Macroeconomics A European Perspective, 4th edition By Olivier Blanchard Solution Manual by Ace Test Banks

Instructor’s Manual Macroeconomics Fourth edition

Olivier Blanchard Alessia Amighini Francesco Giavazzi

Contents 1: A Tour of the World

2: A Tour of the Book

3: The Goods Market

4: Financial Markets: I

5: Goods and Financial Markets: The IS-LM Model

6: Financial Markets II: The Extended IS-LM Model

7: The Labor Market

8: The Phillips Curve, the Natural Rate of Unemployment, and Inflation

9: From the Short to the Medium Run: The IS-LM-PC Model

10: The Covid Economic Crisis

11: The Facts of Growth

12: Saving, Capital Accumulation, and Output

13: Technological Progress and Growth

14: The Challenges of Growth

15: Financial Markets and Expectations

16: Expectations, Consumption, and Investment

17: Expectations, Output, and Policy

18: Openness in Goods and Financial Markets

19: The Goods Market in an Open Economy

20: Output, the Interest Rate, and the Exchange Rate

21: Exchange Rate Regimes

22: Should Policymakers be Restrained?

23: Fiscal Policy: A Summing Up

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24: Monetary Policy: A Summing Up

107

25: Epilogue: The Story of Macroeconomics

111

Answers to End-of-Chapter Problems

115

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CHAPTER 1. A TOUR OF THE WORLD I.

MOTIVATING QUESTION

What is macroeconomics? The chapter does not provide an explicit or formal answer. Instead, it takes you on an economic tour of the world. At the beginning of 2020, the world population was hit by a serious pandemic caused by COVID-19, a new coronavirus that forced entire countries into quarantine and stopped production in many sectors. The world economy had just been hit by a disastrous economic crisis in 2008, the deepest since the Great Depression in 1929. World output growth, which typically runs at 4–5% a year, was negative in 2009. Since then, growth has turned positive, and the world economy has largely recovered. But the crisis, now known as the Great Financial Crisis, has left several scars, and some worries remain. Today, however, the pandemic will cause an even deeper recession. The chapter also provides an overview of the three main economic powers of the world: the United States, the Euro area, and China. The chapter concludes with a list of other regions of the world and macroeconomic issues of growing importance. A working definition of macroeconomics at this point is the study of output, unemployment, and inflation, terms that will be defined precisely in Chapter 2.

II.

WHY THE ANSWER MATTERS

This chapter attempts to provide students an incentive to master the theoretical material that follows in the remainder of the text. The implicit promise is that the theoretical model developed in the text will allow students to make sense of the various macroeconomic issues that continue to impact countries around the world.

III. KEY TOOLS, CONCEPTS, AND ASSUMPTIONS 1.

Tools and Concepts

Chapter 1 does not provide any analytical tools. However, it does force students to confront some basic data and introduces data sources for various regions of the world. In addition, the chapter introduces and defines the concepts of output, growth, the unemployment rate, and the inflation rate. A more precise definition of these terms follows in Chapter 2. Chapter 1 mentions in passing the terms standard of living, productivity, and purchasing power parity. All of these terms and concepts will be explored in later chapters in the text.

Assumptions

Implicit in the Tour of the World is the assumption that the same basic macroeconomic tools can be used to analyze economies throughout the world. It might be worth making this point explicitly. The macroeconomic framework developed in the text would be neither terribly useful, nor compelling as a theory, if it applied only to the United States, and not to the other market economies.

IV. SUMMARY OF THE MATERIAL 1.

The Pandemic of 2020

A serious recession begun in the world in 2020, with few precedents in history. In just four months, the pandemic caused by the COVID-19 virus spread from the Chinese city of Wuhan throughout the world. This is an event that will mark this century, as last century was marked by the 1-1 .

‘Spanish’ flu of 1918, a virus that caused more deaths than the First World War. Recessions caused by a pandemic are different. They are not produced by any imbalance in the economy, but rather by an exogenous and unexpected shock, the diffusion of a virus. This shock affects the economy in three ways. First, by breaking the production chains. Second, to slow the spread of the virus, most countries have chosen to limit the mobility of people and many – all those who cannot work remotely – have stopped working, as vividly shown in Figure 1.2. Intermediate goods and workers, as we shall see in the next chapters, are essential factors of production, without which companies cannot produce. Their disappearance has therefore represented a ‘supply shock’, i.e. a shock that has limited production (more on this in Chapter 9). There is a third factor: the closure of factories and shops, and the associated fall in family incomes – since not all workers receive unemployment benefits – has caused a sudden slowdown in consumption. The “supply shock’ has therefore been accompanied by a ‘demand shock’, that is a fall in consumption.

The Crisis

Included in the 8th edition of the textbook is a discussion around the major macroeconomic crisis that occurred in 2008. Figure 1-7 outlines the output growth rates for the world economy, the advanced economics and for the other countries separately since 2000. From 2000 to 2007 the world economy had a sustained expansion. Annual average world output growth was 4.5%, with advanced economies growing at 2.7% per year, and emerging and developing economies growing at an even faster 6.6% per year. By 2008, the world, advanced and emerging economy output growth rate began to decline marking the beginning of the macroeconomic crisis. In 2010, growth in advanced economies turned positive and has remained positive as of 2019. Highlights of the Macroeconomic Crisis: • • • •

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•

• •

U.S. housing prices, which had doubled since 2000, started to decline in 2007. A number of mortgage loans originated during the earlier expansion were to high-risk borrowers which were increasingly unable to make mortgage payments. Declining housing prices caused the mortgages to exceed the market value of the homes thus creating an incentive to default. Banks that originated the loans often bundled, packaged and repackaged the loans into new securities and then sold them to other banks and investors. The holdings of securities, instead of mortgages by banks, added complexity that made it impossible to appraise the value of these derivative financial obligations. The complexity of the value of the securities and the quality of the assets made banks reluctant to lend to each other. September 15, 2008, a major bank, Lehman Brothers, went bankrupt creating borrowing issues and asset valuation problems for other banks. Within weeks the whole financial system was in jeopardy. Figure 1-2 shows how the financial crisis became an economic crisis with the collapse of stock prices indicated in the three stock price indexes (for the United States, Euro area and emerging economies). By the end of 2008, stocks had lost half or more of their value from the previous peak. The decline in housing prices and the collapse in stock prices lead to a decline in consumption of goods and services. Businesses’ concerns over sales and continuous decline in housing prices caused a sharp reduction in investment along with a decline in the building of new homes.

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•

• •

Despite strong actions by the Fed, including a cut in interest rates, and the U.S. government which cut taxes and increased government spending, both demand and output continued to decline in the U.S. A decline in the U.S. imports along with U.S. banks needing to repatriate funds from other countries moved a U.S. crisis into a world crisis. By 2009, average growth in advanced economies was −3.4%, by far the lowest annual growth rate since the Great Depression. Growth in emerging and developing economies remained positive but was 3.5 percentage points lower than the 2000–2007 average. Table 1-1, shows by 2018, economic growth in the U.S. was positive but still not at pre-crisis levels. Tables 1-1 and 1-2 show consistently high unemployment rates for the United States and Euro area since the beginning of the crisis. However, U.S. unemployment rates improved dramatically and are down to 3.7% as of 2018.

The United States

The recovery from the financial crisis started in the United States in June 2009. Since then, output growth had been positive until the COVID-19 pandemic broke and growth abruptly turned negative. In the United States, the 1990–2007 average rate of growth of the economy was 3.0%. In contrast the rate of growth during the crisis (2008–2009) was −1.3%. However, by 2018 the U.S. economy was growing at an annual rate of 2.9%. Beginning in June 2009, the U.S. economy continued to expand and is currently in the longest expansion on record. U.S. unemployment rates increased from a pre-crisis average of 5.4% to an average of 6.8% over the period 2010–2017. However, by 2018 the U.S. unemployment rate was down to 3.7% as firms began to add employees. One of the primary economic issues facing the U.S. is the current Federal Reserve policy of extremely low interest rates which have been necessary to propel growth. Figure 1-10 shows the federal funds rates from 2000–2019 which highlights this policy. Until the end of 2015, the Fed remained near the zero interest rate bound and it was not possible to lower rates much to stimulate growth if deemed necessary. However, by early 2019, the rate was up to 2.4%. This rate is still low by historical standards and continues to limit the Fed’s ability to respond to another recession. The low rates also push investors to take excessive risks in search of higher returns. Another macroeconomic issue is the low productivity in the U.S. Table 1-2 shows that productivity growth is significantly lower in all sectors of the economy relative to the 1990s. Slow productivity growth can decrease the real earnings power of workers and lead to an increase in income inequality. Since 2000, the real earnings of workers with a high school education or less have decreased. Policy makers need to change this trend and one mechanism to accomplish this goal is higher productivity growth.

The Euro Area

Figure 1-12 displays a map the EU17 that uses the Euro as a common currency along with the 2018 output of the Euro area’s output for the countries of France, Germany, Italy and Spain. Table 1-3 shows that over the 1990–2007 time period right before the crisis, the Euro Area together experienced positive but relatively low growth. The Euro Area also experienced low inflation and continued high unemployment. The crisis caused growth to decline to negative 2.0% over the 2008–2009 period while the unemployment rate averaged 10.6% over the 2010–2017 time period. Some Euro Area countries, such as Greece and Spain, continue to struggle with unemployment rates exceeding 15%, even in 2018.

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The issues facing the Euro area are: • •

How to reduce unemployment. How to function effectively as a common currency area.

How to reduce unemployment The debate over remedies for high unemployment in Europe is characterized by two polar views. According to the first view, high unemployment is the result of the financial crisis and the sudden collapse in demand. The suggested remedy is to allow demand to recover on its own and reduce the unemployment rate. According to the second view, high unemployment is a result of rigid labor market institutions, particularly with respect to worker protection such as generous unemployment insurance policies that reduce the incentive to find work. Thus, the suggested remedy is to restructure labor market institutions—in fact to model them after the institutions in the United States. The United Kingdom has followed this approach, evidently with some success in reducing the unemployment rate. Some economists, however, remain skeptical that the U.K.’s approach is the right model for Europe. These economists point out that low unemployment rates occur in many European countries that provide generous social insurance for workers. The way forward, the skeptics argue, is to study the details of worker protection policies in places where such policies have been consistent with low unemployment, and to apply the lessons to other European economies. How to function effectively as a common currency area The Euro offers political and economic benefits. Politically, the adoption of a single currency provides a strong symbol of European unification after the wars of the 20th century and before. Economically, the Euro has eliminated exchange rate uncertainty among participating countries, and thus may facilitate trade and contribute to the economic development of Europe as, perhaps, the largest economic power in the world. On the other hand, the adoption of a single currency has eliminated the discretion of each country individually to use monetary policy to stimulate output and reduce unemployment. Countries that participate in the Euro have a common monetary policy, in the same way that states in the United States have a common monetary policy. This situation creates the possibility of policy conflicts when some countries are in recession and others are in an economic boom. The chapter points to the recent policy conflicts among Euro members. Highlighting the issue are deep recessions of countries including Italy, Ireland, Portugal, and Greece, that are unable to individually decrease their interest rates, or depreciate their currency. These problems have prompted some economists argue that they should drop out of the Euro. Others argue that such an exit would be both unwise, as it would give up on the other advantages of being in the Euro, is extremely disruptive, and could lead to even deeper problems for the country that exits. In a referendum held on 23 June 2016, Great Britain voted in favour of exiting from the European Union, the so-called Brexit. Until December 2020, the UK remained in a ‘transition period’ during which London continued to apply European regulations and pay its share of contributions to the EU budget. During the same period, the UK and the EU have negotiated a treaty that defined their relationship after December 2020.

China

China’s economy commands the attention of macroeconomists because of its exceptional growth over the last three decades. Since 1980, China’s output has grown at roughly 10% a year. Table 1-4 shows that the 2008–09 crisis has had little effect on the Chinese economy. While, Chinese exports slowed down during the crisis it was nearly fully offset by a major fiscal expansion by the Chinese government. The result was sustained growth of demand and, in turn, of output. However, China’s economic growth rate is falling and was only 6.6% in 2018.

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Although official Chinese statistics are not as accurate as in richer countries, research suggests that there is no clear bias in the numbers. In other words, high growth in China is a fact, and not an artifact of poor statistics. China has achieved high growth through rapid accumulation of capital (investment rates exceeding of output) and fast technological progress. The latter achievement is in part a result of the Chinese government’s strategy of encouraging foreign firms—which are typically more productive than Chinese firms—to produce in China. The government has also encouraged joint ventures between foreign and Chinese firms. Such joint ventures allow Chinese firms to learn from more productive foreign firms. Although China’s success seems to provide a model for other developing countries to follow, questions remain about the operational lessons to draw from China’s experience. In most other cases, the transition from central planning to a market economy has been accompanied by a large decline in output. Some argue that the slow pace of China’s transition—thirty years and still incomplete—was an important factor in China’s success. Others argue that the political control of the Communist party during the transition has enabled better protection of property rights for firms, thereby creating incentives for investment.

V. PEDAGOGY 1.

Points of Clarification

Chapter 1 mentions in passing that an annual growth rate of 10% means output will double in about 7 years. The “rule of 70” tells us how long it takes for an amount to double in value so instructors may wish to mention it here. Also, the text does not use logarithms, although it does use graphs on logarithmic scales. Instructors who wish to use logarithms in the course can use the rule of 70 as a way to reacquaint students with the use of the natural logarithm.

Alternative Sequencing

The 2020 Pandemic Crisis. Indeed, instructors could use the Covid crisis as the running example to introduce most the material. The 8th Edition features a streamlined organization where an early and continuous examination of the global crisis provides an integrated framework to think about the short, medium run, and long run. Output, the Unemployment Rate, and the Inflation Rate. Output, the unemployment rate, and the inflation rate are not defined precisely until Chapter 2. Some instructors may prefer to cover the definitions from Chapter 2, and possibly the discussion of why macroeconomists care about these variables, before discussing the material in this chapter.

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Enlivening the Lecture

An alternative to posing the motivating question of this chapter is to ask students what they hope to learn from the course. The answers can be used to construct a description of what the course—and macroeconomics—is about. Another alternative is to begin a lecture on this chapter (and the course) by asking what the Federal Reserve should do with regard to interest rates. Students should develop alternative opinions based on illustrative newspaper quotes or student answers.

VI. EXTENSIONS 1.

The Rest of the World

The Tour of the World presented in this chapter focuses attention on the United States, Europe, and China. Economic events in other regions are discussed only briefly at the end of the chapter. Current economic events in some of these regions are discussed at various places throughout the text. However, instructors may wish to devote more time to these regions at the outset, especially if the course will consider the open 1-5 .

economy. Looking Ahead, section 1-6, contains a number of other important macroeconomic issues that you may want to discuss in class.

Positive and Normative Economics, Policy Disagreements, and Methodology

Instructors may wish to distinguish between positive and normative economics and to discuss how normative perspectives can lead economists to different policy prescriptions even when they agree on the facts. Instructors may also wish to remind students of the difficulties that economists and other social scientists face because of the inability to conduct controlled experiments. A discussion of this sort was presented in Chapter 1 of the first edition of the text.

Distribution of Economic Benefits

The second edition of the text included a discussion about income inequality in the section on the U.S. economy. In subsequent editions, including the current edition, income inequality is discussed in Chapter 14. Instructors may wish to raise this issue in the introductory discussion of the U.S. economy. It may be beneficial to point out that higher productivity growth is one way to address income inequality.

VII. APPENDICES Appendix 1: Where to find the numbers? This appendix provides numerous sources of economic data on the Internet. Economic growth, inflation rates, unemployment rates and countless other macroeconomic and microeconomic data are available for almost every nation. Examples include FRED, OECD stat, and the World Economic Outlook Database.

Appendix 2: What do macroeconomists do? Some of the students may wonder what they can do with a degree in economics. Those earning an undergraduate degree will probably work in the private sector helping the organization assess the economic situation. If you want a job at the IMF or World Bank you will probably have to get a Ph.D. The same holds true for jobs in higher education.

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CHAPTER 2. A TOUR OF THE BOOK I.

MOTIVATING QUESTIONS

How do economists define output, the unemployment rate, and the inflation rate, and why do economists care about these variables?

Output and the unemployment rate are defined in the usual fashion; output as the GDP and the unemployment rate as the percentage of the labor force not working. The text defines the inflation rate in two ways: the percentage change in the GDP deflator and the percentage change in the CPI. The link between output and the standard of living is implicit in the chapter. Economists care about the unemployment rate because the unemployed suffer, particularly if they remain unemployed for long periods of time, and because the unemployment rate provides an indicator of whether the economy is growing too fast or too slowly (concepts that will be defined precisely later in the book). Inflation has three main effects: it redistributes real income away from those who receive fixed nominal income, it distorts relative prices to the extent that some nominal variables do not adjust, and it creates uncertainty about relative price levels.

What factors affect output in the short run, the medium run, and long run?

This chapter introduces the basic framework of the book in terms of time. In the short run (a time frame of a few years), output is determined primarily by demand. In the medium run (a time frame of a decade or so), output is determined by the level of technology and the size of capital stock, both of which are more or less fixed. In the long run (a time frame of a half century or more), output is determined by technological progress and capital accumulation.

II.

WHY THE ANSWERS MATTER

Students need a formal definition of the basic macroeconomic variables before they can analyze them. The discussion in this chapter provides enough information for students to begin looking at macroeconomic data. Moreover, some discussion of why economists care about these variables, particularly inflation, is useful to orient students.

III. KEY TOOLS, CONCEPTS, AND ASSUMPTIONS 1.

Tools and Concepts

i. ii.

Chapter 2 introduces index numbers. The chapter defines formally the basic macroeconomic concepts of nominal and real gross domestic product (GDP), GDP growth, the GDP deflator, the unemployment rate, the consumer price index (CPI), and the inflation rate, as well as associated concepts such as valued added, intermediate inputs, the labor force, and the participation rate. All of these concepts are defined in the usual manner. The chapter distinguishes the short run, the medium run, and the long run in the manner described above in Part I. The distinction establishes the basic theoretical framework for the book.

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IV. SUMMARY OF THE MATERIAL 1.

Aggregate Output

The text considers a closed economy until Chapter 18, so output is equated with gross domestic product (GDP). Output has three equivalent definitions: (1) the value of final goods and services produced during 2-7 .

a given period, (2) the sum of value added during a given period, and (3) the sum of labor and capital income and indirect taxes. Using the first definition, nominal GDP is output valued at current prices. Real GDP is output valued at constant prices. If the economy produced only one good—say, SUVs—and this good were unchanged over time, one could measure real GDP by simply counting the number of SUVs produced each year. Alternatively, one could multiply the number of SUVs by some constant price—say, the price in some base year. Thus, in the base year, real and nominal GDP would be the same. In practice, the construction of real GDP involves two complications. First, since the economy produces many goods, one must decide how to weight the value of the output of each good to produce aggregate real GDP. The text notes that the United States has adopted a technique—chain weighting—that allows the relative price of goods to change over time. The appendix to Chapter 2 discusses the construction of GDP and chained indexes in more detail. Second, the quality of similar goods changes over time. Economists who construct GDP try to account for quality change in goods through hedonic pricing, an econometric technique that estimates the market value of a good’s characteristics—speed, durability, and so on. The growth rate of real (nominal) GDP is the rate of change of real (nominal) GDP. Periods of positive GDP growth are called expansions; periods of negative growth, recessions.

The Unemployment Rate

An unemployed person is someone who does not have a job, but is looking for one. The labor force is the sum of those who have jobs—the employed—and the unemployed. The unemployment rate is the ratio of unemployed persons to the labor force. Those persons of working age who do not have a job and are not looking for one are classified as out of the labor force. The participation rate is the ratio of the labor force to the size of the working age population. Economists care about unemployment for two reasons. First, the unemployed suffer. Exactly how much depends on a number of factors, including the generosity of unemployment benefits and the duration of unemployment. In the United States, the average duration of unemployment is relatively low, but some groups (e.g., ethnic minorities, the young, and the less skilled) tend to be more susceptible to unemployment and to remain unemployed much longer than average. Second, the unemployment rate helps policymakers assess how well the economy is utilizing its resources. A high rate of unemployment rate means that labor resources are idle. A low rate of unemployment can also be a problem, if the economy develops labor shortages. A more precise discussion of what constitutes an unemployment rate that is too high or too low is offered later in the book.

The Inflation Rate

The inflation rate is the growth rate of the aggregate price level. Since there are many goods produced and consumed in an economy, constructing the aggregate price level is not trivial. Macroeconomists use two primary measures of the aggregate price level. The first, the GDP deflator, is the ratio of nominal to real GDP. Since nominal and real GDP differ only because prices in any given year differ from the base year, the GDP deflator provides some measure of the average price level in the economy, relative to the base year. By construction, the GDP deflator equals one in the base year. Since the choice of base year is arbitrary, the level of the GDP deflator is meaningless. The rate of change of the GDP deflator, however, is meaningful; it is one measure of inflation. Measures with arbitrary levels but well-defined rates of change are called index numbers. The GDP deflator is an index number.

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An alternative measure of the price level is the Consumer Price Index (CPI)—another index number. In the United States, this measure is based on price surveys across U.S. cities. The prices of various goods are weighted according to average consumer expenditure shares in the United States. The construction of the CPI and the construction of real GDP involve similar problems. One can also measure inflation as the rate of change in the CPI. The relationship between inflation measured from the GDP deflator and inflation measured from the CPI is very close, but not perfect. The differences arise because the two price indexes apply to different baskets of goods. GDP measures production of final goods, so inflation calculated from the GDP deflator provides a measure of the percentage change in the aggregate price of final goods produced in an economy. The CPI, on the other hand, measures the price of a representative basket of private consumption, so inflation calculated from the CPI provides a measure of the percentage change in the price of the domestic consumption basket. Domestic consumption includes goods imported from abroad, and domestic production includes final goods used for purposes other than domestic consumption. Economists care about inflation because it can distort relative prices, produce uncertainty about relative prices, and redistribute income. Inflation distorts relative prices because some nominal variables do not adjust immediately to the rise in the aggregate price level. Inflation redistributes income because some transactions involve fixed nominal payments. For example, some retirees receive fixed nominal incomes. Inflation may be costly, but there are also economic problems associated with deflation (negative inflation). For example, some of the costs of inflation would also apply to deflation. Moreover, deflation limits the ability of monetary policy to affect output. Consideration of the costs of inflation and the costs of deflation seems to suggest that there is an optimal rate of inflation. Most economists favor a stable inflation rate somewhere between 1 and 4%.

Output, Unemployment, and the Inflation Rate: Okun’s Law and the Phillips Curve

There are two relationships that connect the three main dimensions of economic activity. The relationship between unemployment and output is described by Okun’s law. American economist Arthur Okun found that when output increases unemployment falls and vice versa. Intuitively this relationship makes sense because higher output in general requires employing more workers. Figure 2-5 highlights this relationship. The second relationship was identified by economist A.W. Phillips and is shown graphically as the Phillips curve (see Figure 2-6). Phillips discovered that inflation tends to increase as unemployment falls This finding also seems intuitive given that as economic activity increases, and most people are working, the remaining potential workers must be paid higher wages to get them off the couch. In addition, firms will begin sniping employees from other firms by paying higher wages. The net result is an increase in inflation while unemployment falls.

The Short Run, the Medium Run, and the Long Run

Macroeconomists view the economy in terms of three time frames. In the short run—a few years or so— demand for goods and services determines output. In the medium run—a decade or so—the level of technology and the size of the capital stock determine output. Since these variables change slowly, it is a useful simplification to assume that they are fixed in the medium run. Finally, in the long run, technological progress and capital accumulation are the primary determinants of output growth. Changes in a nation’s education system, the quality of government, or savings rate are examples of long run factors that affect economic output.

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A Tour of the Book

The remainder of the book can be divided into three sections: “Core” material (Chapters 3-14), extensions to the Core, and concluding chapters on macroeconomic policy and the state of macroeconomic thinking. The Core is organized around the three time frames. It discusses how output is determined in the short run in chapters 3 to 6. Chapters 7 to 10 develop the supply side and look at how output is determined in the medium run. Chapters 11 to 14 focus on the long run and looks at output growth. After the Core, there are two extensions: expectations (Chapters 15-17), and the open economy (Chapters 18-21). In chapters 22 to 24 the content goes back to monetary and fiscal policy issues. The final chapter (Chapter 25) focuses on the history of thought in macroeconomics. The book is constructed so that the extensions can be addressed in any order after the Core. Indeed, most of the material in the extension chapters can be discussed without covering the growth section of the Core. In addition, much of the material in the policy chapters can be discussed immediately after the Core, without any of the extensions. Thus, there are a number of options for constructing a course around the text.

V. PEDAGOGY 1.

Points of Clarification

The use of subscripts to index time will be new for many students. A few minutes of clarification may be worthwhile at the outset.

Alternative Sequencing

The chapter does not discuss national income accounting in any detail. Instead the relevant accounting identities are presented in the main text as they become relevant for the development of the analytical model. For example, Chapter 3 presents the expenditure side of the accounts in the course of explaining the composition of aggregate demand. A complete treatment of the real GDP and chain-type indexes is also presented in Appendix 1. Instructors may prefer to introduce the material from Appendix 1 immediately after Section 1 of this chapter.

Enlivening the Lecture

It is difficult to add much life to the definitions chapter of macroeconomics. One way to reduce the number of definitions is to focus only on output at this point. The unemployment and inflation definitions could be postponed until Chapter 7, which introduces the labor market and aggregate supply. A benefit of this approach is a more rapid advance to the Keynesian cross in Chapter 3. A cost is the need to say something about the aggregate price level in the LM curve in Chapter 6.

VI. EXTENSIONS 1.

GDP as a Measure of Welfare

The chapter discusses briefly why economists care about inflation and unemployment, but does not do the same for GDP. It is probably obvious that economists use GDP as a gross measure of aggregate welfare, but instructors may wish to point out that there are (at least) three limitations on GDP as a welfare measure. i.

Measured GDP values goods and services at market prices, since these reflect the relative values placed on them by consumers. However, some valuable things are not sold on markets, and their values thus have to be imputed, a process that undoubtedly introduces some errors. Two important services that do not have a market price are government services and owner-occupied housing. 2-10 .

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Some goods and services not traded in markets are omitted altogether from the GDP calculation. For example, the value of leisure and the value of services performed in the household are not included in GDP. From a broader perspective, one might also cite civil liberties and other political “goods” as nonmarket goods produced by a nation, but not included in GDP. GDP does not account for the fact that some of a nation’s wealth is depleted in the process of producing it. NDP corrects this to some extent by subtracting the value of depreciated physical capital, but depletion of natural and environmental resources is still omitted. The Department of Commerce and others have experimented with adjustments to GDP to account for resource and environmental depletion, but there is no consensus among economists about the proper methodology.

Stocks and Flows: Wealth and GDP

The text does not introduce the concepts of stocks and flows until Chapter 4 (Financial Markets). Instructors could introduce these concepts in this chapter by distinguishing national wealth (a stock) from GDP (a flow). A natural definition of national wealth is the value of the nation’s land (including natural resources), physical and human capital, and claims on foreigners at a given point in time.

VII. APPENDIX The Construction of Real GDP and Chain-Type Indexes The chapter discusses real GDP and also mentions the real GDP in chained dollars. This appendix shows you how to construct the real GDP and then how construct a rate of change in the real GDP. It also extends the computations and shows how to link or chain the level of real GDP to a base year which is currently 2015. In the base year 2015 the nominal and real GDP are equal. Today any mention of the real GDP refers to 2015 euros. This practice provides economists with a measure of real economic output by removing the influence of inflation.

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CHAPTER 3. THE GOODS MARKET I.

MOTIVATING QUESTION

How is output determined in the short run? Output is determined by equilibrium in the goods market, i.e., by the condition that supply (production of goods) equals demand. This condition always determines output, but in the short run, we assume that production adjusts automatically to output without changes in price. Thus, in the short run, output is effectively determined by demand. Moreover, in this chapter, investment is exogenous (and therefore independent of the interest rate), so there is no need to consider simultaneous equilibrium in the goods and financial markets.

II.

WHY THE ANSWER MATTERS

The determination of output is the fundamental issue of macroeconomics. This chapter introduces the topic through the Keynesian cross model, which considers the goods market in isolation. The Keynesian cross provides basic intuition about the building and solving of models, the determination of output, and the role of fiscal policy. The short-run, qualitative results generally survive in more complicated models. Chapter 4 examines the financial markets in isolation, and Chapter 5 combines the goods and financial markets to construct the demand side of the economy.

III. KEY TOOLS, CONCEPTS, AND ASSUMPTIONS 1.

Tools and Concepts

i. ii.

iv.

The chapter introduces functional notation. The chapter introduces modeling terminology: exogenous and endogenous variables, behavioral equations, identities, and equilibrium conditions. The chapter describes the Keynesian cross model (although it does not use this expression), and associated terms, such as the (marginal) propensity to consume, disposable income, and autonomous spending. The chapter introduces fiscal policy.

Assumptions

The text assumes that the economy produces a single good. This assumption is maintained throughout most of the formal work in the book. After introducing the national income identity, the text assumes a closed economy. This assumption is maintained until Chapter 18. For short-run analysis, the text assumes that production adjusts automatically to output without changes in price. This assumption implies that the price level is fixed. Instructors may wish to clarify this assumption before the price level is introduced in the discussion of the money market and the LM curve in Chapters 4 and 5. The assumption that the price level is fixed is maintained until Chapter 7. Within the short-run context, the critical assumption of this chapter is that investment does not respond to the interest rate. This isolates the goods market from the financial market. This assumption will be relaxed in Chapter 5.

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The chapter, in fact, goes further, and assumes that investment is exogenous. It does not depend on output, nor is there inventory investment, either planned or unplanned. Chapter 5 introduces the dependence of investment on output. This chapter discusses in words the dynamic implications of allowing unplanned inventory adjustment, although it does not stress this point.

IV. SUMMARY OF THE MATERIAL 1.

The Composition of GDP

On the expenditure side, GDP can be decomposed into consumption (C), government spending (G), fixed investment (I), net exports (X-IM), and inventory investment.

The Demand for Goods

Assume there is only one good, and use the decomposition of GDP to think about demand for that good. Assume the economy is closed, so that net exports are zero, and ignore inventory investment, which is typically a small part of GDP. Then, demand (Z) can be written as

Z = C + I + G. Write consumption as a linear function of disposable income (YD)

C = C (YD )

(3.1)

(+) The function C = C(YD) is called the consumption function. The positive sign below it indicates that consumption increases as disposable income increases. However, there is some level of consumption that would occur even if disposable income were zero. This consumption is called autonomous consumption and is represented by c0. The parameter c1, which represents the increase in consumption for every extra unit of disposable income, is called the (marginal) propensity to consume. Assume that households do not consume every dollar of additional income, but save some, so that 0 < c1 < 1. Given this new information we can expand the consumption function to the following linear function;

C = c0 + c1 (YD )

(3.2)

When we add the government sector and taxation to the model we see that consumers pay taxes (T) on income (Y). This addition expands the linear expression of the model to;

C = c0 + c1 (Y − T )

(3.3)

The two remaining components of consumption are government spending (G) and business investment (I) which in the next section we will hold constant.

The Determination of Equilibrium Output

Output is determined by equilibrium in the goods market. The equilibrium condition is that production equals demand. Assume for now that production simply increases or decreases with demand without any change in price. Thus, in the short run, output is fully determined by demand. Then, we can write the equilibrium condition, Y = Z, as Y = c0 + c1 (Y − T ) + I + G.

3-13 .

(3.5)

The variable Y appears on both sides of this equation. On the LHS, Y represents production. On the RHS, Y represents national income. Chapter 2 explained why these two quantities are equal. The aim of this model is to determine the value of Y, an endogenous variable. To solve the model, it is necessary to write Y as a function of the exogenous variables, i.e., those determined outside the model. In other words, Y=

1 [c0 + I + G − c1T ]. 1 − c1

(3.8)

Equation (3.8) shows the algebraic solution and Figure 3-2 the graphical solution. In the graph, equilibrium occurs where demand (the ZZ curve) crosses the 45° line (i.e., the line along which Y = Z). Figure 3-2: Equilibrium in the Goods Market

Demand (Z), Production (Y)

Y=Z ZZ Demand Slope = c1 Equilibrium Point Autonomous Spending

45° Income, Y

Equilibrium income is the product of two factors: autonomous spending (the second term in brackets in equation (3.8)) and a “multiplier” (the first term in brackets). Assume that autonomous spending is positive,1 which (given that c1 < 1) will be true unless the budget surplus, (T – G), is very large. The multiplier, which depends on the value of the propensity to consume, arises because consumption is affected by income. Suppose there is an increase in autonomous consumption—say, because of an increase in consumer confidence. The initial increase in consumption because of the rise in c0 leads to an increase in income. The increase in income leads to a further increase in consumption, which leads to a further increase in income, and so on. Thus, the effect of the initial increase in consumer confidence is “multiplied.” The multiplier captures this effect. More formally, the multiplier can be described as the limit of a geometric series of fractional increases in consumption. A focus box on page 57 discusses the impact of the early stages of the financial crisis and consumer concerns over their future disposable income.

Note that this assumption implies that the ZZ curve intersects the vertical axis at a point greater than zero. The restriction that c1 < 1 implies that the ZZ curve intersects the 45° line.

3-14 .

Investment Equals Saving: An Alternative Way of Thinking About Goods-Market Equilibrium

Private saving is defined as disposable income minus consumption, or

S = Y − T − C. Using this definition, the equilibrium output condition (Y = C + I + G) can be expressed as I = S + (T − G ).

(3.10)

In a closed economy, investment equals private (consumer) saving (S) plus government saving (T − G). The quantity (T − G) is called the budget surplus. The quantity (G − T) is called the budget deficit.

Is the Government Omnipotent? A Warning

The equilibrium output condition (3.8) seems to imply that the government, by choosing G and T, has absolute control over the level of output. The text stresses that this chapter provides only a first pass at the analysis of fiscal policy. Later chapters will make clear the many limitations on the ability of the government to control output through spending and taxation.

V. PEDAGOGY 1.

Points of Clarification

The Definition of Goods. The chapter assumes that the economy produces only one item and calls this item a good. However, the model is not meant to be limited to physical goods as opposed to services. “Goods” is generally used to refer to both physical goods and services. The Definitions of G and T. Government spending includes the purchase of newly produced goods and services, not total government outlays. In particular, transfers—such as Social Security payments, veterans’ benefits, and interest on the government debt—are excluded. Note also that government spending includes spending by all levels of government (federal, state, and local) and that some government spending pays for capital goods. The variable T is defined as taxes minus transfers and includes taxes minus transfers at all levels of government. Exports and Imports in GDP. Imports are subtracted from GDP on the expenditure side because the domestic spending categories C, I, and G include spending on foreign goods and services. To isolate spending on domestically produced goods and services, imports must be subtracted. Likewise, exports are added because they represent foreign spending on domestically produced goods and services.

ii.

iii.

Alternative Sequencing

For simplicity, investment is taken as exogenous. Chapter 5 describes the effects of output and the interest rate on investment in the course of developing the IS-LM model. An alternative would be to introduce the dependence of investment on the interest rate in this chapter, and then assume a fixed interest rate. Since assuming a fixed interest rate is essentially equivalent to assuming exogenous investment, this approach removes an (arguably) unnecessary step in the development of the IS-LM framework. It also allows for early experiments with the effects of changes in the interest rate on output as precursors to the derivation of the IS curve. On the other hand, introducing the interest rate at this stage complicates the simple Keynesian cross story.

3-15 .

Enlivening the Lecture

The chapter does not cover explicitly fiscal policy experiments. Explaining these in lecture reinforces concepts and provides an opportunity to link the model to current policy debates. For example, with respect to fiscal stimulus packages, instructors could entertain the notion that the propensity to consume might vary with income (or more accurately, wealth) and discuss how different distributions of tax benefits might have different quantitative effects on consumption. The focus box on page 68 introduces the “Paradox of Saving” which is also an interesting way to stimulate class discussion.

VI. EXTENSIONS 1.

Macroeconomic Models

Some instructors may wish to supplement the discussion of model building in the text by distinguishing a model’s structural form from its reduced form and by explaining the requirement that the number of equations equal the number of exogenous variables. A model’s structural form sets out the model’s postulates about behavior, definitions, and equilibrium conditions. A model’s reduced form expresses the endogenous variables in terms of the exogenous ones. The number of equations must equal the number of unknowns if the model is to provide a complete (not underdetermined) and coherent (not overdetermined) explanation of the phenomenon of interest.

Inventory Investment

As noted above in Part III, apart from a few words in the text, the formal model of this chapter abstracts from inventory investment. This simplifies the presentation and allows the identification of aggregate demand with final sales. As an alternative, instructors could introduce and distinguish planned and unplanned inventory investment and characterize goods-market equilibrium by the condition that unplanned inventory investment equals zero. In this approach, aggregate demand does not, in general, equal final sales.

Fiscal Policy

The discussion in the text omits several familiar fiscal policy issues, including the balanced budget multiplier and the role of income taxes as automatic stabilizers. These issues are examined in problems at the end of the chapter (see the solutions for a discussion). However, instructors may wish to consider these issues in class.

3-16 .

CHAPTER 4. FINANCIAL MARKETS: I I.

MOTIVATING QUESTION

How is the interest rate determined in the short run? The interest rate is determined by equilibrium in the money market, i.e., by the condition that money supply equals money demand. Since the text abstracts from all assets other than bonds and money, equilibrium in the money market is equivalent to equilibrium in the bond market. In this chapter, nominal income is taken as given, so there is no need to consider simultaneous equilibrium of goods and financial markets.

II.

WHY THE ANSWER MATTERS

Investment is a function of the interest rate (as will be discussed in Chapter 5), so output is affected by the interest rate. In addition, the determination of the interest rate is intimately connected with monetary policy. This chapter introduces the simplest model needed to think about the determination of the interest rate and the role of the central bank. This chapter takes nominal GDP, which affects money demand, as given, so the financial markets can be considered in isolation from the goods market. Chapter 5 will address the joint determination of output and the interest rate in the short run. Chapter 9 will address the complexity of the financial system in light of the financial crisis. Chapter 24 will address some post-2008 crisis changes in monetary policy in advanced economies.

III. KEY TOOLS, CONCEPTS, AND ASSUMPTIONS 1.

Tools and Concepts

i. ii. iii. iv.

The chapter defines stock and flow variables and distinguishes wealth (a stock) from income (a flow). The chapter introduces monetary policy and describes open market operations. The chapter makes use of balance sheets for the central bank and private banks. The chapter introduces various terms and concepts associated with the banking system. These include currency, deposit accounts, reserves, the reserve ratio, central bank money (high powered money, the monetary base), the federal funds rate and the refi rate, and the money multiplier.

Assumptions

This chapter assumes that nominal GDP is given. More precisely, the chapter maintains the previous chapter’s assumption that the price level is fixed and adds the assumption that real income is given. Chapter 5 considers the joint determination of the interest rate and real income. For clarity, the chapter assumes that money and bonds are the only assets available and that money does not pay interest. Money is divided into currency and checkable deposits in the section of the chapter that describes the banking system. The assumption that money does not pay interest is maintained throughout the book. Later chapters introduce other financial assets—stocks and bonds of different maturities—and physical capital.

ii.

IV. SUMMARY OF THE MATERIAL 1.

The Demand for Money

Suppose the financial markets include only two assets: money, which can be used to purchase goods and services and pays no interest; and bonds, which cannot be used for transactions, but pay a positive interest rate i. Financial wealth equals the sum of money and bonds. 4-17 .

Financial wealth is a stock variable, i.e., a variable whose value can be measured at any point in time. An individual’s financial wealth changes over time by saving or dissaving, but at any given moment, financial wealth is fixed. Saving is a flow variable, i.e., a variable whose value is meaningful only when expressed in terms of a time period. Income is also a flow variable, as is recognized in ordinary speech. People speak of annual income or monthly income. At every moment, households must decide how to allocate their given financial wealth between money and bonds. Since financial wealth is fixed, the demand for bonds is known once the demand for money is known, and vice-versa. Accordingly, the chapter restricts attention to the demand for money. By assumption, money is needed for transactions. Although it is hard to measure the overall level of transactions in the economy, it seems reasonable to assume that the level of transactions is proportional to nominal income, denoted €Y. So, money demand should be proportional to €Y. On the other hand, allocating wealth to money comes at the cost of forgone interest on bonds. So, money demand should decrease with the interest rate. Putting these observations together, the chapter specifies money demand as

M d = €YL(i ), ( −)

(4.1)

where the function L decreases as the interest rate increases. A box in the text notes that most U.S. currency is held abroad by foreigners, so that factors beyond U.S. economic variables affect U.S. money demand. Nevertheless, the text does not include foreign variables in the specification of U.S. money demand.

Determining the Interest Rate: I

Assume all money is currency, so there are no checking accounts or banks. Consider the supply of money to be fully in the control of the central bank, and take nominal income as given. Then, equilibrium in the money market occurs when the supply of money (M) equals the demand for money (Md) given in equation (4.1). Figure 4-2 illustrates this equilibrium point. An increase in the money supply shifts the vertical line to the right, resulting in a new equilibrium with a lower interest rate. In order to induce the private sector to hold more money, bonds must become less attractive (the interest rate must fall). An increase in nominal income (for a given money supply) shifts the money demand curve to the right and generates a new equilibrium with a higher interest rate. The increase in nominal income leads to an increase in the quantity of money demanded at the original interest rate. Since the supply of money has not changed, the interest rate must rise to reduce the quantity of money demanded and thereby offset the effect of the increase in income. How does the central bank control the money supply? Consider the central bank’s balance sheet. Currency held by the public constitutes the central bank’s liabilities. The central bank’s assets are any bonds that it owns. To increase the money supply, the central bank creates currency to purchase bonds, thus increasing assets (through the additional bonds) and liabilities (through the new currency created and exchanged for bonds). To reduce the money supply, the central bank sells bonds for existing currency, thus reducing assets (through the sale of bonds) and liabilities (through the reduction of currency held by the general public). Purchases and sales of bonds by the central bank are called open market operations.

4-18 .

Figure 4.2 The Determination of the Interest Rate

The text also shows how bond prices and interest rates are related. Suppose a bond promises a payment of €F one year in the future. Call the current price of the bond €PB. Then, the interest rate (or rate of return) on this bond is given by

i = (€ F − € PB )/ € PB . We can solve this equation for the bond price:

€ PB = € F /(1 + i). Given fixed nominal bond payments, we show that the nominal interest rate and the bond prices are inversely related. For example, when the central bank purchases bonds through open market operations it increases the demand for bonds and tends to increase their price which, in turn, reduces the interest rate.

Determining the Interest Rate: II

Now introduce banks into the model. Banks receive funds from depositors (individuals and firms) and allow their depositors to write checks against (or withdraw) their account balances. These deposit accounts are liabilities of banks. On the asset side, banks hold bonds, loans (which are claims against borrowers), and reserves of some of their deposits. Some bank reserves are held in cash and the rest in accounts at the central bank. Banks hold reserves in part to protect against daily excesses of withdrawals (in currency or check form) over deposits and in part because they are required to do so by the central bank. Additionally, in many countries including the United States, the central bank now pays interest on reserves. In the euro area, banks must hold a liquidity reserve determined in relation to the composition of their balance sheet. Until January 2012, banks had to hold a minimum of 2% of certain liabilities, mainly customers’ deposits, at their national central bank. Since then, this ratio has been lowered to 1%. Adding banks to the economy alters the central bank balance sheet only on the liabilities side. Central bank liabilities now consist of currency held by the public plus reserves held by banks. Central bank liabilities— the money the central bank has created—are called central bank money. 4-19 .

Now reconsider money market equilibrium in terms of central bank money (Hd). The demand for central bank money arises from two sources: currency held by the public and reserves held by banks. Since bank reserves depend on the amount of checkable deposits we can model this relationship by letting the θ (Greek lowercase letter theta) represent the reserve ratio. Recall from our original equation 4.1 that money demand is given by;

M d = €YL(i ) ,

(4.3)

The second component of money demand, bank reserve demand, can be modeled with the equation; H d = θ M d = θ €Y L (i )

(4.4)

Equilibrium in the money market can now be depicted as the point where the money supply controlled by the central bank (H) is equal to the money demand (Hd). We can rewrite this equation in the following manner; H = θ €Y L(i )

(4.6)

Graphically this equilibrium is presented in Figure 4-7. Now you can see that an increase or decrease in the money supply impacts the price of money (i.e. the interest rate). The specific interest rate targeted by the central bank is the policy rate.

The Liquidity Trap

The central bank can choose a desired interest rate by changing the money supply. However, the central bank can push interest rates to zero which would limit further monetary stimulus. This condition is known as a zero lower bound. When the economy is in this position and monetary policy is no longer effective the economy is said to be in a liquidity trap. Increasing the money supply beyond this point has no impact on interest rates. Both households and banks absorb increases in the money supply when interest rates are zero so monetary policy loses its effectiveness. The Focus box on page 81 addresses the “Liquidity Trap in Action” as a result of central bank policy following the financial crisis.

V. PEDAGOGY 1.

Points of Clarification

The Definition of Money Demand. Money demand refers to a portfolio decision, the amount of fixed wealth that the nonbank public desires to hold in money as opposed to bonds. Money demand does not refer to the demand for income or wealth. Comparative Statics with Bond Prices. It may be useful to reconsider comparative statics in the money market in terms of bond prices. The text carries out this exercise for open market operations, but instructors could also do the analysis for an exogenous increase in national income. An increase in income shifts the money demand curve to the right, which leads to an increase in the equilibrium interest rate, as is evident from the graph. To tell the bond market story, note that at the initial interest rate, the quantity of money demanded exceeds the quantity supplied. In other words, households are attempting to sell bonds to acquire money. The pressure to sell bonds (effectively a shift to the left of the bond demand curve) reduces the bond price and hence increases the interest rate. The Central Bank Balance Sheet. It is probably wise to assume that many undergraduates have never seen a balance sheet of any kind. A few words of explanation would be useful. In addition, as a

ii.

iii.

4-20 .

iv.

memory aid for students, it may be useful to simplify the discussion of open market operations by noting that when the central bank increases its assets, it increases the money supply. Thus, when the central bank buys bonds, it increases the money supply. Currency, Government Bonds, and the Central Bank. The model without banks implies that the central bank creates currency when conducting an open market purchase. Although this notion has some intuitive appeal, and can be useful as a pedagogical step, it is worth clarifying that in fact the central bank creates reserves, not currency.

Moreover, the central bank does not create government bonds, but conducts open market operations with government bonds. The stock of government bonds outstanding is the government (in popular usage, national) debt, which is the product of past fiscal deficits. Open market operations apportion this debt between the central bank and the private sector.

Alternative Sequencing

Instructors have several options for presenting money market equilibrium. The most straightforward presentation would rely on Section 4.2 for the cash economy and progress to Section 4.3 if banks and checkable deposits are introduced. Section 4.3 equates the demand and supply for central bank money. The interest rate was not introduced in the discussion of the goods market in Chapter 3. Thus, at this point in the text, the determination of the interest rate seems to stand apart from the determination of real output. As discussed in Part V of Chapter 3 of the Instructor’s Manual, an alternative is to introduce the dependence of investment on the interest rate in Chapter 3 and to assume a fixed interest rate. Another option is to introduce some of the material in Chapter 24, devoted to monetary policy, in the discussion of the current chapter. Some of the basic facts about the structure of Monetary Policy and the crisis may be helpful to orient students and to help facilitate discussion of current central banks’ policies.

Enlivening the Lecture

Casual empiricism suggests that undergraduates have more immediate interest in material related to financial markets than in almost any other topic. A discussion relating the material of the chapter to current specific central banks’ policies (perhaps with a few words about the stock market’s response to Fed policy) would probably be interesting to students. In addition, there is a current debate about negative interest rates and whether or not central banks can use negative rates effectively. Another suggestion is to look at the interest rate section of the financial pages of a major newspaper during the lecture. Besides making the financial pages a bit more accessible to students, this strategy might also provide an opportunity to discuss the inverse relationship between prices and interest rates.

VI. EXTENSIONS 1.

The Balance Sheet Constraint

To clarify the relationship between bond market and money market equilibrium, it may be useful to be more explicit about the implications of the balance sheet constraint. The constraint implies M d + B d = Financial Wealth = M + B ,

or ( M d − M ) = ( B − B d ).

4-21 .

In other words, the excess demand for money must equal the excess supply of bonds. When one market clears, the other must clear as well.

The Money Demand Function

This chapter assumes a money demand function of the form Md = €YL(i) = PYL(i). A more general alternative would be Md = L(€Y,i). The functional form assumed in the chapter allows for an easy conversion to real money demand by dividing through by the price level. Introducing the more general form requires explaining to students that money demand should be homogeneous of degree one in P. On the other hand, this exercise does make clear what is assumed.

4-22 .

CHAPTER 5. GOODS AND FINANCIAL MARKETS: THE IS-LM MODEL I.

MOTIVATING QUESTION

How are output and the interest rate determined simultaneously in the short run? Output and the interest rate are determined by simultaneous equilibrium in the goods and money markets. In the short run, we assume that production responds to demand without changes in price (i.e., price is fixed), so output is determined by demand.

II.

WHY THE ANSWER MATTERS

The determination of output is the fundamental issue in macroeconomics. The interest rate affects output (through investment) and output affects the interest rate (through money demand), so it is necessary to consider the simultaneous determination of output and the interest rate.

III. KEY TOOLS, CONCEPTS, AND ASSUMPTIONS 1.

Tools and Concepts

i. ii. iii.

The chapter introduces the IS-LM framework. The chapter introduces the concept of policy mixes to achieve macroeconomic goals. The chapter introduces the use of “+” and “−” below the argument of a function to indicate the effect of an increase in the value of the argument on the value of the function.

Assumptions

This chapter maintains the fixed price assumption of previous chapters, but relaxes the assumptions that investment is independent of the interest rate (assumed in Chapter 3) and that nominal income is fixed (assumed in Chapter 4). Investment is also allowed to depend on output. The point of this chapter is to show how goods and financial markets are related and thus how output and the interest rate are simultaneously determined. The chapter continues to assume that inventory investment is zero and that the economy is closed.

ii.

IV. SUMMARY OF THE MATERIAL 1.

The Goods Market and the IS Relation

First, relax the assumption that investment is endogenous. In terms of the framework developed thus far, investment should depend on two factors: sales and the interest rate. A firm facing an increase in sales will need to purchase new plant, equipment, or both to increase production. Thus, investment increases when sales increase. An increase in the interest rate will increase the cost of borrowing needed to purchase new plant and equipment. Thus, investment decreases when the interest rate increases. This discussion describes an investment function of the following form:

I = I (Y , i ).

(5.1)

( +, −)

5-23 .

Although the discussion suggests that investment should depend on sales, rather than income, the chapter continues to assume that inventory investment is zero, so income equals sales. With the revised investment function, the closed economy, goods market equilibrium condition becomes

Y = C (Y − T ) + I (Y , i ) + G.

(5.2)

For a fixed interest rate, the Keynesian cross analysis of Chapter 3 holds with two caveats. First, demand for goods and services (the RHS of equation (5.2)) is no longer assumed to be linear. Second, an additional assumption is required to ensure that an equilibrium exists (i.e., that the ZZ curve intersects the 45°-line). A sufficient assumption for this purpose is that the sum of the (marginal) propensity to consume out of income and the (marginal) propensity to invest out of income is less than one.

Equation (5.2) is called the IS relation, because (as shown in Chapter 3) goods market equilibrium is equivalent to the condition that investment equals saving. To trace out an IS curve, start with a Keynesian cross with a given interest rate, then vary the interest rate. A decrease in the interest rate increases the level of investment for any level of output, so the ZZ curve shifts up and output increases. Therefore, the IS curve has a negative slope in Y-i space (Figure 5-2).

Financial Markets and the LM Relation

Start with the money-market equilibrium condition from Chapter 4, rewrite nominal income as PY (where P is the price level), and divide by P to derive the real money market equilibrium condition: M = YL(i ). P

(5.3)

Real money market equilibrium is characterized by the same graph developed in Chapter 4, but the real money supply (M/P) is substituted for the nominal money supply (M). The chapter maintains the shortrun assumption of a fixed price and, abstracting from details of monetary policy, assumes that M is under the control of the central bank. Equation (5.3) is called the LM (Liquidity-Money) relation. Since the central bank chooses the money supply, and therefore the interest rate, the LM curve is graphed as a horizontal line as shown in Figure 5-4.

Putting the IS and the LM Relations Together

The equilibrium values of i and Y are those that satisfy simultaneously the goods market equilibrium condition (equation (5.2)) and the money market equilibrium condition (equation (5.3)). Graphically, these values are determined by the point of intersection of the IS and LM curves, as illustrated in Figure 5-5. Changes in the equilibrium values of output and the interest rate (Y* and i*) can be brought about only as the result of shifts in the IS curve, the LM curve, or both. An increase in the money supply, which shifts the LM curve down, increases equilibrium output and reduces the equilibrium interest rate. An increase in taxes (or a reduction in government spending), which shifts the IS curve to the left, reduces equilibrium output and reduces the equilibrium interest rate. An increase in taxes has an ambiguous effect on investment, since the output effect tends to reduce investment, but the interest rate effect tends to increase it. More generally, although deficit reduction increases public (government) saving, it does not necessarily increase investment, because private saving is endogenous.

5-24 .

Fiscal expansions (i.e. lower taxes or higher government spending) shift the IS curve to the right and result in higher output. In contrast, fiscal contractions (i.e. higher taxes or lower government spending) shift the IS curve to the left and result in lower output. See Figure 5-6. Changes in monetary policy shift the horizontal LM curve up or down as the central bank increases or decreases interest rates through changes in the money supply. A monetary expansion lowers the interest rate and shifts the horizontal LM curve down resulting in higher output. See Figure 5-7. In contrast, a monetary contraction increases interest rates and shifts the LM curve upward resulting in lower output (Y).

Using a Policy Mix

The text considers the consequences of combinations of fiscal and monetary policy through two examples: the recession of 2001 and the deficit reduction during President Clinton’s first term. A box in the text argues that the proximate cause of the recession of 2001 was a drop in (nonresidential) investment spending and that the policy response—a sharp cut in interest rates by the Fed and large tax cuts spearheaded by the Bush administration—lessened the severity of the recession. Although the tax cuts provided useful stimulus, they also played the major role in creating large budget deficits in the United States. Many economists worry about these deficits, and argue that the tax cuts should not have been made permanent. Long after the recession of 2001, the loss of tax revenue associated with the Bush tax cuts continues to affect government finances. During the recession of 2001, monetary and fiscal policy both became more expansionary. In the President Clinton’s first term, by contrast, fiscal policy became more contractionary while monetary policy became more expansionary. The Federal Reserve supported the Clinton deficit reduction policy (a fiscal contraction) with a monetary expansion, and interest rates fell. As a result, there was a deficit reduction without a slowdown in growth. In fact, there was a large economic expansion—an outcome supported by the policy mix but also aided by other factors. In Europe similar discussions are taking place with regard to reducing fiscal deficits. Several euro area governments would like to reduce annual deficits in order to decrease debt over time, a policy action known as fiscal austerity. However, given already low interest rates there is little room for monetary policy to offset the fiscal contraction. The debate continues on whether fiscal austerity is necessary, and if so, should it be implemented later when monetary policy can be used to offset its adverse effect on output.

How Does the IS-LM Model Fit the Facts?

So far, the discussion has ignored dynamics. In fact, it takes some time for consumption, investment, and output to adjust to an economic disturbance. How long is an empirical question. To discuss this question and to provide evidence of the empirical relevance of the IS-LM model, the text describes the results presented in Peersman, G. and Smets, F. ‘The Monetary Transmission Mechanism in the Euro Area: More Evidence from Var Analysis’, European Central Bank, Working Paper No. 91, December 2001. An increase in the interest rate leads to a reduction in production. In the euro area, the biggest drop in production is reached in the second and third quarters after the interest rate increase, while in the United States after five quarters. As regards the impact on prices, In the euro area, roughly for the first five quarters the price level remains almost unchanged. Only after the first five quarters does the price level start to fall. This suggests that the IS-LM model becomes less reliable when we consider the medium term: in that case, we can no longer assume that the price level is fixed and changes in the price level begin to be relevant. Comparing the euro area and the USA, we see that, at least initially, both price levels and production react more in the USA.

5-25 .

V. PEDAGOGY 1.

Points of Clarification

The Meaning of the IS and LM Curves. The derivation of the IS and LM curves will take time for students to understand. It is important to emphasize that each point on the IS curve represents an equilibrium in the goods market and each point on the LM curve represents an equilibrium in the money market. Keep in mind that in some texts you will see the LM curve as downward sloping instead of horizontal. If this is the case the value of i on the LM curve associated with any given level of output is given by the intersection of (real) money supply and (real) money demand (given the level of output) in the money market equilibrium diagram. Money demand refers to a portfolio decision, the amount of fixed wealth that the nonbank public desires to hold in money as opposed to bonds. Money demand does not refer to the demand for income or wealth. The Interest Rate and Shifts of the IS and LM Curves. Students may wonder why an increase in the interest rate does not shift the IS curve, since the interest rate affects investment, or the LM curve, since the interest rate affects money demand. It is worthwhile to emphasize that the effects of the interest rate on the goods market and the money market are reflected in the slope of the IS curve and the level of the LM curve. Output and the interest rate are endogenous variables. Only changes to variables exogenous to the IS-LM model can shift the curves.

ii.

VI. EXTENSIONS 1.

Behavioral Parameters, the Slopes of the IS and LM Curves, and Policy Effectiveness

The text assumes a horizontal LM curve but many other presentations show a downward sloping LM curve. It is worth noting that the slopes of the IS curve and the LM curve do have policy implications. With respect to the slopes, the more sensitive money demand is to income relative to the interest rate, the steeper the LM curve. Likewise, the more sensitive goods demand (C + I + G) is to income relative to the interest rate (through investment), the steeper the IS curve. On the effectiveness of policy, there are two options to bring out the basic points. The first option is to choose a simple linear specification and work out the relationship between the output effect of policy and behavioral parameters. The second option is to discuss the issue more heuristically. For example, consider an increase in government spending, and proceed in three steps. i.

ii.

For any given interest rate, the effect of fiscal policy on output will depend on the multiplier, modified to include endogenous investment. The larger the multiplier, i.e., the greater the sensitivity of consumption and investment to output, the larger the initial response of output. Since an increase in G will increase Y, it will also increase the quantity of money demanded for any interest rate, and thus increase the interest rate, in order to maintain money market equilibrium. The increase in the interest rate will be small to the extent that money demand is not very sensitive to income, but is very sensitive to the interest rate. If money demand is not very sensitive to income, then the excess demand for money created by the increase in G will be small. If money demand is very sensitive to the interest rate, the increase in the interest rate needed to restore equilibrium in the money market will be small.

5-26 .

iii.

Finally, the increase in the interest rate will tend to reduce investment and thus offset some of the initial increase in output. This effect will be small to the extent that investment is not very sensitive to the interest rate.

In sum, fiscal policy will have a greater effect on output to the extent that the multiplier is large, money demand is not very sensitive to income, money demand is very sensitive to the interest rate, and investment is not very sensitive to the interest rate. One could carry out the same exercise with respect to monetary policy. An increase in the money supply affects output by reducing the interest rate and increasing investment. Thus, an increase in the money supply will tend to have a large effect on output when it has a large effect on the interest rate, which will be true when money demand is not very sensitive to the interest rate. The interest rate will have a large effect on output when investment is very sensitive to the interest rate, which calls forth the initial response of output, and, again, when the multiplier is large. The increase in output increases the quantity of money demanded for any interest rate and tends to increase the interest rate, offsetting some of the initial effect of the increase in the money supply. This effect will be small when the demand for money is not very sensitive to income. In sum, monetary policy will have a greater effect on output to the extent that money demand is not very sensitive to the interest rate, investment is very sensitive to the interest rate, the multiplier is large, and money demand is not very sensitive to income. These exercises are relatively sophisticated, but they make clear the linkages between the goods market and the money market through the interest rate.

Tax Cuts and the Recession of 2001

The debate over the tax cuts during the recession of 2001 was broader than whether the tax cuts should be permanent. Many economists argued that a stimulus package would be most effective when aimed at those with high propensities to consume. It seems reasonable to assume that low income taxpayers would have higher propensities to consume than high income taxpayers. This implies that tax cuts would be more effective when targeted toward low income taxpayers. The Bush tax cuts were not targeted toward low income taxpayers. An exercise at the end of Chapter 3 examines this issue from the point of view of the Keynesian cross model.

5-27 .

CHAPTER 6. FINANCIAL MARKETS II: THE EXTENDED IS-LM MODEL I.

MOTIVATING QUESTION

What are the macroeconomic implications of a more complex financial system? Prior to the financial crisis in the late 2000s that precipitated a global recession the role of the financial system was downplayed in macroeconomics. All interest rates were assumed to move in tandem so monetary policy was easy to implement via expanding or contracting the money supply using only shortterm bonds. However, we know now that the financial system is subject to crises which can have significant long-term impacts on the overall economy. The primary message is that financial intermediation matters. And it can go very wrong.

II.

WHY THE ANSWER MATTERS

The basic message of the chapter is that not only the financial system matters, but financial crises can have large macroeconomic effects. As we learned in the late 2000s the complexity of the system makes it more challenging to understand the true impact of policy changes. This chapter presents some of the key elements that will help us understand how the financial markets impact macroeconomics and later understand some of the central banks’ actions with regard to the financial crisis (see chapter 24).

III. KEY TOOLS, CONCEPTS, AND ASSUMPTIONS 1.

Tools and Concepts

The chapter introduces the nominal versus real interest rates and how risk factors into the market returns of different bonds. The chapter discusses the macroeconomic role of financial intermediaries. The chapter extends the IS-LM model developed in chapter 5 to account for more than one interest rate.

ii. iii.

Assumptions

This chapter abandons the single interest rate assumption of earlier chapters in favor of multiple interest rates. The chapter continues to assume the economy is closed.

ii.

IV. SUMMARY OF THE MATERIAL 1.

Nominal Versus Real Interest Rates

Nominal interest rates, often called quoted rates or stated rates, differ from real interest rates based on the rate of inflation. Nominal rates are the rates quoted by various lenders. In contrast the real interest rate is the interest rate expressed in terms of a basket of goods. A simple way to express the relationship between the two rates follows, rt ≈ it − π te+1

6-28 .

(6.4)

where rt is equal to the real interest rate, it is equal to the nominal interest rate, and π te+1 inflation expected next period or year. In other words, the real interest rate is approximately equal to the nominal interest rate minus the expected rate of inflation. This equation has several implications: • • •

When the expected inflation rate is zero the nominal rate and the real rate are equal. Since inflation is typically positive the real rate is usually lower than the nominal rate. For a given nominal interest rate higher inflation will lead to a lower real interest rate.

Figure 6-2 shows historical nominal interest rates and real interest rates for the U.S. since 1978. As you can see the spread varies over that time period. Note that the nominal rate is always positive but the real interest rate can fall below zero. Nominal rates cannot fall below zero (i.e. zero lower bound condition) or people will refuse to hold bonds. This zero lower bound condition keeps the Fed from lowering interest rates to stimulate growth once they reach that boundary. The zero lower bound turned out to be a serious concern during the 2008 crisis.

Risk and Risk Premia

Until now we have assumed only one type of bond exists. However, bonds differ based on several factors including maturity and default risk. For example, government bonds are almost risk-free but can vary in maturity substantially and bond investors typically require an interest-rate premium to hold longer-term bonds. In addition, bond investors will demand a risk premium to hold bonds with higher levels of default risk. Two factors determine the risk premium; 1) Higher probabilities of defualt require higher interest rates to entice bond buyers. 2) The degree of risk aversion of bondholders. More risk averse bondholders demand higher premiums. In Figure 6-3 you can see the differences in bond rates over time. Note that higher rated bonds (i.e. those with lower default risk) pay lower nominal interest rates. Also note the U.S. government bonds consistently pay lower interest rates due to the lack of default risk. The key takeaway is that bonds rates have substantial variance based on several factors and investors demand compensation in the form of higher interest rates to take on more risk.

The Role of Financial Intermediaries

Until now we have looked at direct finance, or borrowing and lending between two parties. Most financial transactions occur through financial intermediaries like banks and credit unions. These intermediaries play an important role in the economy by matching borrowers and savers. However, as illustrated by the financial crisis this system can run into trouble. To illustrate how and why we need to understand how a bank operates. Figure 6-4 displays a simple example of a bank’s balance sheet to introduce terms such as capital ratio and leverage ratio to the reader. Where capital ratio is defined as the ratio of capital to assets and the leverage ratio is the ratio of assets to capital (the inverse of the capital ratio). The following example applies the role of the impact of a high leverage ratio on banks Consider two banks. As in Figure 6-4, a bank has assets of 100, liabilities of 80, and capital of 20. Its capital ratio is defined as the ratio of capital to assets and is thus equal to 20%. Its leverage ratio is defined as the ratio of assets to capital (the inverse of the capital ratio) and is thus equal to 5. A different bank might have assets of 100, liabilities of 95, and capital of 5. Thus, its capital ratio is equal to 5%, and its leverage ratio to 20.

6-29 .

Now suppose that some of the assets in each of the two banks go bad. For example, some borrowers cannot repay their loans. Suppose, as a result, that for both banks, the value of the assets decreases from 100 to 90. The bank shown in Figure 6-4 now has assets of 90, liabilities of 80, and capital of 90 − 80 = 10. The other bank has assets of 90, liabilities of 95, and thus negative capital of 5 (90 − 95). Its liabilities exceed its assets: In other words, it is bankrupt. This is indeed what happened during the crisis: Many banks had such a high leverage ratio that even limited losses on assets very much increased the risk of bankruptcy. During the crisis, many banks opted for a higher leverage ratio thus more risk making it the more likely that they would go bankrupt. As the bank’s assets declined in value many banks ended up in a situation where the value of their assets fell below the value of their liabilities. This technical insolvency eliminated these banks’ ability to lend, even to good customers. Some of these bank assets were very difficult to value which resulted in the inability to sell the assets, or forced them to sell at very low prices, often referred to as fire sale prices. Investors also became worried about the banks’ long-term solvency and the safety of their deposits which resulted in rapid requests to withdraw demand deposits and created bank runs. (See the text box on page 120 for a history of the Great Depression and bank runs).

Extending the IS-LM Model

Our initial introduction to the IS-LM model in chapter 5 used only one central bank determined interest rate (i.e. horizontal LM curve). Now we revisit the IS-LM model with the addition of inflation and risk premia embedded in market interest rates. Now our model looks like this, IS relation: LM relation:

Y = C (Y − T ) + I (Y , i − π e + x ) + G i=ι

Where πe is equal to expected inflation and x is a risk premium. Note that the LM relation remains the same since interest rates are still set by the central bank. However, the IS relation changed in two ways; 1) Spending depends on the real interest rate rather than the nominal interest rate. 2) The risk premium captures higher perceived risk and/or risk aversion. You can now see that the interest in the LM and IS equations are now different rates. The LM interest rate is the policy rate (nominal rate) while the IS interest rate is the borrowing rate (real rate). Now the equations become; IS relation: LM relation:

Y = C (Y − T ) + I (Y , r + x) + G r=r

(6.5) (6.6)

The central bank sets the nominal rate (r), but spending decisions are determined by the borrowing rate (r + x) which factors in a risk premium. Now we can see what happens when there is a change in overall risk. If the risk premium increases, it will shift the IS curve to the left resulting in lower output (see Figure 6-5). As the borrowing rate increases spending will fall which potentially leads to recession. However, this lower spending can be offset by higher government spending (i.e. fiscal policy) or the central bank lowering interest rates (i.e. monetary policy). However, monetary policy may not be possible if interest rates are zero lower bounded.

From a Housing Problem to a Financial Crisis

Falling housing prices beginning in 2006 started a process leading to the financial crisis. Prior to that point in time U.S. housing prices increased due to low interest rates, high demand and mortgage lenders willing to lend to risky borrowers through what is known as subprime mortgages. 6-30 .

After 2006, housing prices begin to decline. Once the decline occurred many mortgages were considered to be underwater (this is when the value of the mortgage exceeds the value of the house). It was realized that the mortgages offered were in fact much riskier than either the lender pretended or the borrower understood. This in turn caused many borrowers to default on their mortgages thus creating a large loss for many banks. The section then moves from the evolution of the housing prices to the practices undertaken by the banking system prior to the crisis. The authors highlight terms such as Financial intermediaries, solvency, and illiquidity to explain the dynamic role that banks played in the relationship between assets and liabilities held on the institutions’ balance sheet. Highlighting the scenario that if the assets the bank held went down in value and the liabilities remained the same, liabilities would exceed assets, and the bank would then be considered bankrupt. The complexity of assets held by banks through a process called securitization was an additional undertaken by banks. Mortgage-backed securities (MBS) offered banks a mechanism by which to diversify the risk of holding an individual mortgage. MBS are interests in pools of mortgages. Ordinarily, a pool of mortgages has a more predictable repayment profile than an individual mortgage, because repayment of the latter is dependent on the individual circumstances of the mortgage borrower. In principle, the advent of MBS should have reduced the cost of mortgage borrowing by making mortgage financing more attractive to lenders. Securitization went further with the development of collateralized debt obligations (CDOs), which became increasingly popular in the 1990s and 2000s. CDOs divided up the payments from a pool of mortgages into different streams—for example a senior tranche paid first, and junior tranches paid afterwards (as long as sufficient funds were available). The tranches were designed to match different appetites for risk among investors. The complexity of CDOs can increase substantially with further securitization. There are CDOs on CDOs and so on. Securitization created a risk that evidently was not well understood. The assessed value of the payment streams was contingent on housing prices continuing to rise. Once housing prices fell, many mortgages in a given pool were at risk, and the value of MBS and of the individual payment streams on CDOs became extremely difficult to assess. From a liquidity perspective, banks also relied heavily on liabilities from banks which is known as wholesale funding. During the crisis, investors or other banks, worried about the value of the assets held by the bank stopped lending to banks. Once the lending to banks through wholesale funding became a problem, many banks found themselves short of funds and were forced to sell assets. The securitized assets were complex and hard to value, therefore banks had to sell some assets at fire sale prices. The immediate effects of the crisis were higher consumer interest rates which lowered spending and plummeting consumer confidence. The result was a sharp leftward shift in the IS curve. Governments implemented both fiscal and monetary policy responses to the crisis. In the United States, these responses included: • • • • •

The provision of higher liquidity to the financial system. An increase in deposit insurance limits from $100k to $250k to prevent runs Passed the Troubled Asset Relief Program (TARP) to clean up problem assets from banks (called the bank bailout bill). Implemented unconventional monetary policy given the fed funds rate was zero. Passed the American Recovery and Reinvestment Act which temporarily reduced taxes to encourage consumption and increase government spending. 6-31 .

The net effect of these policies was to shift the IS curve back to the right and shift the LM curve down. Both of these shifts resulted in higher output. In Europe, policy responded to the financial crisis with three instruments: financial, monetary and fiscal policies. But the type of response was somewhat different from that in the United States and, within Europe, the response in the countries belonging to the euro area was again different from that of the countries outside, such as Sweden, the UK and Denmark.

V. PEDAGOGY 1.

Points of Clarification

Balance Sheets. A refresher on balance sheets would probably be useful to students. In the context of this chapter, it is important to distinguish between changes in the value of existing capital and raising new capital. When the value of a bank’s assets declines, the value of its existing capital declines. This happened of course in the financial crisis as the value of MBS and CDOs declined. Faced with a loss in the value of capital, a bank can raise new capital by selling equity in the institution. The bank then uses proceeds of the sale to purchase assets. In principle, this option was open to banks during the financial crisis. Goldman Sachs, for example, received a capital infusion from Warren Buffett. But for most institutions, this was not a viable option as investors were reluctant to purchase shares of potentially insolvent banks. Ultimately, the government provided capital to the banks by purchasing equity with Treasury bonds. Indeed, Goldman Sachs also received capital from the government under the TARP program. (Note that Goldman changed its status from an investment bank to a bank holding company after the financial crisis began.) Monetary Policy and the IS Curve. Traditional monetary policy—changing the money supply— affects the position of the LM curve. The nontraditional monetary policies pursued during the crisis did have an effect on the LM curve, since these policies ended up increasing the money supply, but given the liquidity trap, these policies had no effect on output. The nontraditional monetary policies also affected the position of the IS curve by changing the premium included in the interest rate charged to firms that wanted to finance investment spending. Student may find this confusing. It is important to distinguish carefully the different channels of monetary policy, traditional and nontraditional. TARP Versus Traditional Fiscal Stimulus. There was substantial confusion in the popular press, and consequently among students, about the difference between bank bailouts and fiscal stimulus. Bank bailouts and the TARP program constituted neither increases in government purchases of goods and services nor reductions in taxes, so they did not amount to fiscal stimulus as traditionally defined. Instead, for the most part the bailouts were purchases of assets by the government. (There was also some provision of government insurance, in the form of guarantees provided free of charge.) The bailouts may have helped the economy by shoring up the financial system and allowing lending to continue to finance productive activities (or at least by preventing further deterioration in the availability of credit). But the bailouts did not provide direct stimulus in the form of increased government purchases of goods and services or indirect stimulus in the form of increasing the aftertax income of consumers. Such a stimulus bill—the American Recovery and Reinvestment Act— was passed by Congress and signed by President Obama in February 2009. But this was not the TARP legislation.

ii.

iii.

Alternative Sequencing

This chapter fits naturally before Chapter 24, or even chapter 15, if instructors wished to move quickly to the most topical material. In any case a discussion of the financial crisis can be used to provide numerous examples of both fiscal and monetary policy in action. 6-32 .

Enlivening the Lecture

Students might enjoy a little background on these policy decisions regarding the bank regulation and the bail out. There are a number of entertaining blow-by-blow accounts readily available. Such a discussion could also serve as a basis for introducing the “too big to fail” issue. A review of AIG and that firm’s role in the crisis is also very interesting. Introducing interest rate tranches on some CDOs can show the students why these toxic assets were so hard to value.

VI. EXTENSIONS 1.

Aggregate Versus Idiosyncratic Risk

Instructors may wish to discuss in greater depth the difference between aggregate and idiosyncratic risk, and the risks posed by assets whose payments derived from mortgage pools. The idea of securitizing mortgages is premised on the notion that the returns on a diversified pool of mortgage are less risky than the returns on any one mortgage. The idea makes sense as far as it goes, but in practice risk assessment was premised (implicitly or explicitly) on the notion that housing prices would not decline. The fall in housing prices was an aggregate event that affected the value of all mortgages at the same time. The fall in housing prices made the returns on every mortgage less certain and more difficult to value. No one was sure how to quantify the effect on any given mortgage pool or payment stream derived from a mortgage pool. Thus, the development of CDOs ended up exposing investors (including those in senior tranches perceived to be relatively safe) to an aggregate risk, namely the risk of a fall in housing prices. To make this point, consider a pool with two mortgages. (This example is drawn from Ricardo Caballero, “The ‘Other’ Imbalance and the Financial Crisis,” Paolo Baffi Lecture, The Bank of Italy, December 2009.) Absent a crisis in the housing markets, each mortgage pays $1 with probability 0.9 and $0 with probability 0.1. The payments on the mortgages are independent of one another. Now consider separating the payments on the mortgage pool into a $1 senior tranche, paid first, and a $1 junior tranche, paid after the senior tranche is paid. The senior tranche receives its payment of $1 with a probability of 99%, so it looks relatively safe. But investors in the senior tranche are exposed to an aggregate risk. Suppose that in the event of a housing crisis (a large enough decline in housing prices), each mortgage pays $0 (an extreme example to make the point). Now the senior tranche is completely exposed to a risk of a housing crisis. Other safe assets whose payments are not correlated with mortgage payments are not exposed to this risk. Evidently, holders of MBS and CDOs did not perceive the aggregate risk to which they were exposed.

Systemic Versus Non-systemic Risk

On the theme of regulation, instructors could discuss the relative merits of the “too big to fail” policy, and distinguish between systemic and nonsystemic risk. Existing bank regulation focuses on the solvency of individual institutions, and does not assess the degree to which the activities of an individual institution pose risks for the entire financial system. In a time of crisis, institutions whose bankruptcy might threaten the financial system are either bailed out by the government or bought out by private investors under pressure by the government. But many analysts argue that such after-the-fact policy is insufficient and perhaps dangerous, because it does nothing to curb activities that might pose systemic risk and indeed probably encourages some institutions to undertake too much risk because they believe they will be bailed out by the government if things go poorly. A number of proposals have been offered.

6-33 .

CHAPTER 7. THE LABOR MARKET I.

MOTIVATING QUESTION

How is the unemployment rate determined in the medium run? In the medium run, the unemployment rate tends to return to the natural rate of unemployment, determined by equilibrium in the labor market when the expected price level equals the actual price level. Conditional on price level expectations, equilibrium in the labor market occurs when the real wage implied by wagesetting behavior (influenced by the relative bargaining power of workers and firms) equals the real wage implied by price-setting behavior (influenced by the degree of competition in the goods market).

II.

WHY THE ANSWER MATTERS

The analytical framework in the text is built around equilibrium in three markets: goods, financial, and labor. Following the approach of Chapters 3 and 4, this chapter begins the discussion of the labor market by considering it in isolation. The assumption that isolates the labor market from the other markets is that the expected price level equals the actual price level. In these circumstances, the framework presented in the book produces an equilibrium rate of unemployment and an equilibrium real wage, independent of the goods and financial markets. Unlike the other markets, however, the labor market considered in isolation is relevant not to the short run but to the medium run, a time frame over which it is reasonable to assume that price expectations are correct.

III. KEY TOOLS, CONCEPTS, AND ASSUMPTIONS 1.

Tools and Concepts

i. ii. iii. iv. v.

The chapter reviews the definition of key labor market terms introduced in Chapter 2 and introduces several new ones, including the participation rate, discouraged workers, separations, layoffs, and quits. The chapter makes use of a production function. The chapter introduces wage-setting and price-setting relations. The chapter defines analytically the natural rate of unemployment and the natural level of output. The chapter introduces the concept of an expected price level, the first expectation seen in the book.

Assumptions

The chapter assumes that labor is the only factor of production. The text maintains this assumption until Chapter 10, which introduces growth. The chapter assumes a constant returns to scale (CRS) production function with fixed technology. This specification of the production function (labor only, CRS, and fixed technology) implies that the real wage is constant.

ii.

IV. SUMMARY OF THE MATERIAL 1.

A Tour of the Labor Market

The EU labor market is characterized by large flows between the three states of labor market activity: employed, unemployed, and out of the labor force. The text provides data on the size of these flows. The fact that large numbers of people move from out of the labor force into employment suggests that some 7-34 .

individuals classified as out of the labor force may be discouraged workers, i.e., people who have given up looking for work, but who would take work if they were offered it. If this is the case, the unemployment rate underestimates the number of people available for work. Some economists prefer to use the nonemployment rate as a measure of the state of the labor market. Figure 7-1 provides a visual of how the unemployment rate is computed.

Movements in Unemployment

The chapter develops four facts about the U.S. unemployment rate. First, after World War II, there was an upward trend in the unemployment rate until the mid-1980s; since then, the unemployment rate has declined. Second, year-to-year fluctuations in the unemployment rate are associated with recessions and expansions. Third, when the unemployment rate is high, the proportion of unemployed workers finding jobs is low. Finally, when the unemployment rate is high, the proportion of employed workers losing their jobs is high.1

Wage Determination

The text considers wage determination from two perspectives: bargaining and efficiency wages. Wage bargaining between employers and employees takes many forms. In some occupations, wages are determined by collective bargaining between unions and firms. Unlike in the United States, where slightly more than 10% of workers are covered by collective bargaining agreements - Highly or uniquely skilled workers (e.g., athletes, entertainers) engage in individual bargaining with their employers. For jobs that require little skill, employers may make take-it-or-leave-it wage offers – collective bargaining plays an important role in most European countries, as well as in other advanced economies, e.g. Japan. Efficiency wage theories are motivated by the idea that labor productivity is related to the wage. Paying a high wage may improve employee morale. Alternatively, a high wage may reduce turnover, which can be advantageous to the firm if it takes time to train new workers. From this perspective, firms have an incentive to offer a wage above the reservation wage—the wage at which a worker is indifferent between working or becoming unemployed. The text summarizes the complex wage determination process by focusing on three factors. First, wage outcomes depend on labor market conditions, which can be proxied by the unemployment rate (u). When the unemployment rate is high, it is relatively easy for firms to replace workers and difficult for workers to find new jobs, so worker bargaining power is low. In addition, workers are highly motivated to work and are unlikely to quit, so the efficiency wage motive is weaker. Second, given the unemployment rate, there are institutional and structural factors (summarized by the variable z) that affect the bargaining power of workers relative to employers. These factors include, among other things, the generosity of unemployment insurance and the level of the minimum wage. Finally, the nominal wage depends on the price level, because both workers and firms care about the real wage. However, wages are changed infrequently, so the price level that matters is the one that prevails over the duration of the wage contract. Since this future price level is unknown, wage determination depends on the expected price level. These points suggest an aggregate wage determination equation of the following form: W = P e F (u , z ) ( + , −)

(7.1)

The text provides evidence about job separations, which include quits as well as layoffs. A margin note argues, however, that quits are lower when the unemployment rate is high – as we would expect from theory – so that layoffs actually increase by more than separations when the unemployment rate is high.

7-35 .

Price Determination

Assume that labor is the only factor of production and that firms operate under constant returns to scale. Then, the production function takes the form

Y=N

(7.2)

Since the text assumes that technology is fixed in the medium run, equation (6.2) sets the marginal productivity of labor equal to one. Now assume that the goods market is imperfectly competitive, so firms have some market power. This implies that firms will set price according to P = (1 + m)W

(7.3)

W, the wage, is the marginal cost of production, and m is a markup reflecting the degree of market power possessed by firms. In a perfectly competitive environment, m = 0.

The Natural Rate of Unemployment

If nominal wages depend on the price level then: W = PF (u , z )

And dividing both sides by the price level we get. W = F (u, z ) P (−, + )

(7.4)

This relationship between the real wage and the rate of unemployment is known as the wage-setting relation which is shown in Figure 7-6. The price setting relationship is given by;

P =1+ m W

(7.5)

W 1 = P 1+ m

(7.6)

When we invert this equation we get;

Labor market equilibrium requires that the real wage implied by WS equal the real wage implied by PS, or;

F (u , z ) =

1 . 1+ m

(7.7)

The value of u that satisfies equation (7.7) is called the natural rate of unemployment. The graphical solution is given in Figure 7-6. Note that WS slopes down, since an increase in the unemployment rate tends to reduce the relative power of workers in wage bargaining. The PS curve is flat as a result of the assumption of constant returns to scale in the production function. If the production function exhibited decreasing returns to scale, the price-setting relation would be upward sloping. 7-36 .

The natural rate of unemployment is the rate of unemployment that makes WS and PS consistent when P = Pe. It is a medium-run concept, for two reasons. First, prices can adjust over the medium run. Second, in the absence of economic disturbances, it is unreasonable to assume that workers and firms will continually hold incorrect price expectations. Eventually, workers and firms will learn from past experience in forming price expectations. In the short run, there is no presumption that P = Pe, so the actual unemployment rate need not equal the natural rate of unemployment. Figure 7.6 Wages, Prices, and the Natural Rate of Unemployment

Moreover, the adjective natural is misleading. The natural rate of unemployment depends on labor market institutions and market structure. For example, an increase in competition in the goods market (a decrease in μ) would shift the PS line up and reduce the natural rate of unemployment. An increase in the z index— say, because of an increase in unemployment benefits—would shift the WS curve up and increase the natural rate of unemployment. Note that employment N is given by N = (1 − u)L, where L is the labor force. Assuming that L is fixed, the natural rate of unemployment (un) defines a natural level of employment Nn = (1 − un)L, which implies a natural level of output Yn = Nn. The natural level of output is the level of output that would prevail if price expectations were correct. Like the natural rate of unemployment, the natural level of output is a mediumrun concept. In the short run, the actual price level can differ from the expected price level, the actual unemployment rate can differ from the natural rate, and the actual level of output can differ from the natural level of output.

Where We Go from Here

This chapter discusses the determination of the unemployment rate and output in the medium run, a time frame in which it is reasonable to assume that the price level equals the expected price level. In the short run, when the expected price level need not equal the actual price level, the demand factors discussed in the previous chapters affect the unemployment rate. The next two chapters incorporate the labor market into the model developed in the previous chapters and analyze the determination of output, the unemployment rate, and the interest rate in the short and medium run.

7-37 .

V. PEDAGOGY 1.

Points of Clarification

The introduction of the expected price level, even in the simple fashion of the text, is a big jump for students. The text quickly removes the expected price level from discussion by equating it with the actual price level. As a result, students begin to think of the wage-setting and price-setting diagram as the method to determine unemployment at any time. It is worthwhile to emphasize that the natural rate is a medium-run concept and that there is no presumption that the price level equals the expected price level, or that the unemployment rate equals the natural rate, in the short run.

Alternative Sequencing

The organization of the text allows instructors to move immediately from the IS-LM framework to expectations (Chapters 15-17) or the open economy (Chapters 18-20), before consideration of aggregate demand and aggregate supply. Note, however, that one section of Chapter 21 does use a modified AD-AS framework to analyze the effects of devaluation.

VI. EXTENSIONS 1.

The Concept of the Medium Run

It may be worthwhile to reexamine the concept of the medium run in this chapter. Typically, disturbances are analyzed in the text as follows. Assume the economy begins in a medium-run equilibrium. Now consider an economic disturbance. The new medium-run equilibrium describes a point to which the economy will tend to return in the absence of further disturbances. The new short-run equilibrium describes the immediate effect of the disturbance. This chapter describes the effects of disturbances on the unemployment rate and output in the medium run.

Additional Examples

In Chapter 8, which examines the Phillips curve, boxes in the text examine European unemployment rates and changes in the U.S. natural rate over time. Although these examples fit naturally into a discussion of the history of the Phillips curve, instructors could use these examples in this chapter to reinforce the idea that the natural rate of unemployment depends on structural factors that can change.

VII. OBSERVATIONS The real wage is unaffected by the business cycle in the model of this chapter. Given the labor only, constant returns to scale production function, the real wage is always determined by the price-setting relation, regardless of whether P = Pe. Thus, the real wage is always determined by the degree of competition in product markets and the marginal product of labor (set equal to one in this chapter). Assuming that market structure changes relatively slowly, the implication of this model is that the real wage changes only when labor productivity changes.

VIII. APPENDIX Wage- and Price-Setting Relations Versus Labor Supply and Labor Demand This appendix shows how to reconcile the wage setting and price setting information contained in this chapter with the traditional supply and demand representation students learn in the introductory courses. Factors in the labor market, such as collective bargaining and the use of higher wages to deter quits, make 7-38 .

the standard labor supply relationship inadequate when describing real-world labor supply. Additionally, the standard labor demand relationship fails to account for the fact that firms typically set prices in most markets. The last factor that makes traditional demand and supply analysis inadequate when studying labor markets is the fact that unemployment is likely to be involuntary instead of simply the choice of labor not to work at the given wage rate. For these reasons the wage-setting and price-setting relations shown in this chapter do a better job of representing actual labor market conditions.

7-39 .

CHAPTER 8. THE PHILLIPS CURVE, THE NATURAL RATE OF UNEMPLOYMENT, AND INFLATION I.

MOTIVATING QUESTION

How are the inflation rate and the unemployment rate related in the short run and the medium run? Since 1970, both the U.S. and the UK data can be characterized as a negative relationship between the unemployment rate and the change in the inflation rate. This relationship implies the existence of an unemployment rate—called the natural rate of unemployment—for which the inflation rate is constant. When the unemployment rate is below the natural rate, the inflation rate rises; when the unemployment rate is above the natural rate, the inflation rate falls. The basic message of the chapter is that low unemployment puts upward pressure on inflation, but the form of the relation depends on how people and firms form expectations.

II.

WHY THE ANSWER MATTERS

The material in this chapter provides a way to think about the central issue of macroeconomic policy in many countries, namely, whether the central banck should change the interest rate (equivalently, the money supply) and if so, in what direction. According to the framework developed in this chapter, the economy cannot operate at an unemployment rate below the natural rate without a continual increase in the rate of inflation. This limits the ability of the central bank to stimulate the economy. By the same token, if the central bank wishes to reduce the inflation rate, it cannot do so without increasing the unemployment rate above the natural rate. The next chapter recasts aggregate demand in terms of the growth rate of money, develops a relationship between the unemployment rate and output growth, and considers in detail the policy tradeoffs facing the central bank.

III. KEY TOOLS, CONCEPTS, AND ASSUMPTIONS 1.

Tools and Concepts

The chapter introduces the original Phillips curve and its modern, expectations-augmented or accelerationist variant. The chapter expands the notion of the natural rate of unemployment. In the context of the accelerationist Phillips curve, the natural rate is the unique rate of unemployment consistent with a constant rate of inflation. The chapter introduces the concept of inflation expectations being deanchored or re-anchored during various time periods. In other words, the way people form inflation expectations can and does change over time based on assumptions of how the central bank will react to inflation.

ii.

Assumptions

In the context of the modern Phillips curve, the chapter assumes that expected inflation equals lagged inflation. This assumption gives rise to the accelerationist Phillips curve.

IV. SUMMARY OF THE MATERIAL Prior to 1970, there was a negative relationship between the unemployment rate and the inflation rate in the United States. In the 1970s, this relationship broke down. Between 1970 and 1995 there is no visible 8-40 .

relation between the unemployment and the inflation rate (see Figure 8-3). The traditional relationship vanished because wage setters changed the way they formed their expectations about inflation. Instead, the U.S. data can be characterized by a negative relationship between the unemployment rate and the change in the inflation rate. The original relationship is called the Phillips curve, after A.W. Phillips, who first discovered the relationship for the United Kingdom. The modern form is usually called the accelerationist or expectations-augmented Phillips curve. However, beginning in the mid-1990s the Phillips curve relation changed again and became re-anchored and reacted little or not at all to movements in actual inflation. People appeared to believe the Fed would take actions to keep inflation in check.

Inflation, Expected Inflation, and Unemployment

Impose the specific functional form F(u, z) = 1 − αu + z, and use the price determination equation (7.3) from Chapter 7 to derive

π = π e + (m + z ) − α u,

(8.2)

where π refers to the inflation rate and πe to the expected inflation rate. An appendix to Chapter 8 presents the full derivation of equation (8.2). It is important to understand the effects at work in equation 8.2. which are: • • •

An increase in expected inflation (πe) leads to an increase in actual inflation (π). Given expected inflation (πe) an increase in markup (m), or an increase in the factors that affect wage determination (an increase in z) leads to an increase in actual inflation (π). Given expected inflation (πe) a decrease in the unemployment rate (u) leads to an increase in actual inflation (π).

The Phillips Curve and Its Mutations

Two explanations are commonly offered for the breakdown of the original Phillips curve in the 1970s. First, there were significant supply shocks in the 1970s. Since the Phillips curve is the aggregate supply curve in terms of inflation, supply shocks affect the Phillips curve. The oil price shocks in 1973 and 1979, which the text models as increases in μ, would have affected the original Phillips curve. Second, the way workers form inflation expectations may have changed over time. The text models expected inflation as πet = θπt-1 and argues that it is plausible that θ was zero in the early postwar period because inflation was not consistently positive. However, as the inflation rate became consistently positive and more persistent, it is unlikely that workers failed to take notice. The text argues that the evidence supports a value of 1 for θ since 1970. Under this interpretation, the original Phillips curve,

π t = π + (m + z ) − α ut ,

(8.4)

π t − π t −1 = ( m + z ) − α ut .

(8.6)

evolved to

Equations (8.4) and (8.6) describe fundamentally different relationships between the inflation rate and the unemployment rate. In the former equation, there is a permanent tradeoff between inflation and unemployment. In the latter equation, the unemployment rate is a constant when the inflation rate is constant or more generally, when the inflation rate equals the expected rate of inflation. Note that equation (8.6) uses the change in inflation instead of inflation. Data since 1970 show there is a negative relationship between the change in the inflation rate and the unemployment rate. High unemployment 8-41 .

leads to decreasing inflation and low unemployment leads to increasing inflation. The relationship modeled in equation 8.6 is often called the modified Phillips curve, the expectations-augmented Phillips curve, or the accelerationist Phillips curve.

The Phillips Curve and the Natural Rate of Unemployment

The unemployment rate at which actual inflation is equal to the expected inflation rate is called the natural rate of unemployment. To derive the natural rate, solve for the unemployment rate when the inflation rate is constant in equation (8.6) or when the expected inflation rate equals the actual inflation rate in equation (8.3). Either method produces the following expression: un =

m+ z

(8.9)

In this chapter the authors also revisit the notion of the neutrality of money. The implication of this analysis is that money growth affects only the inflation rate in the medium run. Money growth has no effect on medium-run output growth or unemployment. By the same token, inflation is ultimately determined by monetary policy.

A Summary and Many Warnings

Taking stock of what we’ve learned: • • •

The relation between inflation and unemployment depends on how wage setters form expectations of inflation. If expectations are anchored the Phillips curve takes the form of a relation between inflation and unemployment. If expectations are unanchored the Phillips curve becomes a relation between the change in inflation and unemployment.

The text notes four limits on the use of the accelerationist Phillips curve as a characterization of the economy. First, the natural rate of unemployment varies over time. The text argues that the U.S. natural rate fell in the last half of the 1990s as a result of a variety of factors, some of which may have temporary effects on the natural rate and some permanent. Note that the interpretations of the changes in the natural rate tend to come after the fact. Such changes are difficult to predict. Second, the natural rate, such as we can measure it, varies across countries. European economies, for example, have much higher unemployment rates, on average, than does the United States. Some economists attribute high European unemployment to labor market rigidities, a term applied to a collection of policies, including generous unemployment insurance, a high degree of worker protection, bargaining rules that protect unions, and high minimum wages. A box in the text argues that the relationship between such policies and unemployment is not straightforward. For example, Denmark and the Netherlands have low unemployment rates despite generous social insurance programs for workers. It seems that low unemployment can be consistent with generous social insurance, as long as such insurance is provided efficiently. Third, the relationship between inflation and unemployment may depend on the degree of inflation. For example, if workers will accept real wage cuts only from inflation, and not from cuts in the nominal wage, the Phillips curve may break down when inflation is very low (or negative). In this case, high unemployment may not lead to much reduction in inflation. This point is relevant today because many 8-42 .

countries have low inflation. In addition, this reasoning may help to explain why U.S. deflation was so limited during the Great Depression, even though unemployment was unusually high. On the other hand, when inflation is very high, the relationship between unemployment and inflation may become stronger, because wage indexation becomes more prevalent. Suppose that a proportion (λ) of wage contracts is indexed to the actual inflation level, so that wages depend on the inflation rate. A proportion (1 − λ) of wage contracts is not indexed. Wages in these contracts depend on expected inflation, assumed to equal past inflation. Given these assumptions, the Phillips curve becomes

π t = [λπ t + (1 − λ )π t −1 ] − α (ut − un )

(8.11)

π t − π t −1 = −

α (1 − λ )

(ut − un )

An increase in the degree of wage indexation (λ) leads to an increase in the coefficient on the unemployment rate, and so increases the effect of the unemployment rate on inflation. Fourth, the relation between unemployment and inflation can completely disappear when inflation becomes low and turns into deflation. Inflation can actually be very high even with high levels of unemployment. Figure 8-6 plots the distribution of wage changes in Portugal in times of high and low inflation and shows that the Phillips curve relation between inflation and unemployment can disappear when inflation is near zero.

V. PEDAGOGY 1.

Points of Clarification

The AS Curve and the Phillips Curve. Chapter 8 may well seem to be something completely new. It is useful to emphasize that the AS curve and the expectations-augmented Phillips curve essentially capture the same relationship, one in terms of the price level, the other in terms of inflation. A subtler point is that the assumption that expected inflation equals lagged inflation is not equivalent to the assumption that the expected price level equals the lagged price level. The former assumption generates an equilibrium inflation rate (when embedded in the full medium-run model); the latter assumption generates an equilibrium price level. Graphical Presentation. The material in this chapter is presented algebraically. An alternative is to employ a graphical approach. Instructors could show the downward-sloping Phillips curve and explain that increases in expected inflation and the price of oil both shift the Phillips curve to the right. Moreover, the natural rate of unemployment intersects the Phillips curve where actual inflation equals expected inflation. If unemployment is lower than the natural rate, so that inflation is higher than expected, expected inflation increases and the Phillips curve shifts right. For a given state of aggregate demand, inflation and the unemployment rate both increase as the economy moves back toward the natural rate of unemployment. If unemployment is higher than the natural rate, expected inflation falls, the Phillips curve shifts left, and inflation and the unemployment rate fall as the economy moves back to the natural rate. Note that an increase in the price of oil also increases the natural rate.

ii.

The graphical presentation has some advantages. One is that is easy to show that an attempt by policymakers to maintain an unemployment rate below the natural rate will result in increasing inflation,

8-43 .

since expected inflation will continue to increase, and the Phillips curve will continue to shift up. Another is that the econometric collapse of the Phillips curve is easy to illustrate. As the Phillips curve shifts over time, we collect data from different Phillips curves. The result is a collection of points that do not illustrate a downward-sloping Phillips curve.

VI. EXTENSIONS Instructors could introduce rational expectations by considering the consequences of π = πe in equation (8.6). Under this assumption, the unemployment rate equals its natural rate.

VII. OBSERVATIONS In the medium run, there is no inflation in the AD-AS model. By contrast, the Phillips curve introduced in this chapter implies a constant (not necessarily zero) rate of inflation when unemployment is at its natural rate. In the AD-AS model, monetary policy is conceived in terms of the level of the money stock. In the medium-run model, monetary policy is conceived in terms of the growth rate of the money supply.

VIII. APPENDIX Derivation of the Relation Between Inflation, Expected Inflation, and Unemployment This appendix shows how to go from the relation between the price level, the expected price level, and the unemployment rate given by Equation 8.1 in the text to Equation 8.2. This equation is one of the most important equations in macroeconomics.

8-44 .

CHAPTER 9. FROM THE SHORT TO THE MEDIUM RUN: THE IS-LM-PC MODEL I.

MOTIVATING QUESTION

How are output, the unemployment rate, and inflation determined in the short run and the medium run? Short run output in the goods and services market is determined by demand. Inflation is impacted by the unemployment rate when the labor market is in equilibrium. Therefore output, the unemployment rate, and inflation are determined by simultaneous equilibrium in the goods, financial, and labor markets. Simultaneous equilibrium in the goods and financial markets is summarized in an aggregate demand relation and the relationship between unemployment and inflation is modeled using the Phillips curve (PC). Labor market equilibrium is conditional on the expected price level. In the short run, the expected price level may not equal the actual price level, and thus the unemployment rate may not equal the natural rate. Over time, the expected price level will tend to converge to the actual price level, and the unemployment rate will tend to return to the natural rate.

II.

WHY THE ANSWER MATTERS

This chapter integrates the goods, financial, and labor markets in short-run and medium-run equilibrium. It maintains the assumption that changes in monetary policy are discrete changes in the level of nominal money. The next two chapters introduce money growth and inflation into the analysis and begin to discuss the economy in terms of growth rates (except for the unemployment rate) rather than levels of variables.

III. KEY TOOLS, CONCEPTS, AND ASSUMPTIONS 1.

Tools and Concepts

The chapter ties the IS-LM model and Phillips curve together to analyze the impact of a shock or policy on the economy. The chapter introduces the concepts potential output, actual output, and the output gap. The chapter makes extensive use of dynamic analysis, introduces the term business cycle, and distinguishes between shocks and propagation mechanisms.

ii. iii.

Assumptions

The chapter assumes that the expected price level adjusts to differences between the actual and (previously) expected price levels. If the actual price level is greater (less) than the expected price level, wage setters are assumed to increase (decrease) their expected price level in the future. This adjustment mechanism is essential for the dynamic analysis presented in the text.

IV. SUMMARY OF THE MATERIAL 1.

The IS-LM-PC Model

Consider the IS-LM diagram from Chapter 5. In the short-run output is determined by demand and given by the equation; Y = C (Y − T ) + I (Y , r + x) + G

9-45 .

(9.1)

Output depends on the disposable income of consumers (net of taxes), investment spending (which depends on output and real borrowing rates) and government spending. Real borrowing rates depend on the central bank rate (r) and an investment premium (x). The IS curve represents these relationships graphically. In chapter 8 we derived equation 8.10 (equation 9.2) which shows the relationship between inflation and the unemployment rate. The evidence in Chapter 8 suggests that, in the United States today, inflation expectations are anchored, and a reasonable assumption is that wage setters expect inflation to be equal to the target set by the Fed, denoted π . Given this assumption, the relation between inflation and output is given by equation 9.4;

π − π = (α L ) (Y − Yn )

(9.4)

This equation allows us to see what happens when actual output deviates from potential output, or the output level that occurs at the natural rate of unemployment. The difference between potential output and actual output is dubbed the output gap. When the output gap is positive (actual is greater than potential) inflation will occur. When the output gap is negative, inflation falls.

From the Short to the Medium Run

Figure 9-1 plots the IS-LM and the PC curves. Recall that the real rate (r) is chosen by the central bank. At this interest rate output is given by Y as shown in the top half of Figure 9.1. The bottom part of Figure 9.1 shows us the change in inflation associated with this interest rate and output combination. These graphs show the short-run equilibrium. When the central bank increases interest rates as show in Figure 9-2 you see that output falls and inflation falls accordingly. Conversely, a negative output gap can be countered by lowering the policy rate to increase output. See Figure 9-2 – Medium-Run Output and Inflation The change in output reduces pressure on inflation so this interest rate (rn) is called the natural rate of interest. It may also be called the neutral rate of interest or the Wicksellian rate of interest. The change in output will occur over time as both consumers and businesses adjust spending due to the change in interest rates.

Complications and How Things Can Go Wrong

The central bank adjustment process seems simple in theory but is more complex in reality. One factor that complicates matters is the difficulty in determining where potential output is exactly and thus how far current output is from potential. For this reason, central banks may adjust the real interest rate slowly to see what happens. It also takes time for the economy to respond to policy changes, so a slower approach is typically adopted. When the economy is zero lower bound the central bank may not be able to lower policy rates to stimulate output. Even lowering interest rates to negative levels may not work and could result in continued falling output and prices, known as a deflation trap or deflation spiral as shown in Figure 9-3. This scenario occurred in the Great Depression from 1929 to 1933.

Fiscal Consolidation Revisited

We can now use this model to determine the impact of changes in fiscal policy. For example, if the government attempts deficit reduction via higher taxes it reduces consumption and shifts the IS curve to the left (See Figure 9-4). This shift results in lower output which, in turn, lowers investment. Output will now be below the potential level of output. Monetary action may now be needed to increase output back to the potential level of output. All that is needed is for the central bank and the government to coordinate 9-46 .

carefully. As fiscal consolidation takes place, the central bank should decrease the real rate so as to maintain output at the natural level. Therefore, monetary and fiscal policy need to work in tandem to keep the economy at the potential level of output.

The Effects of an Increase in the Price of Oil

The text provides evidence that increases in the price of oil are associated with increases in the U.S. inflation and unemployment rates. In recent years, however, the economy’s response to increases in the price of oil seems to have been much smaller than in the 1970s that was due to the formation of OPEC. A box in the text provides econometric evidence to support this observation, and offers two possible explanations. The first is that worker bargaining power has decreased, so that workers are more willing to accept wage cuts when the price of oil rises. The second explanation is that expectations of Fed behavior have changed. In the 1970s, oil price increases led to people to expect an increase in the general price level. In other words, inflation expectations were not anchored. In the 2000s, inflation expectations were anchored so wage setters assumed the price increase was a one-time event and did not change their expectations about future inflation. Today, people do not expect the Fed to allow the general price level to increase in response to an increase in the price of oil.

Conclusions

The exercises described in the chapter emphasize the distinction between the short-run and medium-run effects of shocks to the economy. Such shocks can arise from changes in private behavior or from policy changes. The dynamic effects of shocks are called propagation mechanisms. Fluctuations in output (commonly called business cycles) arise from the continual appearance of new shocks, each with its own propagation mechanism.

V. PEDAGOGY 1.

Points of Clarification

Central Bank Policy and interest rates. It is worth pointing out that the LM curve is considered horizontal in this analysis. In other words, interest rates are determined almost solely by the central bank and are not impacted by market forces. This simplification changes some of the analysis that you may have presented in earlier versions of the text. Analysis of Shocks in the IS-LM-PC Model. This is a difficult chapter. Students are likely to feel overwhelmed, particularly by the dynamics. To help students navigate the analysis of shocks in the the IS-LM-PC framework, instructors might wish to outline the steps in the analysis.

ii.

a. Unless stated otherwise, assume that the economy begins in medium-run equilibrium. This implies that output is at its natural level, unemployment is at its natural rate, and the price level equals the expected price level. b. Determine whether the shock affects the natural rate of unemployment. If the shock is to a variable in the IS-LM model, it will not affect the natural rate of unemployment. c. Determine whether the price level is greater than its expected level or less than its expected level. If the economy begins in medium-run equilibrium, the expected price level is the initial price level. Note that inflation expectations have a significant impact on the model’s dynamics. d. If the price level is greater than its expected level, the central bank will increase interest rates to combat the change in prices. If the price level is lower than expected the central bank may lower rates accordingly.

9-47 .

It is also useful to emphasize, as suggested in Chapter 7 of the Instructor’s Manual, that the short-run, medium-run distinction is an analytical aid to help economists analyze the effects of shocks occurring at some point in time. In the real world, the economy is always experiencing some short-run shock and responding to previous shocks. The medium-run equilibrium describes a point to which the economy will tend to return in the absence of further shocks. The actual path of the economy, however, will depend on the sequence of shocks it receives. iii.

Price Adjustment and Short-Run Equilibrium. Chapters 3 to 5 discussed the short run in the context of a fixed price level. The IS-LM model adopts the assumption that the price level is fixed as a simplification. As this chapter shows, what is true in the short run is that prices may not adjust fully to restore the natural level of output, and more generally, that the actual price level may not equal the expected price level. Going deeper, the fundamental assumption is that nominal wages do not adjust to actual prices but to expected ones. This assumption makes sense if wages are set for some period of time, so that wage setters base their decisions on expected prices over the life of the wage contract. On the other hand, wages are allowed to adjust immediately to changes in the unemployment rate, conditional on the expected price level. Clearly, a fully specified model would need to be careful about the terms and timing of wage adjustment. The IS-LM-PC framework in the text is a simplification intended to illustrate some basic issues—in particular slow price adjustment—at a manageable level of complexity.

Alternative Sequencing

In Chapter 14, which examines technological change and labor markets, there is a discussion of the effects of technological change on the IS-LM diagram. Instructors could present that part of Chapter 14 in the lecture on Chapter 9.

VI. EXTENSIONS Instructors may wish to further emphasize the scope for monetary policy to maintain full employment in the IS-LM-PC framework. For demand shocks, countercyclical monetary policy can be used to restore the natural rate of unemployment relatively quickly (as compared to waiting for the economy to adjust on its own). For supply shocks, countercyclical monetary policy moves the economy further away from the natural rate. For example, consider an adverse supply shock, which increases the natural rate of unemployment and reduces short-run output. An increase in M would serve to buffer some of the output fall in the short run, but at the expense of a higher price level in the medium run. A decrease in M, however, would move the economy to its new natural rate of output more quickly and with a lower medium-run price level (than would have occurred without the fall in M), but at the expense of an additional decline in shortrun output.

VII. OBSERVATIONS A horizontal LM curve indicates that money supply and interest rates are both fixed. In previous editions the LM curve was presented as upward sloping which indicates less central bank control over interest rates and more market impact. For example, interest rates were affected by other factors, such as the d in addition to central bank actions.

9-48 .

CHAPTER 10. THE COVID ECONOMIC CRISIS I.

MOTIVATING QUESTION

How has the Pandemic started in 2020 affected our economies? In the previous chapter we looked at a shock – a permanent increase in the price of oil – that affects both demand and potential output. Other shocks may be the product of policy measures taken for reasons that are independent from the economy and one such shock is the so-called Great Lockdown due to social distancing measures taken around the world in 2020 to try and stop the COVID-19 pandemic from spreading further. This shock has very different effects from any other shock we have discussed so far. To understand the macroeconomic consequences of the great lockdown of 2020, the aggregate model we studied so far – which assumes that the economy produces a single good – should be replaced by a model that recognises that firms are affected in very different ways by a lockdown.

II.

WHY THE ANSWER MATTERS

Many macroeconomists are concerned about why output decreased so much. What happened first was a major policy-induced supply shock. The lockdown forced firms in several directly affected sectors, from restaurants to hotels to airlines, to close or at least to drastically decrease supply. In contrast to other supply shocks we have analysed earlier in the book – such as an increase in the price of oil, where firms could pass on oil price increases and continue to operate – many firms had no choice than to stop or drastically decrease production. As a result of sharply lower output and thus income and of increased uncertainty, this shock had a major effect on demand, not just in the sectors directly affected by the lockdown, but also in the nonaffected sectors. Thus, the outcome was a combination of a supply shock and a sharp demand response.

III. KEY TOOLS, CONCEPTS, AND ASSUMPTIONS 1.

Tools and Concepts

The chapter does not develop new concepts, but introduces the possibility that sectors react differently to the shock and therefore head to different equilibria. The combination of a supply shock and a demand shock opens the possibility that the economy experiences inflationary or deflationary pressures.

ii.

Assumptions

This chapter assumes a closed economy, a fixed labour force, and a fixed level of technology.

IV. SUMMARY OF THE MATERIAL 1.

Economic effects of the lockdown

In previous chapters, we thought of the economy as one big sector, and did not differentiate between different sectors. To understand the effects of the COVID shock, we need to relax this assumption and think of two sectors: the first, directly affected by COVID (restaurants, hotels, airlines and the suppliers to those sectors), the second, not directly affected by COVID, but potentially affected by a decrease in demand.

Macro policy response

Fiscal policy cannot do much to increase output in the affected sector, but it can still do two things. The first is to protect the firms and the workers in that sector. Without help, many firms are likely to go bankrupt, 10-49 .

and many workers, having lost their jobs, may go hungry. Fiscal policy can help them. The second is to reduce demand spillovers in the non-affected sector. Monetary policy can help as well, by decreasing the policy rate and increasing demand.

3. Economy post-lockdown There is still a lot of uncertainty about the course of the infection, about the introduction of new drugs, about when vaccines will be available on a large scale, and how good they will be. The hope was that, when the lockdown ended, countries could contain the infection. There are good reasons, however, to think that the recovery will not continue at this rate: Much of the recovery so far has been the mechanical result of (some) firms reopening. Even if demand was lower than pre-COVID, firms rehired some of their workers and started producing again. This mechanical effect is coming to an end. Many firms that survived the lockdown by taking loans have accumulated debt to the point where they may go bankrupt, leading to more unemployment. Many firms are realizing that they may not survive. Many workers are realising that they may not get their old job back.

4. Economy post-vaccine Post-vaccine, governments will face at least three legacies of the COVID crisis. The first is the economic reallocation process. It is not yet clear how much the COVID crisis will lead to a different economy. The second is the large increase in public debt, resulting from the large increase in spending and the large COVID deficits. The third is the large increase in the balance sheets of central banks.

V. PEDAGOGY Students may be confused by the notion that different sectors behave differently (something has never been introduced before). The text provides a number of examples that illustrate how different sectors work to clarify. This can also give an opportunity to elaborate on why different countries seem to have reacted differently (depending on whether they have a majority of high-interaction sectors or low-interaction sectors, on the extent to which the high-interaction sectors managed to react to social distancing measures by increasing their online business, etc.).

VI. EXTENSIONS This chapter can be extended with a number of comments and discussions to different country experiences during and post Covid-19, both on the supply side (e.g. which economies have been more impacted by mobility reduction) and on the demand side (e.g. which countries have registered the most severe demand reduction?).

10-50 .

CHAPTER 11. THE FACTS OF GROWTH I.

MOTIVATING QUESTION

What do economists know about growth? The chapter answers this question from two perspectives. First, it describes the empirical facts about growth across a spectrum of economies in the postwar period, with a brief discussion of growth over a broader time span. Second, it introduces an aggregate production function with constant returns to labor and capital together but decreasing returns to each input separately. The chapter points out that this production function implies that growth cannot be sustained indefinitely by capital accumulation. Ongoing technological progress is required to sustain growth.

II.

WHY THE ANSWER MATTERS

Over the course of decades, the effects of output growth on economic welfare dominate the effects of output fluctuations. Understanding growth is of fundamental importance for the world’s poorer economies, many of which have suffered negative per capita growth rates in the postwar period.

III. KEY TOOLS, CONCEPTS, AND ASSUMPTIONS 1.

Tools and Concepts

i. ii.

The chapter introduces logarithmic scales for variable plots. The chapter develops an aggregate production function with two inputs—labor and capital—and constant returns to scale.

IV. SUMMARY OF THE MATERIAL 1.

Measuring the Standard of Living

Output per person provides some measure of a country’s standard of living. However, to compare real output per person across countries, it is important to use a consistent set of prices for the goods produced in each country. Basic subsistence goods tend to be cheaper in poor countries than in rich ones, and subsistence goods account for a larger proportion of output in poor economies than in rich ones. Unless these price differences are considered, a comparison of real GDP per person will tend to understate the relative real income of poor countries. GDP measures using a common set of prices are called purchasing power parity (PPP) numbers. PPP numbers also remove exchange rate fluctuations from the calculation of the standard of living. Output per person is taken as a measure of the standard of living because economists assume that happiness increases with output per person. A box in the text argues that the relationship between happiness and output per person is more complicated. The evidence seems to support the conclusion that happiness increases with income per person. Overall, rich people are happier than poor people. However, happiness gains from higher income phase out at higher levels of income.

Growth in Rich Countries Since 1950

Using PPP numbers, the text examines growth in four large economies—France, Japan, the United Kingdom, and the United States—and draws two conclusions. First, there has been a vast improvement in 11-51 .

the standard of living in these economies since 1950. Second, levels of output per capita have tended to converge over time. The convergence result extends to the OECD countries and even to a set of countries broader than the OECD. Convergence holds in general among the sample of economies that in 1950 had output per person at least 1/4 as large as the United States. Not all countries in this sample have converged, however. For example, Uruguay and Venezuela were all nearly as rich as France in 1950, but far behind France by 2017. Over time, the force of compounding has a tremendous impact on output and economic growth.

A Broader Look Across Time and Space

From a broader historical perspective—say, the past 2000 years or so—growth rates achieved by rich economies since 1950 seem exceptionally high. Moreover, the historical record seems more accurately described by leapfrogging than by convergence, since the identity of the richest country has changed several times since per capita growth became positive in the West (ca. 1500). A closer look at growth since 1960 for a broad sample of 85 countries reveals clear signs of convergence for OECD economies and most Asian economies, but not, in general, for African economies. Many African economies—already poor in 1960—have had negative growth since then. In contrast, the Asian countries of Singapore, Taiwan, Hong Kong, and South Korea (sometimes called the four tigers) have posted huge gains in average per person output. In 1960, their average output per person was about 15% of that of the United States; by 2017, the ratio had increased to 85%. The text notes these facts about growth in African economies but focuses on growth in rich and emerging economies. There is some discussion of institutions in slow-growing countries in Chapter 13.

Thinking About Growth: A Primer

To think seriously about growth, it is necessary to modify the aggregate production function to include capital:

Y = F (K , N )

(11.1)

The function F defines the state of technology. The function is assumed to exhibit constant returns to scale (CRS) over labor and capital together, and therefore decreasing returns to each factor individually. The CRS assumption also implies that equation (11.1) can be rewritten as Y K  = F  1 N  N′  +

(11.3)

Given CRS, the increase in output per worker from an extra unit of capital per worker will decline as K/N increases. Thus, the aggregate production function has the shape depicted in Figure 11-4. There are two potential sources of growth in output per worker. One is capital accumulation (increases in K/N), and the other is technological progress, which changes the F function so that a given value of K/N produces more and more Y/N. Capital accumulation alone cannot sustain growth indefinitely, because decreasing returns imply that larger and larger increases in capital per worker would be required. At some point, society would be unwilling to save the necessary resources to provide for the required increases in capital per worker, and growth would cease. Sustained growth requires sustained technological progress.

11-52 .

Figure 11-4: Output and Capital per Worker

V. PEDAGOGY The analysis of growth seems relatively disconnected from the material in the earlier chapters. One way to tie things together is to assume that the production function is without capital and define the normal growth rate of output as the productivity growth rate plus the growth rate of the labor force. This definition implies that normal growth of output per worker equals productivity growth. Essentially, this chapter (along with Chapters 12 and 13) asks whether this definition must be modified when capital is included in the production function. In the long run, the answer is no. Over time, output growth is determined by productivity growth. Chapter 13 makes this point more formally.

VI. EXTENSIONS Instructors may wish to explain how the inclusion of capital would affect the analysis of the medium run developed in previous chapters. Essentially, the working assumption thus far has been that the capital stock changes very slowly, so it can be treated as fixed in the medium run. A fixed capital stock and a neoclassical production function (equation (11.1)) together imply that the firm’s marginal cost curve rises with employment, since there are decreasing returns to labor. Thus, the markup over the wage will not be fixed, but will depend positively on the level of employment, as well as the market power of firms.

VII. OBSERVATIONS The aggregate production function in the text is defined in terms of output per worker. If the ratio of employment to population is constant, then growth of output per worker equals growth of output per person.

11-53 .

CHAPTER 12. SAVING, CAPITAL ACCUMULATION, AND OUTPUT I.

MOTIVATING QUESTION

Does the saving rate affect growth? If the production function exhibits decreasing returns to capital, an increase in the saving rate can only affect the growth rate temporarily. In the long run, saving does not affect growth, but does affect the level of output per worker.

II.

WHY THE ANSWER MATTERS

Many macroeconomists are concerned about the low U.S. saving rate (relative to other OECD economies) and the large scale of U.S. borrowing abroad. Changes in the structure of the Social Security system may also have implications for saving and capital accumulation. This chapter clarifies the relationship between saving, output per person, and growth, and discusses the likely effects of increasing the saving rate.

III. KEY TOOLS, CONCEPTS, AND ASSUMPTIONS 1.

Tools and Concepts

iii.

The chapter develops the Solow model of growth for the case of no technological change and no population growth. The golden-rule level of capital per worker is the value of capital per worker that maximizes steadystate consumption per worker. The Cobb-Douglas production function is described in an appendix.

Assumptions

ii.

This chapter assumes a closed economy, a fixed labor force, and a fixed level of technology.

IV. SUMMARY OF THE MATERIAL 1.

Interactions between Output and Capital

There are two relations between output and capital: 1. The amount of capital determines the amount of output produced. 2. The amount of output determines savings which in turn determines capital accumulation over time. To save notation, write the aggregate production function of the previous chapter, Y/N = F(K/N,1), as Y K = f  N N

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Now make the following assumptions. i. There is no technological change. ii. Population, the labor force participation rate, and the natural rate of unemployment are all constant. Thus, N, interpreted as the natural level of employment, is also constant. We have also introduced time indexes (t) for output and capital. The production function can now be written as: Yt K  = f t N  N 

(12.1)

Now we can see that higher capital per worker leads to higher output per worker. Output and Investment To derive the relationship between output and investment we make three assumptions. i.

The economy is closed. Investment, I, is equal to private saving, S, and public saving, (T – G). I = S + (T − G )

ii. iii.

Public saving (T – G) is equal to zero. This assumption allows us to focus on private saving. So, Investment is equal to private saving, or I = S. Private saving is proportional to income: S = sY .

Now we can combine these relations and see the following relationship between investment and output. I t = sYt

Investment and Capital Accumulation Capital depreciates at rate, δ. Thus, the change in the capital stock over time is K t +1 = (1 − δ ) K t + I t

Investment creates new capital, but the existing capital stock depreciates. Any change in capital at the end of the year is the net effect of new investment and depreciation of existing capital.

The Implications of Alternative Saving Rates

The equations above together imply Kt +1 Kt K  K  − = sf  t  − δ  t  N N N   N 

(12.3)

Capital per worker increases to the extent that total saving per worker exceeds depreciation of the existing capital stock per worker. Figure 12-2 plots the separate components of equation (12.3). The dynamics of adjustment are indicated by the arrows on the horizontal axis of Figure 12-2. To the left of point A, saving per worker (sf(K/N)) exceeds depreciation of the existing stock (δK/N), so the capital 12-55 .

stock per worker (K/N) rises. To the right of point A, (K/N) falls, since depreciation exceeds saving. These dynamics imply that in the in the long run, the economy will arrive at point A. Once the economy reaches this point, (K/N) and (Y/N) will remain constant. For this reason, the state of affairs represented by point A is called a steady state for the economy. From equation (12.3), the steady-state value of (K/N) is determined by

 K∗  K∗ sf  =δ   N  N  

(12.4)

Point B indicates steady-state output per worker, which is given by

 K∗  Y∗ . = f  N  N  

(12.5)

Figure 12-2: Capital and Output Dynamics

Now consider an increase in the saving rate. In Figure 12-4, an increase in the saving rate from s to s′ shifts the sf(Kt/N) curve upward in proportion to the change in the saving rate. The new steady-state equilibrium is given by point B. At this point, the steady-state growth rate (which is zero) is the same as the original steady-state growth rate. Capital per worker, however, is higher at point B, so output per worker is higher as well. These results imply that an increase in the saving rate will increase the growth rate temporarily, since output per worker must increase to reach the new steady state, but not in the long run.

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Figure 12-4: The Effects of Different Saving Rates

What is the optimal saving rate? A very low saving rate will result in very low steady-state output and consumption per worker. A very high saving rate will waste resources on depreciation, since extra units of capital per worker produce very little extra output per worker when the capital stock is high. Somewhere in between is a saving rate that maximizes steady-state consumption per worker. This rate is called the golden rule saving rate, which produces the golden rule capital stock. Empirically, it appears that the U.S. saving rate is below the golden rule rate, so it seems likely that an increase in the saving rate would increase the consumption of future generations. On the other hand, an increase in the saving rate would reduce the level of consumption for some time, until the increased output (generated by the higher capital stock) compensated for the reduction in the proportion of output consumed. With these results in mind, a box in the text considers the effects of two proposals to reform the Social Security System. A shift from a pay-as-you-go to a fully funded Social Security system could lead to a higher capital stock in the long run, since Social Security contributions are invested and not simply redistributed as in a payas-you-go system. This result, however, depends on how the transitional costs are financed. If additional debt is issued to finance benefit payments during the transition, there will be no effect on national saving, as the newly-issued debt will offset the additional saving from a fully funded system. On the other hand, if additional taxes are raised or benefits are cut during the transition, then some generation(s) will bear an extra burden beyond financing the retirement of the previous generation. These considerations seem to imply that a shift to a fully funded system would have to be gradual, to prevent the costs from falling too heavily on one generation. Similar issues would arise if workers were allowed to divert a portion of Social Security payroll taxes into private retirement accounts. Either the lost revenue would be borrowed, which would nullify the extra saving from the private accounts, or financed by additional taxes and benefit cuts, which would imply that some generation(s) would bear an additional burden.

Getting a Sense of Magnitudes

A Cobb-Douglas production function with equal shares of labor and capital implies that the capital accumulation equation can be written 12-57 .

Kt +1 Kt Kt K − =s −δ t . N N N N

(12.7)

In steady-state output per worker is given by,

Y∗ K∗ s = = . N N δ

(12.9)

In this case, if the saving rate doubles, so does long-run output per worker. How fast does the economy adjust? Suppose that s increases from 0.1 to 0.2, that the depreciation rate equals 0.1, and that initially K/N=1. Using the dynamic equation (12.3), one can show that adjustment to the new steady state is only 63% complete after 20 years. With the same Cobb-Douglas production function, consumption per worker can be written C*/N = (1 − s)Y*/N = (1 − s)s/δ, which is maximized when s = 1/2. Recall that the U.S. saving rate since 1950 has only been about 17%, so if this model provides even a gross approximation of the U.S. economy, the U.S. saving rate is below the golden rule rate. Therefore, it seems safe to assume that an increase in the U.S. saving rate would lead to an increase in steady-state consumption per worker.1 Read the Focus Box on “Nudging US Households to Save More” for ideas on how to increase the US saving rate.

Physical versus Human Capital

The aggregate production function can be generalized to include human capital (H):

Y K H = f . N  N′ N  ( +, + ) The conclusions derived previously can be interpreted as applying to the accumulation of physical capital for given levels of human capital, or to the accumulation of human capital for given levels of physical capital. Some economists, however, challenge the basic conclusions of the Solow growth model. Following the work of Lucas and Romer, these economists argue that growth can be sustained by the joint accumulation of physical and human capital. If these economists are right, growth is endogenous, because it depends on variables potentially under the control of policymakers and individuals. In the Solow model, by contrast, growth is exogenous, because it depends on the rate of technological progress, which is taken as given. The text argues that the evidence thus far does not support the hypothesis of endogenous growth. Given the rate of technological progress, accumulation of physical or human capital, individually or jointly, is not sufficient to sustain growth. It remains possible, however, that the rate of technological progress is related the level of human capital. Chapter 13 looks at the sources and effects of technological progress.

Note that for the production function, Y = KaN1-a, steady-state consumption per worker is maximized when s = a. For the United States, a typical estimate is a = 1/3, still far above the U.S. saving rate.

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V. PEDAGOGY Students may be confused by the notion that an increase in the saving rate will increase steady-state consumption per worker, since IS-LM analysis suggests that an increase in the marginal propensity to save will reduce output. The differing results arise in different time frames, and both could be true. It may be worthwhile to clarify the short-run/long-run distinction in the context of this example. Moreover, the dynamic simulation in the text provides some idea of the length of the long run.

VI. EXTENSIONS How could the introduction of human capital create the possibility that a higher saving rate could generate a permanently higher growth rate? The issue turns on whether the production function Y/N = F(K/N, H/N) exhibits constant returns to scale in its two arguments, so that if both K/N and H/N are doubled, Y/N also doubles. If so, then accumulation of physical and human capital together can generate ongoing growth. In this case, if saving can accumulate human as well as physical capital, then an increase in the saving rate leads to a permanently higher growth rate.

VII. OBSERVATIONS Depreciation of the capital stock is necessary for the existence of a steady-state equilibrium in the growth model presented in this chapter. Without depreciation, the model generates a positive but steadily decreasing rate of growth. Note that an increase in the rate of depreciation reduces the steady-state capital stock per worker.

VIII. APPENDIX The Cobb-Douglas Production Function and the Steady State In 1928, Charles Cobb (a mathematician) and Paul Douglas (an economist, who went on to become a US senator) concluded that the following production function gave a good description of the relation between output, physical capital, and labor in the United States from 1899 to 1922:

Y = K α N 1− α

(12.A1)

with α being a number between zero and one. Their findings proved surprisingly robust. Even today, the production function (12.A1), now known as the Cobb-Douglas production function, still gives a good description of the relation between output, capital, and labor in the United States, and it has become a standard tool in the economist’s toolbox. The purpose of this appendix is to characterize the steady state of an economy when the production function is given by (12.A1). Recall that, in steady state, saving per worker must be equal to depreciation per worker.

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CHAPTER 13. TECHNOLOGICAL PROGRESS AND GROWTH I.

MOTIVATING QUESTION

How does growth relate to technological progress, and what determines the rate of technological progress? In the long run, the growth of output per person output equals the rate of technological progress. Evidence from the postwar growth experience of four rich economies coincides with this assertion. Most technological progress results from research and development (R&D) carried out by firms. Economics has relatively little to say about the translation of R&D effort into useful products. Economic analysis does suggest some policies—e.g., patent protection—that provide incentives for R&D effort.

II.

WHY THE ANSWER MATTERS

Rich countries want to maintain growth in their standards of living, and poor countries want desperately to improve their standards of living. Chapter 12 ruled out the saving rate as a means to improve the standard of living in the long run. What is left is the rate of technological progress. This chapter confirms that the rate of technological progress is the only determinant of long-run growth. Since this rate is not directly in the control of policymakers, it is critical to understand the determinants of the rate of technological progress and to assess whether there are policy options available to improve growth. This chapter focuses primarily on rich countries, although there is a short section on China and a brief discussion of patent protection in poor countries. Chapter 14 examines the relationship between policies and growth, a topic of special relevance to poor countries.

III. KEY TOOLS, CONCEPTS, AND ASSUMPTIONS 1.

Tools and Concepts

i. ii.

Effective worker is the number of workers (or the amount of labor) multiplied by the level of labor productivity. In symbols, effective worker equals AN. Growth accounting and the Solow residual are described in an appendix to the chapter.

Assumptions

This chapter continues to assume a closed economy, but allows for growth of the labor force and technological progress.

IV. SUMMARY OF THE MATERIAL 1.

Technological Progress and the Rate of Growth

Let the variable A denote the state of technology, and incorporate labor-augmenting technology into the aggregate production function:

Y = F ( K , AN ).

13-60 .

(13.1)

In Chapter 12, which used a production function with fixed technology, it was convenient to describe the economy in terms of output per worker and capital per worker. In this chapter, which uses the production function in equation (13.1), it is convenient to describe the economy in terms of output per effective worker (Y/AN) and capital per effective worker (K/AN). With this new normalization, the analysis proceeds as in Chapter 12. The function F is assumed to exhibit constant returns to scale and therefore decreasing returns to each of its arguments separately. Thus, it can be rewritten as Y  K  = f , AN  AN 

(13.2)

where the function f has positive but decreasing returns to K/(AN). With the government budget deficit set equal to zero, goods market equilibrium in a closed economy is equivalent to I = S = sY, or expressed in terms of effective workers, I  K  = sf   AN  AN 

In the model of Chapter 12, with a constant labor force and no technological progress, the capital-labor ratio reached a steady state when saving was just sufficient to replace capital depreciation. Since N was fixed, K/N was constant when K was constant, i.e., when saving did no more than replace depreciated capital. In this model, in order for K/(AN) to be constant, K must grow at the same rate as AN. These assumptions imply that the level of investment needed to maintain a given level of output per effective worker is given by

I = (δ + g A + g N ) K .

(13.3)

Where δ is the depreciation rate of capital, gA represents the rate of technological progress, and gN represents the population growth rate. This level of investment is sufficient to both to replace depreciated capital, and to allow the capital stock to increase by (gA+gN)K. Substituting equation (13.3) into equation (13.2) gives the steady-state equilibrium condition of investment per effective worker: I K = (δ + g A + g N ) AN AN The economy looks qualitatively similar to Figure 13-2. In steady state, Y/(AN) is constant, so output grows at rate δ +gA+gN. Output per worker, however, grows at rate gA. An increase in the saving rate increases steady-state output per effective worker, but does not affect the steady-state growth rate of output per effective worker which is affected by the rate of technological progress (See Figure 13-3).

The Determinants of Technological Progress

The model in this chapter establishes that long-run growth is determined by the rate of technological progress, but takes this rate as given. What are the sources of technological progress? Technological change is the product of research and development (R&D), most of which is conducted by firms in search

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of increased profits. In general terms, R&D spending depends on the expected fertility of research (its yield of new ideas and products) and the appropriability of the results of research. Fertility depends on the successful interaction of basic research, applied research, and product development. Appropriability depends in part on the nature of the research process. If it is believed that a new discovery will quickly lead to a better discovery by another firm, the ability to profit from the results of research is limited. Appropriability also depends on the degree of patent protection afforded to the inventors of new products. Patent protection allows the inventor of a product to enjoy a monopoly on its sale for a time, and thus offers an incentive for research effort. On the other hand, patent protection makes it more expensive for society to benefit from the introduction of new products, since these products are likely be sold at prices above their marginal cost of production. By and large, rich countries, where most inventions occur, have stronger patent laws than poor countries, where technological progress depends on the adaptation of foreign technologies by domestic firms. A box in the text examines the relationship between management practices and growth. A study by Bloom and Van Reenen (2010) discovered that firm performance differed among similar size firms using the same technology. They attributed the performance difference to good management practices. In other words, firms outperformed peers by adopting and implementing good management practices.

Institutions, Technological Progress, and Growth

Growth rates differ significantly among countries. While many factors contribute to these differences many economists increasingly point to institutions as the fundamental reason why many poor countries remain poor. By institutions, economists generally mean the procedures and traditions in place to protect private property rights. These procedures and traditions span a wide range, including areas as diverse as the degree of corruption in the political system, the efficiency and fairness of the court system, and patent and anti-trust law and enforcement, among many others. The complexity and scope of the arrangements required to protect property rights in a modern economy make it difficult for poor countries to build these institutions. This observation means that there is also reverse causality: poor institutions may lead to low GDP per person, but low GDP per person may also lead to poor institutions. The protection of property rights is a primary driver of growth because individuals and firms that believe wealth will be expropriated have little incentive to work and create. In contrast, countries that protect property rights provide incentive for hard work and creativity. Figure 12-5 shows the high correlation between property rights and GDP per person. A text box highlights North Korea and South Korea which provide a case study in property rights. Prior to 1953 Korea was a single country with no physical differences in population or resources, in other words a very homogenous country. After 1953 the country was divided into North Korea (limited property rights and central planning) and South Korea (protection of property rights and capitalism). A substantial divergence in per capita GDP now exists after 60+ years. South Koreans have per capita GDPs that are more than 6 times greater than North Korean per capita GDPs. The difference is due to the differences in institutions. See the text box on page 283. The text also looks at growth in China since about 1980, and again finds—subject to the limitations of the data—that growth of output per worker has been approximately the same as the rate of technological progress, i.e., about 7.5 – 8%. Today both growth rates hover around 6%. This result suggests that China is also on a balanced growth path. For China, maintaining this path with such a high rate of growth has

13-62 .

required a substantial amount of investment. The inefficient banking system is identified as a limit to growth in China. China has achieved rapid technological progress through two strategies. First, workers have been reallocated from occupations in the countryside to more productive ones in cities. Second, China has encouraged foreign direct investment and joint ventures, which allow Chinese firms to learn from more productive foreign firms and to import technologies.

V. PEDAGOGY It is worthwhile to reinforce the distinction between technological progress and productivity growth. In terms of the production function used in this chapter, technological progress is an increase in the parameter A. Productivity growth is an increase in output per worker. In steady state, the rate of technological progress equals the rate of productivity growth.

VI. EXTENSIONS The notion that technological progress applies only to the labor input in the production function may seem arbitrary to students. Instructors could point out that under the Cobb-Douglas production function, Y = AKaN1-a, the assignment of the technology parameter is a mere convenience, since the production function can be rewritten as Y = Ka(ΛN)1-a, where Λ ≡ A1/(1-a).

VII. OBSERVATIONS The finding that the saving rate has no effect on the steady-state growth rate depends on the assumption that the size of the capital stock has no effect on technological progress. This assumption might not be true for human capital. For example, it is possible that an increase in investment in education geared toward basic research could lead to an increase in the rate of technological progress.

VIII. APPENDIX How to Measure Technological Progress, and the Application to China How do we measure the rate of technological progress? The answer was given in 1957 by Robert Solow and is still in use today. It relies on one important assumption: that each factor of production is paid its marginal product. Under this assumption, it is easy to compute the contribution of an increase in any factor of production to the increase in output. The appendix uses the case of China to apply this model and determine expected future growth.

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CHAPTER 14. THE CHALLENGES OF GROWTH I.

MOTIVATING QUESTIONS

What impact does technological progress have on the future? In the medium run, technological progress does not create unemployment, in theory or in evidence; in the short run, technological progress sometimes reduces unemployment, sometimes increases it. Technological progress does affect income distribution. Many economists believe that the skill bias of technological change has been the primary reason for the sizeable increase in U.S. income inequality over the past three decades.

What policies should be adopted to limit the negative effects of growth? Both technological progress and globalization are blamed for inequality. However, growth is also blamed for various ecological disasters and considered to be a primary driver of climate change. If the evidence supports this claim, what policies should be adopted to ensure responsible growth?

II.

WHY THE ANSWER MATTERS

Chapters 11 through 13 established technological progress as the determinant of long-run growth per person. Nevertheless, workers often fear that technological progress will eliminate their jobs. In response to this concern, Chapter 14 argues that productivity growth does not appear systematically to increase the unemployment rate. However, technological progress may affect the distribution of income. Economic growth also comes at a cost to the planet. There are environmental tradeoffs we must make to spur additional growth. The question of how to balance growth with environmental protections will continue to be a topic of debate among policy makers and economists.

III. KEY TOOLS, CONCEPTS, AND ASSUMPTIONS 1.

Tools and Concepts

Essentially, there are no new tools in this chapter.

Assumptions

Policies should be adopted that make growth a fair and sustainable process.

IV. SUMMARY OF THE MATERIAL 1.

The Future of Technological Progress

We might expect rapid technological progress to increase productivity. Yet, as we saw in Table 1-2 in Chapter 1, US measured productivity growth has slowed down since the mid-2000s, running at less than half the rate of earlier decades. One argument is that technological progress is hard to measure and the we also understate the rate of productivity growth. Some argue that the current major innovations are less important than the major innovations of the past. Major innovations are innovations that have applications in many fields and many products. (For this reason, these innovations are called general-purpose technologies.) Robert Gordon, of Northwestern 14-64 .

University, argues that the two major innovations of the last 150 years were electricity and the internal combustion engine. Others, in particular Eric Brynjolfsson of MIT, argue that digitization, together with the increasing power of computers, will transform our lives as much as or more than electricity or the internal combustion engine did earlier. Artificial intelligence and machine learning may transform nearly any activity, from driverless cars to the mapping of the human genome and major progress in medicine, to the way lawyers access relevant jurisprudence. He argues that the current low productivity growth reflects the slow process of diffusion and the discovery of new applications. He concludes that the future is bright, and he sees no end to technological progress. Time will tell which perspective is correct.

Robots and Unemployment

For the last 200 years workers have worried they will be displaced by technology. We often see the theme of technological unemployment resurface when unemployment is high. From the machine-smashing Luddites in the early 19th century to the technocracy movement that appeared during the Great Depression we often hear workers argue the high unemployment is due to the introduction of new machinery or technology. However, the data show this fear is unfounded. Figure 13-1 plots US labor productivity growth and average unemployment rates for every decade since 1890. Periods of higher productivity growth are associated with the lowest unemployment rates. Technology is one of the primary drivers of increases in productivity. The only caveat is that we cannot be sure this relationship will hold in the future. Will robots replace workers and increase everyone’s standard of living? Or will they simply increase wealth inequality? Policy makers will need to watch closely to ensure everyone receives some minimum level of income in this future scenario.

Growth, Churn, and Inequality

Even if technological progress helps the economy generally and does not lead to increases in the aggregate unemployment rate, it still may hurt some individuals. In the United States, for example, wage inequality has increased substantially over the past 20 years. Workers with a high level of education have enjoyed an increase in their relative real wage; workers with a low level of education have suffered a decrease in their relative real wage. Indeed, workers with the least amount of education have actually suffered a decrease in the absolute level of their real wage. The increase in the relative wage of high-skill workers reflects increased relative demand for high-skill workers. Two common explanations for this phenomenon are increased international trade, which exposes lowskill U.S. workers to foreign competition, and skill-biased technological progress. The trade explanation, however, does not explain why the relative demand for high-skill workers seems to have increased even in those sectors not exposed to foreign competition. This observation, among other reasons, has led most economists to emphasize skill-biased technological progress as the primary explanation for increasing wage inequality. The process of growth that develops new goods and simultaneously makes other goods obsolete has been dubbed creative destruction by Joseph Schumpeter. There is also reason to suspect that the trend will not continue indefinitely. In the first place, the shift in relative demand for high-skill workers may slow down. Computers may begin to replace high-skill workers, or firms may be motivated to explore new technologies that make use of relatively inexpensive low-skill workers. Moreover, the relative supply of high-skill workers may increase, since the wage differential may motivate more workers to invest in education. Wage inequality is evident and appears to be driven by education and skill sets as one would expect. However, we are also seeing significant income inequality. The top 1% of income earners, relative to the bottom 50%, is shown in Figure 14.3. You can see how this income inequality has shifted in the past 14-65 .

30 years to where the top 1% get a disproportionate share of income largely due to their ownership of income-producing assets. One way to measure the extent of the inequality is by computing a Gini Coefficient. Given that inequality is increasing the question for policy makers becomes “How do we achieve inclusive growth? Current policies to reduce disposable income inequality include better education, minimum wage laws, and better governance rules within firms. In addition, countries with lower levels of disposable income inequality have higher levels of wealth redistribution.

Climate Change and Global Warming

Markets do not function properly when externalities are present. One such major externality is the emission of greenhouse gases that have a societal cost but are not always considered when people make market choices. Figure 14.6 shows how CO2 emissions have increased since 1950 as various regions of the world have become more developed. A second graph in Figure 14.7 shows how global average temperatures have increased accordingly. Given the potential damage due to increased global warming policy makers need to find some mechanism to combat this issue. Given the issue is a global issue it needs to be addressed by all nations. However, is extremely difficult to get an agreement across all countries. One solution, proposed by William Nordhaus of Yale University, is to get countries willing to impose a carbon tax on goods imported from countries without a carbon tax. This policy would provide incentive for all nations to adopt a carbon tax to lower trade costs.

V. PEDAGOGY This chapter is optional. It can be omitted without loss of continuity. On the other hand, this chapter is relatively accessible to students, and can be included in a course even if the chapters on growth are omitted. One could also view the chapter as a minor break from the quantitative material in other chapters. The topics covered in this chapter are all good debate topics to stimulate class discussion.

VI. EXTENSIONS Problems at the end of Chapter 14 ask students to add carbon-intensive energy input, E, to the production function. Discuss how a tax on carbon emissions would likely impact production. Behavioral economics can also be introduced in this chapter with regard to individual fears regarding technology.

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CHAPTER 15. FINANCIAL MARKETS AND EXPECTATIONS I.

MOTIVATING QUESTION

How can consumers and firms compare present and future economic opportunities? Future economic opportunities (payments received or made) can be expressed in terms of the present by using a discount factor, which acts like a price. The sum of a sequence of payments, each priced at the appropriate discount factor, is called the present discounted value of the sequence. In practice, future variables are not known, so one calculates the expected present discounted value, which is the present value of the expected sequence of payments.

II.

WHY THE ANSWER MATTERS

Economic agents have foresight, so beliefs about the future can affect the present. This chapter describes the basic tools by which consumers and firms can price future economic events (payments made or received). In so doing, this chapter lays the groundwork for a look at consumption and investment decisions when agents are forward-looking, a discussion of asset markets, and an integration of expectations into IS-LM analysis. These topics are the subject of the next two chapters. Two important applications—the determination of stock and bond prices—are analyzed in this chapter. The concept of asset bubbles is also introduced.

III. KEY TOOLS, CONCEPTS, AND ASSUMPTIONS 1.

Tools and Concepts

The expected present discounted value of a sequence of payments is the value today (i.e., in current nominal or real units) of the expected sequence of payments. The relationship between yield and maturity is introduced via the yield curve. The concept of asset bubbles and the impact on the economy is introduced.

ii. iii.

IV. SUMMARY OF THE MATERIAL 1.

Expected Present Discounted Values

An investment of €1 today would grow to €[(1 + it)(1 + it+1)...(1 + it+n-1)] in n years, if the investment proceeds were reinvested. Thus, to accumulate €1 in n years, one would have to invest an amount   1 €Vt =  .  (1 + it )(1 + it +1 ) (1 + it + n −1 ) 

The required investment today is called the present value of €1 received in n years. This observation can be used to calculate the present value of any stream of future payments. Typically, however, neither future payments nor interest rates are known with certainty, so present value calculations must rely on the expected values of future payments and short-run interest rates. Sequences with constant interest rates and constant payments—over a fixed or infinite horizon—represent special cases. When future payments are expressed 15-67 .

in real terms, they are appropriately discounted using current and expected future real interest rates. In most cases we shorten the name of the concept to present value and the process of computing a present value is known as discounting. When we focus on a sequence of payments, we can expand this formula to: €Vt = € zt +

1 1 € zte+1 + € zte+ 2 +  2 (1 + i ) (1 + i )

(15.2)

Variations depend on whether the cash flows are constant or vary from period to period. This formula, and other formulations of this formula, has numerous applications including computing mortgage payments or car payments and making investment decisions using the net present value (NPV) method.

Bond Prices and Bond Yields

Bonds differ based on maturity and risk. Maturity is the length of time over which the bond promises to make payments while risk refers to the likelihood of default. Bond prices vary according to both factors. Bondholders earn a yield, or yield to maturity (YTM), which is the interest rate earned if purchased at the market price and held until the bond matures. A bond’s price is the present value of all expected future cash flows. Note that you can use the present value formula (15.2) to compute the value of a bond. The bond payments and maturity value are the cash flows and the discount rate (i) is the market rate on similar risk bonds. Bond yields differ based on time to maturity. This relationship between time to maturity and yield is referred to as the term structure of interest rates. The graphical expression of the term structure of interest rates is known as the yield curve (see Figure 15-2). A bond’s price is the present value of all expected future cash flows when the YTM is used as a discount rate. For this reason, it is a simple process of computing YTMs if you have a current price. These rates can then be plotted to graph the yield curve. Of course, we invoke ceteris paribus and use the same issuer to compute the yield curve. U.S. Treasury securities are used in practice. Yields curves are typically upward sloping (normal) but they can be downward sloping (inverted). In general, the yield can provide us with information about investor expectations with regard to interest rates.

The Stock Market and Movements in Stock Prices

Firms, unlike the government, receive some of their financing from sources other than debt. Firms can either earn money (internal finance) or sell shares of ownership known as stock (external finance). Investors buy stocks hoping the fractional ownership will increase in value as the firm prospers and stocks also pay cash distributions known as dividends. Stock prices, much like bonds, should be equal to the present value of all future cash flows. The future cash flows are dividends and a future selling price. The rate of return used to discount the cash flows can vary depending on risk and also market rates of interest. So, in the real world, a stock’s value is dependent on future cash flows and the discount rate. Both of those factors can and do change periodically causing constant revaluation of a stock. One valuation model assumes infinite holding periods and values the stock as simply the present value of all future dividends, and it assumes the stock is not sold.

15-68 .

Risk, Bubbles, Fads, and Asset Prices

Stock prices change in value according to changes in expected future returns and perceived risk. And, given the risk premium (x) is not constant, valuation shifts accordingly. For this reason, stock prices are reasonably volatile. At times stock prices deviate from their fundamental value which is defined as the present value of all future dividends. Sometimes investors are willing to pay more for a stock than it is truly worth based on their expectations. In other words, a stock price may increase above its fundamental value simply because investors expect it to go up. This type of price movement is dubbed rational speculative bubbles. At other times investors respond to fads and bid stock prices higher. Fads can occur in many markets, including housing and stocks. See the Focus box on page 306 for a classic case of an asset bubble in the tulip bulb market in the 1600s. The Focus box also shows a modern pyramid scheme from mid-1990s Russia.

V. PEDAGOGY This chapter marries two issues: the distinction between real and nominal interest rates and the calculation of expected present discounted values. Depending upon the focus of the course, instructors could make the distinction between real and nominal interest rates and ignore the mathematics of present values. It is also possible to discuss the effects of expected future policies (Chapter 17) without a full presentation of present value. In this context, instructors could describe informally how consumption and investment decisions (examined in Chapter 15) depend upon current and expected future income and interest rates.

VI. EXTENSIONS The presentation of present value in the text can be applied to numerous concepts in the students’ personal lives. Taking a few minutes to go over some of these applications can help them understand present values better. Alternatively, instructors might want to explain informally that attitudes toward risk affect the value of risky payment streams. In particular, distaste for risk tends to reduce the value of risky payments relative to the value of riskless ones. You could also discuss how two different investors can value an asset differently based solely on different assessments of risk.

VII. OBSERVATIONS 1.

Discount Factors as Prices

The discount factor dt = 1/(1 + it) is a relative price that converts future dollars into present dollars. It plays the same role in present value calculations that market prices do in GDP. Likewise, the real discount factor, 1/(1 + rt), converts future goods into current goods.

Indexed Bonds

The text constructs a series for the U.S. real interest rate by using OECD forecasts of inflation. Historically, economists have been unable to observe U.S. real interest rates directly. However, in 1997, the United States began offering Treasury bonds with payments indexed to the CPI inflation rate. The prices of these bonds allow economists to construct a direct measure of the U.S. real interest rate. A number of other countries also offer bonds with payments indexed to inflation.

15-69 .

VIII. APPENDIX Deriving the Expected Present Discounted Value Using Real or Nominal Interest Rates This appendix shows that the two ways of expressing present discounted values, equations (15.1) and 15.3), are equivalent. Equation (15.1) gives the present value as the sum of current and future expected nominal payments, discounted using current and future expected nominal interest rates while Equation (15.3) gives the present value as the sum of current and future expected real payments, discounted using current and future expected real interest rates.

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CHAPTER 16. EXPECTATIONS, CONSUMPTION, AND INVESTMENT I.

MOTIVATING QUESTION

How do expectations about the future influence consumption and investment? If consumers are forward-looking and resources can be transferred across time through borrowing and lending, then consumption should depend on wealth, rather than on income. Wealth includes the present value of expected future income, financial wealth, and housing wealth. Although income fluctuates over time, consumers, in principle, can maintain relatively constant consumption by borrowing when income is low and saving when income is high. To the extent that consumers are unable or unwilling to borrow when income is low, however, consumption will depend not only on wealth, but also on current income. A firm decides to invest in a project when the present value of expected profit from the project exceeds its cost. Therefore, investment depends on expected future profit. In practice, the ability and desire of firms to borrow to finance investment may be limited when current profit is low. High current profit eliminates the need to borrow to finance investment. Therefore, investment depends in part on current profit and in part on the present value of expected profit from a new project.

II.

WHY THE ANSWER MATTERS

The discussion of economic fluctuations in the Core ignored the role of expectations. This chapter provides basic theoretical results about the role of expectations in consumption and investment behavior. Chapter 17 uses these results to incorporate expectations into the IS-LM model.

III. KEY TOOLS, CONCEPTS, AND ASSUMPTIONS 1.

Tools and Concepts

The chapter introduces in passing the terms permanent income theory of consumption and life cycle theory of consumption to describe the consumption theory discussed in this chapter. Human wealth is the present value of expected after-tax labor income. Tobin’s q is the ratio of a firm’s financial value—the value of existing stock plus the value of bonds outstanding—to the replacement cost of the firm’s capital. Theory and evidence suggest that Tobin’s q should be positively related to investment. The user or rental cost of capital is the sum of the real interest rate and the depreciation rate on a unit of capital.

ii. iii. iv.

IV. SUMMARY OF THE MATERIAL 1.

Consumption

In earlier chapters, consumption is described as a function solely of current disposable income. In fact, however, people plan over longer horizons and are willing to borrow to finance current consumption when current disposable income is temporarily low. The modern theory of consumption was developed independently by two prominent economists. Milton Friedman dubbed called the theory he developed the permanent income theory of consumption which emphasized that consumers look beyond current income. 16-71 .

Franco Modigliani called his theory the life-cycle theory of consumption which emphasized consumers’ natural planning horizon is their entire lifetime. To understand both theories, assume that a person wants a constant flow of consumption over her lifetime. In this case, a perfectly rational person would develop a consumption plan in two steps. First, she would calculate her total wealth—assets on hand (financial and housing wealth) plus the present value of future labor income (so-called human wealth). Then, she would calculate the proportion of this wealth that should be spent each year to maintain a constant consumption level over her lifetime. If it happened that this level of consumption fell short of current income, the difference would be borrowed. In practice, most consumers following such a plan would end up borrowing large sums of money early in life, because income during college and early working years is likely to be very low relative to income later in life. In fact, however, most young adults do not borrow the relatively large sums suggested by simple calculations, for several reasons. First, they may not intend to maintain constant consumption over their lifetimes. Some expensive leisure activities will be deferred, and plans will be made for higher expenditures while raising a family. Second, the computations involved in planning for constant consumption may be too complicated. Life is simpler when decisions are based on rules of thumb. Third, human wealth is based on forecasts of future earnings, which may turn out to be less than expected. Consumers may wish to protect against this possibility by borrowing smaller amounts than would be implied by expected present value calculations. Fourth, banks may be unwilling to extend much credit to young adults on the expectation of future earnings. This discussion suggests that consumption is likely to depend on two factors: wealth—because consumers are to some degree forward looking—and current disposable income—because consumers may be unwilling or unable to calculate and implement a spending plan expected to maintain constant consumption over their lifetimes. Evidence on retirement saving suggests that most consumers save sufficient resources for retirement. This finding lends support to the importance of wealth (and therefore expectations) in consumption behavior. On the other hand, a substantial fraction of households (about 20% in some studies) do not save enough for retirement. For many of these households, the present value of Social Security benefits accounts for almost all of their retirement wealth. The fact that consumption depends upon wealth (which in turn depends upon expectations about the future) has two empirical implications. First, fluctuations in current income are likely to generate less than proportional fluctuations in consumption. Unless a fluctuation in current income is permanent, human wealth (the expected present value of future labor income) will change less than proportionally, which implies that consumption will probably change less than proportionally as well. Second, consumption can be affected by changing expectations about the future, even when current income does not change. A fall in consumer confidence helped create a recession in the United States in 1990–1991. A decade later, macroeconomists were concerned that consumer confidence would fall dramatically after the events of September 11 and prolong the recession. In the event, however, although there was some fall in confidence in the latter part of 2001, the drop was smaller than in 1990–1991, and the economy soon began to recover. However, the most recent recession following the financial crisis of 2007–2008 is particularly striking when looking at consumer expectations regarding changes in family income. See Figure 15-1 on page 320 to view the differences in magnitude of expectations.

Investment

When deciding whether to purchase a new machine or to build a new plant, firms compare the expected present value of profit from the machine or plant to the cost. If the present value of profit exceeds the cost, they invest; if not, they do not invest. The calculation of the expected present value of profits

16-72 .

requires not only a forecast of profit, but also a consideration of the wear and tear on the machine or plant from use. Wear and tear is called depreciation. James Tobin pointed out that firms could use information available in financial markets to simplify the investment decision. The financial value of a firm (its stock market value plus the value of bonds outstanding) measures the value financial investors place on capital (plant and equipment) already in place. Firms should invest when the financial value of a unit of their capital exceeds the cost of an additional unit of capital. If firms behave in this way, there should be a positive relationship between aggregate investment and the ratio of the total financial value of firms to the replacement cost of their capital. The latter ratio is called Tobin’s “q.” In fact, there is a strong relationship between aggregate investment and a one-year lag of the q variable. This relationship does not imply that firms use the stock market to guide their investment behavior. However, theory suggests that stock prices and investment decisions should be influenced by similar factors. A convenient special case of the investment decision is described by the following scenario: the real interest rate is constant, a new machine begins producing a constant annual (real) profit stream in one year, and a new machine begins to depreciate at a constant rate in two years. In this case, in real terms, the present value of expected profit, denoted by V(Πet), is given by

V ∏te =

∏t , rt + δ

(16.5)

where r is the real interest rate and δ is the depreciation rate. The quantity r + δ is called the user cost or the rental cost of capital, since it represents the cost of renting a machine. The owner of a rented machine would require the same real return available on alternative assets—i.e., the real interest rate—plus compensation for depreciation. Theory implies that investment should depend upon expected future profit, but there is also evidence that investment increases when current profit increases, even after controlling for expected future profit. Presumably, the effect of current profit is to reduce the amount of borrowing a firm must undertake to invest. Firms may be reluctant to borrow, since they may be unable to repay their debt if the future turns out worse than expected. Firms may also be unable to borrow, since lenders may not share the firm’s optimistic assessment of its investment project. If a firm has high profit, it can retain some of its earnings for investment, eliminating the need to take on debt or find enthusiastic lenders. Investment depends on current and expected future profit, but what determines profit? The level of profit per unit of capital is likely to be closely related to the level of sales per unit of capital. Ignoring the distinction between sales and output, sales per unit of capital can be proxied by output per unit of capital. In fact, there is a close relationship between changes in profit per unit of capital and changes in the output-capital ratio.

The Volatility of Consumption and Investment

Although the consumption and investment decisions have some similarities, the theory developed above suggests that investment should be much more volatile than consumption. After an increase in income perceived as permanent, consumers respond with at most an equal increase in consumption. After an increase in sales perceived as permanent, however, firms may respond by investing in projects many times larger than the increase in sales. In the absence of adjustment costs, firms have no reason to maintain a smooth flow of investment. Once projects become profitable, firms invest immediately. Consumers, on the other hand, desire to maintain a relatively constant level of consumption. In response

16-73 .

to a permanent increase in income, it makes no sense for them to borrow to try to consume the entire future increase today. In fact, although investment and consumption tend to move in the same direction, the movements of investment are much higher in percentage terms. In absolute terms, however, movements of investment and consumption are similar in magnitude, since total consumption is much larger than total investment.

V. PEDAGOGY 1.

Points of Clarification

Instructors may wish to point out that what matters for investment is marginal—as opposed to average— profit. When evaluating an investment possibility, firms care about the expected extra profit that can be derived from employing one more unit of capital (marginal profit), rather than the expected profit per unit of existing capital (average profit). Marginal and average profit can differ.

Alternative Sequencing

Ricardian equivalence is discussed in Chapter 23, which is devoted to fiscal policy. Instructors could easily introduce Ricardian equivalence in this chapter, as well.

VI. EXTENSIONS 1.

The Evolution of Consumption Theory

The text presents modern consumption theory, but does not describe how the Keynesian consumption function (KCF) came to be replaced by permanent income and life cycle theories. The story helps illustrate the differences between the KCF and the consumption theory described in this chapter. The Keynesian consumption function (KCF) implies that the ratio of consumption to income (or the average propensity to consume (APC)) falls as income increases. Cross-section and time-series evidence assembled after the publication of the General Theory bore out these claims. Based on the KCF and the existing evidence, economists predicted during World War II that the economy could not sustain growth after the war without high levels of government spending. Since the consumption-output ratio would fall with income, some other component of output—in particular, government spending—would have to increase to support growth. To the surprise of many economists, the economy did not stagnate after the war, despite the associated fall in government spending. In addition, after the war, Simon Kuznets collected longer-run data that showed no tendency for the APC to decline secularly. The theories of Friedman and Modigliani explained the apparent puzzle between the prewar and postwar evidence. The basic insight becomes clear in a simple example. Suppose that each year half of the population receives an income of €25,000 and the other half receives an income of €75,000. Those who receive €25,000 know they will receive €75,000 in the following year, and those who receive €75,000 know they will receive €25,000 in the following year. Everyone desires to smooth consumption completely, so everyone consumes €50,000 per year. In aggregate, the relationship between income and consumption is stable and unchanging. In cross section, it will appear that the ratio of consumption to income falls when income increases. Although there is no uncertainty in this example, the basic point is clear. The cross-section evidence largely reflects transitory changes in income, which have little effect on consumption. The aggregate evidence largely reflects the relationship between permanent income and consumption. In the long run, aggregate income is driven primarily by permanent changes in income, 16-74 .

which tend to have close to proportional effects on consumption. So, in the long run, there is no tendency for the APC to decline.

Consumption and Real Interest Rates

The text does not discuss the effect of the real interest rate on consumption. An increase in the current period real interest rate has three effects: a substitution effect, an income effect, and a wealth effect. The substitution effect describes a consumer’s response to the change in the price of future consumption in terms of present consumption, i.e., 1/(1 + r). An increase in the real interest rate reduces the relative price of future consumption and tends to shift consumption from the present to the future. This substitution effect tends to reduce current consumption. Intuitively, an increase in the real return on bonds tends to make saving more attractive. The income effect describes the consumer’s response to the change in interest income on existing saving. An increase in the real interest rate increases interest income. The income effect tends to increase current consumption. Intuitively, a higher interest rate means that any given level of future wealth can be achieved with less saving today, so consumption tends to rise. Finally, the wealth effect describes the consumer’s response to the change in wealth caused by a change in the real interest rate. An increase in the current interest rate tends to reduce human wealth (the present value of expected after-tax labor income). This effect is larger to the extent that an increase in the current rate also implies an increase in future interest rates. The wealth effect tends to reduce current consumption. In sum, the theoretical effects are contradictory. The substitution and wealth effects predict that consumption responds negatively to the real interest rate, but the income effect predicts that consumption responds positively to the real interest rate. Empirical studies typically do not find a strong relationship between consumption and the real interest rate.

VII. APPENDIX Derivation of the Expected Present Value of Profits under Static Expectations Investment depends positively on the expected present value of future profits (per unit of capital). The higher the expected profits, the higher the expected present value and the level of investment. The higher expected real interest rates, the lower the expected present value, and thus the lower the level of investment. This appendix shows the mathematical derivation of the investment function under static expectations (e.g. where the future is expected to be like the present).

16-75 .

CHAPTER 17. EXPECTATIONS, OUTPUT, AND POLICY I.

MOTIVATING QUESTION

How do expectations influence the determination of output and the effects of monetary and fiscal policy? Consumption and investment are influenced by expected future output, and investment is influenced by the expected future interest rate. Since future monetary and fiscal policies affect future output and the future interest rate, expectations about future policy will affect output in the present. Moreover, the effect of current policy on output will depend on how current policy measures affect expectations about future policy.

II.

WHY THE ANSWER MATTERS

By incorporating expectations into the IS-LM model and introducing the concept of rational expectations, this chapter prepares students to engage in a relatively sophisticated and modern discussion of the effects of monetary and fiscal policy.

III. KEY TOOLS, CONCEPTS, AND ASSUMPTIONS 1.

Tools and Concepts

The chapter introduces rational expectations in the context of the IS-LM model by allowing economic agents to forecast the effects of future policy and to use these forecasts when determining current consumption and investment.

IV. SUMMARY OF THE MATERIAL 1.

Expectations and Decisions: Taking Stock

Think about time in terms of two periods: the present and the future, which lumps all future years together. Then, in the current period, the IS relation derived earlier in the text can be written as Y = A(Y , T , r , x) + G , (+, −, −, −)

(17.1)

where A—which stands for aggregate private spending—is defined as consumption plus investment. The risk premium (x) is assumed constant in this chapter. Introducing expectations requires thinking about the effects of expected future income (Y′e), expected future taxes (T ′e), and the expected future real interest rate (r′e). Note that expected future government spending has no effect on the current IS relation, other than through its effect on future output and the future interest rate. From Chapter 15, an increase in expected future income will increase consumption and investment (since expected profit is likely to increase). An increase in expected future taxes will reduce expected disposable income, which will reduce consumption. An increase in the expected future real interest rate will reduce investment. Given these relationships, the IS relation can be rewritten as

Y = A(Y , T , r , Y ′e , T ′e , r ′e ) + G . ( +, −, −, +, −, −) 17-76 .

(17.2)

Given the values of expected future variables, the new IS relation remains downward-sloping in Y-r space, but it is likely to be steeper than the IS relation developed earlier in the book, for two reasons. First, given the expected future interest rate, a change in the current interest rate has a relatively small effect on present values (of expected labor income and expected profit) and thus a relatively small effect on current spending (on consumption and investment), given income. Second, the multiplier is likely to be small, since, given expectations of future income, current income has a relatively small effect on consumption and investment. The LM relation is unaffected by the introduction of expectations, since money demand depends on the current level of transactions. Money holdings can be adjusted in the future if the level of transactions changes.

Monetary Policy, Expectations, and Output

The interest rate that the Central bank affects directly is the current real interest rate, r. Therefore, the LM curve is given by a horizontal line at the real policy rate chosen by the central bank dubbed r. This relation can be written as

r=r

(17.4)

Now consider an increase in the current period money supply. Such an increase shifts the LM curve down, increases output, and reduces the interest rate. In the absence of changes in expectations, the increase in output will be relatively small since the IS curve is steep. But if an increase in the current money supply leads people to expect an increase in the future money supply, expected future output will increase, and the expected future interest rate will decrease. Both of these effects cause the current period IS curve to shift to the right, increasing output further. Thus, the effect of a policy change depends on the response of expectations. The preceding discussion relies on sophisticated formation of expectations by economic actors, who are assumed to assess the likely course of future policy and to work out the economic implications. A new box is the text looks at expectations and the impact of quantitative easing in light of the financial crisis. Expectations formed in this manner are called rational expectations. A box in the text describes the historical developments that led to rational expectations becoming the benchmark assumption in economics.

Deficit Reduction, Expectations, and Output

In the basic IS-LM model introduced in the Core, a reduction in the government budget deficit reduces current output. Once expectations are introduced, the effect of deficit reduction on current output becomes ambiguous. In the medium run, deficit reduction leads to a fall in the real interest rate and to an increase in investment. A permanent increase in investment leads to an increase in capital accumulation. Therefore, in the long run, deficit reduction leads to an increase in output. In terms of equation (17.2), Y ′e increases and r′e falls, both of which tend to shift the current period IS curve to the right. The direct effect of the deficit reduction—as a result of an increase in T or a reduction in G—shifts the current period IS curve to the left. The net effect on output—whether the current period IS curve shifts right or left—could be positive or negative. This analysis suggests that a deficit reduction program is less likely to reduce current output to the extent that it is backloaded, i.e., takes place further in the future, because the direct negative effects on output (through reduced government spending or increased taxes) are postponed. On the other hand, a backloaded deficit reduction program may not be credible. People may not believe that the government will follow through on politically difficult spending reductions and tax increases promised in the future. The credibility of the deficit reduction program is key. Consumers and firms must believe the government will follow through with the deficit reduction program before it changes their expectations and therefore spending. 17-77 .

A box in the text discusses Ireland’s two attempts at deficit reduction in the 1980s. The first, in the early part of the decade, was associated with low growth and an increase in the unemployment rate. The second, in the latter half of the decade, was associated with high growth and a reduction in the unemployment rate. Some economists have argued that the second deficit reduction, which focused on spending cuts and tax reform, provides an example of an expansionary deficit reduction. They argue that the first deficit reduction, which focused on tax increases and did not change the size of the government’s role in the economy, did not change expectations about the future very much. The text argues that evidence on the saving rate is consistent with this story. During the first deficit reduction, the saving rate rose, which suggests increased pessimism about the future. During the second deficit reduction, the saving rate fell, which suggests increased optimism about the future. Monetary policy and other economic factors also differed between the two episodes, however, so the difference in results cannot be attributed entirely to expectations. A focus box on “Uncertainty and Fluctuations” highlights how uncertainty about the future affects both consumption and investment and therefore output. For example, a recent survey of firms shows that many of them were postponing some investments due to uncertainty over the tariff discussions between the US and trading partners including China, Mexico and the European Union.

V. PEDAGOGY The presentation of the effects of expected monetary policy can be aided by drawing two IS-LM diagrams, one for the present and one for the future. Begin by working out the short-run effects of expected future monetary policy in the IS-LM diagram representing the future. In the long run, future monetary policy will be neutral. The (short-run) changes in future output and the future interest rate show how expected future output and the expected future interest rate change. Use these effects on expectations to determine the effects on current variables in the IS-LM diagram representing the present. This technique ignores changes in expected inflation, but it does give a sense of the effects of Central bank watching on the economy. The use of present and future IS-LM diagrams is less useful for illustrating the effects of expected fiscal policy, because changes in fiscal policy affect capital accumulation and output in the long run.

VI. EXTENSIONS The first edition of the text used the Clinton deficit reduction package as an illustration of the design of deficit reduction programs. One point that emerged from this discussion was that expectations about the response of the central bank to a deficit reduction program affect the ultimate effect of this policy on output. Instructors might want to include the potential response of the Federal Reserve in the discussion of deficit reduction programs.

VII. OBSERVATIONS Once expectations are taken into account, the effect (on current output and the current interest rate) of a current change in an exogenous variable depends in part on how this change affects expectations about the future. Likewise, current output and the current interest rate can be affected by expectations about future changes in exogenous variables, even when no current exogenous variable changes.

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CHAPTER 18. OPENNESS IN GOODS AND FINANCIAL MARKETS I.

MOTIVATING QUESTION

How does openness modify the closed economy IS-LM model? An open economy allows domestic residents to choose between domestic and foreign goods and between domestic and foreign assets. The first choice is governed by the relative price of foreign goods; the second by relative returns on foreign assets. Firms also have the ability to choose production locations and workers can choose where to work in open economies.

II.

WHY THE ANSWER MATTERS

For countries other than the United States, open economy considerations have long had substantial effects on economic performance. In the United States, open economy issues are becoming increasingly important. This chapter describes the basic determinants of the trade balance and describes the implications of arbitrage between domestic and foreign bonds. Chapter 19 integrates the trade balance discussion into the closed economy goods market model (the Keynesian cross). Chapter 20 integrates the asset market discussion into the closed economy model of the money market, and develops an open economy IS-LM model. Chapter 21 considers a medium run-model of an open economy with a fixed exchange rate, explores exchange rate crises and the behavior of flexible exchange rates, and discusses the choice of exchange rate regime.

III. KEY TOOLS, CONCEPTS, AND ASSUMPTIONS 1.

Tools and Concepts

The nominal exchange rate is the foreign currency price of domestic currency. The real exchange rate is the relative price of domestic goods. An increase in either of these variables is an appreciation from the perspective of the domestic country. The balance of payments is a record of one country’s transactions with the rest of the world over a given period of time. The balance of payments consists of a current account, which records transactions in goods and services, and a financial account, which records transactions in assets. Until recently this account was called the capital account so you still see the term used in the many countries and the press. The chapter introduces basic balance of payments accounting and the balance of payments identity, which states that the current account and the capital account sum to zero. The uncovered interest parity condition equates the expected domestic currency returns on domestic and foreign bonds. Absent transactions costs and assuming that investors do not care about currency risk, investors will not be willing to hold both domestic and foreign bonds unless uncovered interest parity holds.

ii.

iii.

Assumptions

The text assumes that domestic residents do not use foreign currency to purchase goods. This assumption is maintained throughout the formal work on the open economy. A footnote points out that U.S. dollars are often used for illegal transactions throughout the world and sometimes for legal transactions in economies with high inflation (or with a history of high inflation), but these phenomena are ignored in the formal work of the text.

18-79 .

ii.

The uncovered interest parity condition assumes that investors care only about expected returns and not about risk. This assumption is maintained throughout the formal discussion of the open economy.

IV. SUMMARY OF THE MATERIAL 1.

Openness in Goods Markets

Openness in goods markets means that domestic residents are able to buy foreign goods and sell domestic goods abroad. Goods sold to foreigners are called exports. Goods bought from foreigners are called imports. The difference between exports and imports is the trade balance. A negative trade balance is called a trade deficit, and a positive one a trade surplus. In the closed economy model developed earlier in the book, domestic residents made only one decision—how much to spend. In an open economy, domestic residents make two decisions—how much to spend and how much to spend on domestic (as opposed to foreign) goods. The latter decision depends on the real exchange rate, the relative price of foreign goods in terms of domestic goods. The real exchange rate depends on the nominal exchange rate (E), the domestic price level (P), and the foreign price level (P*). The nominal exchange rate is defined as the foreign currency price of domestic currency. So, for example, if the euro area is the domestic country, and one euro trades for 1 pound, the nominal exchange rate is 1 euro/dollar. Given this definition, an increase in the exchange rate means that the domestic currency gains value (i.e., one unit of the domestic currency is worth more units of the foreign currency). A currency is said to depreciate when it loses value and to appreciate when it gains value. Thus, an appreciation (depreciation) of the domestic currency means an increase (decrease) in E. Suppose the euro area, the domestic country, produces only one good; airplanes. If an airplane sells for P euros, its price in pound is EP. Note that E has units of euro/pound, and P has units of euros/airplane, so EP has units of pound/airplane. Now assume that the UK, the foreign country, also produces only one good; cars. One could compare the pound price P* of cars produced in the UK to the euro price of airplanes produced in the euro area. This motivates the definition of the real exchange rate (ε):

ε=

EP P∗

(18.1)

The real exchange rate is the relative price of domestic goods. An increase in the relative price of domestic goods is a real appreciation (an increase in ε). A decrease in the relative price of domestic goods is a real depreciation (a decrease in ε). In the one-good-per-country example above, the real exchange rate has units of foreign goods per domestic good (in this case it is cars per airplane). The nominal exchange rate has units of foreign currency per domestic currency. Since in fact there are many goods, in practice the real exchange rate is defined over baskets of goods, and P and P* refer to price indices. As such, the real exchange rate is also an index: its level is arbitrary (since one can choose any base year for the price indices), but its rate of change is well defined. In terms of price indices, the real exchange rate measures the price of a basket of goods in the domestic country in terms of baskets of goods in the foreign country. So, for example, if the real exchange rate is 2, the price of a domestic basket of goods is two foreign baskets of goods. The composition of the basket of goods depends upon which price index is used. If P refers to the GDP deflator, as in the text, then the real exchange rate measures the price of goods produced in the domestic country in terms of goods produced in the foreign country.

18-80 .

Economists are often interested in the real exchange rate measured against all other countries, rather than against just one country, so the bilateral real exchange rate defined above is often replaced by a multilateral real exchange rate, which is a weighted average of the real exchange rate against all other countries. The weight on a given country reflects two factors: the degree to which the country trades with the domestic country and the degree to which the country competes with the domestic country in international markets.

Openness in Financial Markets

Openness in financial markets means that domestic residents are able to exchange assets (stocks, bonds, and money) with residents of other countries. There is link between trade in assets and trade in goods. Trade in assets allows countries to borrow from one another. Thus, countries that run trade deficits can finance them by borrowing from countries that run trade surpluses.1 The balance of payments summarizes the transactions of one country with the rest of the world. It has two components. The first, the current account, is the sum of the trade balance, net investment income received from abroad, and transfers. As such, the current account is a record of net income received from the rest of the world. The second component of the balance of payments, the financial account, measures the purchase and sale of foreign assets. The financial account is defined as the net decrease in foreign assets (i.e., the increase in domestic assets held by foreigners minus the increase in foreign assets held by domestic country residents). Apart from a statistical discrepancy, the current account and the financial account sum to zero by construction. The intuition behind balance of payments accounting is simple. Think of a country as a single person. A country with a negative current account balance (a deficit) spends more than its income. To finance the deficit, it can either sell some of its existing assets to foreigners or borrow from foreigners (sell bonds to foreigners). By definition, these transactions have a positive sign in the financial account. Likewise, a country with a positive current account balance (a surplus) spends less than its income. It can dispose of the extra income by purchasing foreign assets or making loans to foreigners (buying foreign bonds). By definition, these transactions have a negative sign in the financial account. The financial account measures a country’s aggregate financial transactions with the rest of the world. Individual portfolio investment decisions are governed by the relative returns on domestic and foreign assets. The text assumes that domestic residents do not use foreign currency to purchase goods. Thus, there is no transactions motive for domestic residents to hold foreign currency. In addition, the text continues to assume that stocks and bonds are perfect substitutes, so it limits attention to domestic and foreign bonds. How does one choose between domestic and foreign bonds? Suppose a German resident has a euro to invest. Let it be the interest rate on German bonds and it* the interest rate on UK bonds. Consider the choice between German and UK bonds Option 1: Buy German bonds The return on one euro equals 1 + it euros. Option 2: Buy UK bonds. i. Exchange one euro for Et pounds. ii. Invest Et pounds in UK bonds, with a return of (1 + it*)Et pounds iii. Exchange (1 + it*)Et pounds for (1 + i*t)Et/Et+1 euros. 1

Strictly, countries that run current account deficits borrow from countries that run current account surpluses.

18-81 .

The return on one euro equals (1 + it*)Et/Et+1 euros. The expected return on one euro equals (1 + it* ) Et /Ete+1 euros.

Note that to transfer the return from the second option into euros, the investor must exchange the return at the future period’s exchange rate Et+1, which is unknown at time t. The investor’s expectation of the future exchange rate is given by Ete+1. If investors care only about expected returns and not about risk, then they will choose the option with the higher expected return. If both German and UK bonds are to be held by the private sector, it must be that the expected returns are the same under either option. In other words,  E  (1 + it ) = (1 + it∗ )  et  E   t +1 

(18.2)

Ete+1 − Et Et

(18.4)

which can be approximated by it ≈ it∗ −

Equation (18.2) is called the uncovered interest parity condition. It is uncovered because an investor in foreign bonds is not protected from exchange rate risk. If the actual value of the exchange rate turns out to be higher than expected (i.e., the dollar is more valuable than expected), the investment in UK bonds produces a smaller return than the investment in German bonds. In words, equation (18.4) says that the domestic interest rate equals (approximately) the foreign interest rate minus expected appreciation of the domestic currency. Expected appreciation of the domestic currency makes domestic assets more attractive, so investors are willing to hold them for less compensation (a smaller interest rate).

Conclusions and a Look Ahead

Openness allows domestic residents two choices: the choice between domestic and foreign goods and the choice between domestic and foreign assets. Chapter 19 integrates the choice between domestic and foreign goods into the goods market equilibrium condition. Chapter 20 integrates the choice between domestic and foreign assets into the financial market equilibrium condition. Chapter 21 also combines goods and financial market equilibrium to analyze the short-run equilibrium of an open economy. Chapter 21 considers a medium run-model of an open economy with a fixed exchange rate, explores exchange rate crises and the behavior of flexible exchange rates, and discusses the choice of exchange rate regime.

V. PEDAGOGY The balance of payments is presented only in a rudimentary fashion in the text. The intuition that (apart from investment income and transfers) a trade deficit means that a country spends more than its income will be reinforced in Chapter 20, which presents the GDP identify for an open economy. It may be worthwhile to reinforce this intuition more than the text does. As far as the mechanics of balance of payments accounting, it may help build intuition to imagine that all payments are made in terms of cash (in any given currency, say dollars). In this case, transactions in which the domestic country receives a cash payment get a positive sign in the balance of payments. Transactions in which the domestic country makes a cash payment get a negative sign. For example, the purchase by a U.S. resident of a Japanese car 18-82 .

requires a cash payment to Japan. This gets a negative sign in the U.S. balance of payments. The purchase of a U.S. Treasury bond by a Japanese resident requires a cash payment to the United States. This transaction gets a positive sign in the U.S. balance of payments.

VI. Extensions 1.

The Balance of Payments

The text presents the balance of payments in the modern manner, with a current and financial account. However, it is useful to keep in mind that the U.S. presentation of the balance of payments has changed recently. Essentially, what was previously called the capital account is now called the financial account so previous editions will refer to this as the capital account. In addition, a new category—called the capital account—has been created. The new capital account consists of a small set of asset movements that were previously recorded in the current account. The value of the items in the new capital account is typically very small for the United States. Be careful when making comparisons to other countries because their balance of payments accounting may not reflect these changes. Changes in official reserves are part of the financial account. Official reserves are foreign financial assets held by the central bank. For historical reasons, reserves include gold. An increase in reserves gets a negative sign in the financial account. Instructors may wish to explain how reserves fit into the balance of payments and to note that reserves affect the money supply. Doing so now helps prepare for a discussion of the central bank balance sheet in the context of fixed exchange rates, a topic discussed in Chapter 20.

Uncovered Interest Parity

Although uncovered interest parity is a foundation of open economy models, it has not been an empirical success. There are essentially two categories of explanation for this phenomenon. The first is that investors care about risk and there is a time-varying risk premium for any given exchange rate. The second is that investors make systematic forecast errors. Possibly forecast errors result from so-called Peso problems, i.e., large-cost, low-probability events. If these events occur very rarely, then it will often turn out (ex post) that expectations based on these events are incorrect (although not irrational). Instructors may wish to point out how a risk premium on a currency increases the interest rate paid on bonds denominated in that currency. Unfortunately, little is known about how or why the risk premium changes over time.

The Foreign Exchange Market

The text does not discuss alternative exchange rate regimes until Chapter 20. Instructors may wish to distinguish fixed and flexible exchange rate regimes and to provide a brief history of the postwar transition from fixed to flexible rates. Such a discussion fits naturally within the evidence on U.S. bilateral exchange rates in the postwar period.

18-83 .

CHAPTER 19. THE GOODS MARKET IN AN OPEN ECONOMY I.

MOTIVATING QUESTION

How is output determined in the short run in an open economy? As in a closed economy, output in an open economy is determined by goods market equilibrium, the condition that goods supply equals goods demand. In the open economy, however, goods demand includes net exports.

II.

WHY THE ANSWER MATTERS

The full treatment of short-run equilibrium in an open economy requires several steps. This chapter integrates openness in the goods market into the model of goods market equilibrium. To consider the goods market in isolation from financial markets, the chapter assumes that the interest rate is fixed and treats the real exchange rate as a policy variable. Chapter 20 integrates openness in asset markets into the determination of financial market equilibrium and then combines goods and financial market equilibrium into an open-economy IS-LM model.

III. KEY TOOLS, CONCEPTS, AND ASSUMPTIONS 1.

Tools and Concepts

The chapter introduces an open-economy model of goods market equilibrium by adding net exports to the demand for domestic goods. A real depreciation will improve the trade balance when the proportional increase in relative quantities (the sum of the proportional increase in exports and the proportional decrease in imports) exceeds the proportional real depreciation. This condition is called the Marshall-Lerner condition. It is derived in an appendix to the chapter.

ii.

Assumptions

The chapter considers the short-run goods market in isolation from financial markets, so it assumes that the interest rate is fixed and that the real exchange rate is a policy variable. In keeping with the analysis of Chapter 20, as well as the closed economy IS-LM analysis, a more precise way to state these assumptions is that the home and foreign price levels are fixed and the nominal exchange rate is a policy variable. Since the price levels are fixed, the nominal exchange rate determines the real exchange rate. In addition, production is assumed to respond one-for-one to changes in demand without changes in price (the AS curve is horizontal at the initial price), so demand determines output.

IV. SUMMARY OF THE MATERIAL 1.

The IS Relation in the Open Economy

When the economy is open to trade in goods, it becomes important to distinguish the domestic demand for goods, given by C + I + G, from the demand for domestic goods, denoted by Z and given by

Z = C + I + G − IM ε + X 19-84 .

(19.1)

As in Chapter 5, the domestic demand for goods is C(Y − T) + I(Y, r) + G. Real exports (X) and real imports (IM) are given by the following expressions.

IM = IM (Y , ε ) ( +, + ) X = X (Y ∗ , ε ) ( +, −)

(19.2)

(19.3)

Exports increase when foreign income (Y*) increases, since foreigners have more to spend, and when there is a real depreciation (an decrease in ε), since home goods become less expensive relative to foreign goods. Imports increase when domestic income increases, since home residents have more to spend, and when there is a real appreciation, since foreign goods become less expensive relative to domestic goods. Figure 19-1 displays graphically the effect of introducing net exports into the model of goods market equilibrium. The domestic demand for goods is denoted DD. To derive the demand for domestic goods, first shift the DD curve down by the value of imports (IM/ε). The new curve, denoted AA, is flatter than DD, because the value of imports increases with income. Now add exports to the AA curve to arrive at the demand for domestic goods (ZZ). Note that exports are independent of income, so the vertical distance between ZZ and AA is constant and the two curves have the same slope. The gap between the curves DD and ZZ is the trade balance (sometimes called net exports (NX)), depicted in the lower panels (c & d) in Figure 19-1. Since the value of imports increases with income, the trade balance decreases with income. Note that Figure 19-1 assumes that the real exchange rate is fixed. Figure 19-1: The Demand for Domestic Goods and Net Exports (c & d)

19-85 .

Equilibrium Output and the Trade Balance

Equilibrium in the goods market requires that the demand for domestic goods equals the production of domestic goods, namely that Y = Z. Substituting equations (19.2) and (14.3) into the demand for domestic goods results in a new IS relation: Y = C (Y − T ) + I (Y , r ) + G − IM (Y , ε ) ε + X (Y ∗ , ε )

(19.4)

Note that real imports, which have units of foreign goods, are multiplied by the real exchange rate to convert them into units of domestic goods. Since this chapter concentrates on the short run, it assumes that production responds one-for-one to changes in demand (without changes in price). Graphically, equilibrium is determined by the intersection of the ZZ curve and the 45°- line (Figure 19.2). In general, equilibrium does not require balanced trade. Figure 19-2 depicts an equilibrium condition with a trade deficit. Figure 19-2: Equilibrium Output and Net Exports

Increases in Demand–Domestic or Foreign

When domestic demand increases (e.g., G increases, T decreases, or consumer confidence increases), the ZZ curve shifts up, so output increases and the trade balance falls. When foreign demand (Y*) increases, the ZZ and NX curves shift up by the same amount. Output and the trade balance increase. The increase in imports that arises from the increase in home output does not entirely offset the positive effect on exports from the increase in foreign demand. 19-86 .

Note that increases in domestic demand have a smaller effect on output in the open economy than in the closed economy, because some of the increased income “leaks” out of the domestic economy through spending on imports. In other words, the multiplier is smaller in an open economy. A box in the text carries this analysis further and notes that smaller countries are likely to have larger marginal propensities to import out of income. As a result, fiscal policy will have a smaller effect on output in a smaller economy, but a greater effect on the trade balance. The relationship between foreign and domestic output suggests that policy coordination can be important when industrial countries as a group are operating below normal levels of output. Governments typically do not like to run trade deficits, because deficits require borrowing from the rest of the world. In the absence of coordinated action, an expansionary policy by an individual country in the midst of a worldwide recession will likely generate a trade deficit (or at least worsen the trade balance), because the increase in income will increase imports. Coordinated expansions will tend to have less effect on trade balances in individual countries, because imports will increase substantially throughout the world. On the other hand, coordinated expansions may be difficult to arrange. Countries that have budget deficits may be unwilling to consider expansionary fiscal policy. In addition, once an agreement has been negotiated, each country has an incentive to renege, thereby hoping to benefit from expansions abroad and to improve its trade balance.

Depreciation, the Trade Balance, and Output

The trade balance (NX) is given by NX = X (Y ∗ , ε ) − IM (Y , ε ) ε

A real depreciation has two effects: a quantity effect (an increase in exports and a reduction in imports), which tends to increase the trade balance, and a price effect (an increase in the relative price of imports), which tends to reduce the trade balance. The net effect will be positive if the quantity effect is greater than the price effect, a condition known as the Marshall-Lerner condition (derived in an appendix). If so, a real depreciation will improve the trade balance and increase output. With some qualifications, the MarshallLerner condition is usually satisfied in practice, and the text assumes that a real depreciation will improve the trade balance. If the government can affect the real exchange rate through policy, then it can use two policy instruments (fiscal policy and the real exchange rate) to achieve two policy targets (output and the trade balance). For example, suppose a country in recession has a trade deficit, and policymakers want to achieve the natural level of output and balanced trade. Expansionary fiscal policy will increase output, but will also worsen the trade deficit. A real depreciation will increase output and improve the trade deficit, but there is no guarantee that it can achieve the output target under balanced trade. To achieve both targets, policymakers need a policy mix: in this case, a real depreciation sufficient to balance trade at the target output level and the fiscal policy required to ensure that the economy achieves the target output level. If output is higher than desired after the real depreciation, policymakers should use contractionary fiscal policy; if output is lower than desired, policymakers should use expansionary fiscal policy. The text includes a table that summarizes other policy mixes under alternative initial conditions for output and the trade balance.

Saving, Investment, and the Current Account Balance

The current account can be expressed as

CA = S + (T − G ) − I 19-87 .

(19.5)

The current account balance is equal to saving (private plus public) minus investment. A current account surplus implies that the country is saving more than it invests. A current account deficit implies that the country is saving less than it invests. Note some of the things that equation (19.5) says: • • •

An increase in investment must be reflected in either an increase in private or public saving or a deterioration of the current account balance—a smaller current account surplus, or a larger current account deficit, depending on whether the current account is initially in surplus or in deficit. A deterioration in the government budget balance—either a smaller budget surplus or a larger budget deficit—must be reflected either in an increase in private saving or a decrease in investment, or in a deterioration of the current account balance. A country with a high saving rate (private plus public) must have either a high investment rate or a large current account surplus.

A box in the text examines the increase in the current account deficits of Greece. These current account deficits increased to high levels by 2008, the year the financial crisis emerged. The higher borrowing costs for these nations forced them to reduce their current account deficits as foreign borrowing proved too costly. However, given that exchanges could not adjust the impact was to decrease output and imports. This adjustment is known as import compression and resulted in an approximate 30% decline in output and a 36% decline in imports since 2008.

V. PEDAGOGY The relationship between saving and investment in an open economy is presented at the end of the chapter. There are two arguments for placing it at the beginning. First, the derivation of equation presented in section 6 illustrates that the trade balance is the difference between income and spending. Second, by discussing this equation before the policy experiments, instructors can include the effects on saving and investment in the discussion of fiscal and exchange rate policy. This approach will reinforce the notion that saving and investment are endogenous and that the government surplus is not the only determinant of the trade balance. To illustrate the latter point, note that the U.S. federal budget deficit declined over the 1990s, but the trade deficit reached record levels.

VI. APPENDIX Derivation of the Marshall-Lerner Condition The Marshall-Lerner Condition is the condition under which a real depreciation leads to an increase in exports. It is named after the two economists, Alfred Marshall and Abba Lerner, who first derived it. This appendix shows this mathematical derivation.

19-88 .

CHAPTER 20. OUTPUT, THE INTEREST RATE, AND THE EXCHANGE RATE I.

MOTIVATING QUESTION

How are output, the interest rate, and the exchange rate determined simultaneously in the short run in an open economy? Output, the interest rate, and the exchange rate are determined jointly by simultaneous equilibrium in the goods market and the domestic and world financial markets. In the open economy, goods demand includes net exports. The world financial market allows trade between domestic and foreign bonds. Fixed and flexible exchange rate regimes have different implications for the relative effectiveness of fiscal and monetary policy in stimulating output.

II.

WHY THE ANSWER MATTERS

This chapter generalizes the model of Chapter 19 by dropping the assumption that the exchange rate (under a flexible exchange rate regime) is a policy variable. Thus, the model allows for the joint determination of output, the nominal interest rate, and the exchange rate, and illustrates the importance of the exchange rate as a transmission mechanism in the open economy. These considerations are required for a realistic treatment of modern market economies.

III. KEY TOOLS, CONCEPTS AND ASSUMPTIONS 1.

Tools and Concepts

The chapter introduces a modern version of the Mundell-Fleming model, which is the IS-LM model in an open economy under perfect capital mobility. The treatment in the text differs from the canonical model by assuming that the expected future exchange rate is fixed, rather than equal to the current exchange rate. A devaluation is a decrease in the level of a fixed exchange rate (akin to a depreciation). A revaluation is an increase in the level of a fixed exchange rate (akin to an appreciation). An appendix to the chapter discusses the central bank balance sheet, in the context of monetary policy under fixed exchange rates.

ii. iii.

Assumptions

The domestic and foreign price levels are assumed to be fixed. Accordingly, expected domestic inflation and expected foreign inflation are assumed to be zero, which implies that the real interest rate equals the nominal interest rate throughout the world. Production is assumed to respond to changes in demand without changes in price, so demand determines output. Foreign currency is assumed to have no transactions value for domestic residents. Domestic and foreign bonds are considered perfect substitutes, and there is perfect capital mobility, so uncovered interest parity holds. The expected future exchange rate is assumed to be constant. As long as the expected future exchange rate changes less than one-for-one with the current exchange rate, this assumption does not affect the qualitative results of the chapter.

ii. iii. iv. v.

20-89 .

IV. SUMMARY OF THE MATERIAL 1.

Equilibrium in the Goods Market

Equilibrium in the goods market equilibrium can be written as Y = C (Y − T ) + I (Y , r ) + G − IM (Y , ε ) ε + X (Y ∗ , ε ) (+ ) ( + , −) ( + , −) ( + , −)

In the short run, assume that P and P* are fixed and (for convenience) equal to one, so that E = ε. Since P is fixed, assume that expected inflation is zero, so that r = i. Under these assumptions, goods market equilibrium can be rewritten as Y = C (Y − T ) + I (Y , r ) + G + NX (Y , Y ∗ , ε ) ( + ) ( + , −) ( −, + , − )

(20.1)

Equilibrium in Financial Markets

Initially when we looked at financial markets in the IS-LM model we assumed there were only two possible assets, money and bonds. However, in an open economy we can now also choose foreign bonds. Under the assumptions of perfect asset substitutability (i.e., no risk premium) and perfect capital mobility, the expected return on domestic and foreign bonds must be the same. This arbitrage condition is called the uncovered interest parity condition, and can be written as

(1 + it ) = (1 + it∗ )

Et Ete+1

(20.3)

The chapter assumes that the expected future exchange rate is fixed at E e . Under this assumption and dropping time subscripts, uncovered interest parity can be rewritten as E=

1+ i 1 + i∗

(20.5)

The domestic currency tends to appreciate (E tends to increase) when the expected exchange rate increases, when the domestic interest rate increases, and when the foreign interest rate falls. Note that when the exchange rate equals the expected exchange rate, i.e., when the domestic currency is not expected to gain or lose value, the domestic interest rate equals the foreign interest rate. When the domestic currency is expected to depreciate, the domestic interest rate is greater than the foreign interest rate. In this case, the difference between the domestic and the foreign interest rate compensates financial investors for the expected depreciation of the domestic currency. When the domestic currency is expected to appreciate, the domestic interest rate is less than the foreign interest rate. In this case, the difference between the foreign and the domestic rate compensates financial investors for the expected depreciation of the foreign currency. A box in the text points out that the uncovered interest parity condition derived in the text ignores risk and liquidity. Changes in the perceived risk of holding a country’s assets shift the uncovered interest parity relation and affect the exchange rate, the domestic interest rate, and domestic output. For example, the large capital movements between Brazil and the U.S. during 2008 were due to U.S. investors moving out of Brazilian equities and back to U.S. dollar denominated investments for safety. The Great Recession prompted many investors to move out of emerging markets back to the safety of the U.S. dollar.

20-90 .

Putting Goods and Financial Markets Together

Substituting equation (19.5) into equation (19.1) gives the open economy IS relation: 1+ i e   Y = C (Y − T ) + I (Y , i ) + G + NX  Y , Y ∗ , E  1 + i∗  

Graphically, the IS curve slopes down in Y-i space. An increase in the interest rate reduces investment, as in the closed economy, and in addition, causes the currency to appreciate, reducing net exports. Moreover, in an open economy, the position of the IS curve is affected by foreign output and the foreign interest rate. Since the interest rate is the policy rate set by the central bank the LM relation is given by the equation, i =ι

Together the IS and the LM equations determine the interest rate and equilibrium output. Increasing the interest rate now leads to lower domestic investment and a decrease in output. However, now in an open economy it causes the currency to appreciate which makes domestic goods relatively more expensive and also pushes output lower.

The Effects of Policy in an Open Economy

The effects of an increase in government spending are depicted graphically in Figure 20-4 on page 432. The left panel shows the IS-LM curves. The right panel plots the uncovered interest parity condition. An increase in government spending shifts the IS curve to the right. Output and the interest rate increase. Since the expected future exchange rate is fixed, uncovered interest parity implies that the exchange rate appreciates (E rises). The increase in output and the appreciation of the exchange rate both work to reduce the trade balance. The effect on investment is ambiguous, because the output effect tends to increase investment, but the interest rate effect tends to reduce it. A decrease in the money supply shifts the LM curve upward. Output falls, the interest rate increases, and the currency increases in value (i.e. appreciates). Investment definitely falls. The effect on the trade balance is ambiguous: the fall in output tends to increase the trade balance while the exchange rate appreciation tends to reduce the trade balance. A text box discusses US trade deficits and Trump administration trade tariffs. The preliminary results of the impact of the tariffs on trade deficits are inconclusive. More time will be needed to study the impact given extraneous factors and lags.

Fixed Exchange Rates

Some countries allow exchange rates to float freely (i.e. Canada, U.S., U.K.) while others fix their currency to another currency (i.e. Argentina, several African countries). Countries that fix, or peg, their currencies must often intervene in the foreign exchange market to maintain their peg. The dedication to maintaining the peg varies. Some countries move slowly (i.e. crawling peg) while others move more rapidly. Given fiscal policy, foreign output, and the foreign interest rate, output is fully determined by the fixed exchange rate and the IS curve. Pegging a currency abdicates monetary policy to the foreign currency. In other words, monetary policy is endogenous (i.e., policymakers lose control over the money supply). Given Y, M must adjust to maintain i*, in order to maintain the fixed exchange rate. If i ever strays from i*, uncovered interest parity implies that the exchange rate will be expected to appreciate or depreciate. This is inconsistent with a credibly fixed exchange rate. 20-91 .

Although policymakers lose control over monetary policy under a fixed exchange rate regime, they retain control over fiscal policy. In fact, the effect of fiscal policy on output is magnified, relative to the case of flexible exchange rates. An increase in G would ordinarily lead to an increase in i. Under a fixed exchange rate, this is impossible. To maintain the fixed exchange rate, which requires i = i*, the money supply must increase. As a result, an increase in G leads to an increase in the money supply as well. So, the effect of fiscal policy on output is augmented by endogenous changes in the money supply.

V. PEDAGOGY Confusion over the implications of the uncovered interest parity condition is likely to become an important issue in this chapter. Suppose the expected exchange rate is fixed. If i rises above i*, the domestic currency is expected to depreciate in the future, but the domestic currency appreciates now. Why? An analogy to the physical world is instructive. A roller coaster must rise before it can fall. Thus, if the exchange rate is expected to fall (depreciate) in the future, it must rise now above its expected future value.

VI. EXTENSIONS 1.

Fixed Exchange Rates and the Central Bank Balance Sheet

An appendix to the chapter discusses the central bank balance sheet and the management of fixed exchange rate regimes. Instructors may wish to discuss this point in the main lecture to build intuition for the endogeneity of the money supply under a fixed exchange rate. The asset side of the central bank balance sheet consists of domestic bonds and foreign exchange reserves. The liabilities side consists of high-powered money (or the monetary base). The money supply is a multiple of high-powered money, as described in Chapter 4. Consider a monetary expansion in the form of a purchase of domestic bonds. This transaction creates high powered money, since the central bank writes a check on itself. The monetary expansion tends to reduce the domestic interest rate. A fall in the domestic interest rate implies an expected appreciation to maintain uncovered interest parity. If the expected future exchange rate is fixed, an expected appreciation implies a depreciation of the current exchange rate, which is incompatible with a fixed exchange rate regime. To defend the exchange rate, the central bank must sell foreign exchange reserves to buy domestic currency. As foreign exchange reserves fall, the money supply falls. Ultimately, foreign exchange reserves fall by enough to offset completely the original monetary expansion. The fixed exchange rate and the IS curve determine output, which (together with the foreign interest rate) determines money demand. Since money demand is unaffected by the central bank purchase of bonds, the money supply cannot be affected either. In the end, the monetary expansion changes only the composition of central bank assets (more bonds, fewer reserves) and not the size of the money stock. The amount of time required for the endogenous adjustment of the money supply depends on the degree of capital mobility. The model presented in the text assumes perfect capital mobility, which implies that the adjustment of the money supply happens instantaneously. If capital mobility is limited, the adjustment of the money supply will take more time. In these circumstances, the central bank will have some freedom to pursue independent monetary policy, at least temporarily. The central bank may still lose foreign exchange reserves if it attempts an expansion, but it may be able to increase output for some period of time. Reasons for less than perfect capital mobility include a lack of developed financial markets in the domestic country, a reluctance on the part of international investors to substitute between domestic and foreign bonds, and capital controls—government-imposed limits on trade in assets with the rest of the world. 20-92 .

Interdependencies

The chapter takes foreign income and the foreign interest rate as fixed. In fact, changes in policy in the domestic country can affect foreign income and the foreign interest rate. For example, an increase in government spending in the domestic economy tends to increase domestic output and cause a domestic appreciation. This implies an increase in foreign net exports, foreign output, and the foreign interest rate, effects that in turn affect the domestic economy. A full open-economy model would consider the effects of policy in the context of world equilibrium. A justification for ignoring effects on foreign output and the foreign interest rate is that the domestic economy is small, so that the effect on foreign variables are small, or that the effects on the domestic economy arising from changes in foreign variables are small compared to the direct effects. In any event, a full world equilibrium model with flexible exchange rates is beyond the scope of this text. Matters are less complicated for fixed exchange rates, as suggested by a box in the text. Assuming that the strongest partner—call it the leader—in a fixed exchange rate system is free to set interest rates as it chooses, then the other members of the system must adjust. In this case, a monetary contraction in the leader implies an increase in the leader’s interest rate and a reduction in the leader’s output. The fall in output implies a fall in net exports for other members of the system and a shift of their IS curves to the left. The other members must undertake monetary contractions to match their interest rates to the leader, i.e., they must shift their LM curves to the left. The net result is a fall in output in these economies. A fiscal expansion in the leader increases the interest rate and output in the leader’s economy. The increase in output tends to shift the IS curve to the right in the other economies (through the effect on net exports), but the increase in the interest rate requires a monetary contraction in the other economies. Assuming that the interest effect dominates, the fiscal expansion in the leader’s economy also causes a fall in output in the other economies. For an example of these forces at work, see the box in the text on the effects of German reunification— which led to an increase in German demand and a monetary contraction in response—on other members of the European Monetary System.

VII. OBSERVATIONS The chapter assumes that the expected future exchange rate is fixed. All of the qualitative results for this chapter hold as long as the expected exchange rate responds less than one-for-one to movements in the exchange rate. For example, if the expected exchange rate is given by E e = λ E + (1 − λ )

where λ is a constant, all of the qualitative results hold when 0 ≤ λ < 1. When λ = 1, fiscal policy can no longer affect output under flexible exchange rates. In this case, an increase in government spending leads to an appreciation that fully crowds out net exports. The case where λ = 1 is the canonical Mundell-Fleming model.

VIII. APPENDIX Fixed Exchange Rates, Interest Rates, and Capital Mobility The assumption of perfect capital mobility is a good approximation of what happens in countries with highly developed financial markets and few capital controls, such as the United States, the United Kingdom, Japan, and countries in the euro area. But this assumption is more questionable in countries that have less developed financial markets or have capital controls in place. In these countries, domestic financial investors may have neither the savvy nor the legal right to buy foreign bonds when domestic interest rates are low. The central bank may thus be able to decrease the interest rate while maintaining a given exchange rate. This appendix examines these issues by evaluating the balance sheet of the central bank. 20-93 .

CHAPTER 21. EXCHANGE RATE REGIMES I.

MOTIVATING QUESTION

How does the exchange rate regime affect macroeconomic adjustment? Under a fixed nominal exchange rate regime, there are two methods of adjustment: relatively slow, mediumrun adjustment through the movement of prices and the real exchange rate, or relatively fast adjustment through devaluation, often induced by a speculative attack on the currency. Under a flexible exchange rate regime, policymakers can use monetary policy to stimulate output during a recession. In choosing between exchange rate regimes, the apparently superior adjustment mechanism offered by a flexible exchange rate has to be weighed against the potential benefits offered by offered by fixed exchange rates. The relative costs and benefits of exchange rate regimes will depend on a country’s specific circumstances.

II.

WHY THE ANSWER MATTERS

The choice of exchange rate regime is a perennial and fundamental issue in international macroeconomics. Moreover, currency crisis remains a topical and intriguing phenomenon. This chapter provides students a basis to understand and think about these issues within the framework developed in the previous three chapters.

III. KEY TOOLS, CONCEPTS, AND ASSUMPTIONS 1.

Tools and Concepts

Following Mundell, the chapter defines an optimal currency area as a group of countries that satisfy at least one of two conditions: similar economic shocks or high factor mobility within the group.

IV. SUMMARY OF THE MATERIAL 1.

The Medium Run

Suppose a country operates under a fixed exchange rate, E . Perfect capital mobility implies that the domestic nominal interest rate equals the world nominal interest rate, i.e., I = i*. To simplify, take expected inflation and foreign output as fixed. These assumptions imply that the goods market equilibrium condition can be expressed as follows:

 EP  Y = Y  ∗ , G , T , i∗ − π e , Y ∗  P  ( −, + , −, −, + )

(21.1)

This chapter focuses on the role of the real exchange rate ( EP / P*) in equation (21.1). A real depreciation (a decrease in the real exchange rate) increases output by increasing net exports. An increase in G also increases output; an increase in T reduces output. The export effect is given by Y* while the domestic real interest rate is given by i* − πe. The time subscripts indicate that the domestic price level and domestic output can change over time. For convenience, the text assumes that G, T, and P* are constant. Assuming countries are operating at potential output there should be no difference in inflation rates across countries and therefore no pressure on exchange rates.

21-94 .

Now suppose that the economy starts from a position in which output is below the natural level (Yn) and unemployment is above the natural rate. If policymakers maintain a commitment to the fixed exchange rate, the relatively high unemployment rate will tend to drive down wages, prices, and expected prices. Although eventually the economy returns to the natural level of output, the process takes some time. Output adjustment is limited by the speed of price adjustment. If policymakers want to speed up adjustment, they can devalue the currency (decrease the level of E ). A devaluation creates a real depreciation in the short run and shifts the IS curve to the right. In principle, a devaluation of the right size can return the economy to its natural level of output almost immediately. In practice, however, the immediate effect of a devaluation will be to increase the price of imported goods (in terms of domestic goods), which has two implications. First, it will take time for a devaluation to improve the trade balance (the J-curve effect), and second, devaluation will lead to an immediate increase in the cost of living (since some goods are imported), which will tend to increase wages and slow down price adjustment. These effects suggest that devaluation will not eliminate adjustment and that it may be difficult to determine the size of the devaluation required to restore output to its natural level.

Exchange Rate Crises under Fixed Exchange Rates

The analysis in Section 21.1 assumed that international investors believed that policymakers would maintain a fixed exchange rate of E . In fact, as was demonstrated in Section 21.1, policymakers have the option of devaluing the currency or, in the extreme, abandoning fixed exchange rates altogether. If international investors believe a devaluation is possible, the expected future exchange rate will rise above the current exchange rate, and by uncovered interest parity, the domestic interest rate will rise above the world rate by the amount of the expected devaluation (in percentage terms). Thus, in the face of an expected devaluation, policymakers will be required to raise the interest rate if they wish to maintain the fixed exchange rate. Since raising the interest rate reduces domestic output and increases home unemployment, policymakers may find this course too painful and may abandon the current fixed rate, either through a devaluation (which validates the original expectation) or by adopting a flexible exchange rate regime. At times, international investors may have good reason to expect devaluation or abandonment of a fixed exchange rate. A country’s currency may be overvalued, implying that a real depreciation is necessary to improve output, the trade balance, or both. The quickest way to achieve a real depreciation is through a nominal depreciation. Likewise, a country may want to reduce its interest rate to get out of a recession. A fixed exchange rate precludes this option, but a flexible exchange rate permits an interest rate reduction through monetary expansion and concomitant nominal depreciation. Although there may be reasons to expect devaluation in some circumstances, an expected devaluation can trigger a crisis even if the initial fear of devaluation is groundless. An increase in the expected future exchange rate, for whatever reason, requires policymakers to raise the interest rate and suffer a fall in output to maintain the fixed exchange rate. If policymakers are unwilling to pay this cost, then a fear of devaluation can become self-fulfilling.

Exchange Rate Movements under Flexible Exchange Rates

Chapter 21 assumed that the expected exchange rate next period was fixed. This assumption generated a simple relationship between the interest rate and the exchange rate: the lower the interest rate, the more depreciated the exchange rate. In fact, the expected future exchange rate is not fixed, but can vary, with implications for the current exchange rate.

21-95 .

Rewrite the uncovered interest parity condition as follows: Et =

1 + it

1 + it∗

Ete+1

(21.4)

Applying equation (21.4) to time t + 1 implies that the exchange rate at time t + 1 will depend on the domestic and foreign interest rates at time t + 1 and the expected exchange rate at time t + 2. Thus, the expected exchange rate at time t + 1 will depend on expected interest rates at time t + 1 and the expected exchange rate at time t + 2. In other words,

Ete+1 =

1 + ite+1 1 + it∗+e1

Ete+ 2

Substituting this equation into equation (20.4) gives

Et =

(1 + it )(1 + ite+1 )

(1 + it∗ )(1 + it∗+e1 )

Ete+ 2

Carrying this calculation n years into the future gives

(1 + it )(1 + ite+1 ) (1 + ite+ n )

(1 + it∗ )(1 + it∗+e1 ) (1 + it∗+en )

Ete+ n +1

(21.5)

Equation (21.5) makes clear that the current exchange rate depends on expected interest rates and the expected exchange rate far into the future. In particular, there are three implications. First, the current exchange rate will be affected by any factor that affects the future expected exchange rate. Over a long enough horizon, it is reasonable to assume that the exchange rate will have to be consistent with current account balance, since countries cannot borrow—and will not want to lend—forever. Thus, economic news that affects forecasts of the current account balance may affect the future expected exchange rate, which in turn will affect the current exchange rate. Second, the current exchange rate will be affected by any factor that affects current or expected future domestic or foreign interest rates. Third, as a result of the first two implications, the relationship between the home interest rate and the exchange rate is not straightforward. Suppose the home central bank cuts the domestic interest rate. Financial market participants will make some judgement about whether the cut is temporary or signals the start of a series of interest rate cuts and will then revise their expectations about future domestic interest rates accordingly. They will also assess the likely response of foreign central banks and revise their expectations of future foreign interest rates. These changes in expectations will affect the current exchange rate. The bottom line is that exchange rates can fluctuate greatly even in the absence of large changes in current economic variables. As a result, countries that operate under flexible exchange rate regimes must be prepared to accept substantial exchange rate fluctuations.

21-96 .

Choosing Between Exchange Rate Regimes

Countries that operate under fixed exchange rates with one another are constrained to have the same interest rates. Therefore, fixed exchange rates eliminate discretionary monetary policy and nominal depreciation as methods of adjustment during recession. In normal times, adjustment happens slowly—through price adjustment and changes in the real exchange rate over the medium run. In emergency situations, adjustment happens through devaluation, often forced on policymakers through currency crisis. Thus, the adjustment mechanism of fixed exchange rates does not appear terribly attractive. On the other hand, as Robert Mundell pointed out in the 1960s, the loss of discretionary monetary policy is less important to the extent that countries operating under fixed exchange rates face one of two conditions: similar economic shocks or high factor mobility with one another. If countries face similar shocks, they would tend to choose the same monetary policies even in the absence of fixed exchange rates. If countries have high factor mobility, movements of workers can substitute for real depreciation as a method of economic adjustment. In other words, workers will move from areas that require real depreciation to avoid high unemployment. A group of countries that satisfy at least one of Mundell’s conditions is said to constitute an optimal currency area. As the name implies, it makes sense economically for such a group of countries to adopt a single currency. As the text argues, many economists believe that the countries of the Euro zone do not constitute an optimal currency area, since they satisfy neither of Mundell’s conditions. In some cases, the loss of policymaking flexibility under fixed exchange rates may also provide benefits. If countries have a reputation for undisciplined monetary policy, international investors may fear that a flexible exchange rate system will allow too much latitude for inflationary policy. To the extent that such countries can commit to a fixed rate system, they eliminate the potential for discretionary monetary policy. Since a fixed exchange rate can always be abandoned, however, it is not always a simple matter to demonstrate commitment to a fixed rate system. One method is to enter into a common currency with a set of other countries, as much of Europe has done. Another is to supplement fixed exchange rates with legislative or technical measures that limit or prohibit discretionary monetary policymaking. The latter arrangements—called currency boards—generated much interest in the 1990s. Argentina adopted a currency board in 1991, but abandoned it in crisis in 2001. Some economists argue that Argentina’s currency board was not tight enough, since an exchange rate crisis was not prevented. These economists argue that a country that wants a fixed exchange rate should simply adopt the U.S. dollar as its currency. Other economists argue that fixed exchange rates are a bad idea, and that currency boards should be used for only short periods of time, if at all. A box in the text describes Argentina’s crisis. Finally, the policy flexibility seemingly offered by flexible exchange rates may be illusory. In practice, flexible exchange rates vary greatly. Large and unpredictable movements in the nominal exchange rate make life more complicated for firms and consumers and have real effects in the short run since prices (and hence the real exchange rate) adjust slowly. As described above, movements in the exchange rate are driven by expectations, which are not well understood, and the relationship between monetary policy and the nominal exchange rate is a bit more complicated than it seemed in Chapter 19. Moreover, to the extent that changes in the nominal exchange rate have real effects, monetary policymakers may be required to use policy to respond to unpredictable (and sometimes difficult to understand) movements in the nominal exchange rate. Thus, flexible exchange rates do not allow policymakers complete independence: to some extent, policymakers are at the mercy of the foreign exchange market. The choice of exchange rate regime requires weighing the costs of highly variable nominal exchange rates against the potentially poor adjustment properties of fixed exchange rates. The choice will depend on the circumstances of a given country—in particular, whether it is part of a group of countries that satisfy one of Mundell’s two conditions and whether it needs to establish a reputation for monetary discipline.

21-97 .

V. PEDAGOGY The discussion in this chapter is relatively sophisticated for students just coming to terms with openeconomy macroeconomics. It is important to review carefully the adjustment mechanisms under fixed and flexible exchange rates before tossing around terms cavalierly. It may also be helpful to discuss the role of the nominal exchange rate (under flexible rates) as an automatic stabilizer. Under a fixed exchange rate, a shock to the goods market will affect output by the full amount of the horizontal shift of the IS curve (since the interest rate is fixed). Under a flexible rate, the same shock to the IS curve will have a smaller effect on output (since the interest rate and exchange rate can vary). In other words, flexible exchange rate systems tend to dampen IS shocks.

VI. EXTENSIONS An appendix to the chapter introduces real interest parity (uncovered interest parity with real interest rates and exchange rates substituted for nominal interest rates and exchange rates) and extends it to a long-run relation (Appendix 2). With this in mind, the current real exchange rate is influenced by two factors— domestic and foreign long-term real interest rates and the expected long-run real exchange rate. In the long run, the real exchange rate should adjust to a level consistent with current account balance. If there is a large current account deficit today, then presumably the expected long-run real exchange rate will be lower (more depreciated) than the current real exchange rate, other things equal.

VII. OBSERVATIONS The real exchange rate drives adjustment in an open economy. In the short run, with prices fixed, movements in the nominal exchange rate create movements in the real exchange rate. Thus, in the short run, fixed exchange rate regimes have no avenue for adjustment, and shocks translate into changes in output. In the medium run, the real exchange rate can adjust through prices, and the flexibility of the nominal exchange rate is irrelevant.

VIII. APPENDICES APPENDIX 1: Deriving the IS Relation under Fixed Exchange Rates Beginning from equation 20.1 from the previous chapter we derive the IS relation under a fixed exchange rate regime. The end result is presented as equation 21.1 in this chapter.

APPENDIX 2: The Real Exchange Rate and Domestic and Foreign Real Interest Rates This appendix derives the relation between real interest rates and the real exchange rate similar to the relation posted in equation 21.5 dealing with nominal values. There is some discussion of how this specific relation can be used to think about movements in the real exchange rate.

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CHAPTER 22. SHOULD POLICYMAKERS BE RESTRAINED? I.

MOTIVATING QUESTION

Should external limits be imposed on policymakers? The fact that the effects of policy are uncertain does not imply that limits should be imposed on policymakers. Policymakers understand that uncertainty provides an argument for moderation in setting policy and to the extent they are benevolent, impose their own restraint. On the other hand, the strategic interactions between the private sector and the government and among political parties suggest that economic performance may improve when constraints are placed on discretionary policy. Even so, the need for discretionary policy in times of economic distress calls for care in the design of institutional limits on policymakers.

II.

WHY THE ANSWER MATTERS

Modern macroeconomics was founded on the premise that governments could act to improve economic performance. Toward this end, the previous 21 chapters have discussed policies available to governments and the likely effects of such policies. Although caveats have been offered along the way, the basic message is that governments can act to reduce economic fluctuations and increase the long-run level of the capital stock, but have little ability to influence growth, beyond establishing institutions that reward innovation. This chapter examines the limits on discretionary policy. It asks whether governments can be expected to exercise their discretion wisely and whether institutions can be designed to encourage good policymaking.

III. KEY TOOLS, CONCEPTS, AND ASSUMPTIONS 1.

Tools and Concepts

i. ii.

In economics, a game refers to strategic interactions among a set of players. A government faces a time inconsistency problem when it has an incentive to deviate from a promised policy once private agents have made decisions based on the policy. A political business cycle occurs when policymakers try to generate expansions before elections in hopes of securing reelection.

iii.

IV. SUMMARY OF THE MATERIAL Despite the apparent beneficial role that macroeconomic policy can play, arguments for restraints on policymakers are common. These arguments fall into two classes. One view is that policymakers, in trying to do well, do more harm than good. The other view is that policymakers do what is best for them, rather than for society as a whole.

Uncertainty and Policy

One reason that policymakers may do harm is that the effects of policy are uncertain. In the mid-1980s, an exercise conducted at the Brookings Institution used twelve prominent world macroeconomic models to predict the effects of a specified monetary expansion. There was substantial variation in the quantitative results. Since such models (and their descendents) capture existing quantitative knowledge about the effects of policy on the economy, the implication is that policymakers face substantial uncertainty about such effects. 22-99 .

If extreme macroeconomic outcomes are very harmful, uncertainty provides an argument for moderation in policymaking: the smaller policy changes result in a narrower range of possible outcomes. This argument is less relevant when the economy is suffering a severe recession or hyperinflation. In this case, the effects of relevant compensating policies—no matter how extreme—are likely to improve economic performance. There is every reason to believe that policymakers understand that uncertainty calls for restraint. Thus, the existence of uncertainty does not necessarily provide justification for imposing external constraints on policymakers.

Expectations and Policy

The relationship between the government and private sector can be described as a game, i.e., strategic interactions among a set of players. Private firms and households make decisions based on expectations of future policy. The government forms policy based on the expected response of the private sector. Viewing the economy in this perspective can provide a rationale for external constraints on policymakers. Sometimes a government has an incentive to deviate from a promised policy once private agents have made decisions based on the policy. In this case, the government’s optimal policy is said to be time inconsistent. For example, as discussed in Chapter 8, central banks can temporarily reduce unemployment below the natural rate by generating unexpected inflation. At the same time, if inflation is costly, central banks have an incentive to announce a policy of low money growth to reduce expected (and hence actual) inflation. Combining these objectives, the central bank’s optimal policy is to announce a tight monetary policy to convince the private sector that inflation will be low, but to implement a more expansionary policy to reduce unemployment (temporarily). If the central bank attempts to carry out this program, however, it will lose credibility quickly, and the private sector will set wages and prices in expectation of high inflation. The loss of credibility will contribute to high inflation and eventually eliminate the ability of the central bank to reduce unemployment below the natural rate. In the long run, the central bank’s program will have no effect on unemployment (it will return to the natural rate) but will result in high inflation. Under these circumstances, economic performance would improve if the central bank could commit itself credibly to maintain low money growth. In this case, the public’s expectations would be consistent with low inflation, and the natural rate could be achieved with a lower inflation rate. Thus, time inconsistency provides an argument for external restraints on government actions. External restraints are needed because self-restraint may not be credible. But care should be taken to preserve flexibility in times of economic distress. For example, one way to impose an external constraint on the central bank is to legislate a money growth rule. Such a restraint prevents the central bank from cheating on policy targets (a desirable outcome), but also eliminates its ability to respond to adverse shocks (an undesirable outcome). A superior alternative is to make the central bank politically independent of the government in power and to appoint a central banker with a known distaste for inflation. The evidence suggests that central bank independence is associated with lower inflation.

Politics and Policy

Sections 22.1 and 22.2 assumed that policymakers were benevolent. In fact, politicians may act to maximize their own reelection prospects. If voters are shortsighted, politicians have an incentive to implement policies that generate short-run benefits, regardless of the long-run costs of these policies. There is not much evidence in favor of this proposition in the United States. Until the 1980s and aside from the Great Depression, the ratio of government debt to GDP tended to increase only during wars. Thus, the evolution of deficits and debts seemed to track economic circumstances rather than the shortsightedness of voters. The bouts of increasing deficits and debt in the 1980s and the early years of this decade appear to have more to do with games among policymakers, as described below, than with the short-sightedness of voters. Moreover, if voters were shortsighted, politicians could improve their 22-100 .

changes of reelection without much cost by generating expansions just before elections. Thus, there would be a political business cycle, with growth highest in the final years of presidential administrations. In the postwar period, U.S. growth has been highest in the final years of presidential administrations, but the difference across years has been relatively small on average. Another source of harmful policies emerges out of strategic games among policymakers. Substantial policy disagreements occasionally result in wars of attrition between political parties that result in the postponement of needed policies, such as deficit reduction. For example, the tax cuts of 1980s and the early years of this decade seem to have been motivated in part by a desire to cut spending. In both episodes, the tax cuts led to substantial increases in the deficit, and ultimately to concern about reducing the deficit. In both cases, Republicans typically argued for spending cuts (in nondefense programs) and Democrats for increased revenues. The deficits of the 1980s were eventually eliminated with spending restraint, but the surplus of the last years of the Clinton administration was quickly reversed. The U.S. budget has moved into a large deficit, which is projected to continue for some time. Republicans and Democrats now seem poised to engage in a war of attrition over deficit reduction. Some economists believe that the only way to break the current impasse is with some sort of legislative or constitutional limit on fiscal policy. A problem with this approach is that it may limit needed fiscal flexibility. For example, when the economy is in recession, policymakers should have the option of fiscal stimulus. The problem is to impose an effective limit on fiscal policy, while preserving enough flexibility to respond to changing economic circumstances. This is a difficult task. A balanced budget amendment to the Constitution, which has been advocated by some, would need an escape clause for recession or other emergencies. How to define such an escape clause without eviscerating the fiscal discipline remains a challenging problem.

V. PEDAGOGY The discussion of time inconsistency provides an opportunity to revisit the issue of fixed exchange rates and exchange rate crises. A credible commitment to a fixed exchange rate eliminates a government’s ability to conduct discretionary monetary expansion. Thus, it has been argued, a credibly fixed exchange rate will reduce inflation expectations and inflation. On the other hand, as numerous currency crises indicate, it is difficult for governments to convince markets that they will not devalue or adopt a flexible rate in times of distress. Thus, there is an argument that some governments would do well to completely tie their hands with respect to monetary policy by establishing a currency board or adopting the U.S. dollar as their currency. Argentina’s experience, however, demonstrates that even currency boards do not eliminate expectations of devaluation.

VI. EXTENSIONS For students who know rudimentary calculus, instructors can present a simple formalization1 of the time inconsistency problem described in this chapter. Suppose the policymakers’ loss function can be written as

L = (a /2)π 2 − b(π − π e )

The formalization is based on Barro, Robert J. and David B. Gordon (1983), “Rules, Discretion, and Reputation in a Model of Monetary Policy,” Journal of Monetary Economics, 12:101-121.

22-101 .

In words, policymakers care about inflation and unemployment in excess of the natural rate. The first term of the loss function reflects concern about inflation. The second term reflects concern about excess unemployment, which is determined by the difference between actual and expected inflation. If policymakers announce an intention to achieve zero inflation, and this is believed (πe = 0), they have two options. They can follow through on the announcement and produce zero inflation, in which case, π = 0, u = un, and L = 0. Alternatively, they can act in a discretionary fashion, renege on their commitment, and attempt to achieve the socially optimal rate of inflation, conditional on πe = 0. Minimizing L, subject to πe = 0, generates an optimal rate of inflation of b/a and a loss of (–b2/2a), which is smaller than the loss achieved by following the announced rule. The gain comes from the benefit of surprise inflation in lowering unemployment below the natural rate. Note that the form of the loss function implies that the cost of inflation is zero (at the margin) when inflation is zero, so there is always some gain to surprise inflation. The problem is that the private sector is aware of these incentives. Therefore, in the absence of some credible mechanism that forces policymakers to adhere to their announced policy, the private sector will never believe the announcement. Expecting that policymakers will act in a discretionary fashion, the private sector will set πe = b/a. Because this constant value of πe does not alter the solution of the policymaker’s optimization problem, the actual rate of inflation will indeed turn out to be π = b/a. But since this inflation rate is no longer a surprise, there are no unemployment gains and the loss becomes L = (b2/2a), a worse outcome than would have been achieved by following the rule. Since policymakers are assumed to be benevolent—i.e., their loss function accurately reflects social preferences—society would be better off by removing their discretion if possible.

22-102 .

CHAPTER 23. FISCAL POLICY: A SUMMING UP I.

MOTIVATING QUESTION

What do macroeconomists know about fiscal policy? Fiscal policy affects output in the short run—through its effect on aggregate demand—and in the long run— through its effect on investment. Fiscal policy is limited by the government budget constraint, which links the deficit to the increase in debt. Given the budget constraint, prudence suggests that governments should run fiscal surpluses during booms to balance deficits during recessions. Such a policy allows the government to stimulate the economy during recession, but avoids the dangers inherent in accumulating a large debt.

II.

WHY THE ANSWER MATTERS

The major long-term policy issue facing economic policymakers in many advanced economies (but also in some emerging economies) is how to finance expenditures associated with the retirement of the baby boomers and the continued aging of the population. This chapter alerts students to what lies ahead.

III. KEY TOOLS, CONCEPTS, AND ASSUMPTIONS 1.

Tools and Concepts

The inflation-adjusted deficit is the deficit measured in real terms. It equals real interest payments plus the (real) primary deficit, defined below. The primary deficit is government spending minus taxes. The cyclically-adjusted deficit measures what the deficit would be if output were at its natural level. Ricardian equivalence is the proposition that neither deficits nor debts have any effect on economic activity. Debt restructuring, or debt rescheduling occurs when interest payments are deferred rather than cancelled. Debt monetization occurs when the central bank then pays the government with money it creates, and the government uses that money to finance its deficit. Hyperinflation is a very high level of inflation.

ii. iii. iv. v. vi. vii.

IV. SUMMARY OF THE MATERIAL 1.

What We Have Learned

This section offers a brief review of fiscal policy as covered throughout the text. The author highlights the role of fiscal policy during short run, medium run, and long run time periods. •

•

In the short run, an increase in the deficit increases aggregate demand and real output, with the strength of the initial impact depending on expectations. In the medium run, output returns to its natural level, but with a higher real interest rate and a lower rate of investment. In the long run, output may be lower (than it would be otherwise) because a higher deficit leads to less investment and therefore less capital accumulation. Also, the author highlights the important role of fiscal policy during a case when the interest rate is equal to zero and the economy is in a liquidity trap (see Chapter 6).

23-103 .

The Government Budget Constraint: Deficits, Debt, Spending, and Taxes

The inflation-adjusted deficit is defined as

Deficit = rBt −1 + Gt − Tt

(23.1)

where all variables are expressed in real terms, B is real debt, and r is the real interest rate. The text notes that official deficit measures typically substitute nominal interest payments (iBt-1) for real interest payments (rBt-1) in equation (23.1). The deficit is linked to the increase in debt by the government budget constraint:

Bt − Bt −1 = rBt −1 + Gt − Tt

(23.2)

Defining the primary deficit as (Gt − Tt), government debt can be expressed as

Primary Deficit    Bt = (1 + r ) Bt −1 + (Gt − Tt )

(23.3)

This relationship implies that, starting from zero debt and a zero primary deficit, a one-unit increase in the primary deficit for one period will generate a debt of Bt = (1 + r)t after t periods. To repay this debt after t periods, the government must run a primary surplus of (1 + r)t. If spending is unchanged, this means that a reduction in taxes today implies an increase in future taxes of equal present value. If the government seeks to stabilize the debt instead of repaying it, then the government must run a primary surplus equal to the real interest payment on the debt in every future period. In other words, the government must eliminate the inflation-adjusted deficit, defined as the primary deficit plus real interest payments on the debt (or equivalently, as the official deficit minus inflation times real debt.) To examine the evolution of the debt-to-GDP ratio, rewrite the government budget constraint as Y  B Bt G −T = (1 + r )  t −1  t −1 + t t , Yt Yt  Yt  Yt −1 which can be approximated as Bt Bt −1 B G −T − = (r − g ) t −1 + t t , Yt Yt −1 Yt −1 Yt

(23.5)

where g is the growth rate of output. Given some initial debt, equation (23.5) implies that the debt-to-GDP ratio will grow when there is a primary deficit and when the real interest rate exceeds the growth rate of output. To understand the latter effect, suppose the primary deficit is zero. Then, debt (the numerator) will grow at rate r and output (the denominator) will grow at rate g. The difference in growth rates is approximately the change in the debt-to-GDP ratio.

Ricardian Equivalence, Cyclical Adjusted Deficits, and War Finance

Ricardian equivalence. Ricardian equivalence is the proposition that neither deficits nor debt affect economic activity. For example, given unchanged government spending, a tax cut today implies a tax increase of equal present value in the future. Therefore, consumer wealth is unchanged, and private consumption is unaffected. An increase in today’s government deficit will be matched with an equal increase in private saving. In practice, however, tax increases that are distant and uncertain are likely to be ignored by consumers, because they may not live to see them or because they do not think that far into the 23-104 .

ii.

iii.

future. As a result, although expectations certainly affect economic behavior, it is unlikely that Ricardian equivalence holds in strict form. However, the Ricardian equivalence proposition was updated by Robert Barro in the 1970s and is now known as the Ricardo-Barro proposition. Deficits, output stabilization, and the cyclically-adjusted deficit. The fact that deficits reduce investment does not mean that they should be avoided at all times, but rather that deficits during recessions should be offset by surpluses during booms. In this way, fiscal policy will not lead to a steady increase in debt. The cyclically-adjusted deficit removes the effect of the business cycle from the deficit. Thus, it can be used to assess whether fiscal policy is consistent with no systematic increase in debt over time. Estimating the cyclically-adjusted deficit requires knowledge of two facts: the reduction in the deficit that would occur if output were to increase by 1% and the difference between current output and its natural level. The first fact is relatively easy to determine. As a rule of thumb, a 1 percent decrease in output increases the deficit by 0.5% of GDP. The deficit increases because most taxes are proportional to output, but most spending does not depend on output. The second fact is more difficult to ascertain, because the natural level of output depends on the natural rate of unemployment, which changes over time. Wars and deficits. There are two good reasons to run deficits during wars. First, deficits shift part of the burden of paying for a war to future generations (because they inherit a smaller capital stock). Second, by using debt instead of tax financing, the government avoids imposing very large and distortionary tax rates. Borrowing permits tax increases to be smoothed over time.

The Dangers of High Debt

High debt ultimately requires higher taxes in the future, but it can also lead to vicious cycles. The text explains how the presence of a large debt leaves governments in a vulnerable position. For example, a government may increase debt to the point where investors begin to worry about the government’s ability to repay the debt. These initial groundless fears about the government’s ability to repay its debt can lead to an increase in the risk premium, which will start the process in motion. This process can turn into a vicious cycle which can become self-fulfilling. Figure 23-2 plots the spreads between the two-year interest rate on Italian and Spanish two-year government bonds over the interest rate of two-year German bonds. The figure shows that over the time period spanning from March 2012 to December 2012, the spread for these countries fluctuated between 150 and 660 basis points. The increase in the spread and volatility makes it harder for these countries to stabilize their debt ratios. If a government does not succeed in stabilizing the debt, historically, one of two things happens: (1) Either the government explicitly defaults on its debt; or (2) the government relies increasingly on money finance (i.e. debt monetization), which typically leads to very high inflation. 1. Debt Default: Default is often partial, and creditors take what is known as a haircut: A haircut of 30%, for example, means that creditors receive only 70% of what they were owed. 2. Money Finance: Entails the central bank finding itself in the fiscal dominance case where the central bank must do what the government tells it to do. The government issues new bonds and tells the central bank to buy them. The central bank then pays the government with money it creates, and the government uses that money to finance its deficit. This process is called debt monetization. a. The revenue from money creation is called seignorage. Equation 23.6 gives us the nominal money and real money balances relative to monthly GDP. Therefore, if a country needed to finance a deficit of 10% of GDP through seignorage, given a ratio of central bank money to monthly GDP of 1, the monthly growth rate of nominal money must be equal to 10%. Inflation is likely to follow. And very high inflation is likely to lead people to want to reduce their demand for money, and in turn the demand for central money.

23-105 .

b. Section 23-4 concludes with the economic costs of hyperinflation, which are: the transaction system begins to function poorly; price signals become less and less useful; and swings in inflation become larger and larger and harder to predict.

The Challenges Facing Fiscal Policy Today

Today, debt is high in many advanced economies, often exceeding 100% of GDP. So, what should governments do? The answer is that there is no simple solution to the problem. Go back to paragraph 3 of Chapter 9 for a discussion of the effects of fiscal policy when the interest rate is at zero lower bound. The discretion in fiscal policy in Europe is also limited: excessive fiscal consolidation could lead to another recession, while insufficient fiscal consolidation could trigger a debt spiral. In any case, debt reduction will take a long time. It may be wise to begin efforts to lower the debt-to-GDP ratio. However, the current cost of debt service is very low given the historically low interest rates. Additionally, an argument can be made that an increase in public investment would be prudent because of the low interest rates. Perhaps a slow reduction in debt will work without pushing output down.

V. PEDAGOGY 1.

Points of Clarification

It is worthwhile to emphasize that Ricardian equivalence implies that the size of the deficit has no effect on economic activity, not that fiscal policy has no effect on economic activity. For example, starting from a position of budget balance, the balanced budget multiplier implies that an increase in government spending fully financed by taxes would increase aggregate demand and thus output. Ricardian equivalence implies that the effect will be the same regardless of whether the increase in government spending is financed by tax increases or debt.

Alternative Sequencing

It is easy for instructors to pick and choose from this chapter. Any of the theoretical topics—for example, Ricardian equivalence—can be examined independently. Alternatively, instructors could limit attention to the U.S. budget deficit and ignore the theoretical sections.

VI. EXTENSIONS 1.

The Pandemic Crisis

Clearly, the fiscal picture is an ongoing issue. Instructors may wish to supplement the material with current articles from the Wall Street Journal and The Economist, which highlight fiscal deficit, debt and spending issues within the U.S. and Europe. And of course, incorporating the most recent budget projections is advisable.

Points of Clarification

The concept of the inflation-adjusted deficit provides instructors an opportunity to review the Fisher effect. For a given nominal interest rate, the inflation-adjusted deficit will be less than the official deficit when inflation is positive. Thus, it seems that the government can reduce its real deficit and its real debt burden through inflation. In fact, historically inflation has been an important means for governments to reduce their real debt burdens. Although governments can use inflation in this way for some period of time, they cannot do so indefinitely. In the long run, the Fisher effect implies that the nominal interest rate will increase one-for-one with the inflation rate. Thus, in the long run, an increase in inflation will simply increase the nominal deficit and have no effect on the inflation-adjusted deficit. 23-106 .

CHAPTER 24. MONETARY POLICY: A SUMMING UP I.

MOTIVATING QUESTION

What do macroeconomists know about monetary policy? In the long run, monetary policy affects only the inflation rate. Thus, a central bank should adopt a target inflation rate, based on the costs and benefits of inflation. In the short run, however, monetary policy affects output, so the central bank must decide whether to deviate from its target to respond to economic shocks. Before the crisis, this decision depends on the degree to which the central bank cares about fluctuations in unemployment and inflation.

It is now believed that the crisis has thus presented countries with the challenge of the liquidity trap and new processes to achieve macroeconomic stability beyond stable inflation.

II.

WHY THE ANSWER MATTERS

Whether the central bank should change interest rates or offer new macroeconomic prudential tools are the preeminent macroeconomic policy issues. This chapter provides a basis to think about this question, in light of the long-run objectives of the central bank. Moreover, the crisis has questioned many countries’ monetary policymaking decision-making tools. Looking forward, should the central bank worry not only about inflation and the overall level of economic activity but also about asset prices, stock market booms, housing booms, and creating and implementing regulations to avoid excessive risk in the financial sector? And if so, what tools does it have at its disposal?

III. KEY TOOLS, CONCEPTS, AND ASSUMPTIONS 1.

Tools and Concepts

The chapter introduces monetary aggregates. M1 is the sum of currency and checkable deposits. M2 is the sum of M1, money market mutual fund shares, money market deposit accounts, and time deposits. The Taylor rule argues that central banks should deviate from their target interest rates to the extent that they care about short-run fluctuations in inflation and unemployment. The chapter introduces terminology associated with the organization of the U.S. Federal Reserve. Quantitative easing is presented as an unconventional monetary policy tool. Macro prudential tools are rules aimed directly at borrows or lenders, or banks and other financial institutions as the case may require.

ii. iii. iv. v.

IV. SUMMARY OF THE MATERIAL 1.

What We Have Learned

The analysis in previous chapters suggests that the short-run effects of monetary policy are different from the medium-run and long-run effects. In the short run, expansionary monetary policy lowers interest rates and causes the exchange rate to depreciate. As a result, output and the price level increase. In the medium and long run, money growth determines inflation, but has no effect on output. Thus, the medium-run inflation rate is determined by the medium-run rate of growth of the money supply. With this in mind, the Federal Reserve has to choose a rate of inflation to target in the medium run and to decide when and by how much to deviate from this target in the short run.

24-107 .

From Money Targeting to Inflation Targeting

Until the 1990s, central bankers typically thought about monetary policy in terms of the rate of money growth. A central bank chose a rate of money growth that corresponded to its inflation target, and worried about how closely the growth of monetary aggregates matched its goals. But it turns out that money demand does not have a stable relationship with any of the monetary aggregates. As a result, inflation does not have a tight relationship with the growth of any particular monetary aggregate. Faced with this reality, most central banks now think about monetary policy in terms of the nominal interest rate. A central bank tries to achieve its target inflation rate by changing the interest rate. In the short run, an inflation target might seem to reduce the central bank’s flexibility to stabilize output. In theory, this is not the case. If the central bank sees a recession arising from an adverse demand curve, it knows that inflation will fall. Thus, it should pursue a monetary expansion to increase inflation. This policy of course will also tend to return output to its natural level. Indeed, if the central bank manages to achieve a constant rate of inflation, the accelerationist Phillips curve implies that unemployment is always at its natural rate. In practice, central banks will not always be able to achieve their inflation targets in the short run. If inflation turns out to be higher than the target, it is not clear that the central bank should try to reduce it, since to do so would require higher unemployment. Moreover, the Phillips curve does not hold exactly. Sometimes inflation will increase even when unemployment is at the natural rate. A strict inflation target would require the central bank to undertake a monetary contraction and increase unemployment above the natural rate. Given an inflation target for the medium run, a central bank must decide how to achieve it and under what conditions to relax the target to respond to short-run fluctuations. John Taylor argues that a central bank should think in terms of a target interest rate, since the interest rate affects spending, and suggests an implementation rule. Under the Taylor rule, central banks set short-term interest rates according to

i = i∗ + a(π − π ∗ ) − b(u − un ), where π* is the target rate of inflation, i* is the interest rate associated with this target, and un is the natural rate of unemployment. The coefficients a and b reflect how much the central bank cares about inflation versus unemployment. Note that the coefficient a should be greater than one, because the real interest rate affects spending. Thus, when inflation increases, the central bank must increase the nominal rate by a greater amount to increase the real interest rate and reduce spending. Basically, the Taylor rule says that the central bank should respond to short-run fluctuations to the extent it cares about them. Taylor acknowledges that events could justify changing the nominal interest rate for reasons not included in the rule. But he argues that the rule provides a useful way of thinking about monetary policy. Evidence suggests that the Taylor rule describes quite well the actual behavior of the Fed and the Bundesbank over the 20 years leading up to the financial crisis, however they conceived of their policy decisions. Then the crisis came and raised many questions, about the choice of the inflation target, what to do when the interest rate suggested by the interest rule reaches the zero lower bound, and whether and how the central bank should worry about financial stability in addition to inflation and output.

The Optimal Inflation Rate

The optimal medium-run inflation rate depends on the costs and benefits of inflation. The costs of inflation vary with the level of inflation. Very high rates of inflation disrupt economic activity; low rates of inflation are much less costly. Inflation creates four costs, all of which increase with the rate of inflation. First, higher inflation leads to higher nominal interest rates, which cause people to economize on holdings of money. This effort requires resources, referred to as shoe leather costs. Such costs can become quite large during hyperinflation, but are unlikely to be very important when inflation is low. 24-108 .

Second, when the tax system is not indexed, the real tax burden will depend on the rate of inflation. In the United States, this issue applies in particular to nominal interest income and capital gains. The tax distortions created by inflation affect the allocation of economic resources. Indexing the tax code to account for inflation could address these issues. Third, with inflation, real and nominal values diverge. Evidence suggests that people suffer from money illusion, i.e., they make systematic errors in assessing nominal versus real changes. Thus, inflation leads people and firms to make incorrect decisions. Fourth, because higher inflation is associated with more variable inflation, nominal assets become riskier in real terms. This cost could be avoided through increased reliance on indexed bonds (bonds whose nominal payments are indexed to the inflation rate). A number of countries, including the United States, now issue indexed bonds. Inflation also has three benefits. First, seignorage—the amount of resources the government collects by printing money—increases at higher rates of inflation, at least over some initial range. But the amount of seignorage available at low rates of inflation in countries with otherwise highly developed tax systems is too small to make this a powerful argument for low—as opposed to zero—rates of inflation. Second, since the nominal interest rate cannot fall below zero, inflation makes it possible for governments to achieve negative real interest rates, an option that may be useful to stimulate output during a recession. Third, money illusion may cause workers to resist nominal wage cuts, independent of the effects on the real wage. As a result, ongoing inflation may be necessary to achieve the real wage cuts that are sometimes required to reallocate labor across sectors. At present the debate over the optimal inflation rate is between those who favor low inflation (say 3% or so) and those who favor zero inflation. Those who favor low inflation argue that the costs of inflation are low in this range and that some of these costs could be avoided by indexing the tax system and issuing more indexed bonds. In addition, there are benefits to maintaining some inflation, and the cost of eliminating it (in terms of higher unemployment for a time) may outweigh any future benefits. Those who favor zero inflation argue that such a target corresponds to price stability, which simplifies decision-making and helps alleviate the time inconsistency problem by establishing a simple and clear goal for monetary policy.

Unconventional Monetary Policy

When central banks became zero bound conventional monetary policy was no longer available as a tool. Central banks developed unconventional strategies to affect economic change. For example, central banks began buying financial assets other than short-term bonds. This increase in demand pushed prices higher and reduced longerterm interest rates and stimulated consumption and investment. These asset purchase programs became known as quantitative easing or QE. The primary assets purchased in three separate QE rounds were mortgage backed securities and long-term U.S. Treasuries. The end result was lower interest rates and a massive expansion of the Fed’s balance sheet. Currently most of this money expansion is being held as excess bank reserves. The Fed’s decision point is whether to return its balance sheet to pre-crisis levels or to gradually reduce asset holdings.

Monetary Policy and Financial Stability

Until 2007 most countries saw stable inflation, and output fluctuations that were smaller than they had been in the past. Many central banks believed that inflation targeting provided them with a solid framework for monetary policy. It is believed that the crisis has thus presented countries with the challenge of the liquidity trap and new processes to achieve macroeconomic stability beyond stable inflation.

24-109 .

Liquidity Provision and Lender of Last Resort One of the functions of the Fed is to prevent bank runs and ensure continued confidence in the banking system. Depositors need to feel that their money is safe and accessible. Deposit insurance and the Fed’s readiness to loan banks funds to keep banks from liquidating assets to cover withdrawals (i.e. lender of last resort function). Macroprudential Tools The crisis has created a broad consensus that it is risky to wait, and it is better to prevent high leverage. Also, it is now believed that to deal with bubbles, credit booms, or dangerous behavior in the financial system, the interest rate is not the right policy instrument. Many believe the interest rate is too blunt an instrument, affecting the whole economy rather than resolving the problem at hand. The authors offer an analysis of new instruments, which are called macroprudential tools. These tools are rules that are aimed directly at borrowers, lenders, banks and/or other financial institutions. This chapter section concludes with possible examples of the forms that macro prudential tools could take. There are many questions regarding how well these macro prudential tools work and their interaction with traditional monetary policy tools. Lastly, there is debate over whether the control should be under the central bank or a separate authority.

V. PEDAGOGY Some instructors may prefer to teach this lecture in reverse, starting institution risks proceeding from there to problems of short-run monetary policy making, and then turning to the issue of the optimal medium-run inflation rate. This sequence has the pedagogical advantage of moving from the more concrete to the more abstract. A second possibility involves breaking up this chapter and integrating its various parts into the discussion of previous chapters. For example, as indicated in the Chapter 4 of the Instructor’s Manual, the institutional material about the Federal Reserve System or the Euro system could be incorporated into the description of the money supply process in the United States and the euro area respectively. The existence of near monies could also be integrated into the monetary policy discussion of Chapter 4 as a way of motivating money demand shocks.

24-110 .

CHAPTER 25. EPILOGUE: THE STORY OF MACROECONOMICS I.

MOTIVATING QUESTION

How have the core ideas of macroeconomics developed? Modern macroeconomics starts with Keynes. Since his General Theory appeared, there have been a series of challenges and counter challenges to his basic ideas, as interpreted by Hicks and Hansen. The Core, as described in this book, is a collection of ideas that have survived these debates and that help to make sense of the disagreements among economists.

II.

WHY THE ANSWER MATTERS

Up to this point, the text has avoided describing economic research and ideas in terms of competing camps. Instead, it has provided a unified model, constructed on the basis of widely held views among macroeconomists, and emphasized the orderliness of economic research. This chapter provides students an overview of the tumultuous history of macroeconomic theory. It exposes them to the messier, dynamic aspect of research, and gives them some appreciation of how quickly economic orthodoxy can and has changed.

III. KEY TOOLS, CONCEPTS, AND ASSUMPTIONS 1.

Tools and Concepts

The chapter introduces some terms associated with the intellectual history of macroeconomics. Such terms include, among others, the neoclassical synthesis, Keynesians, monetarists, new classicals, and new Keynesians.

IV. SUMMARY OF THE MATERIAL 1.

Keynes and the Great Depression

Few economists during the 1930s could provide a coherent explanation for the depth and breadth of the Great Depression. Keynes’ General Theory delivered an intellectual framework to explain events and guide policy. Keynes emphasized what we now call aggregate demand. In particular, Keynes stressed the slow adjustment back to the natural level of output after an adverse demand shock. The General Theory introduced a number of ideas—the multiplier, money demand, and the importance of expectations—that are fundamental to modern macroeconomics.

The Neoclassical Synthesis

By the early 1950s, a consensus had emerged around an interpretation of Keynes’ ideas in the form of the IS-LM model, developed by Hicks and Hansen. This “neoclassical synthesis,” as Samuelson called it, omitted the role of expectations and wage-price adjustment. During this period, Modigliani and Friedman developed the theory of consumption, Tobin developed the theory of investment (which was further developed and tested by Jorgensen), and Tobin also developed the theory of money demand and, more generally, portfolio selection. These developments were embodied in large macroeconomic models, pioneered by Klein. At the same time and independently, Solow developed growth theory. 25-111 .

The dissent from the mainstream consensus at this time was represented by monetarists, led by Friedman, who questioned both that governments wanted to do good and that they actually knew enough to succeed. The debate between Keynesians and monetarists centered on three issues: monetary versus fiscal policy, the nature of the Phillips curve, and the role of policy. With respect to monetary versus fiscal policy, monetarists questioned the emphasis of the early Keynesians on the power of fiscal policy to stabilize output. Instead, monetarists emphasized the power of monetary policy to destabilize the economy in the absence of a money growth rule to constrain the Fed. With respect to the Phillips curve, many Keynesians believed that the Phillips curve offered a permanent long-run tradeoff between inflation and unemployment. Friedman and Phelps argued that the tradeoff would disappear if policymakers tried to exploit it. With respect to the role of policy, Keynesians believed that fiscal and monetary policy could be used to fine tune macroeconomic performance to avoid fluctuations. Monetarists argued instead that economists did not know enough to stabilize output and that in any event, policymakers could not be trusted to do the right thing. Therefore, policymakers should be bound by simple rules.

The Rational Expectations Critique

The mainstream consensus of the 1960s received two challenges in the 1970s. The first challenge was empirical. Aggregate demand shocks could not account for stagflation (simultaneous increases in inflation and unemployment) which arose during the 1970s. The second challenge was intellectual. The new rational expectations view argued that people form expectations about the future using all available information, including economic theory and econometric models, rather than solely on the basis of the past behavior of the variables they are trying to forecast. This idea posed three challenges for Keynesian macroeconomics. The first challenge was the so-called Lucas critique. Existing macroeconomic models depicted behavioral variables dependent on expectations as functions of current and lagged values of other variables in the model. Under rational expectations, there was no reason to suppose that these historical relationships would not change if the policy regime changed. Thus, existing models were effectively useless for analyzing the consequences of changes in policy, which was one of the primary purposes for which these models were created. The second challenge arose from the incorporation of rational expectations into the Phillips curve. In existing Keynesian models, output returned slowly to its natural level after a shock because wages and prices adjusted slowly through the Phillips curve mechanism. Lucas pointed out that slow adjustment arose from backward-looking inflation expectations assumed in the models. Introducing rational expectations into Keynesian models implied that only policy or demand shocks that were unexpected should affect output. Moreover, deviations of output from its natural level would last only as long as existing nominal wage contracts that had failed to anticipate the shock. The third challenge concerned the implications of game theory for policymaking. Under rational expectations, policy formulation affected expectations formed by the private sector. Thus, the policy problem was not an optimal control problem, but rather a strategic game between policymakers and the private sector. Game theory led to different implications for policy. For example, the time inconsistency problem (discussed in Chapter 22) implied that discretion on the part of benevolent policymakers could lead to worse outcomes than rules.

25-112 .

In sum, rational expectations implied that Keynesian models could not be used to evaluate potential policy measures, that Keynesian models could not explain long-lasting deviations of output from its natural level, and that the theory of policy needed to be redesigned, using the tools of game theory. Rational expectations quickly became the accepted working assumption in macroeconomics, and theories of economic behavior in goods, financial, and labor markets began to be reevaluated in light of this modification. Hall’s random walk of consumption result and the Dornbusch overshooting of exchange rates model were two early successes. In addition, Fischer and Taylor showed that the staggering of wage and price decisions could imply long lasting deviations of output from its natural level even under rational expectations. This finding resolved one of the issues raised by the rational expectations critique. Finally, research on policy games led to a new emphasis on (and more rigorous thinking about) credibility and commitment on the part of policymakers.

Developments in Macroeconomics Up to the 2009 Crisis

Since the late 1980s, macroeconomic researchers have tended to cluster into three groups: new classicals, new Keynesians, and new growth theorists. The research agenda of the new classical theorists consists of an attempt to explain macroeconomic fluctuations as the outcome of shocks to competitive markets with fully flexible wages and prices. These so-called real business cycle models assume that output is always at its natural level, and interpret fluctuations as arising from movements in the natural level, triggered by technological changes. The problem with this view is that the nature of technological progress does not seem consistent with the types of output fluctuations typically associated with business cycles. Moreover, although in real business cycle models the money supply is irrelevant to output, there is strong evidence that changes in money affect output. New Keynesians essentially accept the synthesis that has emerged in response to the rational expectations critique, and their research agenda consists of exploring the implications of market imperfections for macroeconomic behavior. Research covers areas such as efficiency wages, imperfections in credit markets, and sources of nominal rigidities. New growth theorists have been reexamining the neoclassical growth model to understand the potential role of increasing returns to scale and the determinants of technological progress. Research has also examined the role of specific institutions in fostering or inhibiting growth. Although there was contention among the three research camps in the 1980s and 1990s, a synthesis of sorts has emerged. The synthesis builds on the methodology of the new classical theorists, recognizes the potential importance of changes in the pace of technological progress as emphasized by the new classical theorists and the new growth theorists, and allows for the market imperfections that characterize the research of the New Keynesians. Although there is no agreement on a single model, or an accepted list of market imperfections, there is a basic framework that organizes much macroeconomic research.

5. First Lessons for Macroeconomics after the Crisis There is no question that the crisis reflects a major intellectual failure on the part of macroeconomics. The failure is in not realizing that such a large crisis could happen, that the characteristics of the economy were such that a relatively small shock, in this case the decrease in housing prices, could lead to a major financial and macroeconomic world crisis.

25-113 .

In general, the many components of a systematic understanding of the financial system were not integrated into many macroeconomic models prior to the crisis. The exceptions were works by: • • •

•

Doug Diamond and Philip Dybvig in the 1980s had clarified the nature of bank runs (which we examined in Chapter 6). Bengt Holmstrom and Jean Tirole showed that liquidity issues were endemic to a modern economy. Andrei Shleifer, called “The Limits of Arbitrage” showed that, after a decline in an asset price below its fundamental value, investors might not be able to take advantage of the arbitrage opportunity; indeed they themselves may be forced to sell the asset, leading to a further decline in the price and a further deviation from fundamentals. Behavioral economists (for example, Richard Thaler, from Chicago) pointed to the way in which individuals differ from the rational individual model typically used in economics and drew implications for financial markets.

In conclusion, the consensus from the lessons learned from the crisis is that respect to small shocks and normal fluctuations, the adjustment process works; but that, in response to large, exceptional shocks, the normal adjustment process may fail, the room for policy may be limited, and it may take a long time for the economy to repair itself.

V. PEDAGOGY Notice that this history of economic thought begins in the 1930s with John Maynard Keynes. Some instructors may want to include some earlier economic works from Adam Smith, David Ricardo, JeanBaptiste Say, John Stuart Mill, or Jeremy Bentham to show the economic groundwork leading up to Keynes. Friedrich Hayek and the Austrian school is also quite interesting. Students should also be exposed to the works of Karl Marx to get a well-rounded education in economic history.

25-114 .

ANSWERS TO END-OF-CHAPTER PROBLEMS CHAPTER 1 Quick Check 1.

a. b.

c. d. e. f. g. h. i. 2.

True Uncertain. Output growth returned to a positive value after the negative values in 2009. A complete return to the high levels of growth immediately before the recession never occurred with the time span presented in Figure 1-1. By the end of the time portrayed in Figure 1-1 you could make the case the world output growth returned to the levels of growth seen around the year 2000. True/Uncertain. Most stock markets have recovered to their pre-recession levels but have since retreated as of June 2016. True. The unemployment rate in the United Kingdom has been lower than in much of the rest of Europe. False. There are problems with the statistics, but the consensus is that growth in China has been high. False. European unemployment rates have been higher for several decades. True Mostly true although the gap between output per person in the United States and the richer European countries is not wide as the same gap between the United States and China. False. The interest rate in the United Sates was at or near zero until 2016. Since 2016 it has gradually risen.

More flexible labor market institutions may lead to lower unemployment, but there are questions about how precisely to restructure these institutions. The United Kingdom has restructured its labor market institutions to resemble more closely U.S. institutions and now has a lower unemployment rate than before the restructuring. On the other hand, Denmark and the Netherlands have relatively low unemployment rates while maintaining relatively generous social insurance programs for workers.

Although the Euro removed an obstacle (switching currencies to make transactions) to free trade between European countries, each country is forced to give up its own monetary policy.

Dig Deeper 3.

This calculation is complicated by the fact that the data in China start in 2017 and the data in the United States start in 2018. Your spreadsheet needs to take that into account. The formula your spreadsheet will solve is: 20.5(1.022)t=13.5(1.079)t+1 (20.5/13.5) = (1.07)(t+1)/ (1.022)t ln(20.5/13.5)/[ln(1.07)(t+1)/ (1.022)t] 0.417 = (t+1)(.076) – t(.021) t ≈ 6.21 years Since China’s output started in 2017 and the US output starts in 2018, in roughly 6 years after 2018, the two outputs are equal. That would be 2023. Thus in 2024, total output in China is larger than in the United States.

115 .

The spreadsheet that confirms this answer is: Year

U.S. Output

2017

b. c.

d. 4.

China Output 13.50

2018

20.50

14.57

2019

20.95

15.82

2020

21.41

17.18

2021

21.88

18.66

2022

22.36

20.26

2023

22.86

22.00

2024

23.36

23.90

2025

23.87

25.95

2026

24.40

28.18

2027

24.94

30.61

2028

25.48

33.24

No. At current growth rates, total Chinese output will exceed U.S. output in 2024, but Chinese output per person (the Chinese standard of living) will still be less than U.S. output per person. China has increased the amount of capital per person. This is possible in the United States. China has imported a lot of technology from the United States and other countries. This is more difficult to do in the United States since the number of technologies available for the United States to import that they do not already have is relatively smaller. China does provide a model for other developing countries. Raising output per person by increasing capital per person and by importing technology is a sensible development strategy. When the value of the level of output per hour increases from 100 in 2009 to 103.2 in 2010, the percentage rate of growth in 2010 is ((103.2 − 100)/100) × 100 = 3.2%. This means for the same hour of work, output per person rose by 3.2% in 2010. We call this increase the rate of (labor) productivity growth. The decade average growth rates of productivity are: 1970–79, 2.1%; 1980-89, 1.6%; 199099, 2.1%; 2000-2009, 2.6%; 2010-2017, 1.0%. Productivity growth averages from 2010 to 2017 is lower than any other recent 10-year period. The last decade with productivity growth less than 2 percent per year was the 1980s. This answer will vary with the issue of the Economic Report of the President used.

Explore Further 5.

a/c.

As of February 2019, there had been 6 occasions since 1960, quarter 2, with two consecutive quarters of negative economic growth. There are many quarters of negative economic growth.

116 .

Seasonally adjusted annual percentage growth rates of GDP where two or more quarters in a row have negative growth are given below. 1969:4 1970:1

−1.9 −0.6

1981:4 1982:1

−4.9 −6.4

1974:3 1974:4 1975:1

−3.8 −1.6 −4.8

1990:4 1991:1

−3.5 −1.9

2008:3 2008:4 2009:1 2009:2

−3.7 −8.9 −6.7 −0.7

1980:2 1980:3

−7.9 −0.7

The recession in 2008-09 had the largest fall in output (2008:4) and lasted 4 quarters. Other recessions lasted 2 or 3 quarters. The next largest quarterly fall in output was 1980:2. 6.

a-b.

Behavior of the unemployment rate over the 6 recessions above:

Recession (year and quarter)

Unemployment Rate in month prior to recession quarter

Unemployment rate in month at end of recession quarter

Change over recession

Unemployment rate peak after recession

Change from before recession to peak month

1969:4-1970:1

3.5

4.4

0.9

6.1 (Dec. 1970)

2.6

1974:3-1975:1

5.4

8.6

3.2

9.0 (May 1975)

3.6

1980:2-1980:3

6.3

7.5

1.2

7.5 (Sept. 1980)

1.2

1981:4-1982:1

7.6

9.0

1.4

10.8 (Dec. 1982

3.2

1990:4-1991:1

5.9

6.8

0.9

7.8 (June 1992)

1.9

2008:3-2009:2

5.6

9.5

3.9

10.0 (Oct. 2009)

4.4

a. b.

The answers are in the table above. The recession from 2008:3 to 2009:2 resulted in an increase in unemployment of 4.4 percentage points. This is the largest increase.

a/b.

Answers could vary with the data found. In the early part of 2019, the unemployment rate in the United Kingdom was lower than that in the European Union. The peak unemployment rate in the European Union in April 2013 was 11% and this fell as of the time of writing to around 6.7%. In Spain the peak unemployment rate in April 2013 was 26.3% and it falls to 14.7% in November 2017. Thus, the unemployment rate in Spain fell much more quickly than in the rest of Europe.

117 .

CHAPTER 2 Quick Check 1.

a. b. c. d. e. f. g. h. i.

True/Uncertain. Real GDP increased by a factor of 5; nominal GDP increased by a factor of 38. We usually think of GDP in real terms. False True False. The level of the CPI means nothing. The rate of change of the CPI is one measure of inflation. Uncertain. Which index is better depends on what we are trying to measure—inflation faced by consumers or by the economy as a whole. True True False. There will always be job unemployment due to job switching and skill set mismatches. False. The Phillips curve is a relation between inflation and the level of unemployment.

a. b. c. d. e.

No change. This transaction is a purchase of intermediate goods. +€100: personal consumption expenditures +€200 million: gross private domestic fixed investment +€200 million: net exports No change. The jet was already counted when it was produced, i.e., presumably when Delta (or some other airline) bought it new as an investment.

The value of final goods = €1,000,000, the value of the silver necklaces.

1st Stage: €300,000. 2nd Stage: €1,000,000 − €300,000 = €700,000. GDP: €300,000 + €700,000 = €1,000,000.

Wages: €200,000 + €250,000 = €450,000. Profit: (€300,000 − €200,000) + (€1,000,000 − €250,000 − €300,000) = €100,000 + €450,000 = €550,000. GDP: €450,000 + €550,000 = €1,000,000.

2012 GDP: 10 (€2,000) + 4(€1,000) + 1000 (€1) = €25,000 2013 GDP: 12 (€3,000) + 6(€500) + 1000 (€1) = €40,000 Nominal GDP has increased by 60%.

2012 real (2012) GDP: €25,000 2013 real (2012) GDP: 12 (€2,000) + 6 (€1,000) + 1000 (€1) = €31,000 Real (2013) GDP has increased by 24%.

2012 real (2013) GDP: 10 (€3,000) + 4 (€500) + 1,000 (€1) = €33,000 2013 real (2013) GDP: €40,000. Real (2013) GDP has increased by 21.2%.

The answers measure real GDP growth in different units. Neither answer is incorrect, just as measurement in inches is not more or less correct than measurement in centimeters.

118 .

2012 base year: Deflator(2012) = 1; Deflator(2013) = €40,000/€31,000 = 1.29 Inflation = 29%

2013 base year: Deflator(2012) = €25,000/€33,000 = 0.76; Deflator(2013) = 1 Inflation = (1 − 0.76)/0.76 = .32 = 32%

Analogous to 4d.

2012 real GDP = 10(€2,500) + 4(€750) + 1000(€1) = €29,000 2013 real GDP = 12(€2,500) + 6(€750) + 1000(€1) = €35,500

(35,500 – 29,000)/29,000 = .224 = 22.4%

Deflator in 2012 = €25,000/€29,000 =.86 Deflator in 2013 = €40,000/€35,500 =1.13 Inflation = (1.13 −.86)/.86 = .31 = 31%.

Yes, see appendix for further discussion.

The Consumer Price Index a.

2 × €10 + 6 × €3 = €38.00

2013: €41.80

Indexes are: 2012: 100.0, 2013: 110.0, 2014: 115.6, 2015: 116.1, 2016: 100.3, 2017: 115.6. Price indexes are traditionally expressed to one decimal point.

The rates of inflation are: 2013: 10%, 2014: 5.1%, 2015: 0.4%, 2016: −13.6%, 2017: 15.3%. Rates of inflation are traditionally to one decimal point.

Inflation is negative in 2017. This is a year where there is deflation.

In 2015, pizza prices remains the same, but gas prices rise. Thus “inflation” is just because gas prices increased thus making the value of the index larger and generating positive inflation. In 2013 both the price of pizza and the price of gasoline rise by 10% from their 2008 values. This is the more usual idea of inflation – sometimes called pure inflation – where all prices rise by the same percentage amount.

With €100 in 2012, I can buy 2.63 baskets (you have to imagine buying only part of a pizza and a part gallon of gasoline). With €100 in 2017, I can buy only 2.28 baskets. The percentage decline in the purchasing power of money from 2012 to 2017 is 13.8%. You can see that the price index increased from 100 in 2012 to 115.6 in 2017. The larger the increase in the price index, the larger the decline in the purchasing power of money.

As the price of gas rises, economists expect that consumers would purchase less gas. When it falls, consumers purchase more gas. This means using the 2012 basket to construct the

2014: €43.92

2015: €44.10

119 .

2016: €38.10

2017: €43.92

Consumer Price Index could be misleading in both 2015 (gas prices rise a little bit) and especially in 2016, when gas prices fall a lot. The text mentions that the Consumer Price Index basket is changed every two years to try and keep up with both new goods – think the latest model of your phone – as well as large changes in prices of items like gasoline. i.

Because the basket of good bought in 2017 is slightly different from the basket of goods bought in 2012 (there is one more gallon of gas) the measure of inflation will be slightly different. Consumer Price Index

a. b. c. d.

Year

2017 = 100

2012

86.5

2013

95.2

10.0

2014

100

5.1

2015

100.4

0.4

2016

85.7

−14.7

2017

100

16.7

Inflation rate

Usual output growth is positive as population grows and output per worker grows. The unemployment rate rises more in a year when output growth is −2%. The unemployment rate at which inflation rate is 2% is about 5.5%, considerably larger than zero. You solve the Phillips curve expression 2 = 2.93 – 0.17 u for the value of u. The slope does not, by itself, tell us much about whether one economy is better than another. Assuming the constant in the Phillips curve remains at 2.93, then the Phillips curve with a slope of 0.5 finds target inflation hit at an unemployment rate of 1.86%. If the constant term remains at 2.93 and the slope is 0.1, then the Phillips curve finds target inflation hit at an unemployment rate of 9.3%. You can make an argument that the economy with 1.86% unemployment is better than one with 9.3% unemployment. But it is both the slope and the constant term of the Phillips curve that determine the value of the unemployment rate where target inflation is achieved.

Dig Deeper 9.

The quality of a routine checkup improves over time. Checkups now may include EKGs, for example. Medical services are particularly affected by this problem since there are continual improvements in medical technology.

The new method represents a 10% quality increase.

There is a 5% true price increase. The other 10% represents a quality increase. The qualityadjusted price of checkups using the new method is only 5% higher than checkups using the old method last year.

You need to know the relative value of pregnancy checkups with and without ultra-sounds in the year the new method is introduced. Still, since everyone chooses the new method,

120 .

we can say that the quality-adjusted price of checkups has risen by less than 15%. Some of the observed 15% increase represents an increase in quality. 10.

Measured GDP increases by €10 + €12 = €22. (Strictly, this involves mixing the final goods and income approaches to GDP. Assume here that the €12 per hour of work creates a final good worth €12.)

No. The true value of your decision to work should be less than €22. If you choose to work, the economy produces the value of your work plus a takeout meal. If you choose not to work, presumably the economy produces a home-cooked meal. The extra output arising from your choice to work is the value of your work plus any difference in value between takeout and home-cooked meals. In fact, however, the value of home-cooked meals is not counted in GDP. (Of course, there are other details. For example, the value of groceries used to produce home-cooked meals would be counted in GDP. Putting such details aside, however, the basic point is clear.)

Explore Further 11.

The table below has the data: Earlier recession

Crisis Recession

Date

GDP growth

Date

GDP growth

1999.1

0.798593

2007.1

0.061834

1999.2

0.824294

2007.2

0.765313

1999.2

1.258934

2007.3

0.672566

1999.4

1.735311

2007.4

0.356796

2000.1

0.290507

2008.1

−0.68237

2000.2

1.888487

2008.2

0.496323

2000.3

0.120707

2008.3

−0.47984

2000.4

0.567907

2008.4

−2.1126

2001.1

−0.28393

2009.1

−1.38574

2001.2

0.529925

2009.2

−0.13496

2001.3

−0.31628

2009.3

0.326702

2001.4

0.277819

2009.4

0.967888

GDP growth has larger negative values in the crisis recession (the 2008-09 recession). b.

Within the three years above, the unemployment rate peaks at 10.0% in October 2009 and at only 5.7% in December 2001. The actual peak unemployment rate was 5.9% in April 2002 following the smaller recession.

121 .

The unemployment rate is high even at the end of the 3-year periods above. Unemployment stays high well after the fall in output. The labor market does not recover quickly.

CHAPTER 3 Quick Check 1.

a. b. c. d. e. f. g. h.

True False. Government spending including transfers and interest was 33% of GDP. False. The propensity to consume must be less than one for our model to make sense. True. There are good reasons to interpret a large drop in consumer confidence as a reduction in c0. True False. The equilibrium condition in the goods market requires production to be equal to the demand for goods, assuming inventory investment is equal to zero. False. The increase in equilibrium output is one times the multiplier. False. The higher the propensity to consume the higher the output.

Y = 160 + 0.6(Y − 100) + 150 + 150 Y = 1000

YD = Y – T = 1000 – 100 = 900

C =160 + 0.6(900) = 700

Equilibrium output is 1000. Total demand = C + I + G = 700 + 150 + 150 = 1000. Total demand equals production. We used this equilibrium condition to solve for output.

Output falls by (40 times the multiplier) = 40/(1 –.6) = 100. So, equilibrium output is now 900. Total demand = C + I + G = 160 + 0.6(800) + 150 + 110 = 900. Again, total demand equals production.

Private saving = Y – C – T = 900 – 160 − 0.6(800) −100 = 160. Public saving = T − G = −10. National saving equals private plus public saving, or 150. National saving equals

investment. This statement is mathematically equivalent to the equilibrium condition, total demand equals production. In other words, there is an alternative (and equivalent) equilibrium condition: national saving equals investment. Dig Deeper 4.

Y increases by 1/(1 − c1)

Y decreases by c1/(1 − c1)

The answers differ because spending affects demand directly, but taxes affect demand indirectly through consumption, and the propensity to consume is less than one.

The change in Y equals 1/(1 − c1) − c1/(1 − c1) = 1. Balanced budget changes in G and T do change output.

122 .

The propensity to consume has no effect because the balanced budget tax increase aborts the multiplier process. Y and T both increase by one unit, so disposable income, and hence consumption, do not change.

Y = c0 + c1YD + I + G implies Y = [1/(1 − c1 + c1t1)][c0 − c1t0 + I + G]

The multiplier =1/(1 − c1 + c1t1) < 1/(1 − c1), so the economy responds less to changes in autonomous spending when t1 is positive. After a positive change in autonomous spending, the increase in total taxes (because of the increase in income) tends to lessen the increase in output. After a negative change in autonomous spending, the fall in total taxes tends to lessen the decrease in output.

Because of the automatic effect of taxes on the economy, the economy responds less to changes in autonomous spending than in the case where taxes are independent of income. Since output tends to vary less (to be more stable), fiscal policy is called an automatic stabilizer.

Y = [1/(1 − c1 + c1t1)][c0 − c1t0 + I + G]

T = t0 + t1[1/(1 − c1 + c1t1)][c0 − c1t0 + I + G]

Both Y and T decrease.

If G is cut, Y decreases even more. A balanced budget requirement amplifies the effect of the decline in c0. Therefore, such a requirement is destabilizing.

In the diagram representing goods market equilibrium, the ZZ line shifts up. Output increases.

There is no effect on the diagram or on output.

The ZZ line shifts up and output increases. Effectively, the transfer increases consumption in the economy at all levels of output.

The propensity to consume is likely to be higher for low-income taxpayers. Therefore, tax cuts will be more effective at stimulating output if they are directed toward low-income taxpayers.

Y=C+I+G Y = [1/(1 − c1 − b1)][c0 − c1T + b0 + G]

Including the b1Y term in the investment equation increases the multiplier. Increases in autonomous spending now creates a multiplier effect through two channels: consumption and investment. For the multiplier to be positive, the condition c1 + b1 < 1 is required.

When c1 + b1 is greater than one there is no multiplier effect. When total spending exceeds one the formula is nonsensical. The multiplier should be 1/((1 − (c1 + b1)). So, when c1 + b1 is greater than one the multiplier is negative, which does not make sense. Another way of

123 .

looking at this concept is saving must equal investment in a closed Economy. In a closed economy c1 + b1 can never be greater than one. d.

Output increases by b0 times the multiplier. Investment increases by the change in b0 plus b1 times the change in output. The change in business confidence leads to an increase in output, which induces an additional increase in investment. Since investment increases, and saving equals investment, saving must also increase. The increase in output leads to an increase in saving.

Explore Further 9.

Output will fall.

Since output falls, investment will also fall. Public saving will not change. Private saving will fall, since investment falls, and investment equals saving. Since output and consumer confidence fall, consumption will also fall.

Output, investment, and private saving would have risen.

Clearly this logic is faulty. When output is low, what is needed is an attempt by consumers to spend more. This will lead to an increase in output, and therefore—somewhat paradoxically—to an increase in private saving. Note, however, that with a linear consumption function, the private saving rate (private saving divided by output) will fall when c0 rises.

10.

a. b. c. d.

$450 B $225 B $450 B $450 B

11.

a. b.

Equilibrium output will fall in the short run. A cut in G of will have a larger impact on equilibrium GDP than the same size increase in T. The statement is accurate for any value of the marginal propensity to consume. As the deficit is reduced, the value of c0 increases as consumer confidence increases. This will increase equilibrium GDP.

c. d.

CHAPTER 4 Quick Check 1.

a. b. c. d. e. f. g.

False. Wealth is a stock and income is a flow. False. Economic investment refers to the purchase of productive equipment. False. Money demand describes the portfolio decision to hold wealth in the form of money rather than in the form of bonds. The interest rate on bonds is relevant to this decision. True False. This action decreases the money supply. False except when the economy is in a liquidity trap. If the liquidity trap, even though the Federal Reserve increases the money supply, the interest rate remains at zero. True

124 .

h. i. 2.

True except when the economy is in a liquidity trap. In the liquidity trap, income could increase without increasing interest rates. False. The Fed did find other policy options when interest rates hit zero. They changed interest rate on deposits and changed the mix of bonds they purchased.

i = 0.05: money demand = €18,000 i = 0.10: money demand = €15,000

Money demand decreases when the interest rate increases because bonds, which pay interest, become more attractive than money which pays little or no interest (no interest if money is cash).

The demand for money falls by 50%.

A 1% increase (decrease) in income leads to a 1% increase (decrease) in money demand. This effect is independent of the interest rate.

i = 100/€PB –1; i = 33%; 18%; 5% when €PB = €75; €85; €95.

When the bond price rises, the interest rate falls.

€PB = 100/(1.08) ≈ €93

€20 = MD = €100(.25 − i) i = 5%

M = €100(.25 −.15) M = €10

Dig Deeper 5.

BD = 50,000 − 60,000 (.35 – i ) If the interest rate increases by 10 percentage points, bond demand increases by €6,000.

An increase in wealth increases bond demand, but has no effect on money demand, which depends on income (a proxy for transactions demand).

An increase in income increases money demand, but decreases bond demand, since we implicitly hold wealth constant.

First of all, the use of “money” in this statement is colloquial. “Income” should be substituted for “money.” Second, when people earn more income, their wealth does not change right away. Thus, they increase their demand for money and decrease their demand for bonds. Essentially, the reduction in the price of the bond makes it more attractive. A bond promises fixed nominal payments. The opportunity to receive these fixed payments at a lower price makes a bond more attractive.

125 .

€16 is withdrawn on each trip to the bank. Money holdings are €16 on day one; €12 on day two; €8 on day three; and €4 on day four.

Average money holdings are (€16 + €12 + €8 + €4)/4 = €10.

€8 is withdrawn on each trip to the bank. Money holdings are €8, €4, €8, and €4.

Average money holdings are €6.

€16 is withdrawn on each trip to the bank. Money holdings are €0, €0, €0, and €16.

Average money holdings are €4.

Based on these answers, ATMs and credit cards have reduced money demand.

All money is in checking accounts, so demand for central bank money equals demand for reserves. Therefore, demand for central bank money = 0.1(€Y) (.8 − 4i).

€100B = 0.1(€5,000B)(.8 − 4i) i = 15%

Since the public holds no currency, money multiplier = 1/reserve ratio = 1/.1 = 10. M = (10)€100B = €1,000B M = Md at the interest derived in part (b).

If H increases to €300B the interest rate falls to 5%.

The interest rate falls to 5%, since when H equals €300B, M = (10)€300B = €3,000B.

The table is filled in below:

126 .

Initial Money Demand Curve for real income Y and price level P Initial Y P $Y Md curve Md2 250 100 250

Final Money Demand Curve for real income Y and price level P Final Y P $Y Md curve Md3 300 105 315

Md2

200

160

Md3

250

100

250

Md2

250

100

250

Md3

300

100

300

Increase the money supply as nominal income rises. Prices do not change but real income rises

Md2

250

100

250

Md1

200

190

Decrease the money supply as nominal income falls – both real income and prices fall

Md2

250

100

250

Md1

275

220

Here prices fall and real income rises. However, prices fall by 20% and real income rises by 10%. This combination means nominal income falls and the Fed will have to decrease the money supply to keep the interest rate the same

10.

11.

Action required by the Fed to maintain an interest rate at i* Explanation The Fed must increase the money supply as nominal income rises — both real income and prices rise Increase the money supply as nominal income rises—both real income and prices rise

Choosing the quantity of money or choosing the interest rate a.

M = $100 (.25 − .05) = $20 B

M = $100 (.25 − .10) = $15 B

Both assets (bonds) and liabilities (money) will fall by the same amount. To reduce the money supply and raise interest rates, the Federal Reserve must sell bonds.

Monetary policy in a liquidity trap a.

$20 B

Yes, the central bank can continue to increase the money supply. But interest rates will not fall any further.

Figure 1 in the Focus Box “The Liquidity Trap in Action” shows many years where the interest rate remained at zero while the money supply continuously expanded.

127 .

In the textbook there’s a question e), which is not answered here. I checked the FRED dataset and obtained the following graph. I put the graph below to show, it should be erased. Based on this, answer to e) could be e)

Construction of a graph with the data clearly shows a sizeable increase in the monetary base while the federal funds rate remained barely above the zero lower bound.

Explore Further 12.

Answers will vary depending on when students visit the FOMC website.

CHAPTER 5 Quick Check 1.

a. b. c. d. e. f. g. h. i.

True True False. The IS curve is downward sloping because an increase in the interest rate decreases the demand for goods at any level of output, leading to a decrease in the equilibrium level of output. False. The balanced budget multiplier is positive (it equals one), so the IS curve shifts right. True False. As you move along the horizontal LM curve, as output rises, the demand for real money rises and the central bank must increase the supply of real money to keep the interest rate constant. False. The real money supply falls when the nominal money supply is constant and the price level rises. True. The nominal money supply rose by 10%. The price level rose by 2%. The ratio M/P increased. False. The level of output will rise and at the same interest rate along the horizontal LM curve, investment will rise.

Y = [1/(1 − c1)][c0 − c1T + I + G] The multiplier is 1/(1 − c1).

Y = [1/(1 − c1 − b1)][c0 − c1T + b0 − b2i + G] The multiplier is 1/(1 − c1 − b1). Since the multiplier is larger than the multiplier in part (a), the effect of a change in autonomous spending is bigger than in part (a). An increase in autonomous spending now leads to an increase in investment as well as consumption.

You simply replace the interest rate from the expression in (b) with its policy value ι , Y = [1/ (1 − c1 − b1 )] [c0 − c1T + b0 − b2 ι + G ] .

See Figure 5-5 on page 94 for an example of an IS-LM diagram in equilibrium for a given interest rate.

128 .

The IS curve shifts left. Output falls at the same interest rate. Investment, which depends positively on the level of output and negatively on the interest rate, also falls. The interest rate remains the same. Output falls. So, investment falls.

From the answer to 2(b), Y = [1/ (1 − c1 − b1 )] [c0 − c1 T + b0 − b2 ι + G ]

I = b0 + b1Y − b2 i = b0 + b1 [1/ (1 − c1 − b1 )] [c0 − c1 T + b0 − b2 ι + G ] − b2 ι

This is obtained by substitution of the equilibrium level of income into the equation for investment. You could simplify the expression by collecting terms if desired. d.

From part (b), the equilibrium level of income is Y = [1/ (1 − c1 − b1 )] [c0 − c1 T + b0 − b2ι + G ] . This value is substituted into the LM relation so that

M/P = d1 { [1/(1 − c1 − b1)] [c0 − c1 T + b0 − b2 ι + G]} – d2 ι This term could also be simplified by collecting terms if desired. 4.

The real money supply is on the left-hand side of the equation

The demand for real money is on the right-hand side of the equation

The function L(i) is a downward sloping line. Its value increases as the interest rate falls.

The horizontal axis needs to be relabeled at the real money supply. The variable that shifts the demand for real money is real income. If real income is larger, the real money demand function shifts to the right.

(1) The real money demand function will shift rights as Y rises. To keep the interest rate constant, the central bank must increase the real money supply. (2) The real money demand function will shift left as Y falls. To keep the interest rate constant, the central bank must decrease the real money supply

Y = C + I + G = 200 + .25(Y − 200) + 150 + .25Y − 1000i + 250 Y = 1100 − 2000i

Substitute the interest rate of 5% (numerical value .05) into Y = 1100 – 2000 × (.05) = 1000

Now substitute both equilibrium income of 1000 and the interest rate of 5% into the righthand side of the real money demand expression M/P = 2000 − (.05 × 8000) = 1600

C = 400; I = 350; G = 250; C + I + G = 1000

Y = 1040; C = 410; I = 380. The reduction in the interest rate increases output and consumption increases because output increases. Investment increases because output increases and the interest rate decreases. The new equilibrium value of the real money supply is found by solving (M/P) = 2 (1040) – (8000) (0.03) = 1840

129 .

At the initial interest rate of 5%, Y equals 1300 when G is increased to 400. A fiscal expansion increases output. Consumption increases because output increases. When the central bank keeps interest rates at 5% then investment increases as output increases. The new level of investment is 425. The new level of consumption is 475. The new level of the real money supply is 2200.

Money market equilibrium 1600 = 2Y − 8000i Goods market equilibrium Y = 200 + .25 (Y – 200) + 150 + .25 Y – 1000 i + 400 Solving yields i = 0.1 and Y = 1200

G = 400 C = 450 I = 350

In part f. the increase in government spending increased income from 1000 units to 130 units when the central bank increased the money supply to keep the interest rate at 5%. In part g. when the central bank did not increase the real money supply, the interest rate had to increase to 10% so that the equilibrium in the money market could be maintained at the original real money supply of 1600 units. The increase in the interest rate reduced investment and that offsets the effect of the increase in government spending. Dig Deeper 6.

Firms deciding how to use their own funds will compare the return on bonds to the return on investment. When the interest rate on bonds increases, bonds become more attractive, and firms are more likely to use their funds to purchase bonds, rather than to finance investment projects. a.

The reduction in T shifts the IS curve to the right. The decrease in interest rates shifts the LM curve down by the amount of the decrease in the interest rates. Output increases.

The Clinton-Greenspan policy mix was (loosely) contractionary fiscal policy (IS left) and expansionary monetary policy (LM down).

In 2001, there was a recession, which was triggered by a fall in investment spending following the decline in the stock market. The events of September 11, which came after the recession had begun, had only a limited effect. In fact, the economy had positive growth in the fourth quarter of 2001. The expansionary monetary and fiscal policies tended to weaken the recession, but the policies came too late to avoid a recession.

The central bank keeps the interest rate constant. Fiscal policy is expansionary as either G is increased or T is decreased. Investment will increase as output rises.

The central bank will cut interest rates as the fiscal authorities either reduces G or raises T (or both).

The IS curve shifts left. The value of the parameter c0 falls. Output falls.

The level of consumption falls with the fall in output. There is a lower level of output and a lower level of c0. Both factors lead to a decline in consumption.

130 .

The analysis of investment is more complex. Investment will also fall. Investment depends on output and the interest rate. The interest rate is unchanged. Output falls. Investment must fall. Finally, we analyze the level of saving. The level of savings at the same income would rise as c0 falls. But we are not at the same level of output. So, one factor raises savings and the other factor lowers savings. We saw private investment fell. If we started with a balanced budget and continued to have a balanced budget so G = T, we can use expression (3.10) to conclude that savings must also have fallen. If there was no change in G or T, then the same argument is made, the decline in private investment must be accompanied by a decline in private saving. 10.

This fiscal consolidation reduces G by 50 units and increases T by 50 units. Public savings rises from −100 to 0. Private saving remains the same at 300 units both pre and post policy. Investment rises to 300. Since Y falls, this can only occur if the fiscal consolidation is accompanied by an interest rate reduction.

This fiscal consolidation reduces G by 100 units and leaves T unchanged. Public savings rises from −100 to 0. Private saving falls to 250 units. Investment rises to 250 units. Since Y falls, investment can only rise if the fiscal consolidation is accompanied by an interest rate reduction.

This fiscal consolidation leaves G at 300 units and increases T by 100 units. Public savings rises from −100 to 0. Private saving falls from 200 units in the pre-policy equilibrium to 195 units in the post-policy equilibrium. Investment falls to 195 units. Since investment falls with income, in this policy combination, the interest rate could rise, fall or stay the same. The fiscal consolidation is not accompanied by an increase in investment.

Explore Further 11.

The fall in G and the increase in T shift the IS curve to the left. If the Federal Reserve did not change interest rates, Y would fall. Thus, to keep output at the same level, the Federal Reserve must cut interest rates and the LM curve will shift down. Investment will increase since output remains the same and interest rates are lower.

Receipts rose, outlays fell, and the budget deficit fell.

On September 4, 1992, the FOMC reduced the intended federal funds rate by 25 basis points. Subsequent changes in federal funds rate over the period 1993-2000 are given below. Monetary policy became more expansionary from 1995 to 1998. Changes in the Intended Federal Funds Rate September 4, 1992

March 25, 1997

5.5

February 4, 1994

3.25

September 29, 1998

5.25

March 22, 1994

3.5

October 15, 1998

April 18, 1994

3.75

November 17, 1998

4.75

131 .

12.

May 17, 1994

4.25

June 30, 1999

August 16, 1994

4.75

August 24, 1999

5.25

November 15, 1994

5.5

November 16, 1999

5.5

February 1, 1995

February 2, 2000

5.75

July 6, 1995

5.75

March 21, 2000

December 19, 1995

5.5

May 16, 2000

6.5

January 31, 1996

5.25

In real terms, investment was 11.9% of GDP in 1992 and increased every year over the period to reach 17.6% of GDP in 2000.

Over the period 1993-2000, the average annual growth rate of GDP per person was 2.6%. Over the period first four years of the period, the average annual growth rate was 2%; over the second four years, the average annual growth rate was 3.2%. The postwar average growth rate of income per person in the United States (1946 to 2018) was about 2%. (Series for annual real GDP per capita in FRED data base is A939RX0Q048SBEA – 1947 value 14118; 2018 value 56912 measured in chained 2012 dollars.)

Growth was negative in 2001:I and 2001:III.

Investment had a bigger percentage change, and unlike consumption, growth in investment was negative for every quarter in 2000 and 2001, except 2000 :II. Overall investment was generally more variable than nonresidential fixed investment in 2000 and 2001. Moreover, nonresidential fixed investment had positive growth during 2000, but negative growth in 2001.

Investment had a substantially larger decline in its contribution to growth in 2000 and 2001. The proximate cause of the recession of 2001 was a fall in investment demand.

Investment fell in the last two quarters of 2001, but began growing again in the first quarter of 2001. Consumption growth was slow for the first three quarters of 2001, but grew rapidly in the fourth quarter. As mentioned in the text, the Fed reduced the federal funds rate several times during the fourth quarter of 2001. Moreover, automobile manufacturers offered large discounts. These actions may have helped to generate strong consumer spending. In any event, it is clear that the events of September 11 did not cause the recession of 2001. The recession had started well before these events.

CHAPTER 6 Quick Check 1.

a. b. c. d.

False. Nominal interest rates are expressed in dollars; real rates in goods. True False, by 2019 the policy interest rate was higher than zero. Uncertain. The statement is true when the nominal rate of interest does not change.

132 .

e. f. g. h. i. j. k. l. m. n.

False. Bonds vary significantly in terms of default risk. True True False. There could be a change in the risk premium. True True True False. Prices fell significantly beginning in 2006. True True

exact: r = (1 + .04)/(1 + .02) − 1 = 1.96%; approximation: r ≈ .04 − .02 = 2%

3.60%; 4%

5.48%; 8%

The table is filled in:

Situation A

Nominal policy interest rate 3

Expected inflation 0

Real policy interest rate 3

D E

a. b. c. d.

Risk premium 0

Nominal borrowing interest rate 3

Real borrowing interest rate 3

-2

Situation C and E Situation C and E Situation C has the highest risk premium. Default and risk aversion. When expected inflation is negative, real rates are higher than nominal rates. High real rates depress aggregate demand. Aggregate demand and output are likely to be low at the Zero Lower Bound.

a. Assets Bank Assets

Liabilities 100

Checking Deposits

Net Worth Capital

133 .

The value of the bank’s capital falls to 10. The leverage ratio is 9.

If the deposits of the bank are insured by the government, then the health of the bank is irrelevant to the depositors. So, there is no need to withdraw funds from the bank.

The balance sheet is identical to the one in part (a), except that short-term credit replaces checking deposits

If lenders are nervous about the solvency of the bank, they will not be willing to provide short-term credit to the bank at low interest rates.

The bank must sell assets. If many banks are in this position and selling the same kind of assets, the value of these assets will fall. This will worsen the value of bank capital and make lenders more nervous.

The real interest rate on the axis is the real policy rate.

That value is 2%. The real policy interest rate is 2%.

The central bank would have to lower the nominal policy interest rate by 1%.

No, the position of the IS curve depends on the real borrowing interest rate. Expected inflation does change that rate since expected inflation is part of the definition of a real rate of interest.

No, the position of the LM curve is defined by the real policy rate of interest. A change in expected inflation does not, in itself, shift that curve. The central bank is taking expected inflation into account in setting a real policy rate of interest

No, the risk premium does not shift the LM curve. It is horizontal at the real policy rate of interest which does not incorporate the risk premium

Yes. At the same real policy rate of interest, the real borrowing rate of interest rises. There is less investment and the IS curve shifts left (or down).

If the increase in the risk premium causes the IS curve to shift to the left, a tax decrease or an increase in government spending could be used to shift the IS curve back to the right by the same amount. The level of output would not change

The central bank could reduce the real policy rate of interest so the LM curve shifts down.

Dig Deeper 6.

If the interest rate on deposits at the central bank is negative, then the nominal policy interest rate is negative. This strange event has occurred quite frequently in the decade between 2010 and 2020. The explanation is mundane. Banks owe each other money and need to clear debts. If these debts were cleared with currency, then there are expenses in moving the currency between banks, trucks, guards, counting the currency. These expenses

134 .

are avoided when the inter-bank debts are paid by simply moving deposit amounts within the central bank. This margin is apparently enough to allow the nominal policy interest rate to be slightly negative in practice. The zero lower bound is not quite zero. It is slightly negative.

The real policy rate of interest is negative whenever expected inflation is larger than the nominal policy rate of interest. Holding cash has some costs: it can be lost or stolen; safe storage is expensive, say against fire; large cash transactions may or may not be legal in some jurisdictions.

A negative real interest rate encourages borrowing.

Answers will vary.

a. Assets

Liabilities

Securitized Assets

Troubled Assets

Short Term Credit

Net Worth Capital

In principle, the bank’s capital has a value between −5 and 15. But in practice the equity holders can’t lose more than their original investment, so the negative values are really zero values.

If the government pays 25 for the troubled assets, the value of bank capital will be −5. The government would have to pay at least 30 for the troubled assets to ensure a nonnegative value of bank capital. If the government pays 45 for the assets, but the true value is lower, taxpayers bear the cost of the mistaken valuation.

d. Assets

Liabilities

Troubled Assets

Securitized Assets

Treasury Bonds

Short Term Credit

Net Worth Capital

Bank capital is now 20, and the bank is not insolvent.

135 .

Direct infusion of capital improves the solvency of the bank. Buying troubled assets does not, unless the government is willing to buy the assets at above current market prices. Buying troubled assets at best provides the bank liquidity (because Treasury bonds, which are easier to sell, substitute for troubled assets).

The interest rate on the risky bond and the non-risky (safe) bond are the same.

Solve (1 − p) = (1 + .03)/ (1 + .08) for p. p = .05, or the probability of bankruptcy is 5%

Solve (1 + .04) = (1 − .01)(1 + .04 + x) for x. x = .01. The borrowing rate is .05

Solve (1 + .04) = ( 1 − .05) (1 + .04 + x) for x. x = .055. The borrowing rate is 9.5%

The formula would have a positive value where the zero appears in p times zero [written p (0) above] now appears. The key is that value of the bond in bankruptcy will be much less than (1+ i + x). So, the possibility of bankruptcy will still create positive values of x.

The risk premium is likely to fall. The IS curve will shift to the right. This will increase output and can be thought of as a sort of macroeconomic policy.

The risk premium is likely to fall. The IS curve would shift right and output would increase. Quantitative easing becomes a policy option when the nominal policy interest rate (the federal funds rate) is zero.

Strictly speaking, the increase in expected inflation does not directly affect the level of the real policy rate EXCEPT when the nominal policy rate remains constant. In Figure 6-9, this is the exact situation. The nominal policy rate of interest is zero and the real policy rate of interest is the negative of the expected inflation rate. Thus, if an action by the Fed increases expected inflation, this would decrease the real policy interest rate and shift the LM curve down. You would move ALONG the IS curve and output would rise.

Explore Further 10.

Your answers to this question will vary with time.

11.

Your answers to this question will vary with time

CHAPTER 7 Quick Check 1.

False. The participation rate has increased over time.

False. On average there are 8.5 million separations each month.

False. Approximately 44% of the unemployed quit looking for work.

True

False. Worker pay typically exceeds their reservation wage.

136 .

Uncertain/False. The degree of bargaining power depends on the nature of the job and the employee’s skills.

True

False. Many policy factors can impact this rate.

(Monthly hires + monthly separations)/monthly employment = (5.4 + 5.5)/132.0 = 8.3%

2.0/8.6 = 23.3%

(2.0 + 1.8)/8.6 = 44.2%. Duration is 1/0.442 or 2.26 months.

(3.7 + 3.4 + 1.8 + 2.0)/(132.0 + 8.6) = 8.9%

new workers: 0.45/(3.7 + 2.0) = 7.9%

W/P = 1/(1 + μ) = 1/1.05 = 0.952

Wage setting: u = 1-W/P = 1 − 0.952 = .048, or 4.8%

W/P = 1/1.1 = .91; u = 1 − .91 = .09, or 9%. The increase in the markup lowers the real wage. Algebraically, from the wage-setting equation, the unemployment rate must rise for the real wage to fall. So, the natural rate increases. Intuitively, an increase in the markup implies more market power for firms, and therefore less production, since firms will use their market power to increase the price of goods by reducing supply. Less production implies less demand for labor, so the natural rate rises.

Dig Deeper 4.

Answers will vary.

b-c.

Most likely, the difference between your actual wage and your reservation wage will be higher for the job you will have ten years later.

The later job is more likely to require training, which means you will be costly to replace, and will probably be a much harder job to monitor, which means you may need an incentive to work hard. Efficiency wage theory suggests that your employer will be willing to pay a lot more than your reservation wage for the later job, to make the job valuable to you, so you will stay at it and work hard.

This would increase reservation wages.

The computer network administrator has more bargaining power. She is much harder to replace.

The rate of unemployment is the most important indicator of labor market conditions. When the rate of unemployment increases, it becomes easier for firms to find replacements, and worker bargaining power falls.

137 .

In our model, the real wage is always given by the price-setting relation: W/P = 1/(1 + μ). Since the price-setting relation depends on the actual price level and not the expected one, this relation holds in the short run and the medium run of our model.

The upward slope follows from the bargaining power of workers increasing as t the unemployment rate falls. As total employment N approaches the total labor force L, the unemployment rate gets smaller.

An increase in the markup would lower the price-setting relation. This increases the natural rate of unemployment.

Eat In

Eat Out

Population

100

Population

100

Labor Force

100

Employment

Unemployment

Unemployment Rate

33%

Unemployment Rate

25%

Participation Rate

75%

Participation Rate

100%

Question includes “In which economy is measured GDP higher?” this is not answered. An answer could be: “Both economies have the same population but the EatOut one has more formal employment (in the labour market), hence more production that is considered for GDP, thus in this economy measured GDP is higher. This is due to the fact that meals cooked at home in the Eat In economy are not included in GDP.” b.

The measured labor force and participation rate rise. Measured employment rises. Measured unemployment does not change, but the measured unemployment rate falls.Measured GDP rises.

To adjust the labor market statistics, you would have to estimate the number of workers informally employed at home and add them to the measured employed. To the extent that workers employed informally at home were measured as unemployed, you would have to reduce measured unemployment accordingly. To the extent that workers employed informally at home were considered out of the labor force, counting these workers as employed would increase the size of the labor force. To adjust the GDP statistics, you would have to estimate the value-added of final goods produced at home. You could make comparisons to similar goods produced outside the home or make comparisons to workers involved in similar industries outside the home, estimate the relevant wage and hours worked, and calculate value-added as the cost of labor, as is done for government services. In either case, you need to calculate value-added, since intermediate goods—groceries, cleaning supplies, childcare supplies, and so on— involved in the production of at-home goods are already counted in GDP as final goods in the formal sector.

138 .

Answer for part d is missing. The answer could be: “if the new definitions in c) fully and perfectly capture theproblem of valuing work at home in GDP, then the new measure of GDP would be the same in both cases, and the experiment of part b) would have no effect on labour market or GDP statistics for EatIn. Explore Further 8.

56%; (0.56)2 = .31, or 31%; (0.56)6 = .03, or 3.0%

56%

second month: (0.56)2 = .31, or 31%; sixth month: (0.56)6 = .03, or 3.0%

2000: 2001: 2002: 2003:

11% 12% 18% 22%

2004 2005 2006 2007

22% 20% 18% 18%

2008 2009 2010 2011

20% 32% 43% 44%

2012 2013 2014

41% 38% 33%

The long-term unemployed exit unemployment less frequently than the average unemployed worker.

10.

There is a very large increase in the proportion of long term unemployed in the crisis years right to 2012 or even 2013.

In 2014, there is a slight reduction in the percentage of unemployed who have been unemployed for 6 months or longer. We need to be careful here, some of those persons may have left the labor force.

It would seem that the extension of unemployment insurance benefits did coincide with the larger proportion of long-term unemployed during the crisis. But other factors may be at work.

a-b.

Answers will depend on when the page is accessed.

The decline in unemployment does not equal the increase in employment, because the labor force is not constant. The dynamics of unemployment around recessions. The table below shows the behavior of annual real GDP growth around 3 recessions. This data is from Table B-4 of the Economic Report of the President: Year

Real GDP Growth

Unemployment rate

1981

2.5

7.6

1982

−1.9

9.7

1983

4.5

9.6

1990

1.9

5.6

139 .

b. c.

11.

1991

−0.2

6.8

1992

3.4

7.5

2008

0.0

5.8

2009

−2.6

9.3

2010

2.9

9.6

The unemployment rate is higher in the year following the output decline. This is likely due to some of the characteristics of labor markets discussed in the text: labor hoarding as firms wait to be sure that output has declined; some longer-term labor contracts may be part of efficient contracts; and simply time to make decisions to lay off workers. Some of the workers who were discouraged by the recession re-enter the labor force. The model predicts more generous unemployment benefits would increase the natural rate of unemployment. While unemployment is higher, but it is not clear if it is permanently higher. A closer look at changes in state labor markets – There is a lot of discussion of the decline of the “rust belt” and the differences between labor markets at the state level. The table below is a snapshot of the labor market in California, Ohio and Texas in 2003 before the Great Financial Crisis, in 2009 at the height of the crisis and in 2018 after the crisis. Ohio is considered a rust belt state. State Variable 2003 2009 2018 2003 2009 2018 2003 2009 2018

California Participation Rate 65.9 65.1 62.4 Employment Rate 61.5 57.8 59.8 Unemployment Rate 6.7 11.3 4.2

Ohio

Texas

67.4 66.0 62.4

68.0 60.8 61.7

63.3 59.2 59.5

63.4 60.8 61.7

6.1 11.8 4.5

6.8 7.5 3.8

Participation rates fell by 3.5 percentage points in CA; 5 percentage points in OH and 6.3 percentage points in TX. Thus, Texas is the state with the largest long-term decline in participation, not immediately consistent with the rust belt decline story.

The increase in the unemployment rate from 2003 to 2009 was highest in OH (5.7 percentage points); then California (4.6 percentage points); then Texas (a mere 0,7 percentage points). Ohio was the hardest hit state.

140 .

Using the decline in the participation rate from 2003 to 2009 to measure economic stress, Texas was the hardest hit state. Its participation rate dropped by 6.3 percentage points from 2003 to 2009. This could explain the small rise in the unemployment rate.

There is no state where all three indicators suggest the weakest labor market. As of 2018, Ohio has the highest unemployment rate and the lowest employment rate but has a slightly higher participation rate than Texas and the same participation rate as California.

CHAPTER 8 Quick Check 1.

a. b. c. d. e. f. g. h. i. j. k. l.

True False. After 1970 the relationship between inflation and unemployment broke down. True True False. Expectations are forecasts and rarely exactly meet actual inflation rates. False. They argued the appearance of a tradeoff between unemployment and inflation was an illusion. True False. The natural rate of unemployment varies over time. False. The natural rate of unemployment can vary substantially across countries. True False. This statement describes the de-anchored relation. False. Real wages can change for many reasons including that actual inflation may be different than the expected rate of inflation embodied in the wage contract.

No. In the 1970s, we experienced high inflation and high unemployment. The expectationsaugmented Phillips curve is a relationship between inflation and unemployment conditional on both the natural rate of unemployment and inflation expectations. Given inflation expectations, when the natural rate of unemployment increases (i.e., when there is an increase in z or m), there is also an increase in both the actual unemployment rate and the inflation rate. In addition, increases in inflation expectations imply higher inflation for any level of unemployment. In the 1970s, both the natural rate and expected inflation increased, so both unemployment and inflation were relatively high.

This is not correct in general. The expectations-augmented Phillips curve implies that maintaining a rate of unemployment below the natural rate requires not merely high inflation but increasing inflation. This is because inflation expectations continue to adjust to actual inflation. If expectations remain anchored, then the lower rate of unemployment can be achieved in the short run if there is an increase in output.

It does appear that workers resist reductions in nominal wages even when there is deflation, that is, prices are falling and nominal wages could be reduced without a decline in real wages. This appears to be an example of money illusion.

Solve the equation where actual and expected inflation take the same value to find the natural rate of unemployment un = (m + z)/ α.

141 .

Rewrite the Phillips curve as

π t − π te = −α [ut − ( m + z ) α ] Now substitute for un. Then π t − π te = −α [ut − un ]

We imposed the condition that P = Pe. This is the same condition that actual inflation equals expected inflation.

The natural rate of unemployment is higher when the markup (m) is higher.

The natural rate of unemployment is higher when the catchall variable (z) is higher,

The list mentioned in the text includes the generosity of unemployment insurance benefits; changes in the job-search mechanism; the proportion of persons in jail; the proportion of persons in young age groups; the proportion of employment in temporary jobs; the unionization rate; the minimum wage; employment protection.

If the parameter θ is one, then the expected rate of inflation is the previous period’s rate of inflation. The expected rate of inflation likely varies greatly over time

If the parameter θ is zero, then the expected rate of inflation is the constant π . The expected rate of inflation does not vary over time.

Choices will vary.

un = 0.1/2 = .05 In this case π te = (1) π + 0 π t −1 = π in all periods since θ = 0. Initial unemployment is 0.05 or 5%. In period t, unemployment is reduced to 3%. If we then use Phillips curve, inflation in period t is: π + 0.1 − (2 × 0.03) = π + .04 = 0.06 . Given the model we have, this will also be the value of inflation in period t + 1, t + 2, t + 3, t + 5. This value of inflation is a higher value than the anchored rate of inflation π .

This does not make much sense. Every period actual inflation exceeds expected anchored inflation by 4%. Remember that π = π e in this model.

This will put more weight on previous year’s inflation in forming the expectation of inflation. In the periods from t + 1 to t + 5, a reasonable person might think last period’s inflation (4 percentage points higher than π ) is a better predictor of actual inflation than the fixed value π .

The values will be: t + 6: solving π t = π te + 0.1 − 2ut and using π te = πt-1 t + 6 ut + 6 = .03

πt + 6 = π +.04 + 0.1 – (2 × .03) = π + .04 + .04 = π + 0.08

t + 7 ut + 7 = .03

πt + 7 = π +.08 + 0.1 – (2 × .03) = π + .08 + .04 = π + 0.12

t + 8 ut + 8 = .03

πt + 8 = π +.12 + 0.1 – (2 × .03) = π + .12 + .04 = π + 0.16

142 .

You can see that keeping unemployment below the natural rate leads to an ever accelerating rate of inflation when θ = 1. Hence the other name for the natural rate is the NAIRU, the non-accelerating inflation rate of unemployment. In this case inflation rises by 4 percentage points each year. This does not seem to be a feasible long run policy choice.

If the unemployment rate is at the natural rate of unemployment (5%) and we assume that θ = 1 then we solve πt − πt-1 = 0.1 − (2 × 0.05) = 0. In this situation, in every period actual inflation equals the previous period’s rate of inflation. Inflation does not change.

Dig Deeper 6.

This will move the model of expected inflation so that

π t = π t–1 − 2(ut − .05) = π t-1 + 2% = 2% π t = 2%; π t+1 = 4%; π t+2 = 6%; π t+3 = 8%. b.

π t = 0.5 π t + 0.5 π t–1 − 2(ut − .05) or, π t = π t–1 − 4(ut − .05)

π t = 4%; π t+1 = 8%; π t+2 = 12%; π t+3 = 16%

As indexation increases, inflation becomes more sensitive to the difference between the unemployment rate and the natural rate.

The natural rate of unemployment is where inflation does not change (or, when πt-1 = π te ) and actual inflation equals expected inflation. The left-hand side of the Phillips relation is zero and solving, un = 6.16%

The relation πt = 2.8% − 0.16 ut does not include a specific value for expected inflation. Thus, we cannot solve for the value of (m + z) when we do not know expected inflation. The formula for the Phillip is curve is π = π e + ( m + z )) − α u . The expression gives us only the value of α = 0.16 and the sum of π te and (m + z),

The intercept on the vertical axis is the rate of inflation where unemployment is zero. Its value is 2.8%. Among the reasons to think this is a poor economic outcome would be that an unemployment rate of zero would not allow for normal churn and search in labor markets. The intercept on the horizontal axis would be interpreted as the rate of unemployment need to reduce inflation to zero using the Phillips relation. The value is 17.5%. This is a very high rate of unemployment and would not be desirable.

If we assume that π = 2.0% and that π te = π = 2.0% then the relation is πt − 2.0 = 2.8% − 2 = − 0.16 ut and we can solve for un = 0.8/0.16 = 5.0%. If the unemployment rate is 5% and expected inflation is anchored at 2%, then actual inflation is 2% and we are at the natural rate of unemployment. There is no reason for expected inflation to change. Solution to e) needs more info / rewriting

The Focus Box “Changes in the U.S. Natural Rate of Unemployment since 1990” discusses changes in the natural rate of unemployment between 1970–1995 and 1996–2018. Essentially, speculates on possible reasons for a lower natural rate of unemployment. This would be a slightly lower natural rate of unemployment - from 6.16% to 5.0%. But

143 .

remember both are statistical estimates and these are unlikely to be very different in the statistical sense. f.

The Focus Box “Changes in the U.S. Natural Rate of Unemployment since 1990” speculates on possible reasons for a lower natural rate of unemployment. Workers could have weaker bargaining power. There could be more efficient search mechanisms in the labor force. The population has aged. A larger percentage of the population is incarcerated or disabled. Consider each table below. Is the data presented is consistent with the Phillips curve model of wage determination? Each table has a point A and a point B. Start your answer with true/false/uncertain.

The natural rate of unemployment is 5% Point A B

Unemployment rate 6% 6%

Expected inflation (percent) 3% 2%

Percent increase in wages 3% 2%

True. The rate of wage increase is higher when expected inflation is higher at the same rate of unemployment. This is consistent with the Phillips curve model of wage determination b.

The natural rate of unemployment is 5% Point A B

Unemployment rate 4% 3%

Expected inflation (percent) 2% 2%

Percent increase in wages 3% 2%

False. The rate of wage increase is lower when the unemployment rate is lower at the same rate of expected inflation. This is not consistent with the Phillips curve model of wage determination c.

The natural rate of unemployment is 4% Point A B

Unemployment rate 4% 4%

Expected inflation (percent) 6% 2%

Percent increase in wages 7% 3%

True. The rate of wage increase at the natural rate of unemployment differs by the difference in the expected rate of inflation. The Phillips curve has shifted up to factor in expected inflation. This is consistent with the Phillips curve model of waged determination d.

The natural rate of unemployment is 5% Point A B

Unemployment rate 12% 12%

144 .

Expected inflation (percent) 2% – 2%

Percent increase in wages 0% 0%

Uncertain. Money wage decreases do not take place as expected inflation is negative even at the same rate of unemployment, a rate far above the natural rate of unemployment. This set of data could capture the phenomenon of rigid money wages in a Phillips curve framework. Explore Further 9.

The filled in table for the period will look like this (truncated to one decimal place) Year

Inflation

Unemployment

Predicted inflation

Inflation minus predicted inflation

2006

3.3

4.7

2.0

1.2

2007

2.5

4.6

2.1

2008

4.3

5.4

1.9

2.3

2009

−0.6

8.8

1.4

−2.0

2010

1.8

9.7

1.3

2011

2.7

9.1

1.3

1.4

2012

2.3

8.2

1.5

2013

1.5

7.5

1.6

−.1

2014

1.7

6.3

1.8

−.1

2015

0.2

5.4

1.9

−1.8

2016

1.0

4.9

2.0

−1.0

2017

2.0

4.4

2.1

2018

2.4

4.0

2.2

Future years a.

There is no simple answer here. In the years 2007, 2010, 2012, 2013, 2017 and 2018 – the predicted rate of inflation is within 0.5 percentage points of the actual rate of inflation. In the other years, the predictions of the rate of inflation are further away from the actual rate of inflation. Clearly many other factors affect inflation. The average error in prediction over the period is 0.1 percentage points. So, the Phillips curve as written does a decent job of predicting inflation but is far from perfect. If the expected rate if inflation is anchored on 2 percent, then some of the expectational errors are quite large relative to 2 percent.

If we focus on the crisis years, 2009 and 2010, the model fits better in 2010. In 2009, the actual rate of inflation is negative 0.6% and the model predicts a positive value of 1.4%. The high level of unemployment in 2010 predicts a reduction in the inflation rate from 2009 to 2010 and one occurs. The model does not fare well in 2011. The high level of

145 .

unemployment in 2011 predicts rate of inflation that is 1.3 percentage points below the actual rate of inflation. c. 10.

Answers will vary. Remember that the Phillips curve holds the natural rate of unemployment constant at its estimated value for the period 1996 to 2018. From the 1960’s

π te − π t

Year

Actual inflation

Lagged actual inflation

π te Difference: expected minus Expected inflation under actual inflation under different assumptions different assumptions assume θ=0

assume assume

θ=0

assume

Year

πt

π t −1

and π = 0

θ = 1.0

and π = 0

θ = 1.0

1963

1.2

1.1

0.0

1.1

1.2

0.1

1964

1.3

1.2

0.0

1.2

1.3

0.1

1965

1.5

1.3

0.0

1.3

1.5

0.1

1966

2.6

1.5

0.0

1.5

2.6

1.2

1967

2.7

2.6

0.0

2.6

2.7

0.1

1968

3.9

2.7

0.0

2.7

3.9

1.1

1969

5.0

3.9

0.0

3.9

5.0

1.1

Zero is a poor choice for the both the value of θ and π in the 1960s because it generates a poor prediction of inflation. In every year inflation is under predicted. It seems very unlikely that π = 0. Inflation should move around both sides of the actual value of π .

One is a better choice for the value of θ in the 1960s because the differences between expected inflation and actual inflation are actually quite small. However, because the level of inflation is accelerating all values of actual inflation minus expected inflation are positive. If we had allowed π to be positive as of 1963, the errors in expectations would have been smaller. Fill in the values in the table below for inflation and expected inflation using the 1970s and 80s. You will have the most success using a spreadsheet.

146 .

From the 1970’s and 1980’s:

Year

Actual inflation

Lagged actual inflation

π te − π t Difference: expected minus Expected inflation under actual inflation under different assumptions different assumptions π te

Year 1973

πt

π t −1

5.1

3.2

Assume θ=0 and π = 0 0.0

1974

9.4

5.1

0.0

5.1

9.4

4.3

1975

9.1

9.4

0.0

9.4

9.1

−0.4

1976

5.8

9.1

0.0

9.1

5.8

−3.3

1977

5.8

0.0

5.8

0.1

1978

6.8

5.8

0.0

5.8

6.8

0.9

1979

9.6

6.8

0.0

6.8

9.6

2.8

1980 12.0

9.6

0.0

9.6

12.0

2.4

1981

12.0

0.0

12.0

9.8

−2.1

9.8

Assume θ = 1.0

3.2

Assume θ=0 and π = 0 5.1

Assume θ = 1.0

1.9

Zero is now clearly a terrible choice for the value of θ and π in the 1970s and early 1980s. It is clear that inflation is, on average positive and very large. Ignoring this information in forming expectations of inflation is clearly wrong.

One is a better choice for the value of θ in the 1970s and early 1980s. Once the value of θ is one, the value of π is not relevant - it takes on a weight of zero in the formation of expected inflation. There are some years where lagged inflation predict actual inflation well and some years where it does not. But there are now both positive and negative errors in expectations. The average error is 0.7 percentage points.

147 .

From the 2010’s (which you have partly done in Q. 8):

πt

Year

π t −1

Lagged Actual actual inflation inflation

Year

π Expected inflation under different assumptions

π te − π t Difference: expected minus actual inflation under different assumptions

Assume θ = 0 and π = 2.0

Assume θ = 1.0

Assume θ = 0 and π = 2.0

Assume

e t

θ = 1.0

2013

1.5

2.3

2.0

2.3

−0.5

−0.8

2014

1.7

1.5

2.0

1.5

−0.3

0.2

2015

0.2

1.7

2.0

1.7

−1.8

−1.5

2016

1.0

0.2

2.0

0.2

−1.0

0.9

2017

2.0

1.0

2.0

1.0

0.0

1.0

2018

2.4

2.0

0.4

0.3

Future years e.

The fit of the model where the anchored rate of inflation is 2% between 2013 and 2018 is all right – but not spectacular. There are 4 negative values where inflation is actually less that the 2% anchored rate. In 2017 inflation is exactly the anchored rate and in 2018 inflation is higher than the anchored rate.

If we continue with the model that lagged inflation is expected inflation, the θ = 1 model, this model still has good predictive power. There are two negative values where actual inflation is less than lagged inflation and 4 positive values. The average of the 6 prediction errors in this model is zero. So θ = 1 will be a workable model of inflation expectations even when they are anchored. This makes sense – anchored expectations only stay anchored if the path of inflation is quite stable.

The 1960s capture the acceleration of inflation very well and show that depending on either zero expected inflation or lagged inflation is a poor model. In the 1970s lagged inflation works fairly well. In the 2012s, as makes sense, if inflation is stable, then either an anchored model of expected inflation or a model where expected inflation is the lagged value of inflation works fairly well.

148 .

CHAPTER 9 Quick Check 1.

a. b. c. d. e. f. g. h. i. j. k. l.

False. An increase in taxes (T) will shift the IS curve down as will an increase in risk premium (x). False. When unemployment exceeds the natural rate then the output gap is negative. True. False. The output gap would be positive if the natural rate of unemployment is greater than the actual rate of unemployment. True False. The change in the unemployment rate is typically less than the increase in output growth. True False. The target rate of inflation may be positive, not zero. False. The central bank may be constrained, for example by zero lower bound. True True True

Situations B, C, D, and E are all situations where output is not at potential output and unemployment is not at the natural rate of unemployment. As a result, given that the expected rate of inflation is fixed at the target rate of inflation, actual inflation is not at the target rate of inflation.

If you compare Situation B to Situation A, output is above potential output. Looking carefully you can see investment spending is higher because the real interest paid by firms is 2 – 2 + 1 or 1%. If the central bank increased the target nominal policy rate (i) from 2% to 4%, this would move Situation B to Situation A.

If you compare Situation C to Situation A, output is below potential output. Looking carefully you can see real investment spending is lower because the real interest paid by firms is 4 – 2 + 3 or 5%. The value of the risk premium (x) rose from 1% to 3%. Following what was learned in part b, if the central bank lowered the target nominal rate of interest by 2%, then the real rate of interest paid by firms would fall to 3% and investment would return to 150 units.

If you compare Situation D to Situation A, output is below potential output. Looking carefully you can see real government spending is 20 units lower in Situation D than in Situation A. If we were to lower the nominal and real policy rate of interest from 4% to 2%, we have learned that investment would rise to 170 units and this would restore the economy to medium run equilibrium.

If you compare Situation E to Situation A, output is above potential output. Looking carefully you can see real government spending is 20 units higher in Situation D than in Situation A. If we were to raise the nominal policy rate of interest from 4% to 6%, we have learned that investment would fall to 130 units and this would restore the economy to medium run equilibrium.

149 .

Expected inflation will not change since in the medium run equilibrium actual inflation equals expected inflation. In this characterization of equilibrium, the expected rate of inflation is the anchored rate of inflation and since the anchored rate of inflation is actual inflation, there is no reasons for households or firms to revise their expectations of inflation.

The central bank must lower the natural policy rate by 2 percentage points. The level of aggregate demand associated with the IS curve is determined by rn + x. The value of aggregate demand and income must remain at Y* for the actual rate of inflation to be the anchored rate of inflation. Thus, if x increases by 2 percentage points, rn must decrease by two percentage points.

The central bank must increase rn. The level of aggregate demand associated with the IS curve is determined by G and rn + x. The value of aggregate demand and income must remain at Y* for the actual rate of inflation to be the anchored rate of inflation. Thus, if G increases, rn must increase so that rn + x increases to reduce aggregate demand and leave it equal to Y*.

The central bank must increase rn. The level of aggregate demand associated with the IS curve is determined by T and rn + x. The value of aggregate demand and income must remain at Y* for the actual rate of inflation to be the anchored rate of inflation. Thus, if T decreases, rn must increase so that rn + x increases to reduce aggregate demand and leave it equal to Y*.

The increase in G or the decrease in T in parts d and e constitute a fiscal expansion and in increase in aggregate demand. To leave demand equal to output unchanged at potential output Y*, the central bank must act to raise the borrowing rate by raising the policy rate because the fiscal changes imply an increase in the natural policy rate.

Output increases in the short run as the IS shifts up when c0 increases. Inflation rises beyond expected inflation as the economy moves up the PC curve. Output and inflation is higher than 2%, its value in period t.

Total aggregate demand and output is determined by the intersection of the IS curve and the LM curve. Since the question states that the central bank will leave the real policy rate constant, that intersection occurs at the same values of output and the real interest rate in period (t + 1) and (t + 2). Inflation will be the same value in period (t + 1) and (t + 2) since the PC line does not move. Note: To leave the real policy rate unchanged, the central bank must raise the nominal policy rate by an amount equal to the increase in expected inflation.

If the central bank leaves the real policy rate unchanged, then the upward shift in the IS curve will increase output beyond the natural rate. The inflation rate, read off the unchanged PC line, will exceed 2% and will remain above 2% forever. The issue for the central bank will be that inflation and expected inflation exceeds the target rate of inflation in every period. So, the policy to target inflation will eventually fall apart.

Output increases in the short run as the IS shifts up. Inflation rises beyond the target rate of inflation as the economy moves up the PC curve. Output and inflation are higher in period (t + 1) than in period t.

In period (t + 2) the central bank leaves the real policy rate unchanged since expected inflation remains anchored at π . So, in period (t + 2) output remains above potential, its initial value, and actual inflation is higher than π .

150 .

This policy is not sustainable because in every period actual inflation exceeds both the target rate of inflation and the rate of expected inflation. It is unrealistic to expect expected inflation to remain at the anchored rate forever when the anchored rate is never achieved.

The difference between the two assumptions about expected inflation is subtle. In both parts b and c, output remains above potential. Because the PC curve in this model is not responsive to changes in expected inflation, the increase in output leads to actual inflation higher than the 2% target. In parts (a), (b) and (c), expected inflation rises to be equal to actual inflation. In parts (d), (e) and (f) actual inflation exceeds expected inflation in every period. In both scenarios, the central bank is left announcing a target inflation they never achieve.

Neither scenario seems completely realistic. In part b, the central bank accepts a level of inflation that is always greater than its target. In part c, expected inflation remains anchored at a target rate of inflation that is never achieved.

The PC curve will shift up. In period (t + 1) output remains at the period t level since the components of demand are not changed when there is no change in the real interest rate and inflation increases. The level of potential output decreases. In period (t + 1) inflation would increase beyond the target rate of inflation and output remains at the initial level that it was in period t.

The period (t + 2) equilibrium when π te+ 2 = π t +1 and when the central bank leaves the real policy rate of interest unchanged will have the same level of output as in period (t + 1) and period t. Since the PC curve has shifted up, inflation will exceed 2% by the same amount as in period (t + 1).

The maintenance of the real policy rate at its initial value is not sustainable. Inflation will exceed the target rate of inflation forever. So, the target rate of inflation policy will eventually fall apart.

Output will remain the same as in period t. The real interest rate has not changed and no factors that shift the IS curve are in play. Since the PC curve shifted up, the same level of output is associated with a higher inflation rate.

In period (t + 2) if the central bank does not change the real policy interest, the output remains higher than the natural rate, at the level of output in period t and (t + 1). Inflation remains at its higher than 2% value since the PC curve has shifted up.

This policy is not sustainable because in every period actual inflation exceeds target inflation. It is unrealistic to expect expected inflation to remain at the anchored rate forever when the anchored rate is never achieved.

In both cases output remains higher than the new lower level of potential output. In the cases discussed in (a) and (b) inflation and expected inflation stay at the value higher than 2% forever. In the (d) and (e) case, actual inflation simply remains higher than the target rate of inflation forever.

Neither situation is realistic in term of a supply shock. The large permanent increase in the price of oil would almost certainly be noticed and be expected by participants in the

151 .

economy to affect both the inflation rate (at least temporarily) and the natural level of output (permanently). Dig Deeper 6.

Unemployment rises in a recession so u − u(– 1) will be positive. In a recovery period the unemployment rate is falling so u − u(– 1) will be negative.

3% is the growth rate of potential output.

This coefficient is not unity due to labor hoarding.

The growth rate of potential output would increase, the 3% number would be larger.

Your sketch would show the IS in period t curve crossing potential output where the real policy rate of interest is −π . This would mean that the nominal policy interest rate is zero. Note the real borrowing rate for firms would be 0 − π + x and could be positive. Inflation is equal to π and π − π = 0 In period t + 1 the IS curve would shift to the left (or down) with the cut in G and the increase in T and equilibrium output falls. Actual inflation will be less than the anchored expected rate of inflation.

Actual inflation could become negative if the level of income is a great deal lower than potential. If inflation is persistently less than the target rate of inflation, the expected rate of inflation will eventually fall.

If the nominal policy interest rate is already at zero, the fall in expected inflation would increase the real policy rate of interest. This would then cause a movement up the IS curve and a further decline in income and inflation. The rate of inflation could become negative in income falls far enough. The negative expected rate of inflation is a higher real rate of interest. The cycle would continue. The fiscal consolidation could lead to a deflationary spiral as outlined above.

Explore Further 8.

Output is not at potential in 1933. The unemployment rate is still very high. Although output growth is positive in 1933, it is clearly still far below its value in 1929. The years of negative output growth have not been offset.

The constantly increasing rate of deflation (inflation getting more negative) from 1929 to 1932 suggest a spiral of an increasing rate of deflation.

The actual value of inflation in 1929 was zero. If the expected rate of inflation had remained anchored at zero, the real rates would have been much lower and investment would have been higher.

Had a substantial fiscal stimulus taken place in 1930 or even earlier, perhaps the level of output would have been higher. If the level of output had been higher, the output gap would have been less negative, deflation less and the rise in real interest rates less. The depression might have been shorter and less severe.

Real interest rates would be: 1929: 7%; 1930: 4.4; 1931: 5.6; 1932: 13.2; 1933: 13.4. It would be quite hard to say whether this pattern of real interest rates explains changes in output better. It is not very different.

152 .

10.

11.

1930: −.72; 1931: −.49; 1932: 4.3; 1933: +.14. You notice that unemployment and output growth looks like Okun’s Law in 2 of the 4 years. These are not exact relations. Even though output grew in 1933, it seems likely firms would be wondering if the increase in output was permanent enough to take on extra staff.

There is a weaker deflation spiral. Deflation increases (inflation becomes more negative) from 1929 to 1932 when output growth is negative.

When real interest rates rise in 1931 and 1932 output growth is more negative.

It seems strange that the nominal policy rate increased from 1931 to 1932 when the unemployment rate was so high and output growth very negative in 1931.

President Trump’s comment does roughly match up to our model. With a permanent fiscal expansion, the Fed must raise the neutral real policy rate. However, Mr. Trump would prefer that the economy continue to have a high level of output and a low level of unemployment.

The second comment also roughly fits our model. As we are doing so well – the economy is either above potential or predicted to be above potential and the Fed is raising interest rates to reduce demand.

CHAPTER 10 Quick Check 1.

Whether it provides, or not, a good measure of economic activity, depends on the substitutability between the goods and services produced in the affected and not affected sectors. If substitutability between the two is high, some production will relocate from the affected to the non-affected sector and the overall fall in output will be smaller.

There is an important difference between a lockdown and an oil shock. Although a lockdown is typically temporary, not all firms will be able to wait for the lockdown to be lifted and will close. If the lockdown lasts more than a few months, many firms will go out of business. Thus, a lockdown, even if temporary, may reduce the level of potential output permanently. In other words, the effects of a temporary lockdown could be permanent, with long-lasting effects on production and employment in the medium run. But there are other reasons why a temporary lockdown could have permanent effects. Some sectors, think of business travel, may be permanently affected. Teleworking may change people’s lives with, possibly, positive effects on the labour force: some people, thanks to teleworking, may be able to work more hours.

A lockdown can have three different effects: a.

The first happens when demand during the lockdown decreases so that actual output, Yt, falls exactly to the new (lower) level of potential output, Y′n. Output falls in the short run and will remain at the new level in the medium run. Neither fiscal nor monetary policy can aim to increase output more than the new potential level: any expansionary policy in the short run will be ineffective in the medium run, because any higher demand cannot be satisfied at the new potential output Y′n. Inflation will not move; therefore the lockdown will only result in a decreased level of output.

153 .

If, instead, the fall in demand is much larger than the fall in production, output in the short run falls more than the new level of potential output, Yt < Y′n. As output is below potential, there are deflationary pressures, i.e. expected inflation, πe , increases over π. In this case, governments can opt for expansionary fiscal policy measures to compensate for the income loss in sectors that are most severely affected by the lockdown (those with more intense social interaction). This will mitigate the fall in demand, thereby increasing output form its short run level, Yt, to the new potential level, Y′n. The IS curve to the right, from IS′ to IS″ so as to increase output to its new potential level, Y′n.

Finally, what happens if the fall in demand is smaller than the fall in production? Output in this case falls less (in the short run) than the new level of potential output, Yt > Y′n. At the same time, as output is above the new potential level, Yn′, thereby generating inflationary pressures, i.e. expected inflation, πe , falls below π. As output shrinks, while demand exceeds output, the economy enters stagflation. To prevent overheating of the economy, the central bank must raise interest rates to r′n. In this case, expansionary fiscal policy would push inflation up even more, but could not compensate for the loss in potential output.

Dig Deeper

In a 2012 book, The New Geography of Jobs (a book described by Barack Obama as ‘a timely and smart discussion of how different cities and regions have made a changing economy work for them’, and by William Galston in The Wall Street Journal as ‘the most important book of the decade on the contemporary economy’), Berkeley’s Enrico Moretti analyses the growing geographic differences in economic well-being between cities. He finds that the sorting of highly educated Americans – and high-paying jobs requiring a lot of education – into certain communities has led to other communities falling behind. Moreover, they have been falling behind faster economically as time goes on. This pattern, in turn, has been reflected in other socioeconomic differences, including political attitudes, divorce rates and life expectancies. The book shows why jobs accumulate in certain cities and regions, while other regions remain stagnant or worse. It shows how important a hub of innovation can be. But, while that hub is aided by the presence of a prominent university, it is not sufficient. Other factors tie in, such as the presence of a few prominent innovators – individuals who draw more and more top innovators into the region. People like to ‘be where the action is’. COVID-19 has posed a profound challenge to megacities. Big urban centres are the new plague pits. New York City, the United States’ most crowded big city, has suffered about 23% of all US deaths from the virus in the first three months of the pandemic; London’s share of UK deaths was 23%; Madrid about 32%; and Stockholm even more (see https://www.ft.com/content/e30b16e2-9604-11ea-899a-f62a20d54625).

Nature, a leading science magazine, argues (https://www. nature.com/articles/d41586020-01518-y) that COVID-19 will force universities to confront long-standing challenges in higher education, such as skyrocketing tuition costs and perceptions of elitism – and some of the resulting changes could be permanent. Over the long term, universities might shift many classes online (a trend already under way before the pandemic), have fewer international students and even refashion themselves to be more relevant to local and

154 .

national. At the same time, many institutions are learning the hard way that simply delivering course materials through digital platforms is not the best way to teach students. ‘Zoom university isn’t proper online learning,’ says Sanjay Sarma, MIT’s vice-president for open learning as saying, as quoted by Nature. Based on your university experience a year into the pandemic, what is your view on the future of universities? Explore Further 6.

Download more recent data from Google mobility index, update Figure 10.1 and comment on the evolution of the pandemic.

Compute the change in stock market prices by sector in the UK and Ireland up to the current date (that is the day you are studying this chapter). Is the distinction between affected and non-affected sectors made in this chapter still valid? What do these data tell you about the evolution of the pandemic in the UK and Ireland?

Consider the figure at the end of the Focus box: ‘Fiscal responses to COVID-19’. Why are government guarantees such an important component of the fiscal policy response to the pandemic?

CHAPTER 11 Quick Check 1.

a. b. c. d. e. f. g.

True False. Prices of goods, including food, are typically lower in poor countries. True False. Output per person is converging across countries but most still lag far behind the U.S. True False. Capital formation cannot sustain growth alone, but it does contribute to long-term growth. True The table should read as follows: Transportation Services

Food

Mexico United States

Price

Quantity

Price

Quantity

5 pesos

400

20 pesos

200

1,000

2,000

155 .

U.S. consumption per person = $1(1000) + $2(2,000) = $5000

Mexican consumption per person = 5(400) pesos + 2(2000) pesos = 6000 pesos

From the U.S. point of view, the exchange rate (E) = 10 pesos/$. Mexican consumption per person in dollars = 6000 pesos/E = $600

Mexican consumption per person ($PPP) = $1(400) + $2(200) = $800

Mexican standard of living relative to the United States Exchange rate method: 600/5000 = 0.12 PPP method: 800/5000 = 0.16 Using the PPP method reduces the gap in living standards between Mexico and the US.

Y = 63

Y doubles

Yes

Y/N = (K/N)1/2

K/N = 4 implies Y/N = 2. K/N = 8 implies Y/N = 2.83. Output less than doubles.

No. In part (f), we are essentially looking at what happens to output when we increase capital only, not capital and labor in equal proportion. There are decreasing returns to capital.

Yes. It exhibits the same decreasing returns when addition units of capital per worker are added.

Dig Deeper 4.

ΔY/Y = .5 (ΔK/K) growth rate of output = 1/2 growth rate of capital

4% per year

K/Y increases

No. Since capital is growing faster than output, the saving rate will have to increase to maintain the same pace. Eventually, the required saving will exceed output. Capital must grow faster than output because there are decreasing returns to capital in the production function. Even though the United States was making the most important technical advances, the other countries were growing faster because they were importing technologies previously developed in the United States. In other words, they were reducing their technological gap with the United States.

156 .

Explore Further 6.

Japan tended to converge to the United States in the 1960-1990 period but not in the 1990-2011 period.

Japan United States

Per Capita GDP 1960 11892.57 23373.47

Per Capita GDP 1990 27630.6 36399.6

Average Annual Growth 4.2% 2.2%

Per Capita GDP 35566.22 51958.58

Average Annual Growth 1.0% 1.5%

Average annual growth in real per capita GDP

Had Japan and the United States maintained their growth rates from the earlier period, Japan would have surpassed the United States in output per person as of 2011.

In fact, output growth per person slowed considerably in both countries but much more in Japan. Real GDP per person in Japan in 2014 is much less than real GDP per person in the United States.

There was substantial convergence for the France, Belgium, and Italy. The ratio of per capita income in these countries to that of the United States in 2014 is much larger in 2014 than in 1950.

Three of these four African countries have not converged. The ratio of per person real GDP in these countries in 1950 to that of the United States in 1950 is smaller in 2014 than in 1970 for all but Ethiopia. There is some evidence of convergence in Ethiopia but the level of real GDP per capita in Ethiopia remains low. Real GDP Per Capita 2PPP adjusted expressed in 2011 US dollars Country

1970

2014

ratio

United States

23373.5

51958.6

2.2

France

15742.7

38584.4

2.5

Belgium

13693.4

39950.5

2.9

Italy

11820.3

35323.5

3.0

Ethiopia

509.3

1504.3

3.0

Nigeria

4649.9

5574.2

1.2

Kenya

1650.9

2970.8

1.8

Uganda

994.7

1869.2

1.9

157 .

Real GDP per Capita ($2011), PPP adjusted a.

Richest 10 countries 1970 Country

Real GDP per capita

Bermuda

80424

Brunei

57500

Switzerland

23863

Luxembourg

22362

Kuwait

21488

United States

20547

Bermuda

18490

Denmark

17050

Austria

16857

Sweden

16573

10 Richest Countries (in the data sample) in 2014 Per capita real GDP

Qatar

151763

China, Macao SAR

131850

Norway

78293

United Arab Emirates

70096

Brunei Darussalam

69667

Kuwait

69305

Luxembourg

67324

Singapore

66482

Switzerland

62637

United States

51959

158 .

The ten fastest growing countries are Taiwan

5.067942

Mongolia

5.078347

El Salvador

5.135735

China

5.20462

Egypt

5.220532

Turks and Caicos Islands

5.670956

Republic of Korea

6.404573

Botswana

7.10022

China, Macao SAR

7.207959

Equatorial Guinea

9.431726

Slowest growing countries with data from 1970 and 2014 Bermuda

−9.33751

Cayman Islands

−4.57779

United Arab Emirates

−2.87603

Djibouti

−2.19843

Central African Republic

−1.93212

D.R. of the Congo

−1.60263

Kuwait

−1.46549

Niger

−1.21873

Comoros

−0.90264

Nicaragua

−0.76299

Answers will vary. Wars and revolutions can play a significant role in slowing growth. Large resource discoveries or large swings in resource prices in countries where a single commodity dominates the economy can also play a large role in moving growth rates.

159 .

The graph clearly has a broad pattern where the level of happiness is higher the higher is real GDP per capital.

The most interesting observation in the graph is that for the two most populous countries in the world, India and China, the pattern is very different. In China real GDP per capita increased and so did happiness. In India real GDP per capita increased but happiness fell.

CHAPTER 12 Quick Check 1.

a. b. c.

d. e.

True, in a closed economy, and if saving includes public and private saving. False. The economy will eventually reach a steady state where output per worker does not increase. True. In the model without depreciation, there is no steady state. A constant saving rate produces a positive but declining rate of growth. In the infinite-time limit, the growth rate equals zero. Output per worker rises forever without bound. In the model with depreciation, if the economy begins with a level of capital per worker below the steady-state level, a constant saving rate also produces a positive but declining rate of growth, with a limit of zero. In this case, however, output per worker approaches a fixed number, defined by the steady-state condition of the Solow model. Note that depreciation is not needed to define a steady state if the model includes labor force growth or technological progress. Uncertain. See the discussion of the golden-rule saving rate. Uncertain/False. It is likely that the U.S. rate is below the golden rule rate and that transforming Social Security to a pay-as-you-go system would ultimately increase the U.S. saving rate. These premises imply that such a transformation would increase U.S. consumption in the future, but not necessarily in the present. Indeed, if the only effect of such a transformation is to increase the saving rate, we know that consumption per worker will fall in the short run. Moreover, moving to a pay-as-you-go system requires transition costs. If these costs are borrowed, then the reduction in public saving will offset the increase in private saving during the transition. If these costs are not borrowed, then transitional generations must suffer either a reduction in promised benefits or an increase in taxes to finance their own retirement in addition to the retirement of a previous generation. Thus, whether the U.S. “should” move to a pay-as-you-go system depends on the likely resolution of intergenerational distributional issues and your view about the equity of such a resolution. Uncertain. The U.S. capital stock is likely below the golden rule, but that does not necessarily imply that there should be tax breaks for saving. Even if the tax breaks were effective in stimulating saving, the increase in future consumption would come at the cost of current consumption. False. Even if you accept the premise (that educational investment increases output, as would be implied by the Mankiw, Romer, Weil paper), it does not necessarily follow that countries should increase educational saving, since future increases in output will come at the expense of current consumption. Of course, there are other arguments for subsidizing education, particularly for low-income households. Disagree. An increase in the saving rate does not affect growth in the long run, but does increase growth in the short run. In addition, an increase in the saving rate leads to an increase in the long-run level of output per worker. Finally, since the evidence suggests

160 .

that the U.S. saving rate is below the golden-rule rate, an increase in the saving rate would increase steady-state consumption per worker. 3.

Assume that the economy begins in steady state. One decade after an increase in the saving rate, the growth rate of output per worker will be higher than it was in its initial steady state. Five decades after an increase in the saving rate, the growth rate of output per worker will be close to its value in the initial steady state (this value is zero in the absence of technological progress). The level of output per worker will be higher, however, than it was in the initial steady state.

Dig Deeper 4.

a. b.

This would likely lead to a higher saving rate, so output per worker and output per person would be higher in the long run. Treat an increase in female participation as a one-time increase in employed labor. In this case, an increase in female participation would have no effect on the level of output per worker, but would lead to a higher level of output per person, since a greater fraction of the population would be employed. A transformation to a fully funded system leads to an increase in the saving rate. Ignoring any short-run transition costs, in the long run an increase in the saving rate leads to a higher level of output per worker, but has no effect on the growth rate of output per worker.

K/N = (s/(2δ ))2; Y/N = s/(4δ )

C/N = (1 − s)Y/N = s(1 − s)/(4δ )

c-e.

Y/N increases with s. C/N increases until s = 0.5, then decreases.

Yes. The Cobb-Douglas production function satisfies the two properties of constant returns to scale and decreasing returns to capital and labor.

Y/N = (K/N)1/3

In steady state, sY/N = δK/N, which, given the production function in part (d), implies K/N = (s/δ )3/2

Y/N = (s/δ )1/2

Y/N = 2

Y/N = 21/2

161 .

Substituting from problem 7 part (e) implies K/N = 1.

Substituting from problem 7 part (f), Y/N = 1.

K/N = 0.35; Y/N = 0.71

K/N

Y/N

1.00

t+1

0.90

0.97

t+2

0.82

0.93

t+3

0.75

0.91

Review the steps on pages 230-231

K/N = (0.15/.075)2 = 4

Y/N = (4)1/2 = 2 K/N = (0.2/0.075)2 = 7.11 Y/N=(7.11)1/2=2.67 Capital per worker and output per worker increase.

Explore Further 10.

For 2016, the national saving rate was approximately 18.0%. In steady state, K/N = (0.180/0.075)2 = 5.76, and Y/N = (5.76)1/2 = 2.40.

For fiscal year 2018, the estimated budget deficit (including the off budget items) was 4.7% of GDP. Eliminating the deficit increases the national saving rate to 22.7% (e.g. 18.0% + 4.7%). As a result, in steady state, K/N = (0.227/.075)2 = 9.14, and Y/N = (9.14)1/2 = 3.02. Steady-state output per worker increases by 26%.

The savings rate in China is much higher than in the United States, in 2016, 45% of GDP in the World Bank data.

CHAPTER 13 Quick Check 1.

a. b. c. d. e.

True True False. In steady state, there is no growth of output per effective worker. True False. The steady-state rate of growth of output per effective worker is zero. A higher saving rate leads to higher steady-state level of capital per effective worker, but has no effect on the steady-state rate of growth of output per effective worker. True

162 .

g. h.

a. b. c. d. e.

a. b.

False. Many marketable innovations come from basic research so the quest for profits will ensure private firms continue to conduct all types of research. False/Uncertain. Even pessimists about technological progress typically argue that the rate of progress will decline, not that it will be zero. Strictly, however, the truth of this statement is uncertain, because we cannot predict the future. False. Although China’s growth has been dominated by an increase in the capital stock per worker, there is no reason to believe that China has not benefitted from the increase in technology around the world and contributed to the development of that technology. Most technological progress seems to come from R&D activities. See discussion on fertility and appropriability of research in Chapter 12.2. This proposal would probably lead to lower growth in poorer countries, at least for a while, but higher growth in rich countries. This proposal would lead to an increase in R&D spending. If fertility did not fall, there would be an increase in the rates of technological progress and output growth. Presumably, this proposal would lead to a (small) decrease in the fertility of applied research and therefore to a (small) decrease in growth. This proposal would reduce the appropriability of drug research. Presumably, there would be a reduction in R&D spending on new drugs, a reduction in the rate of technological progress, and a reduction in the growth rate. The economic leaders typically achieve technological progress by generating new ideas through research and development. Developing countries can import technology from the economic leaders by copying this technology or by receiving a transfer of technology as a result of joint ventures with firms headquartered in the economic leaders. Even in the absence of technology transfer, foreign direct investment can increase technological progress in the host country by substituting more productive foreign production techniques for less efficient domestic ones. Poor patent protection may facilitate a more rapid adoption of new technologies in developing countries. The costs of such a policy are relatively small, since developing countries generate relatively few new technologies.

Dig Deeper 4.

The growth rate of output per worker falls in the short run and continues to fall over time. In the long run, the growth rate of output per worker approaches a new steady state with a permanently lower (but still positive) growth rate. Output per worker continues to rise over time, just at a slower rate. Since output per worker continues to grow, the level of output continues to grow.

A permanent reduction in the saving rate has no effect on the steady-state growth rate of output per worker. The growth rate of output per worker falls (but remains positive) in the short run but in the long run it approaches its original steady-state rate. The level of total output grows with the number of workers.

163 .

Nominal GDP Year 1: 10(100) + 10(200) = 3000 Year 2: 12(100) + 12(230) = 3960

Year 2 Real GDP (Year 1 Prices) = 10(100) + 10(230) = 3300 growth rate of real GDP = 3300/3000 – 1 = 10%

GDP deflator Year 1=1; Year 2 = 3960/3300 = 1.2 Inflation = 20%

Real GDP/Worker Year 1 = 3000/100 = 30; Year 2 = 3300/110 = 30 Labor productivity growth is zero.

Year 2 Real GDP (Year 1 Prices) = 10(100) + 13(230) = 3990 output growth = 3990/3000 – 1 = 33%.

GDP deflator Year 1 = 1; Year 2 = 3960/3990 = 0.992 Inflation = 0.992/1 – 1 = −0.8%

Real GDP/worker = 36.3 in year 2. Labor productivity growth is 36.3/30 = 1.21, or 21%.

This statement is true, assuming there is progress in the banking services sector.

K/(AN) = (s/(δ + gA + gN))2 = 1

ii.

Y/(AN) = (K/AN)1/2 = 1

iii.

gY/(AN) = 0

iv.

gY/N = gA = 4%

gY = gA + gN = 6%

K/(AN) = (s/(δ + gA + gN))2 = 0.64

ii.

Y/(AN) = (K/AN)1/2 = 0.8

iii.

gY/(AN) = 0

iv.

gY/N = gA = 8%

gY = gA + gN = 10%

An increase in the rate of technological progress reduces the steady-state levels of capital and output per effective worker, but increases the rate of growth of output per worker.

164 .

K/(AN) = (s/(δ + gA + gN))2 = 0.64

ii.

Y/(AN) = (K/AN)1/2 = 0.8

iii.

gY/(AN) = 0

iv.

gY/N = gA = 4%

gY = gA + gN = 10%

People are better off in case (a). Given any set of initial values, the level of technology is the same in cases (a) and (c), but the level of capital per effective worker is higher at every point in time in case (a). Thus, since Y/N = AY/(AN) = A(K/(AN))1/2 = A1/2(K/N)1/2, output per worker is always higher in case (a). 7.

Probably affects A. Think of climate.

Affects H and possibly A, if better education improves the fertility of research.

Affects A. Strong protection tends to encourage more R&D but also to limit diffusion of technology.

May affect A through diffusion.

May affect K, H, and A. Lower tax rates increase the after-tax return on investment, and thus tend to lead to more accumulation of K and H and to more R&D spending.

If we interpret K as private capital, then infrastructure affects A (e.g., better transportation networks may make the economy more productive by reducing congestion time).

Assuming no technological progress, a reduction in population growth implies an increase in the steady-state level of output per worker. A reduction in population growth leads to an increase in capital per worker. If there is technological progress, there is no steady-state level of output per worker. In this case, however, a reduction in population growth implies that output per worker will be higher at every point in time, for any given path of technology. See the answer to problem 6(c).

Explore Further 8.

Growth accounting The appendix to this chapter shows how data on output, capital, and labor can be used to construct estimates of the rate of growth of technological progress. We modify that approach in this problem to examine the growth of capital per worker. Y = K 1/3 (AN ) 2/3

The function gives a good description of production in rich countries. Following the same steps as in the appendix, you can show that (2 3) g A = gY − (2 3) g N − (1 3) g K = ( gY − g N ) − (1 3)( g K − g N )

where gy denotes the growth rate of Y.

165 .

The quantity gY – gN is the growth rate of output per worker. The quantity gK – gN is the

growth rate of capital per worker. b.

The filled in chart will look (using version 9 of the PWT) Use rgdpo for output (2011 US dollars); emp number of employees labor input; ck for the capital stock (2011 US dollars) The share of labor is labsh. These values are copied directly from the PWT Version 9 Year 2000 N Y

Year 2014

Share of Labor

Share of labor

China

5108341

717.395

11468023

0.599299

17135952

798.3678

69379696

0.567239

United States

13031820

139.2961

35997032

0.6426

16598099

148.4634

52849892

0.603597

The annualized growth rates are (rounded to one decimal place) China:

Output 8.6%

Employees 0.8%

Capital Stock 12.9%

United States:

Output 1.7%

Employees 0.5%

Capital Stock 2.7%

Since the growth rate of capital in China is much higher than the growth rate of labor, K/N is rising.

This is also true in the United States.

Labor’s share of output is slightly higher in the United States.

The calculation of the residual is 2.8% in China and 0.4% in The United States. China has a larger residual.

The residual represents growth that is not accounted for by increases in inputs, labor and capital. We usually label this technological growth.

It seems surprising that China would have so much higher a rate of “technological growth” than the United States. The appendix gives a hint as to what might be happening. Chinese labor inputs are switching from low productivity jobs to high productivity jobs.

CHAPTER 14 Quick Check 1.

a. b. c. d. e. f.

True False. Review Figure 13.1. False. Some workers will always be displaced and must retrain to find work. True False. Mismeasurement can explain only a small part of the decrease in measured productivity growth. True

166 .

h. i.

False. General purpose technologies are major innovations that have applications in many fields and many products. They occur very infrequently. Electricity and the internal combustion engine are two examples. True True

Reduce the gap, if this leads to an increase in the relative supply of high-skill workers.

Reduce the gap, since it leads to a decrease in the relative supply of low-skill workers.

Reduce the gap, if it leads to an increase in the relative supply of high-skill workers.

Increase the gap, if it leads U.S. firms to hire low-skill workers in Central America, since this reduces the relative demand for U.S. low-skill workers.

This is likely to increase the gap since robots are more likely to displace lower skill workers. It is possible in theory that robots could reduce the price of intermediate goods enough to create more jobs for skilled and unskilled workers.

When all inputs double (triple) output doubles (triples). This is constant returns to scale

Units of N

Units of K

Units of E

Output

125

250

128

120

375

192

180

The values of energy inputs are Units of N

Units of K

Units of E

Output

250

128

120

375

85.33

120

250

85.33

120

The statement is false. Even when the consumption of energy increases from 85.33 (row 2) to 128 (row 1) output stays the same, since the 50 percent increase in energy in this case is accompanied by a 50 percent reduction in capital usage when labor usage remains unchanged.

The words would be that you can substitute capital or labor for energy inputs and either produce the same amount of output with less energy or increase the non-energy factors of production and produce more output. If the price of energy were raised through a tax on carbon emissions, economists would predict that firms would use less energy to produce and more capital and labor.

Dig Deeper 4.

In Chapter 12 the calculations for 2000-2014 showed that

167 .

Year 2000

United States

Year 2014

Share of Labor

Share of labor

13031820

139.2961

35997032

0.6426

16598099

148.4634

52849892

0.603597

The annualized growth rates are (rounded to one decimal place) United States: Output 1.7%

Employees 0.5%

Capital Stock 2.7%

The formula for the rate of growth of technology is the residual ≡ gY − [α g N + (1 − α ) g K ] and the rate of technological change from 2000-2014 was 0.4% From 1985 to 1999: Year 1985

United States

Year 1999

Share of Labor

Share of labor

7860199

111.4718

23116866

0.608186

12510232

137.3371

34374992

0.631764

The annualized growth rates are (rounded to one decimal place) United States: Output 3.3%

Employees 1.5%

Capital Stock 2.8%

The formula for the rate of growth of technology is the residual ≡ gY − [α g N + (1 − α ) g K ] and the rate of technological change from 2000-2014 was 1.3% a.

The growth rate of technology between 1985-1999 was dramatically higher than the growth rate of technology from 2000-2014

The description is that the unemployment rate for this group is quite high overall – almost always greater than 10 percent. The rate is very high in the World Economic Crisis from 2009 to 2013 - the average unemployment rate for this group 2009-2013 is 20.9%

Average unemployment rate of this group are 1985-1999: 11.6%

2000-2018: 16.9%

2017-18: 10.7%

For much of the period after 2000, a period of low rates of technological change, the unemployment rate of the low-skilled workforce was higher. It was necessary to look at 2017-2018 because it is apparent that the World Economic Crisis caused both an immediate surge in the unemployment rate of the low skill workers which continued long after the crisis. 5.

Technological change has led to a reduction in agricultural employment, but evidently has had no effect on the natural rate of unemployment.

168 .

W/P = F((1 − N/L), z)

Labor supply slopes up. As N increases, u falls for given L, so W/P increases.

MC = W/MPL so W/P = MPL/(1 + μ)

Labor demand slopes down. As N increases, the MPL falls, so W/P falls.

An improvement in technology increases the MPL, so the labor demand curve shifts right. The real wage increases when technology improves.

Explore Further 7.

Projections for job decline from 2016-2026 Some examples: Reporters and correspondents (– 10%) – technological change Correctional officers (– 7.4%) – demographic change – an aging population has a smaller proportion of people in jail Production Occupations (– 4.3%) – perhaps foreign competition

Projections for job growth from 2016-2026 Some examples: Computer and mathematical occupations (13.7%) – technological changes Health care practitioners (15.3%) – aging of the population

1974: $8.93; 2017: $9.22. Real hourly earnings did rise slightly over this period – in percentage terms by only (ln (9.22) – ln (8.93))/ 43 = .074% per year. It is only in 2015 that real hourly wages recover to the 1974 value. There are many years in between where real wages fall.

The real wage of low-skill workers has fallen markedly, which suggests that the relative demand for low skill workers has fallen markedly.

Other benefits, particularly health care benefits, might be missing from this calculation.

Figure 1 in the text box “The Long View: Technology, Education, and Inequality” shows the 90/10 ratio increasing with data ending around 2000. Figure 13-2 shows a divergence between the relative wages of more educated and less educated persons. Figure 13-3 shows an increasing share of income earned by the top 1% relative to the bottom 50%.

The supply and demand argument is based on the observation that the demand for skilled workers has increased faster than the supply in the period after 1980s.

Here the argument is that the demand for low-skilled workers has fallen due to international competition. More and more goods are being made abroad by low-skilled workers.

169 .

10.

In general Democrats favour polices that reduce income inequality and Republicans do not perceive income inequality as a major problem,

If incomes of the better educated are rising more rapidly than of the less educated and it is more likely that like-educated persons marry each other, then household income inequality will rise even more than wage inequality. Richer earners will marry richer earners.

The carbon intensity of output in the United States per dollar of GDP has dropped from 0.8 to 0.3 units.

The five largest emitters per dollar of GDP in 1990 are China, Trinidad and Tobago, Bulgaria, Poland and Romania. The five largest emitters per dollar of GDP in 2014 Trinidad and Tobago, Palau, Turkmenistan, South Africa and the Ukraine. There is only one country on both lists.

Here is the reduction in carbon intensity in these countries 1990 to 2014: Country

1990

2014

China

2.2

0.6

Trinidad and Tobago

1.8

1.0

Bulgaria

1.6

0.3

Poland

1.6

0.3

Romania

1.4

0.2

You would conclude a reduction in the intensiveness of carbon emissions is possible. To see if total emissions have fallen you would multiply emissions per dollar of GDP in the PWT times the rate of emissions. d.

For the United States Part (a) showed the carbon intensity of GDP per dollar dropped from 0.8 to 0.3 units. In China emissions per dollar of GDP dropped from 2.2 to 0.6. Our other uses of the Penn World Tables help us fill in this table China

United States

1990 GDP Millions of 2755448 2012 PPP dollars

9203227

2014 GDP Millions of 17080304 2012 PPP dollars

16704698

1990 Kilos of carbon 2.180863 per dollar of real GDP

0.806645

2014 Kilos of carbon 0.561283 per dollar of real GDP

0.301492

170 .

1990 Total Carbon

7.3

9.6

5.0

Millions of kilos 2014 Total Carbon Millions of kilos Source: Penn World Tables

CHAPTER 15 Quick Check 1

a. b. c. d. e. f. g h. i. j

True True False. Interest rates change frequently as market conditions change. Uncertain. Bonds typically have a repayment of principal at maturity as well as a constant income stream of interest payments. True True including an owner renting to herself. True False. The assets vary in risk False. Bubbles occur when prices are pushed above the expected present value of future returns. False. The stock market is very volatile and can change in price dramatically over one year.

Uncertain or true. There may be a lag in the protection.

a. b. c.

Real. Nominal profits are likely to move with inflation; real profits are easier to forecast. Nominal. The payments are nominal. Nominal. Car lease and car loan payments are usually stated in nominal terms.

a. b. c.

exact 2.498% approximate 2.5% exact 5.924% approximate 6.0% exact 2.99% approximate 3.0%

The equation discounts the first dividend received so it must be received one period in the future.

The first component is the discounted value of the expected dividend. The second component imagines the stock is sold in one period. It discounts the expected price of that sale. Both payments are received one year from now, so both are discounted.

The price of stock falls today.

The price of the stock falls today.

171 .

The price of the stock rises today.

The coefficient on $ Dte+3 is 0.85 and on $ Dte+10 is 0.46. Thus, an expected $1 increase in a dividend two years hence adds 85 cents to the share price today. An expected one-dollar increase in a dividend 10 years hence adds only 46 cents to the share price today.

The new values are 0.78 and 0.29. Higher discount rates make future events less important.

€V = €100/0.1 = €1000

Since the first payment occurs at the end of the year, €V = €z[(1/i) – (1/i(1 + i)n)] 10 years: €614.46; 20 years: €851.36; 30 years: €942.69; 60 years: €996.72

i = 2%: PV of consol = €5,000; 10 years: €898.25; 20 years: €1,635.14; 30 years: €2,239.65; 60 years: €3,476.09 i = 5%: PV of consol = €2,000; 10 years: €772.17; 20 years: €1,246.22; 30 years: €1,537.25; 60 years: €1,892.93

Very little will happen to stock prices. The present value discount factor for year one will decrease and the stock price will fall slightly.

Now all the discount factors get slightly smaller and the present value of all expected dividends falls resulting in a lower stock price.

The change in stock price will depend on the expected changes in magnitude of future output and future dividends relative to the change in interest rates.

Dig Deeper 7.

In case (i) you invest €2,000 and have €2000 (1 + r)40(1 − 0.25) dollars after taxes in 40 years (accumulated at the real interest rate r. (1 + r)40. In case (ii) you pay the taxes up front, you will invest (1 − 0.3) €2000 for 40 years and have (1 − 0.3) €2000 (1 + r)40 in 40 years. Interest rate 1% 10%

Money in 40 years with case (i) €2,233.30 €67,888.88

Money in 40 years case (ii) €2,084.41 €63,362.96

You choose case (i) in both interest rates. In case (ii) you are paying the taxes both at a higher rate and earlier – so for both reasons you have less money in 40 years.

172 .

Houses last a long time. Rents are likely to rise with inflation. Real interest rates would be better.

Let Rte+ n be the expected real rent on the house. Let QHt be the price of a house. We can let xH be the risk premium on a house. The equation would be

QHt =

Rte+1 Rte+ 2 + + . (1 + r1t + xh ) (1 + r1t + xH ) (1 + r1et + 2 + xH )

The future rents would be discounted less and the price today would rise.

xH would decline in value. The discount factors would be less and the price would rise.

Answers will vary.

Explore Further 9.

This measure did predict the US crash – see the Box “The Increase in US Housing Prices: Fundamentals or Bubble?” which country is currently most overvalued will vary depending on date of access.

The ratio of the house price to income is a sort of measure of the ability to pay the rents on houses - say those rents are a constant proportion of income. If this ratio were way out of its historical norm, this would also predict a crash. This measure also suggested the US housing price crash would occur.

10.

Answers will vary depending on when the website is accessed.

CHAPTER 16 Quick Check 1.

a. b. c. d. e. f. g. h.

a. b.

False. Human wealth for a college student will be much higher since they have their entire working life ahead of them. False. Consumption does appear to depend somewhat on expected future income. True False. Buildings only depreciate about 2.5% per year while equipment depreciates at a rate of 15% or more. False. A higher Tobin’s q corresponds to higher investment. False. Figure 15-3 shows that investment and current profit are strongly related. True True. The percentage change in investment is larger, but the absolute size of consumption is much bigger, so total changes in consumption and investment are of similar magnitude. (1 − 0.25)(40,000 + ((40,000)(1.05)) + ((40,000)(1.052)) = €94,575. Note that the discount rate is zero so you simply add the salary values for each year. €194,575

173 .

d. e. 3.

The consumer works for three more years and will be retired for seven years, so there are 10 more years of consumption. So, since the real interest rate is zero, the consumer can consume one-tenth of her total wealth, or 19,457.50, this year. Consumption could increase by €2,000 annually. Benefits imply extra annual consumption of 0.6(1.052)€40,000(7/10) = €18,522.

The EPDV of purchasing the machine is Π/(r + δ ) = €18,000/(r + 0.08) a.

Buy. EPDV = €138,462 > €100,000

Break-even. EPDV = €100,000

Do not buy. EPDV = €78,261 < €100,000

€44,000(1 − 0.4)36 − €40,000(1 − 0.4)38 = €38,400

€44,000(1 − 0.3)36 − €40,000(1 − 0.3)38 = €44,800

Dig Deeper 5.

EPDV of future labor income = €30. Consumption = €10 in all three periods.

youth: −5; middle age: 15; old age: −10

Total saving = n(−5 + 15 − 10) = 0

0 – 5n + 10n = 5n

youth: 5; middle age: 12.5; old age: 12.5 The consumer cannot borrow against future income when young.

0 + 12.5n − 12.5n = 0

0 + 0 + 12.5n = 12.5n

By allowing people to borrow to consume when young, financial liberalization may lead to less overall accumulation of capital.

Expected value of earnings during middle age is 0.5(€40,000 + €100,000) = €70,000. EPDV of lifetime earnings = €20,000 + €70,000 = €90,000. The consumption plan is €30,000 per year. The consumer will save −€10,000 (i.e., the consumer will borrow €10,000) in the first period of life.

In the worst case, the EPDV of lifetime earnings = €60,000. Consumption = €20,000 and saving = 0 in the first period of life. Consumption is lower than part (a), and saving is higher.

Consumption in youth is €20,000; in middle age is €50,000; and in old age is €50,000. Consumption will not be constant over the consumer’s lifetime.

174 .

The uncertainty leads to higher saving by consumers in the first period of life.

Explore Further 8.

a-c.

Between 1960 and 2018, consumption accounted for 64% of GDP on average and investment for about 14%, so consumption is about 4 times bigger than investment. Average movements in consumption are about twice the average movements in investment. Since consumption is 4 times bigger, even at half the average movements implies investment is more volatile than consumption. The large annual variation in the growth rate of investment relative to the growth rate of consumption confirms this result.

Consumers may be more optimistic about the future (and spend more) when disposable income is higher, so consumer confidence might be positively related to disposable income. However, consumer confidence should depend on expectations about the future, rather than on current variables per se. Hence, there are reasons to think changes in consumer confidence might not always track changes in disposable income.

There could be a weak positive relationship between the variables, but it is not very tight.

The overall relationship between the percent change in disposable income and the change in the level of consumer confidence is a bit stronger. There are many observations where there is little change in disposable income and a substantial change in consumer sentiment. Example: 2011 Q4, disposable income falls by 0.14% but consumer sentiment jumps. In 2007 Q4, disposable income falls by 0.175 and consumer sentiment falls a lot. Presumably expectations about the future can move independently of current disposable income.

Over the period from 2007 to 2009, there is a large overall fall in consumer sentiment. The quarters of the largest fall in sentiment are not always those with the largest declines in per capita disposable income. Consumer sentiment fell 20 points over 2008. Although consumer sentiment recovered in 2009, real per capita disposable income continued to fall. It looks as though consumers anticipated future problems.

Consumer sentiment did not change from quarter 4 2017 to quarter 1 2018. It did rise in quarter 4 2017 relative to quarter 3 2017.

There is average increase in personal disposable income in 2018 – more than one-half of one percent. This is certainly higher than in 2017 or 2016. Is there a change in the index of consumer sentiment between 2017 and 2018? The four quarters of 2018 saw two increases and two decreases in sentiment that net to a small negative number, essentially no change.

CHAPTER 17 Quick Check 1.

False. Changes in the current real policy rate have limited impact on spending.

False. The IS curve gets steeper.

True

175 .

True/Uncertain. If consumers include information about future fiscal policy, for example future tax rates, then expectations about future fiscal policy could affect consumption.

False. Expected changes in tax rates or deficit reduction do appear to impact current economic activity.

True

False. The evidence is mixed on whether deficit reduction leads to output expansion.

False. The net effect of the fiscal consolidations was contractionary.

The announcement of the inflation goal was intended to make it clear that the Federal Reserve was setting a long-term goal of 2% inflation.

But the first announcement said that interest rates would be zero (exceptionally low levels) for a full two years. Thus the combination of the two announcements was trying to suggest real interest rates would be negative over the next two years.

The policy announcement on December 19, 2018 raised the target rate of interest.

However, it added that the policy rate would continue to rise in the future.

It stressed that the economy was strong and the inflation was at or near the target level of 2%.

If inflation was to remain at 2% and the policy rate of interest continued to rise from 2 ¼ to 2 ½ percent, it is reasonable to think the Fed sees that a positive neutral policy rate is correct. Error in the textbook: it includes options c, d, f, g. no option e. it’s a silly mistake. To fit perfectly with the textbook options e and f above should be f and g respectively.

The IS curve shifts right.

The LM curve shifts up.

There are three effects. First, an increase in expected future taxes tends to reduce expected future after-tax income (for any given level of income), and therefore to reduce consumption. This effect tends to shift the IS curve to the left. Second, the increase in future taxes (a deficit reduction program) would require that the central bank reduce the real policy rate so that output returns to potential. At the lower real policy rate, there is more investment. More investment might, in the very long run, increase the level of potential and actual output. This could increase wealth (the expected present discounted value of future output) and thus shift the IS back, even in the short run. The net effect on the IS curve is ambiguous. Note that the model in the text has lump sum taxes. If taxes are not lump sum, the tax increase may increase distortions in the economy. These effects tend to reduce output (or the growth rate of output). So, the size of any increase in potential output could be affected by the mix of taxes chosen.

d. 4.

The IS curve shifts to the left. Rational expectations may be unrealistic, but it does not imply that every consumer has perfect knowledge of the economy. It implies that consumers use the best available information—models, data, and techniques—to assess the future and make decisions. Moreover, consumers do not have to work out the implications of economic models for the

176 .

future by themselves. They can rely on the predictions of experts on television or in the newspapers. Essentially, rational expectations rule out systematic mistakes on the part of consumers. Thus, although rational expectations may not literally be true, it seems a reasonable benchmark for policy analysis. 5.

The answers below ignore any effect on capital accumulation and output in the long run. Assume the tax cut policy in the future is temporary, so we need only worry about future short-run effects. a.

The effect on current output is fairly clear. The tax cut in the future leads to higher expected future income at the same interest rate. Wealth and consumption rises today. The IS curve shifts right and the LM curve remains unchanged. Current output rises. Here it is unclear whether the Fed is expected to increase future interest rates to return output to its original level. If this is the case, then the rightward shift in IS will be smaller and the increase in current output will be smaller.

This means that the Fed will increase the interest rate in the future (shift the LM curve up) so that actual output remains at the same level. The IS curve would still shift right but the LM curve shifts up so the intersection is at the same level of income. The higher interest rate reduces investment by the same amount that the decrease in expected future taxes increases consumption.

The contrast here is to part (a). If the Fed explicitly commits to no change in current and future real interest rates, then the IS shifts right with the decrease in expected future taxes. There is no leftward shift associated with a potential increase in real interest rates to return output to its original level.

A deficit reduction in the medium to long run implies that, if output is to return to potential, the real interest rate must drop. Thus, a fiscal consolidation could lead to higher investment and an increase in the growth rate of potential output.

The discussion in the text states that the first consolidation focused on tax increases and less on government spending cuts. The second did the opposite.

The evidence presented was that in the deficit reduction program that focused on spending cuts, household savings rate fell (which means the consumption function shifted up). Hence although the IS shifted left with the cut in G, it shifted right as consumer spending increased at the same level of disposable income. One interpretation is that consumer expected higher future disposable incomes and were willing to consume more today.

It is worrisome that the latter years of the consolidation continue to show very high unemployment rates, in fact, much higher than earlier in the decade. This cautions against thinking all was well in Ireland during the second fiscal consolidation.

Dig Deeper 7.

Future interest rates will tend to rise. Future output will tend to fall. Both effects shift the IS curve to the left in the present. Current output and the current interest rate fall. The yield curve has a larger positive slope after the announcement.

No.

177 .

Compared to original expectations, the nominee is expected to follow a more expansionary monetary policy. The slope of the yield curve will have a lower positive slope after the announcement.

If you download the daily stock price data - there is little change in the Dow Jones. There is a slight decline in bond yields after the nomination. You might interpret that to say expected inflation was stable or falling on the nomination. Since neither stock nor bond prices in financial markets did not change much, this is a hint that the nomination was not a surprise or at least did not shake up financial markets.

Explore Further 8.

The role of tax reductions and outlay reductions seems to be about equal.

Certainly from the viewpoint of 2009, this was back loaded. Most of the deficit reduction took place in the future.

There would be a belief in a lower future interest rate. This would mitigate any decline in output.

One clear advantage is that even though the nominal policy rate was at the zero lower bound, a positive inflation target, if believed and used to form expectations of inflation, would lead to negative real policy rates of interest.

The Index of Consumer Sentiment steadily increases over the period of fiscal consolidation. The increases in taxes and reductions in outlays did not hurt consumer confidence using this measure.

CHAPTER 18 Quick Check 1.

a. b. c. d. e. f. g. h. i.

True False. GDP = C + I + G + (exports – imports) so imports exceeding GDP is possible, but not likely. False. Not necessarily. It could simply be due to product preferences. False. It implies that FX will adjust to make returns equivalent. False. It is the price of the domestic currency in terms of the foreign currency. False. Differences in inflation rates can cause movements in opposite directions. True False. The domestic rate must equal the foreign rate minus the expected appreciation of the domestic currency. False. The statement should read: “Given the definition of the exchange rate adopted in this chapter, if the dollar is the domestic currency and the euro the foreign currency, a nominal exchange rate of 0.75 means that one dollar is worth 0.75 euros.” False. Domestic goods become relatively more expensive.

178 .

Domestic Country Balance of Payments (€) Current Account Exports

Imports

100 −75 (= 25 − 100)

Trade Balance Investment Income Received

Investment Income Paid

Net Investment Income

−15 (= 0 − 15)

Net Transfers Received

−25 −115 (= 75 – 15 − 25)

Current Account Balance Financial Account Increase in Foreign Holdings of Domestic Assets

80 (= 65 + 15)

Increase in Domestic Holdings of Foreign Assets

−50

Net Increase in Foreign Holdings

130 (= 80 − (−50))

Statistical Discrepancy

−15 (= 115 − 130)

Foreign Country Balance of Payments (€) Current Account Exports

100

Imports

25 75 (= 100 − 25)

Trade Balance Investment Income Received

Investment Income Paid

Net Investment Income

15 (= 15 − 0)

Net Transfers Received

25 115 (= 75 + 15 + 25)

Current Account Balance Financial Account Increase in Foreign Holdings of Domestic Assets

−50

Increase in Domestic Holdings of Foreign Assets

80 (= 65 + 15) −130 (= 50 − 80)

Net Increase in Foreign Holdings

15 (= 130 − 115)

Statistical Discrepancy

179 .

The nominal return on the U.S. bond is (10,000/(9615.38)) – 1 = 4%. The nominal return on the German bond is 6%.

Uncovered interest parity implies that the expected exchange rate is given by E(1 + i*)/(1 + i) = 0.764 euro per dollar.

If you expect the dollar to depreciate, this is expecting the euro to appreciate. The return on the euro bond is already higher (6% instead of 4%). Thus you would earn both the higher interest rate and the appreciation on the euro. You definitely buy the euro bond.

The dollar depreciates by 4%, so the total return on the German bond (in $) is 6% + 4% =10%. Investing in the U.S. bond would have produced a 4% return.

The uncovered interest parity condition is about equality of expected returns, not equality of actual returns.

Dig Deeper 4.

GDP is 15 in each economy. Consumers will spend 5 on each good.

Each country has a zero trade balance. Country A exports clothes to Country B, Country B exports cars to Country C, and Country C exports computers to Country A.

No country will have a zero trade balance with any other country.

There is no reason to expect that the United States will have balanced trade with any particular country, even if the United States eliminates its overall trade deficit. A particularly large trade deficit with one country may reflect the pattern of specialization rather than trade barriers.

The relative price of domestic goods falls. Relative demand for domestic goods rises. The domestic unemployment rate falls in the short run.

The price of foreign goods in terms of domestic currency is P*/E. A nominal depreciation (a fall in E) increases the price of foreign goods in terms of domestic currency. Therefore, a nominal depreciation tends to increase the CPI.

The real wage falls.

Essentially, a nominal depreciation stimulates output by reducing the domestic real wage, which leads to an increase in domestic employment.

Explore Further 6.

We are treating the United States as the domestic country when E is expressed as the number of foreign units (yen) per dollar.

Considering the evidence through 2018, the yen generally appreciated against the dollar from mid-1985 to mid-1995 from 1995 to 2007, dramatic changes were less. From 2007 to 2011 there was a 32% appreciation followed by a similar depreciation to 2012. , From 2012 to 2018 (the date at the time of writing there was an appreciation of the yen from 79 yen per US dollar to 110 yen per US dollar

180 .

Depreciation of the yen.

The appreciation from 2012 to 2018 would not help the Japanese recover from their continuing slump.

These answers are based on the World Economic Outlook published in April 2019. Your answers may vary if subsequent years are used. The sum of world current account balances should be zero. In 2018 (and all previous years), the sum was positive, which implies literally that the world as a whole was borrowing. Obviously, this cannot have been true.

In 2018, the United States was the world's biggest borrower by far. The rest of the advanced economies as a whole were lenders. The Euro area was a lender in 2018. The economies of the Middle East and developing economies in Asia were other large lenders. The emerging economies of central and eastern Europe, India and Latin America were large borrowers.

In 2018, the total saving of the advanced economies including the United States was $371.9B. The US was dissaving by $468.8 B. Thus, the advanced economies in total were saving and lending to the rest of the world, that is, the total saving in the advanced economies was positive, more than enough to cover US dissaving and still lend to the rest of the world.

The projections in the October 2018 World Economic Outlook from 2018 to 2024 do not suggest much change. The most interesting observation is that the United States will move further and further into current account deficit, at least measured in current dollars.

World saving essentially equals world investment, as must be true logically.

In 2018, U.S. saving was 19.0% of GDP, but U.S. investment was 21.6% of GDP. The United States financed the difference by borrowing from abroad.

Recently real GNP is between 1½ and 1 percentage point larger than real GDP. The difference is that Americans earn more income from American assets held abroad than non-Americans do on foreign assets held in the United States.

CHAPTER 19 Quick Check 1.

c. d. e. f.

False. It would appear that the current account deficit in Greece fell as output and imports fell. There would be less consumption in Greece and the average citizen would be worse off. False. An increase in the budget deficit will lead to an increase in the trade deficit, but we can't conclude that from the national income accounting identity. We have to use our model to make that prediction. False. An increase in spending will now be spread between domestic and foreign goods. True True True

181 .

False - when Greece chose to share the Euro currency with its trading partners it made a real devaluation more difficult since prices and wages adjust more slowly than nominal exchange rates.

a. b.

There is a real appreciation over time. Over time, the trade balance worsens. The domestic currency depreciates at the rate of π-π*.

The share of European spending on U.S. goods relative to U.S. GDP is (0.19)(0.123) = 2.3%.

U.S. GDP falls by 2(.05)(.023) = 0.23%.

U.S. GDP falls by 2(.05)(0.123) = 1.23%.

This is an overstatement. The numbers above indicated that even if U.S. exports to Europe fall by 50% (a huge amount), the effect is to reduce GDP by 0.5 × 2.3% = 1.15%. Exports falling by 50% would be a huge amount.

You will need to follow the text. For the upper right corner of Table 18-1, The level of output is lower than desired, and the net exports are positive. Your goal is to increase output and have a zero trade deficit. If you increase government spending, output rises and the trade surplus falls but remains positive. But it may not fall all the way to zero, if it stops short of zero, you will appreciate your currency. This will decrease net exports. You would then have to increase your increase in government spending. You can make choices until you hit a desired level of output and have a zero trade deficit. However, it is possible that your increase in government spending actually moved the trade surplus from positive to negative. Then you would have to depreciate your currency. This is the source of the ? next to ε. You repeat this type of analysis for every quadrant.

Dig Deeper 5.

The ZZ and NX lines shift up. Domestic output and domestic net exports increase.

Domestic investment will increase because output increases. Assuming taxes are fixed and do not respond to income, there is no effect on the deficit.

NX = S – I + T − G. Since the budget deficit is unchanged, and I and NX increase, S must increase.

Except for G and (for our purposes) T, the variables in equation (18.5) are endogenous. An exogenous shock such as an increase in foreign output can affect all of the endogenous variables simultaneously.

There must be a real depreciation.

Y = C + I + G + NX. If NX rises while Y remains constant, C + I + G must fall. The government can reduce G or increase T, which will reduce C.

182 .

Y = C + I + G + X – IM Y = c0 + c1(Y − T) + d0 + d1Y + G + x1Y* − m1Y Y = [1/(1 − c1 − d1 + m1)] [c0 − c1T + d0 + G + x1Y*]

Output increases by the multiplier, which equals 1/(1 − c1 − d1 + m1). The condition 0 < m1 < c1 + d1 < 1 ensures that the multiplier is defined, positive, and greater than one. As compared to the original multiplier, 1/(1 + c1), there are two additional parameters: d1, which captures the effect of an additional unit of income on investment, and m1, which captures the effect of an additional unit of income on imports. The investment effect tends to increase the multiplier; the import effect tends to reduce the multiplier.

When government purchases increase by one unit, net exports fall by m1ΔY = m1/(1 − c1 − d1 + m1). Note that the change in output is simply the multiplier.

The larger economy will likely have the smaller value of m1. Larger economies tend to produce a wider variety of goods, and therefore to spend more of an additional unit of income on domestic goods than smaller economies do. ΔY

ΔNX

small economy (m1 = 0.5)

1.1

0.6

large economy (m1 = 0.1)

0.2

Fiscal policy has a larger effect on output in the large economy, but a larger effect on net exports in the small economy.

It is convenient to wait to substitute for G until the last step. Y = C + I + G + X – IM = 10 + 0.8(Y − 10) + 10 + G + 0.3Y* − 0.3Y Y = [1/(1 − .8 + .3)](12 + G + 0.3Y*) = 2(12 + G + 0.3Y*) = 44 + 0.6Y* When foreign output is fixed, the multiplier is 2 (=1/(1 − 0.8 + 0.3)). The closed economy multiplier is 5 (=1/(1 – 0.8)). In the open economy, some of an increase in autonomous expenditure falls on foreign goods, so the multiplier is smaller.

Since the countries are identical, Y = Y* = 110. Taking into account the endogeneity of foreign income, the multiplier equals [1/(1 − 0.8 − 0.3*0.6 + 0.3)] = 3.125. The multiplier is higher than the open economy multiplier in part (a) because it takes into account the fact that an increase in domestic income leads to an increase in foreign income (as a result of an increase in domestic imports of foreign goods). The increase in foreign income leads to an increase in domestic exports.

If Y = 125, then Y* = 44 + 0.6(125) = 119. Using these two facts and the equation Y = 2(12 + G + 0.3Y*) yields 125 = 24 + 2G + 0.6(119), which implies G = 14.8. In the domestic economy, NX = 0.3(119) − 0.3(125) = 1.8 and T – G = 10 − 14.8 = −4.8. In the foreign economy, NX* = 1.8 and T* − G* = 0.

If Y = Y* = 125, then 125 = 24 + 2G + 0.6(125), which implies G = G* = 13. In both countries, net exports are zero, but the budget deficit is 3.

183 .

In part, fiscal coordination is difficult to achieve because of the benefits of doing nothing and waiting for another economy to undertake a fiscal expansion, as indicated from part (c).

Explore Further 9.

NX = National Saving − I.

2004 to 2008 have the largest trade deficits as a percent of GDP.

c. Year 1980-1989 1990-1999 2000-2009 2010-2018

Average Investment (% of GDP) 23.4 21.5 22.0 20.2

Average Trade Balance (% of GDP) – deficit −1.7 −1.3 −4.4 −3.1

Over these four decades it seems clear that the percent of GDP devoted to investment fell as the trade balance became progressively more negative. .

Yes. An increase in investment leads to more capital accumulation and more output in the future, and therefore to a greater ability to repay foreign debt.

In the early part of the period, the gap between GNP and GDP was about one-half a percent of GDP. In the later part of the period, the gap widens. Americans are earning a larger proportion of their income on foreign investments. We saw this in Chapter 17.

CHAPTER 20 Quick Check 1.

a. b. c. d. e. f.

g. h.

False. Interest rate parity means expected and current exchange rates will adjust to equate returns in countries. True True True True False. An increase in the domestic interest rate leads to an increase in the exchange rate and makes goods in the domestic country more expensive to trading partners and lowers exports. False. Fiscal expansion increases domestic output and creates a larger trade deficit. Uncertain. It depends on the policy response of the central bank under flexible exchange rate when the fiscal policy is changed. Under the flexible regime, the central bank may choose to leave the interest rate at its original value. In this case, fiscal policy has the same effects under fixed and flexible rates since the central bank is acting to keep the exchange rate at the original value. True (up to a possible risk premium)

184 .

True - countries do engage in trade wars where after one country increases its tariffs to try to reduce imports, the trading partner imposes tariffs in retaliation.

The appropriate mix is a cut in interest rates (shift the LM curve down) to lessen the value of the currency (and thereby to improve the trade balance) and a fiscal contraction (shift the IS curve to the left). If this is done correctly, the level of output will be unchanged and the trade balance will be less negative as net exports increase due to the depreciation of the currency. There would be more exports due to the depreciation and fewer imports (at the same level of income) due to the depreciation.

a. b.

Consumption increases because output increases. Investment increases because output increases and the interest rate falls. A monetary expansion has an ambiguous effect on net exports. The nominal depreciation tends to increase exports and reduce imports at the same level of income, but the increase in output tends to increase imports. While we would normally expect net exports to increase, you can construct cases where the marginal propensity to import is so large, net exports could fall.

The IS curve shifts right, because net exports tend to increase as foreign output rises. Domestic output increases if the central bank leaves the interest rate unchanged (the LM curve does not shift). The exchange rate will be unchanged

When the foreign interest rate rises, at the same domestic rate of interest, the domestic interest rate is relatively lower. The UIP curve will shift in so that the domestic currency depreciates. Note that the IS curve also contains a term in the foreign interest rate. The higher foreign interest rate, at the same domestic interest rate, will depreciate the domestic currency and increase net exports. The IS curve will shift out. Domestic output rises when the foreign country tightens its monetary policy. One cautionary note (see below) is that the tighter foreign monetary policy could reduce foreign output and thus decrease foreign imports (our exports).

The increase in both Y* and i* shifts the IS curve to the right. At the same domestic interest rate, the domestic currency depreciates and net exports rise. The increase in Y* directly increases net exports. Output will rise for both reasons. The UIP curve will shift left – at the same domestic interest rate and a higher foreign interest rate, the currency will depreciate.

If the domestic central bank matches the increase in foreign interest rates then although the UIP curve shifts left, the central bank increases the domestic interest rate so that the exchange rate remains unchanged. However, the effect of Y* on exports, net exports remains in play. So the IS curve will shift to the right. It is not clear whether domestic output will rise or fall. It will tend to rise as the IS shifts right. Domestic output will tend to fall as you move up the new IS curve with a higher interest rate.

The required domestic monetary policy change will depend on the effect on domestic output found in part (b). if the net effect of the increase in Y* and the increase in i (and i*) was to increase output, the domestic central bank would have to raise interest rates to leave output unchanged, this would appreciate the exchange rate. This policy might become necessary if domestic output had risen above potential output and there were worries about inflation.

185 .

However, it could be the case that the combined effect of the increase in Y* and the increase in i and i* reduced domestic output and increased unemployment so output was less than potential. Then the domestic central bank would have to lower interest rates. Dig Deeper 6.

The follower country must immediately raise interest rates to match the increase in interest rates in the leader country. Output would fall as you move up the IS curve. Assuming the expected exchange rate does not change, there is no change in the current exchange rate as long as increases in i* are matched exactly by increases in i.

The movement up the IS curve reduces output by reducing investment.

The follower country could use fiscal policy to shift the IS curve out and increase output back to its original level at the higher rate of interest. It would be desirable if the decline in output due to the leader country’s increase in interest rates moved output below potential output.

The fiscal policy that leaves consumption unchanged would have to leave output at the original level and taxes at their original level. Thus a fiscal policy that only increased government spending would work to leave consumption unchanged. When government spending rises, investment spending falls because the interest rate has increased.

The IS curve shifts to the left. Output falls. Investment falls – both due to the fall in business confidence and due to the decline in output. Consumption falls due to the decline in disposable income. Net exports would actually rise slightly as imports fall and the exchange rate is unchanged as long as interest rate and foreign interest rates remain unchanged.

The LM curve will shift down. You will move down the new IS curve. The fall in interest rates will stimulate investment. Net exports will rise as the exchange rate depreciates. You will move along the UIP curve. Consumption would return to its original level. Investment must actually fall in aggregate Here is the logic: since the exchange rate depreciated, net exports must rise. Since output returns to its original level and C and G are the same, I must fall to allow NX to rise.

There are not many policy options for the central bank. Fixing your exchange rate is choosing to follow the interest rate of your major economic partner.

The central bank under a flexible exchange rate has to option to set the domestic interest rate. Under fixed exchange rates, central banks simply set the domestic interest rate to the foreign interest rate.

Explore Further 8.

Et = Eet+1(1 + it + x)/(1 + i*t+1)

The IS curve slopes down as before, but with the result in part (a) substituted for the nominal exchange rate in the NX function.

The IS curve shifts right, because the fall in the expected exchange rate creates a depreciation (which leads to an increase in net exports) at the original interest rate. The interest parity line shifts left. Output increases, net exports increase, and the currency

186 .

depreciates. Note that the output effect, by itself, tends to reduce net exports. But in this case, output increased because net exports increased.

An increase in x tends to increase the value of the domestic currency and therefore to shift the IS curve to the left. According the assumption of the problem, the IS curve returns to its original position. As a result, the combined effect of the increase in the expected exchange rate and the increase in x is no change in output. Since there is no change in output, there is no change in net exports or the exchange rate. The increase in x shifts the interest parity line to the right, back to its original position.

Yes and yes.

a-b.

Answers to this question could vary substantially depending upon movements of the dollar. According to data in The Economist on April 13, 2019, the dollar was expected to depreciate against the pound, Euro and Canadian dollar over the 10-year period (US 10year bond yields were higher than rates in those three countries) and appreciate against the Chinese and Mexican currencies (US 10-year bond yields were lower than 10-year bond yields in China and Mexico)

The largest interest rate gap in the 10-year bond yields above was between the Mexican rate (8%) and the US rate (2.5%). This implies an expectation that there will be a significant depreciation of the peso. This is a nominal depreciation – which would be needed if Mexico has higher inflation that the United States. In the data from the same issue of The Economist, inflation in the United States was forecast to be 2.2% in 2019 while inflation in Mexico was forecast to be 4,1%. If that large difference were expected to persist over the decade, it would account for the large difference in bond yields between the United States and Mexico

10.

You will have many search results. You should find that China did raise tariffs on US exports to China. Stories also seemed to cover how the Trump tariffs raised prices for imported good paid by American consumers. The tariffs were not a large enough factor to move the level of real GDP very much at the time of writing

CHAPTER 21 Quick Check 1.

a b. c. d e. f. g. h. i. j.

False. Real exchanges rates could change as the relative price levels change. False. Inflation rates are independent of whether a currency floats or is fixed. False. A devaluation is a decrease in the nominal exchange rate. True. Britain returned to the gold standard at an exchange rate in terms of gold that overvalued the pound. True True (unless the exchange rate is fixed) True False. Keeping a fixed exchange rate can be very costly. False. There has been some labor mobility within Europe but less than expected. False or Uncertain. Currency boards are specific to a country’s economic circumstances and have had mixed success.

187 .

The (i* − πe) is the real interest rate in the domestic country. The foreign nominal interest rate and the domestic nominal interest rate are the same value in a fixed exchange rate regime.

The term

The real exchange rate is appreciating as P is rising more quickly than P*. Domestic inflation is 3% per year and foreign inflation is 2% per year. Between period 1 and period 5, the IS curve shifts left.

The real exchange rate is depreciating as P* is rising more quickly than P. Domesticinflation is 2% per year and foreign inflation is 3% per year. Between period 1 and period 5, the IS curve shifts right.

The real exchange rate is depreciating as P* is rising more quickly than P. Domestic inflation is 2% per year and foreign inflation is 3% per year. Between period 1 and period 5, the IS curve shifts right.

If the foreign economy is always in medium run equilibrium, then foreign income is at the natural level and foreign inflation is constant.

When both economies are in medium run equilibrium, they will share the same value of inflation at the anchored level π = π ∗.

The key feature of the diagram will be that the domestic country will be in short run equilibrium where the actual level of output Y will be less that the natural rate of output Yn. To return to a medium run equilibrium, inflation in the domestic country will be less than π for a prolonged period. As this occurs, the real exchange rate will gradually depreciate, and the IS curve will shift right.

Start with the same diagram as in part c. Immediately devalue so the real exchange rate falls and the IS curve shift right. The economy returns to full employment immediately.

The devaluation means that the return on the domestic bonds over the devaluation was much lower than the return on the foreign bonds over the devaluation. It is hard to know if the bondholders will believe the devaluation is one-time only. If they believe another devaluation is imminent, domestic interest rates will be higher than foreign interest rates.

The domestic interest rate in period 1 will be the foreign interest rate = 3%.

The domestic interest rate in period 2 will be the foreign interest rate = 3% plus the expected rate of depreciation = 10% for a total of 13%. This continues into period 3.

The resolution of the crisis in period 4 occurs when beliefs change about the expected future exchange rate. The peg becomes credible.

EP∗ is the real exchange rate. An increase in this value is an appreciation and P the appreciation reduces demand for domestic goods. The IS curve shifts left.

188 .

The domestic interest rate has to rise to 23% to maintain uncovered interest rate parity. It only rises to 15%. Foreign exchange reserves would fall in this case.

There is devaluation from period 5 to period 6. The expected exchange rate equals the actual exchange rate at the new lower level. It may be difficult for the government and central bank to convince bondholders that they will never devalue again when they just did.

There must have been a change in the expected exchange rate in the future.

The headline does make sense. From an American perspective, halfway through a 30-day holding period, foreign (European) interest rates are expected to fall. This makes the denominator of expression (20.5) smaller and the value of the exchange rate larger. This is an appreciated dollar and is consistent with the words “dollar rises.”

The headline does make sense. Using Expression (20.5), the markets appeared to learn that American interest rates will be lower longer than they had expected. Thus, the numerator of (20.5) falls and the value of the expression falls and the dollar falls.

In expression (20.5), the current account announcement affects the last term, the expected value of the exchange rate in the future. A larger deficit implies more debts to be repaid and the need for a lower real and nominal exchange rate.

Dig Deeper

The vertical axis is an index of each country’s nominal exchange rate against the German currency. All exchange rates are set to 1 in January 1992. The largest depreciation appears to be Sweden of about 25%. France had the smallest depreciation - essentially of zero.

France.

The group at the bottom – Sweden, Italy, Finland and Spain – had the largest depreciations so the question implies they were the most overvalued.

We redefine the exchange rate so that they are, from the point of view of Canada and Mexico, the number of foreign currency units bought with a unit of domestic currency. An appreciation of the currency makes this a bigger number and a depreciation a smaller number. FRED presents the exchange rates in the opposite way, that is, treats the United States as the domestic country.

There is a very brief period where the peso is fixed to the dollar from March 1994 to November 1994. When the peg was released the peso depreciated (the US dollar appreciated) Following the sharp appreciation in late 1994, the exchange rate (US cents per peso) gradually moved from 15 US cents to 5 US cents per peso. This is a nominal depreciation. There is a substantial appreciation in real terms that peaks around 2002. Mexican inflation must have been higher than American inflation for that period. After 2002 there is a real depreciation of the peso, from a peak value of the FRED index of 130 in 2002 to about 80 in 2018. Such a real depreciation would increase Mexican exports to the United States and reduce Mexican imports from the United States. The nominal depreciation of the peso in the same period was from about 10 pesos per US dollar to 5 pesos per US dollar. This would account for most of the real depreciation.

189 .

The Canada-US real exchange rate has fluctuated a lot - is a real exchange rate that has fluctuated a lot – about 35% or more over the time period. There is no period where the Canadian dollar is pegged (this occurred from 1962–1970). The real exchange rate index tracks the nominal exchange rate index so closely because Canada and the United States have a similar inflation history. There may or may not have been benefits to have a fixed nominal exchange rate between these two countries. The argument against is that Canada experiences different shocks than the US economy, that factor markets are not integrated and that exchange rate crises may have been avoided. The argument for a fixed exchange rate would be that, in a way similar to Europe, the two economies trade a lot and large real exchange rate movements might be undesirable.

Explore Further

The specific answers will vary depending on when the data is accessed. The general answer is given in the comments after part (c). The exchange rate is many times more variable than the interest rate differential. a.

There is a very long period from January 1994 to June 2005 where the value of the yuan was fixed at or near 12 US cents per yuan. There is a second period from July 2007 to June 2010 where the exchange rate appears to be fixed at or near 14.6 US cents per yuan.

The value of the real exchange rate is not fixed during the first period. Instead there is a significant real appreciation followed by a significant real depreciation. In the real appreciation, aggregate demand would have been reduced, in a real depreciation, aggregate demand would have increased.

From July 2007 to June 2010, the value of the yuan was very close to 14.6 US cents. This was a second period of fixed exchange rates. When the exchange rate was allowed to be flexible, there was a rapid appreciation. That suggests markets expected the long run real exchange rate to be a higher below than the real exchange rate in 2010. Thus China may have prevented a rise in the yuan between 2007 and 2010. This would increase aggregate demand in China

CHAPTER 22 Quick Check

a. b. c. d. e. f. g. h. i.

False. Monetary policy has been shown to be effective in stimulating growth. True True True/Uncertain. False. The evidence does not support the existence of political business cycles. False. These rules worked well until they were abandoned after 1998. False. See the Focus box on page 446. These rules have been largely ineffective. True Uncertain. It may be wise for a government to commit not to negotiate with hostage takers as a means to deter hijackings, even recognizing that after a hijacking has taken place, there

190 .

j. k. 2.

a. b. c.

is a strong incentive to negotiate. However, the phrase “under no circumstances” is categorical. There may some circumstances under which a government might wish to violate its commitment. This statement, of course, illustrates the difficulty of precommitment. Can a government really commit not to negotiate, no matter what the circumstances, even if these circumstances may not have been imagined at the time the commitment was made? True False. Tax cuts come first which leads to higher deficits and pressure to reduce spending. Inflation will increase in the fourth year. The President should aim for high unemployment early in the administration, to reduce inflation before the fourth year. The policies are not likely to achieve the increase in output desired in the fourth year. Since people are forward-looking, expected inflation for the fourth year will account for the intentions of policymakers. If inflation equals expected inflation, unemployment equals the natural rate.

Answers will vary, but there is some discussion of this issue in the text.

In 1989, New Zealand wanted to eliminate fears that the central bank might try to reduce unemployment below the natural rate with expansionary monetary policy and higher inflation. The single goal for monetary policy was intended to stabilize expected inflation and prevent any possibility that monetary policy could be manipulated for political advantage.

In 2018, New Zealand decided that the single goal for monetary policy placed too tight a constraint on its central bank to react to shocks to the economy. It was decided that giving the central bank the power to stabilize employment would be useful.

Dig Deeper

π te = 0.5(πD + πR)

The unemployment rate will be less than the natural rate. Inflation will be higher than expected.

The unemployment rate will be greater than the natural rate. Inflation will be lower than expected.

The results fit the evidence in Table 21-1 if one looks at the first two years of each administration, and not just the first year.

The unemployment rate will equal the natural rate, because π = πe. There will be high inflation.

The party who won the election would have no control over monetary policy. The elected party would still control fiscal policy. You would have to make an argument that parties would tend to have expansionary fiscal policy in the last two years year before the election and that the central bank, in spite of independence and an inflation target, was willing to

191 .

allow faster economic growth and lower unemployment lower as a result of the fiscal expansion and the risk of missing the inflation target. 7.

If the Republicans cut military spending, the Democrats get 1 if they cut welfare, but 3 if they do not. So their best response is to vote against welfare cuts. The Republicans will get –2 in this case.

If the Republicans do not cut military spending, the Democrats get –2 if they cut welfare, but –1 if they do not. So their best response is not to cut welfare. The Republicans will get –1 in this case.

Given the answers above, the Republicans will not cut military spending, and the Democrats will not cut welfare. The two parties are locked in a bad equilibrium. They could make a deal: both vote for cuts. If they do, they will both be better off.

Explore Further

Answers will vary.

Although this is clearly a matter of opinion, the objectives of monetary policy as stated in the Act are quite extensive. You can argue that all of the stated objectives are worthy policy goals. It might seem that stable prices (low or zero inflation) would conflict with maximum employment. The Act explicitly says the Fed is to control the growth of money when it now targets interest rates. It is somewhat unclear what a moderate long-term interest rate is. The vagueness of the goals makes “Fed-watching” an activity where market observers try to infer from the Fed’s actions, which goals are most important.

Although this is clearly a matter of opinion, the requirement that the Fed Chair appear regularly before Congress could be interpreted as an attempt to make the Fed accountable to Congress. This would seem to make the Fed less independent. The President appoints and the Congress must approve members of the Federal Reserve Board. However once appointed there is a 14-year term for a member. This long term protects the Federal Reserve Board member from having to take instructions from the Congress. They always retain their job. This would explain why the Fed is a relatively independent central bank in Figure 21-3.

CHAPTER 23 Quick Check

a. b. c. d. e. f. g.

False. The official deficit is a nominal number. True True True False. Cyclically adjusted deficits are fine and should be offset by future surpluses. True False. Many countries have debt-to-GDP ratios over 100% including the U.S.

192 .

h. i. j. k. l. m. 2.

True False. It can be smaller or larger. False. Inflation could be negative. False. The need for a fiscal consolidation depends on many other factors. True False. Borrowing and lending stop which reduces investment and output. First, even a temporary deficit leads to an increase in the national debt, and therefore to higher interest payments. This, in turn, implies continued deficits, higher taxes, or lower government spending in the future. Second, the evidence does not support the Ricardian equivalence proposition. Third, if Ricardian equivalence did hold, then government spending would have the same effect on output regardless of whether it was financed by bonds (i.e., with a deficit) taxes. Thus, a deficit, per se, would not be needed to stimulate output. Fourth, war-time economies are already low-unemployment economies. There is no need for further stimulation by using deficits rather than tax finance. The only correct part of the statement is the first sentence. A deficit can be preferable to higher taxes during a war, but not for the reasons stated here.

Interest payments are 10% of GDP, so the primary surplus is 10% − 4% = 6%.

Real interest payments are (10% − 7%) = 3% of GDP. So the inflation-adjusted surplus is 6% − 3% = 3%.

Output is two percent lower its natural level. Using the rule of thumb in the text, the surplus is lower by 0.5*2% = 1%. So the cyclically-adjusted, inflation- adjusted surplus is 2%.

The change in the debt to GDP ratio = (3% − 2%) − 6% = −5%. The debt to GDP ratio falls by 5% in the first year, and continues to fall thereafter. Ignoring any effect of output on tax revenue (i.e., assuming a primary surplus of 6% forever), the debt to GDP ratio falls below 48% in ten years.

If money growth = 25%, 50%, 75%, seignorage =162.5, 325, 487.5.

In the medium run, if money growth = 25%, 50%, 75%, seignorage = 162.5, 200, 112.5. The fall in real money balances associated with higher ongoing inflation reduces the potential for seignorage. Part (a) did not allow for this effect.

Dig Deeper

The new domestic interest rate is 10% + 10% = 20%. So, assuming that expected depreciation was previously zero, the domestic interest rate increases from 10% to 20%.

The real interest rate increases from 3% to 17%. The high real interest rate is likely to decrease growth.

The official deficit increases from 4% to 14% of GDP. The inflation-adjusted deficit increases from –3% (a surplus) to 7% (a deficit).

In the first year, the change in the debt ratio = (14% − 0%) − 6% = 8%. It goes up very quickly.

193 .

The IS curve shifts right. Output rises. The government finances the extra spending by borrowing.

The IS curve shifts right, but by less than the amount in part (a). In fact, the IS curve will shift to the right by exactly the increase in government purchases, because the balanced budget multiplier is one (see Chapter 4, problem 4). Output increases, but by less than then amount in part (a).

c-d.

The results are the same as in part (b). If Ricardian equivalence holds, the financing mechanism is irrelevant. If taxes are not increased, consumers simply increase saving by the same amount as the increase in government spending. So regardless of the financing mechanism, the effect on consumption is the same.

Statement (i) is false. Statement (ii) is true.

Explore Further

Since the real interest rate equals the growth rate, the annual change in the debt to GDP ratio is simply the primary deficit, or 4% of GDP. In 10 years, the debt to GDP ratio rises from 40% to 80%.

In 10 years, the debt to GDP ratio rises to 93%.

The answer is the same is in part (b), because the difference between the real interest rate and the growth rate is the same as in part (b).

After 10 years, the primary deficit must fall to zero to maintain the debt-to-GDP ratio of 50%.

After 5 years, the debt-to-GDP ratio will be 60%. A primary surplus of 2% of GDP for each of the years 6 through 10 is required to reduce the debt-to-GDP ratio to 50% after 10 years.

If the growth rate declines, the debt-to-GDP ratio will tend to grow more quickly, so a larger reduction in the primary deficit is required to achieve the debt-to-GDP objective.

The policy in part (e) is probably more dangerous. First, this policy relies on the promise of future deficit reduction, which is less credible than current deficit reduction and may make financial market participants nervous about lending to the government. Second, this policy requires a large policy change—from a 4% primary deficit to a 2% surplus— between years 5 and 6. Such a large policy change is likely to have a negative effect on growth, and perhaps a larger negative effect than would be predicted by standard models, which are likely to be more accurate at predicting the effect of smaller policy changes. Answers will depend upon current Fed policy.

Between 2016 and 2017, the latest year in this data: Over 2017, (the latest years as this is written), the ratio of debt-to-GDP fell by 0.6 percentage points of GDP. The ratio of debt to GDP rose sharply in the crisis years. Before the crisis, the ratio of debt to GDP wasaround 65%. By 2012 the ratio of debt to GDP was up to 100%.

194 .

The primary deficit in 2017 was 2.2%. The ratio of debt-to-GDP can fall and did fall in 2017 even if there is a primary deficit as long as the growth rate of income “g” is sufficiently larger than the real interest rate “r.”

The missing term is (r − g) times the ratio of debt to GDP. The latter value is 105% (think of it as 100% or 1). Then the (r − g) term needs to equal about −2% to offset the primary deficit of 2%. This would happen if the real interest rate were zero and economic growth were 2%. This seems plausible in this period. Your calculations may vary.

Japan has by far the largest debt-to-GDP ratio, over 200% in2017. The lowest debt-to-GDP ratio is in Germany at 64%. In 2017, the United States has the largest overall deficit and Germany was the only G7 country with an overall surplus. These are not primary surpluses, these are overall surpluses.

In 2018, there is no year in the next decade without a deficit.

Yes, the outlays include the interest on the debt and transfers.

Rise.

You need to look at three graphs (1) the nominal interest rate is assumed in 2018 to be about 3% over the decade (2) inflation is assumed to be 2% (3) real output growth is assumed to be 2%. Thus r − g = −1%

CHAPTER 24 Quick Check

a. b. c. d. e. f. g.

h. i. j. k. l. 2.

False. Seignorage profits are typically very small and not sufficient to warrant the costs of higher inflation. False. The Fed is also charged with growing the economy and job creation. False. Figure 23-1 shows several years of divergence between inflation and money growth. False. Evidence suggests that people have money illusion, when would seem to imply that inflation would distort decision making. False. The target inflation rate of most central banks is 2%. True. The capital gains tax is not indexed to inflation. True or uncertain. The Taylor rule uses both inflation and unemployment to help determine the interest rate. If you limit the reference to recessions and booms as a reference to the unemployment rate, the answer would be false. False. Zero bound did not emerge as an issue until after the financial crisis of the late 2000s. True True True True In the medium run equilibrium, the real interest rate is at rn. This is the real interest rate where aggregate demand is equal to the natural level of output. Actual inflation will equal expected inflation and target inflation. The target nominal interest rate will be i* = rn + π*.

195 .

The right-hand side of the money demand equilibrium will not change. Thus, the left-hand side must remain unchanged. The growth rate of money will equal the growth rate of prices.

The right-hand side of the money market equilibrium will now grow at 3% per year. Thus, the real money stock must grow at 3%. Thus, the growth rate of M must be 3 percentage points higher than the growth rate of P. You would expect money growth to be larger than inflation if there is growth in potential output.

In the part of Figure 23-1 before 1995, money growth appears to exceed inflation (price growth) by about 2-3 percentage points. This gap would be accounted for by growth in output. The results in parts b and c are consistent with Figure 23-1 up to 1995.

i. ii. iii. iv.

Between 1993 and 2018 the ratio of currency to GDP rose from about 5% to about 8%. It is not clear whether this is surprising. The nominal interest rate which is the opportunity cost of holding currency is lower in 2018 than it was in 1993. However, it also seems like many ways other than cash to make payments were created between 1993 and 2018.

The arguments for zero inflation mentioned in the text are (1) lower shoe leather costs (2) smaller tax distortions or no tax distortions (3) money illusion issues would be avoided (4) you would avoid a slippery slope where is 2% inflation is all right, so is 3%.

The argument in favor of inflation higher than 2%, in the example 4%, is that (1) real wage reductions might occur more easily if needed (2) there would be a tiny amount more seignorage (3) the zero lower bound on the nominal interest rate would be encountered less frequently.

The nominal interest rate is ($100 − $PB)/PB

The real interest rate is [($100/Pt+1) − ($PB/P))] / ($PB/P))

The payment on the bill will rise to $110. The real interest rate will simply be the nominal interest rate.

It depends on your sensitivity to risk and your perception of the variation of actual inflation around the level of expected inflation. The indexed bond offers a certain real return. If you dislike risk, purchasing the indexed bond will appeal to you.

This would reduce average cash holdings – easier to get cash when needed This would reduce average cash holdings This would reduce average cash holdings This would also reduce average cash holdings

The non-indexed bond has some risk. If inflation is lower than expected, its real return will be higher. If inflation is larger than expected, its real return will be lower. You might like the possibility of the higher return and are willing to accept the risk. In addition, you might disagree with the market on the level of expected inflation. If you thought expected inflation was going to be lower than the general consensus, then you would buy the nominal bond.

196 .

The Fed’s goal in quantitative easing was to increase the price (lowering the yield) on these securities by purchasing and holding more of them. The goal was to make mortgages less expensive and stimulate the purchase of new houses. The other interpretation would be that the risk premium on these securities has increased and the Fed was trying to offset part of that increase.

The Fed was trying to raise the price (lower the yield) on these securities. In terms of Chapter 14, the term premium must have been higher. By taking the supply of these longterm bonds off the market, the Fed was hoping to reduce long-term yields on government bonds. Then they wanted to have the private sector see the lower yields and be more willing to borrow for new investments.

You would expect to see the interest rates on mortgage-backed securities rise

You would expect to see long-term bond yields rise.

The changes in the balance sheet between 2015 and 2018 show a reduction in the holding of long-term Treasuries and an increase in the holding of short-term Treasuries. This is evidence of unwinding. But there is a very small increase in total holdings of mortgagebacked securities – evidence against unwinding.

The minimum down payment is 20% of the home’s value or $60,000.

If the loan-to-value maximum is reduced, this increases the down payment. We would expect this to reduce the demand for homes as households have to save a bit longer to achieve the required down payment.

Canadian home prices have continued to rise and the rate of increase was not slowing up to 2015. By increasing the minimum down payment on very expensive homes, the Finance Minister hoped to reduce the demand for homes and control a potential bubble. House prices in Canada have slowed their rate of increase starting in 2017 to date so perhaps the policy had some effect.

This member bank has excess reserves of $10 billion. They would prefer to deposit these reserves at the Fed where they would earn 0.5% than to lend on the overnight market where they would earn only 0.4%.

This bank is short of reserves by $20 billion. They would borrow from the discount window at 0.75% rather than pay 0.8% on the overnight market.

If all banks in America were member banks, then the Federal Reserve would always make loans available overnight at the discount rate to all banks. No loan would ever be made privately at a higher rate than the discount rate. Similarly, if all banks had access to deposits at the Fed’s deposit rate, there would be no overnight loans at a lower rate.

This is a non-member bank without the option to increase its deposits at the Federal Reserve and earn the Federal Reserve deposit rate. They have excess reserves and they would try to lend them. It is possible that another non-member bank without access to the Federal Reserve needs the reserve. They could agree to this transaction at lower than the Federal Reserve deposit rate if a lot of non-member banks had reserves to lend and very few non-member banks wanted reserves. This appears to have been what happened for most of the period after 2015 until 2019 when the two rates converge at the deposit rate.

197 .

Dig Deeper

c. 9.

r = 4% − 0% = 4%;

ii.

r = 14% − 10% = 4%

r = 4%(1 − 0.25) − 0% = 3%;

ii.

r =14%(1 − 0.25) − 10% = 10.5% − 10% = 0.5%

Given the deductibility of nominal mortgage interest payments, inflation is good for homeowners in the United States. Discussion question so answers will vary on whether they agree with the colleague’s statement. The Taylor rule would take the guesswork out of monetary policy and keep policy makers restrained. However, it would also limit a central bank’s ability to combat unusual situations. However, Taylor did not argue the rule should be followed blindly but maintained it was a useful way to think about monetary policy.

Explore Further

10.

The Bank of Japan and the Federal Reserve all spent considerable time with their policy rate of interest very close to zero. Both the Bank of Canada and the Bank of England had policy rates that bottomed at 0.5 percentage points, not quite zero. These central banks still have room to lower nominal rates further. In their circumstances, they did not (quite) hit the zero lower bound. The European Central Bank had a policy interest rate that was negative from 2015 to 2018. Negative interest rates are a story for another day.

11.

Answers will depend upon current Fed policy.

198 .