates (:Ìrecialh at a lime ol Êunncialsccn)Ì iÌÌìoratlorÌ
jn
anl dclcgtrÌation. !hìt led Lo thr adoptiorì of arÌ ex.hense ìate tür8.t a peú)d in 1thìch
tlÌe t\.ursrhnÌ.rrk a\ slìadoite.Ì. and thcn n) ollìclal rRNÍ merì\bersÌrip in 1990.
'ÌlÌc .ìit ol thc Poudd s{cli.g lÌom the LllNl 1!a! !eÌ) co\tLt lor tbe CrÌÌsctr'atì\e
go!ernnìent iÌì politilaL tcíÌs but frovldc.l a $cll linr.d boott to thc Ìlritish ecr:)fonr\ '
llÌc LrK hal l.botred undcr r !e ln.onrpetitiçc c\chânge rate slf.e it entcrcd the
ElìN1 ln 1990. 1hc cxlt lrom thc LRM âmornrted to n shaìr .1etre(iâtion of the effe.th e
nomlf aÌ erclÌa nÂc rate.]\s.nn be reeÌì in !ig 17 6, thr inìlÌorenerÌtin conTetitirencÍ
üasmaj.tairÌedlnrealli'rÌrs,rLhlclÌrÌìcansthrtth(inìfactolthed.p(.iâti{!ÌÌ\.snot
LrpidÌ-\' er{led b,! inilationiìÌv$'aiie clairns There .rc a lr unrbeÌ olrerÍrìs I(Ìtheü!1cd
reslonst ol iÌìllnLìon at t,ìis tinre. itiÌi.ll nrc corÌ\istfrÌt $ilb tÌre Ìì!cro nrodel:
(11 L..cnrÌ)lolmc.t continucd lo Ìi\e lor hlo ) e?Ìs (1e92 and 199.ììü1Ìer thc bottunÌ ol
tlìc eâÌÌ) 19(105 tecessi!Ìl.
i2) The ÌÌrajor .haxgcs L{) the nrppltsde in thf L.K stt in motionìrì 1lìc 191ì(\ griduâ]l!
ted throrrgh arÌd bcgrn to e\en n. a.ti irúlallonarv ettect. llÌc sutth \id€ rclorrn5
corÌÌrÌiscd Ìneanìrc5 to ìedu(e unlon barg.ììnlng ll.n!eÌ rLìnion mcdìbernrip l!'lÌ
 711

trl tnìn Pt
-ì Í'li,I [Íì
LL ri I r
1:

':l 2r

r. rrr
I
I f,

t:
tíl J.:...*..ri.." é f.' .ì".."..'f .ì C +s..!."
Figure 17,7 u( nf al !r ir.r ursiÊ ltÌre Ì 97:t i0:.1

ftonr 5I0.1) fl980ro.l.r1[inl990;the.otrrai]eolunio.wagcagree!ìenr!tclltronl

;00/. n) ll)!n iiÌ the seÌìr period; davs ìosl ln stÌiÌ(et Ì)ei l,00u cmployee5 ir aÌl
irÌftLtÌtri lunÌtÍed ÍÌonÌ 52J iÌr 1980 Lo lJo jrr 1989)r ând thc gcnetujjrr.I
unempìolment be.cìts Ìiis reduce.i lLhc repÌacement ÌirLô rlìiro|r )60t, ro
120,|.rn (ìivrn rhar rhc lrganirati(Ìì otirite seftjrg iI thc Ll( nthepreÌet(rnì
perir ira\ gcnerâÌlv i.krÌo$ledge.l nr hc !rr\ urÌcooÌreÌatj!c ind to pÍxìu.e a lìtgh
! jdr merk up. drt c lf .t ol boür hboúÌ nìarter àn(ì benent Ìcl.íns trìs tiÌ(ÈÌ_y ro
hilve \hiIt(d the llegc-scrtinit ct^ e d(nrnnì.(is
í3) \'lodd price\ oI.oonÌuììtleircrc aÌlnìil, rlhich hclfcd oflsetthe etiecr ot Lhc
dep.cci.tjiÌ on Lhc doDrettic curÌcncl pÌice Ìs rl iD thc L!(.

.\s!!ehâ!( seernrÌhcnÌodel,adepÌrciiliiÌì\trinstheeconoür).rapjdh alofgan:U)

.!r!e t. rhc north easl arÌd il at thÉ 5rnì!r iiÌÌÌe rhe E,tLr ctrÌlc dritt\ to the rtglrl is r
coniequcn.colttreieedlÌÌSthrougholsutpl\\nìeretuÌmr,rrth.c.onoÌubenctlstronl
.ì period oI nln üúÌrLioniìr) il(trlth. lor lhe LK, ìt can bc saÌd th.t üÌe tjnrtfg of t1ìe
colhpse o I tÌr. llÌNi irâs I ortu itour.
'Ìhe secofd h.lloithc lr90\ ttÌrrgh 10
lhc cìrh. veaA oI rhc n.Í .üÌtLìÌy sxir thc nÌ!\t
sr..eníìÌ p!:riod ot maoleconomic peúornince f(, the U( iD the pon war cri llÌe
Ììost Írilii.g Ícature n'as lhe de.LirÌe in uncmplo\ nrenr i. thc larr ot L(rí i.nation (s.Èe
L ig. 1t./1. Thc Jr8urnent Lhat suppj\ \i.lr rcloxÌr ìn the contcrl
of i \en\ìble tÌaÌr.ìÌorti
Iü nÌacr)ccnnomi( poli.r iì(counts ftrr ltÌ,: sLìitrined lalÌ i. unenlto\1ÌL:nr r!ithout
Lr()Li)r,ìtJi,r'tr'rrrÌ,iorir2rJ|lt,i.hi,.ll;SrLjted;tJnrnìtr,frrlrul1;r1rr,\r.rr..Ì9tlt)elrÌrrr
rrliÌrrsÈlrld.arifriorol tr,jrÌrnvr{ì.renÌ r\frd:ir.aÌLri!..1ÌtJrririfln!.Ì.ji?a_:ÍLìrd r.rDin
112

Figure 17.8 L< í m :,qi r!rÊtr 5.. . rÌrL I!r.ir:rs

FìguÌe 17.9 trK t,rrì' !!r i!:r-ê:,rt!. : Ìr rir 5h í- r..tiÈj l

rislngìÌrtÌltion1ronr l99; (.n b. Lllu\tÌatecl iÌì li8 I7 8 Theelorurì\ begins n Ì996 l

ât â point lìlr.l lLllh Lra.1e balani: a.(Ì inÍÌatnÌr.i abt)trt ìhe ÌeleÌol lts tradln pêrtntrs
frnÌmnrs 11Ì.rt th. ÃlU ilÌilts L. lhe rjgÌrÌ d!t t! th. nÌÌ]Ì\ tlde Ìelonn\, tlÌc (rofon\
lliÌÌ erÌ)eÌiencc âlli.g urÌenìtÌol ment aÌLl iÌúl.rllon beÌo$ 1tt conÌPetitrir\ i5 sÌro n
Note 1lì.rt iì..ordi.g n) tlìis hlÌìothc\ì5. tht.lÌanrcl t(Ìtlrt \uÌrÌrl\ sille ref.nìs 1o drjre rl.
ut ortlÌrt i51hr.lgh theìr i.ìtict ot the real eÌ.hi.gc Ìate xnd Ììet e\tort\. llÌc.urent
account úì!ro\ c\ \teadiL]
Ìlorerer, il is oÌ\ious lrom the data nÌ Li! 17 fi lhaÌ there i5 r protrlenÌ Ì!i1lì Lhis
r\ tlÌe \oLc rìfhn.Ìti(Ìì be.auí'of thÉ behariour oi tht Ìerl er.haISe rate. L(Ìn Ì 99;,
there ,r.r\ iÌ largc rerÌ apprc.iilion. dÌi\en b\ nn ,ìppÌ.ciaLio. of the ,rrìnLrl e\.hing.
rate. Yrl n..oÌdi.g to tlie purc suttÌv rnìe rei.ìIÌì s1.Ìl , lhe Ìerì exrhanle rtìte slìould b.
deprc.li1lng._LÌ)jÌhútr.ìtethi\Ìroint.letrìtcoÌìsidrri.onrtletel)dillerenthlpothcsisL.
iì.roufLÍôr lalìint rn€rrìplortrcÌrÌ ar Dule\tiflaLj(tr.IoÌthe\rÌieoithìseranìp1..
\!pp.Ír thaL rìre mpplt r dc kDdiI\unclÌarrlcd buL theìe is r b(!nÌ iI agtsrelite drrnarìd
re.g i rofsunÌrtì(Ìr booml. ln a iÌdtirÌ! e\.Iìingc Ìxre ÌegiÌne. thú Ìroltl ]e.d to il
rìonr niÌ rÌrtìclirtiuÌ Oi(h lì ìÌr lìir 17.9 tolktrlcd bl rdìuitnent al(Ìrs uÌe netr'.Ì/-)
.Ì rlc rrllh ìos intl.rtion rPrth 2). lÌÌe e(ono!n-! c.(Ì\ ut \Ìith lo\!er urÌenÌlto)mrnl, i
rr,rl cr.lìiì.gc rate aptireciillôn, end I sealier.rtrÍnrl balâ.ct. i..
 713

As lhc di.rgranìt \ho(,, b.)th s.enaúix aÌt .:oÌlslsrcnr Ì\'it1ì tlÌ€ corÌÌÌ)inarion o alting
unemdorrÌÌiÌìt aÌìd Ìo(r lnlÌaiion. Yet thev jmpll.!.rJ dilfi.rcnt o tcoÌne5 ft) r Ìcaì rlagcs,
the rcaÌ rxch.ìnge iâtc, irnd i.Ì tlÌe üa.le baìan.c. 1n rhe tuÍ sceÌúÌlo. Ìlal Nages
declinc, thr Ìeal exchen.q€ rate depieciatc\. êÌÌd the trade batüÌce nìpÌorc5. lrÌ ihe
\econd onc, reaL i{agc5 rise, the real e\chargc r.1i. appre.iat€s, âÌìd rìre tÌadc bitrnc.È

Do cither ot the5e slvÌized pntures Êr tÌrc UK's eÌpernìì(e? A\ líe hâ\,e sc.n, lhr tìAt
c. csponds pooÌlv llilh tlÌe behalnD oI rlrc nonÌinal .nd Ìedl eìchangc rnlc. lhe
second cntail\ .r ìeaÌ appreciation but ignoÌcs lhc sLrppÌt s € retì)rnr aD.Ì rcsti on thc
ettcd ol an erogert)rrs aglregate dernan.Ì boodr prod!cing i nonÌjrúl apprc.iâ|on lji
a Ìisc ln thr.iomesrL. intere\t rrte (as ì. thc snìall opcn rconom) Mun.ÌeÌl lìcmtfg
nÌ)dcl). n.clditirìr, is (re h.\'e alrerd\ notrd jn rcÌntion to rlÌe hrÍ h\pothc\t!, lhc
i(lca lh.t ouq)ut grú1h ni]s dri\eÌì l)\, Ìi\jng cornpúlivcnrss (patli 2 ilr Iìg. 17.9) is
al odds l1ith dìe la.ls. loi ÌÌìo\t ol the periôd, LrK inÍlnti.!Ì r!.r\ sli8lrtll abore rhar
oI ils tradirÌS taÌlÌrfts llhere tlÌe Ìúlation ratc was also on, dedirÌjÌrg tÌeD.Ì. But
thcrc ìs \oÌne tÌutÌr rÌ tlÌe notiür that cons(lmrr bthrv]orr w.\ aÌÌ ÌnÌroÌtarr frÌr oI
lhc poÍ 199; g(r\,1h plÌate. üie trisgeÌ toÌ a.oÌìsomptiüÌ boonÌ Ìlrs windriÌl gairi
lo coiÌsurìÌers .lue Lo .hiniie! iÌi the hnan.ial si..lor ic.g. dlnìutu.ìLiz.ìtldr ol buiÌ.ÌÌng
Ír.ìrtiesl; rs the rlock Ìì.rrket d ÌerÌ estarc Ìroom Look hold this probaÌ)Ll' ìed con
sunìrr\ to \ iew thcir Í'l:altlÌ âs lÌigher rncì to Klrr.c 5evinss. 1|c.oÌìsuüptidr boom
sla.k!n..d, prìÌnic cxÌrcrÌditure tool oyeÌ nr mainlni.i.A llìc^sgroúh of denian.l. The
LibouÌ iloleDmcnL Nis.rble to conlLi.late thc ÌrLrÌrlic fnancc! durìn!.r periúlofÍnrLt
prilrte sectoÌ gÌoÌlLh lì its hLt tenÌ, whlclr Salc it thr scotc, r'ithiÌì its frscal ruÌes
(see ChafteÌ 6) lo ntroduce rüjo. pubÌ1c exlcndil(].c progrimÍr$ in its se(ond rerm
lrorÌÌ2001.
Lvnrg behiDd lrlg. Ì1.9 is tlÌe smrlÌ open .co.om_r Drod.l in hi.h ad .ìppre(iation
lollowini{ â tositllc'15 sho(li'ruch a! a con{ÌìpLion hoom ls causcd bJ. ris€ in tlÌe
doüìerti( ì.tcrcst ral. relâtive to the 1!orÌ.Ì iDtffcsr ÌaLc. H.i{.r.Ì lÌoÌr lr9l, t1Ìe LrÌ(
hâd?nirÍlâtjonLirgctiÌìgreiliÌÌìe,withtheNa.kôiF.ngÌandusLngaIivlort)pcRule
to rclju\t ihe rate. lt râi\ed rlÌe iÌrreìesr Ìarc ìn 199; bur ir is unlikcl,! tlÌat 1lÌis
'nrcÌ.51
(dÌ a(count fulÌr Ior t1ìe lrppieciati(lr oi the noÌì i.âl cx.ha.gc ratc. As Ì!c have nres\ec1
thurghout our dìs.us\i(Ìì of the ofen economl, cconorìi. cxpÌi..tion\ ol e\clÌ!DSe
Ì.Lte ino\eme.li arc p.ìor. (ÌÌe hrúheÌ changc lo lhc LJK r.ono.ìJ that ìs reLe!ü!t ni
nonÌjÌraÌexchrnilcritebehaviúrriÌrthepeÌiodtuomthctrìjdì'r9üisrheenÌergenceoi
erport stÌe.gtìr i. knoÌÌLedge br\e.l \eìvices srr.h as banking, llnanccl .oÌÌnÌltirìS, and
otlÌer bu\ì.t$ Í:n i..s.Lr Thit he\\ to expìaj. thc limtlcd dúcr orntion ol rlÌe curenr
rìcco!ntl)alan.ci.thclìceolthelaÌgeÌealaptrc.iatio..SLr.lìaslrltin!Ìportcapabilit\
1a ri\e iÌr net exforts at ü ili\en real eìchangc ralc) ls rcprcsco((d ìn tlÌe rÌodel b) a
rightÌlaicl shi ft o t tlrclI.u e!rÌdÌnarhelptoa..o!.1lorlhcnomlniìlappieciatn)n.ll
Ì\o conÌbireth. ãggrcg.te deuÌancl, rpflv sidc, and 19l sÌrjirsasinÌig. lt.iil,irehave
t1ìe elements hrâ svÍerÌÌrti. con\icìeÌatìon ollhcdriving iorccs brhirxl tlÌe elohúj(D ol
the Brltish economÍs]Ìì(e the nid 19905.

r:1.ÌrnirtrÌ.ínI.dalú\oiir.(rrrgìng\nurLur..trlreLr(laÌm.É.it)a\rÌÉrú\nrrnnrniririon,l
peLjpr.!\er,\!.R.rir!mfu (:.utt\i2ro1,
Figurê 17.10 tl< rôm 1997 srirhÊ1. hYioÌlr:rs

lnilntlon (Clrlr ql fr .
'" u nrieìnrrl.diTed ril -(ir)!q;f
l -
a

"r]

1996 199: Ì9r3 1999l0íJ0 2a0l 20112 :Ìr0.r

2)

Fìgure 17,11 Gdr.rnv qrÒtth, .rner p ovn. n and nl :l'r rq9! 2'J04

1.6 Longer-term eÍÍects on Germany

l hr dÌâmr oI (lemìan uÌìificalion s'as inrltscd Í(Ì \\eÍ a'd Erst Gc rmrÌì)' scP!ÌaÌiì-ï'
n,,Lhoi{ lid the Cernìan econôÌnva!.n cntit! lookasthe 1'r90slro'ecdedl forGerni'rrv
thc (rni1ìcallon ÌJoom i\.rs rapi.Lly rcÌììacecl b-ï a nrary rrcc$i(lr iIÌ Ì993 1!Ì lhc decadc
l.ôm 19!r+.lheeconomvÊÍc\!noivltntarouÌrd I 10/ô p â lhceuìoroncasawhoìcgre$'nt
2 l.,ir lhe reccssi{ÌÌ Ì!as larÌÌv th. outcornc olthe rÌaturaÌ uriliÌìd i' g olthr cxiraoÍ_
Ìr.a.
i " ,u r''' ',r 'rrr;"Irr'r 'r' l

clÌscLÌsred carlier. Unenìplo-v-mcnt renrni.e.l ÍubbornÌ\ lÌìgh th(Dghorú

tìre de'Âde and
ìiì latn!ÌaÍlcÌperki.giÌì 1992rt 50.ifcllloclo$ tozercLrt Ii98llit 17'lIl'lhcnoninì'l
pÌe
ex.hanse rate apprccìat€d b-ï iìboui2Lì1h iÌolÌÌ Ì99I to 1995liìs othertradiniap'nncÚ
vìoun! 1ÌÌ thc LltÌ'J c\teri€n.cd .lepr(ieti ons) | lhcÌe Ìlas ÌÌ11ìc mo\enrcnt in thc second
 Ittl
.ttilt.n {ìF\iÌ:ì

figure t7,12 uff..6-êrnanj, i99!.

IoÌ th.licfiniìn econoDr!isâ Ìlhole. unincntio. (prcscnrcd i neitìii!e e\teìnaÌ úi.lr

\ho.Ì, 1Ììc crpoÌt (apabililv oithe eisteÍr paìtiras rÌrÍ.rnchlo\!liven the Ìe{Ì$agc Ìhal
cnrcÌgcd is pirÍ olthe toliti.al settleÌrÌÈnt. ÌÌeDc. Lhc cconoÌìl h.d ir n..Ì! regirI r,ilh i
hugcrìl.rnildelìcitlnÌìiil.Ìt.12.thi\i\shoÌlnbr',tlìcÌrl$! dslÌiltirÌLroththe.lDând
ÃT .:urrcs Ì\.1oreo!er, LhL: loìr (.rpit:ìL stocli per lasr (ìJnran rlorkcr nnples a negetilc
frodLLclivit! íÌocÌt nÌ rf \: CrxrìdrÌ e(orr)mv as a (lroÌc. i o 1|c rxtenr t1ì.ìt wai{e cÌaiÌns
wocfolrÌoderdtednrrh.ÌiithtoluÌis.tÌÌeE,RLi. trcsÌriÍilctL. lhisnas c\.ì.eÌÌ)ate.t bv
lhr add llon.ìL t.ì\es así.iitcd ÌliuÌ urÌilìcdti(rr rrlììclì el ìcasl i(ì thc \lÌ!ú ten! ilere
rc!i5l(d Lrr \\est GeÌmrn $orleb. lhe Íldenlng l.dÜal go!.cíìmcnt drtì.it.ì$ociated
1!llh unii..ti.Ìr is Ì1keÌvalso to lÌ: re pi!cluc ecl x.Ìorin I'a Ìd Ìcrislon br.onnrnÌers olthen
N!'altÌì: is the de(adc pÌoc.rded, th.È visjdr ol last GríìiÌn! is i prclìliblc 'irÌ\ estnient
proi..t' r€ceded. Thi\ li problblr part ol the exltÌa.eli.n Ior dcfrcss(d c.rÌììrnÌptioD
crpcdditLrre iÌÌ (;ermanÍ wlÌen con\iaered nisether, Oìcsc co.scqucnccs ol rLnitì.ation
n.ìount to a leseti\e rxLlrn.l sLìppLv side nrccÌ( foÌ G.Ìmari and trclldc i m,ìrkr,d
corÌ1ràst 1\ ith the f(Ìrunc5 oluÌe tÌK oler the rame p.riod.
ln.ontr.Ítr)ynneeaÌÌrprr!:licli.nrs.airpidÌrn)ducrnitrcaLchufrobÌtfgth(nìppl)
ildc ol l]in Cennan\ ut lo i l€Ì e1 comp,r rd ble \!ìth thc irtst hrs nor LrÌicr pla.c. ln th!
Ia.c ol a nesrti! e e\tcmiì sLrpplv rjde nÌ,ìcl, nr (r..Ìcr Lr unoìflovrÌcn1 Lo dcclnìe irÌ.1
suÍ.inable Ì!av, tht l:iìlr cur!e xNÍ be shitted t! thc I ght {es sÌroÌ!n bt thc t.quirea'
/lU.unenÌfis.17.121 JnotlÌerÌÌo s.süpplv\ideinrfÌotcrìcntsircÌcqrrlrcdt!enrble
Gcrnì.Ìr) to oÌ erc.mr thc Ìe8ac) ol lniÊcrtion. GcrÌranr .rcds a rciìÌ dc!rc.ìiticÌÌ \Í
ìì-t s i(s miìiÌì irrding faÌt.rrs, man\ ollllÌonì aÌe Ìnsidc Lhc cúrczonc. Rcal r'ises nìLr\t
bc.u( rulati\e to pn).Ìu.LlvÌt) to brnìij aÌrout a ÌeâÌ.1.plcctaLton l rnar bc mok ditìcult
1o a.hlc!. r Ìeal cÌeÌrÌc.iilion slÌen a noDrnraÌ defrcciaLion is .ol arail.ìble to use in
conl('n.tion $ith dnì, rtrlttìr side relonx. ArÌ addih.naì di !lcuìÌ1. 5 thal ilthoush Lolíer
i. nil ion in CernÌaÌì\'i! Ìcquircd to achievr a ìeaÌ dqrrc.iâLt.nj loNÜ ccnì.n irúlatirlr
inrldc lhr eurozone inrfljcs.ì rijro Ìeal inteÌest.elc i. (nrfÌìiìnr than iÌì rtre otheì
nn Drbc15. r\ lÌislÌrÌ Ìeal Lnlcrcst r!te silL clanÌrer in|rsrmcnl n.il orÌì.r iÌÌere5t len\itì!e
sp!.ding. depre$ing rhc o!er.ìLl lereL ol rctn,ltv. \!c slìiìll rcr!Ín io the pÍntenrs of
achicrlrgtlÌeÌecÌuìÌediçagcrenrrnúsithinanrJnclarl!nioointhrnert\ectÌon
Hos,cvrr. ! balanced dlitnotjs ol the cuDe.t nrnknrss ol tlÌe Cenxan eco.om_Ì
req tri rcs atteniion a lÍ) to ÌÌr .lrirÌ!n to the fer\i rten tll dcprrsscd ire ol íld, rr j /ir aggÌ egetc
s I

.Ìcúrând. R€Lìti\e to orhcr rullJzoÌÌe ecoromics nft eaporrs hile pedoÌme.l rLeÌl Ln
 Tãbìe 17,3 a.nir h!ì !ìr oi d.rtstt..r.. rìd a rd r.
.rt:-.a ba ar.. r. GLrP !r.ÌNÌ ì Éurc:.nÊ l,!15 2!Ú5

R.' CDP Don61. dêìãnd Erthâlbaài.ê

(n:ÌmarÌ!, suggeitúÌg lhat tlÌcÍc has bern í)nre turnaro(r.d úr tÌìe lÍrPrci ol unilrca
1io. oÌì €rpoÍjDg ..pacit) . ,\s I abìc 1; J iiÌLrLÌatet. Ccrma.I'5 ìoü gronlb 15 conÌparcd
i{irh other crü)zorÌf ccorÌlrÌÌlics is r\Írciatcd llith a strong contübutjo' of net cxpÔrts
afdanextr(nreÌl Ì!eaklorÌtribuliot oldomrstic delÌÌand \\iith it\ sp.ciiììiTatidÌ in 'at
itaÌ gtr \ .rìd lehicÌi's, (lennafl ha\ Ìrenrlllcd lronì thc stÌo.g itrolÌtlì i' denÌard Ìr)r
rrìa.hjnertindcquipmcÌrthoÌÌrllhin! Ìt has el\o !titizrd the otÌÚrtrìnilìr:s to enhincÊ
cxport corÌpclitj\iencss thaÌ havc fomÉ lÌom outtouÌ(iÌìg a.ti\ itie\ to tlìc ìo1r 'ost transi
t on c.ononìics nr centÌal ìr!Ìopc l hi\ ìt di!.Lr$e!l lLrúlÌcr ln Chaptei lE O)nnüp1ion
i.\'cstnÌent, ancì thr fúl)Ìi( Í'.(.r have nladú a veÌ) lil]ìiL\:d.ortriLrullon to demn"l
lh.r irenkncsr (Í iÌnrdmeÌìt is iì irorrlnìg i..Ìi.ator thal .!en tire rrlalhe ttrength of
thc e\foú scclor nìi-! be \ulÌÌ€Íablc lÌì teÍì: ol Fi8 1:12soÌnere\ersaÌoIthelelÌr'aÌt]
slìiftsolthcAlrnd/,/ìUcuNCsaPleartolìilctalierÌlìla.cimtanÌlhil€lhclll'uneha5
:hiitccìtur(hcÌletì,li'iìljnSth€rcononÌ)ÌÌilha l^t.üÌti.l1:ìLcrtaÌm+lus Wealirro('lh
is ftÌlected ln thÉ lelcrioiìt1on in lhe puÌ)lìc s..t(t hndrÌciil bâlince a dthctjsÉnÌthc
(scc ì:ig 1l Ìll)' As5etout
fÌn ate se.tor únan.ialìraldÌce is \!.rÌl a\ tlÌ. cxtcÌndÌsuIplus
in ahapter 2, the relnLìi)nnÌip bclr'.cn tÌÌe iìnancieÌ l)alanccs crn be seen bl ÌcxrarÌSilrg
lhr Soo.ls nrrr l(et eqrtlìil)rium condìrj(tr'

li jrL!' l'l r0l - iÀ), Íl 1 ,Àr' lg..dsmarlet.qullihriumroÌÌdiLlonì

The süics Í(Ì the prllate secÌor fnrncial baìence in IiS 1l.I :l is connN.tcd urlng tlìr
a.counting l.lentit-! .IÌLri!.l.nl ol lhis e!untlon.Lr TlÌe patt. íì .I the lìrÌancial brÌuÌ"s
ú tlÌe 2i1005 ìI ajr ìxnl is íÌÌìlnlsceìri ol thc ÌratteuÌ hÌ lipan al the outset oi its ÌoÌÌ8
ÌreÌiod of stagnatioÌ1isee lìil. 11.2'1).

1 7 Summìng up
\fcLlsc.lthema.rotnxllllocÌxmìÌrethrIìerueoltheUcÍmiìnunincati{ÌìsJìo.liandto
eaplorcitt.onscqúÊnceslorGcrÌnan) iraí. \!e\t, tìrÌd uÌ1ilìcd rn.ì t(tr othcr .ountrie \
ìrÌ thc F.R\l \vÍcnr. AlthoLrgh lhc nriti.l imllalt tìì t1Ìe íìork Nis x fositi\'c êgCrei{ate
rrrn.Fnin'dr.LnfdrnLLìrL?..eF.ra\\tlLÈniti\ri,idiÍÌrÌirì\1iil!ihÍtlre.!ÍÈnLi.r'trt
ir rn.rì rìn.Ì ilún Lh. ilLlLe DiÌ r.'
 "l
l

(ìe.Êri SorcntriÌeirt iinrn(irl Lìa]üt!

arrrnl r..n,,rril'ilrÌrP
---- arD\1tri.tÊd t)nr aÌe ie.n).baLar..
--lÌrc r)jiÌereÌr!.ÌÍrÌi iLÌr.inr.bi e lcLcflrrf rÌi!.rì\!i

Figurê t7,t3 ai rirj.irrìr..:..ri.r,tr.)at )i)1. 't a)p

dcmand \lucli i{)r \t.st (;ermanr, Lhr d.cper negrrne nÌpÌv sjde.ônsfq!erÌre\ onÌ\
bc.i]nÌ. a|Ì)xÌefl lf Ìirter !erú r.cÌ h cÌc l:xi.eÍlttecl Ìì\ rhe con.titio.! âgrccd at uniÊ
.a(jor1 betllecn ufions. empÌo|eN asn).iations. arrd Sor ennìenr írrr Lh. riui.l .oÌÌ\ eÌ
gcrì..ollastt.\t.slCÈrDrn$ageÌelclslÍcspectjYeolprocl!cti\it\dertl.fnìrnrs.\ve
cnìplì.ìsired the inrfoúaÌ(e ot the lItI{ in !ro\ntjrÌt ìrÌ e\trnÌal anchoÌ [. .](.mbrr\
sc.lin8 to Ìe.lu.r nlLrtjor. Thì\ heb Lo crpl.ìiÌÌ theil re]udan(e t() faÌti.ttnl( in an
o.dcrl)_ rerlignm.nl !l e\(heÌrge rate! i. Llìc .1Ìennath ol urÌ]ficrri(lr. Sú.Ì â rliìlìgn
Ìrì('rìt ü!r hare tÌ.rrìÌted the 5lìeÌt light.nln! ol nÌ!neti[! potic) b\ the Btrndcsban]i
irìdth€mÌ\eqú..Ì.ollqtreolthÊF.R\Í;\swrhdeleen.ÍÌ!e(ountÌie\bcncttcdtÍonl
thc n.nretrÌv câsinA üì.rt rccomt!.ir{Ì Lhclr üit lÌonÌ uÌe lÌìNI. ThÉ lrK e.onoÌì! rc.ol
crcd.ndiÌÌthi5.ofLr\t,iìnermacÌor.onoÌri.poLiotrânÌe$orÌ(r'at.terclofd,Nhich
cu|rìirÌate.l 1n thc indrpendence ol Llrc Bânk ot t tlant iÌr 1997
ü.r the tót d.,.adc the J)eúi)Ìman.c o lh! ajenrdrÌ rxclBriti\h e.onoÌìtcs.ontr.Í
' hc Llritì!h cco.o.n
. rcãp..1tlÌe l)e.ti15 ol.anjer mÌÌrL\' !d. rc oÍm\
' ÌreÌrehtd tromtlÌedetrr:. alion nsslci.rtell \Ì1rh FR\Ic{ir
, lnLÌodu(ed a ltabk: nn.rcecorx!Ìic t(tL.:\. lrinÌenlrk
. e\feriencd 5(rons consLrnrtLio. dclrrirnd {nd I Ììcl! lÍ.iì co.:oli.liìtiorÌ
. bcfcÊird tÍ!Ì r hro!rrble jrDÌIo\.eÌncnr n rlÌe tenn\ oltracte, which lìclpcd.outrnÌ
j.lLil Òüi[\ lres!ur.!.

I
718

'Ih€ Gff man e(onorÌr_\':

nìfl.rcdftomtÌìeufa\ouriblcsupÌlhsidesho.kâssoclatecìilith(ierlnanunLhcrtiorÌ
lott tlÌe rbillly to ute o'ìctaÌr Poli.) bl';joiningLllL
erperi!.ced lreâk cof surnptnr. d.nran.l

2 Mâcroeconomic policy within EMU

Ì ormaÌh, Lcononìi. an.l \hfctaÌ) UrÌ1üÌ b.ga. nÌ i99'r ]!h.. lhe excÌ\uÌSe rnl.s i\'ere
irrclocìbì) Êred ÌrcllLerÌr thc nreìnbers. Hol!úer. it cirnìc i.lo IuìÌ eliect Ìrith tncht
m€mbcr\ irlÌeÌì thc cur) Ì!15 i.tÌoducel afd nxÌionrl .urrc..!.r Ìemol ed on Ì.IenuaÌ!
Z0lì2 Ihi\ represrnLs a uÌìiqrLc xnd xntested 5lÌ!iJÌir e lÒr lhc.on.luct oi rÌ.rcr.c.o.oÌni.
poli.I i. molerrÌ linrer: therc ls (tre iììdepcrìd..t (entrnÌbiìfL, twehe plliticnÌl-Ï Lnde
peÌl.lcnr h\crL aulh.rjLìet. and tlLehelnboLlr nrrrl'Êt\ r'lhir(ÌJÌrtrì rÈÌrs'lhcmr'ro
nìodcl Lo lL!)Ìi at thc Ìrart plalcd bI tlÌe sjlìglc.entÌil tri.Ì, Lhe nrtnnÌâ1lìs.el p(nic!
nukcr: end lrtioniì Ìabolr mrÌÌiett irÌ tlÌ. ol)cratiLÌì oí thc monetn ruÌion ifd the
Ì)eilornra.ce ol its m.:Ììber\.
Fis
2.1 What kind oÍ monetary policy maker ìs the Ëuropean
Central Bank?
TììelclÌirasc5trbllsll!'da\anÌ!ncLaÌvtoliclnìiÌicÌin.leper entolgotcÌ.ments:itÍ'iÌs (li
nì \et i15 own tdriret (tnrget iÌìdrpcndtnLel dnd choore it\ poli.) iÌr51tuÌìcnt(tì (ürstrL!
ÌÌÌeÌìti(ì(lcle..ìerrcl hct]\okl-! n lttenceto!erlL!c(!r\titlìtidÌÌrcrc, on lheoneh.ìnd.
Ìhe legi.\. oi jt\ t)redr.cs!Ì r\ rììoncLaÌr poÌn) mal<cÌ f{)r lurÌrt, thr Gffmrn BurÌdes ri.
.r.r..l
to ho\! nìoÌretrr ÌroÌ1.) nrÌrld b. .onducted lht Bun!leibdÌìk rri5..nslúutirrlrll! .
requrcdtoÌìaìrnrlnisliìblÈP'i.cÌcrclaÌ(1h.diìlfrl\ÌrÌa(ed$eighlond.lcÌrÌnnents L(

nìlhcnrt)netar\.ggir'gatetlrì(âsurcsotthtrÌÌonclsopthrr\.ì:uìdclohoÍ'monet.ìI!
policr \hould Ì,e adl(necl. 1hc .lnstn{\ rìÉtr inroÌrstt econoxrins 5 reÌrtúÌed itr ihr
jd!.n.1Lhe.erÌtral biì.Ìi rbnÌ8 i lillort\Ì)elÌLìlcl(rxrti\eÌvrdi!nthrinLc..!t!ettÍ)rì!
l. stctÌ thr e(uÌonì1 t(rta i. i.flatLon Ì.LrÊ.t in'icÌ bacÌ( nì (lhrplü -l and ahrÌrter 5
Ior dcLails ol tlÌe 1.1'ÌoÌ RrLe iÌr d t. ahatter iJ lor nrônet.ìr\ tarsetlÌrs). rlr.
' hr: l( B sct ìtsdl ên i.tÌation 1ârgL:t 7d,ri' ol0 to 21,, r.d deÊnel 1ts nÌonclif tolic) 'li
slrat!g\ õ lÌariug Lro tiÌLrrs'.1r1ìct üre Ì,iÌl.rrs i( lht jnilrtj(Ìì r!te Ìd thc gu!th
raLc ,)l n(Ìret,,rt eggrcgateJ. llt c..LÌe5l. ihe rÌc\th i.depÈnderÌt IÌtìnl !l l.gland sr\
gilcnú!\t,r,r!.tl.intletionlnrg.lbrrhetotenìnr.nriinilialÌ\25!,'iì;lcìr'ÍLdtÔ2ir,lt rÌ' :

rhccndotl0lì.Jln.dde(.ìb.ilr\sLÌategr d\t1ì.ioi ìnilxtnlr tlrSetirÌa Lllc.o.tÌrstini<

c\terirÌL.t Òi \\.st (;erDLru! ifd tìre l'l( ritlÌ.irljtr el1! es ot tiìrlrtlng monet.ìrl
agsÌesrte\ is r1rrlc.tcLÌ in ihrsc dLlicÌe.ce\ r\ec ( lraftcÌ S nÌ (Ìther dis.ussìofl llndÉÌ
thtl(ll\iÌritliìlscLut.tlÌeI.Ìri!noÌrÌenunftionLhititr!uÌ.1a(tiliÌúÌ.ìtll:]n.ìÌbcl!r
2.r an!1. Si\en lh! rÌrnter\ oI LÌcÌlrti(lr tdi(ls\rd i. ahrfter 5 d Lreh\! i. rcleLi(Ìr
tolata.l.tlÌiJisiÌ!.r)ìngi:Ìrc.L .I the toÌic! d.\igf ÌÌr 2(10:1, tÌÌe ÌrL!.liriLlc(1 jtt
 119

..[
,1,
1

' i' lL'

.r'" ..
.1!" .1:ì .',s rg .rs .rs rif r:Ê,r,*" u.'É

Figure 17.!4 Ofi':; t.r.ï.itê; L5lÈ-1.r. R..Ê1. taj jf.l.ri.fE-niri

denn lion ol ÌrÌìcc sLabìLity n) Llrnt ii ,aim\ Lo rìâif Lã n inllâtidr rates hcìoi! blt
\tar.
Llo!: 1o 2rri.veÌ tlìc üedún terúr' rr Uthough tÌris lÌr{Iúc(s the ,r\)nnnÉtÌ\., iL dor.s not
relrorc it. lhe exf.rien.e ol thc Bi.li ol Ini{Ìr.{Ì aÌír sLLggcÍs rlÌar it nar hâr( trrcn
wLso ior tlÌe ECB lo 1Ì.1!e hr.l l Írnrglhat highÊÌ ÌntarL.f tiÌrgct jrÌjtì.rltI an.t Ltìcn t.

lìÌôDì thÈ anaÌr^ii Ìr\ ecolomirri .\ ( iis eaÌt\ \ eaÌ\ oí otrrir on, it dl)ÌreaA thaL rh.
LClisi.deedopeÌr{ingr'la\Ìd ÌvÌr.mon.t.Lr\ tolic\ mÌr OnccÌrìpjrì..Llstud\ {rgg(ns
thal on the tJa\ii oi thf arrrÌ! ti\ ot {lara r! nr rlìe eÌrd t)I2002, Ltr c tC! s de.ìtli)ns.n rhc
i.tocst r.te {rÈ rr{:ll pre.liLte.l u\ifg a L.ylor Rult i. Ì!h clr ttÌ. seislÌr\ on infiìri.n
and thr lutÌÌú gat .re the \anrc is (hr oÌÌei thar .traÌr.:Lrrtz. the decjsn)n5 o thc US
ì:edcrelHese^e.'lhÉseÌ!€ightstrcdi.tbefteìrÌrrndoLhosrrlÌ,ìt$erechaÌacLcrinj.ot
thÈ BLuldeslianÌ. " \ct rhe F.(t! lras Lrccn Ì\ el! .:r 1i.i7cd a: ractiÌrs sÌugg drlt to the
\Ìohdor,rÌ iÌr thÈ FrLrope.ln e..n.nr! i. :001.Ilg. 17.I.1distÌ.rs rhe offi(ìaÌ jflcÌcÍ Í.res
\et b\. lhr Ì-: Ie.ÌeriÌ Re\en e, the lLB, in.t rlÌe BanÌ oi t ngland
Th.:Ì! ire \evÉÌal n.\ s .f ìc.on.tli.A rlÌ€ t.t rhit rhc t.(:t,s de.i\idrs rccnì lo mrt.h
ü'o\c lÌriÌt t1ìe Fe.l rro!ld harÉ ralic. e.cd Íith rhc iimc dnta a!Ìd re perccpL ,:,n rhdt
tÌre LaB s de(itior\ h e been roo ltlll!., too lrrc.lt thc l_(.U uses Uìe \rnrc lknetrr!

LuÍ,,,,1r (_úa.,1 B,r'i r rtro.rÌ r. l,frr:rrÈ.(n-.r//,-rrd.f,... l0r.lr

L; n. ifigìf, d.rrì.i.d nÌ t LL .dÌ,r (ì izranLL rrnina0.,g.jLt:.
.!1Ìtq.,t. it tÌìr Bnrrd,!t ì. rLìo. ìhrorrÊrrAxt I Ìtr. \.Ìileanlrr
:i!ì\ r. ìÌrìrial ìr .jr i Litr.ìrd IjrÌ.nÌr irr ..rtìrtr!Ì: i\ rii r \i.sÌr1!.I i.i ijtrL0 i l !|i.afÈÌr r.
'r:
ÌrrÌÌs.ritsirrì rnidiÈ\ nf rrlid

I
 Ìl.oiioriÌ Ìrilh hiShlr int!rr\Ì l.oiomr (ithir!leresL
scnsitne e\firrdÌ:iü. ì\rn5 t \ee\Pend fr

Figurê 17.15 t:rÊjt rt-" 13. s.'. t! .rÍ q ài l\ rlìÒ.1

LÌrli.r Tìtrle õ the Fe!leirl H.:.ú, Lt NjÌl fÌo(]u!e the rl)Ì)tu|rirte \trbiliziÌÌ! elle.t lor
Lh.I\,Íltrc(!rorì\ont\illhcr\Íllrco.omrrerÌnrndstoitnrtÌre\anieÍr\at.loe\tlìe
US cconomtto the Feli s declsl.ns. As rrc hr\r 5ccn jÌr (llÌapter 5. tÌre coetÊcients irì the
trÌrtinraÌ'Tal ÌoÌ t) te nÌe tor an rtr)Ìronì) dcÌìcnd o.

. tlÌe \lope ol tlìÉ Ì,hilllfs.tr^ e,

. thcnottt)fthe Lt Qn e,.ìnd
. ihc Ìrcl{ht.n nlâtlon ii the.erÌtrrl brÌrli'\ Èreiercn.. fun.tion

Lrr'.n il thc (cÌghts oI iÌÌil!ti!Ìì .nd o!tput nì lÌìc lo!s Lrn.tl,rn Ò lÍ'o ccnlriìÌ bafks
aft:i.lcnrj.rl,lIoreec(rrtrn)lÌasan.tier|lÌill4ìs.ü!.igrcalrrrcalrr.qcrlftrliltjiìnd
a srcet4 l! ctrr'e íle$ 5en\itirit! of.8grrt.ìtc dcnìand 1o Llìc rcrl lÌìtcrf\t r.trì ilìcn jts
TerìoÌRuÌcnÌ)uÌ.ÌÌrÌacelenÌÌei8htüÌoutfÌridÒ,rlio.srcliìli!ctoinlL,ticÌÌleliations
and x highrÌ lteighÌ on l!)th dÌ.n ill tlÌo rconlmt rf irh sLc.frÍ |lÌillifs c!r'er ind moir
i.teÌe5t tent jtì\'e e\peÌ\ìitrìrr.
At an 1lÌuttratìoÌÌ, we corrp.rÍ. 1tro ..onorÌÌics idcnll.nl n .LlL r.ïìr.ts eÌceÌ)t iÌ] Ìhc
ìrteÌe\t5en\ìti\it\ oteÌrìeÌÌdiiu( ( iA. lt.l5i.llo{lì..on.nrcsircsube(teltotlÌe\aÌÌr€ t..
Deiati\e ierDporrrt lr n]..l c.g.slhcrrsÌLltolalosiol.onlìdenced!etoateÌ.orist
dtt!cl ils shiitt n) 1J'). t!.h.cnlriÌl banli obÍÌlcs a Iill i. orLt put.s slÌorn b\.uÌe ]"rle !
dnd 1!orl\ orúthe optiÌnrl iÌìt.r( slÌnlc rcsPonsc. hisi5lhcrrúintlÌeirÌterettrateth!t$ilL
iri-\e o!tÌÌrt t() tlÌe ler el is\o.ialcd fiLlr Poìft /l if lÌrc Ìora:r panel.,\s ilÌe di!irir Ìrúles
(lear.iheiqÌ)l) \icle oluÌe t\ro r.oÌÌomlrs is id.nli.al iì.d so i51lÌc !tiLit! 1ìì!trtion oltiÌe ur.
tl\ o centìrÌ ìranÌ(\. I leD.e uÌ.loh.c. piìorl ior cach c.o.onr! ì: id.ìti.rl. llut iÌr reÌnÌtre
 711

to tlìe same 'sig..Ìl'ol LoÌreÌ ouiput, the centÌaÌbinÌ ln the ceonorÌ! (o. tÌrr rì91Ìtl wirlÌ
ilÌe iess irìterest !.:nsllive erfeìÌd1ture stuüd lnrtì.menL a ìargeÌ cut ln thc irÌlerest rrte.
Ìi it iÌnplenenL! Lhc sarÌÌe jrÌteren rate cut as thc olÌrcÌ c.onomv, jL irjÌl dclJr the retunì
of th.. e(onoml ro cq uìlibriu nÌ .Ìúput. The sitüalio. ìs noÌ5c ií pÌlrall: scctor.geÌÌt\ are
morealtectedbv lhc pcssimisrn â \soci! ted $,ith rhcshock rhanbv thca.t onand ÍÌetoic
of the cenheÌ bânt aod/or il thev cloubt the eÍIccth cne* rLith rnrìch thc crntrâl b:ìnl
Ìlill resÌur.Ì Lo sÌrocks. 1lÌ1s nÌr) tun a tenrtorârt /J sho.li ìf 1o a Ìongcr liÍiÌìA one:ìnd
therefde ÌequiÌc ìargrr intereit r:ìte cuts 5ì.cc lhc sÌabiÌrzing inrcÌcsr ral( (r!l \!iLlâL\o

IÌÌ a.ldìtir)n to sLLl]stirnti!e concena about the IaB's Ìeaction lun.Ljon, thc anirltsìs ol
xroxetaÌ) poli.a j
n (lha pter 5 nì 8!eÍ\ that th e F.cl shouÌ.tl

. have a cÌerÌlr statcd sunxÌetú iúlatidr target or rarget range. Thir mr_v hcìÌr ro
ltrl)ilìze ltrh âtc scctor e\pedations rnclput ìn tìacc a linneÌ buhlark âgii.st thc
po$ìbllitÍ ot dcfl ntion.
! op.r.te $ith greateÌ tÌansparcn._Í. A clc.rcr !rÌclerstândiiÌg lìt tlìc publi. ot ho\r
d.cisiursaiemadewouìd(.omcÌ!ì1h Lhc pubììcrìtion of nrirrutcs ofthe Cole!ÌirÌS
Coun.il nÌeeiiÌrgr ar.1oI thc r.(lB'5 lonnd lookiÌìg füc.asts Iü inlLntioÌÌ and other
vari.bl.Ès. .\s $e have rcÌr i. ChafLcr t, lhc lrÍera.tion bctrlccn toi$rad looking
privatt se.td aiaent\ a.d a iotri'rrd ìooki.g rcnúal bnnk.a. bc !tabiÌlzing but this
usi'lul leedbdcl nechârirm ir neutraliT.iÌ it Lhc bchaviour ot thc ccnlraÌbn.k is
poorlv explaìnecÌ and poorlv ufdcÌíood.

2 2 Member (ountry adjustments within EMU

ln llhaptcr t1, we slrtrle(ìhoÌ! nr anaLi \e ivhetheÌ â.ountÌ:" $ouldnrlfer lÌonÌ gnnÌg up
t h( nolìlnal er.haÌÌge rate as a poÌj(y Ìrt ment. Th e tarÌe nrols help u \ to eraÌÌÌiÌÌe $l Ìa t
ha pp.ns a t th€ irÌcli!jcluaÌ counir\. le\ eÌ when ìt bec{ìÌ es a üìenÌber ol â coÌnrÌÌon cu r.ÈrÌc}
arci likL the elrorone. The ii\ue ìt hoi! the xbseìrce of the erchaÌÌge r.ìte iÌìnnì eÌlt
{or cqLljraÌcntlv, ol domestic motretrÌ} }roLjcv aut(rÌÌn:"1 rlìe.ts tlÌe.diuÍnÌent olthe
c.onomy to a .ourÌtr) sÌrecihc shocli o. n) ân uÌr.ÌeÌÌ)nÌt nnrctuÌ.rl .hânile thüt is not
,.1 ncmb r-n'n Itì,-.r -r - .r, r

2.21 CounÍy-specific aggregate demand shocks

\\ c rc.all lronÌ Ch.ìpteÌ I I tÌrat the eiïect on ou tÌr ut ol a temÌDraN negatn e aggÌegate
dcmnnd sho.k \loulcl be lirìÌ_Ì ott.set un.leÌ a Ue\ihÌe exchange rate reijnne lia a clepre
clallon. Ho\lever, ãn ÌÍlatìon tr.getilg ceDtrxl bâ.k i5 uDliÌ(eLt to alLo! tuÌl ollsettlnii
bcciìrLsc ol thr consequence5 f(n ftrture nÍÌatìon íbv cuttius reaÌÍai{e!, the .letieciati(Ìr
lakcsllìcc.orÌcÌnv.trovethetÃillineandtheìef.Ìeertailsaise âLbeittenporarl nr
inllation). Ne!ertlÌeless, to the extent that somr dcfÌeciatìon take\ tÌace in Ìeìrnrre to
thc slìo.Nl the ÌÌÌp:ct on output rliìÌ be les hiBh rha. ir an econom) ìn a cuüencv

Ck.rlv deprecirtion is nor an ottìo. in thc Ín.c.I a coonlÌ) ste.llic shocÌ ìnsjLle
lhc curozone. hespectne ot lhe eÌchange Ìatc/rÌoÌrctaÌl toiic_v reillnre, the âuloÌnâlic
lìscnl stabilter\ will otelatc nr crìrhìon th. itrìtacr o. the economv of th. âggÌcgatc

J
722

dtsmán{Ì nrock lhe\ nrc Ì)rer'..|c.Ì tìonì torkj'g b! ì frsrâl ruÌe lrì aLl'litiorr'
úÌrless
the S.vcrnrÌ1ef1 m.) usr discrctn!ÌâÍt lical polic\ to otftet tlìr 5hocÌ( \\' have tecn

poÌi.\'lor stabilizalron nìu\t ersure Ìhat the DreastrÌet aÌe rcÍÌted Ì!hct c"'1i'al
nscâl
conditio.\ ì prc\'e. llls miìI cetse Íircater polLtìcdl dllhcuLtil:: lhan lloes th€ use oi
nronetiÌï rex(hange rrtc ret)orì!És to tcnrtor.rry Ilu(tL'ntìon\'

2.2 2 Real exchange rate adiustment Figr

,\ mrior isue tlÌat âÌise\ itilhiÌì n corÌxÌror currcn(:\' arrn it h'r! rcqrLiÌe't
(h"96 ni tlìc
rcrl eÌ.bangeraicbetì!cc. m€nìber\.af bt Ìrrcughtrboúl ItrLl's pL: úonrÌrn ÌrÍ)! idr s
'c
a tr\ehrl cxmrplc. Tìre lr.xÌ(ness ol Ìt.n-t s €aport periornrrnre otcl tÌìe pnsl is
']e'ad(
delül' )a
rctlected in the dala úÌ liÌble Ì7 3 Ìlhrcoler siJì'e 2000 there lÌas been a 20Ì
jthich ü ouÌ(1 \.
rati(Ìì in ttaÌ) s .omleljtileness as !ÌÌeasuÌecl bl rehti\ c unit Lbortr !o\ts'
pãsl' Ìtalt lre'Ìiii.Ìrêlh
bc cxpe.lcd to lro(Ìuce a iuÌth. r weitricning ol ncl exl)orl\' hr thr
r!ìje.ioÌÌ pcÌiodi..letr€.]âti(!Ìs oiuÌ€ n.müul r\cÌrrngc Lìte t':i rrstoÌe its
'omÌretilive
positnÌì. $ ithiÌÌ llÌll-, ihjt i\ r.t lo\slÌrì.
We lÌ.ìt( eÌrtr.lv en.ountered the caÍ'of
(ienÌrn\, hich r\ a o1 uJìl
'on\eqt(n'e aI
lì.aLjon ..\peÌìencc.1 a ncgatìtc e\telÌral lÌrlle shorli llah \ !rcIìeÌn\ ÌetÌe'l â

nìore 3rai1(taÌ eÌosloI !l lr\ (LrìÌretitjrr slÌensth seÌìclere'i Ìr\ thc erÌrergcn'e o1 f'w
s,nlÌces oÍ strpPh ol nrnülactlirc! nr lLrnÌre iiìs Lhe tÌinsjlioÌÌ e'ontììies
hatc ÌenÍrL'
1(rc.ì thclr Podu.L(tÌ scct(Ìs iìn.l tfgradecì t1Ì!'
(lu!lì1r of üreir r\toú\ì and Àsiiì lo
rcttore orúprìt in.] errìpÌo)uÌc.L iÌ is ..ce\iary lr)r thcÌt n) bÊ a reaÌ deprccirticÌì
Ôl

the e\chaÌrge rilc. For (hjt to be nrna naÌ)le. lhe |?lr ctrre his lo \lÌ11Ì 1lr the right'
i.e. \Ìptlr\ ..banir.s nNn bt iÌÌÌpÌrnreìúed A! disrt6\ed nÌ Chrpter + LheÌearca
urge ,:,1pini. dreat!rcs thrt cal nriil lht IÂtr cune: c g' ÌaÌ)oLü â'd prodLl'l núrkcl
renÌrns.Í)cì.rlsc.ltit)ir:l()rns,aÌ!r!ricco.lhtnÌiÍl inthelÂt' l\ Ìequircd iresfec-
Lj\ e oi the Érchange Ìitc rÊgiÌÌrc, hos etrr, heni'h!ngrlnthenominalerchangeriìtc
i\ not â\'rilabl(. elÌthc a.ljustnìent nnlsL talie plâ'e t|rÔugh donÌ$tic irale ând ÌrÌi'(
ìntÌa{ion Ìoser LÌlÌ\ llstwherc nr thc union whcl LìÌìion !ÌrÍÌation te! arr
'uücnc\
rLk'ad-r l(tr!. thìs Í lik.lrto b( houÌ djillcult !nd totentielìr hdl ou! r! letÌa(ion
DÌi\'

lhc oÌ1}úsilc rìtrrntlon c.f aÌso.rlsc i!ìtlìin rhe euroT'ne 5!ppose thrl a trtruìtrl
ln thc eurozc,nc erpericrrces i Ìloiitit( c\tem.l lÌxlle slì"1(' IrelaÌl'l t()rÌLd bi'ã good
cândl(Ìate Ìn thi\ .lsc, tÌ1e e.ononÌl .cc.lr t! nì'!e tu n 'eN nre'li!m ruÌ eq!illbìnun
.1 loieÌ !nrmtlo)rrÍfL arÌd ('ith r rciìì allre.iaLL(Ìr: hiSheÌ real s'iìgc! are colìsideut
ÌÌith lÌacle bnÌince. 1o a.hietc tÌrìs ldiultment itithout iÌ noÌnìÌül nplreci!t1orì there
nccds to b€ a fÊÌiotl lriLÌr Ìri5h ìniÌatjon abo!r thrt ol tÌrc rctt oi thc u'ion ts slrown
irì Lìig. 1;.16, 1 lfvoÌ!ìng a rÌonìinel atÌ)I..iatìon i5 arailLblc to IÌeÌ!rÌd itithìn
ltath 'ol
'. L r

that requirc such r rcaÌ aÌ)lÌrcjaticnÌ sÌì.uÌ.lrÌo1 bc mbi.rl Lt) cÌiticiìÌ Í'ilhiÌr tlÌc tÚrit)n
bc.au\€ oI Lhe üse in 1n1Ìrli.n: tlrjs 5 the orÌll 1!a\ tlìa1 rcal Ér!lÌ'ìngr Ìrte 'rcliuslmÉnt
.an o(.!r. Onre ailnin, the sitlÌatìon is ÌiÌ(eL] tri he comtÌi'ited br thl lct tlì'i n Ìi\e
i. ÌÌi\lÌ iÌìlletnrÌ liilÌ Ìedu.f the rcaÌ inteÌest ratc atrll nìaf itelL ìLrc a domenic ilgÌe
gâte denìand booÍìi â liglrtrnlng ol domc5ti( hscrl toli.-! llouìd Ììe to hc\r
'pp(Ìrúrte
 .. 723

Figure 17,16 a.l6tnrer o a pcs ti!ÊÌ.a.l. sho.[

nide (2t and ô!15 de tt) ir'1u

2.3 Does EMI.J need fis(al rules?

5irÌce thcfleribÌc oatidraÌLrsc ofhscaÌpolicl fd ÍatriÌtzaLjorÌtâkes on gre.terimÌrorlnnce
i Lrlri.\ lr'.vii r,r.1), ,.r,r,rrrr,.r^ rrrr,.,.t..
ÌÌÌ Ch apter 6, {.c sct orLt ihc aritonrents lor cormrrjc! al l hc rrtn Ìdl lcÍcÌ ÌÌÌanasi n A their
rl i- rl,nr.t, t,,.,,.itLvi , r ,,,t-rt",,.
fornsciÌnìles at lhe jrllrrrâr r/leveìoI [\,ltÌ,1t js ncccssar! to arguc

'thalmeÌnberhDolaconünoncurienctiìreareduccslhccorÌsúainLsontlìeuseoi
national Iìscel poli.vto achieleÌoÌ{eÌ mcdnrnì rür uncmployÌÌrentand
'reduceslhcincenrivcsloÌcounLricstoì.t{)prtìs.alnrle\thateniuretheyìvcn.vof
the govcÍnnent, and
.lhattherearcspillo\eFi.onìn.rrjdraÌls.alpr)fligacvtothcu idr as asrhole.
'Iht lìs.otlotìc,r pi\r ers'díLr11 td jn ddnetfl Mn,j. Aswr haveseen, tora s alt ope.
econonÌy, a lscal erpan slon .1loÌ!\ the c.onoÌnv to move ro a nìednuÌ run cquilibrjunl
atloi\'erunenìtÌo) nÌenrarittr Íable inÍlârion (.ìttÌretarget rarc) bccause the rcnnsottra.le
cân b! shiited in ìts iìvou r. l.{t.ÈnÌaì con s l raìnts from the rca.tion ot rhe nron.r rìker
rl 'rò, .. ,,r. r-rl" t..ro .t-. .,,.,r,i,.r t.-.,,,..1
ofcratirÌg undcr citheÌ fLXcd or 1ìeribÌe
c{.hirnge rete\. Ho$,cçer, with such eritexÌat
disciplirÌe abscnt lLrr indtriduiìl Ìrrember counüìe5 1n thc curozone, tìre tcDrptation n)
sccktorecluc.uoerÌ4to)rì€ntb\alìscalcxpansionì\apolcnIialprobÌem.IÍâllÌÌrerìÌÌreÌ\
reason tlÌe \âmc Ì\râv, rhc result Í a hlghcr iÌìteÌest Ìate lor the ÌÌÌoneraÌÍ urÌioÌÌ ar.Ì
a phase ol hlglìcr iìúìarion thlt i\ costlr lo elirììnate sincc tor the curÌcn., uÌÌjon as
'hol . -.t rt I. ,r' ì r .t .\ r."., ,. ü..r -.
',
Th. rcots ol thc Ìogic ol rhc StabjÌity and crotlth i,act ot lhc curozone nìay lie jrÌ this
pÌìsonerJ dìÌcnìrìa in ns.aÌ policy. A lrorc detajte.Ì ânaìvsis of the pÌi$ncÌs' diternma jn
:l r itlÌhÌ this coiÌte\t it frovide.l i,ì scctioÌr.1ot arhapter 12.
' Bn1l out' la t n Soteü . t itL n t un lntt uniatì. If a couDtrt js unirLrle to nnancc its eÌpen_
dlt!'rc (i.e.pay torit\cü f nt expencliiluc a nd ser vlce irs ex tnjrÌg outjtan.Ìing debtj eithc r
bv Ìaising taxarion or bv lcllìng u.e bofd\, it ìs said ro ta.e . ctebt cÌisis. \\ h:ìt aìe rhc
corscquences? lt rìst eithcr delâuit on irs d€bts, Ìectivc rransteÉ tìonr olher counúics.
oÌ Ì.ducethelalueolthc dcbt b\, ÌÌx)netjzingitthrclrgh inflatior]. The oscofa ri\eiÌì ìnna-
tion lo Senerarc scignorâgc rclenue is extlniÌìecììn Chaptcr ó. Lhcs€ argumenrs
to F.lVlU counrrics, a nrembcr be ,bailcd out
^pp\.nrg
lìcjrg a.lcbr.ri\js could dcfiult, bv orhcr

,/
724

intÌâtion
Ìrr( ml)ers, or se.üre thc help oí the l aB to rcÌA monettìrt foÌnv
and alLoi{
to rìse. Sirrce ea.h oì the5e illcÌnatiçcs potcntìallr'' cntaiÌ\ spìllo\ers lo othrr
elüozrrne
mcmÌ)ers. Lhere js a prima lacic aÌS!mcnt lff Lhe eìistenc€ ol
n5crL flrìcs
cttect that
Spitn)rr,fiÒttì d1íÒtì,11 lìsn1l llt.lliin.f ültnalilies ür'lLidc dre 'o'tasìo'
or tr'iÌs !ìr
mÌ;ìrt íloN to tr1her hÌìinciaI ÌìarÌ(ets in ihc curozone 1t orÌc 'ourtr! {Ìefaultcd
da;ger oi dctrìrrillni{. rÌthough tìre aÌkets ma\ price úr thc a'Ì'lltiolìal Ì1515oìel) 1o the

(Òúirtrv.o.cerrcrì,thcÌeisadrlserthatthlswoLrldÌr1Ìlolctt{)otlÌcÌìneÌÌrb'a LìislnS
ilÌc ri!Ìr lìrcnrirìm rnd thereloÌc the.ost of Lrorro$'!'g t'r '11cun)zorrc countÌie5
SLr'h a
theÌe Ì!oL1Ìdbea bnil outol thefrs'aÌl]
\piìÌoverwoull bc mor.ìiÌrell iI it Ì!as thouÊhltlrtt
()nÌ othcr nembctr irould nnpose a
irrcsp(Dsiblc SolcrnnÌcnt .\'bail out \'ìa trinsle6
imfo\e
clirJt.ost on tlÌcnr; a rjsc itÌ union iÌìilation itlCLl bcha!iourwas 'ìiIc'tÊd s'oukl
jncrciìse iÌr irì lrtior' At note'Ì iÌÌ Chapter Éi' there is a \igorcus
arÌ indiÌe.l .oÍ tia tlÌc
.letrnte d\ lo tÌì€ pì.1ìsibiÌiÌl iì..Ì Ìik.]! size of su'Ìr eltects in acldilion to the q!csli(!Ì
jsnÌe oIllh€tÌrcr tlÌe irì'entit'i ftÌ lìsrel Prudcnce
ol Nheth€r ert€rniìiti.s exisl ìs tÌìe
areiÌllectedb\n].nrl)e^hipoÍrc!ÍcnïunìiÌÌ'\s'otedibore'ioracounlÌ\o!lsidel
cuÍcnc-v u.idì, nscrl pft)Uiga(v can pÌ()Inpl Ïre'uÌation ilr lhe lolcig'
erchange rnarliet

"gaÌ',rtihc.u.rn.r'lhi5polcntialpunìshmeÌrtnìâ-Ìbenncílectivcerienìaìcontdon
go\'cÌ.ìnenlbeh.!iorìrlìrrti5rcmoVcdonlntìvto
'Ìhe trenchìÌark ol thc pNdcnt iìsrâl Polic! Nlc aìÌoN! nscal poliq to pìa) ì rcìe iÌÌ
nibìlizatio. íthr iuÌÌ cílects oí rìre iìulomntl' stabilizeb 'ìrc aìÌo\!cd tí) Ì!ork Ìrhrs dlscre
tionâÌ) 1ìscâÌÌ)olicv i\ ataìlabì.: ft)r usc úr thc e\ent of a coLl'Lrv\pc'ìnc &mand sho'Ìi)
go!emÌnent cÌpen
N1oÌeo\er, Lt Plovi.les i íramcNork ior evrtuetnÌg irhether slructulal
dituÌe rJrobÌeÌns .arÌ bc \dkìl acìdr.sse.l b-v aìLoÍ{ifg boÚo Ìng ú lncreasc oÌ ÌÌhcther
tnxatioÌì har to rite. .\1 DoÌrd in (lh.pteÌ 6, Lhe frs'iÌ ìuÌe\ in lhe LL 's S(ìP arÌ not ncces
saril-ÌconsirteÌìlwiththeILlrRB)1nìitnìggo\er'mentdellcitsto'llrnthesGlnÌntliÌnit
t|c (rLe ol tìre nut(tnntic nabjllzer\' The con\equc'ce ìs tlìiìt Ê\'iÌ polic! 'an becoÌne
pFcvcli(.el.Thc eilrtrcoitlìcÌaÌgeeuiozoÌìcc'o Òdìiesto!Ìrc'ttheJfiìÌúrÌitintherarÌ\
of a poorÌv dcsignel poÌic} !y laiÌÌrg1o teÌÌall7e
l ciì; ol I N{rÌ highÌight\ thc iÌanseú
on ürr otherlÌa'd'
ihc5ecountÌies, Lhe .rc.ìiL,ililI ol tlÌc polic) IrrnierÌork ì\ un'lcÌmirÌed'
he.l prnaÌties bccn imtoseil. an e!en stÍÌìgcÌ plo'-ÍcÌicaL 1ÌnÌrtrl5e iÌÌa,v
ha\e o'cured'
TÌrescconclcomponentoÍlhe5Gl',thatlhec)clicalì)adjÌ6leddc1ì'lLtoLil)I'Ìatiobe
lc$ thnn or eqúaÌto 7erc, iÌrfoses.n aÌÌ)iúar) 'onslraìnt oJì lbe apprcpìitìti' mediod
oli
deaÌiÌÌjj ilith slÌuctLrraì ProbÌems, su.h as sllLìrtiÒns i' $lÌich a cunÌulâtive short ll i'
erltn(lilureo.ÌruÌ)lÌ.:infrnstÌLrcturl:.eecls1oÌrerrìadegoodlqtraÌÌv1hcÌuleisunrÌe'cs
*,; fo, tl ol econonrle\ Ì\'ilh l'Ìr dcbt to (il)l rati'x an't iÌì Í'hj'ìr thc
",f. "n.u "t the".rsc
real lnteren rate (rrÍcr bacli 1o Chaptcr ó n)r tlìc detuils on debl
grorvtb rate erceecls
àvD.ìnìict. Such a ruÌc nr,1'lhtrelorr lÌevenl íìnìe o Lh c accessìon econo nr 1es
Ì\'h ich rrc

catchlngup arA ttrerctore Ìrave 3rotr1h rates in e\"ss ol tire rcnÌ i'tere( rate tìonì setiiÌìÂ

an oP(iÌnaL 1ìscaì Poliq

2.4 Summing uP
!!ro!cha\nrLÌoducc.la1ìiiihl)expÜimeniaìíÌanÌe\!ortlornÌa'ÌotconomicpoliqÌnak
nrg. One ruc.c* ollhc tìamcK)rÌi lÌns beetÌ rcleaLed b! lhe episodc r)ithe dctrecin
ìr) oi I
'1
 125

Lhelolhri.2rxl+ s tn prerious drcr.tÊs i dcpÌeciition oithe.ìoìÌir kd rr) ut\!aÍ1Ì)res

sure ontÌr. L)eut5chÌìart and nr eÌchangc .nte tÊnston\ betrleen LuÍofean r.onorìììer.
hc\iÌìgl!.!rren.rf.i\enGlhis. {rrrlrr,evahrxlin!tlìelìanrcirortuÌr rhtlÌelenr
'I . n I

I(lLl'\ iloaÌs .Ììa choi.. or Ìnslrunren15 la.k tlÌe cÌiril1.ot the ìnílâL on t.rrgetj. friÌne
forl ertahliíìecl ar.una th.: sanìe tjììc Ior llÌe Ba.k of tnirlar.Ì. Ìhc tcB bas lajled n)
con\er its ntqrtion oi ÍnrusLll Í.1bìlizi.g rh.. !uropi.an econonrl.. \s $e \hall sc<. tlìì\
.ontir\t\ r. tlÌ ure bch.rjour oluÌe LIS Icdcral lÌe5eNc. 1lÌe tìttem|r to dÌitigare rÌìr FSjt
im.te Ì)ìobÌcnì ol â priso.eF' dilennÌr in nscrl tìolj.v in lreDbo slnte\ Ì)\ ìmposiÌÌg
llsc.ìl Ìulc\ hiìs Ì)rcÌl.Ll ds rlìc nrle\ 1reÌt tnlnv dcs
ilned irrÌ.i hrlc pro\ed inrtossible
lo imÌrleÌntnt iÌÌ thr coilte\t ol i sÈat Iurop.dÌ ecofonl!. ÌiÌìatÌì,. toÒ little aÌr.nlion
nppedL n) hi\e l).cr gi!e. to thÉ pful)lcms thrr {Ìjsc lronì tlÌe neÈ(] or real exchan8e
rntes to .lringe l)elirrfrÌ Ì.eDrb.. colÌÌrtÌLes

3 USA: the new economy boom and its aÍtermãth

'lhe.Ìc.ideoltlrL:l99(\iQs.gooct(DcloÍtheLJSc.orom\.Iheecr)nom)djjpÌr!..1
both ifcrcfied d!nanìi\ÌÌr afd 16s iÌÌnabiliLl. thdÌr srns 1ru. ot eìiÌìeÌ
tosl rr.r !tec.kl,,s
labÌc ì 7..l5luls lhr le\ ..ononÌic in.li.aLor5 td ca.| posr ì1dr.te.a(Ìc l.hr iÌnÌrrtr.._
Ìnent n peúÌ)Ìman.e nr tlrc Ì99{\ rs côÌrpirÈct rliLh tbc Ì!r7(À and l1)81)s i\ (leaÌ j.
tenìs oi iÌúÌatÌon irnd LÌnÈnrplo\ nÌent. Lo.li n.l nt GDÍr grúÌh, uÌe \ rrlah lit\ oi !u!th
r\ mc.slEd br lhr \taìrLÌa..I deri.rtion is lorÌeÌ than n in! otthe tÌ.iols polr Í,rÌ
.Ìe.:i{lcs. llÌi\ Ìcd ÍìIne.b\..i(r\ t() cleim a1 rhe eDctot thc Ì rrOs ihir,ucc.!s rLlnì,trÌage
m'.1 oi US macrcr.orÌoìri. polio hld MÍltft1jrÌ th. c.d ot trusiÌìe$ (ycL!. hr se(on.ì
t{,.t,..,,
.1Ì iIn)mitioD a.d.Ònnururlcxrions Lc.lnroÌrJgì, (t( lj. Lhe iÌ\ o coDb f cd
tr c,r b! rÌre
'endol.\(Le\'aDd1ìÈrtechnlloil)tioonr'nri.reÌercÌÌ(ÌLonstlÌe,NeÌ!Elononì!i. 1.he
,t.:
thaL .t.1e\ har. bc€n eÌimi.ited Ì!a\ t.o hrsr\

3.1 The beniqn '1990s

Â\.onr!iÍ(Ìl sith thr. drrneLt!. d(rel(ÌrÌef Ls:n tuÍÌrt rÌiLh lhr hll ot(ommLLnjsnr, tlìe
reunjll.alion ot Gcrnan), a.(l the (rertir)r ol nn e\|.ÌinrcnLaÌ nì.Lcr)Éco.onìì. potic|
1Ìine1ro.k iÌì the lurcpeaÌì \lonei.ìI LÌIir)n. LÌr c 19!]{ls rlas a d(.ade tiee oI nra .r e\ter
i]rl or (Ìr)n1cÍi( nr..ks tor rh. I i5r.or!!n\. Ìr.like rhe t9;1\ in.l 19S(\ in rt]i.h tlìere
ÌleÌe maior sNing\ i. ( orlcl c.rrnÌldit\. xnd cncrgÌ
ÌrÌi15. Llrcsr. price\ Ì!eÌr raLher \i.Ìbte
rncl or a\ c ,JSe pÌi.c slìocls r,(.rc lor Ìrlarts ntheì rhrn rLtrfJds.
Ìllacr)c.onlnìic ÌroÌ1.\ r'xs iìso .hrra.ieÌt7cd b\ the abjc..( of Ìai(! foÌ .t nìAraÌtc\.
\liÌetaÌ! poLic\ I rs ìn uÌe ìrands olihe rcril i5l l,e!ìÊÌal Rrscn c underthe ( tha xìrnrhjÌr
ol lÌr. (ÌrccnrÌran ( l!Ìriru Ll rr\ rÌrÉ hrÌlrìrrt.f rlr! pcriod the ì:ed 5crrÌed nr b.
nìlon ing in iÌnÌrÌ .i( irúlahon rirrgerjìrg Ìroltc\ Íjth thc oblc.tj\ e ot \rrbjÌ Tjog SrrrrÌl
126

Ìãble 17,4 Lr! e.oiÕrr. pe J.rma rIe [!.].Ldcê 1 s505 1990s

42

of monetary
erpcctationr.ìs it'etl a\ kectìIÌg inUrtion Ìow irrd stable L' drì oteniciç
tolicy üì lhe t9r0s,
(ire3 \4âÌìkrN (20021 corÌcìucle'l h ÌÌoting thntl

. thc feriod w.s abeÌrìgn one for llre led in thc serìsc thrt slìocÌts'
csPeciaÌl-ÏÌradones'
srcre largclv absentr
. $h ã teÌio.l üaket the poìi.-r nÌrkcÌ Ìook i{oodì
. thc nrc.gtÌr oí the dolLar nÌacle the red's job L:asieÍ b,r clampennìg i'ÍÌationarv

Ihe(lliJrnnÌ
liscaìpoliry s'as reÌicved ot actit'. ltabiÌl7atìorì'iltics duriÌìg thìi dccade
olb!o}ant pÌj!ate sl]c1rr
acimini\traLì{ÌL tookadvatrtage olthc lavoutat)l€ ciÌc!Iì1slxnces
e strÌÌctürell
cle.ìandtoúÌrdenakeirstrìoushtcalc.nÍìlidatio' Th"tcìic'ì LÌJ adjust cd {ì
golcnmrnt b.rlnnce slcnt iron I dclÌcit oi 1 51!o in 1990 Lo a s!rdtr\ oi 0'90/o ìn 20i10 n'd
itrc rrtio oi grcs go'ernnÌc.t cìebi lo GDi'] teakc'Ì at tóA' nì 1!93
rnd had lallc' to 5{rt'n
bÍ 2000.Ì' CÌir1;n,rd!ìsors aÌii!.d that e 'let'ÌìnirÌed ns'd1'on\olidatlon
KNld not
(scc Châpt$ 6 ìor Lhe clelaLl\ of lhe
lì( .ontra.Lìonary rnd .otrÌ.1e\en bc erpan\ìonery
(llnt{!fs5c'Ìetar-!olthcTÌeasrÌ}
1.igic of \o-cr Ìkd erPiì. slon aÌ Ês.iìì consol nìatl' n \l
Noìert RLrÌrjn.rguel thrt tht h \ca1 .onsoljdrtbn was a condition ior Ìhcb(!Ìn jn
'rucial
t|c second half of tlÌe l99osrr3
a trni'l ol h\"1
i lìare rìÒ dotrÌrt tlìaÌ thc l o9.l klen.jt irducÌnÌrl ffuSram ind the
eÌiìhl ]eaA
ì'ìÌ rcd!'tirti 'l
PÌonrotúY irr(rrllr
rii\.ilnjne \dc \ev.nd irdúPrnsrÌ)Lc in n Ìnt!ous c-rtl€ Òl de

rLhì.1ìnrrtheÍiedu..drhctìen:itr'hichiÌ1!!nrtlrrinrrherirìLrcrsedilÍrLtlrrnd50'rrba'li
an(ì füúr. xnd lhnt tlÌn t.Li{ rrs th!\ kct an'Ì úxli\l)rdj'lr e
rÌ lcte!âÌi13 tfÊ !r'nomÌr and
ns.âlne\eÌ(ifrnert\ol1Ìrc( nntrÍear\ lilrjnkih\inìgelrrlotÌhi\idmini\Ìr'tioìniLlbe

oLi-O r,1,rri, orriúrk iL)e..fìl1r 2(r0lr rr..x trl't 2n

! lu )ir rlrnil lli lì ltÌrirrdnrrÌ'rÌilr\mÉfiF'ÌiÌì l2lr RtrildÌì'ìcrnt'Ìrifr!ÚrnÌiLadrtrr'
\1iÍirr!Èldí.irrliú.ftrr.ìrrìlinniÌ)rÊkLifr:AÌtf'uBhrLr!nÌrl)ri'ÈÌ'üÌni'l:rr"lru{ì!rnÚiÌr\'"!
r.lrl .sikp,ú!\.IfrtturiLÈÌìLì.drüúr,IÌhnLLtlì'ÌriÌiui\\ntlnrLÌìLrR!ÌìrÌrlIx'itì1orgÌe$rrÍn'ef
irnilrng if,rLrts r1ìnrlÌe5id.ri(:1trììofL)L.iÌiÉ{lR!Ìnrlrlirrt niti:L\'\nr'útLilr\
I he Írc.e$l!l erpcrnncnt .ú pio!ÌolìÌrg e.onomi. re.over ) ân{ì {\rrr ìcd gÍ\vtlì th.otr3h hicJl
diÍiplìne rather than thiorgh lls.a e\fansjon

3.2 New technology boom

lhc US econonÌ] e\perieÌì.ed a positne mppLt sldc 5hock así)ciate.l with the introcllìc
tjon ind diflLrsion ot ner! technolo8r" lronÌ thr mid-1990s. The evnÌence mggests thai
thc Lr5,\\!as unique amoiÌgn thc advanced econonries jn relati{)n to the neiv technol.ìiiy
slÌocli ìn t$o importar ú respects:

(l) kr) ìnnorârions in th. l(. f secnÌ í!k phce iÌì t1ìe LJ51,.nd
thc bLrìk ol thc
(2) .liftiúidr of th e ìn novrtion\ ! ( ros\ the econornl o..u Íed nrÌe apd\' th ere thaD Ì

e\ewhere. Table 17.5 shor!\ lÌo1r the contributÌon oI ICT lo lhe ac.eleÌatìoD ol
pnrductn iq gut'th fÌom 1995 cân be quarÌutìcd.r!

From the groirtìr accourÌtirÌg ( r 1( ! hticns iÌr l ablc I 7.5, we cân see that IC I ÌrÌ.Lles a
coÌitributl(ÌÌ to pÌoducti\ itv Sro\!th rii c.pitil d.cpc. in g i.e in the loÍn of hiSher lc!
el\ olconÌtÌrteÌ hadware, nÍì$,are, an.l other comÌnunìcatìons e!uipmeni per r,orÌicr.
Thir contributnÌr Ìnore than doubhs to.c.ount IoÌ ÌrearÌv 1% pe. tìÌìÌuÌn grorúb ol pro'
duciivit) alÌer 1995 Note thit thc.o!ìtlibutiod oI'otheÌ tvpes olcipital'ilrd oi'libour
quaÌitv is unchanged üì the post 1995 peÍiod. h c Ìow 'nÍal lì.tor prod u.t ìtl 1J groirth'
L

\horísthe contÌibLìt1{)n to labour pÍoductivltl gíNth that cìrÌnot b€.ttrÌbulcd tocirÌrcÌ

Ìable 17.5 trt Í;:er.'rÈ rr e.í iê,r t.Lhr! lqr

i drê !út lt!i L5 p,od!.i,rÌ/ Í.vÌ,; :..t;
!Êr.en1a!lÊ raiÊ5.í.r.n!rÊ

r arrrr a.Ê.eì ng,.t irr.l

a r,! l;i:.r proauÌr li.1{r.rì

r" llì!iiablÈ!rúút!11ihI..rnLingnì.ilr.{lflflt!iJ,.:ir<n1,,(.iiaft?LÌ3 \oLetÌrâLlh.rii.rnra(it,,i

ôjÌCÌrip,LaÌisr.riiLÌrèdenDrflri\pr.d!1ii1, Tlì.(.l.rl\t.lthebotrL.'..l.allrdtlìi!ra\rr.irlrlrl\
thr ri:.'riLÌr thr r1rÌL,nq.rr!:
724

.atiliìdeepennì8 or lo chanse\ hì libouÍ qualitv. Thi\ nÌcÌed\ed slì.rpÌ-v bccause oftech

noÌogiceÌ tr)gress bv ICT produ(ers iìnd clscwhere Ìr dÌe e(ononÌ-t, Í'hi.h rcflect5 tÌÌe
di ír15ion ol th€ ner, l cch noloSie\.
ln ahapteÌs13 aÌìd 1.1, lre e\.ìmlncd lÌrt ivr) t1Ìe ecoÌÌoml adiusts ro a íarter nìte
ol Lc.hnìcal progÌcss i. the Solo$ \warr iiÌo$Ìh moclel. ÌÌÌ this se.lion, içc locus on the
i.ìpliceti{Ds olr liÍcr rate olteclÌrÌìc,rl pr.gre$ tor nÌ:ì(roeconorrìi. polic-\',InÌ a nÌoú
to mcdiunr nuÌ perspcctne. ÌÌÌ Chaptcr.r an.l asahÌ iÌì Clìaptcr l5 jn thc se.tidÌ on
r\'agc and prìce settiig,lle rais€d the quciLjo. ol Ìlhat I rise iÌì pÍodLlclh'il) means lor
equiÌlbrjtrm enrplovrncnt. tt $ü\ ârgucd lhcte that eterÌtua11! chingc! in Pnxlüti!itl'
(or i. f(rducri\itv groaÌh) $iLl be iÌr.orÌroÌated irÌto w.ìge sctting bchavnÌu rÌiuÌ t1ì.
rcsull rhat 1Ìi the longìun equilibrtunì trnenÌrLo! Ìent i\ unaÍl(.lcd Hoi{e\e! it Ini!
takc sonre )esrs lor n .hange irÌ kend pn ucti!it) 8roÌ\'th to bc dìsliniiuì\htÌJle lronì
a purcl,r cvcÌi(il clfccl oi horÌÌ . transiloN pÌo.Luctivitl shock, and itcorl!)rited hlo
rÌagc-seuìng belìavjotrr. DuriÌìit this tiÌrc, equiLlbriLun cmfloJÌrcnl rites because th. /'J
cun c nriftt ut relirtÌrc n) the i,l.\ turvc.
ljlg. ì 7.1; iÌlustralcs horv rìn iÌúLiìtion lxÌgetitÌs.cntr.Ì bank ksl)()n.]st{) a Npplt sidc
, , tì ' )r'' i l r' ' lir r''r'
Ìh€ ilrsl i.dnrticÌÌ ot Lhe P( uttivjiv sìro.k ìs â ìill lì iÌìÍlallon, laster PÍ{hrcÌivitt
glorúh meâns i ll]rfcr SntrluÌ ol unj( cotts ar hence oI pri.cs (Á lo B) TlÌe.clìtíal

l,Lrinr=0, f,l)

(l

Fiqure 17,17 r.rt!e 5!F.f r .Ll tlÈ Lr5 tê.'n..aÌ/ b..r

 129

b,rnk can dcdu.e lÌonì 1lÌis sigxal thar â ÌrossibLe cau!e i\ a tosiriv. nrpp\'sntc sho.N.
lis optlÌal (sponse is a cut üÌ ilÌe jlrteÌesl r.te to ,/ as str(tr!. lpoirlts C and t_-'1. l.a.h
pcriod, the rc[trâl banÌ lÌll]st c\ânÌile thc dâtiì to che.k thar il is .ortrirtent N l]Ì a
pcrmrìnent supplr 5ìde inrprolcment and to see lrhether iragc bchirioui has b.g(ln to
incorporate thc producri'i(v gro\luÌ impÌorriÌìent. h irúÌatìon bchales irÌ tine Nith thls
hypotlÌesis, Llìc .enirrÌ bânk Ì\'ill o\e ts monctârr rúe ír iaui.L Ltìc cronom\, along lhc
.cÌ! ì1À curc ii.:Í,C/) ba.k to iarget inilarion ar the loweÌ equjÌihr unÌ unempÌoJdrcnt
ralr (ÌxriÌrt Zl. lt is unlikrlv that the reductiod irì eq!iLibúuì uncdìpÌlvnent l,jìÌ Ìasl
lndchrÌ]teÌv, h.wever. rirì.c src r{ouLd expecr real lr,rge itÍrlth extc.tarions elentualÌr
1(r adjust to tlìc ne$ fastff ilÍoÌ\t]Ì rate oí Ìrro.luctivit)r. Ìn rerms ot Ìhc snnpÌe ÌnodcÌ,
thjs nÌear\ tììnt fr enrueÌh,1hc Lt/-\ cuNe sìri ts up iÌì line Ìlith the j.iliaìíìitt jÌr tìre Ij.
rctuxìiÌÌij e!ÌúilibÍnìm enrplol'dìrnt to its (, igtnaÌ l€rÈt.
Ittbe Fonttn Rtp.itaftlÌ. /Ì.it/.rt 2000 (ilrltten bv uÌe (thairÌan ol the Council oi
L,conoDÌìc Adris€rt, ir is nolcd tlì.tr.
ihr nen h ghÚ trrrì!ì ArowüÌ iarc .f I)i.du.rtrlr_! snìcL ltt5 ..uld ha\e temfÒr.rjly l.NeÌea
th. \1Ìlì{r, trc..rir ú.an ral<c m.nv ÌúA f(ìÌ lìÌnìs a.d $Òrtrb t. re.o:inizc üris faÌ(tralnr
dclclÌnìe.Ìann nìc.rlÌÌaLeil iiroúìcirr'rie \el{úìgpú.csj titlr!nìcarirr.re.úeprodu.ti\jt\
núpriJt Lan \tabili2c nÌfìnrjon o rDir labÒr.o\t\ and fri.es ev.r.t rn.rjtÌ.\jÌefr rarcs bclúv

'lhe Rcport suggesrs that a one peÌce.ragc poiÌìt positile mÌnise i. prodlctilitI
Sr^lth has the elfect of lowernÌil the e.ÌtrilibriuÌÌ rate ol uDentlovmc.l b\ one rnd
a quaÌtc. Per( eDiage ltoitìts.

3.3 lmbalances, twin deÍicits, and the decline of the dollar

Thc counte{)aìt ot the lìscal conroÌj.Ìation !ndeú!lien Lì! the CÌnn.)n admìnìstrrti.trl
duringtlÌe 1990s n'âs.ì dranatic $\'jng ìn thr pri\ dte secror'\ 1ìnâncìaì bala n c( kom.r sur
PLúsol5%olGDlin L!r1r1 2toadeJicitoia)1/0iiÌthevedr2000(Iìi{.1;.18).4ÌÌrijordrj\er
oÍ thc d€terjoratir)n in theÌrrivateseckÌ baÌarcr ov€rthe 199t\ $arachâ.gc tn househoLct
savings treh avl(tr' Ì, irÌÌich $a\ a liolÌt 7Ì, o disposable n(omeiÌr rhe erÌÌr', ìr)(r0s butorÌÌ)
1.711ì irÌ 2001 (conrpn.iilthetwore.essiony..b).Asthedi\cusrionoítatiogsbelÌâvidrr
ìn ( hapier 7 nrakcs clear. the iúhrentr o the tecltrn)Logr boom on tlrc clilu.intrr by
househoklsoldrclrÌÌletiÌÌreÌveaÌthmavh.!rpla),e(ìaÍ)leTheretlunroil.ar.ì,ì1baÌance
oI lhc pri\âte seclo.b\ ZLìO:I jsniajdvdtrc lo aÌìunumaLlvlaigeìncrcasc in rcti iÌrecl p()l
itt í1.c. busiÌÌe$ srcbr \ò üÌijrl and a dc.lior iÌÌ business sector i.vcsrmcot in this perio.Ì:
thc lìousehol.t \arings ratio ha5 renrajrcd !n.haniiecìat about 29n o disÈrs.ìbleiI.ome.
Thc irnrly\ìi oi trs peildmance in thc Ì990s tu rhi\ polnt hâs lârgch jgrore.ì the
otenfcss ol the econonÌv. ìiut in the úarl,Í 200$, the L5 economv 5aw rÌ1e emergeÌr.e
oI a vcÍ! lâr8e cuÌrcnt .ccount cìehcit âs slÌo\ln iÌr FiS.l7.l8. lndccd thr US e.ononrl
ha! bccn clÌrractcrizcd b', the í ceÌlcd Ls,ìrÌ.leiìcìrt $,ith rìre trnâLc scctor hÌ lìnarciaÌ
brlancc aÌÌd a largc goveÌÌrnÌeri delicit ll.aÌìced bv ÌroÌrrving Ihm abro.d. DuÌing thc

:ì Lr!(nr.rìm.Ntt{ro|r

t
 8l (;eneÌnl govemÌì.nl Íitnn.ial bxÌân.e
C!fern Â..onnt balan.c
.l - Con\ÚucLerl Ìrri!rte 5erntr baLancc
-
,l
'l
2|ar0 2001

,l
"]
ol
Figure 17,18 lr5lni'.àlhààr.e5 99t l't4,9! GLIÊ

I990\.thc.let!'rioÌaÌioniÌÌ lhe crìrrcntrc.olnìt paÌtL\ rcLlected sL(ÌÌg prnat€ Ì'

estÌÌìcnt
!ìvjngr i c it ivrs iinarÌcìrìg pÍllate
if Lhe L.SA aÌìd PaÍìÍ tlÌc coÌÌrpsc oi househol'l
lsnr'rìrt-! htÌar)cint
rrrestmcntandionsumptìonirÌtheUS,\' Súrcc2000, it Sovenxncnt
íÌoÌt tÌr€ inÌrÌenÌcntrtion ol a !cry eripiÌnsìd ry tìsc'l toli" in
boroìli.g. lÌì lhÊ rLr.,
h(r)s1 íhiclÌ rc Ln torccd the aggress ivt
2i102 and200-l lro\'ided i stÌ(trìgltcountcÌc,\ c1i'rl
loo5eÌÌÌig of nìonetaÌ\ pdìc) LregLtn iÌr 2001 iscc Fìg 1t'l'll lhls
helpcd the c'ononìv
to Leturnio strcng grdvth as nÌown irÌ l'!g llrg lhiscontrâí5 witlÌ1hc nN'b ti8h1cÌ
fÌscal poìic) na.ce i. th. cur)zorìc. Tâblc l7 ó ìnrìÌs that tlÌc discretionrÌ) tìs'rÌ booí
puiàcOlvltreU:governnrentinLheìoüÌleirsfÌ(trn2000rlas'560/ioìlil)l!\1:omP'rcd
ruttr a boosr ol l)..1% oí GDl'] Lìovicled bv eu(rzoÌÌe gr)vemnrcntt tr4ânl e'o'onÌlsLt
belielc lhdt LrS n\.alpolic-v has b(cn ÌrrsÌrusiblv erpinsi(trì'ìr-v'' ìn this pcÌn)d lltr)zotìc
th la't'
goveírnlenlshalr]been critnized I(Ì brcaÌlÌ8 lherules olthe 5labilit\iìndCro
h,,r is ae can see. the Ês.aì ìnìpuÌ5c irüs nctualll verl snìâll
TaNlngr..ouut oi the open e.of.nly isfects,lheriàie'1oÌ-Ì oìthcU5 e'ononÌr'oveÌtlÌc
1990s car bc nlow. iÌÌ 11g 1720.Thee.ononìlbeSani'appro:imate'uÌrerúnccoxnl
bdlince itÌ 1990 anLl I'ilh \talìic jnlÌ.1ion Iy 20Or_), cqtrilibrnrm unemllovmcnt
$âs
Ìow$ lsÌLnçn 1ÌÌ the clingranÌ ir tcÌìns oi highcr outputìi there I'es Ìittlc i' uÌc
qrbstantial ':hatÌilc
(^er the ferio.Ì arÌ.I tìreie rì ÈtrÌent ncco!n1 detìcìt
!e.l cxchange r.tc '\
at thr erÌd. The shift in the.'1D cuive $'as dÌitcn ìn thi5 leÌiod b-\ \tÌ'Jnil fÌi\
a1c sector

consumption atÌd !nveslnretìt erpcncìiturcrthc tÃU !1ÌiflL:d to thr rigìÌt âs a conscqrten'e

oi the posittr,e süPpÌ) 5ìroc! associatcd úlÌ lhe techlroìoiit boon lh( tlealicnìng
oi
prìi.aLe sectorcìemand n 2000 l('atoilseltuaìargeerricttÌrtcorrnterc-!'ÌlcaÌnìrr'etarv
ard lscal polic) r5 discLrsc.l abovc.
 131

lÌril.LtuÌ ( l)lrli !.r GIJÌ'',i,...1

IÌ.rrf i.rÌnÌ.trrÌ /r,d
'rl
-

Figure 17,19 tliA .r'Òrih, riêmro,rment, àr: r':r.i, 199! .240.:1

Ìable 17,6 D5.rÊ:.narÍ5.. fr.r! r

tiìê Ll5A:nd the eJ !ror!,

2a0l 20!: .hiri. r th..!. .d !
;dlJst-êd i51!. rÍi ).ê'. Ì rz GDli

:].1!!i
''liL!

ll lÌirs bccn lfidcÌ-Í arg!.d Lhat the LS current dcco(rl]l dtlicìt is not s!staúìabk 'r A
p.rti.ul.rly .lcar Nal of clì a.leriTnrg the pÍnrÌeÌÌÌ lor lhc ltSA i\ that uÌe tradc d.lì.11
íi.c.goodsn.dscNi.cs)lsnbourthesane\izea\thecurlcnLrccountcleÈcit.loreÌam!ìc,
iÌ1 2003, (hc .urrc.l a.cornl $ai .1110/ô ol CD| it{Ì the ha.ìe delì.it in.ludÌng
dÊhcit
tranícrs such as lhc rcmlttiìn.es ol ìnnìii{Ìant ivorkcrs i,rs 5.1D./ô To see Ì!h} this is
nìpoti.t, ll is LricILl to drnrr r taÌaÌlel ilith the l€bt dlnâÌìjcs ol the public sector i]s
e:iplaincd ln Clìap(ff 6. w. sair there that i/ the real inlcÌcí Ìate e\ceecl\ tlÌe sro\fth
.|lrinrol..IirLa!lìla..qÌLjgHi|i2l)1)]]
i2l0lt Fnr inrirl'n {u\!orr dlÈ!ifdÌ7!rnÌr,lorll

I
732

ttÍ

Figure 17,20 Ìh. l9-rúi . th! LlSA

rate,thcdcbtÌatio\!iÌlonhbcconstautiìthcrclsaprlmarybadgetnupha.ilÌ.a.lLnÌ
t)ldgct baÌifce crn bc n dcl.jL ÌeÍlectnÌg t|c lntcrciL Palmcnts on the debt bul thc
púüì.rl'balen.e mun bc in írìtus. TÌartrtèrriig Ìhis ônalysis to c\teìDaÌ borrol\'ing. Lhc
anrÌogueo LhL: ÌrÌinrart_ balilfcc is Lhe trade balar.c ifclrLdln:j 1ra.íeF and olthe actúal
budtetbalan.ci\tìre.uÍc.laccountbrÌuÌ.e,\!h.hijìclLtd.sncLi.leÌestlld!\.Juna5a
ÌrÌiÌxaÌl bLLdgcL.Ìeiìcit is i..o.slslc.t Ìliur stabillTiÌrg thc golcÌnment debt r.ìtio and Lhc
act!al d.lì. t. a LÌade dcnril ls i.coDsident tr'ith slabìliTlng th.: trti{) of ertenì.1 dcbl 1o
(lDÌ) rnil hoìdÌnii tlÌe clÚÌc.l â..ount delidt.o.s1a.l. lhclogicof.lebtdvnauÌicsnìcêns
tlì.11lÌc lrS rracÌe r€dLrccd in ord$ to slabiÌize the crìrreÌìt ac.oLúrt
detì.il Ììtrsthc râdicalLl
d!1ì.it and lhe erternnl dchÌ Ìatio.rz
l rom lrjg. 17.20 itis.lcaÌ lhat a re.luctioninthc Lrndc,lc l.il ÌquiÌes Í)me cotÌÌbirÌition

. a Ìeducti.ü iÌì .gg regate .lemand tlÌrt slìl[Ls iì]c 1D cur e nr the Ìeit (lìoÌn.1r')
rhÌoush iÌì.r.asc! Ln p.i\ rte srrirÌgs and a relur. oI lhe tubÌìc secíÌ to $+Í!sl
' i rcalrÌcpÌtcìaüm oI Lhc dolÌar. rlhlch Ìlould prcdu.e. shift 1o 1]ìc noÌlb-eatt aÌon3

. arJosìÌivccxtcrnaltrrr:leslÌockthatilouldnrifttheËTcu Ìen)therislÌt.
ls thc diagÌaiìì nÌak.s .lcaÌ, [.]r i {Ltxilrble reducticÌÌ of tlÌe delìcll, i dcptcclâtjon
Noúìd hale to be r..omtanicdb! a tjghreuúÌs of aggre!.ìte deÌnand to tik. Lhc (onomv
to a posirion or the l/ì(r'r .rrrc .loseÌ to the irÌtersecti.trì \!itlÌ the lJl cun'c. lJc.ause
ol Lhc siTr ol tÌre LÌs c.o.om_\., a d.ÍcLt ol 5 ó1]1) ol it\ cDÌ] entriL\ r rapi.l Lru ld ut ot
torcign orlneìshit) ol LrS aslcls. 1 con\cquerÌce of 1lÌe lnalL \ire ofuÌe tndeabic sc.lor in
rr'larion r{) the LÌS econonìtrs aiÌhoìe Ìs thatr l.r:e real d epreciâtirÌÌ is req!irrd lo br nS
âbout the recÌrìired dcll.it Ìcdrr.Lior. ObstieÌclând ÌloiloìiÌ)(ride aÌì illLtrtr.ti\c s.rfnrio

rr rh(r\nf,u f.\iinÌr.I Ìlìr LÌ5 \ tr.onìÌr i1tÍl Ì,.-tr1\É it lLn Ì,uts<,\!n \ r$d\, rl,rlÌ ri!ì i ÌìLÂhü
r.hnn iÌ,Jrr ir eìe! Li!Ê.ln\.r!.A j.Ìbilin\ ri:rrenn\ilÌrii,,r\rúliIÌe.ÉtrIL!r.lri.I(iDliiniL
Ì)r.lÌrrfntro'Ìè!)20r:r3d.\fjn.hJrinEf.i.ì,r(r\iabilitier.Ir.dÈlj!,,.1(irli.lhúdalèstìl.FÌitionnrf
rÊr\eÈnrlì?rúdedrÌìrt rrL!r,trtJrÌrt! ni tlieieiÌd.rri iÌ!mme.nnFÌ.xLhrnLÌrei.ilÌr\nfinrt hìi'
i?.!Ì i. a-hiD1!a íi. \.Ì{ rrle$ dÌÈ r...1ÌLn.n rÌìrL tÌr. Ìi\ nrd! d.!ú n!n !r Ìrìi.iLÌ!
.\eÉeis{ì?bÌ.rfr (rg,\ n, r aúrìimLìle útio tr cDl n lih.l,r|!.d
 to {ggcs1 Lhat.ì irÌr1.ì rrdL,.tirrn olthe cluÌerl n..oÌuìt br:1,/0 ol (;Dl.otrld cot.jl a reaÌ
cleprecirtion ol r\ rnuch as,10'li.
Although (he doÌlâÌ dcpr.riated iÌì 2003 I br ovcr 301/. rìgijrat ihe rÌrro. t1ìe core
spondnrgúader!eighlcddcprLciiìti.n$âsmu.hlcss,rro!Ìrct1:ì%.ThecxplinitiorÌljes
ìÌì thÊ behavlouÌ ol go\ ft.Ìrcnis rnl ceníal banks in jrren c.cd h€.\il) t()
^siâ.lapan
preveÌrt lhc afpre(iarion o lh( 1erÌdrÌd the Chjncs. cuÍ€ncr hü\ Ìem ai. rd lìrcd ,r g.LiÌbt
the dolÌar, r'iththe ahincscnls,r b!ildirrgrlPlargcoltì.ialrcsen esold(nÌrÌs. lhlsc\,rÌÌrtte
hishÌighLs thr dillìcuÌLjcs Ì!Ì1h iì.hirvirÌi{ oÌ.1.rÌv.Ììangcs in r(al eÌclÌangc raLcs wcs.r$
irÌ the discrrss oD ot ll\.JU thc dìlÊcuLtie\ thal ârisc h'hcn rcal €\.hanile .atc chanscs .ìre
requiÌe.Ì rÌ Lh n.r curre.cv rLnlofrllÌis earnìtL bÌ ngs oul LhcdithcuLtjestÌretcìis( (rlÌcn
noniinal e\rhinte rate cha.gcs arc posljbìe It is u.ckâr hoh .ppropúate changcs n
the n(rÌiniìloiclÌanse reLcca. bc brouitht abour i.di\'hclhcr intrnru()naÌcootcÌaInrJÌ
Ì)etrLee. go\ cflÌnÌeÌrt' caf pìay a lole. 1lÌe diilcultics o i.1(.fiÌationdl poÌic! cooÌdina
tior ar dis.ussed jI ahnplcr i2. Ìi.rn oÌdeìlv adjustürcfl ol thr 1,5 ecoÌxrÌy is nol
achìevcd lhrough r comìrinatlon oliÌìcÌeü\e.Ì {!ing iÌrrivaLc.nd pubticl, depie.iatn)n oi
the dolÌar ind seÌi{\L toì .lc5 1o rcduce inÌroÍs, ior.xampÌc lhÍrugh policiei nr redu.c
tÌre consLúÌption oi 1mÌrorlcd oiÌ, adjunnÌeÌrt ma) rakt fla.c i. a .Ìore clÌ!otic nranncÌ
viaicurcn.vcrLtr(e.g.rsnrons(qucnceoirrÌrcculetj\caLrrcÌonrhcdollariimiÌaÌkr
thaton F.R!l currencìes Ln I9t)2ì.

4 Japan: more than a decade of stagnation

The Ìro5('ì!90 Jiìprìne\e c.ononr! proridcs â clraÍÌati( contÌr\t to thar ot Ìhc Lr.ircd
Stale\. (,ro(,lh in Jata. Ìras bft n haÌ as list rs tlirt oi tlÌe USA and unenrf ìornrc.r ha5
been riring stc.rdiL\ since 1990, reâ.hlnil rat(\ ibo!e tlÌose iÌÌ the LÌSA ld the h Ìsr rtmc
since thc rar. ,\s lrbLr 17.7 makes cÌrâr,.liìlan Areìr verr fan i!Ì ilÌe p.e 1973 teÌn)dt ìitc
the othoh g blo.s, gurth nowed \hardr tdlowirìg thc irn oil.risi\ jrÌ 19;:l:but unÌiÌc
ifg
the USA a.d lhc lU, the 19E0s war â de.edc oi frirlr .apid groNllÌ loÌ lâpdn. The 199fi
theìenÌe tÌoridrsir (oÌúÌast irith lafa.'\ prcvious d,uanìisnÌ as $elL r\ \!ith rhe ÌevjvaÌ

Table 17.7 a. rr ririïr. qr.i,th ri:es l;pan,JiÁ E! ooeèÌ.

Rê' CDP qrowth Làbomprod!.lvty qÌowth

(ei p.â qÌowth rà1êt suriiêssedo,(0,6pà qÍoúhraren

iÌÌng
734

lÌìf â1i.n 1(rl'l) )'op... tÌ ral.ía.dâi.lized'r'i cDLrr)'.p...

-
LnÌr.r trcfd l(iÌìl) !,i fal

Figure 17,21 l.pi' lr.tth !r.mp.!r.ii,; d nÍai.n lq'lr rani

ol trcducti\ii-v'' growth iÌì the U5.\. lluÌofe\ dvn.Lrrìisrn has dÍiilcd -st.lÌ-Ì .Ìoirnt!dfts

Th e strong grotrLìr at uÌe €nd oÍr I 980s ìtr I dp.n is Seneri lll !i.r'cl1 a\ repÌesentiÌìil a
t h

'bubble'phrromcnorÌiÌÌIlhìchassclfÌice\ botlì noctri nÌi rkcl nn d p rollt rÌv iÌ(reased

welL Lretond lcrcls corÌsisteÌÌt r,lth lhc underLliÌÌg iund.nÌenlils. lhis rcstrlted nÌ a wa!e
of jrn,estm( n L i n lt Ì oje. ts !\'ith !,!'ry poô Ì Ìetlutrs .\s .r coÌÌsequ cnrr. tlì c rc ilas r substaDtitìl

'correction' in â*et pri.rs loÌlon'cd bv â PeÌiol oi lo$ inlcÍÍÌrc.l Úihilsl a$et pri(e
bul)bÌe\ harc Ìrccn obserrcd in a nLtmbtr oi tÌÌe.ìd\an.e.L economics (c.9. sift.Ìen rnd
tÌre l-li in thc lrte 1980s, thr U5]\ ln lÌrt late 1990sr, uÌe\ do rÌlt ne.rssarilt tnduce
Ì)rclongrd rccrssjon.1lÌcJap.nc\c btrbble and its ültenÌÌtìth h.!e rii\cd qrLcslio.r about
tÌÌe so!fdnra\ ol tÌÌe lìrp.ncsc llfiìr.jal s.vstenÌ .ìÌx1 the irÌterconnecllo.s bchfce. ihe
La.!r .orporare gìoulx arìd thr biìnlis.rr ft has.r15o raised quenions abouL (hr írnrdne!
oi ÌÌriÌclôccoroÌni. poll.v nralilng, Ì!hich Ì!e tocus !n hert.
'lhcdc.Ìineingroi"thotcrlhcposll990periodisslÌo$rÌiÌì1i8.Ìt.2llthcdadrtdÌ1ne
slÌ,rrfs1lr.r íend). TlÌc stcadJ ris!: i. u.cnÌrLo!iÌÌeÌú l(ÌÌÌ tlÌe lery lo$ ralcs io lc$lban
J'r,ì.hiracteÌi5tì(olthc.laÌriìrìc5ccco.oìn\b€loÌel99ilis.pplrentiasistlccmcÌgcn.e
forthcfirrriÌneúranndrin.cdrconoÌìtjntÌrrpott$rrterj( otdeiitìiiLÌr.i.c.i'ìl ilion
ritcs bcl.Í'7rÌo. Defl.tion was obscÌtc.t in 1995 rÌ tiren lun 1999 tlÌ(ughto 200.+.
lhc kcv macrceconomi. icn(rLrcs oI thc 19!r{\ 1!ere ileaÌ( r*retsdte lerÌÌand or lhc fi,I
oÍ thc doÌnestic prilaic scclor ns i.vcstment an.L .onnunptnÌì st)endnìg 1!€rc Í.dlL.rd
Ìr! irÌms an.l househoÌds lhal súiIcrcd crÌritrL lo$e\ in the a$et pÌile craslÌ. hjs rçes
conrtoundecl b\ â ncgâtlrc úidc ìrock ür 1996 as a (onseluen(e of the,\si.ì(] .risii.
r'htre Ìlas {Ìso i s eatrc.iÌrg ol rhc 5uÌrpÌ) \ide reUected nr poor púd!(ti\ itr SrojrlÌr. Lhc
.tfosite ot the \it!atlon in thc (rSA. Tìre otheÌ notabÌe nLìcr)e(ononÌj. devrhpnÌ(n1
rr 1.r,,..r,r\h.,,ltÌtinlrnti!.5irdii{nìNrg.\,,ltlrrlìÌ,|.inrJri.L \ri,mrrn rldir,Ìlì.tÌrl
ì)r,rn, ( hritrtrnnL.s .I h nD.! ..,|tr ii.ì ÍÌ Ln)1Ì,tan I rÈr rrrÍr
 7ì5

.1D(1t90t

FiguÌe 17.22 ÌÌ, rglcs n liprr

1ça5 tìre \ubstarÌlial noÌÌriiÂl (500,t1 arìd ÌeaÌ rplÌec]âtion l+0o/o) of Lhe e\'hangc ìate
bcti\'ccn I 990 and I 995. 1 h c Ì ertter thc cxcÌirngc ì ate ÍÌu.Luatecl bu t lllth Llttlc re n 'lL

'ÌhclÌajector!ofthclaPtìIÌi's.cconom-vi.the1990tcanbctepÌesentcdinFiSll22The
ecorìomtbeij:ntlìcteriod('itÌracurrcrlãc.orrrlsurPlus(lotheLeltoltheÜ7cuNe)ancl
tr'ilh i.ÍlatirÌÌ.nd lhe reai c{chrnile rilc stable so ire c,rÌl think ol tbc ccononÌl is benÌil
oÌÌ lhc ÃnU rt poidl 1 TIìc wcakrÌen oI aggrega tc .lenÌi n d is shoìÌn it the tefti!'aÌ.l sÌìifi
oi the 1D cur!c, i.d the dclcrioration on the suptl\ sidc b-v the leilwad üriit oi tÌrelÀi'
curvc, iÌrcìic.Ìing that dt any real erchange r.1c, equiiibtium uÌÌcrìflovÌrren! Ls hiilher
lhc sl(Ìrg apprcclatidÌ o the --eÌÌ dmve the c.onoÌÌr-ï írth wcst ar nÌoÌ\'n AÌihough
thc alU nriited Ì.|t, the conrbiÌÌation oiüe altreciatlon aìÌd lhc ertreÌrìc Í'eaknrss ol
dorncíjc denl.nd ÌìerIìt that ÌúLation r!a! lalìinil contnrnousÌt thÍtrrSh lhis Period'
t.NÌig it. as noted, ìnto deflilion.
jìr thc Japa rsc nurÌip?r \{elìIst
\,\ Jiiì L rte h.s c.on onÌic Pohcv dal c.l
'on'idernlon
etary foìic) ÌÌì ChepteÌs 2 ancì 5 Ì\'c dncusscd hoN lhe lresc'ce of a liqukÌitt traf or
thr nltriÌr Ìent oÍ Lhe zero nonÌilÌnl ìnreÌest ralt bouÌld inlÌibits Lhe norlnaìoperation of
rÌìon.1rÌ)poLicva..Ì\!e5lÌtsredtJìL:inÌn)rtan.elorthenÌonrlaÌ.vautlÌoritiesolsctting
tlÌcir foÌi.i en!,LronnÌenl i. a Ì!a,! lhet pre\'c.ts cleÍlatjon trom emergìrìg'r' on'c deila
tion scts ìrÌ, ÌÌronr:taÌ\ poÌlc) becomcsnNchha er(otr\eeiÍcclneLl lheBaÌÌkoi.laparÌ
dlil not aclopt n. ìnilatìon ta.grti.g regnnci haci it done so ìth I s-v''mÌnetric inllatltÌÌ
targcl oí, ta! 2'fi,, il is fo\slbìe tlÌat dcílation ma) lÌavcbeen'!oided
Hos,ever,.LsÌiii.Ì7.231ÌÌultratesoncedetÌalionprctelÌs,evcnanìtúlationtârgetoi29i
.locs not bl itnìí ÌtÌo\idc a Ìneans tor tìre e.o.(tÌÌ! 1o e5cape tÌom thr úat lhc
(aÍrn
is thâl iíìth Ìleik eggregal. .tenÌ,ìnd, the 15 cLr\ e is loi! Gho('n b-Ì 'A 1990j'l rnd
h'ilh
dcíliìLron, uÌe újn / liÌìe shoi{ìIÌg thc 7t() rrrrnÍjl ìntcren Ì'1c is high (wl!h cÌe1Ì'iion of
:.irhn)2001. l1rì.rherLnLìÌincisrtarcaÌlÌrter€sL Ìateolltri') Thus trnÌen thc núla rn trÌiiet oi 2Ìr it
il](.orln)rated in private sc.tor erpc.lations so tÌràt thc rrLir I lì]rc shitts do1çn' tÌLe rcijìon
oI lhe IJ.ur!. that is slìoirn as dnslìed 1\ unattainiÌblt u\ing Lbe nÌoÌìelaÌl' policl' ruìe
bccau5e ot thc zcrr nonÌinal iÌìtercsl Ìate boun.l Ìhcmo\itbccentr'ìLbankcJrÌdoiitt)
iJìflement a zÜo interrsl rate poli.-Í, ZIRI, .nd attaii toüú tl slnce unrnrtìo.trÌÌent ln
lhcc.ono ls iìbore thc cquiLlbrl u Ìì, .ÌelÌ.rtjo n iliLl woben, whi'h rilL pünr up the rciÌ
l
:'F.ri,f,rrrfirrgúD.frìstDÌÌrrr.lt.le..noiìi.t.Ìi.Ìri{rles Ì1!n Ì"'ixÌ\ pnlnl urihÈ
'\lL!
!enú15.,'lJtrn\deLlrLrfr,\.eln!.n i2rr)3)itdr.\tn Ìl lnr r21)rrli
ri l.rir.,r! r,njrl\ rir.J laÊ. ar: lirÌÌüii! raf r.. (aL!ÌrN iL9e$l
736

-6
af..rdjn3 Lo nì.f ct.ìr!Nle
irÍÊn\ibl. lre.rtrir it iÌnfÌn\ ir0

l a IIìI
l'1""'

Fiqure 17,23 li:!an ,qÍ! icÍ rà n:e .ii rlÊ lìo I nl

ìntercst ÌaÌe (i.c. tlÌe rÌ,i!,'Ìlne rritl slìjft !pnalll\), rcducing acln it) lLìíhcr' discussrd
^s !G efïe'l
irÌ ( hipter -5, .]etÌation is lileìt, to dcPÌels .8gÌegi1c 'ÌemarÌd luÌher bccrute oÍ
('r bel;n(. sÌreets f.ìctÌation ìncreiscs tlìe Ícel vrlLtc of debt\l an'i th' conseqücfl laìlurc
(o
ofb(6iuesscs. TlÌisNtrìl.l shlltthc /J curvc i(trther ìhe Ì€1t'
,\saìSuedinClÌirpler5,itrÌa\IÌolheeasltogenÚarctheposiÌhe1Ìú1ntio!realrccratiorÌs
torcÌea5elhcecoÌìoÌn)ìronralleÍlaLloItrap.NotÌ!iLhstanlnìglhesenìhÜcntdiili'uìtles'
thrre has bccn nnich crlliritÌ oftlÌc !aúr ollalan bolìr ntr its lâilLÌre to s!'riouJlÌ alternPt
to tìevenl .lttÌation lÌom beconÌlng e\tabìlnred and thÊn lor laiìnÌ8 io ún'lertake the
rò IÌrere
nrcasrues thrt roLLlcl enlrrnce thr Ìrr)\pr.ls tur a rcLurn to posjtì!e inllatft!Ì
ntterÌtubâ\e bccn tail(rret b! tbc Banl ol.Iatrn:

to .i).!istenlì1 Ìrresc.t tlìe r'icN thrl ll5 1nt1|tl'n taÌSeÌ ls r Ìate ol5al 2!í afd úÌ
.
over eqtrr\ìzúÌ:t lh e likcliìxnÌ1 oI rurJÍ'n-v itúla1io'' 1littaLrs more dctc Ìnìed slcts
r. o\er.oÌne dctlêti{!Ì. ln fa.t snrct ìts indt|endcncc nr 1998, Lhe IÌank ol JaPan hâ\
cnÌ)Ìi.si7c.1it\ Ìnandrlc ji pricc slabìÌit!. he CotcrnoÌ oì t1ìc Ba'k oiliìfa' \t'rtcd in
rl
20(i0tlÌal nú1.1io n ìs nì ost Ìilell Ll ncorÌtrolìab]l orì.1: lÌi#elcd
. itÌ nrc$nÌg 1oo nnich 1t\ 'indcÌrcndencc tu thc d'trimeÌìt oí 'ooPeratio' wiÌh the
go\ e!Ììcnt iÌì iìL1dÌetsj.g laÌìarÌ's prülenrs lor erianrtìt as notcd ìn {lhaplct 5, a conl
biÌied lscal anil nuÌetary poli.t ma-v be u5ctuÌ ÌLh.n lhtìe is a ljquì'lltv trip k)r eÌanl
pÌe, thc central brnl.ouìd dire.tl-v fruxl 1e\ c!ts b! nÌrnetling Lhe goverrìnreìú dcbll
tÌÌe gortÌnnÌiJrL seÌls bon.ls to Ìllc ceÌúral banli ând scn'15 out c|cqtres to 'r1l 'ilizens
. \'Í(Ìe spl..liLcall) it ú rrgucd Lhat Ìhc BanN ol.lalan tlüotllcd lhe rÌrs'cnt recotot
iìonr lhe nÌid 1990s bJ raisilÌg lht lnterrsl rate too soon A serolìd nr1\tatric Í'rs nÌadr in
2000 Nhen thc Baú ol lapân 1ìatìnij irÌtírduce.L,,cÌo LnteÌest rilc folic), ZlRP irìeâdl

r.L.,rÌ)LÈ Í. n rianNr 12r)(rl)r See il!. l'rxür ú lnr rllÍÈ

 - (,.r!tr1Ì g.y!rìi.cnt nfan.ial rxlJn.e
(lürtruct.d unìt. \!LnÌ linaìLial brÌânc.
- (ìrrent r...uf l br r...!

'1-

:l
Fiquret7,24 ldpàntn:r.; LdarlÊr, l99c 2lo4 lacrP

I 999 I i ll cd it h 2r-)00, tiglìtenirÌg poli.t nÌ the fa.e ol d €tÌaii,m. I he econonÌv contr.Lcted

and ZlRlj lvas reirú(Ì1uced.

Ii\caÌ poÌic! aÌso apÌr.rrs to hrvc bc(r poorÌÌ j .]ge.l in Japa.. Ìt nas tighteìre.l ìn
I997, heìting ro prc\ cnl Ì.(olrÌ! troÌÌr ralilng hoÌ(1. Meanshile the lengthl period ot
depÌerse.lguflhh;ÌshrdlhcL:ltc.toIprcdÌr.ingÌargelir.aÌ.leh.itsardaiapidbuìÌ.luf
in the nraÌe oI govcr.mcnt .Ìcbr rtronr 689i) in 1990 nr 155v. in 2003). \ote that just
as $itìr frjvatc iccLor drìrt, lh. Ì{l viÌuc oi govemÌnent debt iÌrcreases irÌ a \ìtrutidr of

The stÌiklng chaÌact.r.IJata.\ elolrúion sìnce 1990 is Ìe1Ìected iÌÌ a dillerent wav
üÌFit 17.2.1. InanccoD(nìvwiÌhachronicìacl(ifclenÌand,tlÌerelsax.Ìr,r.e\.e$
oi cìonrettjc \a'irgs o\..r in\iestnxìrl. This drives o tÌNt doiu. LooliÌìg at the hnarÌciaÌ
l)aìan.e5, therc l! a rì5i.9 rÌcnd ol thc f.i\';rtc stctoì hnancirÌ nüphb, Ìlhich Í niiroÌe.Ì
l)_v the ab!ÌpLion ol thorc srutÌuscs in Lhc gÌonth ol the iiolernnent cleiìcit aDCl a 5ub
\tantlaÌ, drough !laÌrìc, crtrf.:.t acrounL srrpÌur. A Ie\ ivaÌolpÌivate ìn\.e5tìnent is cÌeallv
neecle.l as fa11 ol lhc lolullon to lrÌranr problcmsr thi5 worìì.1 Ìaire the Ìeveì of actì\ it),
Ìeduce the pÌirat. sc.tor lnanciaÌsurtl(Ls) end bv ÌaisiÌrgtax Ìe!enLre Ìe'eÌse tìÌe tÌeÌr.Ì ol
the tubÌiciecloÌ halan...
A\ noted aborc, thc rQl apiÌeciation in thc eaÌÌv 1990\ lt'eeÌiened aclivitr inJapan
b! daÌnÌreìrì.9 ..t uxpoÌts. lìÌom lìLg. Ì 7 22, il js cleeÌ tìrat a reaì .lepreciâtion takiDg rÌrc
econom_v to thc north Êasl sould hclp Lroosl deman.Ì an.1 Ìna.f commentanÌs halc
rhi.k aboul lìoÌ\' lno.craÌr l)oljcv couìd conLribtrLc rojalan\
argued tÌrat onc ir'al, to
recoler\ì\nrtcÌnr5oÍcrcerjngìnlaLloncxpcclatio.5asa$'â).frlcakcningthe
'Ìrcnc\.,
lit 17.22 aÌ$ nìakc! 11.Ì.:ir LÌrâLslrongcr domcsli1: dcnrard Kruld nccd 1o accomtan! a
clepre.iatt)n il thc.úrcnt â..ou.l súrlL!s is n.t to ridcn tuÌlhÜ ad.ÍcÌolnìcnLlit(ìv
to undermìne rtr(aìfrs ro achic\rc â s(rstaincd dcfrccìarion.
 iìr thc lìglÌt ol the anaÌysis in se.tion '1 on the US ecoÌÌlml' llhcrc i !'s
argued lhat
the dollar is rcquúed $'e cüÌÌ scc that a subttantial cleprccì
a sob\tantiaÌ dcfrecialioÌì oÍ
thc Bank of.latan had n) inlcNel̀ rcry
aridr ol rhe \ c. ailainst thc .ÌolLâr ls unlìtricÌ-vi
groirth
h ravily lo pretc nt tlìc YeÌÌ üonÌ â rrcci:ìting 1n 200 1 CÌìe so urce of I h e revival ol
is a new \ource ot crPoú
iÌr lap.ìn fÍüì 2002 l\rs thc grD!ih of eripoÌt\ to Chnr'r' Lhis
jsnot exLiniauishcd l)t alaÌge
dcm;nd and ìrill genc tate faÍeÌ tsloNth nìlnlaÌì aslont as i1
rcal rpprc.lation (re.iìll thc analtsis ol a poslti!' cxteÚral lrade
slÌock: Ál and ill sìritì
:tt," c:hu,"r" cutt"ncl jt 1ìred t{) the doLlâr but the strbstantialh lÌighcÌ nìfliìlìorÌ
rlgtrti
ol lhe
ìriCÌrìÌÌa lhall in lapan is hcbúi{ to ofnet lhe elic't oi tlÌc noDÌiÌìal dePre'ìatidì
alhlnesc curren.r againn thc rerÌ
Signs ol .n cftl to Japancse stag.ation and deÍlation are
apparent iÌì 200'1 5 Th€
strenitttr ot nel erPorls has brc.rdcne.l b.yond ChÌÌa has bcen a"omptìÌÌlcd Ì)v
'nd
tlcLecorcLloilnresrmurlasischara.terisLLcolnornÌal'btrsüress'vcle!pssiÌtssliscâl
ancÌ nLontarr policv mistiìkes lÌàlc not bcen rcteated a"Ì
both the govcrnncnt rnd
aLüel!
thc BanÌi ofJapan lÌale Ì1ìade publÌc commltÌÌìcnLs not lo tislÌtcn totic-v tre
qrppl-v ricle Ìcnrrms iÌÌìdeÌnentcd orl]r the past clecadc teed 0rÍnrgh' a {stainablc
^s
r.cover!_ i5 possible
r!

5 Conclusions
We hare sbo n ho{ th. Ìna.ro mo,:lcÌ can b' u\€d 1o interPrct the role thal ha! bccn
tlalcd by

. itorcünncnt poliry, afd

. innitution.l cìrangcs
.lnanunrberoftevepitoclesi.(Ás!uírpe,tÌrcLSl,andJap'rninrecenl'lec'dct'
We have made un'of
. thc 3 equatìoÌÌ nn eÌlo characleÌlze nronetaNln)Ìi'y malirÌg'
. the open €conorÌìv nrodcl kr examìne how ecolÌorÌies rdjust':d nr dlíIcìent shocl\'
. the iìrÌancial balân(es ìdentity lotÌacN the rrletiotÌship betÌ!eeIr lrlvate scctor' pubÌic
scctor..n.l the c{terllnl acc.urì!,
. thc anaÌysls of lìscal {siaitâbilitf, ancl

. grrlth accounlins.
Dcs.ÌiÌ)tivc.lata ha5 becÌr tre\erÌtcd.nd ììnked (Iilh the kc-ï conc€pls in the Ìnodels'
lle hale \eür hoÌ\ the cUla can be use.lto .hecl ('helher Ìhc treclictioÌrs of th! ìnodeÌ
we use'l tlìc
a.e broa.lÌ-v consistcnt ivitÌr lhe fa.ts. Iìr the case oi rcccnt tJK Pcúonn'nce'
cìâta lo help rclììre our hypotheses
 Ìn this book, r,e hìve lrught to consLruct nn iÌìtegr.ìted i{av ol un.leAranding hos,
the macrcecononìl Ì!orks (1.e. a posltive anaÌvsis) a\ ìlell as identifvlÌÌS the poìi.v iürplj-
câtion\ (a norÌìatìve ânaÌv\is) an.1 halc cÌrìplÌasized ilÌe clrnsen\u\ that has.:ÌìcÌgcd
imongst econorìists
'ìì lx)th of thes. dimcÌìsÌorÌs. How€ver by Ìooljlg ar the pracltcc ol
nìacm policl in this chapteÌ, rle have norcd some ilaps betlle€rÌ lvhat Ìrouid seem ro bc
optirnal poìicìcs and those thât have beer implement€d. Whit ÌrÌight account lor Llìis?
. ÌÌtiticâl c.onorÌ\ fact(Ìs are eridenrly present iÌì sonÌe ca\es. For e\amtìc, Lhcrc
ntcrests (ìn the short teÌrÌ) ol tlÌr, uÌÌions, rrÌìplo),er\'asÍrciations, and
Sovemment in l!cn Cermany in pusìring Ior h'a8c .onvcrgcn.c irÌ last CemÌany. I Iort
eveÌ, in otÌrer .ascs, the coaÌition of ìntercsrs is ha.d€r to uÌì.orer nrch as nÌ rhe rciusâl
of üÌe Bank ol.lnp.n io act in ÌeÌx)nre t{) thc dangcr ol d.llntlon or the un\ljllingness
of the ERNÍ mcmbcrs to reaÌign theiÌ exchangc ritcs ldloh'iÌìg Gcrrnân urÌilìcaiidr. hl
::\ìi both these cascs, cxce\si\e ireightseems to hatl: bcen pÌa.cd on ihc need to lÌoÌclpolict

. Ar is oftcn thr case, it is easleÌ to .ljagnosc thc nnturc ot shocks r,ith t1ìe benelit
ol hìndsjgh!. 1lÌls $as üLre ol the exteÌnal suÌrdv shocks of lhc l.rltx (a5 discussecl iÌr
ChapteÌ I ll and is also tNe ofthe GeÌDran unjlLcation shock. |csr cconoÌrìists recognize.l
how veÌy rÌcâli Ìh. productive ba\e ofthe lasi Gcíìan cconomv wâs. Howcler, rfe lÌâ\e
aho ieen an jnlcrcÍiÌìg ca\e where a sensiblepolicl lranì$!ork sccnìs lo havc alloÍ'ed the
poÌì.v mâlicÌ Lo ìcarn aboutthe nahue olthe shock. ln the ìarc I990s, Lhc l,cd$al Rcscrlc
was wìÌling to cìprrirÌÌeÌú l)v allowirg uneDrpÌot nrcnr Lo keelt laÌlirg b.ìo(r Nhnt Nas
thought tobc thc equilibÌllrm rate whìlst ìDÍl atiorìarl prcsÍnes Ìcmaincd abscnl.

QUESÌtONs FOR DtSCU55tON

QUlSÌiON A. EuÍ) zonc groúh ii bcing rh.oltÌcd b)'monclary poìicl'lhal ls too tìght
and lì\.al poLjcv that ìs roo loosc.'IvaÌúalc Lhls.Ìaim, s'h ich r,as rìâdc i. 2Oi)5.
QUESTION B. Undcr the presnìre ol politic al objectn es and oltlÌe potentiìÌ iìr
nrigratií)n of'chcapÌibo!l lÌo ÌrâÍto \ JestUernrany, C ennarÌ unilìcâtion t(xtt rhe
f(Ìm ofcxrcnding nr lja!t {jenìant wellare benent5 and coÌlecti!e bari{airìing wage rates
tiom \\ietl Gcíì an)'. I he renüt was hiilh and pers irtent ruÌelÌploytneDt iD last
:iij' CeÌmâ.v ard n ìoog terÌì Lrurcle! oll the GeÌman econonÌ!. In the Ìight ofthis
experience discr'ss the pos!iÌ)le . onse! u enc es of the Ìemo\ al olcontÌoÌ5 or tìre
migration olNorkcrs ftoÌü the LL ac.essjor colürtÌiet to the rest of tÌre lU. Note that
aveÌage laboúrcoÍs in theac(essi.trr couÌÌtÌie\ aÌe rbout one seventh tìÌose 1n \\iesr
(leÌman) . Ltaì
ua tc al terrÌ.ìtive policie\ tlÌe non âcce$ìon EU member .ounh i ei couìd
1Ìnplement. [Rclcran( reâding: SnÌì (200.1].1
QLr151ÌON C. Addpt the anaì)'sìs oldcbl dvnami.s in Chaptcr 6 to írorL ht,ì co!rÌüv
ca.not ruì. trade (ì.e. gr)ods a.d scn'lccs) dclì.ii irdefrnlt.li. What is the analogue nì
lhis casc to the pÌnnary delìcir ln rhc casc ot tÌìc golernnÌerìt\ indebtedn€ss? You nra)
assumc that the reaÌrate.)t lnlcrcs{ on orclgn oÌlned assets is greatcr thâ r ihe SÍrlth
ralc. AppÌy )'our !naÌvsìr ro dcrclopmcnls in the LJS goods and (r!i.es delìcit lnd
curÌc.l a..oulltdefrcit.
740

QLTfSTION L) A ÌeÈrn in ilÌe tnrdrr i/ ri,re! nrlanuar)

2005 \aid'\{hileJapnn hat
enio,ved a pcrio.l ol tlcccDt SLtt'th, pÌices, banlt Ì€nding and l.ÌÌd lallret have
'ontln!ed
to Ínì1. crosrlh pet€Ìed out in lhe seco dhalfotl.n-teaÌ.Longcr1cÌm,nìounlingpubli.
dcbr anclânagcìng popuÌation threaten flscaÌdi\rstcf E\plaiÌÌ thc dangers posedb)'
inapp(4ni.1c mâcrocconomic poÌicy to thc nLtairÌcd recovery oÍ lhelaPâncsc

QUESlÌON E. Choose aIÌ OICD cou.tÌ! to anall se Usc lhe atteÌìdialables

tor t1ìc
()Ft'.D t|Ònonic (rLu..k. \!hìch are availabÌe lrom the OI CD Rot,,rt. O't/rÌrk Pagc on
rhe OLCD ebsite. ahoo\e a nve v€at ftrni (do not choosc an EN1U 1:oLtntÌ) after lL')99)

an.Ìan.lvsc therolc of the nomilÌalcÌchangr riìLc and thc Ìeaìexchingc Ìâteinthc

clohúion ol nÍÌatlon and unenÌplo-vnìent
first r)und ts lhe case Íor
QLJIISTIO\ t. lhe UKan.lStr'edcn have noljoi ed Ë\'ÍU 1ÌÌ thc
rnd agaìnst ÌÌìrnrbe.shìp lhe sanre íoi each of th€sc courÌtries? lRcler to t1Ìc rcítrrces on
the UKTìerwÍ-v'''s luro 1çcbsitc:$1ïw h _treaNry gor.rrk/do'trments/lhc euro/
euro _inde\ index.cÏml
QUESÌÌON G. 'Ior a nrenÌbcr ol thc curczore' i1s tconomic periormn'ce no 1oiÌgeÌ
dcÌrcndsonthereâÌcxchangcÌate'ComÌnentonthisslatcmeutlì'slusnrgtlÌeorcli'al
argumerÌts an.1, \eco..l, by kÍ)liing al lhe düta lor a e!rc7one counlf-t olyour 'hojce
 Unemployment:
18 Institutions, Shocks, and
Policies

lheaimoflhs.hapt€ri\toi.ve5Ìigalcinimportiìntlsnr€olecorìorìÌicItÍorÌan.Ì:and
poÌicvusinglhcnÌldel5pÌelerredinLlìlsbooltolÌelpoiganizeündcÌaÌìivthearal\,5is.
The Ì1\e oI l.(Lírpran unempÌr)ymcnr sriíi.g in th.. errlv 1!t0\ hr\ been a maìor tÌeoc-
cuÌratìon br (.onorÌÌist\ and poìrct malic15. Un..ü\Íouìent represerÌr5 a warte ol eco
Ì rn i. Ì clou rces ìl the uìrem Ìrlovcd a c nvolLr ntarjlt ioble\s. Iloieo\ ei recent ÌeseaÌ.h
Ì I

hnds thât llncrÌÌplo]Ìnent js as$ciatcd irilÌì \ubstrÌÌtirlp\l.hi. (ost\ o!er and above
th e Ìi^s o I i ..onx,. ' SuN ev eriden.e also súgg.sts th.rt those Ìllìo do not be( onÌe unem
ployed aft: ncvertlÌele$ u.hrpÌrjer wh.r trncrÌìplo)-m€nt is highlr: tlÌis is irÌteÌneted as
5uppoÌtforlhcÌlotio thattìreteaÌoÍurcÌì!lovnìcntiflcctsNcllbcjng.fiÌiÌÌit.Lbroad
Ìiea o ('lllit) .ìna not sìnrflJ countifg Lhc in.oÌÌÌe and output .ost rs\o(iated llith
job loss cdìph.\ize\ the ìmf.rrarcc ol undcrstandinS thc iorccs bchì l the trends and
cÌoss-counlrti \ iriiìtj(!r5 ir úncnÌnoynrcnr.
i)rrrlngthcluropean'GoÌd.nAgeoiLhcÌ951ìsandl9ir(hrììüìrapidgroNthnÌCìl)Ì,
fcr cãp ti prod!ced a cÌear catchi.g uÌr olliving Í.n.lards to rhosc i. thc L. n itc.l stnt!.sl
trncnìplotjmlnt fttes Ì!ere lor iD !pile ot Ìatld Íruclu,al clìa.gc. Ìn this lrcriod rapid
súucluraÌ.hange td)lt tìre nÌm of the nrjft oI Ìibour out of rhc agÌjculruraì sccÌor inro
indr6lNj and uÌe groivth of lhe servjce seclofs slìarc oi empÌr)ymenl. As'labÌc ì8.Ì
illLrslnlcs, in lurope one quârleÌ olemplovm.nl r'as itilì in agricultuÌe in 1950 an.l lhis
hed alÌ(n lo 100/0 b', l9t3i in lâpan. the \hìfr i!':Ìs lÌom just Lnr(ÌeÌ onr Ìrâlf lo llÌ, ln

Tâble 18.1

Âgrku tuÈ lôdunry súvrês aqÍnuftÍê nd6ty sêni.s

L\un.Ì,Ìid,f..iihnriÌr.!irqu.riÈ.rtrrrLrÍÌiirrdnüÌirr5jrn11 ìr rìf rÌ)úf .rì rr rriÚ .r n{ì LÌri LÌ5.\

Ir.njtlÈ ìe,(r\n)ih. r9tü'riTeÌÌ.ì.r1..(frÌL!ì.h,amL(\trrldL1il).1ì

I
 98

;r,
ê
E1

Figure 18.1 Ll e- p !triÊnt n tr. Ll5Á, Eur.i€, ail rr..L.r.z.n. I s6a 2r.ll

19:il. Botlì lurcpr and Jatan nrove.Ì n) rn er4ìLol ÌÌent ttrìdure nure Ljle th.t ol tlÌe
US.\ bv Ì9;J. Oncc unemplovment had tìlLen a1ÌeÌ the eÌìd ot the Secor \{lrrld W.r
iÌì lurope, it rc.ìiine.Ì \'erl,Ìon th()ugh the 1!r60s and núo ure 197ü iI \pite ol the
t.r!€ slÌilts in thc pattenr oi empÌr)vÌnerÌt rcrriss sectors It iQ\ $eÌl Ìreld! that ol the
Ì-nitftl Slitcs Hn c\tÌ,1n the ìa\t thìÌtt veas, tlÌe tÌeÌ has been utrva \, rerchnril
r higher pcnk altc. cach ruccetsne Ìece$ion as !h(nLn nr Iì9. 18.1. Br conúart. 1r the
1.5^, u.(nrtìoÍmcnt har Íluctuate.l ârrurcl r irte ol5 6rrr, rÌith ìoweÌ peak Ìdtes ot
uÌ1cnÌplo_\.rÌrcntaiLcÌtÌrenÌi!l 198ü. The lnÌe ìorl!Í)J)esluvttheu.weliihted rveÌrge ol
L!ropcan roLrn Lriesrthe hii{heÌ le\ eÌolunenDLo\ nÌent tÌ)r tììe eurozoDe ìeÍlects both tÌrÉ
abscncco lh c Ìoi unenipl(ì! Ìnen t countrìes ol the U K, Sire.le., \o rwav. a n.l SwltzeÌ lan.l
ând thc cllccL oirlelghthÌg:it ìr the l)ig eurozorÌe countrie5 that have higheÌ !han r\eìrge

ibis hÌoa.l contralt bet$een ure iiendi nì Luropern and US uneÌìplovment nts tìrat
ut sonrc btrr nol aÌÌ hìropean couDtìies lt 1\ characteÌinìc, toÌ e{xmtÌ.:, oi GeÌma.v.
I ran.c, ItaÌ_\., end Stain LÌìt not 1he lrK or ÌÌian\ oi the \mall EúÌopcân cÕunlrics. Thc
woÌtr f.riod ft)Ì BÌitidr uÌÌenÌÌtovment ${\ the i980s. h Ìecrrl vr:rÌ!, reLcs âs ìoN is rhr:
caÌÌ_v l9;(ls hâ\,e been r.hie\ ed h conha\t,rndì\ olthelnaÌÌItrropcancoú.lricsÍ'ctr:
xble tr) aroid the l)is úse in unempÌr)vment j]Ì tlÌe 19805
Iig ln 2 Ìrnr,nìes a SnrLìhi( ilLLì!trrtion oltlì€ di\pernD oi unenrflormc.t ritcs e.n)Í
tÌìe OEaD countries iÌÌ the Lrn ìüt) t€rÌs bt pllttìÌrs the h! e ! caÌli ìrcÌagc LLncnìÌrlov
m€.t Ìate5loÌ Ìrineteen OlaiD countúe\ lhe Ol(lD s stan.ÌirÌi7.d mcasLLrc ol (úrcnì'
plovDÌent is r\e.1. 1lÌis i\ brsel oD coDlprrabLe Labou. Drarket su^..1 bes.d dclLnlLi..s
oi uneÌnÌ)lotÌnent, $hiclÌ aLl(rrt cr^s (ouÌúr] cornfaÌiÍ)ns lo bc madc. hc lifl: Ílo(s
tÌrÌr)LÌgh the drtx |oìnts 1or tÌÌe USA {nd Ì!e carì see tìrat tÌrc.lo('d oi rounlrlcs bcloi lhc
 143

"]

,:l
'']

t: ,,,1
r]

:l

/1) /1 75 r)7 80 8.1 85 il9 90 9.1 95 9e 2aA1) 2nO2

Figure 18,2 ÌrÊrd:aì. r.r.roqerÊrt r!r:rp.vmerìrà.r.5j euÈ.D..!.t.s j!6a 2ool

UsAuptothecan\ l9Sosnxnesabo\elhrUsAthercaiìeÌ \cvcrthe tess se veÌal t Lrropean

.ourúlrs hrvc had spcdrclrÌar iüprorclnenrj ir their ruremplolrÌ..i pertormnrÌce i.
l ' ,...,,,rro,. Lt..,,o. \l.r ,"-,.,r., rl,c.
A!stna ancl \oôrd\ hiÍc vet Ìo\! rates (hroughouL and Srle.tcn .nd Ì:i.l.nd hrvc verv
- ú rr r' iwon u. ! ,rh, ,.rr
t990r.spaníh unemÌrÌolrÌÌenr js lhe high€Í at 200r, in the mnÌ-l960si jt falls n) Ìcsi than
Ì2% b! tlÌe erd olthc pcriod
ln rlìjs chapler. wc bcgln bi .laril\irg the liev d.lìnìiidr\ ÌcÌ€\dnt ro rhe {niÌrsis ot
rr r' l, ' -' ,.r..,u..rt.
crplarirtionrlorthebroidtraìe.Lor)ot(rnerÌ4toymcntiÌrthrO|CDcountrie'nh\,dnÌ
i,l
,t-,,.,rty.r,r,,,,t_
' iì.r , rò r.,, r,' 'r i.' I
,1,r., i \ \\ t,,' ..r- ., I
'''-\' p' ., r, r,'r .,n. \p ".t ,,t ,l-,.
'\r"t
and lÌelanl. ID S.Ècrio. .1. we Ìnlcstjgârc rhe cÌuerrjon ot ünr.rhei increa\e.t Iuropean
unenìpìornìent iÌì thc l98Os and increascd Ìlage jrcquâlitv tn the l,SA \!ere rhr sicte\ ol
lÌr€ samc úin: l\'rrc comÌrìon tcclìnotogl. irÌÌ.1h.â.lc çro(ks rcll.de.tÌn Lrnemploynìent jn
Fi'rope and nrcquaÌi1v lrÌ the tÌS1 because ol.liUc.l:nces in l.boüÌ nrarket lnstituti{rrs
in the lÌlo bìocslsec(i,rn 5 exarÌÌiÌÌer F,ÌìeiheÌ Llrc clÌangc irì Ìx)nclirr\ aÌÌanjrenìents
rl. t .r'.1- ,,r,t,, t ,o...,,Vor ,,d.rr,rúr,r -I,.i.,t
aflect unenrtìorDÌeDt. l inau, I,e corclucte b! cxJÌniÌìi.g rhe calìs tor leborlr xraÌkct
744

ncrìhilitv artÌÌe solution L. Europc\ uneÌÌrÌrlovDÌelÌt pf'ttenì 'ìnd c1pìarÌ'ìtionrntÌ!h!

s ,.h , ei.rmt aÌe dllncull to achie{..

1 LabouÌ market outcomes

1.1 Definitions: employment, unempìoyment, and inactivity

Therc i5 not r onc h)r one relatìonnrìp bcLÍ'een cha'get nr rnrtìo,\uLent ân'1ìn uncnl
p!púÌrÌìon ol\!orliints agc is dn idcd jnro
tlo!nÌc.1. To scc this. h't ne€d 1C) note tÌraL lÌre
ihee hbour r]]artet starcs: enÌplol.:d, rtrÌcÌìPÌo!cd (r'tj\ eÌ! lookiDg lor r'ort and abÌc t')
begirÌ], n.d itÌi.tlve l hus

PaP=Li l:'l
-Lt' I
ìÌhcfe fdlr is the poÌrtrÌrtìon .l u orking aS€, LI i\ thr runnrer unrrnÌrìoled' I lhe rÌunìbtr
enrflo\ed,I the irìacti!r, and lf tlÌc labour l(Ìce 1hc LtnemPloJnrentr'1r, rr, úclcine'l
ill tcrnA oÍ the Lab.ur lor.c:
ULI (ÌnenÌplolmeÌÌt rilel
"=u F Li

Ìvlìcrcas thc cnÌrlolnretÌt raLc, f, ìt ÌÌoIÌnalÌ) dcnned iÌÌ tcrÌìs oltlìe wÔÌÌtnÌil aÂc toPuliì_

Ihc.onnr.lion brlileerÌ thc o.emdotment and emtÌ()\ cnlÌatesispÌoricledbtthe

pertic\iatìon Ìate. n'hnh sho\Ls tìre protoÌtion ol the rorLing age popúlatlon aclive ìn

l',ú
'I h5e delìnili(!r5 nìlÌ) l

a=r *1
Thur..ì rlsc cnÌrL!!nìcn. Ìate will .nÌl br Ícilccld nr ! lalliÌr !ìr c urÌerÌÌpk)) nrent
nr tlÌe
rateiothcc\tentthatitisnotolt5etblarlseüÌpirrti.ìlalionr\tlÌclcononÌicalÌ-Íjnacti\e
are brouijhtbackinlothc labotrrnr(e lhctrftìcipntìon rate is rÌ!Ì Íxe't lurìng a Ìcc€s
sjon, ì!hrn uneÌnplovnìerÌt r iscs, particl paljorÌ rirtc5 tr:ndto faLl lhcolÌ]o!ite h'ÌlÌlensiIl
 745

u|sr{ings. Theic arc eÌso lx4rorlant long ruÌ trcnds. at $Ionretr\ prÌticipatlon has rÌscn
o\cr Lhe laÍ h.lÍ-crnìurl and nren\ has tendrd lo laÌl ln adclitio'r, tolici$ atteci parlL
cipalion. TtÌe nrost jnÌÍtrtant tronÌ thc PeÌJlectilc of iÌìt( {Ìeting lrenls irì IurÌre have
beer sickness arrd .lisrbilitv rcgulrtiürs auci lctir!ÌneÌìt ptactices, cÌ)e(inìl-t the usc ol
earL)' rctìÌe!ÌÌenl scheme\.
,\tlcmptt to rcduce Ìhe rìnrmtlotmcnt rrt€ b-! bi{ering parti'iÌlatnnÌ lhíNgh earÌ}
Ìetircmcnt scherÌrcs oÌ east arctst to disabiLitl bc.clìts are likell t() ha\( scÌn)u\ 'on
sequcnce\ lor ma.rcecorÌoÌrìj. man.ilcÌneDt Such meâsuÌes car be courlcrPÍ{hctive
have
bv rcdrtcing €qLriÌlbrju i empÌo-vìÌÌenl th(Nghti{o chdÌìn'ìt:Èrsl iftlÌesc schenres
the cÍlcct of isìng lhÉ taÌ burdor, thcn tq!ilibrium enÌ o-vÍÌenlgoesdo\!nbecluscthe
pri.( 5.ttln8 curvc nritÌs (l.Nnsar.l\' Sccon.l. rncasure\ to Ìentovc leoPlc lrom tlÌc lahour
torce ma' Letlucc ompetjtnrn lor iobs, whi.h sÌrLft\ tlÌc \!a3€ s'lling curtc uPNards'

1.2 Who are the jobless?

InÌrlo-tnìcnt tutes ãre Ìoser iot womcn and lot (nder p(4te: thú is thc ortcomc of a
comOinaLlol ollorto participiìLion ratcs and hìgheÌuncnÌrLoïÌìent Ialcs As lable 1S 2
shoÌ!s.lhLs 15 a conìmonleirluí: a(ross the OlCl) c(ruúrìes NctcflÌelcss theÌrareinter
c5tiÌìgcín\ co!n1ryl'ariatiorì5: lhe shorttaLl ol lhe wonr'n \ enrplo\mcnt Ìate bclow thal
ofÌììen ls lte\t in thc \o i.countricsataÌ.Nrìdl0perccntâ8cPirúsotlessithcrhortiall
i\ hisbcsl nr the alalhoìic sotitherÌ lu()pean countrics and l'cìanl al nearl! 30 peÌcenl
nge poiJrls or nÌorc.lìor older pcople (aged 55 6 1ì ' tlÌe cmPlo,lm
etrt rale 5hoÍfaÌl a\ conl
p," *,lrn trtut" tt"Ltt'"".i tlÌc iges of 25 atÌd -5:l
jt ìowesl ìnlapan rnd Silitzenand (!bouL
I S p"rccnL"g" p,:,int t] ,t,l 1Ììgh en iÌr lhe coÌÌllnent!l c.ononìlcs ol]\u5tia Bcìgllun' nt'l
theNethcrÌan.ls (bcttleeÌì'+5 iì.d 52 pcrceÌìtagc Poilns)
UÌÌemplo-vmeÌìt râLes nÌ voúnser pcotÌ! (15 2l !eaÁ) rrc high€r thanthose íÌ oÌ'ìtr
Nôrì.eÁ a.r)$ t]ìc OL(lLl. lhc \nÌiÌlest eri.css un€rntlovrncnt ralcs tor younil p'opÌe
arc irÌ tlìc F.utupcaf countrics with wetl enabÌished atPrc'ticeslìlP
\chcÌìes l]\ustúa'
Ìn
GcnÌÌrnv, an.l5$'il7eÌlandl, inJrpan anl iJr DennÌ.rk,Ir(la'd 'ìnd the Nclherl'Lnd5
ot thc scaÌe' r'c hu'l
cach ..sc Lhe 8ap is ìe$ thin 5 Per.cntà3e poÌnt\' .\t lhe other end
ourÌg pc(Ìr1"f bet\\'cen 17 an'ì 22 pojnt\
llalv anil SÌt^irÌ \{llh trnelÌÌpÌolìneÌìl rates for )
higher Ìlìa. nÌ oldcr woÌl€rs
AÌong the cììIÌÌcnsloìrs ciis.u$ed so frr, t|r lISAiocs Ìrcú stand outlÌon lhe hrropcu
.outrtries. Ìt does ho ever,s'henìÌcìook.ìt(heireightolthcÌoÌil-teÌnÌu'cnÌrlovcdìn
lotalunüìflovÌrìl:nr. Th(xe u.eD+tote.ìlor m.Ìethan ti!elvc nonlhsnÌakc uPÌe\s thaì1
.netenlh;ftheÌrfcnrtloyedjntlìeUSAOnl,v\orÌ!a-v-ì!sìmLlxÌinluìopeAìÌtlÌeolheÌ
.outrtrics hale nìu.h hislÌel shâres ollorìg tcÌm urÌeÌìPÌo]Ìrent rengiÌÌg lronì arornd
30% ijr lhe UK, thc No ic .ountrj.s AuÍÍia' and S\fitzedan'l to 50v' irÌ Gcrman!'and

As ü,c shaÌl erploÌe tlutlìrr in Se.llon 1, thc buelì ol ioblcs!Ìes5 has lalÌcn uìe!!''ì)
ecco ìng t{) le\,cÌs ol ed!.aliou ]\ìlhough u.employìnenl rates are nNCh hlglÌer k)r
those ;o hdle not conÌplcted si'cond.Í schoot, as 'ompared NitÌr Ìh'rsc with lcÌ
tiaÌ\ edLtcati(!Ì (l abìe 16.31, cven úore strikìng i5 uÌc dilt€rcnce ìr thc r''plof'"'l ralcs
or tiresc gnrup: on\' one halr ol th. populatjon ol ilorkitìg a3e Í'ho hivc les t1ìan
secoldary ectrcatlon in thc furopciìn Union aÌe erntìoved a\ comÌlârel wlth 80'lo of
rh(re r'!ih teni.n, c.lucrtion. TlÌesc nunÌlÌÌs N1lì be ìnUuenctd bi 'omplsiLion elfc'ls
746 .'
Ìablê 18.2 Patt. Ís oflobÊín!Í, 1993

Íromêít emp oymènl oldêr1s5 6a)êmplovmenr Yornqe. (ls 2a)

Gie rhodíallwth ràÌê: sho*lâlL wirh unerpoymeniEìê unêmploymêíì,

nên't % pôints 25 to of ioÌal
verÌt
54
%Point

2l

t2

t2

Ìãble'18.3 Diíí.re..e n olrÈÍnesr bv ed!.auon. 9Íolp EU l!9e 1!

Le$ ihàn (ômp!èrêd secondÍy êdu.a on comp e&d tÍtiaÌy educãiiôn Dilferen.ê

!lL:

5."(otlJlq!0ixê|..|Ìl]ol

âccor.ììn8 to lhe lactoÁ ür'l able Ìil2 i e. thosewith Ìe$thaf secorÌd ary educ'tio
n are

rÌìolc lìkelytobes'omen and to bc oìder'

We caÌÌ sumnlarlTc the slate ol rtnemplo-ïment and e pÌo-ïmert i]Ì lìtrope as conÌ
2

par..Ì with the UÌììlcd Statcs at thc besi Ìlng oi thc t!!entt-nÌst ceÌìtuN by usi'ìg the ll:
daLa ìn labìr 18.4. The sixLeerÌ I urcPeân .ountries aÌe diridc'Ì ÌÌto tlso
gÚups: hliah
!rcmtloymcnt dÌÌd low !rcmpÌo,vment Ì)üIoÌma.ce üì thc nine /'1t ufcmplo,vment
luroltan coonüics h conpdrâbÌc Lo tlÌe USA 'ìì all 'IlÌrìensiont The ìncÌease in tìre
emplovrlent rates in tne NctìrerÌands and ÌIcìand arc stÌikiÌìg and letÌd strppoú to the
ter;ì 'eÌÌìplovnre t miracle', whi.h has been used to detcrib€ lhciÍ p€doíÌance ilr lhe
r(Jqo\ This ls.Ìircüssc.Ì ÌÌ moÍe.lclail in \eclioìr:l
Ìable 18,4 5. ÌÌ;rr.íÊnf.iì Êrrjril. r.Íp.rÍÈrr - F!.r,e r ilr Ê._5Â

ERU tnp ôymeDl râte chânqê in êìproym€ Employm€nl rre

1002 2001 êãned quÍrh

'th€ lurÌrcaÌ11Ìish unc,Ìrplounent gm(Ìr ol !e\er counLrjcs has

lìigheÌ a.rüÌ ind
.:qrLllibúÌm ufcmplovmcnl a|d nÌailedÌ\. loner en4)toÌÌnent Ìitcs botÌi on ar.rngc
a.dilrtheÌ.asl educeL,,d ,\sdisru$edÌn ( haptÈr 17. (ìeÌÌnr.!\ pcrfonnan.c nLÌrc
Ì!90s hr\ ìn:c. nrorÌgli i.llLilnc€d bv Lür ll.ari.Ìr axd its rftÈÌmith. HoNelei lìÌan.c
and lt.ìL\ harc .o \Lrrh 'r\.Lrsc'. L\peljall! rloÍi\onÌe lre the Ìow .:.ìpl!!ÌÌrent Ìatcs tf
l:Ìi..r tìn.l Ìraì), and in Itelr, LÌrc tacfthat onl! j!5t o\.eÌ orÌÉ tìriÌ.ì o Lhc leâ\t edu.arcil
quartile aÌe i. norl.

2 Trends and cross-country variation in European

unemployment

2 1 Framework and overview

'1he jÌrgÌcdicniJ thaÌ ârc
r.:.orniiÌrg nrr ìrolh rhr p:th ol a\.ftiÌgc jrrrcper.
u\elìrt ìn
unenÌÌnovnrcnt nrown ìrÌtiir. 18.I, a.d orrhe!r)r-.ouflrl rlri!ti(!r ln rn(d4Ío\Dre.r
r 'l \
(11 Thc dctermirrnts ol5hifts jf iclu.ìt un enr tlorÌrìrnt .rou nd the cqrLjlibrjun. Thts!.
.ax aÌisc konÌ donrcsli. .LsgregaÌe dciìint poliq, lo. i.r.nrple ro purh unelìdoúìrn L
up irÌ ordc r to rcd uce iÌÌl etnnÌ (sce liils l7.1arÌd 17 2) lÌlcnratìv!l,v, aggreilatc
dcmand
c;n flu.luate nì rcsÌronsc l{) 15 sìrocks or lÌÌnÌÌ inlcinatio'al shocks lo tra'ìe, thc lnterest
Ìate or 1l] irorld.oninÌodit\ Plice\ (e il liigs. 1 1 3, I 7 9, n'd I 7 1 1)'
jn and
12) l1Ìc dete Ìi.rnts oÍ ecÌuillbÌnuÌÌ Lrncnrplcì,lnretrt as discu$ed
'haptcr'1
Chapter 11. These.entÌe.)n tactors shiìting lhe slagc setti!Ìg in'Ì/or prlrc settiÌìg curves
or rlie uncnìplo-vmcnt/!rcaDCv {ÌleleüdiliJ cur\e'] iìn'i hencc, in the opcn economt'
tlÌe
lÂLr cu . Gee Fig. ì1.7):

. lvscu ,cshittsupwltlÌaiteinLrnionb.rgainiÌìgtower:âiallintheco5lofjobloss
TlÌe
(e.g. n rúe iÌì the !ncmllÌovment ben c lì t ÌeplaccìneÌì t tatel lhc dcgree ol'oÔünì'1!o'
oì l\'agc settbg âho atlects the 11 icuÌ!e
in th' ilorid lctn! oI
' LhÊ r5(r) .uÌ!€ shilts down wilh a.ise in laxesi i 'teterloration
u ntlciPated falÌi' trerìd p(trhì'
rrnae heti!'een mafLÌtact(rÌes .nd ìai! nìalcÌiaL\i an
tltit) gro thiarj!cúrthcreali.teÌestralclah11intheprc5suÌeofconrpeiitìoninthc

. The ufcmplo,vmerÌ1Íacan.! {Berrridge) (urle shiils L{) the rìght ür !ncÌìtloyrncnr

lrcanq ï;cc herÌtheÌeisarl5eiÌìthcnlivnatchbrl eeriobsi!41ÌrLrlea'dPotenliaÌ
eDìPlolce5 lsec ìriS. 1Ì.'1)

) irterncli(!rs bct'!een shocNs an.ììrÌstì1utnrÌs: lhis is I'hcÌethe elicct on!ncmplo)

(ll
Ìncnl oì r shock tlclcnds on tÌìe mptlv \id. úrstitrttnnÌs in lhe couÌìtï lor exanrple' iì
suppÌ) sidc nrocN s(ch .rs an oil shork or a nowdo n in p roductivitl' gnNth shilts
thc
rrne plotment depcnd\ on the nopc
lSN e down: thc imPa.t ot this on equilibÌnun
ol the LV5 caìie, Lc. on 1Ìow sensitn e aÌe rcaì wìlcs (rl s'agc setters) trnenÌpÌo-\Ìnent'
(o

One r!.ì)'ol chal.cleÌiriÌìg a tÌexjbìe ÌaboÌrr maÍke1 is orÌe ìn $'hìch thr lvl_ curtc it ver-v
jnun€rÌrpìo-vment Lllhel1'l'isveN
slctp i.e. ÌeaÌi!.rges aÌevcÌl respon5ì\etocharÌ!es
Ílat, tÌÌen ftÌ a Sivct neilal!!e er{lc râÌ terms oltradc sho'k, a much largct Ìì\e iÌì u'eni
plovnìcrìl is Ìequìred to bring nhout the fcce$rry downward acìjustnÌcnt ol reaì wage
clâlìs Gce I13. l8.3 f(Ì an illu Írâlidì ÌhcdegreeoIÌ!age'ooÌdìnatiolìintheeconomv
ìsal\o likeÌv to jnfluerÌcc tÌre uncmpÌoyrncnt irnpâct ol prod(ctivitr. groath and cxter
naÌ sutplv sÌìo.ks. In particulnr, in a lÌighlv.oor{Ìjnrted ccononÌv, sincc wag€ sctter\
optirnì7c bl (hooslng thc beí poritioÌì !n tìre l\ cune (i c Lhe real Ì\'ngc i\ tikcn a\ â
c;nstrnint), d doiúrw.rd shilt irr lhe PS cLll!c ìeads onlt to highcr \ oluntiry unemPlov
ment f5ince thc l,1/5 cun'c nÌ thc fuìÌt coordnrated ecorroÌÌÌl coincicles I'ilh the Ìibour

r.1) tÌ1,stcre\ìs afd PeÌlislcÌ1c€ !Ììcch anisÌns i iL i\ drgucd that r sustâined

p€riorl of hish
uneÌÌÌplovnretrÌ .ause.l bv $'eal aggreiiate dcnr'f{i 'en iÌr trìrn causc a deterloratioÌ irl
Lhe ìÌìpì! 5icìe oi Lhe eclnomv so lhai the equiÌibriLrm unempLlrynìcnt ìate is
pulìecì up
rúi. ljor c\amplc, weal aggÌeilaic dcmenl ralscs uderÌtìo) nÌent, I'h ich le'ìds lo hì3her
l(!rg tcrm unempìo-vmenl renìltlng jn tlÌe Ìong terÌì únenÌÌ)Loted beconiiÌÌs detaclÌcd
tunn thc lâl)our torce. a cotÌs(qdence, conrPetitnrÌr í(n ìobs is lcst ctfectivc an'l the
^s
I N.te. ba.N n, ( hltrú I tlÌ in úÌ) rnxtúr or th. Lrè\ Üig"u^È h'r ii Ìelates L' il\' Ì1/\l\ cunr
'rtl
 749

Figure'18.3 a.in Ìon iho.t nt.Êrr..,aihrerreand i,4b. re. n .5

iij nl ei,-.. .. !ra.j:! if,a! Ja . !
lNr er h. rci EoÈ: i'i i. r I
Tâble 18,5 lJ3trÌ...r!.ì...,Êi!!àr.l nÊmrôrr:.r,O:aDl!út]ú19!!t.!È!É.rr,reri!r.sl

Produúivíy qÍowlh reÌm5 ofÍâdê ri trPdqê

ì
ll t .rLrvc slìiltr upwaÌd. \iÌìrple mo.lÊÌ5 oI hrstffc\is aÌe \et ort nÌ (lhxptÊr .1 Gcc (.g.
ILgs.I 8 .1.i01.

BrtoÌc l.olirÌS dt attemÌr(s io tetr the ìmÌroÌtrnrc oloìe or otlÌer olrÌre\e nrechrn íìs.
Ì!e ser ouL a bro..lor eÌrjciç oi t1ìe perir)cìtiom lÌrc Ìiì t. Ì9óOs lrlÌen rÌre ri\e ìn urcmtìo!
ment bcgâi nì hrÌre Tibìc tE.5 pÍ\i.let the licr nìâcroecoÌìonÌic dara ior thr Or.!.t)
countries üoÌì Ì960 +tl) ì!95 9
-llrc
1961 7.1. Ì96(\ Ìlar a p.riod oieÌiecieÌlv lorÌ !nenDlo\lnent ÌiSht acr^r Furopc
ÍeÌl bel(trr th.t iÌì ihe USA. IÌe roots olthe Ìisc if LuropÈln uneÍÌÌrlo\Ìnent etu oÍlcn
trrced nr thc rrar! tìom l9aìil to 1!r13, llhen bargeìni s foÌler tìppraA to hâ\.. stìifrcd
!$'arfÌomcnrplorebtdÌadr!.rlebtaDupwa nr tiÌìiheLr5cün,easunli)nsrcducrd
the .iegrcc ol birlaìÌri.g Ìc5trairÌr tÌre\ eÌeÌciscd, scÊ (thdpteÌ ll. This ns rcl(.tcd irÌ
a $are oi strikrs ünd irâgc rÌpl(Áii!r\. Thi\ ias also r |eiúl 1I whilh lfork$s sLrc
ceede.l at th!. lolitical ÌÉrel i. Scttirrs an eìrensio. otthe i!eliare nare taaariofr,(nrup
7t0

oÍ ireÌlârc ttate bcnefits

1p!slrìni{ thc pri.c settìng cLrÍtc cìo$'n) arÌd Ír did lhe SerÌcrosit}
j' is sh oi! f inT'ìbÌc 18 5
1*agc."tti"g.r, -+rlÍtturì. lhe sharÌr ìncreale the t'x
Necli{e

l,rZ: ;v. iL" llot on s1ìo.k PÌLrs a rrorl{Ì conìmocìit! pÌìce hìke occ(ttred in 197'l
jìnpovemenls iÌr tlÌc leÍnÌs of Ú'rtlc ior oil
bri.ging 1c) an cn.ì two cìe.ides of nnien
atÌd;ommtÌÌìt) lnrtorljng.ou.tÌies ÍseelÌg 13_1and lable18:) This
asincxtexÌaì
ìtúla
upplv slilesnock Ltìt,1ePrc5se.Ì output andenìplo]ÌÌent, putupwaú prc*ureon
rir'ì. ;nd shlited lhe l,4Li (urvc to t1ìc lelì. rcflectlng highcr equilibriluÌÌ u'euìpìoytÌÌenl
at a given rcaÌ e{chaÌÌijc râte lsee fig!' 11 13 and l l l li lhere
h'âs also a slìarÌr sÌotr_
fSí,r cìotrn (Trblc l8 5l
Au*,n in ttrc gru*'rt, .at",)l p(ÌÌuctilitv. ÌÌhìch rlsÔ \hi1Ìcd the
to thc producúit\r gÍ)f;lb
It appcars th;t thc adiustÌÌ1cnt ol $Iage clnim! iJr Ìe\PoÌÌsc
stowàoiqr was exLremcÌy prolracted, irlÌich hâd e lalti'g clf€ct
on equilibiL"ì uÌìcnì
pÌot'ment. lhe it l enÌpl oi pol jc! !ÌÌaker! io ute aggÌeilatc denÌ'r n {Ì to1i"
to olisct risi 3
'
ìntÌation
i!rempro!ment lcrt urcmplo-tment beÌos' lhe equiÌibrium' with tlre Ìeínt
tlÌat
r{as rlsing thìoughort lhi\ Pcrì( .

l9l9d;;lr9s0r.rh€sccoÌÌdoìldÌocl<oc.ür!edin1979úceIìgllì'ldndTabÌc18slA\
was dilfer(ìÌt
Lli(usse.lilì ChrpleÌ tl Gection'i 2ì' th€ rcsÌntìsc to thc secoÌìd oil nÌock
the inUatiorìaÌ\ inpact oi lhe shock lrom
iÌorn the firsl: coúntrics sorrght to pÌevenl
nt N tought
leedifgthÌoLtghto Lhe cc(tÌonì-v N1on Êtdr-1' policl'ii'at tigh tened as ea ch cou
'
ol erchrngc Ìate to Ìnitigate
1,, :,'ip.r ag!'egat" Ac-and ând usc atr attre'ìatloÌì
Lhe
Ì!.ìs i úse in 1ÌoÌÌ'lrrnl üìteÌcst
the eil(t! olìi]e oìl úoclt on !nÍlatio' 1hr o!t'oÌne
the
Na\
Ì,tÈ Gcc l.bìe 1IJ.5). $'hnlÌ sÌrìitel the rsil') doNr (\ee llh r|ter '1 se( tion
2 21' This

foÌloìrecì bv e ÌeigtÌry pernxl.l tiShl ma'roeconomi( polict inìc'i

at brìngitìg intlitior
Ìac\ down [ÌoÌÌ] doubÌc dìgil ltvels
Mìt1 1t)tr}t anl th(eolta ln lhe nìi'Ì 19ôü, thcrc
i!"rc ílne fiÌtour'ble \hock5: thcre
w.rs a ÌeversaìiÌì Lhe ojìand.oÌnrnoditÌ Pricc\ Gcc
IìS 13'1arÌd LabÌet8'51rndú\ome
((nintÌie\. labour mârkeÌ and weLliir: natc ÌetorÌìs $erc ìnìp1erÌcnt€d that ÌlcakeÌrcd
union\ and Ìollc.l brck ínnc of thr gaìns ol the raÌì) 19t0\' TlÌc Snrsle
liÌr+ì'ân \1ar
keÌ prrSranrnÌe r,ai paÌt ol a bi)adrr Ìnotc td;ard ìreighlcned
conrtetitì'n in frcdLl't

N(alotLlr.È I Ìrr71.l i dtilatÉd Lìr (;S..nnrnìÊi tÌi'(5

'l
"l
'l

rl 1!tll

Figure18.4 O Pr.e: l-o50 2l-r:

 151

nÌ.ìrkets. $hÌ.h as Ìr. hde \een nrNÌ.lredu.c cqui ìbrirLm unrnì!lD!nìeDt lÌo.11Ì.t1\jt!
gru\ruÌ rnd the trr ih.re \trblLjrecl, |Ìerentlfg thr .rcd lor iLrthcr do rn\a r.ljurr
nìrnl iI] e\tectcd lliÌ niire rire\ orÌ the faÌt o Í'agc scLlrrs (l abk tE.5l.
Ìet deï)ite thcsr (!ersrL\. !xenìtÌovnrrnt did not rü!Ír i.i ils pre 197(\ le\eÌs. ts
sho(Ìì jrr Fig. 18.2. oi plúiculu (onceÌn jr tÌr( Pc.s slcncr oi r gh unenÌÌ)lo\ment in
thc liìrge LuÌot.an LclrÌoxriei: uniiìe.t ctmri.fj .an.c, r(ah, .Ììd SÈdil FoÌl(ning
hilh !neDtlo$rc.t hÌ the 19-ü aìú I980s. rhr Lr]( is (hc oi.cption rnÍlrg\t the largc
.ountrjes nì e\È:r cn.iÌìir r nra4) t.ìÌl i. a.cnrplot.nì!.nL in thr t9()íls.nd iÌÌto tìre nÊr!
crntul hÌ 5tjl(,or la.i S connnou prÍluctililÍ slondon. and cÍicrnll tiìde nn)cÌ(5.
tìì.ìn! ol the !nrrll c..rÌornies l.r' uncÌìDlo!mlnt fute\ tlr nNch
n ere rbÌe n) nralf Ln rr
oi the:5 \eaÌ teÌ .d

2.2 Empirical studies

5tâÌtirÌ3 n(ÌÌ thc 11-\ liJ drÌd n]dtcÌÌnÌt D(trìtì\ lBcr.Ìidgr .:urrL:1. rÌafÌ.i]ttcmpts h.\e
! been Da.t. hoLh lr poli!! ÌeÌrte.l s1)rÌ\ and ln a.adcnric rrLi.lcs Lo sorl olt thr rolc ol
iÌrstitutio.xl e.L.rs lÌìl (n \hocli {technoÌ.g\ j r.riìr oi LIad.; .r. I i. .ìflijfìr! OICD
urÌenÌrÌt)vm.nL lhr OIllD \ /r ú\ .\rÌrf oi l991 jr â standarl Ìc cÌcn.c, hìri.h rlis lol
Lorrll ìn I 999 b\ rrf /dro'rnÌi 1rr lrn Srìrl, tÌrr ( )Ì.( D \ rcf oÌt oD h(n! rhc rc.onìrx.n
altjinr ol thc lobs \hrn! ÌleÌe iruflenÌented 1n.ach countN. The fÌamciroÌk o a.el\ 5is
!sed in dre ()Ìla Ì)\ studie\ i! broaal! tirrihÌ nì rhar uicd ìn the xladeDic frÈÌs rhat ir
Ìeloúe.l jn Lhii í.r{ion llÌeerllutìdroltirei.\rirtrtj(üaLi!ct(!\i5\hoinjf labÌ.:18.ô,
r h1!h al\. tr.tidcs ârr in!lic!ti(!Ì oi the broa.t conÌrnris(rr ol i.ttjiutjo.al .hrrâ.1.Ì
1\ti.\ a\ bcnrc(. .oÌìtiÌÌeni.1l luÍÌiean cou.hLe\ nnd an lngÌ{) Sa\o. grrlÌrjrg lÌrrt
in.ltrd.r lrclilìd. Cànr!ld, AurtraLi!, aud NrwZúrlend O.eÌeÌei{eiÌr.ontjnenlallun)tr,
trrdt trn .n .l(.si1\ irÌ(rer\rcL honÌ l!ró{) Ìltrrgh nr the errÌv 19E{\ dÌ!l thr. ieÌl ba.li.
The e\1tnL Lonhi.lÌerrÌ)Ìo)ee\are(o\eredb\ tÌrde urÌi(!r ratsr aSÌeeDent\ it Ìnrìch
higlrer thif mcnìbrrÍriÌi rÌú rlthoush.o\ erage rre Í ith !len\it! to ure eaÌl\ 19S{\,it
hrt ÌemaLn.d sliÌrl. iirÌ(e therÌ rt o\er 6{l% l{dge c({trliÌutnÌr lÌrr l.ìtteclren iÌ{\l\
do1!.irarl r.rosi Lhc p€rilcL ls l I hole.
TuÌfjfgL. Llrc tü1er pdrt ()l lrt)Le 18.6. thr c(mÌLri\on Ì)etÌleerÌ c(ÌÌtirÌÉ.taÌlurofe
end LÌrc AnSlo \a\on !rüÌ) i\ !le!Ì !Dn!r! rÌe much Ìe\t ilÌr.rtaÌri iI tÌre ldtteÌ mrú
c(Ì)r.ìjDâLlof ln Í a!e t)rrgaìlnril i\ illo r!u!h l(!\ rÌ (D r\ rtuge. A\ Ì!e l.d\ h(n th€
C.ìlnrIoÌ\ l)'l11ìll mcÌlellerÌrlaìÌìrd nr (:lìrÌrfuÌ +rÌrdi.ÌnorÉdet.ìilin(:hrtltrI51,!.t)Ì
.ìiÌltjof ln llaÂr sriiiÌrs .rÌì otiret the cite.i !f urcDtlolnrent ot hlgheÌ unjrnjTarj{)r.
ThÊ gencn\]1\ .l unÈr+ìio\ !ÌeDi beDelit\ hâr LncÌeâsed o\ ÈÌ tiÌìe i. co.tinr.lal LurÌìe
rnd ì\ highcÌ Lha. nuÌrAnSl() Sr\orÌBÍrrÌr ThcdurationoiÌrcuentthrúrÌ!)go.rut.
ÌrulpeÌ het! so.rclrhiìt ìrttrìilÌ!l\ ìs Ì(nÌeÌ o. arcrage thrn irthe.atÉn1tht A.gÌo 5eÌL)f
3nÌÌ). r\ hjgh lnll il b.rrclìtj irÌ ÌÌrrn\ rontnrrntal couÌrtrie5 ere \caled l)a(Ìi loÌ lh.!È lhxr
reÌÌraiÌr unenrtlnì cd lhre!4r1,,\rruÌt|r)tecti,inÌnde\nrhÌnrÌreÌre.ìledr.Lhclrrlr
I9,!0t end Ì..rnirrs nnì(h hirheÌ tÌÌar nr thr Ânsl) Sr\(Ìr ..u.hi6. It hâ\ hccf rÌ!ucll
tÌÌai achlc l.bo!Í mar|tt Ìrolicie\ ilL\Jll to li!Ìì lht ufcnrtlorcd jf tou.h r! 1lr lhc
kÌ)ouÌ nrarÌ.t is5 \i uÌe rìrdtchlìrs troceí end ÌrelrtâLn d.it.raÌd |Ì6srrtu:.n nigrs.
OntheoLhc.hâ.d.\lÌ!ilth!tarÌlrurtn)fr.\idi.gsubrdiTrdcnrtloirìcfri.thcflnrll.
\ecnr h . hcc. iÌ1ü\rÌ jrÌ uicrr \tudie\ nr hrr. Lh.,)|Ìr(Ájt rlfucr, tÌc\rnìabl\ Lìc.irLs.
752

Ìable 18,6 Ìrerd5 à r.l..xìÊ.r s.n5 r ahoLr nãr[.Ì .51 tt:cns

5.yêÍavo. ÌÌaderniondêtriiY coverage w:9êcooÍd Unêmp. Bènefr DmâlÌonotUB Enploymênr AIMP

Repla.ement rete!Í Lfdêx

i>.l a.rr,ÈiI Euro]?in tr,.ìd!

l1

ilr..it r.rìì ir Í.rêàniÀiq. !à!.: r.mri,r.1

.oÉ: r( Í!.r J !!
';i'l:

sìch prcte.t(d cmdoynÌenÚcdu.cs the tearch nìtensìtÌ oi thcsc h'orkcn in the outsicie
ldbour InarkcL. \,Íoìe Ìesour.c arc dc\(Íe.Ì to these ilr lurop( thi. ln thc AngÌi) SaÌon

Although lhe Ìe{Ìts ol stridìcs that attenÌPt to contìrÌn Ìhc rolc ot lhc facnr5 ìÌì
'l.bles 18 5 an.l 18.6 are still dlspúLcd, ú ì\ uselul to erphin briúÌ)'tìrc main strateiale\
that harc bccn un.iertük€lì i. Lhc cnrpiÌìcaì Ì!ork. lhe siinplest kind oI slLtd-Í altcnrpts n)
e)iphin rhc crÁ\ country'\arlalion jr uneìÌpÌo) Ìent r.t€s .cro\s tlìe OLCL) countries.
'lhis io.(scs on the relatnc roritn ? of the I1'5 and ljs .unes in diilcrcnl .outries A
\,, ,1, \..,r.ror'r,,\: I I, r, ',r,1't
b)'Bìanchalll and 1\olfcrs,+ toruses on the iclea t1ì.i .lthoulh irÌstitutìons bccame Ìest
'cmtÌo)nrent ftiendl!' i. lhc Ì970s. the chrnRes siÌÌ.e Ìhen hrve tcndcd lo bc in tìre
opposire dnectidr, lri Lrnemtìo) nre.t hat contiÌÌrd to rise iÌì tÌìanv courì1rlcs. The,v
rhcrchrc j.Ìentilt the ìnLcÌaction bet eel l)rorll:- \t.ble ìÌìstituti.ÌÌs .nd slìo.Ìis as Lhe
litcÌ_Í Í{trce ol ttÌe iiÌcrcas.d dispcFir)n of uneÌÌrplo}Ìn€rÌt râtes: this focus€s on a conl
nron nrÍt iÌr tlie /i5 cun c that inteÌâcts with Ì'1f.ulles ol dilÌerirÌg slopes, is illuslÌâ1c.1
jn lig. 18.:.ì. ln nÌore r(ccnl $ork, NicleÌÌ and co a!thoA rtteiÌ4Í to identily thc roÌc oI
i ìrstituti(nraL .r.rìij. irì acc.Lürting íoÌ tì1e tirne series r.ìÌiation irÌ uneÌrDlo!nìcrìl ac(Ís

the Ol(lD c.ìrnkics: i.c. irithìn countÌf \hi]ìs in the lÏ5 or lij .uÍ e dre to inslilulional

i \i.1.èlÌLÌ!9iì' llLr.LlrdrfnÌ{rlÈlrll)lLll
 753

2.2.1 CÍoss-country unemployment rates (Nickell 1997;Baker

et al.2005)
Ni.keÌlfresent5 Ì.gre$rorì resullsfd.lhe uncoÌploÍorent rite
iÌì 20()tUU coadtÌies LrsiÌìg
del;rtìrt\1operiods,t983Sindt9899.1..l.heequitjon1hâtìscÍimatedcanberrrìtieÌl

!. . \Í, .ljxrr - t)s, eL r,

Ìvh.re lrcpreÍrntt thc counLry andlrepaents lhe innirLrtìon.

Ler us l.úk at each !ariaÌrte
illtunÌ:thc1ìÌslvarialrle, \i!. js thc chanSe i. intÌâtnrn ancìcaptu.rs
tlÌe cxrent lo ÌíhjclÌ
the.ou.l.!\úneìÌtorÌne.tisrboveorbeÌífftheErt.Ihcsecoidtenì,_{,,,i5the;;
olrarirbÌcsthalmeâsur..thcinstit(tjo.srlÌatârcerpe.LcdtoshitÌtlìcl,!L,fj.e.tìrcì!rq.
oÌprice puslì frctort llÌei.ilterrì,rsrq,irsiÌÌplvaso.aìÌcdduÌüx\\,arirÌrtcrhriis
i.Ì,l.-,r , I rl.-.,1
(1983 8) aÌìd the sc.o ctpcrio.ì
i1989_9:tl. .i is itre crroÌ tcín tu rhe rcgression. rlc
iestrlis can be sunìnìirize.Ì .s tdÌons: rhc o.Ì).!.rjablc t1ìrt js
completeì\:jn\ignifrcanl
is the ìndü oÍ rDrpÌo) nen l pn)tc.tior. ,\hn os L alt rc
ourer raLiarrirs arr signiitcaÌt ar
con!e.tioÌìal lc\eÌs íi.e. at Ìeasr S%l aDd ha\{: the slgn pre.li.ted b!
econorìic therÌ.r
r'ì , - ',i l, t, r.ò.rr -,..t I.,.- t\ ;ir,,d,,, ,, , tr.A rr r
ia\ hectgc raiscs uncmplorment. Hiijh.r unenrÌrÌ,ryÌncÌìt
rrencrìts afd ldrgr.r duration
oi benehLs raúr urcrÌìplofmeni; acri\e Ìibour nì.rtel policr lo!1,er
it. Iligher uDioD
clensjiv o.corc..Ne râises ir and coor.tìnition ÌíNcr\ jt I he results caDLure thc jdea I hâr
' Ì;' r ' ',., .,t,.rt.r- , ,.t.. .r;.. rJa , ,.
..,...i.rr. rts, L fÊr u, I
dcnsitv and/or.overage, rvlrjclÌ raiic\ uncrnfkÌ nìcÌìt. SiÌìilarlv, rhiÌsr
ir rno; generou!
uncrÌÌpÌolÌnent svrLcnr tends n) raìse ünernpÌoÍrìent. this can be ot
set b| an acIve
Ìabour mirkeL policr.
'labÌe 18.; prrserts
a nmDì.ìÌr oisiÌ srudier, in.ludini{ rhat of\i.teìÌt Lr)97ì. nwhi.h
| ,.r.,, r' r-..r .u.\ úr rtrL,r.r
',".i.r, |,t, ,, r,t ,,,. ,.,.,.,,,,,1.
I ll-(,, ,i.,.r ,t ,.,\ .,.t ,r - , r.r . , , d Lr L rd r r .
.,, ...t ..,..,,t-,.. ,:
eslinratcd ei1è.t\ !aÌie\ wj{lcÌy. Iìr all bur one íLrdy, stÌonger cÌìltoymert
Urotechon
Ìeilislatiod Ìaisi.\ uncÌrìdovrÌìent, but bÍ ontì, a srndll aÌrìount jn
two ot them. \{hcr
etcl it has indiìdd, longer duratjon ot LLnemÌrÌovrnent b€nenÌs râì\es
unenrpÌovmcnt;
a lrigher rlpÌa.cment rdre aìso raiscs uncqrlo) nìcÌìt
in ÌroÍ \L(ldie\. A le\ÍD ftln] lhe
conìpaÌiÍtrr ìs that.ro$ countÌr sLu.ììcs.lo not nfpear to gìrc pre.js.
answcrs to Lhe
' i r' ,i I ..,, ..i,.\, i.r I rír ,
uncn4toynÌen r our.onÌer.

2.2 2 Stable institutions; Ío(us on interaction of shocks wjth jnstjtutions (Blanchard

ãnd Wolfers)
lhe evjdencc Írgile\ts ihat LlÌe cÌÒss coLurtr! relâLjctrÌshiD ber*ccn
inslirrrrj.n\
^lthoush .r .,; .rr,,. -\t ., rrr I
üenr across couftries fose\ an.\en greate.clÌatÌe.ge ! lân.hrr.l and
lvolter\ (20oii) t.l t
i 11,r !Ludr hfBal.r.r.n it|oj)
0rnnterx\1.r1?rrtrin..orìt)dr.rúr r.rFjJ r.!rrÌ rmDúi.ì rÌ Lrpirr
75ll

Tãblê 18-7 E!t mà-.eil ÈíÍÊ.tt.Í fítúiiôis.f ú ienìpô!m.nt !ríúcÊr

the h) poÌheristhntitÍ'âs the inlcÌactidì bet\!ccn diiìercnl lstable) irÌÍitutiont ancìconì

.i lo!^ tr{ r" i ' ll '
tion in urenÌto!_mctt rates ovcÌ tiÌne. lÌÌ slìoÌ1, the idca is that the iÌÌstitrúiots in soÌÌÌe
countrics tÌanslated ba.l shocks (t.g. to prodÌtcljvit\ Srowlhl innr rnu(h morc PcÌsistent
unenìpìo)'mentprcbìcnrs than in otheis (as ilÌuíÌated,lor.{ample ìn Fiii 18 3).Ìhe}use
frve I'caraverages of unemPlot Ìì ent Ìates and theiÌ Ì)tseiÌnc sfccihcatiou teÍs lhc ìnter
actior h)poilìesis b-v'' regreslirg urempl.ryÌÌrc.l on coünlt! (.J ân.1tilÌÌe dunìmìcs {di)
(to rattLne Ìespcclhelv. I)erslslcnt dilferenccs jn ulemplovment acro\s countr]cs and
comNrn trends in ú nenÌplotm ent .J\ er thc pcriocì) rnd on tht inteÌaction bet$ccn üe
ljmc.lumml al]d â set olinstllLúidÌaL variabìcs (X,r, Ìikr lhose use.l Ìrt NlckelÌ) lhctnÌe
dunrmv can b€ thoughtolâs shiftilÌStlÌe|J.un'e eaclÌ fcar in lhe saìÌe Ìlay irÌ cach coun
trÍ. The basic cquation e\tiÌrìalc.ì Ì))' Blanchard ân(ì$ollc6 can be r{rittetÌ as loìloirsl

('.ì,,"')
$'here.,, ls lhc crror terrn.
1lÌ€ir rcsrlG (Blan.t rd and Woiiers 2i100, tal)Ìe 1) srrggcst, h rst, that the sho.ks them
ielves accoúnl an âvüage Ìi\e in lhr ÌrtcmtÌo)Ìrìerl Ìrte ol7 :ì0/i and' se.o.d, that
nÌ
higher rcpla.ement nrtes, loniaer duralio. oI beneÊts, higheÌ enÌtolnent protc.ljon'
â highcr !aÌ s'edije, highcÌ union.olcrigt an.l cleÌÌsjt! Ìea.l shocks to havc a ìargeÌ
elfèct orì uDcmtìoynì€n1i \!heìeas molc coodinated s'agc baìgalning ìÌÌd actilc lâbouÌ
!Ìarket poÌicies re\uÌt iÌì i snrauer effc.t. l. conhaÍ to Ni.teìÌ, BÌanclìard ind lvoìler
 755

Ênd â (ne f.n strongcr erÌ4tovrÌent pìotection Ìcgjslition in raiilfg unl]mplo) nÌent (see

tÌo$eveÌ, wher thc hrpotlÌelis it Ìnestìijated üroÌc dccplv b)' rcpl..ìng the dunn!
vari.ble f.Ì tirÌ. âs a m.ÈasuÌe of coDÌmon 'rhoclis' alIccLing üc OICD couÌÌtrie\ ilith
Ìne.nrre\ of 5pccillc shoch that yaN acrcss count.ics su.h as mcasures of proclucti\itv
grottth, terms oi úadc clÌarÌges etc., thenthe eqúalio. pcllonìilcsswclÌ. lhisi\ llorNinii
r\ it süi{:terts tÌrât thc iÌúeracti(lr between the rinlc dunrmlcs nJìd 1lÌc.ourÌt.viÌtrtitrìtìons
mâv be picklng up sonÌe.Jther ÌÌÌechanlsnr than 1lÌc onc i.lcndcd.

2 2: Changing institutions (Nickell et al. 2003)

.\ dillerent enrpiÌ icaìapproa.h is talen LJy Nickell ct rÌ.,1' whosc idca js to usc an nual data
ând to e\tìmatc a dvnamic model lor unempÌovmc.t. \"arjablcs arc thcÌclorc includcd
tlÌat $ltril.lbccxpc.tcd topushunempÌovmenLawar lroÌì equilibriunr asrclìas dct.firìi
rants ol the cq(riìibrìuÌÌ itself. Thjs is a uselìì e{.rcisc becâuse it hìghljghts lhc possiblc
r)Ìe ofcha.gcs in nÌstìtution\ ir the erperlencc o diil$cntcoonrÌics.Ilu!âs thc authors
ponrt out th$l: arc un$he.l econorìrebic frcltcms atsociated rrjtÌr thcir approa.h
AÌthough thcÍ do not use jrteraction te.Drr bel]!'ecn institlrtion! ând shocks, thct do
ìnteìâct.ÌillcÌcnl idstitutions with each otheÌ (\u.h as un1{)n.len\itv and r!âgc.ooÌdina-
ti()n) t(r exflorc lhe ìdea thrt the presence olyrmc instiiuti(ms togetheì ìn aìr economv
can eitheÌ ÌcinÍorcc or o1Ìset each other.
lÌr ahap(Ü,1 tlÌe.otrnectl()n betríeen the malching efhcìencv of the economv as
shonn bv thc Eeveridile cun e and the 115 f5 mod.ì ìs explaìne.ì. Nickelì et aÌ. estjnrate
a Bcvcridgc .urve equatì(rì aÌ an unempklmcnt eqÌuatìon. Their plot\ of Be\eÌidge
cun'(l in cach courÌtiv aÌe ìntere(ing because lhev show that l(Ì e\ eìv counhy except
S edc. and Nonla) tlÌerewa\ an outward nriftìn lhe BevernìSe cu e between the I960s
^
and Ììid- Ì rslìs indi.atirÌg a deteÌi{)ration ÌÌ the abllìtl of tÌÌe labour !Ìarket to mrtch
!hc rúrcÌìflo_ï€d to va.aÌÌcìe\. Atìe. the ìÌÌid 19,S0s, counties (ürÌ be divided irúo tlÌree
gÌouÌrs (scc I ablc 18.8) : tho\e with a luúher cleteÌnÌatìon iÌr rìÌat( hirÌg $ith the BeveÌilge
.uNc 5Ìrilli.g frúther to the Ìightj those where jt has shiltecl back to the lelÌ; arÌcl a Sroup
irhcrc lhc sltuation is ulcÌeaÌ (there ì\ no vacan._v data tor ItaÌv or lreLand). FiS. i8 5
.-, r\'t.1, òri.Õ. L... I.

Ìãble 18.3 Sl '\ n rl È ÊÉvÊr..È. !ê

BêvaÌdqe.u,v€rh,íi 1960 m'd r93& M'rlis30s 1999

! Nnk.lriil i:ooll. _
lJrrdlrlÌ\r\ kurdrÌ {uÌtirdLrl ìurr\n./iair
756

ìtl I tt
1.1

:0.7

0.Ì
02.1 iiSl0 l2 1'1 0:l I ô 8 l0 l2 1.1

Unenìtl.y!ìe.t nrtc (q1,1 ri Ìe!ÌplovmentraÌe frl

Fiqure 18,5 BÊvêr rl!e.úr!Èr Ío th: LrK ; ìd 5/,ed-ên l q6' l qq9

'Ìhc Be\ erldgc curlc bv rcgrelsiÌìg tÌre ann(raì unenÌplotment ratc on the
ìs estimatecl
!i.a.cy ratc, a trcrr'' l.n thc separ:tion rate .nd a set ol shift lrclor5 The clolt'n$ard
sÌoping Bereridge c!lvc ji oblainel be.atrse thÜc Í a hiShìr \iS ilì'nnt neilatlt': coet
1ìcient on thc lrca cy rate. he \hift faclo!s thal atPear 1o bc enÌpülcally nÌìpoÍant
iÌì
nÌiftlnii tlÌe Llcleridgc(.ur!e 1o ihe dllht are

. ÌongcÌ berelì I .luratÌon

. a hishcr ownero.cup.lion râtc and
. hlgheÌurÌion densìt,v

. lÌi8lìü eÌnpLo-vnìent pro tectio.

itargue.ìtlÌat a hì3hrr r^{rÌer oc.utâtlon rnLr ÌedLr.cs worker mobiìrt-v aÌÌcl thcÌefore
is
inhibits lhe mit.hing proce$. lhc rr{Ìt thal hli{hcr cnÌtovxrenl Ìrtnection rcduces
misÌnaLch i\ rathcr nì+Ìi5ìni{.nd couìd itxlì.alc ìts roÌc in increaslng the iÌ(€Iì1ile lor
hÌns 10 iìrveÍ in poLicl.s to a.hìc\'. bettrr dìatchiiÍl lbecause cú lhc hlgher costs ol
5everancel. Bxt a strÌ!rg co.clusion ishaÌcìtodrai{ l)ecausc oLheriÌnporlattrariabÌcs ntch
asactllcÌabourmad(etÌÌìcanúe\thatmalbecoreÌâteds'ithemPlovtìcntnote'tjo'aÌe
orÌÌitlr(Ì iÌonÌthc tquatio. bec.rÌrsc ollacÌt oidiìla Pt
]\s c{ÌrìaìIed in Chr ff 4, th€ cquiÌlbriLlÌÌ ünemplo-Ím.:.t ìate wiÌl bc atïected both
byslìitlslnuÌeBc\eÌidgccur\eandbl11S/?JshlitsandsoÌìefactoÌsNiÌlPÌâ)arclcin
bolh (ee ClÌ,rptcr.1, fig. 1.11Ì. ln ad.Ìitl{Ìì to Lhe levcriilge cune, \i.tcìÌ eÌ al rslim
ale a dyna!Ììic üneìnploJÌnent lqualioÌr atrd thcjì ÌesLrlts pírvde Írmc sLllÌn)ú foÍ lhe
r.,lc ot jnstitutlonaÌ clÌargc rs an cxllânrtor)' lâctor. 1hc time var!ürg idíjlutiuìs tlìat
ap|Ìar t() be inrPoÌtant aÌe uncrnpìo,rnlent bcntnfi:'d nrrÌrÌì(Ìì tlìe 'líccl ot Ì!hi'h is
iÌ1tc.sitel if gcnerous bcnefits irc ã.comPânicd by ÌonÍl duratìons, uÌìÌon densitl, n'd
thc tax Ì!e.lgc, lhe nrpacl ol ea.h ôI irhich .an be conrplclti! ollset bt r'âiae coordl
natìon. tnìplotnreìú protection doct not.ppcaÌ io b. sig.ilLcant llv using lnìe scrics
 157

drt!dr a.Ì\.eiìi.iÍirndÌnDmeth(tr]IoÌ trn.rnìplo)Ììtnt, Ni.lcllet.l. !rÈ rbÌetopÌo

d!.e counh! rim rLlililÌìt: the\ nrd!nÌtach.ounq llÌe path !l..tuirl uÌìerÌìplo.vme.r,
unerÌ4to\ menl llì nt llìe rnode I ÌrÌ e.lict', ard lhr pitlÌ th.ìt thc nÌodel predictt ii tìre insti
tutiorÌll variabl.s irr lÌtLd at dreìÌ l9ai0 \aìrrs irr scrn..olntrie\ {ch a\ AlrsoeÌir
lelsn'nÌ, IÌrn.c. th( \rthrrlandt, staln, and tlìc L.K, the rìodel hts â(t!ül unempÌo\
nÌent Iirettv lrcll e.d 1\1Ìe sinruletÉd hoÌdi.g lhr institutì.!Ìs .onstanr, ii !pÌ)eâA rtrit
iÌìttjiLúi(rìal chrn.iÌ. hiìs Ì)lared r slgnjncanr trrl in thr p.11rnÌ ot !nenrplo\nrenr. ì:or
s!|ìe lurer couflrlrs:u.h a\ FìnÌan.l, Gemanl, ênd N.tr,/cilind. th.re is little dilieÌ
.nce betreen lh. slmrLlaied Ì)dtÌr $iÌh rnd rÌithouL ÌÌ5titüljoniÌl thinAe. lrlÌich m!!e\rt
thit ilr5tiÌutiorâl .harÌir€ ha\ Ì!)t beel lDfoÍa.t ior thcir ! Íì cnulovflìüÌ1 ir,r jecnirie\.

2.3 Country case"studies (l.JK and Netherlands; lreland; Sweden and

Finland; Germany)
Ont r,i! to apptuclÌ a courLr! 5lLkÌl o rLncnÌplo)xìerÌt is 1o .rppll the reìÌtr n(rÌ !
tcgrcs5ion anaLr!Í, d\ Ìlas donc bv \i.kcltirnd \n ()us (2í100t irÌ a tÌlo (ount.v 5tu.l\
ot lhr d.aÌrili. tulls ìÌì u.enrtìorm..r obÍ n cd in tlie UÌ( ind thc N.thrrhnds Ìr rhe
l9r)(\. Spc.ihc.rLlv, the\ u\e thc co.Ill.icfls roIn \i(kell s 1(r97.ross .ountr) e!u!ti(rì
t.r csLlmal( lhe predicte.leffccr on c{ÌuiljbÌiunr uncrÌplôvnÌ€n1llr.i.lÌ1:ount{ of.rn,lj.J
obÍ tr.d in union dersit\'. co|cragc. !..ftlinalio.,..tì!c iborLr marÌicl pol cl,thrberÌ
cl L rqr n..mcnt rati(), al.l rhc rax wcdg. ÍÌonì (hc.irlJ, ì9Ell; to Lh( .rld l9()iìs. l,or
Lhc \cllìrLl.ìnd\, tlÌe Ìrre(ìicrcd .:ift:.ts inroun L Lo a lúu.tìon in (rncnrpÌor.rcrt oI.1.5,/o
poi.rs as.onÌpareli ÌÌith af r.ruÌ rc{Ìu.rìr)n oi 5.;'l! il]d o. Llìc LrK, 1lìr !Ìcd .lcd titl
is l.ô liì conìp.ìÌecl with ân a.ruaÌ IaÌÌ oI.1. ì li,. l,or thc \clhcrlands, thc kcr roflriÌrrLl-
as
ìÌÌ.1f.ì.tols irre ! úse nr rrag..ooÌdi.ario.. â risc in..(ilc labour nìaÌkcL toÌl.lcs iì.d
süall clntriblti(Ìr tÌom a liÌl i. lhc rctìrccrì.nl ralr end in lÌrr l]\ 1rc.lgc. Ì:or lh.
Lrl(, llÌc miirÌ contriblìtn)n\ conrc IÌom l.wo trn on dcnslli a.d coveÌagt. rrjth rmallcr
.ontlibutiorÌ\ ÌoDÌ r talÌ ì. rlrr: lr\ nedgr anLÌ i. thc rctÌactnre.t Ìate. ln terÌ\ oi lhr
Ca nrlor's l)Iii1ìLlxÌocLel, theUKeppeeÌ\ to molt towaÌ.1 the.ìelentÌrÌìzed ÌroÌe rLitÌl
low.r orì(nÌplor nÌentl andthc \rrhÊrla..Ì\ ntrÌarÌ Lhc (oorallnrtcd polÉ alí) llith l(trÌtÌ

l hi5 Jnall sis pLace\ dÌl dre ileighton {rÌrtìr \Ld. ia.toÌs, but jt is iÌÌunnratinH nr ÌrÌt( al
lhc bíradrr fi(tLìre nÌcllÌ.ìing lhc c\teÌnaìaL..u.l. labÌc 18.9tÌovj.Ìes nrrcÌrerononric
dita Iü r.ch.o!ÌÌtI\ nn thc Ìì jd ì981^ ]f.t t{)i Llìc L:arlv 2000\.tr
\! iÌr1Ìrcd ìn ClÌrpter 17 1n thr .ti\cu$i(!r ot U( nra.n)cco.(rnjc peÌloÌmancr jr thc
I990s. it s.cDrs cssrrÌtirl to lÌcÌLÌde jÌr tlrr dÌah si\ ol fxllins uneÌnplo] nÌent tÌoD I99:
the nte Ìrlarcd bv Lhr s!bltrntial dÌd per\i\tent reaÌ rfÌrÌecìrtiiÌr ol the eÌ(hdnge Ìate.
Th1\ ì\ reilecLed Ln lhc drt!,riorrtioÌì ol !nit Lrbour.o\tt iihe rise irr ÌìLiLai nrr\rÌ in
lable 1lì.9r an.l rlrÈ ars.. iLtrd .L(tcrioration iÌÌ tlÌe clrÌerÌt rc.ount 1lÌe \itLr.rtidr i\ dit:
lerent 1rÌ the \etherla.di, rlÌere thr adjunnìerÌ1to ldler !ncn4rlo)ment t.rles p]"le
tìi r rtrìSIÌlt c(DslanL rcaÌ cx.lÌan.rc nìtr.nd ütcrn!Ì bül.ìn.r. Ìhis sLrSSrÍs tlÌ.ìt slÌilst
tlÌ. Dut.h urÌemltovmenL rÌ racl( i\ prcdoÌr nanllr ! Ìpplv sidr plìcnorncn.n, ilÌ( UÌ(
orì..onÌbnì..s mÌÌrl\ !.le lnrprovc.rcnLÍ'iLh i rìorr nìbniutiol cliÌncnl of arl iitgrcg.tr
d.mand ll,i:l e\pansion \Ìa a ron5rLmfr on booÌÌr. wherc ihc isso.lircd üirh.n!. ratr
 Íable 18.9 Ìhree ui.Írto!Ílnt mÍà'Ê! iEu'oèrl'!

Èir r . $!.r!: oi:fr:ii hinÈ i r:f,'. r oÍì ra rb

;l:.':lljÏi!ïl lìl:., , .".,' ,. Êr!: R!1. fÈ:i, h

.n,-crl::r""',
.'.."..'.'-c'.'..".".''",fÚi.]r1Í.!R!!tL]:tì.'.i.,ìlo,ILlgt
{-,;1,"r,,ú rl

,,r.- ':or '. r-.' q\ L,

"rrr '
t 1. 'l -
. ..
' 'r or".,"d,'r' ii ',' ro "
-,1, ,;,-.1'r.,.. t" l

r'ni.l r. Il' iJ
thc authors nole,lìowercr. that
tlìe hÌg8eí piob erì iÌr ass.ssing Lhe th! rclonnj on enÌPlo]úcnl irtn miLroslÌtrÌ
'oftÌibutnnr 't U( ccon'ml (L' ìiÌratei Òr'eiall cnÌìoçrÌ€'t
ut, ,n .,ìcÌoper rÒúÌnr
"
Ì'c or thc
'", '',.'r:c,,""",
'-t,".,.rLtltnia,rctoÌi.rledpolÍ:\retdnsirtlÌelnlrornrrrkÚt'ouÍiLìut€dtoli'lengtÌi
calra sion, ÌÌìev Ì{oÚld irdee!ì lÌelf €ìflô!f tlÌc 8"d peÚt)inìarì'c
1",i,' .* . ,r."
"""..',
"iin","na,utg,,-tt"r4ri)rmentnÌlhúpcri(,lrut{rchn'onlIiÌruÌiofcúnoIb'iet(liÌ}'
dctcnÌr!cd Lr.tì miLoe..nofrÌ. datx'!
iell iftÌÌl 16 50/o 1985 to jn
A thiÌ(l case ol intercst is lÌelan'ì, whcre unenÌplo,vÌÌrcnt
.r.41ro jn 2002 (lable 18.9l. lhe c5tinÌ.tc{ì ElìU faÌls ltrÌì I3 2oi lo 5 91,) and lfÍlatio' ìs
js the cqÌuilibrilun and
ta[ing ìu the iìúL perio.l iÌr irlÌi.h actLÌiìl uncnÌno-vìn€nl above
Ìning nr tlìc second, \çhcnil ú bckn!
suppì\' sfte inlprove
i,rìr,"ir a.^L'sl..rtr,"'rrish haÌe ' Ho'^haf end W'Ìsh'! i'ÌerÌtlt-l
menLs tlrat woulcÌ hrve shilte.l lhe IRU curtc to
lhe rlght: a drânì'ruc Ìi\e ln Ìaboui
cooi(lÌÌalion (as iÌì ( haptcr'11 and
productnit-v 3 {Ìh, at
in.Ìeasc in Nagc 'Ììscus5ed
iome tall ioilailc union,l-'nsìt! Asaconsect!cnceotvelvstìÌ!Ìginu(\\5oíioreìgndÍcct
.,.rn '. l, .r'. 'f r',r'"d 'l p" ' n ' -
e-{poÌt Íìarket sh rre .lNbLcd bets een t 'r8
5 an rì l 9 99 As showÌÌ i' the table its ÌeÌatile
a (rons rightlvard nrift of
.u,lL toto,o.ortr.ror" tiÌan l]ah'ecì lhis ì! consislcnt l{ith
'he sNclcÌres f(Ì rnch coÌintÌ! iÌÌ ìrig 18 6 shoi{
thc rÃU cuie as slrorvn b Fig l8 6
íìÌltt nì the reÌctarÌt.uìves thal aÌe consi\ten! titlì the macroecononÌi' data prcse tcd
i. Iable Ì8.9.ìIìd with the narralì! e oulìined ln eâch crse'
ì J Ê.nihrrr rnd r\rLsÌr l2o02l
( r.d Jfd IrÈ.nìr.l2O0l ill
 759

FiguÌe 18,6 Ìh. Ll(, tlìÊN-"ihcr:nd5, ind Êrid !nÊípôyri Êfr'm ã..s

The nex! !ho ..ses Ìve co.sìdcr are thos€ of fl JrÌ.1 and sweden. Both countrirs had
ÌelatjvcÌv ÌoN unerÌÌplo!rnent uf to tlÌe end ol the 1980r f(nÌo$'e.Ì bv a .iÌamatic risc nÌ
tht cxrlv Ì91)0s alld a mbse!Ìücni d..line. Ìhe top pancl in Iìg. lE.7 sho$ rhc pnths
ot unemplordrcnt âtrcl jÌÍìario.. LooiiìrÌB.rt urÌeDÌÌtolment llÌst, in borÌr co(lnLrÌcs,
unemtlovmcnt lell tuÌtheÌ ar lh€ €nd ol th€ 191ì0s.Ìuc ro pooÌÌ) riÌìcd flacrorco
nomic folicic5. IiÌìarÌcjaÌ libcÌallzation and ta\ cutr I'crc intÌ!.Ì(ed âL a limc whrn
the ecoDomics h'rre alrea.ìr ovcrhciting.
760

ÌÌrÌ.rìrn,\.r.f . uLfl.Lnf r:'r,)

ì:l
,l:

tl
resrr,lì:ì9s6 !r-L951ll939lrqfl99ìÌ9r219!3lrr'r1l!!iÌ':i6 rq7 ìq9s rl,9:l0lì01(ioL

lluf ,ntir.otr.t,!a l)|ì

ìl
rc91 r9qi L!!ú lrr9i ,.r9rl l!r9t lliorrllrf

.,]
q9- l!9È l'rt!lorrl20L)l
Ì9sll9rjlqt6Ì9ri lqNsì!3!Ì!r0 !!,rrn!2l9g.llqtlllqi1916

Figure 18,7 f,'à. .... r.rr. ilrÌ,.. )rÌê r' ire.lÊ. ;nÍ ! ì'r r'i

Jf tl,r srt:.]irlÌl:ase. " thoe was a massiue connüncr booÌn r$o'iiìlcd witlÌ i houslìil
iÌset Ìrri.c b ubÌ)Lc. \. indiütjon olthc txteÌú olÌhe tJ!üÌ ìs tÌlttlÌc Ìrouieholil sivlll\
ratio l€11 b! ;'.n point5 bcL('een 19E5 ând l9EiJ TÌre ÌesLrlL nas I tlÌ'rp Ìi5e nÌ inflition,
n'hiclÌ in Si{eclen ilent irì1o cìouL,le digitj lrrrrÌìtÌo}Ììì.'l he'ì t!Ìlrn 1o le$ tlÌan 2r)irl
The Lroonr i{ \ lol a c lassi. b u5t r\ Ìrìicroeconoln l. foÌicv Ì! as Ì ightencd -o!er
l.lte.l b}
aÌ)NlÍl-!, rariclÌ lrd to thc collap\. oÍ connìnìftl{)rÌ and n\cstnrentandiItlÌewakeol
tìrit. oI a nunÌbcr oI banks. The \t\ j.gs r!tio incÌer\ed bl l2 tercentagc toiÌús b'tweex
1989 ind l!r93 iÌn.]ìÌÌrcst ent fcÌl b) l0'l/. Ihe LjÌnÌlsÌr 'bu\t'ilis cìaceÌlntcd b-Ì arÌ
extenrel lÌr.le sh.cl( ch. lo the tlisiittgration ol uÌe \o!ict UniorÌ' ínìich lvr\ a majoÌ
úadìng tertner iscÉ thc Ìnnìdl€ panLì fi)r tlìc ÌratÌr of thc ctrrrent 'ì"ounÌ balnìccl ÌÌl

r,Ì,i iì..a.fuiLrdii,,Jni sr.ar f t.ô Li!'rr)

 761

bo th .ou rtiies, t\.h.nire rate dcvalu.rìons in th c cadl i !r90s {shown bf r ta ll in rehtn.e

uD il ìalrour.osts jn thr bortrìÌ panrll helped rhe rccovcÌv ot aggregate .Ìeúr e n d irnd rlith
un.mplolnìen rcÌl ibo\e equiÌ Lrrnrm, irúlari{n .:ontjrÌued io clecÌiÌre.
\\ilh tlÌe reco\..rv oi iÌìteÌfal ind ertenÌat .tcnì ìd, u eÌÌ4tovmcnr has graduatÌy
ÍaÌlcn n both cotrnLries. Strrrg cxteÍì.1su4)lu\rs j,ì both (dses \uggesr ttral lln! uneDr
tìormcnt is sustajnable. (losL conìpriitiveÌresr has.ontiÌNed to 1nÌrrorc, reiÌectjng
5()und productn ilv gro$th afd adequâte wege icslrniÌÌt. Ìhete two cascs ilÌunr.fe tÌrât
agg.r8.ìte leDrand dlrÌârÌici can ha\e r dramari..:ltc.t on urÌenÌttovmcnr o!.r a peind
as lons âs a decâdc nnd â half.
l he hnal casr stud\ is (leÌman!. ,\1fig. I8.2 shoÍ,s, Cern.üÌ unempl{\1ncnl r,is ver!
Ìos, below.l0r, untilihemid,ìtr80s.lÌ]mthemid,Ì9E0\tothexìi.t 1990s, uncmploy
nìcnt Nâs snÌìÌar to thitin rhc L,Sr\ and lronÌ rhr mid 199ll!it ha\ been hlghft. lrhereâs
rnrnìplolNe.t in tÌre USA shoi\r no trencl sìnc. lhr 196lls, GeÌman unenrflovmext
lrends have becn strorÌSÌ! up\{ard\. ÌÌì the pa( dc.ed( int ! half, (tenÌan (ncmplo!
nìent contÌarts shar ! i!ìth a nurÌìber of Euìopcin c.onoxÌies, mch as the llX and t1ìe
NetherÌands,Nh.reitharfalÌcn. Ìh€ jclearhâtaicrÌran!xenrdo) ìentitaf ulchnrpplv
siclethe.onrcnonrootediD 1s l.b!urÌrìarÌ(et and r,cliare state clÌaracteÌlstics is cÌpÌored
iÌìacletaiÌed(o,np.ri\onofrlìc\tthen:ndsan.ÌGcr.ìanv.ÌÌ1lÌeconlrarlíDshoh,slhat

'iÌrcentivestoNork!regìeatc.inCernìa )rhrnthcNetherlinds{wirhthee\ccpLion
olsìngÌe cârnl:r low iÌÌcoÌìc.ouples Ì!ith .hiklÌc.)
. 1. la \-t, .,,
. "
empÌotDcft pínectìoÌr is s miLar in the Netherìands.nd in CelrììrÌ!.
The polirv debate 1n GcÌÌÌirn) and iÌr the Ìetoís on Crfirì.nf b\ the OICD havc
\trcícd thc nìpoúa.ce.I l.bour rÌarket and r,cllare nirtc rel,rrrÌÌ loi nìtr)ving
(,enìanv's uncrÌÌpLovmeÌrr tcrlonÌÌaxce.ln line irith Lheirre.onnnendatl!ÌÌ\, tlÌe OtCD
retoús thal Lheiollo\liìrg mcasure\ h.ìre been un.ltrteÌicn in Gc rnÌi nv: improveÌnent i n
activ.labour mârlietpoÌi.!, en orer:ll reducti(lr in thc lax Írdgc, i i(.du.tion iÌÌ emplov
nreDt tÌolcclÌon tor temporarl contrâ(t\. a Ìeductl{)n tn lh( duralton oi unrnìplourent
benelrts and tiShtenÌìg iroÌk iìlailabilit\,.or itirms, and thc prolrorloÌ1of nxrre decen
h al i7.:d Ìlagc settiÌrg. Yet llÌlcmplo\ Ìnent has co n ri n ucd to irÌcrcasc. 1 he U( erperi e n ce
wirh suppÌ_Í s € retarms suggcÍs tlÌat it mav tâli. nìnnv lcars tur Íì.h rel(trrn\ nr pai
off. H.r'crcÍ, otlÌer evjden.c nr$Sens that ìÌÌpÌumcnting labour marlet rnd lreltarc
stâre rclo.ms Ìì.r] rÌot iolvc CenÌìarÌ', s rurempl()_vnìcrÌt probl€nì. l]ìe apparenr\ ÌiÌn
ite.l effc.tivcrÌcss olthe ÌrloÌnÌs impLemented t.) dalc n C ermany is consjstent ríith borh
the cr\s srcli,Ìì.1 evìdencc on CenDün) rnd the NcLhLrl ìds and ÌlitlÌ the \imuÌatlons
repoÌted in sc.tnÌÌ 2.2.:1. whffc.hrngesirÌ inrtturjonsrÌere not found to account toÌ ttrc
traje.toÌÍ ot únLmdolDre.L iD CernìaìÌv.
ThearaÌÍsisolCenÌan\'rmactueconomicpeúoÌminceiÌÌChapterlT\rressÉdthe.on-
lequen(5oIGcrÌÌÌ:ìnunjlr.alion lti!â\ drgue.Ìrhcrc lhat CennarÌvneede.ttr)nÌtFvc ls
compelilivcncss a clto ol.rconìe the weakne\s in donìeÍic :Lililregate de ran.t.hprtn
ciÌte, ìaboúr marlet a.cÌ ircÌtirre Íaie rennìÌ! ol (hc k]Ììd thât ha\ e Ì)een imflemc.lcd
sllrÌd nrii{ the lïLi curvc lo the Ìight ân.Ì taÌ .L1rs s1ìo!lt Lroost connnneÌ sÈrrdi.g,
762

slÌìILìngthe,1/)cuÌ\etolherightandaìÌ{ú'anoni tÌationart ex}rarÌsion olrctivltr_ and

rcduction iÌì un cÌnploynr ent. Hos'cver, atÌa L)'sls ol tlÌe D u t ch and Iúsh ca scs slrgilests th a I
l\,agc accolds playecl a lÌì()re imporlant Ín€ if achieving thc ÌequÌed .cal n'age Ìestrai't
thffc tharÌ dld chanS€s iÌr Ìeplaccment Ìates, lax iredgcs, or.ÌnpÌovnÌent pi(Ìection Bt
conoast, iÌì thc t:K, i ras a Ìrìorc LraditnÌìal packtge ol labouì maÌket and sellare nale
relornrs th,rtl\'ês implemcnted. 5Íong agsregat. ilânând n'l r
' 'tnrere't
nìadoeconomic
poÌìcl tÌameÌÌotk were aÌso presenl in lhe tÌÌ(case ((lhâplcr 17ì. There ârc scveÌaÌreasons
Ì!h! ncither tlÌc Dutch/lrisìr appÍoach nor thc BÌiti\lì oÌìc may worl Í'cll or 'ÌulclÌy it

,\lthough t!agc settiÌÌg ln Gentìin-vhastÌrditionallt becn al tìremore coor'Ìinat€d'l:nd

ol thc itectrunì, lhe prosPects for rcìnforcing coordinatìon and achievi'g a righti\'âr'1
nÌift ol the üU lh(trrgh coordinalcd wage ÍcttrtiÌìt (Ì.c sìriititÌil Ì!J doirn) Ì!ìay be
hnited. Theie arc three rcaíÌÌs l,rr1hìs:
(1) l.Ílaiion jd Genünt ì\ alrcadv veÌv los' ãnLìevldcncc sui+eÍs thal ú 1s norc dith
cultto achieve rcal(aile rcductìonsth(D3lÌnonrinall\agc cut5 thanÌhrough nÌodcratins
ìnoner''r'aiie incrcare\ in lhe clrntcÌtofmodcsL intlâtìon. NÍ.teover nìan-Í oi G ernr any\
tradiÌìg paìhrers r,jthnì Ll4U operntc with coodirÌat.d i'age settÌng lolicie\ aimcd at

(2ì Section 3.2 hjghììghls the ìact that ürcr.ased unelÌUÌo-vÌnent dispcFion a'ross
('cnL
rcgi(lb has lhe elfcc! ol reducìng wigc rcstìaiÌÌ1: the dispÈision 'l uDe!ÌìpÌo-Íment
up ür Cìerman) nì lhe 1990s, both be.aüse ol t1ìc itchrsilrn ol lhe Last Cernran Lànd'r,
rlhiclÌ hivc very hjgh uÌÌ€nìdo,vÌÌÌent rãter and hecau\e ol lncreasecì dispcl5i(n across
We\tCÜman LãndcÌ.
(31 As $'c shalÌ \ee ln \ection 1, iraSe r.strajÌ1t iI] (ìclnran,v nÌav lÌaÍe been í'catere'l
bl !ìovc to EML., as the dÌscilì1niÌLN rolc of the uunde\bânk oi rcactlng t'r ilÌcÌeâses
the
in GeÌnÌrìn i.Ílation disatpearcd.

notcd abo!e, a .ombrr of UK tvpe rclomú nr lhe labou. nìarlicL and ilelfnlc stÀte
As
ha\ e Lrecn intÌoduccd in Ccrman) Yet thc Genn.n cconon| Ìelnai's nNCh ÌÌrorc sinÌi
laÌ in its institutionâl arrangcment\ to olheÌ contÌncntal luropcan cconomies such as
the \ethrÌlanls. On tlÌe one h.nd, sonìe nnali.ountlies irÌ lurope app€âr lo have
beeÌÌ.bìc k) nnpÌcmtnt pro_enTloyme.L Ìeturnìs that have bren bha'll,v consistent
irith thcir tre erisllng irÌÍilutir)naì arrângcnrents. and o. the othcr' the UK h's inrPle
nrented rcionÌis to.reat." â nrorc coherent sd of lnarÌitÌ íÌiend4'labouÌ mâÌÌ(et ardweÌ
faÌeÍntcarìaÌÌgemcnt\.1'zlbcftxpeclslorGenÌìaf-ïachieütìil€ithcroftìrese0ppcaÌ

r\n ünintended side effecl of tÌÌe ÌâboLrl mrÌk€t a|d h'tìfaÌe Íìte rctorÌns tlÌât have
been imtìeìÌented in Germanv nrav be to dcPÌe\s lÌouschold consrunptÌon cxItnditurc
hÌ an c.ononÌy Írch a! CctÌna.| itÌ Ìlhich job tel rc has t-vtic!Ìly bccn longer than,

[ leeür.inhodu.tionr.d!Jüpter\nì(:rrdttal i2oo]j Ìrrl)rri.rÌar.t.fr.!1 121)01 225ipLovid'!tÌLdür"

.nLÌre.lìrrrgr\trìlÌitiihirrdrrtirlrrl.ti.r\.\erúÌ.l{ì1\aÌü1t90slÌ(1..11ürlòrÌútìvillttdÔtLb'
Ì9r0r rr rs..úri,ìr td L.fÌilnì lÍnlìúniilafFÈrrs rì hJle beerLrr.krf
.r.$ÌÌ'th.s.Ì!orkt,lrLÉ.ÌrÌr.r.nÌlnlunion5triSaiÌr\ctiil.v\urrtrgtnredLìI8JnÌiÌì3isn'lrtrfunLì
li'ì!er i Lì.torall)Ìt$iig ÌâborÌ)rtrLu.!\rl'
lor cxinÌpLe, in th. L |i. ar in rìÌl.h the rìììd câÌc.r Ìabour nì.uket ij Ìe\s dcrcloped,
Ìelorms nÌa! ralst jfÍruri\ moÌc ard proiÌìpt higheÌ t.(ca!tionrr) savings. DomcÍic
aggrcgaii. detrÌa..Ì in GcrnÌanr grcrr broadll irÌ lire irirh rlÌe ren of rhe Eurrpcen rrniorÌ
Íronr ì991 to 199; but llealeDcd marliedlv theieattcr. Cenna v recoì.Ìed rhc Ìargest
regatlvc 8.rp betÌ\ ftn tlÌe ünnuaÌ9rc\lth iÌì ciolrestic dcmând ârÌd tÌeÌrcìgr)wrh in CDÌ)
anrongst eisht ÌaÌgc QlaiD counhjcs tr the 2000 3 pcriod ri ìhis reUe.ts bolh rleak
pÌiralc.on mptjon and iNesrmcnt. ind.r highÌl co.Írrüìed p!bllc sect(n.end íin.ls
jr sharp contr.r\t tr) Lhc role thâL buovirnt househoÌd and p!blic secnr spending ha!€
plâ)'cd in both the Uli ind USA in suÍ.ìrÌing asgregatc dcnìand o!€r the rja\t.lecadc ílcc
(lhaptcr 1ll.

2.4 Hysteresis (Ball 1999ê)

L.$rence BaÌl sct out to test NlÌether there irâs.vidcnce tÌÌat rnacr)economic polìcy
.lÌoices by govcrnment\ and ccntr:l binls ì.Íhìcnc(.d equiljbijLurì unenrpìo) nrcnt by
\iúue of thcir cllect on rctuÌ (]nerìIto)me.r. His iìrsr claim Na\ that somc.oú.tries
purued cÌ.c!sivcly tlght Ììa.nr..ononlc poÌicjes i. the earl) 1!r80s, rvhich l.d ro pro
longÊd re.csion! rnd trodrccd Írtre ldrg teÌm trncmploynreut. A\ we ha\c Írco irl
Chapteì.1, it the lorÌg teÌm uncmploved are inettccrÌrc irÌ daÍipenjrrs wage prc*Lrrc,
equiì1bÌn'nr uncnìplolnreDl i5 puíìed ut. 'O\,er tjghl' polici€s becrnÌe a setirfulnlìing
tr)Ìtrec) h.:caLrsr the uÌNard shilÌ in tlÌe lVS.uNc Lhen requires tiilhter nìacr) fol-
ic) to nahìl izc üÌÍÌrtjdr. I ljs sccon,i:l claiÌn Ìlas th at co unüi€s s4ìer! urÌenÌto\ men t IcìÌ
nÌÌntrntiiìÌÍ ln the 1990r irffc ilÌose that underook cxparÌ\ion.r) nrücro poÌlcies, L.c.
hvÍercsis opcrirted nÌ revrÁc Nlth nrDg aggregatc drmand reduciÌrg uner4to)menr,
whl.h in lLrnÌ brought dorÌ. cquilibrnüÌ unemplovmciìt.
This i.tc4Ìetation ìs clca.Ì)'ar odds Ìlith the ccononìetric studies discu$ed abo\r
$'hcÌc Lhc cmphasi\ ì5 o. sÍpplv \ide deteìNìnants o cquilibriLìm unenÌplovnent. Balì
dr:nìonslratcs thât the cenlral baÌÌl\ irÌ the USA a.d (:nnada cut int.rest rates much
nroÌ.vigorouslìrndcìoc(lr.nlsiÌìcentralbankìepoÌtsth€ippaftnrlrgreâter(oncern
to irìpa.l a coarÌtercyclìcaÌ \rinìulLìs tlú!l was the casr in tturopcin co!ntrils in tlÌe earÌv
I980s Ìcccssion. Ho$e!er, ir is cxire Ìel\ cliiïcuÌtto trcrtdcclidrrì.c tlìat Ì!orld contìÌm
oÌ rclLrlc thc hlsteresis hlpothcsìs:lÌo$ crn tlìe h),torhrs \ that
. ccnúaìbanNs pu6uecÌ tighL polì.\, tìr longeÌ ì.luropc becaust rhe Ìpplv side tra.ì
dclcrloril(d ti.e. tightcÌ polj1:,! $as neecìe.l tr) ensurc dlsxÌflatìorÌ)

be dìstinguishcd lÌom Balì\ htpotlÌe\ij that

. the n'Ìrdy side deteÌìoÌatcd Ìrc.a use the cen rÌal bân ks ln turopr lailed tLr curjlterest
Ìates raarcssiv€ll toÌiromotc r.coveÌ\ l
AÌthough Lúìrcsol\ed, thìs qúcstiotr renrairs an jmlto.tanÌ one. ln th.È coxtert oltNÍÌt,
me.rber.oúntries do not havc .oÌìtrol o!e. m(rreraN policy and, âs, we ha\e see. i.
CÌrapter 17, Ior courÌtrjes wiLh Neali âgtregate dema.dj lo$ iníÌirttÌr penerseÌl Ìaiscs
tÌre Ìeâl jnlcfcÍ rate t\ì.ce rhc nonÌiral ilteÌert rarc is co ìrnon ìcur t\4U) and can
reinf or ce sLagnitiorÌ.
I ajLaD,r,,x,,ìn nn.folao,','r itír01,::5 ó
764

3 Trade, technology, and unemployment

TlÌe anaÌ-Ísis scúnnÌ 2 eraÌÌÌincd aggreilalc rìnerÌìplotmc.t llÌ se.tjot 1 2' sharP
if
cìitìeor.c\ irÌ enrÌrìoyrÌìc.l ând !ncÌìPlovnìcnt rate! try educati(lral iyotlÌr ire'e 1ìigh
lìthted. ln this sccljotr, Í\,c brins t.igdheÌ thesc Lwo isnìes. wc begln Ìlith (hc anaLysls of
the varìarion iÌì uncmployÌnentrat€sbctween ditferent i+oüPs ithiÌrcoÌrnlÌiesarÌdthcn
txa ìnc lhe c o!Ìrì cctioÌÌ bc tl!een !ü.Ìr dlfferen.csand ìilgrcga le e+rilibri!r Ìì uneÌÌrplov
nrent.lrlbetìÌìalpaItoithìssection,wcloolia1Ìtcentcì€felopÌnent\iÌìoulÍrurcirÌgan'l
oft-shori.g ând th.jt Ponible nndiciI lon\ lor ünempÌovmrrì1

3.1 Unemployment and the relative demand Íor skilled labour

(Ììe locu5 of $câÌch otcÌ tlÌe pisl decade hns beeÌÌ on the varitìtion in (un)€mplovnÌenl
I -r l. .ior, r It L, | Ò: 'l r'' I
rvìS€ distersionhetÌ!ecn the \lilÌcdrndunskilled. Ìn l'r9'1, taul Krugman suggcÍedtlÌ'rt
the risc jn utÌeÌÌÌto\ Íìcnt nÌ l]!ropc and t1ìc r1\e iÌÌ n'agc LnecÌualit)'ln lhe Saxon
conì'lI] irhiclÌ diltcreÌrt lìbour maÌket^ÌÌglo
insliliúiorìs
cor trics were '1rt 5ft.s olthe satnc
r f'l ìn lhc rehti\e dcman'lfor un\kiÌled
trcclu.cr1 .ontrai ting oirlcomÊs i. rcsÌnnÌn'1o
labourlntheÌi.hcourúicsrr'llÌisl5anotheÍclanìplcollhepo\siLrhjnlcractlonbetrleen
a conÌmo. nÌo.k a ncì cliÍlcrent i!Ì\t iltú1(! Ìa I aÍaÌrEenÌc'ls' TwocoÌÌtc'di'3
erplanatiorìs
tor Ìhc hll üÌ ih c reÌatiçc .lenÌãnd Ío I unslllÌcd laboul' rcl ate to
. tÌÌe roìc oi iÌÌ.rcasecì com tetition úonr defcÌopÌì g .ounl rlcs ìn the pÍoduction oI
Lo$, skiìÌ nÌtenslve tood\ the \o cãlle.l trade' hlpothcs is and
. lheenÌergc.ceof abiÀ\iÌr lc.hnoÌogi.al Pr)gress toNald\liilÌ iÌrlc'slve
lnno\ dtion the tcchnoLog]' h vÌrodìcsl5.

ln Lhe iìist rcuncl olcmtÌic.l r(!caÌch, thc Iads \rcrc m.re consl\tenl with uÌ€tcchnol
oB-rexpLa,rtlon.ThrPuÌetr.deh-vtothesisÌ!asbasedodtheapPli.itlo'oítlÌeÍandaÌcì
no{ìeÌ ol conìtaÌati\'c a.h,üÌìta8c (tht larÌìoLrs lÌeclischcr OhìiÌÌ nÌod.ll ì:olld!ìng tÌade
libcralization, the productiuì oI goods t|nt âÌe intrrÌ5i1'. in th€ irsc ol the labour ot
r,orkeÌr with low educâtidÌ 1!ot1ìd be relocâled to.ounlries lvitlÌ a Ìarge erÌdoNmcnt
oi un\Ì(illeil lahouÌ ,rnd \'1ce lcrsa.r" Ift^levcÌ, thi\ $as i.consì\tent s'ilh rhe lollo('jng

(Il lhe skilL prcnrilun, i.c. the Ìel.livcNage of skjìÌed tuurÌskjìÌcd worker\, his rì\en lÌ
aÌl sectcús iÌn.i h alì countii€s, lnclu.tirÌN lcss.leveÌoPed .nd no!Ì\ ilxluíriaÌiznÌil
.ountries asweÌl as OECD c.JunÍ!cs.

Ì(ugranr rÌ991 !Í,1.Ì .1Ìr(r Jnr r$ h.Ìe inrrtÌ!ikd ÌnrÍ tont.ldir3 ÚiLl.fr\' ' g iÌìe 'hrfnÌ\ uì
r;Thlrnrh.êLr{ì.lr.trartolìoriÌ\ÍriinLskiLll,iì\efnrilLsfl.úÌnndrrdrdh r lr(it ind nÌrrth'r
tÌrr rrthrÌtÌrtrn.Iü.ìrn,lnÈl:rll!inurrnrÌi41iofdìd!ha^3.iiÌrnìifirrud!Ìrage5 r'(r(rÚ\ÌnÚllrl'nìilLe
$iÌr!if.quxlú1 iÌrth.tr\\útr( les0\ei ar d,udDi\'lrfot'o'rì
L' loÌ ir r\.rlLÈnt pL.! rtr!o. n rhr hade,ú$ nrrÌ \Éê trI.od i rrlrii
r .rr.aÍ.Ínrrt.ltlì.nrilelrlp.tìrent nÌ L)c\onqüÍ! \lr.lÌirì ann\',rflìr'neniì!1991 r'rL\nL?n'e
.rr \r.rlLbúj.i na I nLìÌ pÍi3r A\, j?e fe!Àr f Lrrtruü. rl\lIhi. (1993ì
 765

\ 1th th.: r i\( üÌ ure rÌtiÌl Ì!eNÌum, rh.ll lÌas bc.rì i Íi\r irÌ t1Ìe ütì() oi niiÌlcd to
aldÌi<
!oslille.lÉnrfl.\nrintirÌaLl\ernÌ5,bothskillcd.ndunstriill€dhLiouÌirte.nrc
tJ) thctr hâ5 br€n no rsn lr.an I dc.lìnc iÌì r..l!tj|e ÌrÌicet t{r'the ltÌod(r.Ls.I Ìoì1 \kiLled
irLÌLrslri.s ÒÌiili!Ê rÌr.l S1

ln tÌÌir tc.Ì .Ìr riur on Õrrblishi.g h!\! r Ìiüt irr relati\ e .ìemrDLl .r 5ktltcd
í)cln j5
labolÌr wheLc!.i it\ !(ürcc elle.ts thr LnulorÌnrÌrr, unenÌrlovDtnL, rnd diti!e
ÌÌase\ olskiÌlcd.ìnl !rtrliìÌÌe.t hl)rÌcrs. n LÌrcne\i\ecúnÌ,Ì!rdi\cu$howrn inc.fisi.d
di\t)eLi(ìr oI uncmplornìe.r rarÕ.a. r íc.t cquilitirium unenÌÌrlo\Ìnent in rh. ccon
omv. To e.trrc'thc lìrt !Ìuetrion, rho. i.r thr c. iÌnportr tirr8reclienti:

(11 uìe relatn c dctrìirìd loÌ rÌtiÌlecl ! eÌnb urskiÌlrd l.ìbourl

(lr thc rcl,rtlr È nÌÌrl\rand
lJr .oI\tÌaj.ts on r.iatiÌ e Iqge ile\il)1lit\ as r r!5rúi,1rrr (ranrplc, ol !niür \ tìSe \eftìÌìS
Ìreh{\ Ìour.r i mirÌimuu Ìlage.

Iiir. 1S.8puid.salclr \ìm|Ìe 1!r) olilìustrilinghonrclâLi!{ dcmind, iutplr, irnd

iÌìstitL'tionnl i[9. riijidìt) nÌtÊLLct. lhe deìÌaf{Ì o. !kiÌlcd Ìabortr s driÌrn lrom thc
Leìi rn.l the dema.d ior lrtrliilLel l.1borìÌ h.m rhc Ìighr ha.d side. Ih. L.lal liÌrour
ìo(e i\ rh(trln .n Llrr. horiront.ll r\ì!. lhe mtÌtr oi hhouì it di\ jdc.l hcrr\aÌ. lìlgh
and l.n\ n\ìÌÌe.l Ír)rÌcrs a\ shoÍì LJ:- the Ì erti.rÌ Ìinc. Il tÌre i.itieÌ sÌtlralioÌr, rhÚc ir n.
unenÌÌ)io\ììe.t rnd lhr hisher deDÌaÌ loi\liìlÌe.lÌihourÌelati\en)ì \utìÌrL_Ìmca.!rhrL
high sliiÌle.Ì work.15 rc.cile d hiilher Ìrase thdn do Ì.r'\Ì!1Ìled worÌier\ Thjr i\ Ìabclìcd
at the inltjal rligr 3aìr. ,\ \lÌj1Ì iÌr LaÌ)orr denirnd tdúl.l niiÌÌe.l r (rì(er is tlroirn b! lhc
' ,. r ,l./
.ÌjlleÌenL lilfds oi .b!ur i\ held (oÌbtaDt li Ìrage\ adjtr\t ile\ìl)Ì\ to Ìhe.lemrn.l \hifl,
then the Í'egc {ip íldcra at dúrD. Ìt, lu\ereÌ. \oÌnetÌrirÌg |re\erÌt\ the \Ìase ol Ìrrt

5!p!ìlrol highr!lrti\. to lir! niìlL

""..J
'LÌ-slitt u*,ìcarpru, otnL ,igia
'i
''rqc

figure 18,8 !r: n...1!.n.r.rai.5l er irr! rod!i .ib:(ì.rÊr

766

s|Ìlìc.Ì worNcts 1ìonì laÌÌing. then !ncÌnPÌovnrcnt of lo(' skiÌled \!orN'ts i!il1 cmeÌiae as

shor,n. Ircm this dÌngram, ìr 1s olJvious tirât dcveÌopnÌcnLs ou the Írütv sidc siìl also
irÌULrence tbc out.onre. ll. ftÌ era ÌpÌc, the Ílfd,v ol hjgb n) Ìow sNille'Ì Ìabour Soes
up

ishiltìng thc llne ÍrotlitÌil lhú to thc right nì lrìg L88l,1hhwiÌ1it€nl'nthe€flcctolthc

sÌìill in r..1.1ive delnancl
'lhc bÌoad âÌSumcnt that a \hilÌ in the ielative c:lemand f(t skillcd labouÍ irouLd bc
rcflccted iI] Í'aiie irÌc.Ìuilì1l in the countúes ith tlexiblc wages and in unernPli)vÌlì'rìt
iÌì€qualit) iÌr Lhose NitlÌ iriklible l\'age5 lÌas beelì influcntìal ill thc poÌi') dcbate buL
en4rjÌicaÌstudies ha\.e ltìilcd to corìirnr th€ pÌtdi.tions. ìroÌ erampìc' unempÌo)nÌenl
rB
Ì.Ìrs incÌeascd f(tr aÌl skill groups iÌÌ luÌopeân counüìcs

3.2 Dispersion oÍ unemployment rates and the Efu

I cle.r lb ât nel! tec ÌÌnolog\ arì d in cÌei s i ng 81oÌral openncss ma)' â ffec I s age inc'ÌuaLity
t is
or utrenrplovrncnt nrequaÌit) a.ross educnlir!Ìal grNÌx or bolh loli',v Ìnâkers arc
otìeÌì
concerncd ríith ìncÌe.5cs irÌ inc{ÌualitÍ ('hatevcr the lorm il takes but there Ìroten_
is

lialÌ) ân jnÌrcrtant diìfcÌeuce bctrleen thc stuatioÌr nr Ì!1ìich the ìorccs tencliÌìÍi to raisc
incqualitv prcducc wagc or uÌÌenìPlovÌÌÌcnt nÌeq(úllty 'ì\ thc pre'l'Jninant oulcone
Ìt
has beef ergued that ifcÌeases iÌr !,L?,1fiof,rort ine!Ìualit! rai\€ cquilìbriLrm uìrenì-
'in
plo\Ìnenl.ThelogicoltlrerÌil!mcnthi!ÌgcsorÌtbcshapeollhewagescl!ingcÜlvel!id_
cn* s.,gg".t, ttrat tt " "'"iie setti.g cün'c it no._lineaÌ: s'hcn emplo,vnrcnt is hìgh and
únenplolnÌent low, rcal wag€s rcs|{rÌd sLÌongh to changcs i' unenìplolnent tlheÌe's
wherÌ(Jnfìo!mcntÍloi! aÌÌd u Ìr cnÌto-v''nr tnt high ani crcase ir uÌìc nì PlovnÌür t terÌd s
Lo produce relatìtett lntle itÌcrcasc in Ì!agc nrod'rati{Ìr'
r\\ Ilg. 1 8.9 llÌusii:ìtes, a contcìt'aile scLlinijcurle ìmpÌi€s thatthe lv\ loÌ the 'rononÌt
a5 a \lhole i! higher foÌ a giçef aleragc rate ol rtnempLol_nìcnt 1n thc c']ÌÚm-v
when

r\ç1E uì rÌ, Ìhr \trL.ÊlLl '\dtlüúìa I waije ÌrÌ.ss!Ìe

noÌi unernFlovrìcnt dis!eÌ\iÒn

ÊLúh L ,L, l,,!rrLDL e!rt,r L,r rLsn{r

r,.

Figure 18,9 Lì 5fe6.n.í tr eìF ovnrF l-:rÊ5ir.ÈlU

ri lor.xr.rf !È. K .g,Ì r.d Pi\,Ìì[r rÌ g9i] 1f d (.td fÌ,nr'- l

unen|L{)vmenl raLl.s art dispebed:iÌÌ tlÌe exaDÌte nr the diagram, the compariÍ)n is
behÌeex one ecofonrt in \!hì(h un€ÌnpllrlnÌent is uninÌnÌ ac(x\ secnrs ancl Ìegìonr
irnd anotheÌ econôÌì! ln 1\iÌiclÌ hÌ hall the sect(Ì5 oÌ Ìegìons. unempÌ{)vment í higher
thrnthe aveÌage a.{l i. thr ot1Ìer h!11, loller. ll we takean a\ erai{Ê empL(Ì Ìnentle! eìollì)
iÌì erch ol these eco n. m c\, tlÌe lv-t cun .. lor the econonr ) with dnltbed unemplovm e nr
rate\ Ìies al)o\r lhil or lhe €conomy ì!ith uniínm uneÌnpÌotment. The ÌeaÍD is drat
high unemplovmcnl ls cspe.itìlLt in€lÌecti\e iI d!ìÌpennrg \!ai{e claim\ ivhereai in the
hìli ol the eco n onr v r!l l h a tight l.ì bou r m.Lrket, $age pre$ure i\ d i\piopoÌtionatel) h 1gh.
5iÌ(e uÌe Ii5 fr)r lhc ccorlorÌÌ) a\, ìrhole is higlÌer. equilibriLtrü uDenìplo:"rÌent ìI the
ec.JnonÌv !!ith grcat$ ltncmplolnent disp€niorÌ $iÌÌaÌ$ trehiglÌer.
This eiièct h ighl igh l s not onl) t1Ìe conseq ! erÌces ol .n), rise iÌÌ uÌìenÌplo] nÌeÌÌt dittèr
ences bve.lucaLjo.al group butâlso of dilÌer€n( es a cÍÁs Ìegions. Ìh€ role ofthe reglon!l
behavir)ur of urcrÌpÌolment ir Lurope is con4raiecl with t1ìe U:l has been quite clllfer
entoveÌ the 1990s. n thc LrS]\, regioÌÌâl !nenìploymeÌú rdte\ h.ve tended to converge,
ivìth oneestimalc su{gcÍing t1ütthis has b€enre\pon\iÌ)Lel.Ì. reductioÌÌ ol2 percent.LSe
poirts ìn US ÈqlriliìrriurÌ imerÌptotnÌent. r'
B) conhasl, in LLrrope, r..gi.nÌal unemplor-Ìrìent rütes h.ve d]l..rged. What hâs
haptene.l in thc *'alic olincreased luropÈan iÌÌteitratnÌÌ lollowiÌrg th. \inglc \larkrt
ol l98li is LncÌ.ascd lpati.l.o centration of ecorÌonÌic â.tlritl ìn nggÌoDffntìons that ^.t
mav .r)s naLio.al boders. UnenÌpllrvÌnent hr\ beco!Ìe rxÌc polarlTcd, 1!ilh rcgi,Ììs
Ìlith uncmpÌovmcnl lnitiâlly n€.ìrirverage lòr luÍ4Je shiftlng cilhcÌ to a position oI
high or loN urcnÌphlnìent. lhe.JutconÌe ìs thrt, especialh'nì thc largc contnìcnlal
economGs,(hcdìsprisioÌÌofunenÌplot ent r.úe\ çithnÌ . ou ntrici hns go nc Rcsca lfh
(

'p.
nro$ thal bcl cen 1986 arcL 1996. th€ ch;nges irÌ un€n4rlo_v''n1c.t o rcgions arc morc
cÌosch rclatcd to unemplovment .h.ìnÊes in th€iÌ geoBr.phi.il ncighboux (insidc or
oLrlsìdc lhc countrvl ih.n to the arerage chan:e irÌ ot1ì$ rcgions in lh.ir cotrnú-Í.rÌ)
lvigcsclling.oftirÌuestot.rleplì.e.rt.nationalle!el,r,ìlhthcconsequen.eolhigher
cquilibriurÌr uncn4rlolnÌent.
Orcnìao and l\ga a1ír 1ìncl th,rt not onlt is the fall lr rúrcmplol Ìnent in the nn
rcundins gcograplìicil ire.r irnpoúint iiÌ i..ountiÌìg fcÌ lalìing regkDaÌ unemtlovment
bul so is a Ìor,(Ì slÌare ol loÌ! llilled \!orl€rs and a lÌigher slÌarc oI marule.tuÌLng ind$
tl' al lhr oulsct of tlÌe peÌn{ì. the positile role oi t]Ìe iniliêl ìcvcl oí mrnufâcluring
indL$lN ln kccpirÌg lìnenìplo.,"nÌeni r€1.ìtn elylo1\ i\ Fesu mabì)' cap tL ui ng thc rcgiors iD
F.úrc|c lhat hnd nì..esÍÌrllv DÌo\ e outolher!! rnclloì! skillma.Lrla.luÌiÌrgbelor lhe
nìi11-l9E0i, yct rctained nrorÌit iÌÌarÌul.cturiÌìg bd\e. ilÌe cridcncc o. r.gional uncrì
.
ltìo) mc.l pallcrÌÌs r,lthnì lurope highliglÌts tlÌe irnpact that ÌoÍ'lcrcìi ot ìabour mobìl
ìlt bolÌr i'ilhin .nd bct\!eeÌÌ courúrie\ pLâys iÌr corìÌLriÌration Ì\'ith rat ional wegc-scLli.g
svstenrs. Nalio.aÌ Êscal sr"stenL oper.te to olJset soxre of thc jmpecL oi Lhc dlr$gcn1
u.cmÌrlo) nrcfl pat(Ìns .!Ì resionaL /í,nrj Í,rr./rl^ bul unÌc5s such lra.ncrf hcìp Lhc
Ìcijdcnls oI lhc high uÌÌcmpLovÌreÌìt regions to o!€rcorr.. thc skilì, slr(clural, nnd olhff
d Lsad!ân lagcs clì ara.tcristic ol iire\e regions, red istibution is not Ì kcÌ)' to ! ro rn otc s u5.

tainabìe conr$gcn.c. lÌÌe evirleoce âbo!1 reilional urÌenÌployrrcjìt pal(círs mal clc.-
tuaìÌ\. pnividc lhc basis for a nue corÌclusi\e e!:ìhatnÌì ol the rol€ thal labour maÍkct

:r\!tr trfdz..si (?o0r) r! arY?rìân iid hL*i L20Oìì

768

instit!tions plaÍ in !ürcpe's anempl{}ment p!zzlc tlÌan 'Ìo tlÌc 'ftÁs ü1lo!1Ì sludies
discusscd iI \ec(ion 2.2.

3.3 New research in the'trade and technology' debate

Thc preliour nrbscctlon shows thit iI sliilÌìlased teclÌni'il Progres or
increascd
outsotlrcing or ollshoÌìng irìlcÌacts \!ìth lalìoltr nÌarkct
Slobalization tìrioush \o caÌled jt
ìrÌÍjtutioÌÌs 1o prodrtce a greatcr Ìeilionnl oÌ sNill rel'rtcd clispcsion oi u'erÌployÌnent'
(his n](tstbe sct the pos!ìhilit) thatclelcl
cdÌÌ rajse equìliìrÌillnr rüÌi'mplo,vnrerÌÌ
oprì cnt\ i; rad€ o t te.lú oli)gl Ì aise
1
^gairÌÍ
p rodu( t h c homc ccononì! tÌÌiftì n i'
tn'it-Ì groath in
lcast for $n1e lcars
tÌÌe /'\ cuivc upÌ!ards anil redücinN equìlìbÌiLim urÌenrPÌovnìcnt al
untìl i!.3e clalnrs adjuÍ
Outsourcitg relates io the dccisÍÌì h-Ì thc nÌnÌ to nÌilt Írom nr /''!s' productio' ot
ìnpúLsnrtlÌc1 r.lÌnteoilnptt5ftonÌasctar'lcnrppllcrlìnì'i!ìri(lÌma\bebasedtìbmad
tlÌe frnn:
OlfshoüÌg rclates 1o a llÌitSe in tlÌe loiÌìtn'r oI lhe po'luctlon olinpLtLs u\€d bÌ
estâblìnrìÌìg an aì1ìllate.rbÌoacl (í{)reign (lirect inveÍnrentì' sNit'hilìg lÌo Ìa donrestìcto
turclgn supplier oi inpuls or dccìdnìg 1o (trúsouìce iÌ'Ìi!ili(s abÌoad
ere eranìpÌe\' Since
a

-,.o,ì,."tg i,, rot",S" tutl]Licr ìt sìbstrnÌed

i' the dchrÌitjo' oi olfshoritÌll' Ne dÌrÌl use

lo the idcathal iob\

LÌ Ìropuln, .11(ussn!Ìs oÍuÌìcmPLo-ïÌìcnt' much altentio' ú prìd
b"rìg lott itr lhe ol.CD .ourtrjcs ancl gained in Ìolf llage couÌrtÌies thrNgh
01Ì
"rc
shorins.lr a rec.Iìl.letaiÌcd Íu.l) of GcrnÌal] an(l \Ì6tri'n fÌmsf'ir Lhe l99i)sthatco\e's
80,l) ot:Cermanand 100rt, oltustriân direct iJ e\tÌrìcntirÌÌ
esteÍnlrLrcPe'itìsfouÌÌd rhat
,r', t' ' !', o _l' l-r r'' 'i ' ì

'I I .\ "r '' l

opcrations i; (lenlÌ{Ìandfuncrn Lurole are Ì oirhosc in Gemranl arÌd prr'ìuclivjt\

'r'5qr nrm\' tÌ]c llagr dif
i;ô0,/n, í'súÌtirÌg in unìl Ìabour co\ts oÍ 27 ii1,l)' Ììr thc cr\e oÍ Atr\triar
icrcntiai is 5ìÌÌÌilar bul p(xhrclj\ itl ol onÌ) -10% ol the Aus(rien Le\rl is rchictcd abroâd'
lca\ iÌ\g un jt lalìoúr cos(s (ÌÌe halìthosÈ in,\ustrfu Lhcner\'n)uìceofchtaprndabuÌìdent
skilÌed Ìabour ha5 aÌlcNcd tìrÌÌ\ to rcduce thcir lroduction rnd rcmài!Ì conÌJetiLh e
'osts j!r
in uÌe tace ol in.Ìer\i.g intcrnatirrnal coÌÌrpctition The data suggr5t rhat iì rcduction
co\ts irì rllìliate hnÌ in C( ntral an{ÌlàÍrrn Eulopt Ìe'ìds Lo an üÌ'rcare nì 'nìlÌolnìcnt
i.
in thr peÌcnt firm. Simìhr rcstrÌts.rc re|ortcd n' s('edinÌ ÌìtrltinrtlonaÌ5 NcvcftlÌeÌcss
Lhe !u.stion rcmairÌs as tothc d!nnÌìic conscquen'c5 l()r Íriltue
trNrslÌnent erìplo!
'nd
nlenii.'oÌclIL!Ì4re'olthearaiL.ìbilil)oìn.irprodltctionìÕ'aììonsin'ne$lu(Ì)e'r\s
the lcvds ollÌümatrcnlÌtal a..uÌnulati{D and in(it(rli{!Ìal qurlitv úÌ Cc'tÌdl 'rnd
lanc l
l!rcpr cornc 1o ìÌLat.h thosc Ln tbcir neìilhbou$ Ì'ìc'oÌÌrpnÌetj!en'lvi'taseoI\\ieÍ'nl
runjtan ecooo[rics ln p ducinghjghqualit!rÌÌ'ìnuìacturcdgood51çil]b€thicaterÌed
\lLrrh re.cft clebale h.ìs centrcd on tht off\horing ol scÌlice sc'tor ioLrs lhì\
phc
i
tÌomrìrorÌ brìng\ tollcther de\elqrments irì technoìotl iìnd ìn tradc' New te'hnologics
lÌav.wnìeÌìc(Ìtìre po*iÌ)ilit ìc5 lor tÌe.Ìe atÌd ortlÌ€rcÌoctìtirÌroíenìplolmerúâbÌorcl(eg'
iÌì ciÌl cexú$, bsck{rffice opeintlon\' arÌd ÍÍtiQrc lrntoìtj of btr\iÌìess
'le\eloPÌnent)
s.n,ice\lÌodìabrlri(lr."nÌ.rinveÌr-smaìÌiÌìqlrntltnll\etexìsimountingt{)O1'Iool(;Df
irÌ lhe US]\ and 1.24, ol GÌìl i| lhe UK if 20il1 !'he LÌ51 en'l t1Ìe l-K are thc Ìarses(
]Ì\liLìL?(]0])F.\itLÌ:L.]nlen..n'\n?do]
 769

net.Ì1./Ì.,j ofbuslne$ serviccs I'ith the UK s surphb ríinij nrongl).tÌom thc nìid 1990s
{a!cìiscussr.lil(lhalierI7t'Gcrm.nlh{5Nnnsrnülldencitllìnrrghoutrìrcì98020Ol
perìod, r'hi(lì hx5 ten.ie.ì to I'idl]r somesnìat irÌ uÌe t990s.r2 1he aDalvsis.t,trrr,Ì
'| J.' ,r | .. r', | , !o, i,, t),i .r. t,.r
hâ! been irgue.l that tlÌe abjÌìtv Lo increare its c.lnpüraiì\ e adlnnt.ge ür busincss \eN i.es
b\' oflshoriÌrg Da! h.r e heÌprd Lhc UKt{) olcrcorìÌe its Ìrroducl litv sap releLjlc to lrancc

RescaÍ.h on oÍfthoring relreins ÈrijmenL.r\ inct the imtâcL on relatiyc unenÌrÌ(Ì.

rÌent ralcs bv skiÌl level (Ì hr rcgion lÌas noL b€en ertl(nr(Ì. hc irìpa.t may also dii
tèr acÌoss corürtrics. hÌ thc nrnr-lclel dara lronÌ Cennanv a.d AustÌi! dìscusscd .Lbove,
lor eÌeDìple, it i5 ary!ed thât oltshorirÌS takcs lhr lorn of cÌearjrg high stilì iobs abrcacl
$heft:as the lo.us in tlÌe LÌSA and L.K hat l)ecn on the íÌiiÌ of Ìr)i skllt iobs abrcad.
ThrorLBlÌ the dcraile.lanrìÌ) sts oI rlÌe cortcnt ot jobs ancìthe usc of co rÌÌúe6,nmüe
nÌÌnlc vcrsidr ol rhc hlpoth.5is ol slilL l)iascd tcclnÌicât pr)gÌess has been .lerclopcd. zr
\,\:hcrcas tlÌe 5llI hlpothesir Ìrrcdict\ clemafd tor stilled labotrr h,ould ise ÌcÌali|e to
u.slillìcd lâb.ur, it i\ Dor ar:lucd that 1r i\ Lhi'denÌud loÌ nor-ÌoutiÌÌe co:!niLtrc .n.t
nraníal skilÌs thaL \!oul.l ì.i\.: rclatÌve to rìrc dcman.l tor Ímri.c skiÌÌs tlÌat can be.irrìed
out bv conÌtulcrs. HeÌìcc, tcchnlcal p()grcss depresse\ ure demand tor ivorkes (rjrh
Ìnjddlins leveÌs ol edu.atkD irho are eÌnpÌolcd doiÌìit rouriDized (rÌte oÌ btuc coìÌnr
tasks (irorÌÌac.ou.tiÌìi<ro machi.iogl \!hereat il boc)sts ihe relariye.ÌoìaÌld l.ìrthehighlv
edu.aled, wholc skills aìe coÌìplcnÌentary Ìo(.ompurrrs. rvith ÌnoÌc rap pÍntlrctlrìLr
grú'th irÌ nranula.turìng ard comp!t..r reÌarcd scr\ iccs, theÌe 1s aì$ e ri5e jrÌthe Ìeìari'c
dcDìand lin unslilllcd \voÌkerNho do rr, rrr
rrÍ.rrìcesecntrrasts,r,hi.h.nnl()tebilt
bc carlied ouLh\.nÌd(hìnrs. Thc latteris a lersion ofthe nândr
aÌgunrc.t.lueoriijìnalÌÍ
Lo \\illjrm IJarÌÌrol thât c.ononÌ) malLrlls, the slÌare ot enrpìormcnt üÌ seÌriccs
as an
rlsl:siìnd'dei.duÍrialìzrtLon'occun.z!lhìstttloNslromtÌ\odsnunptì.n!rth.tdenÌan.l
in .onstant fÌlccs gros's lor rnanui.rctlres FLLgIÌÌy in Ìjne $jth that for s.rvice\ arcÌ
that pro.luc t iril)' gro$.tìr is taícr in nÌanufaclurlÌÌg. hìdeÌÌce tronr thc UK hnds that
hch\,€ell the l!7(\ .LrÌ.ìthc Ìatc ltr(ros, there has bccn rapj.t groìlth ìn eDrploymerÌr iÌl
proÍcssionaì ând rnanaijeÌ ial iobs, ÍÌìe SÍrlrìr in Ìro. routüÌe ser!ice occlrpations such
as Íackilg sìr.Ìvcs arÌ.l caÌ. o rk \!111Ì olcl peoplc and J d e.lirÌe ir Ì ttre Í) callcd nìid dlinia

lobs ((lerical and \killed ÌìanLol jobs iÌÌ nÌanu a.r(iÍnÌg).2ó lhe iÌúerâctjon beiween the
jnrpÌem€ntatnrÌÌ ol nerv trdrnoìogies, hÌstìtürionnÌ ÍructLrres ot the Ìabou.
mirket, rn.Ì
age âncìuncmplo] ment incquility bv sÌiiÌl Ìclel reÌÌr.riÌÌ\ io Lre nrvesrigat.d.

4 Unemployment and EMU

The iocreâsjlg i.lcaritj(rr oi thc luropean e.:onomlcs follo\liÌÌij thc Strgtr tütutea.
MarkcL prosraÌnmc appeaÌs io ha'c a1ìecte.l rhc lo.arìo. of ecoÌrrmlc acri!,irje\, $.hlch in
tL D h iì s irìfluen c.d reili{)naì an d cq u ili brnüÌ ì aLcs oI n.rjonâ1unenìtlovnlcnt. l hi\ Ìea.Ì\
rr Lor a.ra Ìs, s.r,1Ìririrna r,-Ë, rto(J]) I \tL. ,r . rhrr rr\trlrli
1 1Ìrkern\..tr.h irprÈ\erto(ìif lunr . LeÌ_r,, ard \rm r2u03).
r; For alúiJrr .üÌfri\.i driiritrsúúÌran.r, \r.llarÈì
l2l)(rìr; lrrnih.rf rÌl li.raír.nfJ i ,c7): md
R.r'tÌr.!r .{trr ( .rts ttrrl r, f.orând\knrjnsi2d)rÌ
170 .

to the qLtestion of r'Ìrctìrer lhe cbâniae iIÌ 'Dddrl '"1r?í' ]ri

witlÌ thc mo\e to L(cì
F'uropcan unrmÌlìotmc't (ÌÌ'cagaiÌÌ
romic andNlonerary Llnionhas playe.ldny role iIì
ì sj'gìe ÌÌìrÌr'tary polict' a
the.omparison aitlÌ the L.SA is n sLúkirÌg one:the USI has
a combinaticÌr oí ìnnllLúnnÌal
sìngÌe 1ìs.aÌ Polic\, ãnd a liÌbour market charactcrized by
anìngorenis ano mob it-v that kccps thc ìn unemplí)vÌn€nL ìâte\ bctrfeen
'liflercnces teÌ-v poli'y' tllelvc n atioÌr aì hs"l
u o,", q u, ," Lo*' h thc euroToue theÌe is n súslc
mon(
'
policie;, a.cì trtlve Ìrnl1{trÌaì Ìabour niarNct\' ls we have cììscusstd 1ÌÌ connectìon rvith
anaÌvsing moncLaLr pohcv in ll'lll (Chaplels ll, 12, ancÌ 1l) nnd üÌ thc Íìs'al toli'I
.hatteÍ (!haptcr 6), t|c intc.d€d pohcv assignmc't iÌì ìrlvÍU Ì!as:
. lhe itr€sponsibÌc lor ÌnàiÌÌtaìn1ÌÌ8loir and stablc inflati':in'
lcll
mbicct to thaL to
. Nalional iscâÌ a u Llturitìc5 arc responsìble foÌ hscalnÚtainabìlity a'd
prori.lnìg nrtional Ìevcìttâbìlization ìn thc tace oÍaslrnìetrìc shocks or â5ÍmmctÌic
eflecn olcomrnon snocts lheStrblÌìt)rndGroNtÌrPa'lsariÌÌtürdedtolÌevenl
the i'ìflaticÌì
nâtionaÌ Èscal r!tho.itìcs lrom pursuing policies that could threatcn

. e'ÌuilìbÌtuÌÌ
NatnnìallabouÌ m:rkets {an.ìtlÌc slrÌ4nvsl'le more boa'lÌ,v) dcteÌnÌhc

'lhÌee dilferenl aÌSuments hâvc bterÌ put foriça to suggest that lÌ\Íll clruÌd atì€ct
equihbriLlnr urÌenÌnot merÌt ln uìc ÌìenÌbcr coÌrntrles:

(I ) Creati onnlon cuúcn.-v ar€r ì n creascs thc Lranspa rcnc| of rclâti\'c laÌro! r
o t a conr
oltlìe ìabour d€nrancl that iragc
cosLs across courLries. rtì! increales lhe eÌasllcit) 'uÌve IvJ curve
DrilliÌÌ model, thÀ prcdrr'er â loNer
scller\ fac.. Accor.liÌÌg lo thc CalÌnio$
an d hen.c l(Nrr c.Ìu iljb rium tr enÌd oyÌìl€n t { \ee
fig '15 i' Chaptct {ì hÌthe{lâlrnit)rs
DriífiIÌ tenÌirÌol.gy, íoÌ cou.tries $Iitìr an internrecìiatc lcrel ol irâge scLlinS üneìn
pìo\rÌÌent faÌls toward lhât asiocialcd irith decenltaÌir'd wage n.lling lhc Peal oi
the

h(Ìnp shated .uNe is flattened.

(2) MenìbeÌ$ll of a coÌÌìrìon .urrencv area mikes it rnoÌe clilÊcult to i'ntlerÌìcnt
labo!Ì arketrclonns an.lthcretìremayrÌÌ.tc reductionsin cquilibrtum uÌìenrPl(),vmcnt
reforrÌì: il mâv bc
1ìader to achievc. This algunr cnt .€1Ì1Ìc\ on lhe Pol ìtica1 eco nonit oÍ
to pcxuadc nìpo aÌìt iÌÌterest gÌouPs ìn the tconom-v to !ccep( Ìetonn il ÌaboLrt
easier
rÌarÌtetrclorn (to ihilÌ !he Ì1'Scurvedo northelisctrÌve!pat'lh€ÌÌ'cdrelÂUcuÌvrlo
the rightl ìs a(conÌranic(Ì bt ctrts iÌì intereÍ raler r'ìd a Nrren'-v
dePrcciatìdì lìre Ìoiljc
istìratdctÌeci.rtiontrkcsthrccouolnÍmoieswlltlyaìoniitlìc'1IrcLìr\'clothenoúìreâsl
s'!th risiÌrg eÌnployÌÌrent thân iro!ld he the cate iì tht SaiIÚ
j' conÌpc tì tn erÌess had to
leed thrctrgh ria lou er a ail,e anclpri.c ìntÌatìon rlÌân in other coutrtriix

(3) alreiìti{ÌiotecoÌÌrnroÌÌcúrrenc)arcaalleclsthe*'â-vìarsewagesettersintera'l lth

c' tlaile scltinB
the centraìb:ìnk. lfthis pir).lLrrts a nLüt trom 'cooÌdinal cd' to 'úìt cnÌedia
(

i. the srnse of the (ìlnìfors t)Ì11Ê11nro.ÌeÌ' thcn equiÌlbriu ì t]ncnÌtol'mcnt $'lÌì úse
Wc e\dnrine tlÌis arguÌncnt irì rìoÌe detail ú thìs section'
jn
f_.ach these argunìcnts iÌÌdìr:ate! that llhcn wâ8c serter\ c laÌge a chanilc
of
ÌÌÌonctrrt anangenrents cen aifc.t tìre rril s eoitheecononÌ\' Ìn ÌìostlMLr coxnÍies
 . 171

wrgc! a.. set thrcugh c.ìÌcctive bâr8airÌjrÌS rt recroraÌ (ind$1ry) lclcÌ r\'ith coordinr
t1()n al üoss sectoraÌ Ìevcl or c.odorÌÌt Ìride in yrìc hcc Tabìe .1.2 in 1ììc io
^ppendi-\
In thc prcserÌ(e ol union rrirge setthÌ$, ho\r docs (hc movc lo monet.iy union
alícct cquiÌlbriunÌ uneìnfloyrÌÌi'nt? lt can be arsued lhãL thc rcÌtaccrncft oi a niìtlonat
nro.claryauthoritvbvasupra nationâl one nìch as Lhc LCB mayÌcâd Loa rÌsc iÌÌequilib
rjum ú.cmploynÌent sìnc. lhc lCLl does ÌÌot'punìsh' .ârionaÌhagc icrLcrs br ti8htenirÌii
nron.taff poii.' if the! e\crl less r€nrai!Í in $aiie 5cttirg. The simpÌcs1 (,nt to thinli
abou! lhis Ìs to inìasine thal without l\lU wages aÌe !er at secnÌaì ÌcveÌ in cach countr!
and 1ììc number ot secto15 if the €conoÌny is nú1icìentÌÍ smalì rhat each trnìon is a(are
ol lhc .o.scquerÌcei ol irs rÌagc deci\ion in tenDs of the ÌeÌÌ)nse of thc ccnúaì banN.
\\:agc 5ctlcrs irúemaììze thc cxtern.l elÌect ol theü aage .iecisn)n becauÍÌ rlrc antici
palcd rcaction ot tìre cenlral baÌÌk üeate\ t1Ìe incenLile loÌ i{age restrainr. It Í'c oow
considcr the sitrratl{)n of Lhc sanì€ unions la.ing the LCB, 1t ìi ÌikeÌv that tÌre! r'iìl a.l i.i
palc Ìi\s response to thejr rrnge decrsion and he .e wiìl exercì\e Ìe5s ìestÌaint. Thc rcsult
j5 thai the Ì15 cuNe is higÌìer under jrMU lâ nÌjit íÌoÌn coor.llnatecL' to 'i.termcdialc'
in thc CaLmlìú DrifnìÌ mod.ll .nd hcn.e !rÌeÌnfÌq nrent ì\ hii{her. Ai we Ìnro1r Imnl
thrC.lmfors DÌifiÌl modcÌ, tht unìon\.re $oLe oflwhen theverercjse less ÌestÌaint: thc
rcil wdge i\ the same, eÌìployment is lirw€r, .rÌd theÌe is r buAt ol higheÌ iniÌatjon as
lhc c.onom) acìjuÍrt()thc n.Ì\' eq u iÌibriu m.
Ì orthis analvsì\ kr be Ìeìcvint to thc cirse oflìr1u, it ì\ necessâr) to recognize thatthek
1!âs a nÌoÌÌetaN ar'ângcmcdt iÌì plac! prior to L\lu, nanÌely the tlìM.2' As cìircu$ed nl
Chapter 17, (lennaDv r,as de l.cto the k€y curency country úÌ the tlÌNl, which nean5
thai the Buncleüank ira! lhe IRM\ rnonet.rt polic), malier. One wat ofÌnod€lliÌÌg the
operatlon ofthe LRl\.Í is to treat iìl1thr countries otlÌer thar cexnrÌÌl s)1ÌÌÌüeiricall), and
to as\rtrne that each wagc sctter nÌaxirnizes utility bv setting th€ wa8e at tÌìe úngeÌìcl
betlíeen tlÌe lal)ouÌ .1.mand curle and thc union in.lilferen.c curve. lÌÌis procedure ìs
\llNn .liaiiÌanratical\' in Ìig. 18.10.r3 lhis produc€s the cun'c tyj.r. ccxnan) is dilfèr
ent bec:ìuse (ìernran wagc sctters kno(r that any iÌìcÌer\e iÌì Gcrman üìÍÌitìon wìll lead
the IÌu ciesban Ì( n) tjgh tc n lìoÌÌ€ t ary poli.r. 1he llund€sb.nN\ nÌarìdarc ri.Ìi ted only to
Cenrìrn inflrtìon. If thjr 'cxt€nÌâl effl..t' is inco.poràted lì Cerman union b€haIiorr, it
can be represented i n ìrlg. I 8. Ì Lì by ir fÌitter la bour d eniarÌd curv.. I hc reÍtlt is th.t tlÌe
CennarÌ l,VScuNe, l1'.t , is bclo\t that of thc rest llÌlví counirics. Sincc the Llundesbanl
sets !ÌotretaÌ) poÌicv loÌ aÌl IRM nìembers, all colrÌtiies mlst be on a labour derÌìa d
cur!e irÌde\ed by the sanrc lcrcl ol ailgrcgatc demâÌìd. To nì.Ne thc analysis sirÌÌpler, it is
.ssu ed tlÌât the colürtrics (lncludÌrìg GcrnìaiÌvl are iderÌti.iìliÌì evcr! ruplct erc€pt hÌ
their rehtionship n) th e m o n i.ta rv poli.r oÌiì krr. lqrì iÌibrnun ! neÌÌìplot ent lor the LlÌlví
syÍenì is íÌo$n by poinr À in 1ig. tli.l0. OÌ!'Êo that the B!ÌÌdesbank has set ÌÌlo erâry
poli.y so thât the ÌeleÌ of âggrcgatc dcmand is 14', therÌ eâch ol the rest lÌì\4 tuunüie!
optimizes by chooslng to in t ,9 and GcrnÌi nv optinìize\ bv choosing ponÌt C. IìnÌini< thi\
around, we kno!vihat thÊ rcasorÌtlÌc !un.lesba ük c]Ìooses lj) is t1ì. t t1ìis isconsistent lvjth
.onstant iÌÌflltidr. The oulcome is a conÍant iníÌatnn equilibriu lor the tlÌI,l ststem

ftnar!udrerii:Ít.rijn drlriÌnÌS.sk,.êan.ì he^en ll99$r ÂrÌ,ÌcilÌe.reh.rlÌ,Ìc\entrh,r,i\irr\.\rnc

rfa Ìyeser(:0001. 'r r..anÌnìâÌmofel see a-lì.D
772

l5

a"i!n/ll r:"1Ìen ["irj:Ilv]

J:lì,ul

Fìgure18.10 Eq! Dr'fi'Ìp!r'Írenl I ERr'l iÍìd n Errlil

$'agc and high€r emfÌotmcnt

\ln$u by point 1: CcmÌan'v hrs a 1d\cì lcaÌ
rs a ltìroìc ror thc r'RM s'vsten as r
{vctagc
ii";' ì;;; ,ì'" ;",i t-"' cotr trie\ atrd thc ilcishteil
";''''''.'''LJ\'l'','].'.:'
\ c!u\. rr,drL rh'nh'lfri 5 nhtr thtìl

",.,1.'""
'";i:il1"ilì1.:ïììr, ;Ì,prjes to the ì al' \{ithout trÌe addúiorla1i'ase
rotraìnt in
eqtrilibrium Í(Í üÌc r\'rtr slnem r at
wÌtrÌ
;t.;ì.;ìì
:." 'i""
ì,ì" .,,',',,,,ì ,;úlation
poìnt
''
,,_,.
", '-; r'
.,,.',' '!r'-l
'
'l_ ILJ
us^'*'hercwâse
H;il;ïì;;;".G '"r'"'ii"'s"'""g"'"tt""'"'Drcsenr'aÌÌdiÌìLhe
r"r'r'1"

t-,
t::. ,,, "
rh e iÌr LìÌis sectllrn pro'idcs a n tr rrerotìvpolh€sc\
dúcLr$ìo n
"i;ì'ì,il,'i';.-,,,,jt" aboL'lt the rorccs at work but il
ìs not ÌrossiÌrLc to riÌ'i!
:'ï;':ï;ì;";;ì;;;,;;;;bnir inÌpact
."ìì.*'",,' ro*, oÌles arc 1Ìa\ i!ìs the moí itrìpoÍnnt
'nrio'

5 Why is reÍorm so difficult?

l()
lììÉ OI.UD's 199.1/.tt.!rÌt,ir ha5lorÌned
tÌicb'rsì5loÌ d decrde ol rclonn cfiiÌts dcsìgned
ïÌrt
t';:,t:).trrt Ì.ìbo!r m'ìrkels and PÍ)'ruce ro'rr me Ìrro)'moit
úte5
il:ì;;;;'" or lrre deter
"r
lll::l;iì;;"; ";ì;ì;;:;,".iLdics iÌÌ trììs chÂpte' un'rerìines trÌc conÌrrexìtl
researchcrs *idì oÌìr)
ì:ì::ìì:',,t ;,ì";;i;;;,";'i n.r ,r* "'p'r'"r dirlì'úìties rdcin:r
corìr)nri\on oi lhe rcnt]ts or
Ìinrii"ì'ì,ì;';:;';;;rtÌie5 in rheir s'ìlìplc sv't€nlrtic
"srÌ,,lies ba\ shownthat 1ìrn conctusions al)oLrtthc rirc ofthe cífecìsoI'lìiÍcrent
'harving
 idstituú)rel nÍrdrÌgenrcrts dnd cvcn abour ilhclhcr mch effecrs arc sìgrÌi1ìcant js prena
tur€. Coruriry c. se ttlrl ics high Ìigh I rhc irìpoúen.. ot to owledgc of iÌìstjtuth n aÌ detaj Ì
aDd olnÌacrccconomic drveLopmcJrls tor undeÉtarÌdjrrgu.emfìorment patteÌDs.,\s the
analÌ\is iìr this chapter has shonn, jnÍitLúnnrs, policjes, an.Ì nro.ks iÌÌteract in cor4tex
Ìral\, lítrjch Ìr(.rÌtr thaL slmpÌe rcÍorm reciÌrej aÌc clÌan.e.

5.1 Labour market policies interact

To lakc oìÌe exa,nple, tht OjiCD has urgcd countÌjcs 1c) r.Èduce the cxrcfr ot eDrpÌor-
mcnL protecti()n.,\s dÍcusscd nÌ \ectjoD 3, a ntrvev ol rfccnt nudies sìro s lhirtirÌmoÍ,
stÌi.lcr cnÌpl{)vmcnt pÍ)tecrion raíes eq(ilibriLtrn u.cmpÌornÌent but rìrc cstirnlte.lsizc
ot thc r1ïect va rics wicle\ . lrì the eÍìmatcs oI the Bercrìdgc.urve presentcd in scctidr 3,
highrr enÌplotmcnt prorc.tion \hitts thc Lle\erjdgc .ur!c to the Ìefr s(ggcsriÌÌE thaL
slriclerNlet rDhince the mat.lìiDgprcccss bcil{een emplover rÌd enrpìoycc. Jr is ârSue.1
1lìit both enrployment trorectidr and urerÌÌplovmcnl benefit\ caÌr pÌa! an etÊcienc)
ro k iÌì a sitlra t io rì $heÌe I'o rlieó aÌe Ìík avcrse .rÌ.1 irh crc they cannot insurc thcnÉeh e,
egntrìst jotr Ìots both ol*'hich jeeÌn rcasonabte arsumptions.]\ pivate lnsuran.e mar
k.l Ì\'ill not exìst becâure.ri the moÌalhaTard ptubteÌn: sifcc rh€ worker,, etJoú cannot Ì)e
obscrved, jt 1s .ot geneÌaìÌv positrÌe tl) disr nguistÌ berh,ccn lob loss due to poor perlor
rnance and job loss due n) a Ìabour.ìemand stÌock.r'Ì Thc vicN lhat \rrÌempk)!Ììcnr aÌÌct
inconÌe in \e.ü ritl' create thc d..rììand LrÌ ìabour m:ìÌl.ier instjlLL ons ânct reiiuÌarioos, c.ÌÌ
be conha5t.d with the o.c disc rsedatlcngthiÌÌthe.haftcrlhat,labourmâÌlictÌrÌstìtLì
tìon\ an.1ÌeguìaticÌ* cÌealc unempÌo\'nrcn r' (i.e. wheÌcNigc orprice pusÌr factors shifi
the Ì,ti cuÌlc upÌlal.ts or lhel,S.üÌvc doarrìì.
WlÌen ÌevicNing the c\.idence about lÌrc clfe.t ol emfÌovnrcnl proie.tbn or ìabouL
nìarletpeìnrrDrance ÌÌ 1999lrand riiaìn ìn 200:1, the OECD ÌtpoÌrs nìilicd renüis. Retccl-
ing aÌÌ i\nìe gn en pi.Ìnjnencc in this chaptcÌ is rhc.oncÌu\i(D of rhc Ol.!tL) thât:

ÍnÌe coúntrics â|Ìteôl to ha\ c {r..e$lullv rcdured trnenifloÌrìcnt râÌr! afd mnjDtailcd hj!Ìj
emflovnent tÒ prÌÌÌÌaLiodr. Á through (h!.ÒnìÌriired !Í oItÌrcsc nnÍunÌerrt {emplo_vmcnÌ
prote.L orlpro\ nio.\,acLi|clìÌ!Ìn nrar(er policicsl,\t.\I )tand ctt..tilcrc rÌÌn.ymen seÍ i.cj I. L

()thers seenì to ltrre equall! lnhrn.ed Labour.ìàrkct ÌteÍoi!Ì.n.c by rrdtrci.ij tÌÌh U)L a.d
nn.r ntlo!Ìnent bcnrn t\, Ì!i(h ljrtlc r ecor rse ro AL\ÍP. (o t.t. .n Lr4)tor Ì. t OÌtLltnk (2at)1), 9r) t

Thur onc reason whr rcform ìs so dì 1ìcult is that Ìeloín pacNiges are compÌìcalcd b\,
uÌe rÌav Ìabour rarÌieL i.stitutn).s i.Lc.a.r with each olhcr and ÌliuÌ other aspc.ts ot
poli(v such is the tar ând benelii Ìegimc.

5.2 Product and labour market regulation ìnteract

\ol only has rhc uneniÌrloÍm€nt recod ol Ltìc targ€ contjnentat Lrropea econonììcs
bccn pooÌ jrr comfarison irith tlÌat ot the llnilcd Stares in thc ta5l lwrrÌry years b(L s,r
ir ltrrúnc\ i2mr ) pr.Ì Ldo\ ,ir r..enrb L r.Jtriir oi rÌri! n r ,gii|Í
lh. tri.kdírD .t i I rrÌr ìils ún
,rn!lovneúÌrrtr.(inrnnìrÌkot(r)!tobJ\tut\ arr.ihf rjenrÌartiLL(,n Àgrl í20rtl
174

jn per
too has tlìeir dlnâmisÌn a5 mcaÍtrecl b-ï grrrtlì 'afjta
CDI'oÌ morc narotr'l-!
br labour trccluclivit-v gÌowth in the lìusiness scctor iscc c g lrtrlc l7 {1, Chapter 1ll
A Ìecent strand ol ecofonÌic rcseâÌch sLrggeÍs lhat one Ìink l)etÌ\'cc' the Ìrso
mat bc
jD t1ìe cconoÍÌy
rlÍiLrd
pÌolided bv thr rne pÌalecl Ìr,v fìoclu.t nrarket reiiuLation
;raÌkÊt rcguÌation i\ used n) Ìclcr to the cxtent cÍ c(tìpetjlion in tlÌc p(xìu't mad(et alìd
1o the easc with rnrlclÌ new firnìs can e.te! dÌÌd gtrN r Ììajor eflort is nos' rn'ìen{a-!
(c.g. attlÌc OLCD, theNorld ìlink, rstat) to coÌl€ct da ta or Ì crosi_country m ean'rcs
and lru
entrr'''
oÍ regul.tory baÌrlcs aÌìd to €çaìúate ho(I lhe) ar' !eÌatcd lo the c]-vnamìcs ol 11rm

A. iÌÌtuilì\ e €ìpìaration oi lìow tÍiducl mirkct relulalion and lnbour nÌarket irÌÍitL1
tio.sn\.v inter,r.l anclbc connc(.le.l irith mactul:cí!Ì1rÌ]]ic outcomes is as lollÕ\\rli!nilcd
comtetition irL tlÌc pÌodL1cÌ markct iÌÌÌpljcs th.t there irc Ììotlopol-ï Ìents '!ajìab1e anLl
this crealcs an i.ccntìlc ft)r empÌ()) ed rlo!Ìers 1o act collcctivelv and baisrirì
k)r tì shaÌe

oÍ these rcnts. LquaìÌ) h'ìreÌì pírdrì(t marhet 1:onrpetitlon i5 iÌÌtc'se rents are sÌÌraller
afdthegainsirorncolle.ti!e.clionirÌ1lìelab'rrnìrrk'r ireless his ÌilÌe olrÌ!!mc't

. thaLp(tici$toírii!thelJclìr\cul arr:lsìrvÌeducintproductmrrlictÌegul'tloncould
havcttreef cctolaìvrpunrúÌilthc it5cuÍtcdowlì ards 1llsirouldrcduceeqtrilibriLrdì

. thrtth.sequc.cnÌilolreform\nì.t1crssiÌì.celfeclh'cp(xluclmarkeircí(ÌnÌ\ lrukl
a Nertcning olthc incenln'es lor(oÌlers to sulPort sone lornrs of
ìrr1ÌÌg in their 1t'.lie
laboür mrrk.l regulnlitni.

tloirrrcÌ, arguÌìents of this k!.d lsÌrall) rlso ìelv on the role ol ne\r iob creâtion
úoD th€ cntrv ind grcnrth ol nei! hnns. \{hi \r if neÌr !ìrÌns 1arÌd i"]u(rjcs erc'\iÊ
aged b! i more comlìl:liti\t' c.lnonnrcnt Ì!h$e ue$ cnlt] is easìcÌ) ìlorker
IÌÌal'
l,;,\e .* in.eÌÌtlle to Ücate or onr lnions,lor cÌânrpk, cmpÌo!Ìncnl in old ltì! \!llÌ
shÌhÌl a.LÌ sonìc oìd hrms $'ill c1ú tìonì tìre matket lhis hjghliSlìts lhe redìs l Ì rìrlìtivc
tífe.ts of deregulation. Therc i'jìÌ be loseb,rs tìÌ 'ìs trin'eb and lhú iliLl create a
IuúlÌcr ob5taclc i.) r€loÌn: poìiticâÌ opPotitioÌì. AmoÌÌgÍ lht lactors likeÌv to generâtc
opposilion to rcldìn, clcn iI ll irere Ìo reúe rggkgrte $tliaÌe urÌambiguousll' âÌe the

. there arc morelosebthan wilnìcÁ ftonÌthc ch.nijc lj e' th'Èrc Ììr) Ìre no mriorill in
mpport of tlÌc rcii)nrì)
' cxi!tnÌ8los.rareba.lÌ\ organìzed ind are a rnLnoÌitl ic.g the!nernplo\ecll
. ÌviÌÌlrca tÌlrnr (he retutÌ dre hcLctr)gerÌcou! íe 8.lhc uÌìerÌ4ìlolc'Ì and tho5t attlìc lot
o1 thc incotnc diniibrúiox)

. theÌe is Ìr.certaúìl)'abo!Ltlho lrill ('ln alrd h'ho $ill Ìosc'

,rt,tèlLif.iJ andrìj.tra/z' JrÌr jl

I'rrrJrmnraritrrd5LurlìtlÌilhr\\rinrulaLenrììrhÌ?.!ni\'o"ire\i't'iri eial Ì2n0Lr
 775

6 Conclusions
1n this chaplcr, \íe halc shoiln how rhc modets pÌetcntcd in the book can bc used to
inresiigate thc paih ol u.cÌrìplolDÌent r.ross the OtaD sincc the 196$ a..Ì lìos,unenÌ
piornÌent varies acÍÁs countÌ]e\. Both aitgreglte {ìcnìa.d and aggÌegate srrppli, plav a
role in thc anallsi\ of úncn4toyÌnent. l. rhe simtì.sr .asc ot,r closed econoDr Ìli r a
Íable nippÌ! sì.le (ì.e. sLable jrÍìtrÌtlons and consranr p roductilit}. gÍrlth ), ihocks n)
agitÌegate dc'Ììand pn)duce business cÍcìc Uuctuatirrìs in ourput arÌd unenrplolment.
positive dcm.nd sìFck ririse! outtut and reduces uncmpÌovmiÌÌt. Ìrútatìon riscs aÌÌ.t
^ pnxluccs a r€slxmse b,v .n irúlatÍD ta
this ryftiÌìg cer h âl brn k, ich i. h r.ìi\es th e Ìral i oter
est iate ard guide! the economv back to rhc .onstant ìnflaLion cqujlibriuÌn. hr ân open
econ oÌnv Ì!itiÌ . nable upplv \Ììe, Ulrctual ions i xggÌrgatc dc mand mâ ) have mo rc per
s

sAteÌrtetÌc.ls on outpuL and unemplovrncnt because th.rc ts a raogtol.drstanL innation

unemÌrÌol m.!nt Ìates Ìcpr€sented b! thc / RU crrrve.
The E/iU cu^e \hllrs witlì changes i. labour nÌarkct Ìroìi.ìcs and ìnÍìturn)ns, chang€s
in the laÌ wedile, ì. ltrcduü ÌÌrarket compcrition. ard Nith su!pÌy side stucks sLrch as
changes in the reaÌ pÌi.c ol oiÌ a..Ì in Lhc groNth iâte ot tÌoductjvltv. trì4rìÌìcaì rrud-
jes nnd lhat n]anr oI Ìhcse tìct(Ìi heb lo raphiD borh the carss
countrr prtrern o
unempÌoyücnt aD.l changes hÌ unenrpìo) mcdt o!er tìme. IÌr)ncr$, cn!tion nee.ìs to bc
ererci Írd \!hen clÌawi ng policv concìus io n s be.a use I

'lhe€niÌnate.lmagnltucleolrhccltc.rofdlllerent(,agc-a.dpricepunrtacro6rârics
a'ideh acr)s sludi€s.
' the ellccl on!DenÌtornìe t of ÍDe ìabo|Ú ÌÌr.rlet üútjhújons depcnds on the
pres.n.c ol othe. instì 1u tion\, j.e the intcÌi.lion bet\leerì institutn)ns millcrs,
.labourandtrcdl].tnÌaÌketÌcgL1ìalionsma\,iúeÌâ.ra.d.hangcsinuÌÌenÌpÌovment
nì.y therenÌe dcpend on th. scq(rcn.in3 olreínms.

'1
he cour tn .a se stu.lles d ral{ .tr€rÌtioÌÌ to:

. UlrclualionsnÌ aggrcgate d€rìÌand as a maior dÍiverolLdÌg ${iÌÌgt 1n u.cnrtloliÌìent

(s$'cdcn and iinÌandl,
. tlÌ€ etÌectìve.css ol diiÌeren L .o nìbinatiorÌs olsuppll. sÌdc poìicies alorÌg with rìrc
reÌi!al olaggrcgate lenrand (1hc Netherl.lrÌ.l\, hcland, aod tlÌe UÌO,
. the pÌobÌeÌns in.lesignlnS an.linpìemenring a coüi\rent \et of sultÌrlv sidr retüm\
coÌnpou nded by ihe co nt€\t ol a tigh tÌ) co n s rr.i!recl mr cÍreco. onr i. poÌÌc!
tramenorli (cer Ìan)I.

Gìobal trer r in úade an.l ttcbnologr c.n aftèct thc hcLcÌogcncitv olunemplo!nrcnt
wjthin co!ÌÌtúes. Wc have aÌí se.n hoN tlÌe jucreascd sliìlÌ or rcgìoÌì:l dnteÌsio. ot
uncrÌpÌovmentca. raiseequìÌ1bÌiuÌn unenìplolNeÌrL. hjsmay bemoreI)nntemat jcIor
leÌgc than for smâll .ounüies and Íor those $heÌe labou. nìaÍk.t iÌìnitutìons t.nd to
prcducc nìcìre comÌrrcssed wagc disrÌ ibutions.
 A thcÌne that hâs cnÌeÍgc.] ìIÌ illl!chapteÌ ìs that succcss in revcrsjnS kngthl adlebe
rretrds ìn u.cnÌrlolmedl atpears t{) requiÌe tÌr:] rlìe i{'lorm\ bc ìn a nrjcro
'oherrtìl
r L' , ' - " econolnies
onÌÌÌcnl. T1ìis ma) bc nÌuch Ìnorc ditÊ.ult to n'hieve iIÌ lhc Ìarge contìtÌental
in ljÌ!JtJ tìrnn in eitbcr t1Ìc snrall oncs or in Lhe ]\nglo Saxon corrrÌ1rics

QUÉ5ÌìON5 FOR DISCUS5ION

Q(JI5l lON A. L)oe! dcinduslrìaìizatl.n, i e

thefnÌllntheshakolcnìpÌolnìcntúì
iÌìC1ústry', cau\r une!ntìo!lncnt?
ìn lhc un€mtÌolmcnt nrtc
QUISIÌOlì B. WlÌ-v ì\ it nriderdjng toiìssunìc lhât change\
Ì;Ìl bc rcfl€clc.ì dircctLr in oppo!ile chiÌnge! the elnpk))Ìnenl Ìate? SltiaiieÍ rhe ll
jn !i
nrorr nttroPÌiate lo analvse uneÌnpÌoyJìent rater tlìaf cmPlo-ïÌìent raL's
and 1ìce

(llrISTÌON !i.ce the 198(\ Swedish urcÌnPÌolnìcnt lÌâs l'ìÌ(tr\'cd a verr'' dllìercnt
C.
prtlcrn from tlìc alerage (Í lr(Ìr€ad co!flÌies WhyÌ
lrÌternaÌì"Ìal IcorÌomic\ lÌns
Qlrls1ÌON L). Aclam toscn olth.lis ÌÌìs!it!t' IrÌ 'Ìrimc'Ì
is anrtìe
rhatll'ÍLr is ineÌetant ior rhe CcrÌnan.conorn! ltÌpanicul'Lr' hc statrsr'Thcrc
c\1de.cetlìitch.ngeslnmonelaìreslmetinducelittlcchangcinÌealccoÌÌorìic
structuÌes su.h as Ìaboroi hnaÌì.ìaÌnÌ.rkets NloÍiÌìPoúnnlì_r'thcí:ì!Ììogood
rers.,]] k) bclieve that thc f.Cll s'iìl behale aÌÌ)''Ìitìererì1ll uÌar the ìi!nden)ânk
'
flnÍilute ior hrternationâl lcolìonlics hi{)rki'g lapeÍ No' 99 5,ApÌi1lq99)L)o-Ì(trì

macírcconolnics arÌd the

QUISlÌON ì1. 'tntonc wlÌo IoÌl{Ns botÌÌ nìainnn'am
I proccÍ is
nc1!Ìr. pLÌt knosa ilìat t1ìc tcxtbook modcl ol tlìc ifage uicc trnempl()) nÌÜr
in tì(iublc. B\ the texlbool nrocìe1, I mearÌ the n'rndard àc'cÌdationist lhilÌlps cur!'c
(w iìlianÌ Nol!Ìhaüs'
.cnterrd on. slrbte ìlAIllu dctennjning s'âge iÌìllnlion '
'ConÌÌÌ]l:nt', ttrdlnr.gt rrpcl:r o,r Ã.drìo,,n ,Ì.tirirl', No' 2 í1!99), 2'11 ì
rlllaill
an.lcralutte il (ith rcferencc (o urÌelìployxrent ú Ol'CD
ì,iorcìhaüs s nnlcnÌent

(lL,lrsTlON l Arc ìnnitut()nal riSìLlities bacllor e'ononìic te cÍmance?lIÍ)'\Lhl 'lo

Nobel prize s'innei
QUESÌlON C. ln clingnoting I urcpc\ urenrÌrlolrnetrl PrÍrlerì'
oílct rleÌt to the
lanÌes Heclmn. hâs clanÌ1edÌ that'^n econoniic rhât 1!iìs
'daPtedhis becom!
Ìnore s1âbÌe a n d pÌr'dictü trlc .conoÌIjc envÍonnrent oI the 1950s and Ì'r60s
.l!\1ìi..tion.l in tlÌclate tú'cnlieth and earl-Ï trlent) lrstceÌÌtLlrici'Hc alír argucs tlÌat
rhenfi\'cerÌturlrequiìesneifecoÌÌoÌìics':'lheoldrronorni'síoctedonstabìc
tech ologies NheÌe br)r(laggrciaates su.h as caPital a'dlabor('cre asrünìcLlto bc
hoDÌogc!Ìous The cconoÌnjcs of ttÌc Ìno.ieÍ' tra iocusc! oD rÌxrdtìt ol maLchiÌrg an'ì
nirtnrg oI h(tcrogeneous ndi!iüral\iÌrto rradingarÌclprcduction units i. lhc i.ce ot
un.ertaìnr\ aLr.trrt the \uìlability ol anv paÌticulnr tr:LdiIg oÌ pìocÌuctjon arrinAerÌìent.'
Do )ou agrcc r!ìth IleckmaÌì's as\essnìeìrt?
(ÌUl-151ÌONILThcltalianu.emÌrìovrÌrcntr,rterlasll.6Lr)nl9rr5and9.1olôìn20ill.
Dl5cLrss the data o. rcgnÌraÌeconomic pcrloxnance in tlalv 5hor1,rÌ irÌ Iable 18.10, ls
iürpli.ations iar nali,Ìì.l economic pcrlorrna ce. and sugitcsl appropriâte polict

Ìable l8.i0 rÊ:jorà ..ói.nr{ F.Íiornìa..e tr Ji

Noth cêDtÌe Mozogiôrôo

aDr_rrÊ.r,!. tü 105I lr.r5 tal

E,ìÍ,.,rii:rtrt. ti a0! a5:r tl
.rnÉrrFnri.ì r;i.(e. ;6 rs 104

ncr:: .:.D.(dli nrry.,iÈt. lur t

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rì9!r9â) \Nxrqrie Denìod i nl
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-nenrpÌo\mc't
if ta.\ l'U !r! I n\üsl' rLlrrrr'
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il9trlìbì. Ì In.n ÏRulÉ\ ntrì1nnrlâN idddl.100ia!0' 6ri 6
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srbstitLLt.nanda.n!,nr.ÍÍrcrl!,rrrnìt./ Srr\r) !rrirnb' Q,r n4 Jrür1ntt.lFt. . 1it\
l..drdrri.lrrtrli.r. an ll:5l 3l)
lrllrr0, A., inl I. Co{r!rLr:0001 Ihe
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nei' re LÌre f..n.drll t)1lnnlLtritl\ rll]rrúrri. ljÌ.rrth\lodcl',/r!r,,r0l,r'tuì rr,:n,!,,id.

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l..hfÒÌo8 .al(:hange rnd lii!Ìng Ì!.90
ÌÌi.cs ô.d ih. QÌr!d!l oi lrN r\tmrrt'. ll s
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l)0Ìtornan.c rÌ1d lÌrli.v', ( )Ì&n1Â.riì r ol D!.iLl6 ol IJÌiiinr F.of onri. lìcÌ.rm D.ln.r.dl'
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a$\\, r1956l. The V..ela.! Drnanì i$ .l
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lbsohrc P!r.ha\inij rorle. h.t!,
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,\.Ènn)g u,DâÍ)n 553, 5sl !rcdir.onsúaÌr\ 265 269

..úel]Ì,o!rnaÌ11ipoÌiriÉ\ ,l,ournìaÌrri{urlnÌnrn 55
lÂr.\ÍP) 7sÌ,. il tsrn.tÌreot í, g re ttreor):
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. nr -lJ.!nr 55. -ió sll rrfrrh,rzanl 2a2, t6.l

.lD.u^ c rJgAregitc d..ìândl, 5.hu Ì)rnjiúrr:rnrill

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Ltrg. (.n.rrr ' nodel i06 iSri.urtnÍ., iDd ed!.rrnitr 50.1
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rrpe.kiil)nr, nrllan.r
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lroh.rc\r iir, ii3

rnv0 \. ioÌe.!.n, ilrnÌìern lnrnlÌ groÍlhnrrtacnj 169
nÍ.mrnrr tril 21,2
hai|!irdindr.rnúnÌhod,
. ri (. cÌrg.p'odr.t.i ripiLrÌ) gr.r ih.or 6lJ
r\!imrei.L ntu.k5. .Ìren
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e,lìj ibria 616 6l: (.v.red t rknÌrJLirl. ,mlril]n(\ lr7 ll8
zeír Éq!,'rro 116.1Ì7
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dciifrd 313 lt9
.rrrrv.ìrÌket{uitibk r ,ì5.!rÉ, JggÍ.tâLe mÌrÌrlr 5i, ió

dnúirÌti.r l3 l.:, moret.r\ÚJlr\mì!lon

rì..hinnon 231
L.\rd e...!nrÌ 53 is il .nÍt frÌi'È n!ÌÌ,ì, demardnÌ l,rl.,n..d brdlei.Ì,Ì1ipÌÌêr, lìÍ rr
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\Í.f.itr! LÌrli.'r rmnrtr.r.

rrd n?Í rìrlÍrmodrl r.r.itsn rnf Ì!on,,,t,erlê.t tcrt.(intcrra!oül m.bLlúr
iubnÌui.ÌL)iliq lir6
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r\tdìelri. jnnnÌt,or nrr)deÌ \ eú 5.l.ntr nrnÌìr'rr tìrln,rna 315 jl6
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(dtLâÌ!; (r.t.Ìbrfk !!rüof Ì\jlrtrì5 Llx.d r\LlÌa^le .Jt,iiìL ndriÌitr, irìf d iert
op.f..orr'.) .130 l:ll
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i.rlLúe or.
bâÌar.r li!..J60
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hou driaiiÌd Lrnif! 210 211
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r.d rquilibrirnì oi !..nún!
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l,?rlert lìrtr\irn t!rililinrr rrr.Ìtrn nÌ tcll rl\n'l)eii
IPLì r r,5i 65rì ó5!
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3.m. r;5e 612, òú'
hLi$Ì,.! drhn.a l1J nrF re.LtuiìÌ)enror eqnL iÌia,.1hcr 662

n\.rlpoÌlct l7e lsl perl..i1..,l)è!!tr 1d'gh brnri

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írL.1rúlpoÌi.i.j!l ..f{urrl)non \ itrrir3

eduL.úir)nJrtrâ.d r3 501
iid Íorld,.Lon'. di!.Lbr1ron .oníanrlrl.tron rl, Ì r5 r.16 \eÍ (er.esiân m.del s6S,

a lrriar. Ìli.hfud i9,,41)6 r.frinu.ur nnr..o!.epr sr ilì

lggÌrgtrn: d..rnI nnr.k I 92 rilunn.hon 21 531 L.rYrÌts..1r,tr,ÂrnÌn rr0 505
a.rL.lÌn r.r 1 l]i,3,uj .onn.dLLerÍrx !ì \.aÌc r(.1ì\j
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(lolrLr D.trgÌas
Frôd!.!!n .onn ner 0ri.c uÍÌe\ lsl
tur.ti.rn .167 .148.172 f!rarììr ì1il S!loïtqúa!ôn
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ên'r.!cn.ni !fi|q\ 509 tu..tnìr..{imrún! ],trn,rr.r ta s(rl slrl
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lnorrÌÊdgÉ lpnlòÈr 512
t.rÌìn.ÌoìririÌ pr.g.ês 18 1
budgeiL.rrnrrir 2I spe..lnreâsúreminL leb l9rj
rn,pir ral rÌin.ri.ns 2-ìO 2l:j dfia 6tinì.tirllronÌ
r!!Ìe!atrdlrx 2:rr 212
h\.11 ronn,lnltrinfr..iL! l3s, .etsÍÌrLl, ÌÌÌitcd siúr\ lr):r,

sâ.rii.È nu.\ â!d dnnririi,Nl k.hnoÌo8] LúnnìL s0i

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lr\Lei\en\Íj\it\ ot 2]ì' 225
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núe ênìAÌâlrÌ..tÌÌrg
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ireaonì-- aì qooai nìncro-ócotìoÌr 5i n Ìl'e ploae55

O i'rì-"r BLanchartl, Class of 1941 Professor, [,4assachusetts Lnst]tuÌe ofÌechnology

' Thc lle5t lrrav lo eaÌ 'eaoìotaLt5 ! Lclìã!'e.ìtexlLìookr''rlrich d'"rrclols a

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clci]! ju5t ilr 5 Thcl)ookl!ba5cdorìtlìL''ran',ilea:níTlo"l"l'l!màlloqìod!
nf c 1 5 lqu.r 1! cls !5ed by l-rotlì aaadcm c5 and po cj'r r'aief5 t 5íìo!rt5
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lìo!'! Ìh ! mode anìrt)eussdto.ltJclÌ-'!r.ìr-anor-ìou5\/aletyoipl'l'tr(a

que5t oÍr5 .Tl' 5 t rì'oCtlatì lrlaa loetonomlc5 iol L rde'!lr'dLlatcs, io5i
qr.dLrates. ì.1 llL5iÌle!: r.oforn ll5 a lk(l "
Stephen Nicke l, Schoo Professor of Economics, L5E; [/enber of the ìVlonctary Pol cy

committee, Bank of E n gland

"YJfref tencì r'ìq ÌrÌi: lrlad:te maalceaonorr (! r l; !i d CLl n!l il'epà:L

ye:r:, deep y Í-. L ihni !)i 5t'ìq iextbooKs \,lrele à acklìq l)llcp!
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:ìp-" íeat on5 | ltsf lllotilLat, ibot ol i nàr'c a rÌr.l' ki:ls' 2l 'ì iL tab "
ireaÌÌrìeft ci q ot'\'th Ìl'eo y tll.ll raf !1ì!c qht of otl:eÌvcd "rr'ì\''er!l':trtl
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sfìoL d b-. ale5 q'ì..tal nvallcu:loLrnt e5.ìt d í;e'crìl5iaqe5 of d"velopme ìÌ ÌlcoÌlodìics at t-lni\ er sity ColÌl!.
tlr-" f irst tomp clreÌr5lÌ.'e ailer-rpi
Be f g nt jl fq tleSe!àp5' Lhr'aÌ rr- Ì oÌldorÌ ilnd RcscaÌch ïreìlolr ol
l:cd any n!illLclor who tììe (llÌÌlrl for Ìrcoìlolllif lÌ)Ìif\
So:k ce racroeco rorlì c5 textbock 5lloL d be by
lrtinÌ! to b ìq her 5i!de ìt5 Ìo .he Íroíìi er oí mod"rn rlactoecorlrlltllc: "vhl e Ì{csciìrcll
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aLd c Ìrf{:. " , Ìs ìì.e!c. rclì
Ì)rofcs'ior irì Ibliticill Ì coÌìonì\
Phllippc Aqhion, Robert C. Waggoner Professor of Écononrics, Harvard Unlvers ty
at l)Llkr Uììiversil\ iììld al Tllr
" ÌÍìperfeat corÌrpetrÌ ol, k ror,r etlqc .lased qtowth, lli àt olì-tarqet lq \\'i\\('n s(Ì aitlzcÌìtÌ 1rÌr Ììetlin
an(l (lr'Ììtcnniiìl l)lofct!or iìl
rf ìÌr.ì baÌ1k5i] td niìÌry othcr le ìlr. Íeallli'r oi rnode n 'ò[oron] t 5\/51'll5
Ir.l\,'c recently bc-.Ìì lntcqlaLe.i ì:o Ltc h!al'1 cl raafoeton(lrTl ihco'y la' I thc lì.1ìÌopearÌ llstitLLte, l.SIl
'
lìg .l texillook :ha1
ar ì.1 Solk ae co t r. ptoÌr:siotl a ! e.ìL 5e vlae by'"'uI Ì

ll]arKe5 thes-Ê d:ve oflrNent!.ìcae!5ill -' :o L. 'oe'!l adLlatl:!. Tre blok i c5'
ì1''

Ìr;ìaÍleto rorÌr L: li i! be5Ì a5 a u:eÍu ftatrler''.'o I ior ana iz lq r.(r! iÌÌr.!L ilr\.1 rrLLr ( r]|]. \1ri:,'1 '
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mfro.t.,ì ì. qL,a!i
\1,)\l\ ! rr)lr: l)Lrilr rì)rs! I r\L.
P.ter IJor".rltt, Lyn crost Proless0r oÍ Sociaìl S.iences' Brovún UniversiÌy \lrlLirr \r: \11rìLirliri.,!r ll,r! (,
r.lj.rrrrrÌ! 1,'nl irrlloij ,!rrÌ\Ì I:
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sBN 978 0'19 877622 .

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