Summary Macroeconomics n Gregory Mankiw

Summary Macroeconomics - N. Gregory Mankiw

Macroeconomics 1 (University of New South Wales)

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Summary Macroeconomics

N. Gregory Mankiw 8th Edition


Summary Macroeconomics

N. Gregory Mankiw 8th Edition


Contents

Epilogue. What We Know, What We Don’t Don’t ........................................................................................... ............................................................................................ .. 5 1. The Science of Macroeconomics Macroeconomics ...................................................................... ......................................................................................................... ................................... 7 1.1. What Macroeconomists Macroeconomists study ..................................................................................................... ..................................................................................................... 7 1.2. How Economists Think ................................................................................................................. ................................................................................................................. 8 1.3. How This Book Proceeds ...................................................................................... .............................................................................................................. ........................ 9 2. The Data of Macroeconomics ........................................................................................................... ........................................................................................................... 10 2.1. Measuring the Value of Economic Activity: Gross Domestic Product ........................................ 10 2.2. Measuring the Cost of Living: The Consumer Price Index .......................................................... 12 2.3. Measuring Joblessness: The Unemployment Unemployment Rate..................................................................... Rate..................................................................... 14 2.4. Conclusion: From Economic Economic Statistics to Economic Models ...................................................... 15 3. National Income: Where it comes from and where it goes .............................................................. 16 3.1. What Determines the Total Production of Goods and Services? ............................................... 17 3.2. How Is National Income Distributed to the Factors of Production? .......................................... 18 3.3. What Determines the Demand for Goods and Services?........................................................... Services?........................................................... 21 3.4. What Brings the Supply and Demand for Goods and Services Into Equilibrium? ...................... 22 3.5. Conclusion ....................................................................................................................... .................................................................................................................................. ........... 25 4. The Monetary System: What It Is and How It Works ............................................................. ........................................................................ ........... 26 4.1. What Is Money? ......................................................................................................................... 26 4.2. The Role of Banks in the Monetary System ............................................................................... 27 4.3. How Central Banks Influence the Money Supply ....................................................................... ....................................................................... 28 4.4. Conclusion ....................................................................................................................... .................................................................................................................................. ........... 29 5. Inflation: Its Causes, Effects, and Social Costs .......................................................... ................................................................................... ......................... 30 5.1. The Quantity Theory of Money ............................................................................ .................................................................................................. ...................... 30 5.2. Seigniorage: The Revenue from Printing Money ....................................................................... 31 5.3. Inflation and Interest Rates .................................................................................. ........................................................................................................ ...................... 31 5.4. The Nominal Interest Rate and the Demand for Money............................................................ Money............................................................ 32 5.5. The Social Costs of Inflation ....................................................................................................... ....................................................................................................... 32 5.6. Hyperinflation................................................................... ............................................................................................................................. .......................................................... 34 5.7. Conclusion: The Classical Dichotomy ......................................................................................... ......................................................................................... 34 6. The Open Economy ........................................................................................................................... ........................................................................................................................... 35 6.1. The International Flows of Capital and Goods ........................................................................... ........................................................................... 35 6.2. Saving and Investment in a Small Open Economy ..................................................................... 36 6.3. Exchange Rates ....................................................................................... ........................................................................................................................... .................................... 37 6.4. Conclusion: The United States as a Large Open Economy ......................................................... 39

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

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

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19.3. The Traditional View of Government Government Debt ............................................................................ 108 19.4. The Ricardian View of Government Debt........................................................... ............................................................................... .................... 109 19.5. Other Perspectives Perspectives on Government Debt .............................................................................. .............................................................................. 110 19.6. Conclusion .............................................................................................................................. .............................................................................................................................. 111 20. The Financial System: Opportunities and Dangers ....................................................................... 112 20.1. What Does the Financial System Do? .............................................................. ..................................................................................... ....................... 112 20.2. Financial Crises ....................................................................................................................... ....................................................................................................................... 114 20.3. Conclusion .............................................................................................................................. .............................................................................................................................. 116

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Epilogue. What We Know, What We Don’t There are things in economics that we know, but there are also unresolved questions that are still heavily debated.

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

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

The four most important unresolved questions in Macroeconomics

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


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

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

1.1. What Macroeconomists study Macroeconomics is the study of the economy as a whole. Macroeconomists attempt to explain the macro-variables that affect the lives of all individuals in an economy, most importantly, Real GDP, the inflation rate, and the unemployment rate. They are different from micro economists and from economic policymakers.

Most people are casually introduced to the subject of macroeconomics through political debates, news events and debates. They are thereby informed of the largescale economic events and processes that influence every individual in the economy. Everyone has some understanding, even if it is vague and rudimentary, of the questions that are related to the economy as a whole, and it is the discipline of macroeconomics in which these questions are rigorously studied: What explains the vast differences in wealth between rich and poor countries? What explains the periodic recessions and depressions that all countries are affected by? What explains inflation? And what can the government do to improve these issues? Macroeconomics is the systematic study of these phenomena, of everything related to the economy as a whole. It is contrasted to microeconomics, which is the study of individual firms and markets within the larger economy. It is also contrasted with economic policy, which is the job of politicians, not necessarily of macroeconomists. The difference is that macroeconomists try to explain and understand the economy, but they do not necessarily have the political power to form policies. On the one hand, macroeconomists use models to attempt to understand and predict the economy. These models are simplified mathematical “simulations” of the real economy that try to capture the ‘essence’ of particular macroeconomic processes. On the other hand, macroeconomists also study actual historical events and processes in all their complexity, using these models. For example, macroeconomists are still trying to understand the causes of the economic crisis of 2008, a historical event, by using various macroeconomic models. There are many macroeconomic variables, too many to name them, but they all revolve around the three most important variables: Real GDP, The total level of income in an economy, the inflation rate, the rate at which prices are rising on average, and the unemployment rate, the amount of workers that don’t have a job as a percentage of the amount of workers (also called the labour force). Most of

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

1.2. How Economists Think Macroeconomists attempt to explain the economy objectively. The predominant approach to economic theory is the building of models. Models are collections of endogenous and exogenous variables and relations between them that attempt to explain aspects of the complex economy in a simplified manner.

Economists address issues that are often politically and ideologically charged, but attempt to do so in an objective way. The predominant way that economists build theories of the economy, is by building models. A model is a collection of endogenous variables and exogenous variables, and a relationship between them. Endogenous variables are the variables that an economists tries to explain, for example the short term fluctuation of GDP during an economic crisis. Exogenous variables are the variables that are thought to explain the changes in the endogenous variables, for example consumer confidence. In other words, changes in the exogenous variables are assumed to be the causes of changes in the endogenous variables. In this example model, a change in consumer confidence is assumed to result in a change in GDP, but not the other way around. A simpler way of putting it is: Exogenous variables go into the model, and endogenous variables come out. The most famous economic model is the supply-demand model. The supply function of a good is given by the equation Qs = S(P,Pm). Where P is the price of the good, and Pm is the price of the materials used to make the good. The demand function is given by the equation Qd = D(P, Y) Where Y is the aggregate/national income. The final part of the model is the assumption of market clearing: that the price of the good adjusts so that supply equals demand: Q = Qs = Qd Where Q is the amount of that good produced after the market clears. This is called the equilibrium quantity, and the price at which the market clears is the equilibrium price. In this model, Q and P are the endogenous variables, and Y and Pm are the exogenous variables.

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

1.3. How This Book Proceeds An overview of the structure of the book.

The outline of this book is as follows: Part one: Introduction Chapter 1 and 2 Part Two: Classical Theory: The Economy in the Long Run Chapters 3 to 7 Part Three: Growth Theory: The Economy in the Very Long Run Chapters 8 and 9 Part Four: Business Cycle Theory: The Economy in the Short Run Chapters 10 to 14 Part Five: Topics in Macroeconomic Theory. Chapters 15 to 17 Part Six: Topics in Macroeconomic Policy Chapters 18 to 20

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2. The Data of Macroeconomics The three most important statistics in macroeconomics are G DP, the inflation rate, and the unemployment rate.

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

Economists use economic theories to explain and understand the economy, but a theory that is not based on empirical data is likely not valid. Data is used to 1) build theories, and 2) test their validity. In other words, data is the evidence used to test theories. Economists have become better and better over time at systematically collecting data relating to the economy. This chapter focuses on the three most important macroeconomic statistics on which data is being collected: GDP, the inflation rate, and the unemployment rate Income, Expenditure and the Circular Flow GDP is measured by combining a large amount of “primary data sources”: administrative data such as data of tax collection, data from government programs, regulatory programs, and statistical surveys of firms. These are then used to estimate the value of GDP.

There are two interpretations of the GDP statistic: 1) The total income of everyone in the economy, and 2) the total expenditure of goods and services in the economy. These quantities are the same, because every time a good is purchased, the expenditure on that good by the buyer is exactly the same as the income provided by that good for the seller. The system that is built to categorize and relate all the components of GDP is called national income accounting, and is based on the “circular flow model” of the economy. The circular flow model consists of two actors: Firms, and Households. There are two flows in this model: 1) the flow of goods and services. Households provide labour to firms that are used to produce goods. And firms provide these goods to households.

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2) The flow of currency (e.g. Dollars/euros). Firms provide income payments to households in exchange for their labour, and households provide expenditure payments to firms in exchange for their produced goods. The two measurements of GDP correspond to the total income and total expenditure respectively. The values of goods measured in the national income accounts come from the market price of that good. If there is no market for a good, an estimate is made of its value (called its imputed value). The underground economy, or black market, is not included in GDP.

Real GDP versus Nominal GDP

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

The Components of Expenditure

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

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

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





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

The national income accounts identity summarizes these components of expenditure: Y = C + I + G + NX Besides GDP, there are a number of other very similar but subtly different measures of income. Gross national product (GNP), which corrects for cross-border factor payments, net national product (NNP) which accounts of the tearing down of goods over time (depreciation), and a number of other measure. Seasonal Adjustment

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

2.2. Measuring the Cost of Living: The Consumer Price Index Inflation is the gradual increase in the price level of an economy, the weighted average level of prices of all goods in an economy. There are multiple measures of the inflation rate, of which the CPI is the most commonly used, and it is a Laspeyres index. Another is the GDP deflator, which is a Paasche index. Neither of

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

Inflation is the process that the price level rises over time. The price level is a kind of “average” of all the prices of all the goods in the economy. There are multiple measures of the price level, and the most commonly used measure is the Consumer Price Index (CPI), that measures the price level of a large number of consumer goods. Another example is the GDP deflator (explained in the preceding subchapter). The CPI and other price indexes are always measured with respect to some base-year. If the base year is 2000, then the CPI in year 2012 is: CPI = (2012-quantity of apples X 2012-price of apples) + (2012-quantity of oranges X 2012- price of oranges)/ (2012 quantity of apples 2000 price of apples) + (2012 quantity of oranges 2000price of oranges)

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

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

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

2.3. Measuring Joblessness: The Unemployment Rate The unemployment rate is the fraction of unemployed workers as a percentage of the labour force. It is related to but distinct from the labour-force participation rate, the number of people willing and able to work as a percentage of the adult population in a country. The unemployment rate is measured using a household survey.

The unemployment rate is an important economic measure because a high unemployment rate suggests that the economy is not using its resources to its fullest extent, and because high unemployment means a large number of people who are unsatisfied. The unemployment rate is estimated by a government agency (e.g. the U.S. Bureau of Labour Statistics), using a large survey of households. People are categorized into one of three categories: 





Employed Unemployed Not in the Labor Force

The labour force equals the amount of employed workers plus the amount of unemployed workers (L = E + U), and it refers to the number of people that are able and willing to work. People not in the labour force include those who would want a job but have given up looking for one, or those who cannot work or do not want to because they are disabled retired, or students. The unemployment rate is the number of unemployed as a percentage of the labour force (u = U/L). Similar but distinct statistic is the labour force participation rate, the number of people in the labour force as a percentage of the adult population. In most western economies the labour force participation rates among men have decreased slightly, whereas that of women has increased steeply over the last 60 years.

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

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

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

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







What determines a nation’s total income (GDP)? How is this income distributed among workers and owners of capital? How is the output of production distributed among households and firms? How is equilibrium between demand and supply of goods and services achieved?

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3.1. What Determines the Total Production of Goods and Services? The production function and factors of production together determine the level of output.

In the classical theory, GDP is determined by two things: 1) The factors of production of an economy 2) The production function of an economy The current consensus of economists is that the classical theory is a theory of the long run, and therefore does not explain short run fluctuations in GDP, nor the very long run development of the economy. For this, see chapter 10 and 8 respectively. Factors of production Factors of production are inputs used by firms to produce goods and services. There are two main factors of production, Labour (L) and Capital (K). Sometimes Land is also included as a factor of production, but it is omitted in this book. We make the simplifying assumption in this chapter that the factors of production are fixed, i.e. they do not change over time. This is depicted symbolically by an overbar as follows:

K =K, L = L We also make the simplifying assumption that all factors are fully utilized in production at all times, which effectively means zero unemployment, and zero idle capital. Production function the production function is a function of form:

Y = F (K, L) It reflects, among other things, the available technology in an economy that allows it to use the factors of production to produce goods and services. This means for example that an economy with a very highly educated and skilled labour force will have a different production function than a country with a lowly educated and unskilled labour force. The former country will produce more with the same amount of labour and capital than the latter, which is represented by a higher value of the production function given the same K and L. One possible property of a production function is constant returns to scale. This means that increasing the amount of labour and capital by 10% will also increase production, and therefore GDP, by 10%. This is depicted mathematically as follows:

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zY = F(zK,zL) Production functions can also have increasing and decreasing returns to scale. We also assume that the production function is fixed over time. The supply of goods and services the production function and the factors of production together determine the supply of goods and services in the classical model. Because both the factors and the production function are fixed, GDP is also fixed in the classical theory:

Y = F(K,L) = Y (WITH OVERBARS) Growth in GDP is addressed in chapters 8 and 9

3.2. How Is National Income Distributed to the Factors of Production? National income is distributed among the different factors of production, labour an d capital. This chapter addresses how this distribution arises.

This subchapter explains the so called neoclassical theory of distribution, a neoclassical theory that predicts how the income is distributed among the factors of production. The theory is a synthesis between classical (18th century) theory of supply and demand, and the 19th century theory of marginal productivity. Factor prices Factor prices are the amounts paid to the factors of production per time interval (it is therefore a flow-variable). The factor price of labour is the hourly, daily, weekly, monthly, or yearly wage. The factor price of capital is the hourly, weekly, monthly, or yearly rental price of that capital good (for example the monthly rental price of renting an office building, or of a factory machine). In the classical (long term) theory, the factor price is determined by the equilibrium between the supply and demand of that factor.

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

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

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Because firms maximize profits, they keep employing a factor of production until doing so would no longer increase profits. In other words, they stop employing it as soon as marginal revenue equals marginal cost (i.e. until the extra revenue of employing 1 unit of a factor equals the extra cost of employing it): ΔProfit = ΔRevenue – Δcost = 0

For Labour this is P * MPL – W = 0 And for Capital it is P * MPK – R = 0 From this we can derive the wage rate and the rental rate of capital: W = P * MPL R = P * MPK Alternatively we can write the real wage and real rental rate instead of their nominal values (just like deriving real GDP from nominal GDP): W/P = MPL R/P = MPK So the firms demand each factor of production until marginal product falls to their real factor price. The Division of National Income

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

F(K,L) = AKαL1-α, Where 0<α<1 It has two important characteristics: 1. It has constant returns to scale 2. A constant percentage of economic output is distributed to the factors of production, namely its power. The second means that a share of α goes to the owners of capital, and a share of 1-α goes to labour. The cob-douglas function is often used, because it has been shown empirically that the share of income that goes to labour and capital is indeed very constant.

3.3. What Determines the Demand for Goods and Services? Demand for goods and services is determined by those who a re willing to purchase its output: consumers, investors and the government.

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

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Consumption Consumption is done by households, and is thus based on the income of households, Y. However, households have to pay taxes T to the government, so the amount that they consume is not based on income, but on disposable income Y –T: C = C(Y-T) This function is called the consumption function, and its derivative is the Marginal propensity to consume. Investment Investment is expenditure on goods used for the future. The interest rate is the major determinant of the quantity of investment goods demanded. The interest rate is the cost of funds used to finance investment. However, just as there is real and nominal GDP, there is a real and a nominal interest rate. The real interest rate (r) is the nominal interest rate (i) corrected for the effect of inflation (π):

r=i–π Investment is a function of the real interest rate: I = I(r) Note: there are in fact an enormous number of different interest rates, but since they are all strongly related, we simplify this by speaking of “the interest rate”. Government purchases Government purchases or government expenditures are all expenditures by all layers of government (local, state, federal/national). Government purchases are not the same as government spending. Government spending also includes income transfers, such as social security programs, and retirement programs, but this is not included in government purchases. If government expenditures equal taxes, then the government is running a balanced budget. If G is less than T, it runs a surplus, and if T is less than G it runs a deficit. Both T and G are fixed variables in the classical theory.

3.4. What Brings the Supply and Demand for Goods and Services Into Equilibrium? In the classical model, equilibrium between supply and demand of goods and services is determined by the interest rate, which is determined by the ma rket for loanable funds.

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


question is, what brings supply and demand for output in equilibrium? Equilibrium in the supply and demand for goods and services the supply of the goods and services in the economy is determined by the production function Supply of Y = F(K,L) = Y- WITH OVERBARS the demand for goods and services is

Y = C+I+G, Where C = C(Y-T) I = I(r) G=G T=T So because the economy is in equilibrium: Y = C(Y-T) + I(r)+G The interest rate r is the only variable that is not determined. It is the interest rate that changes in order to equilibrate supply and demand for goods and services. When supply equals demand, we speak of the “equilibrium interest rate”. Equilibrium in the financial markets Why is it the interest rate that equilibrates the supply and demand of goods and services? To understand this we turn to the financial market, and its role in the circular flow. Households do not spend all their disposable income. They allocate their disposable income to consumption and private saving. The government also does not necessarily spend all their tax revenue, or more than it. The budget surplus is equal to public saving. National saving is the sum of public and private saving, and is fixed because all its constituent elements are fixed:

S = Y-T-C(Y-T) + T-G Saving is equal to the supply of loanable funds in the financial markets. The financial markets serve the function of redirecting national saving to investment. Loanable funds can be seen as just another good, where the interest rate equilibrates the two: S = I(r) The interest rate adjusts until the amount that firms want to invest equals the amount that households and the government want to save, so that the quantity of loanable funds supplied and demanded are equal.

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Changes in Saving: The Effect of fiscal policy From the equation of the market for loanable funds, it can be seen that if government purchases increases, saving decreases. So the interest rate must increase, and therefore investment decreases. Because the level of income is assumed to be constant in the classical model, the increase in government purchases is offset exactly by a decrease in investment. Therefore we say that government purchases crowd out investment. A decrease in taxes has a similar effect, but also influences saving by increasing disposable income, so the effect of a decrease in taxes on saving is smaller than an equal increase in government expenditures. Changes in investment Demand It is possible that investment demand increases, because for example there is technological innovation, or because the government encourages investment through its tax or regulatory laws. In this case the investment function I(r) shifts to the right. However because saving is fixed, this has no effect on investment, only on the interest rate.

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

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

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

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

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

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

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

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

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

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

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How the Quantity of Money is controlled. The quantity of money of a certain currency is called the money supply. Monetary policy is the control of the government over the money supply. Monetary policy is delegated to a central bank in most countries. The central bank of the United States is called the Federal Reserve. Central banks control the money supply primarily by open market operations, which is the purchasing and sale of government bonds. A sale of a bond in exchange for money reduces the money supply (because the money used to purchase the bond from the central bank, is now no longer in the economy but in the central bank’s vaults), and the purchase of a bond increases the money supply. How the Quantity of Money is measured. There is not just one measure of the money supply, because what counts as money is somewhat vague. What is always included is currency, the total paper money and coins in an economy. Also included are demand deposits. In another measure, savings deposits are also included. M1 equals Currency + demand deposits. M2 equals M1 + money market mutual fund balances + savings deposits.

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

The central bank does not actually directly control the money supply, because the money supply is not just currency. The money supply is determined by both the central bank, and the banking system, and in order to understand the money supply we must understand fractional reserve banking. Throughout the book we assume that M = M1. 100-percent-reserve banking In a world with 100-percent-reserve banking , banks do not lend out the money that people deposit. This means that if one puts money on the bank, the deposits on that bank will increase just as much as the currency will decrease (because the currency is now in the bank’s vaults, and no longer in the economy). The balance sheet of a bank thus looks like this

In this type of banking system the banking system does not affect the money supply. Fractional Reserve banking For the last centuries, the banking system has been a fractional-reserve banking system. This means that banks only keep a fraction of their deposits as

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reserves and give out the rest as loans. The balance sheet of the bank now looks like this: The amount that is loaned out is now held either as currency or it is put back into a bank. Therefore “the same dollar is counted twice”, because it is counted as a deposit by the person who went to the bank, but also as a deposit by the person who loaned from the bank. This in turn is again lent out, and so forth. We say that banks create money . They do this by transferring funds from savers to borrowers, and this process is called financial intermediation. Bank Capital, Leverage and Capital Requirements In the previous examples, a bank only has bank deposits, but in reality, banks also have their own capital. The fact that banks use deposited funds besides their capital to invest is called leverage. The leverage ratio is the ratio of the bank’s total assets to its capital (owner’s equity). One of the regulatory restrictions on banks is capital requirement. This means that the leverage ratio is not allowed to be higher than a certain amount (i.e. the capital to asset ratio must be higher than a certain amount).

4.3. How Central Banks Influence the Money Supply The central bank determines the monetary base, and the banking system determines the money multiplier. Together they determine the money supply.

We now combine the model of the banking system and the central bank to build a model of the money supply. A Model of the money supply The model has three exogenous variables: 

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

We use M = M1, which is C + D. Dividing the money supply by Monetary Base gives M/B = (C+D)/(C+R) Dividing top and bottom of the fraction by D gives M/B = (C/D + 1)/(C/D + R/D) = (cr +1)/(cr + rr)

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We call m = (cr +1)/(cr + rr), the money multiplier. Therefore, M = m * B The monetary base is for this reason sometimes called high powered money, The Instruments of Monetary Policy The Central bank has multiple ways to change the monetary base. The main one as described earlier is open market operations. The CB can also lend directly to banks at the so called discount rate (the interest rate on these loans). The Central bank can also influence the reserve-deposit ratio by multiple means. The main instrument of doing so is the reserve requirements, a regulation that imposes a minimum on the reserve-deposit ration of each bank. This tool has become less effective because banks have started to hold excess reserves. Another tool is that the CB can pay interest on reserves at the CB. This means that if banks hold reserves, the CB pays those banks an interest on them.

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

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

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

Inflation can sometimes take such proportions that we speak of hyperinflation, periods of extraordinarily high inflation, such as the 500 percent inflation per month in Germany in 1923. “Normal” levels of infl ation are between 2 and 20 percent.

5.1. The Quantity Theory of Money The quantity theory of money describes the effect of the money supply on inflation in the long run.

This subchapter explains the Quantity theory of money, the dominant (classical) theory of the effect of the money supply on the economy (in the long run). The theory consists of the quantity equation: Money X Velocity = Price X Transactions MXV=PXT Where V is the transactions velocity of money, the number of times a dollar/euro/yen changes owner during a given period of time. T is the total amount of transactions done during that period of time. The quantity equation is an identity (it is by definition true, due to how the variables are defined). However, the amount of transactions is hard to measure and not very meaningful, so therefore we change the equation to M X V = PXY Where Y is output, or income (GDP). Output is not the same as the amount of transactions, but they are roughly proportional, so that the equation still reasonably holds. Within this equation, V becomes the income velocity of money. The money demand function and the quantity equation. We can express the money supply in terms of how much goods and services it can purchase. This gives us the real money balances, M/P. We can then write the money demand function, the demand for real money balances:

(M/P)d = kY

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By assuming that money demand must equal money supply, we can rewrite this to M(1/k) = PY, so that we see that V = 1/k. We conclude that the money demand and money velocity are two sides of the same coin. Using these definitions, we now formulate the quantity theory of money by assuming that money velocity remains constant: MVUPBAR = PY. Since Y is fixed in the classical theory, there is a direct linear relation between the money supply and the price level. According to this theory therefore, the central bank has ultimate control over inflation. Again, this classical theory works well in the long run, but not so well in the short run.

5.2. Seigniorage: The Revenue from Printing Money Seignorage is government revenue caused by increasing the money supply.

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

5.3. Inflation and Interest Rates The real interest rate can be derived from the nominal interest rate and the rate of inflation.

There is an important relation between inflation and the interest rate. Just like many economic variables, there is both a nominal interest rate and a real interest rate. The nominal interest rate is the actual interest rate paid (e.g. by government bonds). The real interest rate is corrected for inflation: r=i–π Thus the real interest rate is a theoretical variable not actually observed, but derived from the nominal interest rate and inflation. However, if we write it in its opposite form, and assume that the real interest rate remains relatively constant, we get the Fisher equation: i=r+π

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We can see that the nominal interest rate can change either because the real interest rate changes, or because the inflation rate changes. The one for one relation between the nominal interest rate and the inflation rate is called the fisher effect. Two Real interest rates: Ex Ante and Ex Post We distinguish between two types of real interest rate: 

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Ex Ante r = i – Eπ, where Eπ is the expected level of inflation at the time that the contract of a loan is signed. It is the real interest rate expected beforehand. Ex Post r = i – π. It is the real interest rate actually realized afterwards.

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

5.4. The Nominal Interest Rate and the Demand for Money There is a relation between the interest rate and the demand for money.

The money demand function in the quantity theory is based on the assumption that money demand is proportional to income (addressed in 5.1). However in reality money demand is also dependent on the nominal interest rate. The nominal interest rate is effectively the price of holding money, because it is an opportunity cost of foregoing the income of saving. Therefore we introduce the more complete money demand function: (M/P)d = L(i, Y) This can also be written as (M/P)d = L(r + Eπ, Y) This shows us that the current money demand depends on the expected future price level. Therefore the demand for money depends on the money supply growth, which complicates the earlier quantity theory of money.

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

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

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view. Layman’s view: Inflation is bad because it diminishes the real purchasing power of people’s income. The classical response to this is that nominal incomes also rise with inflation, so that inflation does not cause a diminishing real purchasing power. The actual costs of inflation according to the classical view can be put in two categories: expected and unexpected inflation. The Costs of Expected Inflation There are a number of costs associated with inflation that people “saw coming”. 

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

The Costs of Unexpected inflation Economists generally think that unexpected inflation, inflation that the public didn’t see coming, is more harmful than expected inflation. 

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It arbitrarily reallocates wealth from creditors to debtors It diminishes the incomes of individuals on fixed pensions

Therefore highly variable inflation, which has a larger element of unexpected inflation, is relatively damaging. It is an empirical regularity that higher inflation is also associated with higher variability of inflation. One Benefit of Inflation An inflation of 2 to 3 percent is a good thing according to some economists. According to this argument, nominal wage cuts don’t happen often, and inflation is a way of allowing a reduction of real wages in case this is necessary to equilibrate the labour market.

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5.6. Hyperinflation Hyperinflation is an extreme level of inflation. Hyperinflation is “extraordinarily high” inflation and this is usually defined as inflation larger than 50 % per month. The costs of hyperinflation are the same as the costs of expected inflation, but these costs rise to extreme and unmaintainable levels. The causes of hyperinflation boil down to an extreme growth in the money supply. Most often this growth is necessary to finance government spending. The government doesn’t have enough other sources of revenue, so uses seignorage revenue. However due to the costs of high inflation, this is a downward spiral, so that the government is eventually “trapped” in a policy of hyperinflation. A famous example of this is Germany from 1922 to 1924, where inflation reached 100 percent per month, until a new central bank was installed that was banned from buying government bonds. This hyperinflation started because of Germany’s fiscal problems after WWI, leading it to turn to seignorage revenue. Another famous example is Zimbabwe, where in 2008 inflation reached 231 million percent.

5.7. Conclusion: The Classical Dichotomy The classical dichotomy is one of the fundamental theoretical propositions i n classical theory.

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

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

6.1. The International Flows of Capital and Goods International capital flows and the flows of goods and services always balance out.

When we include international trade in our analysis the national income accounts identity of an open economy needs to be expanded: Y = C + I + G + X – IM Where X is exports and IM is imports. Imports need to be subtracted from GDP, because imports are not produced in the domestic economy, but they are included in consumption, investment and government expenditures. Equivalently, they have to be subtracted because people expend income on imports but nobody in the domestic economy earns income from those expenditures. We define net exports as exports minus imports: NX = X- IM. Now the identity becomes: Y= C + I +G + NX International capital flows and the Trade Balance. In chapter 3 we derived the equation S = I for a closed economy, but in an open economy we have to take into account net exports. Saving S is still equal to Y – C – G, and rewriting the open economy income identity now gives: S = I + NX. This can be rewritten as S-I = NX. This gives us the relation between capital flows and the trade balance. The trade balance is simply another word for net exports (because it shows the balance of inward and outward trade). Net capital outflow is the outflow of loanable funds minus the inflow, and since saving is the total domestic amount of loanable funds available, and these funds are expended on investment, S-I is the net capital outflow. So the trade balance must by definition equal net capital outflow. If NX and S -I are positive, the domestic economy is in a trade surplus, if they are negative it is in a trade deficit, and if they are zero, it is running balanced trade.

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In summary:

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

We now use this identity (an equation that is by definition true and therefore is not a theory, because it has no empirical content), and build a theory for a small open economy with perfect capital mobility . A small open economy is an open economy whose GDP is so small that it has no effect on the world interest rate r*. Perfect capital mobility means that there are no barriers between the financial markets of the domestic economy and the world economy. Because of this assumption, the domestic interest rate must equal the world interest rate: r = r* r* is determined by global demand and supply of loanable funds, but since we describe a small open economy, the domestic economy has no influence on r*. We assume a small open economy because it simplifies the analysis. The Model We use three assumptions from the model for a closed economy: 

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

We can now write the accounting identity as NX = S – I(r*). Therefore, Net exports are determined solely by saving, and investment at the world interest rate.

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How Policies influence the Trade Balance. 

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

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

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

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

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The real exchange rate ε is the relative price of goods of the two economies. It is the nominal exchange rate adjusted for the price levels: ε = e * P/P*

Where P is the domestic-, and P* the foreign price level. Because people’s willingness to t rade with a country depends on the real exchange rate, we write Net exports as a function of the real exchange rate:

NX = NX(ε) The determinants of the real exchange rate. We know two things about net exports: 

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It must equal saving minus investment It is related to the real exchange rate

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

How Policies Inflience the Real Exchange Rate.

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Fiscal Policy at Home . Increasing G or lowering T shifts the S-I curve to the left,

thereby increasing the real exchange rate. Fiscal Policy abroad. Foreign countries increasing G or lowering T increases the world interest rate. This decreases investment so shifts S – I to the right.

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

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

The Determinants of the Nominal Exchange Rate. We can rewrite the relation between real and nominal exchange rate as follows: e = ε *(P*/P)

And we can now derive what would be the change in e given a change in one of the other three variables: % change in e = % change in ε + % change in P* - % change in P This can be rewritten as % change in e = % change in ε + (π*-π) Where π* is foreign inflation and π is domestic inflation. So we see that the nominal exchange rate over time changes due to 1) a change in the real exchange rate 2) differences in levels of inflation. The Special Case of Purchasing-Power Parity. There is an important hypothesis in economics called the law of one price. This entails that two identical goods in different locations must have the same price, because if one were cheaper than the other, buyers would flock to that good instead of the more expensive one. This law applied to the international marketplace is called purchasingpower parity (PPP). It refers to the situation where all goods in the economy have the same real price in each country. In our model it is described by the situation where the Net Exports curve is very sensitive to changes in the real exchange rate, so that the real exchange rate maintains purchasing-power parity. This entails that 1) changes in saving or investment do not change the real exchange rate, and 2) the nominal exchange rate is only changed by changes in the price levels.

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

6.4. Conclusion: The United States as a Large Open Economy The assumption of a small open economy is only a simplification in most cases.

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

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

There is always some unemployment in all market economies. Economists distinguish between long term unemployment and short term fluctuations in unemployment. Short term fluctuations are only addressed in the theories of the Business cycle, chapter 10 to 14. In this chapter we discuss the natural rate of unemployment, the average rate of unemployment around which it fluctuates.

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

We introduce here a model of labour-force dynamics that shows the determinants of the natural rate of unemployment. We start with the definition of the rate of unemployment L=E+U Where L is the labour force, E is the employed labour force, and U is the unemployed labour force. The unemployment rate here is U/L We assume that the labour force is fixed, and that a fraction of the employed E loses their job each month, and that a fraction of the unemployed find a job. We denote the rate of job separation (the rate at which employed people lose their job each month) as s, and the rate of job finding (the rate at which unemployed find a job each month) as f. We now find the condition of steady state to determine the natural rate of unemployment. In the steady state, the amount of people that lose a job must equal the amount of people that find a job so that fU = sE Substituting L –U for E, and rewriting, we find U/L = s/(s+f) or equivalently, U/L = 1/(1+f/s) This shows how the natural rate of unemployment depends on the rate of job separation and the rate of job finding, and that a policy aimed at reducing the natural rate of unemployment must either make it easier for people to find jobs, or decrease the rate at which people lose their job. There are underlying reasons for why the rate

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

7.2. Job Search and Frictional Unemployment Frictional unemployment is one of the two main categories of natural unemployment.

One important element of natural unemployment is frictional unemployment. This is unemployment that is caused by the fact that it takes time for workers to find a new job. Workers are not all the same, so it usually takes time and effort to match a worker to the job that suits him or her. Frictional unemployment is inevitable, because there are always shifts in demand and shifts in production technologies for goods. If such a shift occurs, there is also a shift in the demand for labour needed to produce those goods, so certain jobs will disappear and new jobs will be created. Such a shift is called a sectoral shift, and they will cause both job separation and job finding. Another cause of frictional unemployment is the failure and creation of firms. Public Policy and Frictional Unemployment The government often tries to decrease frictional unemployment using for example employment agencies to match workers and jobs more quickly. However they inadvertently also create frictional unemployment sometimes, for example with unemployment insurance. This is insurance by the government to unemployed workers, which tends to increase the time spent unemployed. However this need not necessarily be a bad thing, because the longer time spent unemployed may result in a more efficient allocation of workers to jobs.

7.3. Real-Wage Rigidity and Structural Unemployment Structural unemployment is one of the two main categories of natural unemployment. Wage rigidity is a second reason for natural unemployment. It is the tendency that wages do not adjust to a level that equilibrates supply and demand. Unemployment that results from wage rigidity is called structural unemployment.

This book describes three main causes of wage rigidity: 

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

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

7.4. Labour-Market Experience: The United States The U.S. labour market is used as a case study of unemployment.

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

7.5. Labour-Market Experience: Europe Europe is used as a casy study of unemployment.

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



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

7.6. Conclusion Natural unemployment is unemployment in the long run.

Natural unemployment is a permanent phenomenon that cannot be completely removed. The government can try to reduce structural unemployment, but some causes of structural unemployment, such as minimum wage laws, are desired. Frictional unemployment can also be tried to be reduced, but it is a normal part of the economy that results from the job matching process, which is necessary for a wellfunctioning economy.

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8. Economic Growth I: Capital Accumulation and Population Growth The Solow Growth model is the basic model that describes long run growth of GDP.

Part II, Chapters 3 to 7, explained the classical theory of macroeconomics. It is a theory that is now thought to apply to the Long Run of an economy. Part III, chapters 8 and 9 address growth theory, the theory of the Very Long Run. In this theory, GDP is no longer assumed to be constant. Instead it tries to explain economic growth over time. This is usually a slow process, 2 to 4% per year, and changes over one year are not very noticeable, but over decades and centuries has enormous effects on the productive power and standards of living in an economy. The model introduced in chapter 8 and 9 is the Solow Growth Model, the basic standard model used for economic growth in macroeconomics.

8.1. The Accumulation of Capital The basic elements of the Solow growth model are savi ngs, investment, and the level of capital.

We introduce the fundamentals of the Solow Growth model Supply of goods and the production function The Solow model uses a basic production function for the economy, the same as is used in the classical model in part II:

Y = F(K,L) And just as in part II, it is a constant returns to scale production function: zY = F(zK,zL) However, in the Solow model, we rewrite the production function into a different form. Instead of using the standard production function, we use the production per labour function, and we write quantities per worker in lower letters, so that y = Y/L, k = K/L, and the production function becomes Y/L = F(K/L,1) = y = f(k). We can now derive the marginal product of capital: MPK = f(k+1)-f(k), or equivalently, MPK = f’(k)

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Note that this is not the absolute marginal product of capital, but the marginal product of capital per labour. The demand for goods and the consumption function. We ignore the government and trade in this simplified model, so that the demand for goods and services is given by

y=c+i Where c is consumption per worker, and i is investment per worker. A fraction of the income is saved by households and this is given by s. this means that a fraction 1 – s is consumed. Therefore the consumption function is: c = (1-s)y W can plug this into the goods market demand function to obtain investment y = (1-s)y + i => i = sy Which is again equivalent to saying that investment equals savings. These two ingredients, the production function and the consumption function are the basis of the Solow growth model. Growth in the Capital Stock and the Steady State. The purpose of the Solow model is to explain long term growth, and it does so by analysing the effect of investment on the capital stock k (capital per worker). Besides investment, the building of new capital equipment, the second force that influences the capital stock is depreciation, the tearing down of existing capital equipment. The rate of deprecation each year is given by δ. So the change in the capital stock is given by Δk = i – δk, which is written as Δk = sf(k) – δk. The depreciation of capital goods increases linearly with respect to capital per labour, but since the production function has constant returns to scale, investment increases at a decreasing rate with respect to capital per labour. This means that there is a point at which there is a steady-state, a level of capital per labour that makes that new production of capital goods equals depreciation of old capital goods. We denote the steady state level of capital by k*. So the steady state level of capital is defined by the following equation: sf(k*) = δk*, so that Δk = 0 For this reason δk can also be called the break-even level of investment here.

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

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able to produce the pre-war level of production. This caused investment to be much bigger than depreciation, so that there was a period of fast capital accumulation. How Saving Affects Growth The Solow model predicts that an increase in the savings rate should also increase the level of capital per labour. A higher saving rate means higher capital stock and therefore a higher level of output in the steady-state. However a higher saving rate does not mean higher long term growth. It only means a higher level of output at the steady-state. Factors that influence the level of long term growth are addressed in chapter 9.

8.2. The Golden Rule Level of Capital The golden rule level of capital is the level of capital that maximizes consumption in the long run.

The previous subchapter addresses the relation between the saving rate and the level of output, but it does not address the relation to consumption. If the saving rate is 1, then the highest output is maintained in the steady-state, but none of this output goes to consumption, so this high level of output does not increase the standard of living. The question arises, what is the “optimal” level of capital? I.e. what level of capital maximizes consumption in the steady state? This level of capital is called the Golden Rule level of capital , and is denoted by k*gold. To find it, we can rewrite the demand for goods and services as: c = y- i Because in the steady state, investment equals depreciation, and y = f(k*), we rewrite this as follows c* = f(k*) – δk* Where c* is steady-state consumption, and the golden rule level of capital is the level of capital that maximizes c*. Using the First Order Conditions (FOC), of maximization of a function using derivatives, we conclude that the derivative of f(k*) must equal that of δk* (if you do not understand this, consult a calculus textbook, or simply rote learn the result). This is written as: MPK = δ When this equation holds, we have reached the golden rule level of capital. For example if MPK = 1/(2sqrt(k)),

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We derive that k*gold = 1/(4 δ2). This is summarized in the following graph:

We can also derive the necessary saving rate to achieve this golden rule level of capital by equating the steady state level of capital to 1/(4 δ2) and solving for s. The Transition to the Golden Rule Steady State Policymakers can influence the saving rate, so the policymaker’s problem is to set the saving rate such, that the golden rule level of capital is achieved. Here are two graphical depictions of what happens if a policymaker corrects for a situation of higher than golden rule level and lower level of capital respectively:

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

The basic Solow model predicts that capital accumulation by itself is not able to explain sustained long term economic growth. By itself, it can only explain growth towards the steady-state in cases of low levels of capital, such as the examples of Japan and Germany show after WWII. There are at least two other elements that produce growth that must be added to the model. The first is population growth, which is added here, and the second is technological progress, progress, added in chapter 9. We introduce the labour force growth rate n. if n = 0.01, this means that the labour force grows by 1 percent every year. The Steady State with Population Growth To reiterate, k is the level of capital per labour. If the labour force grows, then this will slow down the growth of capital per labour, so that the function of capital accumulation must be adjusted: Δk = i – (δ + n)k

We see that the rate of population growth effectively functions the same as the rate of depreciation in its effect on capital accumulation accumulation per labour. The study state consumption now becomes: c* = f(k*) – (δ+n)k* And the k*gold is now the k* at which MPK = δ + n The effect of an increase in the rate of population growth can be seen here:

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This is an important effect for policymakers, because it means that in order to increase the steady state level of income per labour in poor countries, population growth must be decreased. Alternative Perspectives on Population Growth The Solow growth model does not capture all the effects of population growth. Two of those effects are captured by the Malthusian model and the Kremerian model respectively. 

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

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

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

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9. Economic Growth II: Technology, Empirics, and Policy In this chapter we introduce technological progress in the model, and we apply the model to empirical problems.

9.1. Technological Progress in the Solow Model Here we introduce technological progress in the Solow model. The Efficiency of Labour Technological progress is included in the model by the new variable E, efficiency of labour. It reflects the knowledge and capabilities of production methods. New available technologies and methods of production increase the efficiency of labour. The new production function becomes:

Y = F(K,EL) In this model, E increases at a constant rate g. This way of incorporating technology in the model is called labour-augmenting technological progress, because it changes the effect of labour in production. It could also have been capital augmenting, or both capital and labour augmenting, but this is not done in this book. The Steady State With Technological Progress. In the previous chapter, we measured variables as “per worker”. We now redefine these variables as “per effective worker”. This means that k=K/EL now and is called capital per effective worker. Similarly, y= Y/EL, output per effective worker. This means that the capital accumulation equation now becomes: Δk = sf(k) – (δ + n+ g)k

So (δ + n+ g)k becomes the new break-even level of investment. In a similar way as in the previous chapter when introducing population growth, technological progress alters the steady state level of consumption per effective worker, and the level of capital at which the steady state level of consumption is maximized (golden rule level of capital k*gold) c* = f(k*) – (δ+n+g)k* MPK = δ + n

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

9.2. From Growth Theory to Growth Empirics The Solow model is applied to make empirical predictions and comparisons with evidence. Balanced Growth Growth of output per worker and capital stock per worker in the steady state is caused by technological progress and is called balanced growth. IT predicts that there is sustained economic growth at the rate of technological progress, and we approximately see this in the real world. Convergence The Solow model predicts that convergence should occur if two economies have a different capital stock but the same level of technological progress. We also see this in the examples of Germany and Japan, which had about the same technological progress as the rest of the western world, but destroyed capital stocks. They quickly converged to the rest of the western world. However it predicts that convergence should not occur with countries with different technological progress, and this is indeed the case, as Africa and the West for example, have not converged yet. In this case we speak of conditional convergence: countries converge to their own steadystate, but countries do not have the same steady-state level of output. Factor Accumulation versus Production Efficiency An important question is the source of differences in income. It can come from either 1) differences in the factors of production such as physical or human capital, or 2) differences in the efficiency with which the economies use their factors of production, that is differences in the production function. On empirical inspection, it turns out that high levels of the factors of production are correlated with high efficiency of the use of those factors.

9.3. Policies to Promote Growth We can now use the Solow model and its empirical application to make some analyses of the policy decisions that governments face. Evaluating the Rate of Saving We take the example of the U.S. and ask the question: is the U.S. above, below, or approximately at the golden rule level of capital? We obtained three facts about the U.S. economy:

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1. k is about 250% of GDP: k = 2.5y 2. Capital depreciation is about 10% of GDP: δk = 0.1y 3. Capital income is about 30% of GDP: MPK * k = 0.3y (we make this conclusion from the classical theoretical prediction that the factors earn the share of income equal to their marginal product derived in chapter 3) Using these facts we derive that δ = 0.4, and MPK = 0.12, this means that net marginal product of capital (MPK –δ) is 8%. This is much bigger than the U.S. economy’s average growth rate (n+g = 3%). This indicates that the U.S. is well below its golden rule level of capital. In fact all countries in practice are below their golden rule level of capital, which indicates that in practice, increasing the savings rate is a good thing. Changing the Rate of saving The government can increase the rate of saving directly by increasing public saving, by either decreasing G or increasing T. The government can also affect saving by affecting the level of private saving through tax incentives. One possibility is to shift from income taxes to consumption taxes, but there are disagreements over how effective this would be Allocating the Economy’s Investment

In the Solow model, capital is simplified as being only of one type but in reality there are many types of capital. This means that capital must be allocated. Some economists say that the capital allocation process should be left to financial markets. Others say that the government should invest in infrastructure, a form of public capital, and in education, a form of human capital. It is also suggested by some economists that governments should actively encourage particular forms of capital if there are externalities associated with certain types of investments (for a theory of externalities look for a microeconomics textbook). Establishing the Right Institutions Not all countries have the same institutions guiding the allocation of scarce resources. Different institutions might have very different effects on production efficiency. An example of an institution is a legal tradition. Different countries often have very different levels of development of legal institutions. The development of government is also an important difference in institution. Some governments do not work effectively for the development of the domestic economy, or are corrupt. The development of these institutions is an important necessary element of economic growth. Encouraging Technological Progress The Solow model takes technological progress as exogenous, so does not explain it.

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

9.4. Beyond the Solow Model: Endogenous Growth Theory Endogenous growth theories try to explain technological progress.

The Solow model developed in the previous sub-chapters and chapter 8 does not explain technological progress, but instead takes it as given (an exogenous variable. This subchapter introduces four examples of an endogenous growth theory, a theory where technological progress is explained (i.e. where technology is an endogenous variable). The Basic Model This basic model makes one key assumption different from the Solow model, namely that there are constant rather than diminishing returns to capital, using the following production function:

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

We can calculate the growth rate of output ΔY/Y = sA – δ

This shows that as long as the saving rate is high enough, there will be constant economic growth. Because K also includes knowledge, it models technological progress as part of investment. A Two-Sector Model This more expanded model is a kind of combination between the Solow model and the Basic model. It consists of two sectors: Universities that invest in technological progress, and manufacturing firms, firms that produce output. The addition of universities is what distinguishes it from the Solow model. The model consists of the following three equations: 

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Y = F(K, 1-u)EL) ΔE = g(u)E

(Production in manufacturing firms (University investment in technology)

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ΔK = sY – δK

(Capital accumulation)

Where u is the percentage of workers employed in universities. Just like in the Solow model, the production function has constant returns to scale. If we include knowledge E to be a part of capital, then it also has constant returns to capital. For any given value of u, this model works just like the Solow growth model. As a result, there are two decision variables in the model, the saving rate, and the percentage of workers employed in research. The Microeconomics of Research and Development These two models do not go into the microeconomic foundations of decision makings with respect to research. Three key facts show the relevance of this:

1. Much research is done by firms and is driven by profit motive. 2. Research is profitable because it gives rise to temporary monopolies, due to intellectual property rights and first mover advantages. 3. When one firm innovates, this opens the door to new innovation The study of the microeconomics of R&D is focused on the positive and negative externalities generated by private research. In practice, positive externalities dominate, which is an argument for research subsidies. The Process of Creative Destruction The economist Schumpeter came up with the theory of creative destruction, the process by which entrepreneurs innovate and create new products or new ways of developing an old product, thereby destroying the markets for old products or production methods. The theory says that economic progress is always associated with the destruction of old industries. I.e. there are always losers to economic progress.

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

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

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

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Unemployment and Okun’s law. Okun’s Law states that there is a negative relationship between unemployment and

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

The approximate numerical relation that is taken from empirical research is that the there is a linear relation between the unemployment rate and GDP with a factor of 2: Percent change in real GDP = 3% - 2 * Change in unemployment rate Leading Economic Indicators Many economists are busy trying to predict short run fluctuations. There are two reasons why government economists need to do this:

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

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

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

This list is far from complete, but contains some of the important leading indicators

10.2. Time Horizons in Macroeconomics The short and long run is an often used distinction with a specific meaning.

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


done in this subchapter. How the Short Run and Long Run Differ The predominant view among economists is that there is one main difference between the short run and the long run, and that is that monetary neutrality works in the long run, but breaks down in the short run (meaning that money is not neutral in the short run). The fundamental reason why this is the case, according to this predominant view, is that prices are flexible in the long run, but sticky in the short run. This means that it takes time for prices to adjust to equilibrate supply and demand. For example, in the long run, according to the quantity theory of money, increasing the money supply will cause an equal increase in the price level. But in the short run, the price level is not immediately affected. The result is that in the short run, real variables, such as real GDP, the real interest rate, and unemployment, are affected, until the price level catches up. The Model of Aggregate Supply and Aggregate Demand In the classical model, output is determined by the supply of goods and services, which is determined by the production function. However, due to short run price stickiness, in the short run model, aggregate demand also influences output. The next subchapters develop the basis of this model, which is then fully developed in detail throughout the next three chapters.

10.3. Aggregate Demand Aggregate Demand (AD) is the relationship between the aggregate price level, and the quantity of goods and services demanded. The Quantity Equation as Aggregate Demand. We build here a simple theory of Aggregate demand based on the Quantity theory of Money. This is a simplified version and it will be refined in the subsequent chapters. The quantity equation is:

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

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

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

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

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

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

We see here that in the long run, output is determined by AS, and the price level by AD, but in the short run output is determined by AD and the price level by AS. In Chapter 14, this statement will be nuanced to an extent. From the Short Run to the Long Run. We now have two models, one for the short run, and one for the long run. We can combine the two to see the transition between the short run and the long run. See the next figure for this explanation. For example, if an economy is in long run equilibrium (Point A), and the money supply is decreased, then in the short run this will leave prices unchanged (point B) and output decreases, but as prices start to adjust over time, output starts to increase again, and prices start do decrease, so that in the long run, we are back to the original level of output.

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

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

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Demand Shock Suppose that the velocity of money suddenly increases. This shifts the aggregate demand curve to the right. The central bank could stabilize this by decreasing the money supply, thereby shifting the AD curve partially back. Aggregate Supply Shocks Say that some exogenous event has a short run adverse effect on supply, such as a drought that destroys the crops in an agricultural economy. This will cause the Aggregate supply curve to shift upward, threatening a short run decrease in GDP. The central bank could compensate this by increasing the money supply, shifting the AD curve to the right:

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

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

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11. Aggregate Demand I: Building the IS – LM Model The IS-LM model is the most widely accepted interpretation of Keynes' theory.

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

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

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

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

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

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

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

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From these multipliers we see that the short run effect of increasing government expenditures (or decreasing taxes) is to increase income by a larger amount than the increase. This is consistent with Keynes’ proposal that in times of recessions, the government should stimulate demand. There are many examples in history after WWII where governments have done precisely that. For example the Obama spending package tried to stimulate the economy in 2009. The Interest Rate, Investment, and the IS Curve. The second element of deriving the IS curve is investment. Investment is negatively related to the interest rate and also part of planned expenditures, so this means that an increase in the interest rate will shift the planned expenditures function downward, thereby decreasing income. The IS-curve is the curve that summarizes this relationship between the interest rate and income, through the effect of an increase/decrease in investment through the multiplier effect on income. This derivation is summarized here:

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

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

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

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

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11.3. Conclusion: The Short-Run Equilibrium The IS-LM model is the basic model of aggregate demand.

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

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IS: LM:

Y = C(Y-T) + I(r) + G M/P = L(r,Y)

(Goods market equilibrium) (Money market equilibrium)

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

12.1. Explaining Fluctuations With the IS –LM Model Fluctuations in the economy can be explained by shocks in the IS-LM model.

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

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The Effects of Monetary Policy The effect of monetary policy on the level of income happens through the so called monetary transmission mechanism: An increase in the money supply lowers the interest rate through the money market. This lower interest rate increases investment. In the ISLM model, this is summarized by a downward shift of the LM curve. The Interaction between Monetary and Fiscal Policy Monetary and fiscal policy both have effects on the interest rate and income. If the government or the central bank want to alter course, then it is sometimes desirable for the other party to coordinate so that income is stabilized.

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

12.2. IS–LM as a Theory of Aggregate Demand The IS-LM model is the most widely accepted interpretation of Keynes' theory of aggregate demand. ©StuDocu.com


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

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



IS: LM:

Y = C(Y-T) + I(r) + G M/P = L(r,Y)

(Goods market equilibrium) (Money market equilibrium)

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

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fixed at the production function, and prices are flexible: Y=Y

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

There are two main hypotheses on what the causes of the great depression were. The Spending Hypothesis: Shocks to the IS Curve According to this hypothesis, shocks to demand for goods and services were responsible. Allegedly, the stock market crash of 1929 caused a large downward shift in consumer spending (because people suddenly became less wealthy), and that the residential investment boom of the 1920’s suddenly stopped, both causing the IS curve to shift to the left. Because policymakers at the time were concerned with balancing the budget rather than stabilizing the business cycle, they further decreased government expenditure, causing a further shift of the IS curve to the left. The Money Hypothesis: A Shock to the LM Curve This hypothesis says that it was a fall in the money supply that caused the depression. They blame the Federal Reserve for letting the money supply drop by 25% through 1929 to 1933. Allegedly, however the channel through which this happened was not through the decrease in the supply of real money balances, because there was a period of deflation as well. Through what is called the Pigou effect, the effect that deflation causes real money balances to rise thereby increasing people’s wealth and their spending, some economists would expect the economy to restabilize. However there are two proposed theories for why the deflation would depress income rather than stabilize it. 



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

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

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13. The Open Economy Revisited: The Mundell–Fleming Model and the Exchange-Rate Regime The Mundell-Fleming model is the open economy version of the IS-LM model.

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

13.1. The Mundell–Fleming Model The Mundell Fleming model replaces the IS and LM curves with th e IS* and LM* curves.

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



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

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

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

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

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

13.2. The Small Open Economy Under Floating Exchange Rates Floating exchange rates are one of the two main exchange rate regimes.

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





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

13.3. The Small Open Economy Under Fixed Exchange Rates Fixed exchange rates are one of the two main exchange rat e regimes.

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

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

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

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

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13.4. Interest Rate Differentials There can be differences in interest rates among countries due to differences in country risk and expectations of exchange rate changes.

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

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

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

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Y = C(Y-T) + I(r* + θ) + G + NX(e) (M/P)d = L(r* + θ,Y)

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

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

The Mexican crisis of 1994-1995 and the Southeast Asian crises of 1997-1998 are clear examples of crises that started because of an increase in the risk premium.

13.5. Should Exchange Rates Be Floating or Fixed? A country must choose between floating or fixed exchange rates, and every country faces the dilemma of the impossible trinity.

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

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

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

Advantages of fixed exchange regimes and disadvantages of floating exchange regimes are: 

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A fixed exchange rate removes exchange-rate uncertainty, which helps international trade A fixed exchange regime disciplines a monetary authority so that it does not perform excessive inflationary policies

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

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

Benefits 

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No exchange rate risk No costs associated with exchanging currencies Political unification

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

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Free Capital Flows Independent monetary Policy Fixed Exchange Rate

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Every country must choose two of the three of these, and this is called the impossible trinity.

13.6. From the Short Run to the Long Run: The Mundell–Fleming Model With a Changing Price Level The Mundell-Fleming model can be used to show how we move fro m the short to long run.

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

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

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

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

14.1. The Basic Theory of Aggregate Supply There are two basic theories of aggregate supply but they come to similar conclusions.

In this subchapter, we explain two prominent theories that explain the shape of the Aggregate Supply curve. The Keynesian Aggregate Supply c urve was horizontal, assuming that prices do not alter supply of goods and services at all in the short run. In this chapter, this assumption is nuanced to an extent, so that the aggregate supply curve becomes upward sloping, which is in between the classical model and the Keynesian model. Both theories explained in this subchapter result in the aggregate supply equation of the following form, but in a different way: Y = Y + α(P – EP), α > 0 Where EP is expected inflation, and Y = F(K,L) . Sticky-Price Model The sticky-price model is the most widely accepted explanation for the upwardsloping nature of the SRAS curve, and entails that because prices are sticky. The model begins by assuming that firms have a desired price p = P + a(Y- Y) There are firms with sticky prices and firms with flexible prices. Firms with flexible prices simply set the desired price, but firms with sticky prices set their prices to what they expect: p = EP s is the fraction of firms with sticky prices and 1-s the fraction with flexible prices, so the price level is:

P = sEP + (1-s)(P+a(Y-Y) We rearrange this to: Y = Y + (s/((1-s)a))(P-EP) ©StuDocu.com


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

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

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

14.2. Inflation, Unemployment, and the Phillips Curve The Phillips curve gives the relation between inflation and unemployment in t he short run.

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


relation between inflation and unemployment. It is derived by combining the AS curve and Okun’s law (see chapter 10). Okun’s law can be written as follows: (1/α)(Y-Y) = -β(u-un) If we substitute this in the aggregate supply equation and add a variable v for a supply shock, we get the equation for the Philips curve: π = Eπ - β(u-un) + v

According to this equation, trying to decrease inflation in the short run will increase unemployment. Adaptive Expectations and Inflation Inertia In order to make the Philips curve useful for policymakers, we must know what determines expected inflation. One often used theory for this is the theory of adaptive expectations. The theory states that economic agents base their expectation of inflation on inflation levels in the past. The Philips curve now becomes: π = π-1 - β(u-un) + v

we see here that the rate of unemployment will be equal to its natural rate, if inflation stays the same. For this reason the natural rate of unemployment is also sometimes called the non-accelerating inflation rate of unemployment (NAIRU). Two causes of Rising and Falling Inflation There are two types of shocks that can cause inflation 

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Demand-pull inflation. Inflation caused by high aggregate demand. Cost-push inflation. Inflation caused by an adverse supply shock (v in the Philips curve)

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


is captured by the sacrifice ratio, the percentage of GDP that must be forgone to reduce inflation by 1 percentage point. Typical estimates range around 5% Rational Expectations and the Possibility of Painless Disinflation The previous analysis is based on the theory of adaptive expectations, that expected inflation is based on inflation in the past. However, some economists advocate rational expectations. The theory states that inflation expectations are based on people’s analyses of the determinants of inflation, including government policy. A conclusion of this theory is that if the government can make clear beforehand to people that they will decrease inflation, then expected inflation will decrease as well, so that there can be a decrease in inflation, without an increase in unemployment. Hysteresis and the Challenge to the Natural-Rate Hypothesis The chapters 10 to 14 have all been based on an assumption called the natural-rate hypothesis. This is the hypothesis that fluctuations in aggregate demand and supply only affect the short run levels of unemployment and output, and that in the long run they will move back to their natural rate, described by the classical model. However, this hypothesis is not uncontroversial. There is a different hypothesis that there i s a phenomenon called hysteresis, which refers to effects to the natural rate caused by short run fluctuations. In other words, an economic downturn not only changes income in the short run, but also in the long run by diminishing the natural rate of output or increasing the natural rate of unemployment. There are multiple possible channels for hysteresis: 

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

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

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

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

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

In the dynamic model, the variables are defined for each period, rather than just for their equilibrium. This means that all the variables have a subscript that denotes the period which that variable denotes. For example, Yt means income in period t. We first go through all the constituent elements of the model before we solve the model and determine the DAD and DAS curves. Output: The Demand for Goods and Services The demand for goods and services is given by: Yt = Yt – α(rt – ρ) + εt Where εt is some demand shock, such as a change in fiscal policy or a change in consumption demand due to a stock market boom, and where the constant ρ is the real interest rate for which aggregate demand is equal to natural output. The constant α is the sensitivity of investment demand and consumption demand to a change in the real interest rate. This equation is similar to the equation for the IS curve, but the variables of the income identity are simply written less explicitly. The Real Interest Rate: The Fisher Equation The real interest rate that we use in this model is the ex-ante real interest rate. This

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should not be controversial, since it is the ex-ante real interest rate that determines demand. We derive it from the fisher equation: rt = it – Etπt+1 Where Etπt+1 is the expectation in period t of the level of inflation in period t +1. Inflation: The Phillips Curve The supply curve in this dynamic model is derived from the Phillips curve. This form of the Phillips curve denotes the relation between inflation, output, and supply shocks: πt = Et-1πt + φ(Yt – Yt) + vt Where the constant φ is the extent to which inflation responds to a change in output away from its natural level, and where v t is any supply shock, such as one caused by a drought, or by an oil cartel. Expected Inflation: Adaptive Expectations In this model, we simply assume adaptive expectations of inflation (see chapter 14): Etπt+1 = πt The Nominal Interest Rate: The Monetary-Policy Rule One of the key differences between this model and the static model is that in this model, monetary policy is inserted more explicitly in the model itself. In the static model, a monetary expansion would be formulated as a shift in the AD curve to the right, but in this model we formulate an explicit monetary policy rule: a target for the interest rate for which the central bank then allows the money supply to change in order to achieve that interest rate. This interest rate is then inserted in the DAD curve, so that monetary policy influences the slope of the DAD curve, but does not move it. The monetary policy rule is a rule that sets the nominal interest rate as a response to the level of inflation: it = πt + ρ + θπ(πt – π*t) + θY(Yt – Yt) Where θπ is the sensitivity that the central bank gives to staying at the target inflation π*t, and θY is the sensitivity that the central bank gives to staying at the natural level of output. Note that the central bank is indirectly targeting the real interest rat e by including the current level of inflation in the first part of the equation. One assignment of values to θπ, and θY is done by the Taylor Rule, formulated by the economist John Taylor, who said to assign 0.5 to both.

The following table summarizes the equations in this model:

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15.2. Solving the Model By solving the model we derive the dynamic aggregate demand an d dynamic aggregate supply curves.

It follows from this model that the values in every time period t depend on the values of some variables in period t-1. Variables in period t-1 are already determined from the perspective of period t, they happened in the past), and so within period t, they are called predetermined variables . We can determine the DAD and DAS curves using this model, and determine the long run equilibrium and the short run equilibrium in each period. The Long-Run Equilibrium The long run equilibrium is reached when output is at its natural level, the real interest rate is at the rate which sets aggregate demand at natural output given no demand shocks, inflation is at the central bank’s target inflation and expected equals inflation, and when the nominal interest rate is at the natural real interest rate plus the target level of inflation. The Dynamic Aggregate Supply Curve To derive the aggregate demand curve, we simply substitute the equation for adaptive inflation expectations in the Phillips curve to find: πt = πt-1 + φ(Yt – Yt) + vt The Dynamic Aggregate Demand Curve To find the dynamic aggregate demand curve we take the equation for the demand for goods and services and we substitute the Fisher equation in, and in that equation we substitute the monetary policy rule and the equation for adaptive expectations. After simplifying, the DAD curve becomes: Yt = Yt – (αθπ/(1+ αθY))(πt – π*t) + (1/(1+ αθY))εt As hinted at before, the DAD curve is similar to the AD curve, but it has two essential differences: 



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

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

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

We can use the model to analyse long run growth, supply shocks, and demand shocks, in order to predict the movement of variables over time. Long Run Growth In order to see the effect of long run growth, we only have to increase the natural rate of output. If you do this, both the DAD and DAS curves shift to the right, so that inflation stays the same, and output rises. We conclude that this model predicts that stable long run economic growth with stable inflation is possible Aggregate Supply Shocks and Aggregate Demand Shocks An aggregate supply shock is formulated in this model as a change in vt if there is a negative supply shock of one period, inflation will rise and output will fall. However this will not immediately recover, as expected inflation will stick at the new level of inflation. It will take time for the policy of the central bank of higher interest rates to take inflation back at its original level. This example denotes a period of stagflation, a situation of low output and high inflation caused by a negative supply shock. The movements of all the endogenous values in this model ar e given here:

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A similar analysis can be done for a demand shock. A sequence of 5 periods of a demand shock is depicted here:

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

15.4. Two Applications: Lessons for Monetary Policy The two main lessons of the DAD-DAS model are the trade-off between output variability and inflation variability, and the Taylor principle.

We can use this model to conclude two lessons for monetary policy. The first has to do with the weight that the central bank puts on balancing output versus balancing inflation. The second has to do with the effect that inflation can spiral out of control if the central bank does not apply the right policies. Both have to do with the values that the central bank assigns to θπ and θY. The Trade-off Between Output Variability and Inflation Variability. The values of θπ and θY determine the slope of the DAD curve. This slope determines the effect that a supply shock has on inflation and output. If the weight on output is higher, then the effect on output of a supply shock will be balanced, but the effect on

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inflation less so. This trade-off is an unavoidable choice that the central bank must make. One example that shows this is that the Fed and the ECB (European Central Bank) have assigned different weights to them. The ECB is primarily focused on stabilizing inflation, whereas the Fed has a more balanced weight distribution. The Taylor Principle. Besides the trade-off between inflation stabilization and output stabilization there is also something called the Taylor Principle. This principle states that for inflation to be stable, the central bank must respond to a percentage change in inflation by increasing the nominal interest rate by higher than a percentage change. This can be shown by the DAD-DAS model, but it can also be explained intuitively: If inflation rises, and the nominal interest rate rises by exactly the same amount, then the real interest rate has remained the same. Because it is the real interest rate that determines demand, demand will not change as a result of the central bank’s policy. As a result, inflation will stay at a higher level. In order to stabilize it, the rise in the nominal interest rate must be higher than the rise in inflation. If the rise in the nominal interest rate is even lower than the rise in inflation, then inflation will spiral out of control. According to some economists, this is exactly what happened during the period of high inflation in the 1970’s.

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

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

16.1. John Maynard Keynes and the Consumption Function Keynes hypothesised three conjectures about the consumption function.

Since Keynes, the consumption function has been central in the macroeconomic debate. Keynes made three basic conjectures about consumption: 1. The marginal propensity to consume is between zero and one. 2. The ratio of consumption to income, the average propensity to consume, falls as income rises. 3. Income is the primary determinant of consumption; the interest rate does not play an important role. These three conjectures are the basis of the Keynesian consumption function used in this book: C = C + cY, C > 0 , 0 < c < 1 This consumption function captures the three Keynesian conjectures. These conjectures were tested using household surveys and at first were upheld. However there were two empirical tests that the theory did not withstand: 



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

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

16.2. Irving Fisher and Intertemporal Choice The model of intertemporal choice is the basis for two theories that try to solve Keynes' consumption puzzle.

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Irving Fisher developed a model to describe how rational individuals make intertemporal choices, choices about allocating goods over time. He assumed that consumers have an inter-temporal budget constraint, a budget that limits what they can spend during their lifetime. The consumer can choose how much he consumes today and how much he consumes tomorrow. If he wants to consume more tomorrow than he earns tomorrow, he will need to save. If he wants to consume more today than he earns today, he will need to borrow. Both are done for the interest rate. So we have: S = Y1 – C Where Y1 is income in period 1. He can consume in period 2 the amount that he earns in period 2 plus what he saves plus interest: C2 = (1+r)S + Y2, which can be written as C2 = (1+r)(Y1 – C) + Y2 We can rewrite this to find the inter-temporal budget constraint: C1 + C2/(1+r) = Y1 + Y2/(1+r) You see that the income and consumption done in period 2 is divided by the factor for the interest rate. This is because a dollar today is worth more than a dollar in the future, since a dollar today, if invested in a bond, will give 1+ r dollars in the future. This process is called discounting. This gives the following budget constraint:

Consumer Preferences Consumer preferences can be represented by indifference curves , curves that show the set of allocations between the amounts of two goods for which the consumer is indifferent (If you don’t understand this, see a microeconomics textbook for a full explanation). The slope along an indifference curve is the marginal rate of substitution. A rational consumer will chose the allocation of current consumption and future consumption such that the slope of the inter-temporal budget constraint is equal to the marginal rate of substitution, as shown here:

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Choosing the optimal consumption given the consumer’s indifference curves is called optimization. We can formulate a change in income as a shift of the inter-temporal budget constraint away from the origin. In this case, as you can see from the graph, both consumption in period 1 and consumption in period 2 increases. A good that is consumed more when income increases is called a normal good. The key insight gained from this model is that both goods are normal goods, and therefore consumption smoothing occurs. This means that an increase in income, whether it is in period 1 or in period 2, will increase consumption in both periods. How Changes in the Real Interest Rate Affect Consumption The real interest rate determines the relative cost of period 1 consumption and period 2 consumption, and it determines the discount rate of period 2 income. This means that a rise in the interest rate will make consumption in period 2 less expensive, and make income in period 2 less valuable. This means that we can analyse the effect of a change in the interest rate into two effects: 



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

So we conclude from this that depending on the relative sizes of the income and substitution effects, a change in the interest rate will either depress or stimulate saving. Constraints on borrowing An element that will not be studied in depth here is the notion of borrowing constraints. The most extreme form of borrowing constraint is a complete impossibility of borrowing. This effectively means that period 1 consumption cannot

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be higher than period 2 consumption. For these type of consumers that want to borrow but cannot, consumption is only determined by income.

16.3. Franco Modigliani and the Life-Cycle Hypothesis the Life-Cycle hypothesis is a possible solution to Keynes' consumption puzzle.

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

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Precautionary saving. They want to save money as a precaution in case they get older than expected, or in case of unexpected (healthcare) expenses. They want to leave wealth to their children.

16.4. Milton Friedman and the Permanent-Income Hypothesis The Permanent-Income Hypothesis is a possible solution to Keynes' consumption puzzle. We now turn to Milton Friedman’s permanent-income hypothesis. This hypothesis suggests that we can view income as consisting of two components: permanent income Yp, the part of income that people expect to persist in the future, and transitory income YT, the income that people expect to be specific to a certain period, i.e. not to persist. Y = YP + YT An example of a change in permanent income is if you get an unexpected job promotion which you think will persist during your career. An example of a change in transitory income is a onetime lottery prize. Friedman thought that people want consumption smoothing, and therefore do not let increases in transitory income affect their current consumption very much. Rather, they would spread it out over their life ©StuDocu.com


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

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

16.6. David Laibson and the Pull of Instant Gratification Behavioural economists have criticized the rational-choice based theories of consumption on a number of grounds.

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

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

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

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

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

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

The determinants of these three types of investment differ, so to fully understand total investment, we must analyse them separately, which we do in this chapter in that order.

17.1. Business Fixed Investment The neoclassical model of investment is a model that explains business fixed investment from the costs and benefits of investing in capital goods.

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

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

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

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

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

These combine to determine the cost of capital: Cost of capital = iPK – ΔPK + δPK By assuming that the price of the capital good rises with the price of other goods (inflation), we can write it as a function of the real rather than nominal interest rate. We then rewrite it as the real cost of capital, the cost of capital measured in a unit of the economy’s output. Real Cost of Capital = (P K/P)(r + δ) The Determinants of Investment Rental firms can decide to buy new capital goods or not. They do this if it is profitable to do so. Because we earlier derived the relation between the real rental price and the marginal product of capital for which production firms want to rent capital, we can substitute this to find the profit rate of rental firms: Profit Rate = MPK - (PK/P)(r + δ) If the profit rate is positive given a level of capital stock, then rental firms will want to increase the capital stock. We now have the relation between the incentive to invest (profit rate) and the increase in the capital stock given by the net investment function In(): ΔK = In(MPK - (PK/P)(r + δ)) We now also see that the theoretical separation between rental and production firms is not necessary, since we only use the cost of capital and the marginal product of capital. Both can be associated solely with production firms. We now find the investment function, which is the net investment function adjusted for depreciation (since the depreciated capital goods also need to be replaced): I = In + δK We now see why a lower interest rate increases investment: it decreases the cost of capital. We can also find the steady state level of the capital stock by setting profit to zero, which is equivalent to setting revenue equal to cost of capital: MPK = (PK/P)(r + δ) Taxes and Investment Two examples of taxes that are important for investment are:

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

The Stock Market and Tobin’s q A stock is a share in the ownership of a firm, and the stock market is the market of such shares. Tobin’s q is defines as follows:

q = Market Value of Installed Capital / Replacement Cost of Installed Capital It gives information about whether investment is profitable. If q >1 then investment is profitable, but if q<1, it is not. This is similar to the neoclassical model, because the stock market value is a representation of profitability (MPK), and the replacement cost of capital is similar to the cost of capital. Tobin’s q effectively measures the same thing. An advantage of Tobin’s q is that the stock market value is easily measurable, and is therefore often used as an economic indicator that predicts investment fluctuations. Alternative Views of the Stock Market There is a debate among economists about whether stock market fluctuations are rational. There are roughly two positions: 

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

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

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17.2. Residential Investment Residential investment is investment in increasing the stock of hous es. The Stock Equilibrium and the Flow Supply In order to understand residential investment a model has been developed that contains two elements: 

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

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

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

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

There are four reasons for inventory investments: 

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

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

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

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

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

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

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

18.1. Should Policy Be Active or Passive? There is a debate over whether the government should try to actively stabilize the economy in response to exogenous shocks.

We have assumed throughout chapters 10 and 14 that it is possible for the government to respond to shocks to the economy, so that if there i.e. a supply shock, the government should stabilize the shock with fiscal and/or monetary policy. This idea is a relatively recent idea that started to gain support after the great depression. However not all economists agree that this should be done, and we address some of their arguments here. Lags in the Implementation and Effects of Policies Some economists argue that stabilization policy is not feasible because there are time lags associated with these policies, so that stabilization policy will be too slow to respond to be effective. There are two types of time lag associated with stabilization policy:

1. Inside lag. This is the time it takes between the exogenous shock to the economy and the response of the government to enact stabilization policies. 2. Outside lag. This is the time it takes for the policy to take effect in the economy. Monetary policy has much shorter inside lag than fiscal policy, at least in the U.S. and Europe, because the government needs to first pass the policy decision through the legislature, and go through the political process, whereas the central bank can decide to change the interest rate/money supply overnight. However, monetary policy does have an outside lag of about half a year, because it takes time for firms to respond to the interest rate change by writing new contracts and setting up new projects. There are however certain policies, called automatic stabilizers, that don’t require an explicit policy change by the government, but stimulate or depress the economy ©StuDocu.com


automatically in case of a shock. For example, the income tax system automatically reduces taxes in a depression because incomes go down. The Difficult Job of Economic Forecasting Because of the time lags associated with stabilization policies, it is required to forecast the economy in order to respond to shocks in time. However, economic forecasting is incredibly difficult, so one argument against stabilization policy is that the government should not even try to do it, because it will only do more harm than good. Ignorance, Expectations, and the Lucas Critique The economist Robert Lucas formulated what came to be known as the Lucas critique. The critique is that the models developed in this book make the wrong predictions about the effects of stabilization policy because they do not take into account the change in expectations that are the result of these policies. If a policy tries to stabilize a shock, but people see this policy coming, their expectations will change such as to reduce the effect of the policy. Some economists conclude from this critique that policy evaluation is too hard to really make stabilization policy effective. The Historical Record Apart from theoretical arguments about the effectiveness of stabilization policy, economists have also looked at the effectiveness of specific stabilization policies in history. However the historical record is not perfectly clear on this, because it is often too difficult to determine the cause of a recession.

18.2. Should Policy Be Conducted by Rule or by Discretion? A second debate topic on stabilization policy is about the question whether policy should be conducted by rules that are stated beforehand, or whether the policy should be left to the discretion of policymakers.

There are multiple aspects to this debate which we will go through step by step. Distrust of Policymakers and the Political Process One question related to this debate is whether policymakers can be ‘trusted’ with the discretion of choosing policies at their will, rather than by rule. There are generally two arguments why they should not be: 

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

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

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

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

All three of these policy rules target nominal variables. This is because it is hard to measure the true real variable of something and hard to measure for example the natural rate of unemployment, even though real variables are more indicative of actual economic performance. There are two further institutional observations to be made about the practice of monetary policy.

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

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

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

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

19.1. The Size of the Government Debt The government debt increases in periods where the government is running a deficit, and decreases when it is running a surplus.

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

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

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

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

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Before we move on to the theories of debt, we address four problems in measuring government debt. This is because some economists think that the way government debt is currently measured does not reflect the extent to which burdens are shifted to the future or the effect of the debt on the economy. 1. Inflation. This is not a very controversial measurement problem, and it entails that the nominal level of government debt should be adjusted each year by inflation to find the real level of debt. This means that if the real level of government debt is stable, the nominal level should be rising by the rate of inflation: ΔD = πD. 2. Capital Assets. The government does not just expend money for current use, but it also expends money to purchase capital goods/assets. Therefore some economists propose that the government uses capital budgeting, a procedure that takes into account these assets as well. This means that if the government purchases a capital good, this will be subtracted from the net level of debt 3. Uncounted Liabilities. Some economists argue that the level of debt is misleading the way it is currently measured because it does not take into account certain liabilities. For example the pensions of government workers will have to be paid to them in the future, and therefore are just like debt, but they are not counted as such. 4. The Business Cycle . Due to automatic stabilizers addressed in chapter 18, the budget deficit automatically rises during recessions and decreases during booms. This is not an unrealistic representation of the deficit, because this deficit cycle actually occurs, but it nevertheless does not represent policy changes in the budget deficit. Therefore some economists propose to calculate a cyclically adjusted budget deficit that is based on estimates of what government spending and tax revenue would be if the level of output would be at its natural level.

Few economists deny the existence of these four measurement problems, but not everyone agrees on how severe the problems are.

19.3. The Traditional View of Government Debt The traditional view of government debt can be deduced from the models introduced in this book.

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

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

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

19.4. The Ricardian View of Government Debt The traditional view of debt is criticized by the Ricardian view.

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

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Myopia. This basically means that people are short-sighted and do not fully

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

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The debate about the validity of the Ricardian view versus the traditional view is ongoing. At this point there is evidence to support both theories.

19.5. Other Perspectives on Government Debt With the two theories in mind, we address some debates about government debt. Balanced Budgets Versus Optimal Fiscal Policy On the one hand, we would like to run a balanced budget and not have any government debt, but on the other hand there are three reasons why we would want to have deficits and surpluses: 

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Stabilization. The argument for stabilization is clear from chapters 10 to 14. Tax smoothing . Besides stabilizing output, budget deficits and surpluses can also

be used to smooth taxes so that people don’t have large fluctuations in their disposable income due to the business cycle Intergenerational Redistribution. A budget deficit causes a shift in the tax burden from current to future generations. For example, if the current generation fights a war. It is only fair that future generations share some of the burden of that war.

Fiscal Effects on Monetary Policy some economists argue that if the government has a large public debt, the monetary authority may try to decrease it by stimulating inflation, thereby decreasing the real public debt. However in practice this does not happen in developed countries, because central banks are relatively independent, and the fiscal authority knows that inflation is not a very good solution to fiscal problems. Debt and the Political Process some economists think that the possibility of public debt worsens the political process. They argue that debt is a way to move the negative effects of their policies to future politicians, so that a true cost-benefit analysis is not done. This has caused some economists to argue for a constitutional balanced-budget clause, so that politicians are forced to bear both the costs and benefits of their policies. Others oppose this because it makes stabilization harder, or because it is impractical. International Dimensions the budget deficit and the level of government debt does not just affect the domestic economy, but also the relation of the economy to foreign economies. The budget deficit is namely also related to the trade deficit, which has to effects:

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

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

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

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

20.1. What Does the Financial System Do? The financial system has a number of key functions in the economy.

The financial system is a broad term that refers to all the institutions and mechanisms that channel the loanable funds of savers to the borrowers that need them to invest. Financing Investment there is a large variety of mechanisms used to channel funds from savers to borrowers, and this is one of the most important functions of the financial system. 

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

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

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

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Systemic risk . These are risks that affect the income of all firms. For example, an

economic recession hurts all firms, not just a specific one. This risk cannot be removed by diversification. Idiosyncratic risk . This is risk that is specific to one firm, such as the risk of the CEO dying in a plane crash. This risk can be removed with diversification.

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

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

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


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

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

Chapters 10 to 14 described short run fluctuations by showing the effects of an ‘exogenous shock’. Such an exogenous shock can take many forms. One type of shock is a financial crisis, a major disruption in the financial system making the process of moving funds from savers to borrowers less efficient. We first look at how a financial crisis works, then at possible responses by policymakers, and finally what can be done to prevent them. The Anatomy of a Crisis not all crises are exactly alike, but they all roughly follow the same pattern:

1. Asset-price Booms and Busts. First, there is often a speculative bubble in the financial markets, an increase in the market price of a financial asset that doesn’t represent its underlying value. At some point investors see that the market value is too high for the underlying value, so they sell the asset and the bubble ‘pops’. 2. Insolvencies at Financial Institutions. Financial institutions hold such assets on their balance sheets, so when the bubble pops, they suddenly have fewer assets than before. Because financial firms often use leverage, borrowing funds to finance investment (discussed in chapter 4), they may suddenly have more debt than assets, causing them to go bankrupt. 3. Falling Confidence. Because financial institutions now suddenly are heavily indebted, investors lose confidence in them and take out their capital. This forces banks and other institutions to stop lending and sell assets. Because they are forced to sell these assets, this drives down their price, and they sell them at lower than value. This is called a fire sale. 4. Credit Crunch. Because many financial institutions fail or heavily hold back on lending, borrowers find it difficult to obtain investment funds even though they have profitable investment opportunities, and investment spending is contracted.

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

Policy Responses to a Crisis There are three broad categories of policy responses 

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Conventional Monetary and Fiscal Policy . Because one result of a financial crisis

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

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

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

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

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Summary Macroeconomics n Gregory Mankiw

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