Blanchard Macroeconomics Global Edition, 6E Olivier Blanchard Solution Manual

Instructor’s Manual for

Microeconomics 6th Edition Global Edition By Dr. LaTanya Brown-Robertson Bowie State University

CONTENTS CHAPTER 1

A Tour of the World

1

CHAPTER 2

A Tour of the Book

7

CHAPTER 3

The Goods Market

12

CHAPTER 4

Financial Markets

17

CHAPTER 5

Goods and Financial Markets: The IS-LM Model

23

CHAPTER 6

The Labor Market

29

CHAPTER 7

Putting All Markets Together: The AS-AD Model

34

CHAPTER 8

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

43

CHAPTER 9

The Crisis

47

CHAPTER 10 The Facts of Growth

55

CHAPTER 11 Saving, Capital Accumulation, and Output

59

CHAPTER 12 Technological Progress and Growth

64

CHAPTER 13 Technological Progress: The Short, the Medium, and the Long Run

68

CHAPTER 14 Expectations: The Basic Tools

72

CHAPTER 15 Financial Markets and Expectations

77

CHAPTER 16 Expectations, Consumption, and Investment

82

CHAPTER 17 Expectations, Output, and Policy

87

CHAPTER 18 Openness in Goods and Financial Markets

90

CHAPTER 19 The Goods Market in an Open Economy

95

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

101

CHAPTER 21 Exchange Rate Regimes

107

CHAPTER 22 Should Policymakers Be Restrained?

113

CHAPTER 23 Fiscal Policy: A Summing Up

117

.

CHAPTER 24 Monetary Policy: A Summing Up

121

CHAPTER 25 Epilogue: The Story of Macroeconomics

125

Answers to End-of-Chapter Problems

129

.

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 begins with an overview of the macroeconomic crisis then moves to describe the issues of concern to macroeconomists who study the United States, Europe, and China. 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 macroeconomic crisis which has impacted 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 briefly the concepts of output, growth, the unemployment rate, and the inflation rate. A 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.

2. 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 Crisis Included in the 6th edition of the textbook is a discussion around the major macroeconomic crisis that occurred in 2008. Table 1-1 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 3.2%, with advanced economies growing at 2.6% per year, and emerging and developing economies growing at an even faster 6.5% per year. By 2008, the world, advanced and emerging economy output growth rate began to decline marking the beginning of the macroeconomic crisis.

Highlights of the Macroeconomic Crisis: • U.S. Housing prices, which had doubled since 2000, started to decline in 2007.

• Mortgage loans which had been given out during the earlier expansion were of poor quality causing many borrowers to increasingly be unable to make mortgage payments. .

• •

• •

•

• • •

• •

•

•

Declining housing prices caused the mortgage of the homes to exceed the market price of housing thus creating an incentive to default.

Banks that mortgaged 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, created a complex understanding of the value of the asset making it impossible to appraise.

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 causing other banks that were also unable to borrow, and holding assets of an uncertain value to be perceived as a risk. Within weeks the whole financial system was in jeopardy.

Figure 1-1 shows how financial crisis became an economic crisis with the evolution of the three stock price indexes (for the United States, Euro area and emerging economies) declining by the end of 2008, loosing half or more of its value by 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 cut back on investment along a decline in the building of new homes.

Despite strong actions by the Fed, to cut the interest rate, and the U.S. government which cut taxes and increased government spending, the demand and output continued to decline in the U.S. A decline in the U.S. importing goods from abroad along with U.S. banks needing repatriate funds from other countries moved a U.S. crisis into a world crisis.

By 2009, average growth in advanced economies was -3.7%, by far the lowest annual growth rate since the Great Depression. Growth in emerging and developing economies remained positive but was nearly 4 percentage points lower than the 2000–2007 average.

Table 1-1, shows by 2010, both advanced countries and emerging and developing economies began to turn positive, thanks to strong monetary and fiscal policies and the slow repair of the financial system.

Figure 1-2 displays consistantly high unemployment rates for the United States and Euro area since the beginning of the crisis. The chapter discusses the factors behind the high unemployment rates and low growth of output, which are: o Housing prices are still declining. o Housing investment re-mains very low. o Banks are still not in great shape, and bank lending is still tight. o Consumers who have seen the value of their housing and their financial wealth fall are cutting consumption. o The crisis has also led to serious fiscal problems.

2. The United States In the United States, just before the crisis, the rate of growth of the economy was 2.6% which was a bit lower than the previous 20-year average, but still fairly high for an advanced country. On average, the unemployment rate and the inflation rate was lower over this period than over the period since 1980. During the crisis output did not grow in 2008 and declined by 3.5% in 2009. The economy rebounded by 2010, with growth of 3%. Unemployment increased dramatically, to nearly 10%. Inflation declined, being slightly negative in 2009 and then staying positive but low since then. The numbers of 2011 and 2012 are forecast as of fall of 2011.

The high unemployment rate along with the very large budget deficit in the United States tends to .

be the preeminent issues facing the United States.

Figure 1-4 shows the evolution of the U.S. federal budget surplus since 1990.

• The 1990s - After an increase in deficits due to the 1990–1991 recession, the rest of the decade was associated with a steady improvement in the budget, and by 1998, the budget had actually gone from deficit to surplus. o The main reasons for the steady improvement were twofold. First, strong output growth for most of the decade led to strong growth of government revenues.

Second, rules were devised and implemented to contain government spending, from the use of spending caps on some categories of spending to the requirement that any new spending program be associated with an equal increase in revenues. - (Once the budget surplus appeared Congress became willing to break its own rules and allow for more spending.)

• The Early 2000s - The budget deficit returned due to Bush administration convincing Congress to cut taxes with the goal of spurring growth.

• The Crisis - The budget deficit in 2007 was 1.7% of GDP increased to 9% of the GDP to 2010 due to: o Lower output growth which has led to lower government revenues. o A decline in Federal revenues, from 18.9% of GDP in 2007, to 16.2% of GDP in 2010. o Increase in Federal spending, from 20.6% in 2007, to 25.3% in 2010.

• There is an agreement that the budget deficit must be reduced but the disagreement is based upon when and how. o When- Some economist argue the deficit should start now and proceed rapidly to convince people that the U.S. government will do what is needed to stabilize debt.

Other, economist argue that too fast a reduction through an increase in taxes and a decrease in spending will slow down growth at time when the unemployment rate is persistently high. o How - Republican s believe the deficit reduction show be achieved through a decrease in government spending. Democrats most programs are justified and the adjustment should occur through an increase in taxes.

2.

Europe Figure 1-5 displays a map the EU17 that uses the Euro as a common currency along with the 2010 output of the Euro area's output for the countries of France, Germany, Italy and Spain.

Table 1-3 shows that over the 2000-2007 time period right before the crisis, the Euro Area together experienced positive but relatively low growth The Euro Area also endured low inflation and continued high unemployment. The crisis caused growth to decline to negative 4.2% by 2009 and the unemployment rate to reach 10.1% by 2010.

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 tight monetary policy by the European Central Bank. The suggested remedy is lower interest rates. According to the second view, high unemployment is a result of rigid labor market institutions, particularly with respect to worker protection. 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 Denmark and the Netherlands have low unemployment rates, despite providing 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 surfing among Euro members. Highlighting the deep recessions of countries from Ireland, to Portugal, to Greece, unable to individually decreasedtheir interest rate or depreciated their currency. This has 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, and extremely disruptive, leading to even deeper problems for the country that has exited. Policy issues associated with monetary union are discussed further in Chapter 21.

4. 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 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.

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” is discussed in a margin note in Chapter 10, but 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.

2. Alternative Sequencing i. The Global Crisis. Indeed, instructors could use the global crisis as the running example to introduce most the material. The 6th 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. ii.

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.

3.

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 Congress should do at federal budget deficit and the debt. 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 economy.

2.

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.

3.

Distribution of Economic Benefits .

The second edition of the text included a discussion about wage inequality in the section on the U.S. economy. In subsequent editions, including the current edition, wage inequality is discussed in Chapter 13. Instructors may wish to raise this issue in the introductory discussion of the U.S. economy.

.

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 begins with an overview of the macroeconomic crisis then moves to describe the issues of concern to macroeconomists who study the United States, Europe, and China. 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 macroeconomic crisis which has impacted 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 briefly the concepts of output, growth, the unemployment rate, and the inflation rate. A 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.

2. 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 Crisis Included in the 6th edition of the textbook is a discussion around the major macroeconomic crisis that occurred in 2008. Table 1-1 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 3.2%, with advanced economies growing at 2.6% per year, and emerging and developing economies growing at an even faster 6.5% per year. By 2008, the world, advanced and emerging economy output growth rate began to decline marking the beginning of the macroeconomic crisis.

Highlights of the Macroeconomic Crisis: • U.S. Housing prices, which had doubled since 2000, started to decline in 2007.

• Mortgage loans which had been given out during the earlier expansion were of poor quality causing many borrowers to increasingly be unable to make mortgage payments.

• Declining housing prices caused the mortgage of the homes to exceed the market price of housing thus creating an incentive to default.

1

.

2 ❖ CHAPTER 1

•

• • • • • • • • • •

Banks that mortgaged 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, created a complex understanding of the value of the asset making it impossible to appraise.

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 causing other banks that were also unable to borrow, and holding assets of an uncertain value to be perceived as a risk. Within weeks the whole financial system was in jeopardy.

Figure 1-1 shows how financial crisis became an economic crisis with the evolution of the three stock price indexes (for the United States, Euro area and emerging economies) declining by the end of 2008, loosing half or more of its value by 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 cut back on investment along a decline in the building of new homes.

Despite strong actions by the Fed, to cut the interest rate, and the U.S. government which cut taxes and increased government spending, the demand and output continued to decline in the U.S. A decline in the U.S. importing goods from abroad along with U.S. banks needing repatriate funds from other countries moved a U.S. crisis into a world crisis.

By 2009, average growth in advanced economies was -3.7%, by far the lowest annual growth rate since the Great Depression. Growth in emerging and developing economies remained positive but was nearly 4 percentage points lower than the 2000–2007 average.

Table 1-1, shows by 2010, both advanced countries and emerging and developing economies began to turn positive, thanks to strong monetary and fiscal policies and the slow repair of the financial system.

Figure 1-2 displays consistantly high unemployment rates for the United States and Euro area since the beginning of the crisis. The chapter discusses the factors behind the high unemployment rates and low growth of output, which are: o Housing prices are still declining. o Housing investment re-mains very low. o Banks are still not in great shape, and bank lending is still tight. o Consumers who have seen the value of their housing and their financial wealth fall are cutting consumption. o The crisis has also led to serious fiscal problems.

2. The United States In the United States, just before the crisis, the rate of growth of the economy was 2.6% which was a bit lower than the previous 20-year average, but still fairly high for an advanced country. On average, the unemployment rate and the inflation rate was lower over this period than over the period since 1980.

During the crisis output did not grow in 2008 and declined by 3.5% in 2009. The economy rebounded by 2010, with growth of 3%. Unemployment increased dramatically, to nearly 10%. Inflation declined, being slightly negative in 2009 and then staying positive but low since then. The numbers of 2011 and 2012 are forecast as of fall of 2011.

The high unemployment rate along with the very large budget deficit in the United States tends to be the preeminent issues facing the United States.

Figure 1-4 shows the evolution of the U.S. federal budget surplus since 1990.

.

A TOUR OF THE WORLD ❖ 3

•

The 1990s - After an increase in deficits due to the 1990–1991 recession, the rest of the decade was associated with a steady improvement in the budget, and by 1998, the budget had actually gone from deficit to surplus. o The main reasons for the steady improvement were twofold. First, strong output growth for most of the decade led to strong growth of government revenues. Second, rules were devised and implemented to contain government spending, from the use of spending caps on some categories of spending to the requirement that any new spending program be associated with an equal increase in revenues. - (Once the budget surplus appeared Congress became willing to break its own rules and allow for more spending.)

• The Early 2000s - The budget deficit returned due to Bush administration convincing Congress to cut taxes with the goal of spurring growth.

• The Crisis - The budget deficit in 2007 was 1.7% of GDP increased to 9% of the GDP to 2010 due to: o Lower output growth which has led to lower government revenues. o A decline in Federal revenues, from 18.9% of GDP in 2007, to 16.2% of GDP in 2010. o Increase in Federal spending, from 20.6% in 2007, to 25.3% in 2010.

• There is an agreement that the budget deficit must be reduced but the disagreement is based upon when and how. o When- Some economist argue the deficit should start now and proceed rapidly to convince people that the U.S. government will do what is needed to stabilize debt.

Other, economist argue that too fast a reduction through an increase in taxes and a decrease in spending will slow down growth at time when the unemployment rate is persistently high. o How - Republican s believe the deficit reduction show be achieved through a decrease in government spending. Democrats most programs are justified and the adjustment should occur through an increase in taxes.

3. Europe Figure 1-5 displays a map the EU17 that uses the Euro as a common currency along with the 2010 output of the Euro area's output for the countries of France, Germany, Italy and Spain. Table 1-3 shows that over the 2000-2007 time period right before the crisis, the Euro Area together experienced positive but relatively low growth The Euro Area also endured low inflation and continued high unemployment.

The crisis caused growth to decline to negative 4.2% by 2009 and the unemployment rate to reach 10.1% by 2010.

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 tight monetary policy by the European Central Bank. The suggested remedy is lower interest rates. According to the second view, high unemployment is a result of rigid labor market institutions, particularly with respect to worker protection. 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 Denmark and the Netherlands have low unemployment rates, despite providing generous social insurance for workers. The way forward, the skeptics argue, is to study the details of worker protection

.

4 ❖ CHAPTER 1

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 surfing among Euro members. Highlighting the deep recessions of countries from Ireland, to Portugal, to Greece, unable to individually decreasedtheir interest rate or depreciated their currency. This has 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, and extremely disruptive, leading to even deeper problems for the country that has exited. Policy issues associated with monetary union are discussed further in Chapter 21.

4. 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 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.

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.

.

A TOUR OF THE WORLD ❖ 5

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” is discussed in a margin note in Chapter 10, but 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.

2. i.

Alternative Sequencing The Global Crisis. Indeed, instructors could use the global crisis as the running example to introduce most the material. The 6th 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.

ii.

wOutput, 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.

3. 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 Congress should do at federal budget deficit and the debt. 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 economy.

2. 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.

.

6 ❖ CHAPTER 1

3. Distribution of Economic Benefits The second edition of the text included a discussion about wage inequality in the section on the U.S. economy. In subsequent editions, including the current edition, wage inequality is discussed in Chapter 13. Instructors may wish to raise this issue in the introductory discussion of the U.S. economy.

.

CHAPTER 2. A TOUR OF THE BOOK I.

MOTIVATING QUESTIONS

1.

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. 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.

2.

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.

Chapter 2 introduces index numbers.

ii.

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. iii. 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.

7

.

8 ❖ CHAPTER 2

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 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.

2.

Unemployment and Inflation

i.

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. ii.

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.

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A TOUR OF THE BOOK ❖ 9

Measures with arbitrary levels but well-defined rates of change are called index numbers. deflator is an index number.

The GDP

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 (although the text notes that U.S. Social Security payments rise with the CPI).

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 0 and 3%.

3.

The Basic Macroeconomic Framework and a Road Map for the Book

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.

The remainder of the book can be divided into three sections: “Core” material (Chapters 3-13), 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 the short run in terms of the IS-LM model, the medium run in terms of the AS-AD model (which incorporates IS-LM), and the long run in terms of the Solow growth model, with some additional discussion of other approaches. After the Core, there are three extensions: expectations (Chapters 14-17), the open economy (Chapters 18-21), and pathologies (Chapters 22-23). Pathologies include the Great Depression, Japan’s economic slump, and hyperinflation. After the extensions, the book concludes with three chapters on the scope for economic policy and a final chapter on the history of thought in macroeconomics.

.

10 ❖ CHAPTER 2

The book is constructed so that the three 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.

2.

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 national income and product accounts is also presented in Appendix 1. Instructors may prefer to introduce the material from Appendix 1 immediately after Section 1 of this chapter.

3.

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 6, 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 5.

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. ii. 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.

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A TOUR OF THE BOOK ❖ 11

iii. 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.

2.

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.

.

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.

The chapter introduces functional notation. Appendix 2 discusses functions in more detail.

ii.

The chapter introduces modeling terminology: exogenous and endogenous variables, behavioral equations, identities, and equilibrium conditions. iii. 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. iv.

The chapter introduces fiscal policy.

2.

Assumptions

i.

The text assumes that the economy produces a single good. throughout most of the formal work in the book.

This assumption is maintained

ii.

After introducing the national income identity, the text assumes a closed economy. assumption is maintained until Chapter 18.

This

iii. 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 6. iv. 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.

12

.

THE GOODS MARKET ❖ 13

v.

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.

2.

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.

(3.1)

Write consumption as a linear function of disposable income (YD), which is income minus taxes (T): C=c0+c1(YD)=c0+c1(Y-T).

(3.2)

Note that “taxes” (T) refers to taxes minus government transfers. Government spending (G) does not include transfers.

The parameter c0, which represents how much consumption would occur even if disposable income were zero, is called autonomous consumption or consumer confidence. 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.

Assume that investment is exogenous, and call it I . Assume that government spending and taxes are exogenous, and under the control of the fiscal authorities. Substitute for consumption and investment, and rewrite demand: Z= c0+c1(Y-T)+ I +G.

3.

(3.3)

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.

(3.4)

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14 ❖ CHAPTER 3

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/(1-c1)][c0-c1T+ I +G].

(3.5)

Equation (3.5) shows the algebraic solution and Figure 3.1 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 3.1: 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 (3.5)) 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 box also discusses the impact of the early stages of the financial crisis an consumer’s concern over their furture disposable income.

4.

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

1

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.

.

THE GOODS MARKET ❖ 15

Private saving is defined as disposable income minus consumption, or S=Y-T-C.

(3.6)

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

(3.7)

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.

5.

Is the Government Really Omnipotent? A Warning

The equilibrium output condition (3.5) 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

i.

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. ii.

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. iii.

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.

2.

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.

.

16 ❖ CHAPTER 3

3.

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.

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.

2.

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.

3.

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.

4.

Econometrics

Appendix 3 introduces econometrics in a rudimentary fashion. Instructors may wish to cover this material during lecture.

.

CHAPTER 4. FINANCIAL MARKETS 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.

III. KEY TOOLS, CONCEPTS, AND ASSUMPTIONS 1.

Tools and Concepts

i.

The chapter defines stock and flow variables and distinguishes wealth (a stock) from income (a flow). ii.

The chapter introduces monetary policy and describes open market operations.

iii.

The chapter makes use of balance sheets for the central bank and private banks.

iv. The chapter introduces various terms and concepts associated with the banking system. These include currency, checkable deposits, reserves, the reserve ratio, central bank money (high powered money, the monetary base), the federal funds market and the federal funds rate, and the money multiplier.

2.

Assumptions

i.

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. ii.

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.

17

.

18 ❖ CHAPTER 4

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.

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 $Y. On the other hand, allocating wealth to money comes at the cost of forgone interest on bonds. So, money demand should decrease with the interest rate. Putting these observations together, the chapter specifies money demand as Md=$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.

2. The Determination of 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 4.1 illustrates the solution.

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

.

FINANCIAL MARKETS ❖ 19

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.

Figure 4.1: Equilibrium in the Money Market

Interest Rate, i

Ms

Md=$YL(i) Money, M The text also considers open market operations in terms of their effect on bond prices. 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.

(4.2)

Equation (4.2) can be solved for the bond price: $PB=$F/(1+i).

(4.3)

Given fixed nominal bond payments, equation (4.2) shows that the nominal interest rate and the bond price are inversely related. For example, when the central bank purchases bonds, it increases the demand for them and tends to increase their price, which reduces the interest rate.

3.

The Determination of 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 checkable deposits 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. In the United States, the Federal Reserve may set the required reserve ratio between 7% and 22% of checkable deposits. The actual reserve ratio in the United States is about 10%.

.

20 ❖ CHAPTER 4

A box in the text contrasts bonds with loans as bank assets. The box links the existence of relatively illiquid loans as bank assets, combined with fractional reserve banking, with the possibility of bank runs, and explains briefly how the United States has dealt with this problem with federal deposit insurance.

With the implementation of federal deposist insurance has led to morale hazard problems. Lastly, the focus box considers the role of wholesale funding, which was popular just before the financial crisis.

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.

Now reconsider money market equilibrium in terms of central bank money (H). The demand for central bank money arises from two sources: currency held by the public and reserves held by banks. The supply of central money is under the control of the central bank. Thus, equilibrium is given by H=CUd+Rd,

(4.4)

where CUd refers to the demand for currency and Rd to the demand for reserves.

On the demand side, assume that overall money demand is determined as before, i.e., Md=$YL(i), and that the demand for currency (as opposed to checkable deposits) is a fraction c (where 0<c<1) of overall money demand. In addition, assume that banks keep a fixed fraction  of checkable deposits as reserves.

Putting these assumptions together with equation (4.4) gives H= CUd+Rd=cMd+(1-c)Md=[c+(1-c)]$YL(i).

(4.5)

Equilibrium can be depicted just as in Figure 4.1, with H substituting for M on the horizontal axis. An increase in H (through open market operations) leads to a decrease in the nominal interest rate.

4. Two Alternative Ways of Looking at the Equilibrium Equation (4.5), which equates supply and demand for central bank money, describes money market equilibrium in an economy with banks. There are two ways to think about this equation.

First, consider equilibrium in the market for reserves. The supply of reserves is central bank money minus currency. The demand for reserves is Rd. Equating the supply and demand for reserves gives H-CUd=Rd,

(4.6)

which is clearly identical to the equilibrium condition in equation (4.4). The advantage of thinking about equilibrium in this way is that it facilitates discussion of the federal funds market—the market for bank reserves—and the federal funds rate—the interest rate that adjusts to clear this market. In the federal funds market, banks that need reserves at the end of the day borrow them from banks that have excess reserves.

Second, consider equilibrium in terms of the overall supply and the overall demand for money (currency and checkable deposits). Reorganize equation (4.5) to read H/[c+(1-c)]=$YL(i).

(4.7)

The quantity 1/[c+(1-c)] is called the money multiplier. The money supply equals central bank money times the multiplier. Since c and  are assumed to be fixed, the central bank can control the money

.

FINANCIAL MARKETS ❖ 21

supply by controlling H. For this reason, central bank money is often called high powered money or the monetary base.

Note that 0<c<1 and 0<<1 together imply that the money multiplier is greater than one. Thus, a given increase in central bank money leads to a larger increase in the overall money supply. The source of the money multiplier is fractional reserve banking. A given increase in deposits leads to a smaller increase in bank reserves, because banks hold only a fraction (today about 10%) of total deposits as reserves. The remainder of a deposit increase is used by banks to purchase assets (e.g., bonds). The purchase of bank assets puts more money in the hands of the nonbank public and hence creates more checkable deposits, and so on. Thus, the money multiplier can be described as the limit of a geometric series, in much the same way as the output multiplier was explained in Chapter 3.

V. PEDAGOGY 1.

Points of Clarification

i.

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. ii.

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. iii.

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 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. iv. 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.

2.

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.

Alternatively, to emphasize the federal funds market, instructors could present equilibrium with banks in

.

22 ❖ CHAPTER 4

terms of the supply and demand for reserves; to emphasize the money multiplier, instructors could present equilibrium with banks in terms of the supply and demand for money. These latter approaches are presented in Section 4.4. Note that Section 4.4 is entirely optional.

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 Fed policy.

3.

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 Federal Reserve policy (perhaps with a few words about the stock market’s response to Fed policy) would probably be interesting to students.

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 Md+Bd=Financial Wealth=M+B, or (Md - M)=(B – Bd).

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.

2.

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.

.

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.

The chapter introduces the IS-LM framework.

ii.

The chapter introduces the concept of policy mixes to achieve macroeconomic goals.

iii. 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.

2.

Assumptions

i.

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. ii.

The chapter continues to assume that inventory investment is zero and that the economy is closed.

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)

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.

23

.

24 ❖ CHAPTER 5

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 5.1).

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/P=YL(i).

(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. To graph it in Y-i space, start with the money market equilibrium graph and vary Y. Chapter 4 demonstrated that an increase in nominal income would increase the interest rate. Since the price is fixed, clearly an increase in real income will have the same effect. Thus, the LM curve has a positive slope in Y-i space (Figure 5.1).

3.

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 5.1.

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.

.

GOODS AND FINANCIAL MARKETS: THE IS-LM MODEL ❖ 25

Figure 5.1: The IS-LM Model

Interest Rate, i

LM

i* IS

Y* Output, Y The appendix to Chapter 5 explains how to use the IS-LM framework to recast monetary policy in terms of interest rate rules. The monetary policy rule affects the slope of the LM curve. The traditional LM curve is derived by varying income (and hence money demand), and tracing out the implications for the interest rate, under the assumption that the money supply is fixed. Hence, the traditional LM curve corresponds to a strict money-targeting rule. A strict interest rate rule, on the other hand, implies that the LM curve is horizontal, because changes in income (and hence money demand) are fully accommodated by the Fed at the target interest rate. An intermediate rule—some mix of money supply and interest rate increases in response to an increase in income—produces an LM curve with a slope flatter than the traditional LM curve, but still positively sloped.

4.

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.

.

26 ❖ CHAPTER 5

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.

5.

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 Christiano, Eichenbaum, and Evans, “The Effects of Monetary Policy Shocks: Evidence From the Flow of Funds,” Review of Economics and Statistics, February 1996. The paper describes the dynamic responses of several important macroeconomic variables to an increase in the federal funds rate, i.e., a monetary contraction. An interest rate increase does lead to a decline in output, as the IS-LM model would predict, but adjustment happens relatively slowly. It takes almost two years for monetary policy to have its full effect on output. The price level remains more or less unchanged for about six quarters and then declines. The behavior of the price level supports the assumption that the price level is fixed in the short run.

V. PEDAGOGY 1.

Points of Clarification

i.

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. In other words, the level of Y on the IS curve associated with any given interest rate is given by the intersection of the Keynesian cross for that interest rate. Likewise, 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. ii.

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 slopes of the IS and LM curves.

Output and the interest rate are endogenous variables. Only changes to variables exogenous to the IS-LM model can shift the curves. iii.

The Interest Rate and the Effectiveness of Fiscal Policy. The effect of fiscal policy on the interest rate limits the ability of fiscal policy to influence output. To reinforce this point, it is worthwhile to compare the output effects of an increase in G in the Keynesian cross model (modified to include endogenous investment) to the effects of the same policy in the IS-LM model. An increase in G shifts the IS curve to the right. The horizontal shift at the initial interest rate is the change in output from the Keynesian cross (see Figure 5.2). Clearly this is larger than the change in output from the IS-LM model, unless the LM curve is horizontal. In the IS-LM model, the increase in G leads to an increase in the interest rate, which tends to reduce investment. The interest rate effect is not present in the simple Keynesian cross model.

.

GOODS AND FINANCIAL MARKETS: THE IS-LM MODEL ❖ 27

Figure 5.2: Fiscal Expansion in the Keynesian Cross and the IS-LM Models

Interest Rate, i

LM

Increase in Y in the Keynesian Cross Model

IS

Increase in Y in the IS-LM Model

Output, Y

VI. EXTENSIONS 1.

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

The text does not discuss the slopes of the IS and LM curves and the influence of behavioral parameters on the effectiveness of policy. 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. 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. ii. 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.

.

28 ❖ CHAPTER 5

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.

2.

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.

.

CHAPTER 6. 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 so-called natural rate, 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. The task of Chapter 7, which discusses aggregate demand and aggregate supply, is to unite all three markets in general equilibrium, in both the short and medium run, and to consider the transition from the short run to the medium run.

III. KEY TOOLS, CONCEPTS, AND ASSUMPTIONS 1.

Tools and Concepts

i.

The chapter reviews the definition of key labor market terms introduced in Chapter 2 and introduces several new ones, including the nonemployment rate, discouraged workers, separations, layoffs, and quits. ii.

The chapter makes use of a production function.

iii.

The chapter introduces wage-setting and price-setting relations.

iv. The chapter defines analytically the natural rate of unemployment and the natural level of output. v.

The chapter introduces the concept of an expected price level, the first expectation seen in the book.

2.

Assumptions

i.

The chapter assumes that labor is the only factor of production. The text maintains this assumption until Chapter 10, which introduces growth. ii.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.

29

.

30 ❖ CHAPTER 6

IV. SUMMARY OF THE MATERIAL 1.

A Tour of the Labor Market

The U.S. 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 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.

2.

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

3.

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. In the United States, less than 15% 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.

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:

The text provides evidence about job separations, which include quits as well 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.

1

.

THE LABOR MARKET ❖ 31

W=PeF(u, z).

- +

4.

(6.1)

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.

(6.2)

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+)W.

(6.3)

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

5.

The Natural Rate of Unemployment

If price expectations are correct (i.e., P=Pe), equations (6.1) and (6.3) yield two different expressions for the real wage: W/P=F(u,z)

(6.1')

W/P=1/(1+).

(6.3')

and

The text refers to the first of these equations as the wage-setting relation (WS) and to the second as the price-setting relation (PS). Conditional on P=Pe, labor market equilibrium requires that the real wage implied by WS equal the real wage implied by PS, or F(u,z)=1/(1+).

(6.4)

The value of u that satisfies equation (6.4) is called the natural rate of unemployment. The graphical solution is given in Figure 6.1. 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.

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.

.

32 ❖ CHAPTER 6

Real Wage, W/P

Figure 6.1: The Natural Rate of Unemployment

1 1+

un

Unemployment Rate, u

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 ) 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 medium-run 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.

6.

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 three 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.

.

THE LABOR MARKET ❖ 33

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.

2.

Alternative Sequencing

The organization of the text allows instructors to move immediately from the IS-LM framework to expectations (Chapters 14-17) or the open economy (Chapters 18-21), 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. Chapter 7 describes the short-run effects of economic disturbances and the transition from the short-run to the medium-run equilibrium. In the process, Chapter 7 describes the adjustment of prices over the medium run. In the real world, the economy is always experiencing some short-run shock and responding to previous shocks, so it is rarely in medium-run equilibrium. The medium-run concept is an analytical tool.

2.

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.

.

CHAPTER 7. PUTTING ALL MARKETS TOGETHER: THE AS-AD MODEL I.

MOTIVATING QUESTION

How are output, the unemployment rate, and the interest rate determined in the short run and the medium run?

Output, the unemployment rate, and the interest rate 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; equilibrium in the labor market is summarized in an aggregate supply relation. 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

i.

The chapter introduces the aggregate demand and aggregate supply relations.

ii.

The chapter makes extensive use of dynamic analysis, introduces the term business cycle, and distinguishes between shocks and propagation mechanisms.

2.

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.

Aggregate Supply

Substitute the wage-setting relation into the price-setting relation to obtain P=Pe(1+)F(u,z).

Express the unemployment rate in terms of output to derive the aggregate supply (AS) relationship: P= Pe(1+)F(1-Y/L,z).

(7.1)

34

.

PUTTING ALL MARKETS TOGETHER: THE AS-AD MODEL ❖ 35

For any price level, the AS relation gives the level of output consistent with equilibrium in the labor market, conditional on the expected price level (Pe), the markup in the product market competition (), and institutional and structural conditions (z). As output increases, employment increases, the unemployment rate decreases, the nominal wage increases (since workers are in a better bargaining position), and the price level increases (since price is a constant markup over the wage). Thus, the AS curve slopes up in Y-P space (Figure 7.1).

Along the AS curve, the price level equals its expected level when output equals its natural level. This statement is true by construction. It is merely a restatement of the definition of the natural level of unemployment. The price level exceeds its expected level when output exceeds its natural level. The high level of output leads to a low unemployment rate, which tends to increase the nominal wage and the price level.

The position of the AS curve is determined by the markup, the institutional and structural conditions in the labor market, and the expected price level. For example, an increase in the expected price level leads workers to bargain for a higher wage (for any given unemployment rate). The increase in the wage leads to increase in the price level through price setting. Thus, an increase in the expected price level causes the AS curve to shift up.

2.

Aggregate Demand

Consider the IS-LM diagram from Chapter 5. The diagram takes the price level, which affects the real money supply, as given. For given G, T, and M, an increase in the price level reduces the real money supply, shifts the LM curve up, and reduces output. Plotting all combinations of Y and P implied by the IS and LM model produces a downward-sloping relation, called the aggregate demand (AD) curve (Figure 7.1). For any given price level, the AD curve plots the level of output consistent with equilibrium in both the goods and financial markets.

The position of the aggregate demand curve depends upon the factors (other than the price level) that determine the positions of the IS and LM curves. For a given price level, any change that increases output in the IS-LM diagram will shift the AD curve horizontally to the right by the increase in output implied by the IS-LM model. In symbols, the aggregate demand relation is given by Y=Y(M/P,T,G). + - +

(7.2)

The signs below the arguments in equation (7.2) indicate the effects of an increase in the variables on output in the IS-LM model and thus on the position of the AD curve.

3.

Equilibrium in the Short Run and in the Medium Run

Figure 7.1 plots the AD and AS curves. The intersection of these curves is the short-run equilibrium of the economy. If it happens that P=Pe, then the economy is also in medium-run equilibrium. If PPe, then the text assumes that expectations will adjust. In particular, the text assumes that if P>Pe, the expected price level in the future will increase. If P<Pe, the expected price level in the future will decrease.

In the short run, there is no presumption that P=Pe. Suppose that P>Pe, which implies that output is higher than its natural level. Given these initial conditions, the expected price level will increase in the future, causing the AS curve to shift up. The price level rises, and output falls. As long as output remains above its natural level, the actual price level will exceed the expected price level, and the expected price level will increase in the future, leading to further shifts of the AS curve. The process will stop when the

.

36 ❖ CHAPTER 7

AS curve intersects the AD curve at the natural level of output, corresponding to the natural rate of unemployment.

Figure 7.1: The IS-LM and AD-AS Models

Interest Rate, i

LM(M/P2)

LM(M/P1)

IS

Price LeveI, P

Output, Y

AS

P2

P1

AD

Output, Y

.

PUTTING ALL MARKETS TOGETHER: THE AS-AD MODEL ❖ 37

In general, when the price level is higher than the expected price level, the AS curve shifts up over time.

When the price level is lower than the expected price level, the AS curve shifts down over time. The next three sections reinforce this point by considering the short- and medium-run effects of specific shocks.

4.

The Effects of a Monetary Expansion

The effects of a monetary expansion are described in Figure 7.2. Suppose the economy begins in medium-run equilibrium, with the expected price level equal to the actual price level and output at its natural level. An increase in the money supply shifts the LM curve down in the top panel of the figure (to LM'), and simultaneously shifts the AD curve to the right in the bottom panel. At the original price level, the horizontal shift of the AD curve (point B in the figure) equals the change in output in the IS-LM diagram before considering the change in the price level.

The shift of the AD curve, however, tends to increase output, reduce the unemployment rate, and increase the nominal wage (through wage bargaining). The latter effect leads to an increase in the price level (through price setting). In other words, since the AS curve is upward-sloping, the new short-run equilibrium (point C) involves a higher price level. The increase in the price level shifts the LM curve up (to LM'') through its effect on M/P. This secondary shift of the LM curve offsets some of the initial shift of the LM curve. As a result, in the short run, the output increase from a monetary expansion is less in the AD-AS model than in the IS-LM model. The increase in the price level offsets some of the effect of the monetary expansion on the real money supply.

At the new short-run equilibrium (point C), the price level has increased above its expected level. As a result, in the next period, the AS curve will shift up over time and the equilibrium will move along the arc CD. The AS curve will continue to shift up until Y returns to its natural level at point D in the bottom panel. As the AS curve shifts up, P increases, reducing M/P and shifting the LM curve up. At point D, P has increased sufficiently to restore M/P to its original value, which implies that the LM curve has returned to its original position.

The new medium-run equilibrium is exactly the same as the original one, except that the price level has risen in proportion to the increase in M. The composition of GDP is the same as in the original mediumrun equilibrium. Since a monetary expansion does not affect any real variables in the medium run, monetary policy (or in short, money) is said to be neutral in the medium run

5.

A Decrease in the Budget Deficit

A reduction in government spending shifts the IS and AD curves to the left. As a result, output and the price level fall. The decline in the price level generates a (relatively) small downward shift of the LM curve, to make output in the IS-LM diagram consistent with output in the AD-AS diagram. As expectations adjust to the new price level, the AS curve shifts down. The price level falls, but output begins to rise as the economy moves along the new AD curve. The AS curve continues to shift down until the economy reaches a new medium-run equilibrium with a lower price level, but the same level of output as in the initial equilibrium. In the IS-LM diagram, the reduction in the price level shifts the LM curve down until it intersects the new IS curve at the initial level of output, but a lower interest rate. With output at its initial medium-run level, but the interest rate lower, investment rises in the medium run relative to the initial medium-run equilibrium. The rise in investment exactly offsets the fall in government spending. In the short run, the effect on investment is ambiguous, since output falls (tending to reduce investment) and the interest rate falls (tending to increase investment).

.

38 ❖ CHAPTER 7

Figure 7.2: A Monetary Expansion in the AD-AS Model

Interest Rate, i

LM

LM

LM

IS

Price LeveI, P

Output, Y

Medium-Run Equilibrium

AS D Short-Run Equilibrium C

A

B

AD

Yn

Output, Y

.

PUTTING ALL MARKETS TOGETHER: THE AS-AD MODEL ❖ 39

6.

An Increase in the Price of Oil

The text models an increase in the price of oil as in increase in , since higher energy costs increase the marginal cost of production, given the wage. The analysis of labor market equilibrium in Chapter 6 implies that the natural rate of unemployment will rise (the price-setting line will shift down), so the natural level of output will fall. Assuming that the economy begins in medium-run equilibrium, output will fall in the transition to the new medium-run equilibrium.

The AS relation in equation (7.1) implies that an increase in  increases the price level for any level of output, so the AS curve shifts up. The new AS curve (labeled AS in Figure 7.3) will intersect the vertical line above the new natural level of output (Yn'), where the price level equals the expected price level (i.e., the original price level). As a result, in the new short-run equilibrium (point B in Figure 7.3), the price level has risen above the expected price level. In response, the expected price level rises and the AS curve begins to shift up over time. The process continues until the AS curve intersects the original AD curve at the new natural level of output. In the new medium-run equilibrium (point C), output is lower and the price level is higher. In addition, in the IS-LM diagram (not shown), the increase in the price level reduces the real money supply and shifts the LM curve up, so the interest rate increases in the new medium-run equilibrium.

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. 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. 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.

Figure 7.3: An Increase in the Price of Oil in the AD-AS Model

Price Level, P Rate, i

AS

AS AS

C B A

AD

Yn

Yn

.

Output, Y

40 ❖ CHAPTER 7

7.

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

i.

AD and AS versus Demand and Supply Curves.

It may be worthwhile the clarify the distinction between the AD and AS curves and the demand and supply curves from microeconomics. The AD curve plots the combinations of P and Y consistent with simultaneous equilibrium in the goods and financial markets. It slopes down because of the effect of P on the real money supply, and hence on the interest rate, investment, and output. The AD curve does not slope down because a lower price level makes goods more attractive to people. The AS curve plots the combinations of P and Y consistent with equilibrium in the labor market, conditional on the expected price level. It slopes up because higher output implies a lower unemployment rate, which leads to a higher wage, which leads to a higher price level. The AS curve does not slope up because firms desire to supply more goods when the price level is higher. ii.

Analysis of Shocks in the AD-AS 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 ADAS framework, instructors might wish to outline the steps in the analysis. 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. If the shock is to a variable in the AS curve (other than the expected price level), it will affect the natural rate of unemployment and thus the natural level of output. c. Determine the initial shifts in the AD-AS diagram and IS-LM diagram. Do not neglect the secondary shift in the IS-LM diagram because of the change in price in the AD-AS diagram. d. 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. e. If the price level is greater than its expected level, then the AS curve will shift up over time until it intersects the (possibly new) AD curve at the (possibly new) natural level of output.

Likewise, as the price level increases over time, the LM curve will shift up until it intersects the (possibly new) IS curve at the (possibly new) natural level of output. If the price level is less than its expected level, the AS and LM curves will shift down.

It is also useful to emphasize, as suggested in Chapter 6 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

.

PUTTING ALL MARKETS TOGETHER: THE AS-AD MODEL ❖ 41

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. In this chapter, the short-run equilibrium is the intersection of the AD and AS curves. Prices are allowed to change in the short run. Students may find this confusing. 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 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. Such wage adjustment accounts for shifts along the AS curve in the short run. Clearly, a fully specified model would need to be careful about the terms and timing of wage adjustment. The AS framework in the text is a simplification intended to illustrate some basic issues—in particular slow price adjustment—at a manageable level of complexity. iv. The Natural Rate Hypothesis. Instructors may wish to say more about the natural rate hypothesis, as described in the context of the AD-AS model, and to explain the relationship between this hypothesis and the assumptions imposed in this chapter. The natural rate hypothesis typically has three elements. First, a natural rate exists, i.e., when the price level equals its expected price level (or when inflation equals expected inflation in a model with money growth), there is a unique unemployment rate consistent with labor market equilibrium. In the context of the model developed in Chapter 6 (in which the wage-setting relation implies a negative relationship between nominal wages and the unemployment rate), the existence of a natural rate is guaranteed by the assumption that wages (in the wage-setting relation) are proportional to expected prices. Second, the economy tends to return to the natural rate after shocks. In the AD-AS model, this result is generated by the assumption that the expected price level adapts to the history of the actual price level, i.e., when the actual price level is greater (less) than the expected price level, the price level expected in the future increases (decreases). Finally, the natural rate is reasonably stable, in the sense that it does not change so rapidly that economists can never measure it.

Although the first two parts of the hypothesis could hold even if the natural rate changed very rapidly, the usefulness of the natural rate as a policy guide would be limited if it could not be measured with any confidence.

As will become clear in Chapter 8, the main evidence in the United States for the first two parts of the natural rate hypothesis is that the unemployment rate has a significant negative relationship with the change in the inflation rate. The benchmark empirical specification (with the change in the inflation rate on the LHS of a regression) incorporates two assumptions—that wage inflation is proportional to expected price inflation (i.e., that a natural rate exists) and that expected price inflation equals lagged price inflation. In reality, expectations formation is not all that well understood. At a minimum, expectations probably include some forward-looking elements. The text also notes that the natural rate can change over time and that relatively little is known about the determinants of the natural rate. Even if one accepts the stability of the U.S. natural rate since the 1970s, conventional techniques do not estimate it with much precision.

In sum, the natural rate hypothesis provides a powerful, unifying conceptual framework, but economists’ understanding of labor market equilibrium remains limited.

.

42 ❖ CHAPTER 7

2.

Alternative Sequencing

In Chapter 13, which examines technological change and labor markets, there is a discussion of the effects of technological change on the AD-AS diagram. Instructors could present that part of Chapter 13 in the lecture on Chapter 7.

VI. EXTENSIONS Instructors may wish to discuss the scope for monetary policy to maintain full employment in the AD-AS framework. For AD 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).

Essentially, a change in the money supply substitutes for a medium-run change in P, so that M/P adjusts as needed to restore the natural rate of output. For AS shocks, countercyclical monetary policy moves the economy further away from the natural rate. For example, consider an adverse AS 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 short-run output.

VII. OBSERVATIONS In the medium run, the interest rate is determined by the intersection of the IS curve and the natural level of output. Effectively, conditional on the natural level of output, the interest rate is determined by fiscal policy. Regardless of the value of the money supply, the price level will adjust so that the LM curve intersects the IS curve at the natural level of output. Thus, monetary policy has no effect on the interest rate in the medium run. Once money growth is introduced, this conclusion will be refined. In the medium run, monetary policy (defined as the choice of the growth rate of money) will have no effect on the real interest rate, but will affect the nominal interest rate through the Fisher effect (Chapter 14).

.

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, the U.S. 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.

II.

WHY THE ANSWER MATTERS

The material in this chapter provides a way to think about the central issue of U.S. macroeconomic policy, namely, whether the Federal Reserve 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

i.

The chapter introduces the original Phillips curve and its modern, expectations-augmented and accelerationist variants. ii.

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. For this reason, the natural rate is sometimes called the nonaccelerating inflation rate of unemployment (NAIRU).

2.

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. Since 1970, 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.

43

.

44 ❖ CHAPTER 8

1.

Inflation, Expected Inflation, and Unemployment

Impose the specific functional form F(u,z)=1-u+z, and use the AS relation from Chapter 7 to derive π= πe+(+z)-u,

(8.1)

where  refers to the inflation rate and πe to the expected inflation rate. An appendix to Chapter 8 presents the full derivation of equation (8.1).

The intuition for the relationships in equation (8.1) is the same as the intuition developed in the presentation of the aggregate supply relation. Given the price level in the previous period, an increase in the current price level implies an increase in the inflation rate, and an increase in the expected price level implies an increase in the expected inflation rate. Thus, an increase in the unemployment rate, which tends to reduce wages (because it reduces the relative bargaining power of workers) and thus to reduce prices (through the price-setting mechanism), also tends to reduce the inflation rate.

2.

The Phillips Curve

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 , 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=πt-1 and argues that it is plausible that  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  since 1970. Under this interpretation, the original Phillips curve, πt= (+z)-ut,

(8.2)

πt-πt-1= +z-ut.

(8.3)

evolved to

Equations (8.2) and (8.3) 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. The unemployment rate defined by correct inflation expectations 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 (8.3) or when the expected inflation rate equals the actual inflation rate in equation (8.1). Either method produces the following expression: un= ( +z)/.

(8.4)

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.

.

THE PHILLIPS CURVE, THE NATURAL RATE OF UNEMPLOYMENT AND INFLATION ❖ 45

3.

A Summary and Many Warnings

The text notes three limits on the use of the accelerationist Phillips curve in equation (8.1) as a characterization of the economy. First, 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.

Second, 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.

Third, Suppose policymakers wish to reduce inflation. The Phillips curve implies that a reduction in inflation will require an unemployment rate higher than the natural rate for some time. The issues are the size of the unemployment cost and how the structure of a disinflation program affects the cost.

In the mid-1970s, Robert Lucas argued that the disinflation analysis described above was likely to provide a misleading guide to the effects of policy. Necessarily, the estimated Phillips curve and Okun’s law depend on historical data. Changes in policy, however, might change the historical relationships between variables. In particular, the way inflation expectations are formed might vary with the policy environment. This argument has come to be known as the Lucas critique. The Lucas critique implies that credibility is an important determinant of the costs of disinflation. If policymakers can convince wage setters that a disinflation will be implemented, the policy can be carried out with relatively little increase in unemployment. The Volcker disinflation, provides a test of the credibility argument. Over the period 1979-1985, the United States reduced inflation by 10 percentage points at a cost of 12 point-years of excess unemployment. There were no obvious credibility gains, even though Volcker had (and has?) a reputation as a tough anti-inflation fighter. Credibility theorists, however, can argue that Volcker lost his credibility when the Fed eased policy in 1980, in response to the recession.

Fourth, 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 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  of wage contracts is indexed to the actual inflation level, so that wages depend on the inflation rate. A proportion 1- 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 πt=πt+(1-)πt-1+(+z)-u or

.

46 ❖ CHAPTER 8

πt- πt-1 =(+z)/(1-)-[/(1-)]u.

(8.5)

An increase in the degree of indexation () leads to an increase in the coefficient on the unemployment rate, and so increases the effect of the unemployment rate on inflation.

V.

PEDAGOGY

1.

Points of Clarification

i.

The AS Curve and the Phillips Curve. The jump from the AS curve of Chapter 7 (in price levels) to the expectations-augmented Phillips curve of Chapter 8 (in inflation rates) may be difficult for some students. Chapter 7 itself required a big conceptual jump by analyzing wage-price dynamics.

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 more subtle 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.

ii.

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.

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, 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=π e in equation (8.3). 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.

.

CHAPTER 9. THE CRISIS I.

MOTIVATING QUESTIONS

What caused the global recession, how effective was the policy response, and what is the outlook for the recovery?

A sharp decline in housing prices beginning in mid-2006 triggered a financial crisis in a highlyleveraged and interlinked financial system with substantial holdings of complex mortgage-related assets whose value, it turned out, depended upon a strong housing market. The effects of mortgage losses were magnified by changes in the financial structure over the past two decades. The financial crisis became an economic crisis through effects on confidence and on credit markets, since firms wishing to invest were unable to get credit at favorable interest rates. Strong policy measures helped stave off a disaster, but prospects for a return to the natural level of output remain uncertain.

II.

WHY THE ANSWER MATTERS

Clearly, understanding the worst economic crisis since the Great Depression is the central issue of modern macroeconomics. As a matter of analysis, the crisis raises several important issues: the continuing relevance of the liquidity trap and the scope for nontraditional monetary policy measures in a zero-interest rate environment, the size of multipliers associated with different fiscal policy measures, and the reconsideration of financial regulation as a tool of macroeconomic stabilization.

III. KEY TOOLS, CONCEPTS, AND ASSUMPTIONS 1.

Tools and Concepts

i.

The chapter introduces general financial terms, including collateral, leverage, the Libor rate,and securitization. ii.

The chapter introduces terms describing specific financial instruments and arrangements relevant to the crisis. Such terms include collateralized debt obligations (CDOs), credit default swaps, mortgage-backed securities (MBS), structured investment vehicles (SIVs), subprime mortgages, the Ted spread, and wholesale funding. iii. The chapter describes and identifies two major pieces of legislation: the Troubled Asset Relief Program (TARP) and the American Recovery and Reinvestment Act (ARRA).

IV. SUMMARY OF THE MATERIAL 1. From a Housing Problem to a Financial Crisis This section of the chapter begins with a historical analysis of the U.S. housing prices from 2000 to 2011. Much of the emphasis is placed on the 2000 to 2006 time period in which 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.

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

47

.

48 ❖ CHAPTER 9

the borrower understood. This in turn caused many borrowers to default on their mortgages thus creating a large loss to 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.

Figure 9-2 displays a simple example of a banks 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 9-2, bank A 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. Bank B has assets of 100, liabilities of 95, and capital of 5. Thus, its capital ratio is equal to 5%, and its leverage ratio to 20.

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. Bank A now has assets of 90, liabilities of 80, and capital of 90 - 80 = 10. Bank B 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.

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

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THE CRISIS ❖ 49

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, therefore many stopped lending to banks.

Once the lending to banks through wholesale funding became a problem, bank found themselves short of funds and forced to sell some of its assets. The securitized assets were complex and hard to sell, therefore banks had to sell their assets at very low prices, which is often referred to as fire sale prices.

Figure 9-3, shows the Ted spread, which is difference between the riskless rate (measured by the rate of three-month government bonds), and the rate at which banks are willing to lend to each other (known as the Libor rate). If banks perceived no risk in lending to each other, the Ted spread would be equal to zero. The Ted spread increased sharply in September 2008 due to Lehman Brothers bankruptcy and financial participants concluding that many, if not most, other banks and financial institutions were indeed at risk.

2. The Use and Limits of Policy The Immediate Effects of The Financial Crisis: 1. Figure 9-4 displays how the yields on AAA, and BBB corporate bonds became very high after September 2008, relative to the 10-year U.S. Government Treasury yield.

2. Figure 9-5 shows the decline in U.S. consumer and business confidence after the financial crisis. Where consumer confidence, which had started declining in mid-2007, took a sharp drop in the fall of 2008 and reached a low of 22 in early 2009, a level far below previous historical lows.

Initial Policy Response The high cost of borrowing, lower stock prices, and lower confidence all combined to decrease the demand for goods and an a sharp adverse shift of the IS curve. Policy makers initially responded with an aim to strengthen the financial system. Listed below were the measures adopted: • •

•

• •

In order to prevent a run by depositors, federal deposit insurance was increased from $100,000 to $250,000 per account.

To prevent bankruptcy in the financial system, the Fed put in place a number of liquidity facilities to make it easier for banks and other financial institutions to borrow from the Fed. The goal was to increase the set of assets that financial institutions could use as collateral when borrowing from the Fed. The government introduced a program, called the Troubled Asset Relief Program, or TARP, aimed at cleaning up banks. o The initial goal of the $700 billion program, introduced in October 2008, was to remove the complex assets from the balance sheet of banks, thus decreasing uncertainty, reassuring investors, and making it easier to assess the health of each bank. o The new goal became to increase the capital of banks. This was done by the government acquiring shares and thus providing funds to most of the largest U.S. banks. By increasing their capital ratio, and thus decreasing leverage, the goal of the program was to allow the banks to avoid bankruptcy and, over time, return to normal.

Worried that some markets were slow to recover, the Fed directly intervened by purchasing mortgage-backed securities.

Figure 9-6 displays the reaction of the Fed by decreasing the T-bill rate due to worries over slow growth caused by the crisis.

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50 ❖ CHAPTER 9

The role of Fiscal Policy: When the size of the adverse shock of the financial crisis became clear, the U.S. government turned to fiscal policy, using a combination of reductions in taxes and increases in spending.

• When the Obama administration took office in 2009, its first priority was to design a fiscal program that would increase demand and reduce the size of the recession. Such a fiscal program, called the American Recovery and Reinvestment Act, was passed in February 2009. o The program called for $780 billion in new measures, in the form of both tax reductions and spending increases, over 2009 and 2010. The U.S. budget deficit increased from 1.7% of GDP in 2007 to a very high 9.0% in 2010.

The Limits of Monetary This section refers the reader back to the money supply and money demand graphs derived in Chapter 4 of the text. The authors highlight the understanding from the money market that the lower the interest rate, the larger the demand for money- and thus the smaller the demand is for bonds.

• Chapter 9 extends the model developed in Chapter 4 by exploring what happens to the demand for money when the interest rate becomes equal to zero. The conclusion is found in Figure 97,which shows that once the interest rate is zero, people are indifferent to how much money or bonds they hold, so they are willing to hold less bonds and more money at the same interest rate, namely zero. The money supply increases, but with no effect on the interest rate—which remains equal to zero. o Once the interest rate is equal to zero, expansionary monetary policy becomes powerless. The increase in money falls into a liquidity trap: People are willing to hold more money ( more liquidity) at the same interest rate.

• Figure 9-8 displays how the LM curve is derived in the presence of a liquidity trap. It shows that as Money demand continues decline due to lower income levels the interest rate will eventually decrease to zero, thus creating a flat segment of the LM. As shown in the figure, or values of income less than Y'', it is flat at i = 0. Intuitively: The interest rate cannot go below zero.

•

To answer the question of whether monetary policy can help the economy return to a higher level of output. Figure 9-9 displays the IS-LM model and the effects of the Liquidity Trap. It shows how the LM curve is shifted to an increase in monetary policy. the figure shows that once the interest rate is equal to zero, conventional expansionary monetary policy no longer has an effect on output; it cannot therefore help output increase to Yn.

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THE CRISIS ❖ 51

•

Whiles Figure 9-9 explores conventional monetary policy, the Fed has during the crisis under went unconventional monetary policy initiatives known as credit easing or quantitative easing. This is when the Fed buys other bonds that hold a higher interest rate than the traditional T-bill. Examples are mortgages or 10 - 20 year Treasury bonds. The expectation is that by lowering the the interest through a unconventional monetary expansionary route this will help to increase demand.

The Limits of Fiscal Policy The limitations of Fiscal Policy is that, if the demand for goods does not recover over time by itself, if people or firms do not eventually become more optimistic and increase spending, the government must continue to run deficits to sustain higher demand and output.

• Continuing large deficits lead, however, to steadily higher public debt.

• In advanced countries, the ratio of government debt to GDP has increased from 46% in 2006 to 70% in 2011; in the United States, the ratio has increased from 42% in 2006 to 72% in 2011.

• As we will see in Chapter 23, high debt implies that, sooner or later, either taxes will have to increase, or spending will have to decrease, or the government will be unable to repay the debt.

3. The Slow Recovery This section explores the reasons why the recovery from the crisis in the U.S. is very slow.

• Some economist argue that the banking crisis has decreased the natural level of output, therefore making it wrong to think that output can return to its pre-crisis level. o The Focus Box labeled: "Do Banking Crisis Affect Output in the Medium Run",which highlights an econometric study by researchers at the IMF, suggests that after examining banking crises across many countries in the world, on average output remains below its old pre-crisis trend line for many years.

• Another reason for the slow recovery points to the new regulations introduced to decrease the risk of another financial crisis, such as increases in the capital ratio that banks must maintain, may indeed decrease risk; but they may also make intermediation between borrowers and lenders more costly, thus decreasing the natural level of output (review Section 9-1 definition of the capital ratio for further detail).

• Other economist suggest that insufficient aggregate demand is the issue for the slow recovery. o The point to the limits of conventional monetary policy (found in Section 9-2 explanation of the liquidity trap) and the limited and uncertain effects of unconventional monetary policy practices. o Secondly, economist highlight that worries about the debt places strong pressure on the government to reduce the deficit, to pursue fiscal consolidation instead of fiscal expansion. o They also highlight that due to the liquidity trap, the process moving output back to its natural level in the medium run (see Chapter 7 for details) fails.

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52 ❖ CHAPTER 9

•

Figure 9-10 displays that if the economy is in the liquidity trap the aggregate demand relation found in Chapter 8 would from:

to:

Thus increase in the real money supply due to decrease in the price level due to monetary policy will not impact spending (where the AD curve is seen as being vertical) therefore the adjustment mechanism which would return output to its natural level fails.

The authors conclude by stating that the U.S. economy will eventually return to normal. pointing to the following reasons: o The damage done to the banking system should slowly be repaired. o Very low housing investment and thus a stable housing stock, together with a growing population, should eventually lead to an increase in prices and higher housing investment in the future. o Also, economist point to that the mechanism of pent-up demand, where deferred consumer and investment demand will occur sometime in the future.

V. PEDAGOGY 1.

Points of Clarification

i.

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.)

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THE CRISIS ❖ 53

ii.

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. iii.

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 after-tax 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.

2.

Alternative Sequencing

This chapter fits naturally before Chapter 22, which in turn could follow Chapter 7, if instructors wished to move quickly to the most topical material. Going further, one could use the global crisis as the running example to illustrate the essential ideas in Chapters 1-7 and 22, and even to some extent the material in Chapters 18-21, which cover macroeconomics in the open economy.

3.

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 (see below.)

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.

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54 ❖ CHAPTER 9

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.

2.

Systemic Versus Nonsystemic 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

.

CHAPTER 10. 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.

The chapter introduces logarithmic scales for variable plots.

ii.

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 taken into account, 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 output per person at low levels of income—say up to $20,000 or so. At higher levels of income, however, happiness seems to have more to do with relative income levels than absolute ones.

55

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56 ❖ CHAPTER 10

2.

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 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, Argentina, Uruguay, and Venezuela were all nearly as rich as France in 1950, but far behind France by 2003.

3.

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 70 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.

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 12.

4.

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).

(10.1) ++ 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 (10.1) can be rewritten as Y/N=F(K/N, 1).

(10.2) + 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 10.1.

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

.

THE FACTS OF GROWTH ❖ 57

increases in capital per worker, and growth would cease. technological progress.

Sustained growth requires sustained

Output per Worker, Y/N

Figure 10.1: The Aggregate Production Function

Y/N=F(K/N,1)

Capital per Worker, K/N

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, defined 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 11 and 12) 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 12 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 (10.1)) 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.

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58 ❖ CHAPTER 10

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.

.

CHAPTER 11. 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

i.

The chapter develops the Solow model of growth for the case of no technological change and no population growth. ii.

The golden rule level of capital per worker is the value of capital per worker that maximizes steady-state consumption per worker. iii.

The Cobb-Douglas production function is described in an appendix.

2.

Assumptions

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

To save notation, write the aggregate production function of the previous chapter, Y/N=F(K/N,1), as Y/N=f(K/N). This step is valid because the second argument of the original function is a constant.

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. iii. The fraction of real GDP devoted to saving (the saving rate) is constant, i.e., S=sY.

(11.1)

59

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60 ❖ CHAPTER 11

This assumption captures the empirical regularities that the saving rate (s) does not appear to change systematically as a country increases its income and that saving rates in rich countries do not appear to differ systematically from saving rates in poor countries. iv. The economy is closed and the budget deficit is zero, so goods market equilibrium is I=S.

(11.2)

v. Capital depreciates at rate . Thus, the change in the capital stock over time is Kt+1-Kt= It-Kt.

(11.3)

Investment creates new capital, but the existing capital stock depreciates.

2.

The Implications of Alternative Saving Rates

The equations above together imply (Kt+1/N- Kt/N)=sf(Kt/N)-Kt/N.

(11.4)

Capital per worker increases to the extent that total saving per worker exceeds depreciation of the existing capital stock per worker. Figure 11.1 plots the separate components of equation (11.4).

Output per Worker, Y/N

Figure 11.1: Capital and Output Dynamics

(Y*/N)

K/N f(K/N)

B sf(K/N) A

(K*/N)

Capital per Worker, K/N

The dynamics of adjustment are indicated by the arrows on the horizontal axis of Figure 11.1. To the left of point A, saving per worker (sf(K/N)) exceeds depreciation of the existing stock (K/N), so the capital

.

SAVING, CAPITAL ACCUMULATION, AND OUTPUT ❖ 61

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 (11.4), the steady-state value of K/N is determined by sf(K*/N)=  K*/N.

(11.5)

Point B indicates steady-state output per worker, which is given by Y*/N=f(K*/N).

(11.6)

Now consider an increase in the saving rate. In Figure 11.2, 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.

Output per Worker, Y/N

Figure 11.2: The Effect of a Change in the Saving Rate

K/N sf(K/N) B sf(K/N) A

Capital per Worker, K/N

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

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62 ❖ CHAPTER 11

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 pay-as-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.

3.

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 (Kt+1/N- Kt/N)=s(Kt/N)1/2-Kt/N. In steady state, s/=(K*/N)1/2=Y*/N. 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 (11.4), 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/, 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 1

Note that for the production function, Y=KaL1-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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SAVING, CAPITAL ACCUMULATION, AND OUTPUT ❖ 63

4.

Physical versus Human Capital

The aggregate production function can be generalized to include human capital (H): Y/N=f(K/N, H/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 12 looks at the sources and effects of technological progress.

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.

.

CHAPTER 12. 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 11 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 13 examines the relationship between institutions and growth, a topic of special relevance to poor countries.

III. KEY TOOLS, CONCEPTS, AND ASSUMPTIONS 1.

Tools and Concepts

i.

Effective labor is the amount of labor multiplied by the level of labor productivity. In symbols, effective labor equals AN. ii.

Growth accounting and the Solow residual are described in an appendix to the chapter.

2.

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).

(12.1)

In Chapter 11, 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 (12.1), 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 11.

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TECHNOLOGICAL PROGRESS AND GROWTH ❖ 65

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/N=f(K/(AN)),

(12.2)

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, or in terms of effective labor, I/(AN)=sf(K/(AN)).

(12.3)

In the model of Chapter 11, 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, so in steady state, ∆K/K=∆A/A+∆N/NgA+gN,

(12.4)

which implies ∆K=(gA+gN)K,

(12.5)

where gA and gN are the growth rates of productivity and the labor force.

In order for equation (12.5) to hold, investment must be sufficient both to replace depreciated capital and to allow the capital stock to increase by (gA+gN)K, or I=K +∆K =(+gA+gN)K.

(12.6)

Substituting equation (12.6) into equation (12.3) gives the steady-state equilibrium condition: sf(K/(AN))=(+gA+gN)K/(AN).

(12.7)

The economy looks qualitatively similar to Figure 11.1. In steady state, Y/(AN) is constant, so output grows at rate 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.

2.

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 its sources? Technological change is the product of research and development (R&D), most of which is conducted by firms in search 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.

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66 ❖ CHAPTER 12

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 improvements in information technology (IT) and productivity growth. There has been rapid technological progress in the IT sector, and this sector has increased as a share of the U.S. economy. These developments have led to an increase in the rate of technological progress and the rate of productivity growth for the economy as a whole. On the other hand, in the non-IT sector, which still accounts for more than 90% of the economy, technological progress has only increased by a small amount in last decade, despite the fact that non-IT firms have increased their stock of IT capital. Still, there is reason to believe that productivity growth will remain relatively high—as compared to productivity growth since 1970—in the near future. Technological progress in the IT sector is likely to continue to be rapid, the share of IT firms is likely to continue to increase, and non-IT firms are likely to continue to increase their non-IT capital. These factors will likely create relatively high productivity growth in the future, but probably not as high as over the past decade.

3.

The Facts of Growth Revisited

Having incorporated technological progress in the growth model, the text compares measures of technological progress with output growth for France, Japan, the United Kingdom, and the United States.

An appendix describes the Solow growth accounting methodology used to calculate the technological progress measures.

There are two conclusions about postwar growth in the four economies studied. First, the rates of growth of output per worker have been very close to the rates of technological progress, a fact that suggests that the four economies are on a balanced growth path. Second, convergence among these four economies has occurred because the poorer of any pair of countries in 1950 has had a faster rate of technological progress since then. This result extends beyond the four countries analyzed in this chapter. In general, convergence among OECD countries has arisen largely because the poorer the country in 1950, the faster has been the rate of technological progress since then. Note that these conclusions do not mean that capital accumulation has been irrelevant. Sustaining a balanced growth path requires ongoing capital accumulation.

The text also looks at growth in China since 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 8%. 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 required a substantial amount of investment.

Using equation (12.3) and dividing by output, the text calculates that China has required investment of about 41% of GDP to sustain its growth path.

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.

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TECHNOLOGICAL PROGRESS AND GROWTH ❖ 67

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(N)1-a, where 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.

.

CHAPTER 13. TECHNOLOGICAL PROGRESS: THE SHORT, THE MEDIUM, AND THE LONG RUN I.

MOTIVATING QUESTION

Does technological progress hurt workers?

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.

How do institutions affect productivity growth?

Institutions that protect property rights create an environment more conducive to productivity growth, but causality runs in both directions. If better institutions lead to faster growth, faster growth also leads to better institutions. Poor countries find it difficult to create institutions that support growth.

II. WHY THE ANSWER MATTERS Chapters 10 through 12 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 13 argues that productivity growth does not appear systematically to increase the unemployment rate. However, technological progress may affect the distribution of income.

Most economists believe that developing better institutions is a prerequisite for growth in poor economies.

III. KEY TOOLS, CONCEPTS, AND ASSUMPTIONS 1.

Tools and Concepts

Essentially, there are no new tools in this chapter. The wage-setting, price-setting framework of Chapter 6 is adjusted to include productivity.

2.

Assumptions

Since the focus of this chapter is unemployment, the text assumes that labor is the only factor of production.

IV. SUMMARY OF THE MATERIAL 1.

Productivity, Output, and Unemployment in the Short Run

To focus on employment issues, ignore capital, and write the production function as Y=AN.

(13.1)

Since there is no capital, there is no distinction between technological progress and productivity growth in this chapter. An increase in A reduces the cost of producing a given level of output (because less labor is required), so the short-run AS curve shifts down. The effect on the AD curve depends upon the reason for the increase in A. The introduction of new technology may lead consumers to spend more, in expectation of higher future income, and may lead firms to invest more, in anticipation of higher future profits. These effects would cause AD to shift right. On the other hand, if the increase in A is a result of better use of 68

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TECHNOLOGICAL PROGRESS: THE SHORT, THE MEDIUM, AND THE LONG RUN ❖ 69

existing technology, workers may worry about the safety of their jobs, leading them to save more. In this case, AD would shift left.

Equation (13.1) implies that the effect of productivity growth on employment is ambiguous: employment rises (falls) when output grows by a greater (lesser) percentage than productivity and remains constant when output grows at the same rate as productivity. Even if AD shifts right in response to an increase in productivity, employment could still fall in the short run.

Empirically, changes in output in the United States tend to be larger than changes in labor productivity.

This fact does not imply that increases in productivity increase employment, because causation also runs the opposite way—from output growth to productivity growth—as a result of labor hoarding. Since firms tend to keep extra workers in bad times, measured productivity tends to increase in good times simply because firms make more use of their employees.

2.

Productivity and the Natural Rate of Unemployment

In the medium run, unemployment returns to its natural rate, determined by the wage-setting and pricesetting relations. Productivity growth affects both equations. Given the production function in equation (13.1), the marginal cost of production is W/A. Thus, the price-setting relation becomes P=(1+)W/A.

(13.2)

The text notes that empirical evidence suggests that wage setting reflects productivity growth. This observation suggests an extension of the wage-setting equation. Letting (Ae) denote expected productivity growth, the new wage-setting equation is W=AePeF(u,z).

(13.3)

When price and productivity expectations are correct, equations (13.2) and (13.3) can be written as equations (13.4) and (13.5) below.

W/P=A/(1+)

(13.4)

W/P=AF(u,z)

(13.5)

The solution to these two equations implies that the natural rate of unemployment is independent of the level or growth rate of productivity (i.e., A cancels out). In terms of the wage-setting, price-setting diagram of Chapter 6, an increase in A shifts the wage-setting and price-setting curves up by the same proportion at the initial natural rate of unemployment, so the natural rate does not change.

Empirically, a plot of decadal averages of labor productivity growth and the unemployment rate for the United States over the period 1890-2000 suggests that the two variables are basically unrelated. If anything, there may be a weak negative relationship (i.e., when productivity growth increases, the unemployment rate falls). The negative relationship can be reconciled with the preceding analysis if expectations of productivity growth (which affect wage setting) lag behind actual changes (which affect price setting). If so, a period of slowing productivity growth would be associated with a higher natural rate of unemployment. To see this, suppose price expectations are correct, substitute Ae for A in equation (13.5), start from an original medium-run equilibrium where Ae=A , and assume that A falls, so that Ae>A. Then, at the original natural rate (where Ae=A), the real wage demanded by wage setters exceeds the real wage paid by price setters. The natural rate will rise to reduce the real wage demanded by wage setters.

When Ae falls to match the fall in A, the natural rate will return to its original value.

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70 ❖ CHAPTER 13

A box in the text examines U.S. labor market history since the 1990s. In the late 1990s, high productivity growth was accompanied by optimism about the future, so spending by firms and consumers was high, output growth exceeded productivity growth by a substantial margin, and the unemployment rate fell. In the “jobless recovery” of 2002 and 2003, exceptionally high productivity growth was accompanied by skepticism about the New Economy, so spending was relatively low, and output growth was not high enough to prevent a rise in the unemployment rate. Finally, consistent with the earlier results in this chapter, the unexpected increase in productivity growth since the mid-1990s has been associated with a lower average rate of unemployment, and it seems, with a lower natural rate of unemployment. The results of the chapter suggest that the effect of productivity growth on the natural rate will be disappear over time. Since high productivity growth is no longer unexpected, the modified wage-setting equation implies that wages will eventually increase to capture the benefits of higher worker productivity. Recall, however, that the box on the natural rate in Chapter 8 discussed several factors (including productivity growth) that may have played a role in reducing the U.S. natural rate of unemployment. Some of these factors may persist.

3.

Technological Progress, Churning, and Distributional Effects

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 highskill workers reflects increased relative demand for high-skill workers. Two common explanations for this phenomenon are increased international trade, which exposes low-skill 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. 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.

4.

Institutions, Technological Progress, and Growth

Economists increasingly point to institutions as the fundamental reason why many poor countries remain poor. By institutions, economists generally have in mind 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.

A box in the text compares economic growth in North and South Korea after the Korean War. In 1953, the two countries looked very similar culturally and economically; by 1998, GDP per person was 10 times higher in South Korea than in North Korea. Presumably, different institutions account for the different economic results.

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TECHNOLOGICAL PROGRESS: THE SHORT, THE MEDIUM, AND THE LONG RUN ❖ 71

Another box looks at China, and asks how it managed to avoid the drop in output that other centrally planned economies experienced at the beginning of their transitions to capitalism. The cultural explanation argues that the dominance of Confucian values—hard work, personal responsibility and the like—created a foundation in which market institutions could thrive. The historical explanation argues that the short history of central planning in China meant that people still knew how a market economy functioned and were able to adapt to a market economy relatively easily. Finally, the political explanation argues that the ongoing political control of the Communist party allowed the government to control the pace of the transition and to encourage foreign investment (and support foreign property rights). Despite China’s fast growth, there are problems. The banking system remains inefficient and more progress needs to be made on property rights.

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.

VI. EXTENSIONS Problems at the end of Chapter 13 ask students to incorporate productivity and expected productivity into the AS relation. Instructors may wish to discuss this topic in class.

Equations (13.1), (13.2), and (13.3) together imply the following AS relation: P=Pe(1+)(Ae/A)F(1-Y/(AL),z).

(13.6)

An increase in A has two effects. First, to the extent that Ae lags behind A, Ae/A falls. This is the effect that tends to reduce the actual and natural rates of unemployment for a time. Second, for a given level of Y, an increase in A reduces Y/A, increases u, reduces W (through the F function), and reduces P. This is the effect that tends to increase the actual rate of unemployment in the short run. Both of these effects shift the AS curve down. A change in A may also affect the AD curve, depending on the nature of the change in A.

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CHAPTER 14. EXPECTATIONS: THE BASIC TOOLS 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 three chapters. Two important applications—the distinction between real and nominal interest rates and the effect of money growth on real and nominal interest rates—are analyzed in this chapter.

III. KEY TOOLS, CONCEPTS, AND ASSUMPTIONS 1.

Tools and Concepts

i.

The (expected) real interest rate measures the cost of borrowing in terms of goods, rather than money. ii.

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. iii. According to the Fisher effect, in the medium run, money growth has no effect on the real interest rate, but a one-for-one effect on the nominal interest rate.

IV. SUMMARY OF THE MATERIAL 1.

Nominal versus Real Interest Rates

The nominal interest rate is the interest rate in terms of dollars. The real interest rate is the interest rate in terms of goods. The one-year real interest rate (rt) is the cost, in terms of goods, of borrowing the equivalent of one good for a year. This cost is given by rt=Pt(1+it)/Pet+1–1.

(14.1)

The first term on the RHS of equation (14.1) is the number of goods that have to be repaid at the end of the year. The second term is the number of goods borrowed at the beginning of the year.

The repayment term in equation (14.1) represents the expected cost (in terms of goods) of borrowing Pt to buy one good today. The nominal interest rate on the borrowed funds is it. Repayment is in terms of goods, so the nominal principal and interest payment has to be converted into goods at the future price.

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EXPECTATIONS: THE BASIC TOOLS ❖ 73

Since Pt+1 is not known at time t, the expected repayment is expressed in terms of the expected future price level.

Defining the expected inflation rate (πet+1) as (Pet+1/ Pt-1), the real interest rate must satisfy (1+ rt)=(1+ it)/(1+πet+1).

(14.2)

Equation (14.2) can be approximated as rt ≈ it - πet+1.

2.

(14.3)

Nominal and Real Interest Rates, and the IS-LM Model

The LM relation is unaffected by the distinction between nominal and real interest rates. The interest rate enters the LM relation through real money demand, which concerns the choice between bonds and money.

Bonds earn real return i-πe, and money earns real return -πe; the difference in returns is the nominal interest rate. Therefore, the LM relation should include the nominal (and not the real) interest rate and so remains as derived in Chapter 5.

The IS relation, on the other hand, is affected by the distinction between real and nominal interest rates.

Investment depends on the real interest rate. Suppose that firms must borrow to invest. Firms produce goods and care about how many goods they must repay, not how much money. Thus, the real interest rate should enter the investment function and the IS relation.

Given this reasoning, the IS and LM relations can be rewritten as follows.

IS:

Y

= C(Y-T)+I(Y,i-πe)+G

LM: M/P = YL(i)

(14.4) (14.5)

The approximation in equation (14.3) has been substituted for the real interest rate in the IS curve.

3.

Money Growth, Inflation, Nominal and Real Interest Rates

Given expected inflation, the IS and LM relations can be graphed in Y-i space as in Chapter 5. The intersection gives the equilibrium levels of output and the nominal interest rate. Since expected inflation is known, the real interest rate is determined by the nominal interest rate.

For simplicity, consider an economy with a zero normal growth of output. Assume this economy begins in a medium-run equilibrium with output at its natural level (Yn), and suppose there is an increase in the growth rate of money. In the short run, as demonstrated in Chapter 7, the increase in the nominal money stock leads to an increase in the real money stock. As a result, the LM curve shifts down. If inflation expectations are not revised in the short run, as seems reasonable, the IS curve does not move. The new equilibrium is demonstrated in Figure 14.1. Output is higher, and the nominal interest rate is lower.

Given expected inflation, the fall in the nominal interest rate leads to fall in the real interest rate. In the short run, a monetary expansion stimulates additional output by reducing the real interest rate, which leads to an increase in investment.

To think about the medium run, substitute the natural level of output into the IS relation: Yn=C(Yn-T)+I(rn,Yn)+G.

(14.6)

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74 ❖ CHAPTER 14

Equation (14.6) makes clear that given Yn, the real interest rate is completely determined by the IS relation. Therefore, in the medium run, when Y=Yn, monetary policy cannot affect the real interest rate.

The text calls the medium-run real interest rate the natural real interest rate (rn).

Interest Rate, i

Figure 14.1: An Increase in the Growth Rate of Money in the Short Run

LM

IS Yn

Output, Y

In the medium run, there are three relations that link monetary policy to the nominal interest rate. First, by definition the nominal interest rate equals the natural real interest rate plus expected inflation. Second, expected inflation equals actual inflation. Third, if the normal growth rate of output is zero, inflation equals the growth rate of money.1 Putting these relations together, i=rn+πe= rn+π=rn+gm.

(14.7)

Equation (14.7) contains a relation between inflation and the nominal interest rate. In the medium run, the nominal interest rate rises one-for-one with inflation. This relation is called the Fisher effect, after Irving Fisher, who first stated it.

Summing up the results of monetary policy, in the short run, an increase in money growth reduces the real and nominal interest rates. In the medium run, an increase in money growth has no effect on the real interest rate, but increases the nominal interest rate. In fact, in the medium run, inflation and the nominal interest rate rise one-for-one with the growth rate of money.

How does the nominal interest rate fall in the short run yet rise in the medium run? The adjustment is driven by inflation dynamics and associated changes in inflation expectations. In the short run, output rises above its natural level. As a result, over time there is an increase in wage and price inflation, which 1

If the normal growth rate is positive (and constant), then in the medium run the change in inflation will equal the change in the growth rate of money.

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EXPECTATIONS: THE BASIC TOOLS ❖ 75

tends to reduce the real money supply. In fact, ultimately the real money stock falls, so that in the medium run, the LM curve shifts up. In addition, as inflation rises, expected inflation also rises. This effect shifts the IS curve up by exactly the increase in expected inflation. In the medium run, an increase in the growth rate of money leads to no change in output, but to an increase in the nominal interest rate.

Interest Rate, i

Figure 14.2: An Increase in the Growth Rate of Money in the Medium Run

LM

Increase in Expected Inflation IS Yn

4.

Output, Y

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 $Vt=1/[(1+it)(1+it+1)...(1+it+n-1)].

(14.7)

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 in real terms, they are appropriately discounted using current and expected future real interest rates.

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

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76 ❖ CHAPTER 14

present value. In this context, instructors could describe informally how consumption and investment decisions (examined in Chapter 16) depend upon current and expected future income and interest rates.

VI. EXTENSIONS The presentation of present value in the text assumes that economic agents are risk neutral. Although a formal treatment of uncertainty is outside the scope of the course, the appendix to Chapter 15 discusses the implications of allowing for a risk premium on assets. Instructors could discuss the risk premium in this chapter. 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.

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.

2.

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. Chapter 15 provides a brief discussion of indexed bonds.

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CHAPTER 15. FINANCIAL MARKETS AND EXPECTATIONS I.

MOTIVATING QUESTION

How do expectations affect asset prices?

An asset is expected to provide a stream of future payments to the owner. Putting aside speculative bubbles, an asset’s value (its price) at any moment in time is the expected present discounted value of the stream of future payments. Putting aside risk, the expected real return on all assets should be the same; otherwise, investors would be willing to hold only the asset with the highest expected return. Since asset prices depend on expectations about the future, only new information that changes these expectations can affect asset prices. The more unexpected an economic event—e.g., a monetary policy decision—the greater its effect on asset prices.

II.

WHY THE ANSWER MATTERS

At present, apart from the obvious topical interest in finance, the discussion of expectations and financial markets seems a bit of a sideshow. Chapter 16 will link asset prices and the real economy by introducing relationships between consumption and wealth and between investment and stock prices. Other chapters will discuss the possibility that a fall in asset prices can lead to a financial crisis, with repercussions for the real economy. In this context, Chapter 9 discussion of the crisis impact financial system offers a great connection .

III. KEY TOOLS, CONCEPTS, AND ASSUMPTIONS 1.

Tools and Concepts

i.

Arbitrage refers to the notion that (ignoring risk) expected returns on two assets must be the same.

If two assets have different expected returns, investors will purchase the asset with the higher return and sell the one with the lower return, thereby increasing the relative price (and reducing the relative expected return) of the asset with the higher return. The process continues until expected returns on the two assets are equalized. ii.

A bond's maturity is the length of time over which it promises to make payments to the holder. A bond's yield to maturity is the constant interest rate that makes the present discounted value of future payments on the bond equal to the price of the bond today. The yield curve (also called the term structure of interest rates) is the relation between the yield to maturity and the maturity of a bond. iii.

The chapter introduces a significant amount of basic financial vocabulary.

iv. The fundamental value of a stock is the expected present discounted value of future dividends. A rational speculative bubble occurs when the stock price exceeds the fundamental value because investors expect the price to increase.

IV. SUMMARY OF THE MATERIAL 1.

Bond Prices and Bond Yields

Bonds are assets that (typically) promise a sequence of fixed nominal payments. Ignore default risk, so that the promised payments actually occur. The price of a bond is the present value of these payments.

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For example, the price of a bond that promises to pay $100 in one year is given by $P1t=$100/(1+i1t).

(15.1)

The numeric subscript on the price and the nominal interest rate indicates a one-year bond. Note that the price of the bond varies inversely with the interest rate.

Likewise, the price of a bond that promises to pay $100 in two years (i.e., a two-year bond) is given by $P2t=$100/[(1+i1t)(1+ie1t+1)].

(15.2)

Note that price of the two-year bond (the present value of $100 received in two years) depends on the expected one-year interest rate next year.

An alternative derivation of the two-year bond price relies on arbitrage, the principle that expected returns on all assets (in positive supply) must be the same. If investors do not care about risk, as is assumed throughout most of the chapter, then no one would be willing to hold an asset with an expected return below the expected return on other assets.

Suppose investors choose between holding one- and two-year bonds. The one-year (gross) return on a one-year bond is 1+i1t. To derive the expected one-year (gross) return on a two-year bond, note that at the end of one year, the two-year bond will become, effectively, a one-year bond, with expected sale price $Pe1t+1. Divide this sale price by the original price to arrive at the expected one-year (gross) return of $Pe1t+1/$P2t. Equating the expected returns from the two assets and rearranging gives $P2t=$Pe1t+1/(1+i1t).

(15.3)

The expected sale price of a one-year bond next year is simply the present value of the bond proceeds next year, or $Pe1t+1=$100/(1+ie1t+1).

(15.4)

Substituting equation (15.4) into equation (15.3) gives the two-year bond price, which is identical to the price derived in equation (15.2).

The expression for the price of a two-year bond involves two interest rates: the current one-year rate and the expected future one-year rate. Likewise, the expression for the price of a bond that matures in n years would involve n interest rates. A summary measure of the return on n-year bonds is the yield to maturity, defined as the constant interest rate that equates the bond price with the present value of the future payments on the bond. The yield on an n-year bond is approximately equal to the average of the current one-rate interest rate and the expected one-year rates over the next n-1 years.

For example, the two-year bond yield (denoted by i2t) is defined by $100/(1+i2t) =$P2t=$100/[(1+i1t)(1+ie1t+1)],

(15.5)

which implies (1+i2t)=(1+i1t)(1+ie1t+1)

(15.6)

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FINANCIAL MARKETS AND EXPECTATIONS ❖ 79

or i2t≈(i1t+ie1t+1)/2.

(15.7)

The yield curve plots yields against bond maturities. The yield curve will slope up (yields will be higher on longer maturities) when financial market participants expect short-term interest rates to increase in the future. The yield curve will slope down when market participants expect short-term interest rates to decline.

The text compares the downward-sloping yield curve of November 1, 2000, with the upward-sloping yield curve of June 1, 2001, and offers an interpretation for the change. In November 2000, financial market participants believed that output was above its natural level, and that the economy would adjust to its medium-run equilibrium. In particular, market participants believed that the IS curve would shift left.

Therefore, the nominal interest rate was forecast to fall. By June 2001, the United States was in a recession. The IS curve had shifted very far left. Meanwhile, the Fed had undertaken a monetary expansion, so the LM curve had shifted down. As a result of these shifts, the nominal interest rate at short maturities had fallen substantially. Evidently, the expectation was that the economy would recover relatively quickly, because the yield curve sloped steeply upward for maturities of one year and longer.

Presumably, financial market participants expected that investment spending would pick up (a fall in investment spending was the proximate cause of the recession) and that consumption would increase (partly as a result of the tax cut passed in May 2001). These expectations implied that the IS curve would shift right. In addition, market participants also likely believed that the Fed would reduce the degree of monetary expansion as the economy began to grow. This expectation implied that the LM curve would shift up. The expected shifts of the IS and LM curves implied that the short-term interest rate would increase in the future, and as a result the yield curve sloped up.

2.

The Stock Market and Movements in Stock Prices

Firms raise needed funds through debt (issuing corporate bonds or taking bank loans) and equity (selling ownership shares—stock—in the firm). Corporate bonds promise interest and principal repayments and are priced according to the methods described above. Stocks, by contrast, have no predetermined payments. Periodically, the firm pays some of its profits as dividends to stockholders, but the amounts of these payments are under the firm's discretion.

Ignoring speculative bubbles, described in Section 15.3, the price of a stock (denoted $Qt) is the expected present discounted value of future dividends. Thus, the ex-dividend price—the price after the current year's dividend has been paid—is given by $Qt=$Det+1/(1+it) + $Det+2/[(1+it)(1+iet+1)] + . . .

(15.8)

where $Det+1 is the expected dividend next year. Note that the stock price must take into account dividends over the entire life of the firm. Equation (15.8) can be recast as an expression for the real stock price by replacing nominal dividends with real dividends and by discounting by real (instead of nominal) interest rates.

As described in an appendix to the chapter, the expression for the stock price can be derived from arbitrage between stocks and one-year bonds. Intuitively, arbitrage implies that expected returns from stocks and bonds will be equalized, so dividends will be discounted by bond interest rates (and expected interest rates). Moreover, the one-year return on a stock depends upon the dividend and the sales price of the stock after one year. The future sales price, however, will itself depend upon future dividends.

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80 ❖ CHAPTER 15

Ignoring bubbles, repeated substitution for the future sales price (farther and farther into the future) implies that the stock price can be written as an infinite series of discounted dividends.

Since stock prices depend upon expectations about the future, they change only when new information (“news”) changes these expectations. As a result, apart from those cases where a few investors have better information than the rest of the market, changes in stock prices cannot be predicted. News that leads to an increase in the expected level of output tends to increase stock prices, because higher output means higher profits and higher dividends. News that leads to an increase in expected interest rates tends to reduce stock prices, because higher interest rates make investment in bonds more attractive relative to stocks. In practice, the effect of news on the stock market reflects depends on beliefs about the likely policy response of the Federal Reserve.

For example, consider the response of the stock market to an unexpected increase in consumer spending.

If the Fed is expected to do nothing, the response is ambiguous, because output is higher than expected (which tends to increase stock prices), but interest rates are also higher than expected (which tends to reduce stock prices). If the Fed is expected to increase the money supply to prevent interest rates from rising, stock prices will increase; if the Fed is expected to reduce the money supply to prevent output from increasing (and thus to reduce inflationary pressure), stock prices will fall.

An unanticipated monetary expansion will lead to higher output than had been expected and to lower interest rates than had been expected, and therefore to an increase in stock prices. An anticipated monetary expansion will have very little effect on stock prices, since expected dividends and interest rates do not change. In this case, the monetary expansion itself is not news. The information that led to the expectation of the monetary expansion was news, and stock prices incorporated the effects of the monetary expansion then.

3.

Risk, Bubbles, Fads, and Asset Prices

The present value of dividends is called the fundamental value of a stock. At times, stock prices deviate from their fundamental values. Sometimes this occurs for no good reason. Some financial investors may not be rational and may pay a high price for stocks simply because they have done well in the past. In contrast to these fads, sometimes stock prices exceed their fundamental values because investors expect stock prices to rise in the future. These episodes are called rational speculative bubbles. Even though a crash is possible when stock prices exceed their fundamental values, it may make sense for investors to pay a high price for stocks if there is a chance that prices will increase in the future.

Bubbles and fads are important because overpriced stocks are vulnerable to crashes, which can affect real activity. A new box in the chapter discuss an increase in housing prices due to the crisis (covered in Chapter 9) and its connection the fundamental understanding of bubbles.

V. PEDAGOGY 1.

Points of Clarification

Bubbles cannot exist on bonds with fixed maturity. The possibility of an asset bubble depends upon the price exploding (growing forever at too high a rate). Since bonds have a fixed terminal payment, there is no possibility that bond prices will rise forever.

2.

Alternative Sequencing

This chapter is optional, even within the module on expectations. It is not required for most of Chapters 16 and 17. If the chapter is covered, instructors pressed for time could omit discussion of the stock market.

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FINANCIAL MARKETS AND EXPECTATIONS ❖ 81

VI. EXTENSIONS The main text assumes that investors are risk neutral. An appendix explores the implications of allowing for risk. Essentially, riskier assets are charged a risk premium (denoted by ), which requires them to pay a higher expected return. As such, the risk premium acts as an increase in the discount rate, so that increases in the risk premium reduce stock prices. The text notes that the average risk premium on stocks over bonds has been about 5% in the United States over the past century and that the risk premium varies over time, contributing to variations in stock prices.

.

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

i. 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. ii.

Human wealth is the present value of expected after-tax labor income.

iii. 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. iv. The user or rental cost of capital is the sum of the real interest rate and the depreciation rate on a unit of capital.

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. As a benchmark, 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 82

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EXPECTATIONS, CONSUMPTION, AND INVESTMENT ❖ 83

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.

2.

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 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

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84 ❖ CHAPTER 16

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, since 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(et), is given by V(et)=/(r+),

(16.1)

where r is the real interest rate and  is the depreciation rate. The quantity r+ 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.

3.

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 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.

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EXPECTATIONS, CONSUMPTION, AND INVESTMENT ❖ 85

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.

2.

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

2.

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.

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86 ❖ CHAPTER 16

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.

.

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. The model in this chapter is much closer to the way economists think about macroeconomic policy than the model of Chapter 5.

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)+G, +--

(17.1)

where A—which stands for aggregate private spending—is defined as consumption plus investment.

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 16, 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. +--+ - -

(17.2)

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.

87

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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.

2.

Monetary Policy, Expectations, and Output

For simplicity, assume that expected inflation is zero, so that the nominal interest rate equals the real interest rate. Then, the LM relation can be written as M/P=YL(r).

(17.3)

Now consider an increase in the current period money supply. Such an increase shifts the LM curve to the right, 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.

3.

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.

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

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EXPECTATIONS, OUTPUT, AND POLICY ❖ 89

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.

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 Fed 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/AD-AS 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.

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

i.

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. ii.

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 capital account, which records transactions in assets. 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. iii. 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.

2.

Assumptions

i.

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. 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.

90

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OPENNESS IN GOODS AND FINANCIAL MARKETS ❖ 91

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 United States is the domestic country, and one dollar trades for 100 yen, the nominal exchange rate is 100 yen/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 United States, the domestic country, produces only one good, airplanes. If an airplane sells for P dollars, its price in yen is EP. Note that E has units of yen/dollar, and P has units of dollars/airplane, so EP has units of yen/airplane. Now assume that Japan, the foreign country, also produces only one good, cars. One could compare the yen price P* of cars produced in the Japan to the yen price of airplanes produced in the United States. This motivates the definition of the real exchange rate (): =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 ). A decrease in the relative price of domestic goods is a real depreciation (a decrease in ).

In the one-good-per-country example above, the real exchange rate has units of foreign goods per domestic good (in this case, 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.

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.

.

92 ❖ CHAPTER 18

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.

2.

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 capital account, measures the purchase and sale of foreign assets. The capital 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 capital 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 capital 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 capital account.

The capital 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 U.S. resident has a dollar to invest. Let it be the interest rate on U.S. bonds and it* the interest rate on Japanese bonds. Consider the choice between U.S. and Japanese bonds.

Option 1: Buy U.S. bonds The return on one dollar equals 1+ it dollars.

Option 2: Buy Japanese bonds. i. Exchange one dollar for Et yen. ii. Invest Et yen in Japanese bonds, with a return of (1+it*)Et yen iii. Exchange (1+it*)Et yen for (1+i*t)Et/Et+1 dollars.

1

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

.

OPENNESS IN GOODS AND FINANCIAL MARKETS ❖ 93

The return on one dollar equals (1+it*)Et/Et+1 dollars.

The expected return on one dollar equals (1+it*)Et/Eet+1 dollars.

Note that to transfer the return from the second option into dollars, 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 Eet+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 U.S. and Japanese 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, 1+it = (1+it*)Et/Eet+1, which can be approximated by it ≈ it* - (Eet+1-Et)/Et.

(18.2)

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 Japanese bonds produces a smaller return than the investment in U.S. bonds.

In words, equation (18.2) 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).

3.

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 20 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 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 .

94 ❖ CHAPTER 18

1.

The Balance of Payments

The text presents the balance of payments in the traditional manner, with a current and capital account.

The U.S. presentation of the balance of payments has changed, however. Essentially, what was previously called the capital account is now called the financial 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.

The text also omits several details of balance of payments accounting. An important one is that changes in official reserves are part of the financial account (which the text calls the capital 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.

2.

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.

3.

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 presentation of evidence on U.S. bilateral exchange rates in the postwar period.

.

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

i.

The chapter introduces an open-economy model of goods market equilibrium by adding net exports to the demand for domestic goods. ii.

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. iii. The J-curve describes the dynamics of trade balance adjustment after a real depreciation. Initially, the trade balance falls, since the real depreciation tends to increase the relative value of imports. Over time, however, consumers and firms start buying more home goods and fewer foreign goods (since real depreciation makes home goods cheaper), and the trade balance improves.

2.

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.

95

.

96 ❖ CHAPTER 19

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/+X. (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.

X=X(Y*,).

(19.2) + IM=IM(Y,).

(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 ), 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.

Substituting equations (19.2) and (19.3) into the demand for domestic goods produces a new IS relation: Y=C(Y-T)+I(Y,r)+G-IM(Y,)/ +X(Y*,).

(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.

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/). 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 panel 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.

2.

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. 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 with a trade deficit .

.

THE GOODS MARKET IN AN OPEN ECONOMY ❖ 97

Domestic Demand (DD) Demand for Domestic Goods (ZZ)

Figure 19.1: The Demand for Domestic Goods and the Trade Balance (NX)

NX ZZ X

I M

Trade Balance, NX

Income, Y

0

Income, Y NX

3.

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.

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.

.

98 ❖ CHAPTER 19

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.

Demand for Domestic Goods (ZZ)

Figure 19.2: Equilibrium Output and the Trade Balance (NX)

ZZ

45º

Trade Balance, NX

Income, Y

0

Income, Y NX

.

THE GOODS MARKET IN AN OPEN ECONOMY ❖ 99

4.

Depreciation, the Trade Balance, and Output

The trade balance (NX) is given by NX=X(Y*,) - IM(Y,)/.

(19.5) 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 Marshall-Lerner 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.

5.

Looking at Dynamics: the J-Curve

The effects of a real depreciation have a dynamic dimension. The price effect happens immediately, but the quantity effect takes time. As a result, the trade balance tends to worsen immediately after a real depreciation, but to improve over time. In other words, it takes some time for the Marshall-Lerner condition to be satisfied. This adjustment process of the trade balance—a temporary fall followed by a gradual improvement—is called the J-curve. Econometric evidence suggests that in rich countries, the trade balance improves between six months and a year after a real depreciation.

6.

Saving, Investment, and the Current Account Balace

The national income identity (equation (19.1)) can be expressed as NX=Y-C-I-G=(S-I)+(T-G), (19.6) where private saving (S) is given by S=Y-C-T. The first equality in equation (19.6) says that the trade balance equals income minus spending.

The second equality of equation (19.6) says that the trade balance is the excess of private saving over investment plus the government budget surplus. Ignoring the distinction between the current account and the trade balance, a trade surplus implies that a country is lending to the rest of the world. The funds for this lending are derived from the two sources on the RHS of equation (19.6).

Since saving and investment are endogenous, equation (19.6) can be a misleading guide for policy analysis. For example, since the real exchange rate does not appear in equation (19.6), one might

.

100 ❖ CHAPTER 19

conclude that a real depreciation has no effect on the trade balance. In fact, a real depreciation affects output, and therefore affects saving and investment. If the Marshall-Lerner condition is satisfied, a real depreciation will increase saving more than it increases investment, and improve the trade balance.

A box in the text examines the increase in the U.S. trade deficit over the period 1996-2006 and concludes that the increase resulted primarily from a reduction in saving—and in particular private saving—rather than from an increase in investment. In terms of the determinants of the net export function, the text notes that relatively high U.S. growth, shifts in the export and import functions, and a real appreciation of the dollar between 1996 and 2002 all played a role in the increase in the U.S. trade deficit.

V.

PEDAGOGY

The relationship between saving and investment in an open economy (equation (19.6)) is presented at the end of the chapter. There are two arguments for placing it at the beginning. First, the derivation of equation (19.6) illustrates that the trade balance is the difference between income and spending. Second, by discussing equation (19.6) 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.

.

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 sun 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

i.

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. ii.

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). iii. An appendix to the chapter discusses the central bank balance sheet, in the context of monetary policy under fixed exchange rates.

2.

Assumptions

i.

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. ii.

Production is assumed to respond to changes in demand without changes in price, so demand determines output. iii.

Foreign currency is assumed to have no transactions value for domestic residents.

iv. Domestic and foreign bonds are considered perfect substitutes, and there is perfect capital mobility, so uncovered interest parity holds.

101

.

102 ❖ CHAPTER 20

v.

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.

IV. SUMMARY OF THE MATERIAL 1.

Equilibrium in the Goods Market

Since NX=X(Y,)-IM(Y,)/, the goods market equilibrium condition can be written as Y=C(Y-T)+I(Y,r)+G+NX(Y,Y*,).

In the short run, assume that P and P* are fixed and (for convenience) equal to one, so that E=. 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,i)+G+NX(Y,Y*,E).

2.

(20.1)

Equilibrium in Financial Markets

Foreign currency is assumed to have no transactions value for domestic residents, so the choice between domestic money and bonds can be summarized by the LM relation, M=YL(i),

(20.2)

which was introduced in Chapter 4.

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+i*t)Et/Eet+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= E e(1+i)/(1+i*).

(20.4)

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 (so that E> E e), 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.

.

OUTPUT, THE INTEREST RATE, AND THE EXCHANGE RATE ❖ 103

3.

Putting Goods and Financial Markets Together

Substituting equation (20.3) into equation (20.1) gives the open economy IS relation: Y=C(Y-T)+I(Y,i)+G+NX(Y,Y*, E e(1+i)/(1+i*)).

(20.5)

The LM relation is given by equation (20.2). 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.

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. The appreciation of the dollar in the 1990s, for example, was driven by the perceived safety of U.S. Treasury bonds, and their high liquidity. Demand for U.S. assets continues to be strong, despite relatively low U.S. interest rates.

4.

The Effects of Policy in an Open Economy

The effects of an increase in government spending are depicted graphically in Figure 20.1. 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 (equation (20.4)) 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.

Figure 20.1: Expansionary Fiscal Policy in an Open Economy with Flexible Exchange Rates

Interest Rate, i

LM

Interest parity relation (given i* andEe)

i* IS Output, Y

.

Exchange Rate, E

104 ❖ CHAPTER 20

A decrease in the money supply shifts the LM curve to the left. Output falls, the interest rate increases, and the exchange rate appreciates. Investment definitely falls. The effect on the trade balance is ambiguous: the fall in output tends to increase the trade balance, the exchange rate appreciation tends to reduce the trade balance.

5.

Fixed Exchange Rates

If policymakers fix the exchange rate (credibly) at E , then expected depreciation is zero, and i=i* by uncovered interest parity. As a result, the IS and LM relations can be written as follows.

IS: Y=C(Y-T)+I(Y,i*)+G+NX(Y,Y*, E ) LM: M=YL(i*).

Given fiscal policy, foreign output, and the foreign interest rate, output is fully determined by the fixed exchange rate and the IS curve. As a result, 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.

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.

.

OUTPUT, THE INTEREST RATE, AND THE EXCHANGE RATE ❖ 105

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.

2.

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.

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106 ❖ CHAPTER 20

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 Ee=E+(1-) E , (20.5) where E is a constant, all of the qualitative results hold when 0<1. When =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 =1 is the canonical MundellFleming model.

.

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, medium-run 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

i.

Following Mundell, the chapter defines an optimum 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: Yt=Y( E Pt/P*,G,T).

(21.1)

This chapter focuses on the role of the real exchange rate ( E P/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.

Equation (21.1) specifies aggregate demand (AD). 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.

Aggregate supply (AS) is given by the same relationship derived previously, namely Pt=Pe(1+)F(1-Yt/L,z).

(21.2)

107

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108 ❖ CHAPTER 21

The AS and AD curves are depicted in Figure 21.1. Note that the AD curve slopes down in output-price space, as in a closed economy, but for a different reason. In a closed economy, an increase in the price level tends to reduce the real money supply and thus to increase the interest rate and reduce output. In an open economy with a fixed exchange rate, however, the interest rate is fixed at the world rate, so an increase in the price level has no effect on the interest rate. Instead, an increase in the price level causes a real appreciation, which tends to reduce net exports and output.

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. This scenario is depicted in Figure 21.1. 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, and to shift the AS curve to the right until it intersects the AD curve at the natural level of output. Note that the increase in output along the AD curve results from the real depreciation created by the fall in the home price level. 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.

Price LeveI, P

Figure 21.1: Adjustment in an Open Economy with a Fixed Exchange Rate

AS

AD Yn

Output, Y

If policymakers want to speed up adjustment, they can devalue the currency (decrease the level of E ).

The effects of devaluation are depicted in Figure 21.2. A devaluation creates a real depreciation in the short run and shifts the AD 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. Note that the possible effect on wages and the AS curve is not shown in Figure 21.2.

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EXCHANGE RATE REGIMES ❖ 109

Price LeveI, P

Figure 21.2: Devaluation

AS

AD

Yn 2.

Output, Y

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.

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110 ❖ CHAPTER 21

3.

Exchange Rate Movements under Flexible Exchange Rates

Chapter 20 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.

Rewrite the uncovered interest parity condition as follows: Et=Eet+1(1+it)/(1+i*t).

(21.3)

Applying equation (21.3) 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, Eet+1=Eet+2(1+iet+1)/(1+i*et+1).

(21.4)

Substituting equation (21.4) into equation (21.3) gives Et=Eet+2(1+it)(1+iet+1)/[(1+i*t)(1+i*et+1)].

(21.5)

Carrying this calculation n years into the future gives Et=Eet+n(1+it)(1+iet+1)...(1+iet+n)/[(1+i*t)(1+i*et+1)...(1+i*et+n)].

(21.6)

Equation (21.6) 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.

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EXCHANGE RATE REGIMES ❖ 111

4.

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 optimum 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 optimum 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 20. 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.

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112 ❖ CHAPTER 21

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. 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.

.

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 take action 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 take action 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.

In economics, a game refers to strategic interactions among a set of players.

ii.

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. iii. A political business cycle occurs when policymakers try to generate expansions before elections in hopes of securing reelection.

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.

1.

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.

113

.

114 ❖ CHAPTER 22

If extreme macroeconomic outcomes are very harmful, uncertainty provides an argument for moderation in policymaking: the smaller the change in policy, the more narrow the 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.

2.

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.

3.

Politics and Policy

Sections 24.1 and 24.2 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 changes of reelection without much cost by generating expansions just before elections. Thus, there

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SHOULD POLICYMAKERS BE RESTRAINED? ❖ 115

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 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)π2-b(π-πe).

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.

1

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.

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116 ❖ CHAPTER 22

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.

.

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 U.S. economic policymakers 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

i.

The inflation-adjusted deficit is the deficit measured in real terms. It equals real interest payments plus the (real) primary deficit, defined below. ii.

The primary deficit is government spending minus taxes.

iii.

The cyclically-adjusted deficit measures what the deficit would be if output were at its natural level.

iv. Ricardian equivalence is the proposition that neither deficits nor debts have any effect on economic activity. v.Debt restructuring, or debt rescheduling occurswhen interest payments are deferred rather than cancelled vi.Debt monetization occurs whenthe central bank then pays the government with money it creates, and

the government uses that money to finance its deficit. vii.

Hyperinflation is very high levels of inflation.

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 authors highlight 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 authors highlight 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 9).

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2.

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

The inflation-adjusted deficit is defined as Deficit=rBt-1+Gt-Tt,

(26.1)

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 (26.1). The deficit is linked to the increase in debt by the government budget constraint: Bt-Bt-1=rBt-1+Gt-Tt.

(26.2)

Defining the primary deficit as Gt-Tt, government debt can be expressed as Bt=(1+r)Bt-1+Primary Deficit.

(26.3) 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)tafter 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 Bt/Yt=(1+r)(Yt-1/Yt)(Bt-1/Yt-1)+(Gt-Tt)/Yt, which can be approximated as (Bt/Yt)-(Bt-1/Yt-1)=(r-g)(Bt-1/Yt-1)+(Gt-Tt)/Yt,

(26.4)

whereg is the growth rate of output. Given some initial debt, equation (26.4) 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.

3.

Ricardian Equivalence, Cyclical Adjusted Deficits, and War Finance

i.

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 (according to the benchmark consumption theory presented in Chapter 16) 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 future. As a result, although expectations certainly affect economic behavior, it is unlikely that Ricardian equivalence holds in strict form. ii.

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

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FISCAL POLICY: A SUMMING UP ❖ 119

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 cyclicallyadjusted 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. iii.

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.

4.

The Dangers of High Debt

High debt can lead to vicious cycles. The text explains how the presence of a large debt leaves governments in a vulnerable position. Moreover,in a vicious cycle which can be a self-fulfilling. 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.

Figure 23-2 plots the spreads between the two-year interest rate on Italian, Spanish and Belgian government bonds over a two year interest rate of German bonds. The figure shows that since the beginning of 2011, the spread for these three countries have increased from 200 to 400 basis points. The increase in the spread 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, 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. b. Chapter 23 concludes with the economic costs of hyperinflation, which are: the decline transaction system; price signals become less and less useful; and swings in inflation become larger and larger and harder to predict.

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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.

2.

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. The 6th edition also offers a section that explains the risk countries facing when running a high debt.

VI. EXTENSIONS 1.

The Global 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.

2.

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.

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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

i.

The chapter introduces monetary aggregates. M1 (which was mentioned briefly in Chapter 4) 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. ii.

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. iii. The chapter introduces terminology associated with the organization of the U.S. Federal Reserve. iv. Macro prudential tools are rules aimed directly at borrows or lenders, or banks and other financial institutions as the case may require.

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.

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2.

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.

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.

3.

The Design of Monetary Policy

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.

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MONETARY POLICY: A SUMMING UP ❖ 123

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 andb 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 past 20 years, however they conceived of their policy decisions. Today it seems that most central banks think in terms of interest rate rules rather than in terms of nominal money growth. Indeed the growth rate of any particular monetary aggregate seems to be of little concern to central banks or financial markets.

4. Challenges from the Crisis 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.

The challenge of a liquidity trap has been explored in Chapter 9, this section of the text offers issues of how economics can: avoid falling into the trap through having a higher average inflation; getting out of a liquidity trap by altering the affect of inflation expectations; and whether unconventional monetary policy tools can be used to deal with the liquidity trap.

Macro Prudential Regulation 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 macro prudential tools. These tools arerules that are aimed directly at borrowers, lenders, banks and/or other financial institutions. This chapter section concludes with possible examples of the forms that

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macro prudential tools could take. There are many questions regarding how well these macro prudential tools work and its 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 could be incorporated into the description of the money supply process. The existence of near monies (described in a box) could also be integrated into the monetary policy discussion of Chapter 4 as a way of motivating money demand shocks. Finally, the discussion of the the crisis could be incorporated into the discussion in Chapter 9 to discuss the Fed’s recent and nontraditional policy measures.

.

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.

2.

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.

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.

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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.

3.

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 Keynsian 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 Keynsian 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.

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.

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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 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.

4.

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 classicals 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 classicals, recognizes the potential importance of changes in the pace of technological progress as emphasized by the new classicals 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.

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 4).

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• •

•

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.

.

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

b. Although the Euro will remove obstacles to free trade between European countries, each country will be forced to give up its own monetary policy.

2. a. True. b. True/Uncertain. Stock prices certainly fell around the world in the crisis. Emerging market stock prices mostly recovered as of 2010, stock prices in the United States and other advanced companies had not reached their pre-crisis levels as of 2012. c. False. d. False. There are problems with the statistics, but the consensus is that growth in China has been high. e. False. European unemployment rates have been higher for several decades. f. True. g. True. h. False

Dig Deeper 3. a. We will have to wait until ERP 2012 comes out b. We will have to wait until ERP 2012 comes out c. This answer will vary with the issue of The Economist used.

4. a.

14.7(1.026)t=5.8(1.105)t t = ln(14.7/5.8)/[ln(1.105/1.026)] t ≈ 12.53 yrs This answer can be confirmed with a spreadsheet, for students unfamiliar with the use of logarithms.

b. No. At current growth rates, Chinese output will exceed U.S. output within 31 years, but Chinese output per person (the Chinese standard of living) will still be less than U.S. output per person. c. 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

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130 ❖ ANSWERS TO END-OF-CHAPTER PROBLEMS

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 fewer. d. China does provide a model for other developing countries.

Explore Further 6. a/c. As of February 2012, there had been 6 occasions since 1960, quarter 2, with two consecutive quarters of negative economic growth. There are many quarter of negative economic growth.

Seasonally-adjusted annual percentage growth rates of GDP where two or more quarter 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

1980:2 1980:3

-7.9 -0.7

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

-3.7 -8.9 -6.7 -0.7

The recession in 2008-09 had the largest fall in out and lasted 4 quarters. Other recessions lasted 2 or 3 quarters.

7. a-b. Behaviour of the unemployment rate over the 6recessions above Recession (year and quarter)

1969:4-1970:1 1974:3-1975:1 1980:2-1980:3 1981:4-1982:1 1990:4-1991:1 2008:3-2009:2

Unemployment Rate in month prior to recession quarter 3.5 5.4 6.3 7.6 5.9 5.6

Unemployment rate in month at end of recession quarter 4.4 8.6 7.5 9.0 6.8 9.5

Change over recession

Unemployment rate peak after recession

Change from before recession to peak month

0.9 3.2 1.2 1.4 0.9 3.9

6.1 (Dec. 1970) 9.0 (May 1975) 7.5 (Sept. 1980) 10.8 (Dec. 1982 7.8 (June 1992) 10.0 (Oct. 2009)

2.6 3.6 1.2 3.2 1.9 4.4

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

CHAPTER 2 ©2013 Pearson Education

ANSWERS TO END-OF-CHAPTER PROBLEMS ❖ 131

Quick Check 1.

2.

3.

4.

a.

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

b.

1st Stage: $300,000. 2nd Stage: $1,000,00-$300,000=$700,000.

GDP: $300,000+$700,000=$1,000,000.

c.

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.

a.

2005 GDP: 10($2,000)+4($1,000)+1000($1)=$25,000 2006 GDP: 12($3,000)+6($500)+1000($1)=$40,000 Nominal GDP has increased by 60%.

b.

2005 real (2005) GDP: $25,000 2006 real (2005) GDP: 12($2,000)+6($1,000)+1000($1)=$31,000 Real (2006) GDP has increased by 24%.

c.

2005 real (2006) GDP: 10($3,000)+4($500)+1,000($1)=$33,000 2006 real (2006) GDP: $40,000.

Real (2006) GDP has increased by 21.2%.

d.

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.

a.

No change. This transaction is a purchase of intermediate goods.

b.

+$100: personal consumption expenditures

c.

+$200 million: gross private domestic fixed investment

d.

+$200 million: net exports

e.

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.

a.

True/Uncertain. Real GDP increased by a factor of 5; nominal GDP increased by a factor of 28. 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.

b. c. d.

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132 ❖ ANSWERS TO END-OF-CHAPTER PROBLEMS

e.

Uncertain. Which index is better depends on what we are trying to measure—inflation faced by consumers or by the economy as a whole. f.

True g.

True h.

False i.

False. The Phillips curve is a relation between the change in inflation and the level of unemployment.

5.

a.

2005 real GDP = 10($2,500) + 4($750) + 1000($1) = $29,000 2006 real GDP = 12($2,500) + 6($750) + 1000($1) = $35,500

b.

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

c.

Deflator in 2005=$25,000/$29,000=.86 Deflator in 2006=$40,000/$35,500=1.13 Inflation = (1.13 -.86)/.86 = .31 = 31%.

c. Yes, see appendix for further discussion.

6. a. Usual output growth is positive as population grows and output per worker grows. b. The unemployment rate rises more in a year when output growth is -2%. c. The unemployment rate at which the rate of inflation does not change is about 6%, considerably larger than zero. d. The slope does not tell us much about whether one economy is better than another. A slope of 0.8 simply says that, on average, inflation falls more with a given increase in the unemployment rate.

7.

a.

2005 base year: Deflator(2005)=1; Deflator(2006)=$40,000/$31,000=1.29 Inflation=29%

b.

2006 base year: Deflator(2005)=$25,000/$33,000=0.76; Deflator(2006)=1 Inflation=(1-0.76)/0.76=.32=32%

c.

Analogous to 4d.

Dig Deeper 8.

a.

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.)

b.

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

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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.)

9.

a.

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.

b.

The new method represents a 10% quality increase.

c.

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

d.

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

Explore Further 10.

a.

The table below has the data

Earlier recession Date 1999.1 1999.2 1999.2 1999.4 2000.1 2000.2 2000.3 2000.4 2001.1 2001.2 2001.3 2002.4

GDP growth 0.890595 0.781715 1.272143 1.795443 0.261704 1.950406 0.084453 0.592452 -0.32848 0.654689 -0.27549 0.349502

Crisis Recession GDP Date growth 2007.1 0.135753 2007.2 0.899962 2007.3 0.730248 2007.4 0.423518 2008.1 -0.44424 2008.2 0.329394 2008.3 -0.92859 2008.4 -2.30077 2009.1 -1.70994 2009.2 -0.17294 2009.3 0.420843 2009.4 0.937414

GDP growth has larger negative values in the crisis 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.

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c.

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.

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

b.

YD=Y-T=1000-100=900

c.

C=160+0.6(900)=700

2.

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

True.

False. Government spending excluding transfers was 20.4% of GDP. False. The propensity to consume must be less than one for our model to make sense.

True.

False.

False. The increase in equilibrium output is one times the multiplier.

False.

3.

a.

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.

b.

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.

c.

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.

a.

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

b.

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.

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ANSWERS TO END-OF-CHAPTER PROBLEMS ❖ 135

5.

6.

7.

8.

c.

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.

a.

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

b.

There is no effect on the diagram or on output.

c.

The ZZ line shifts up and output increases. Effectively, the income transfer increases the propensity to consume for the economy as a whole.

d.

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 lowincome taxpayers.

a.

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

b.

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

c.

Both Y and T decrease.

d.

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.

a.

Y increases by 1/(1-c1)

b.

Y decreases by c1/(1-c1)

c.

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

d.

The change in Y equals 1/(1-c1) - c1/(1- c1)=1. Balanced budget changes in G and T are not macroeconomically neutral.

e.

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.

a.

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

b.

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

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c.

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. b. c. d.

10.

a.

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.

a.

Output will fall.

b.

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.

c.

Output, investment, and private saving would have risen.

d.

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.

11.

a. b. c. d.

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

CHAPTER 4 Quick Check 1.

a.

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

b.

Money demand decreases when the interest rate increases because bonds, which pay interest, become more attractive.

c.

The demand for money falls by 50%.

d.

The demand for money falls by 50%.

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2.

e.

A 1% increase (decrease) in income leads to a 1% increase (decrease) in money demand.

This effect is independent of the interest rate.

a. b. c.

False.

False.

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.

False.

True.

True.

d. e. f. g. h.

3.

4.

a.

$20=MD=$100(.25-i) i=5%

b.

M=$100(.25-.15) M=$10

a.

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

b.

When the bond price rises, the interest rate falls.

c.

$PB =100/(1.08) ≈ $93

Dig Deeper 5. The money multiplier is 1/[c+(1-c)], where c is the ratio of currency to deposits and  is the ratio of reserves to deposits. When c increases, as in the Great Depression, the money multiplier falls.

6. a.

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).

b.

$100B = 0.1($5,000B)(.8-4i) i=15%

c.

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).

d.

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

e.

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

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7.

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.

8.

a.

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

b.

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

c.

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

d.

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.

a.

$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.

b.

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

c.

$8 is withdrawn on each trip to the bank.

9.

Money holdings are $8, $4, $8, and $4. d.

Average money holdings are $6.

e.

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

f.

Average money holdings are $4.

g.

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

Explore Further 10.

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

CHAPTER 5 Quick Check 1.

a.

The IS curve shifts left. Output and the interest rate fall. The effect on investment is ambiguous because the output and interest rate effects work in opposite directions: the

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fall in output tends to reduce investment, but the fall in the interest rate tends to increase it.

2.

b.

From the answer to 2(c), Y=[1/(1-c1-b1+b2d1/d2)][c0-c1T+b0+(b2/d2)(M/P)+G].

c

From the LM relation, i=Y(d1/d2)–(M/P)/d2.

To obtain the equilibrium interest rate, substitute for equilibrium Y from part (b).

a.

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

b.

M/P=1600=2Y-8000i i=Y/4000-1/5

c.

Substituting from part (b) into part (a) gives Y=1000.

d.

Substituting from part (c) into part (b) gives i=5%.

e.

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

f.

Y=1040; i=3%; C=410; I=380. A monetary expansion reduces the interest rate and increases output. Consumption increases because output increases. Investment increases because output increases and the interest rate decreases.

g. Y=1200; i=10%; C=450; I=350. A fiscal expansion increases output and the interest rate.

Consumption increases because output increases. Investment is affected in two ways: the increase in output tends to increase investment, and the increase in the interest rate tends to reduce investment. In this example, these two effects exactly offset one another, and investment does not change.

3.

4.

a.

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

b.

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.

c.

Substituting for the interest rate in the answer to part (b), Y=[1/(1-c1-b1+b2d1/d2)][c0-c1T+b0+(b2/d2)(M/P)+G].

The multiplier is 1/(1-c1-b1+b2d1/d2).

a. b. c. d.

True.

True.

False.

False. The balanced budget multiplier is positive (it equals one), so the IS curve shifts right.

False.

e.

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140 ❖ ANSWERS TO END-OF-CHAPTER PROBLEMS

f.

g.

d.

Uncertain. An increase in government spending leads to an increase in output (which tends to increase investment), but also to an increase in the interest rate (which tends to reduce investment).

True.

The multiplier is greater (less) than the multiplier in part (a) if (b1-b2d1/d2) is greater (less) than zero. The multiplier as measured in part (c) measures the marginal effect of an increase in autonomous spending on equilibrium output. As such, the multiplier is the sum of two effects: a direct effect of output on demand and an indirect effect of output on demand via the interest rate. The direct effect is equivalent to the horizontal shift of the IS curve. The indirect effect depends on the slope of the LM curve (since the equilibrium moves along the LM curve in response to a shift of the IS curve) and the effect of the interest rate on investment demand.

The direct effect is captured by the sum c1+b1, which measures the marginal effect of an increase in output on the sum of consumption and investment demand. As this sum increases, the multiplier gets larger.

The indirect effect is captured by the expression b2d1/d2 and tends to reduce the size of the multiplier. The ratio d1/d2 is the slope of the LM curve, and the parameter b2 measures the marginal effect of an increase in the interest rate on investment. Note that the slope of the LM curve becomes larger as money demand becomes more sensitive to income (i.e., as d1 increases) and becomes smaller as money demand becomes more sensitive to the interest rate (i.e., as d2 increases).

d.

I= b0+b1Y-b2i=b0+(b1-b2d1/d2)Y+(b2/d2)(M/P) To obtain equilibrium investment, substitute for equilibrium Y from part (b).

e.

From part (b), holding M/P constant, equilibrium Y decreases by [1/(1-c1-b1+b2d1/d2)] when G decreases by one unit. From part (d), holding M/P constant, I decreases by (b1- b2d1/d2)/(1-c1-b1+b2d1/d2) when G decreases by one unit. So, if G decreases by one unit, investment will increase when b1<b2d1/d2.

f.

A fall in G leads to a fall in output (which tends to reduce investment) and to a fall in the interest rate (which tends to increase investment). Therefore, for investment to increase, the output effect (b1) must be smaller than the interest rate effect (b2d1/d2).

Note that the interest rate is the product of two factors: (i) d1/d2, the slope of the LM curve, which gives the effect of a one-unit change in equilibrium output on the interest rate, and (ii) b2, which gives the effect of a one-unit change in the equilibrium interest rate on investment.

Dig Deeper 5.

a.

The reduction in T shifts the IS curve to the right. The increase in M shifts the LM curve down. Output increases.

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b.

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

d. 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.

6.

a.

Increase G (or reduce T), which shifts the IS curve to the right, and increase M, which shifts the LM curve down.

b.

Reduce G (or increase T), which shifts the IS curve to the left, and increase M, which shifts the LM curve down. The interest rate falls. Investment increases, since the interest rate falls while output remains constant.

7.

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.

8.

a.

The IS curve shifts left. Output and the interest rate fall.

b.

Consumption falls. The change in investment is ambiguous: the fall in output tends to reduce investment, but the fall in the interest rate tends to increase investment. The change in private saving equals the change in investment. So, private saving could rise or fall in response to a fall in consumer confidence.

Explore Further 9.

a.

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

b.

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.

c.

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.

d.

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.

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142 ❖ ANSWERS TO END-OF-CHAPTER PROBLEMS

10.

a.

The fall in G and the increase in T shift the IS curve to the left. The increase in M shifts the LM curve down. The interest rate falls, and investment increases.

b.

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

c.

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.

Changes in the Intended Federal Funds Rate September 4, 1992 3 March 25, 1997 February 4, 1994 3.25 September 29, 1998 March 22, 1994 3.5 October 15, 1998 April 18, 1994 3.75 November 17, 1998 May 17, 1994 4.25 June 30, 1999 August 16, 1994 4.75 August 24, 1999 November 15, 1994 5.5 November 16, 1999 February 1, 1995 6 February 2, 2000 July 6, 1995 5.75 March 21, 2000 December 19, 1995 5.5 May 16, 2000 January 31, 1996 5.25

5.5 5.25 5 4.75 5 5.25 5.5 5.75 6 6.5

d.

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.

e.

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%.

CHAPTER 6 Quick Check 1.

2.

a.

(Monthly hires + monthly separations)/monthly employment =(5.4+5.4)/132.4=8.1%

b.

2.1/8.4=25%

c.

(2.1+1.9)/8.4=47.6%. Duration is 1/0.476 or 2.1 months.

d.

(3.6+3.3+1.9+1.8)/(132.4+8.4)=7.5%.

e.

new workers: 0.4/(3.3+1.8)=7.8%.

a.

W/P=1/(1+)=1/1.05=0.952

b.

Wage setting: u=1-W/P=1-0.952=4.8%

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ANSWERS TO END-OF-CHAPTER PROBLEMS ❖ 143

3.

c.

W/P=1/1.1=.91; u=1-.91=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.

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

False. The participation rate has increased over time.

False.

False.

True.

False.

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

g. h.

True.

False.

Dig Deeper 4.

a.

EatIn Population Labor Force Employment Unemployment Unemployment Rate Participation Rate

100 75 50 25 33% 75%

EatOut Population Labor Force Employment Unemployment Unemployment Rate Participation Rate

100 100 75 25 25% 100%

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.

c.

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 valueadded, since intermediate goods—groceries, cleaning supplies, child care supplies, and so on—involved in the production of at-home goods are already counted in GDP as final goods in the formal sector.

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144 ❖ ANSWERS TO END-OF-CHAPTER PROBLEMS

5.

6.

7.

a.

When the unemployment rate is very low, it is very difficult for firms to find workers to hire and very easy for workers to find jobs. As a result, the bargaining power of workers is very high when the unemployment rate is very low. Therefore, the wage gets very high as the unemployment rate gets very low.

b.

Presumably, the real wage would grow without bound as the unemployment rate approached zero. Since a worker could always find a job, there would be nothing to constrain aggressive wage bargaining. At any positive rate of unemployment, however, there is some constraint on worker bargaining power.

a.

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

b.

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.

c.

In our model, the real wage is always given by the price-setting relation: W/P=1/(1+).

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.

a.

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.

d.

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.

Explore Further 8.

a-b.

Answers will depend on when the page is accessed.

c. The decline in unemployment does not equal the increase in employment, because the labor force is not constant.

9. The dynamics of unemployment around recessions.

The table below shows the behavior of annual real GDP growth around 3 recessions. This data are from Table B-4 of the Economic Report of the President : Year 1981 1982

Real GDP Growth 2.5 -1.9

Unemployment rate 7.6 9.7

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ANSWERS TO END-OF-CHAPTER PROBLEMS ❖ 145

1983

4.5

9.6

1990 1991 1992

1.9 -0.2 3.4

5.6 6.8 7.5

2008 2009 2010

0.0 -2.6 2.9

5.8 9.3 9.6

Use Table B-35 from the Economic Report of the President to fill in the annual values of the unemployment rate in the table above and consider these questions. a. The unemployment rate is higher in the following year. b. Output can be increased without a proportional increase in the number of workers if the production function is not exactly linear. c. Some of the workers who were discouraged by the recession re-enter the labor force. d. The model predicts more generous unemployment benefits would increase the natural rate of unemployment? Certainly unemployment is higher but it is not clear if it is permanently higher. d.

10.

a.

53%; (0.53)2= 28; (0.53)6 = 2.2%

b.

53%

c.

second month: (0.53)2=28%; sixth month: (0.53)6 = 2.2%

d.

1996: 17%

2000: 11%

2004

22%

2008

20%

1997: 16%

2001: 12%

2005

20%

2009

32%

1998: 14% 1999: 12%

2002: 18% 2003: 22%

2006 2007

18% 18%

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

Note the very large increase in the proportion of long term unemployed in the crisis

CHAPTER 7 Quick Check 1.

a.

Money is neutral in the sense that the nominal money supply has no effect on output or the interest rate in the medium run. Output returns to its natural level. The interest rate is determined by the position of the IS curve and the natural level of output. Despite the neutrality of money in the medium run, an increase in the money supply will increase output and reduce the interest rate in the short run. Therefore, expansionary monetary policy can be used to speed up the economy's return to the natural level of output when output is low.

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146 ❖ ANSWERS TO END-OF-CHAPTER PROBLEMS

2.

b.

In the medium run, fiscal policy affects the interest rate and investment, so fiscal policy is not considered neutral.

c.

False. Labor market policies, such as the degree of unemployment insurance, can affect the natural level of output.

a.

SR:short run MR: medium run

SR MR

WS up

WS: wage-setting curve PS: price-setting curve

AS up

same as SR

PS no change no change

Y falls falls further

i rises rises further

P rises rises further

up further

AD no change no change

IS no change no change

LM up up further

b.

SR MR

3.

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

4.

True.

True. In the AS relation, if P=Pe, Y=Yn. Note that Pe must be known to graph the AS curve.

False. The AD curve slopes down because an increase in P leads to a fall in M/P, so the nominal interest rate increases, and I and Y fall.

False. There are changes in autonomous expenditure and supply shocks, both of which cause output to deviate from the natural level in the short run.

True.

False. Fiscal policy affects the interest rate in the medium run and therefore affects investment.

False. The natural level of output changes in response to a permanent supply shock (other than a change in Pe). The price level changes in the medium run in response to either a demand or a supply shock.

a.

IS shifts right, and LM shifts up. AD shifts right, and AS shifts up.

b.

Y returns to its unchanged natural level. The interest rate and the price level increase.

Consumption rises: with taxes falling and income returning to its unchanged natural level, after tax income rises and so does consumption. Investment falls since the interest rates rises and the level of income, the other determinant of investment is unchanged.

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ANSWERS TO END-OF-CHAPTER PROBLEMS ❖ 147

Dig Deeper 5.

a.

SR:short run MR: medium run

SR MR

IS left

LM down

AD left

AS no change down

same as SR

down further

same as SR

Y falls back to original Yn

i falls falls further

P falls falls further

C falls Increases from SR but still lower than original level

I ambiguous rises (above original level)

Private S ambiguous rises (above original level)

b-c.

SR MR

SR MR

In the medium run, consumption must lower than its original level because disposable income is unchanged, but consumer confidence is lower.

The short-run change in investment is ambiguous, because the interest rate falls, which tends to increase investment, but output also falls, which tends to reduce investment. In the medium run, investment must rise (as compared to its short-run and original levels), because the interest rate falls but output returns to its original level.

Since the budget deficit does not change in this problem, the change in private saving equals the change in investment. It is possible that private saving will fall in the short run, but private saving must rise (above its short-run and original levels) in the medium run.

6.

a.

The unemployment rate rises in the short run and rises further in the medium run. The real wage falls immediately to its new medium-run level.

b.

The unemployment rate falls in the short run but returns to the original natural rate in the medium run. The real wage is unaffected, but after-tax income rises.

c.

In our model, the real wage depends only on the markup. A fall in the markup increases the real wage. Policy measures that improve product market competition—for example, more vigorous anti-trust enforcement—could increase the real wage.

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148 ❖ ANSWERS TO END-OF-CHAPTER PROBLEMS

d. The fall in income taxes tended to increase the after-tax real wage. The increase in oil prices tended to reduce the after-tax real wage. Intuitively, the immediate effect of an oil price increase is to reduce the real wage by increasing gas prices. Thus, the increase in gas prices tends to absorb the extra after-tax income provided by the tax cut.

7.

The Fed’s job is not so easy. It has to distinguish changes in the actual rate of unemployment from changes in the natural rate of unemployment. The Fed can use monetary policy to keep the unemployment rate near the natural rate, but it cannot affect the natural rate.

8.

a.

The AS curve shifts up in the short run and shifts up further in the medium run.

Output falls in the short run and falls further in the medium run. The price level rises in the short run and rises further in the medium run.

b.

The unemployment rate rises in the short run and rises further in the medium run.

c.

The Fed could increase the money supply in the short run and shift the AD curve to the right. The AS curve would shift up over time.

d.

Output and the price level are higher in the short run in part (c). Output is the same in the medium run in parts (a) and (c), but the price level is higher in part (c).

e.

The unemployment rate in the short run is lower in part (c), but the same in the medium run in parts (a) and (c).

a.

The AD curve shifts left in the short run. Output and the price level fall in the short run.

In the medium run, the expected price level falls, and AS shifts right, returning the economy to the original natural level of output, but at a lower price level.

b.

The unemployment rate rises in the short run, but returns to its original level (the natural rate, which is unchanged) in the medium run.

c.

The Fed should increase the money supply, which shifts the AD curve right. A monetary expansion of the proper size exactly offsets the effect of the decline in business confidence on the AD curve. The net effect is that the AD curve does not move in the short run or medium run, and neither does the AS curve.

d.

Under the policy option in part (c), output and the price level are higher in the short run.

In the medium run, output is the same in parts (a) and (c), but the price level is higher in part (c).

e.

The unemployment rate is lower in the short run in part (c). In the medium run, the unemployment rate is the same in parts (b) and (c).

a.

Open answer. Firms may be so pessimistic about sales that they do not want to borrow at any interest rate.

b.

The IS curve is vertical; the interest rate does not affect equilibrium output.

9.

10.

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ANSWERS TO END-OF-CHAPTER PROBLEMS ❖ 149

c.

The LM curve is unaffected.

d.

The AD curve is vertical; the price level does not affect equilibrium output.

e.

The increase in z reduces the natural level of output and shifts the AS curve up. Since the AD curve is vertical, equilibrium output does not change, but the price level increases.

Note that output is above its natural level.

f.

Since Y>Yn, P>Pe. Therefore, Pe rises and the AS curve shifts up. In fact, the AS curve shifts up forever, and the price level increases forever. Output does not change; it remains above its natural level forever.

Explore Further 11.

a.

1959:IV – 1969:IV 1969:IV – 1979:IV 1979:IV – 1989:IV 1989:IV – 1999:IV 1999:IV – 2009:IV

b.

The 70s, 80s, and 90s look remarkably similar. The 60s had by far the highest growth.

Clearly, the first decade of the 21st century will have the lowest growth.

53.1% 38.1% 34.9% 38.6% 19.5%

Note, although the problem did not ask for the growth rates of GDP per person, the ranking of the decades would be similar. The growth rates of GDP per person are given below.

1959:IV – 1969:IV 1969:IV – 1979:IV 1979:IV – 1989:IV 1989:IV – 1999:IV 1999:IV – 2009:IV

12.

34.0% 24.4% 22.8% 22.7% 8.7%

a.

P=(1+)(Pe)a(F(u,z))a(PE)1-a

b.

P=(1+)(Pe)a(F(u,z))a(Px)1-a P= Pe(1+)1/aF(u,z)x(1-a)/a

c.

The AS curve slopes up in Y-P space.

d.

If P= Pe, then 1=(1+)1/aF(u,z)x(1-a)/a.

An increase in x implies that F must fall to maintain the equality. F falls when u rises.

So, an increase in the relative price of energy resources leads to an increase in the natural rate of unemployment.

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150 ❖ ANSWERS TO END-OF-CHAPTER PROBLEMS

e.

The AS curve shifts up in the short run and shifts up further in the medium run. The unemployment rate and the price level rise in the short run and rise further in the medium run. Output falls in the short run and falls further in the medium run.

f.

An increase in the relative price of energy resources causes the AS curve to shift up in the short run. If Pe remains constant, the AS curve will not shift further after the initial, shortrun shift. In order for Pe to remain constant, wage setters must be expecting the Fed to reduce the money supply, thereby shifting the AD curve left. This monetary policy moves output to its new, lower natural level right away, and maintains the original price level, so there will be no price adjustment in the transition to the new medium-run equilibrium.

CHAPTER 8 Quick Check 5.

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

True.

False.

False.

True.

False.

True.

False False True True

3.

a.

No. In the 1970s, we experienced high inflation and high unemployment. The expectations-augmented Phillips curve is a relationship between inflation and unemployment conditional on the natural rate and inflation expectations. Given inflation expectations, when the natural rate of unemployment increases (i.e., when there is an increase in z or ), 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.

b.

No. 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.

a.

un=0.1/2 =5%

b.

πt =0.1-2(0.03) = 4% every year beginning with year t.

c.

πet= 0 and πt=4% forever. Inflation expectations will be forever wrong. This is unlikely.

d.

 might increase because inflation expectations adapt to persistently positive inflation.

The increase in  has no effect on un.

4.

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ANSWERS TO END-OF-CHAPTER PROBLEMS ❖ 151

π5= π 4+0.1-2(0.03)=4%+4%=8% For t>5, π t= 8%+ (t - 5)(4%). So, π 10=28%; π 15=48%.

Inflation increases by four percentage points every year.

e.

e. Inflation expectations will again be forever wrong. This is unlikely.

1. The neutrality of money revisited a. Fill in the empty spaces in the chart below: Year

1 2 3 4

M Nominal Money Supply (billons) 380.95 400 420 441

gM – growth rate of nominal money supply NA 5 5 5

P Price level (index) Year 2=100 95.2 100 105.0 110.25

Inflation

NA 5 5 5

(b) 5% per year (c) 5% per year (d) 0% per year (e) Output growth is zero ( the economy is at a constant natural level of output).

2.

a.

πt-πt-1= -(ut-.05) ut- ut-1= -0.4(gmt-πt-.03)

b.

Assuming gm,t-1=13%, πt-1= 10%, ut-1=5%, and beginning in year t, gm=3%, the economy evolves as follows.

t: t+1: t+2: t+3: t+4: t+5: t+6: t+7: t+8: t+9: t+10: c.

π 7.1% 3.1% -0.7% -3.2% -4.1% -3.5% -2.1% -0.5% 0.8% 1.5% 1.6%

u 7.9% 9.1% 8.8% 7.5% 5.9% 4.4% 3.6% 3.4% 3.7% 4.3% 4.9%

Inflation does not decline smoothly. In the early years, the large unemployment rates (relative to the natural rate) reduce inflation to negative values. In this example, money growth equals the normal growth rate of output, so negative inflation drives real money

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152 ❖ ANSWERS TO END-OF-CHAPTER PROBLEMS

growth (and hence output growth) above the normal output growth rate, and unemployment falls. Eventually, when unemployment falls below the natural rate, inflation begins to increase again. These cycles continue, with decreasing amplitude. d.

u=5% and π=0% in the medium run.

Dig Deeper 7.

a.

un=01./2=.05 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%.

6.

b.

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

c.

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

d.

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

a.

=1: uu=6%; =2: uu=3% As wages become more flexible, more of the effect of supply shocks (changes in  and z) is transmitted to changes in wages and less to changes in the natural rate of unemployment.

b.

=1: uu=9%; =2: uu=4.5% In an environment with more wage flexibility (higher ), the natural rate of unemployment rises less in response to an increase in the price of oil.

Explore Further As of 2010, the equation that seems to fit well is πt – πt-1 = 3.3% –0.55ut, which implies a natural rate of approximately 6%. This is the equation in the text. Your values may be different.

8.

a-c.

9.

The relationships certainly implied a lower natural rate in the more recent period ending before the crisis, say in 2007. As of writing, in 2011, it is hard to say if the natural rate has increased.

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ANSWERS TO END-OF-CHAPTER PROBLEMS ❖ 153

10.

Money growth and the growth in real output over time (a) Fill in the empty spaces in the chart. This economy is in medium run equilibrium in every year: Year

M Nominal Money Supply (billons) 367 400 436 475.3

1 2 3 4

gM – growth rate of nominal money supply NA 9.0 9.0 9.0

P Price level (index) Year 2=100 95.2 100 105.0 110.25

Inflation

NA 5 5 5

Real GDP (billions of Year 2 dollars) 1500 1560 1622.4 1687.3

(b) 9.0% (c) 5.0% (d) 4% (e) Output is growing at 4% per year. Thus additional real money is needed so real money demand equals real money supply.

CHAPTER 9 Quick Check 1.

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

True.

True.

False.

False.

True.

False False

2.

a.

The AD curve has a vertical portion because, in the liquidity trap, as price falls, the real money supply rises but the interest rate does not change.

There will be no change in the AD curve. Additional real money will not change the interest rate and will not change demand. Thus equilibrium output will not change.

The only policy traditional policy option is to use fiscal policy, a cut in taxes or an increase in spending to increase demand. The American Recovery and Reinvestment Act mentioned in Question 2 did just that.

The real rate of interest would increase. This would further shift the AD curve to the left.

Chairman Bernanke was very anxious to make it clear that a deflation or an expected deflation would raise real interest rates and lower demand.

b. c.

d. e.

3.

b.

The LM curve will shift right, but equilibrium output will not change.

c.

With traditional monetary policy unavailable, the only traditional policy is a fiscal expansion, some combination of higher government spending and lower taxes (or higher transfers). These measures will shift the IS curve to the right. At the urging of President Obama, the U.S. Congress passed a fiscal stimulus plan in February 2009, and President Obama signed the legislation into law. The legislation, called the American Recovery and Reinvestment Act, called for $780 billion in fiscal stimulus, in the form of increases in government spending, reductions in taxes, and increases in transfers.

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154 ❖ ANSWERS TO END-OF-CHAPTER PROBLEMS

Dig Deeper 4.

a.

Assets Bank Assets

100

Liabilities Checking Deposits

80

Net Worth Capital

5.

20

b.

The value of the bank’s capital falls to 10.

c.

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 need to withdraw funds from the bank.

d.

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

e.

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.

f.

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.

a.

Assets Securitized Assets Other Assets

50 50

Liabilities Short Term Credit

80

Net Worth Capital

20

b.

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.

c.

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 Troubled Assets Other Assets Treasury Bonds

25 50 25

Liabilities Short Term Credit

80

Net Worth Capital

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

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ANSWERS TO END-OF-CHAPTER PROBLEMS ❖ 155

6.

e.

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).

a.

The premium will fall and the IS curve will shift to the right. Output will increase. So yes, a financial policy is a kind of macroeconomic policy.

b.

Again the premium will fall and the IS curve will shift to the right. Output will increase.

So the Fed does have some policy options when the federal funds rate is zero. Most economists believe that the Fed’s policy of quantitative easing during the financial crisis has been beneficial to the economy, but it is difficult to quantify the effect.

Explore Further 7.

a-d.

Answers depend on the current state of the Ted spread.

CHAPTER 10 Quick Check 1.

The table should read as follows.

Transportation Food

Mexico United States

Services

Price

Quantity

Price

Quantity

5 pesos

400

20 pesos

200

$1

1,000

$2

2,000

a.

U.S. consumption per person = $1(1000) + $2(2,000)=$5000

b.

Mexican consumption per person=5(400) pesos + 2(2000) pesos = 6000 pesos

c.

From the U.S. point of view, the exchange rate (E)=10 pesos/$.

Mexican consumption per person in dollars = 6000 pesos/E=$600

d.

Mexican consumption per person ($PPP)=$1(400)+$2(200)=$800

e.

Mexican standard of living relative to the United States Exchange rate method: 600/5000 =0.1

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156 ❖ ANSWERS TO END-OF-CHAPTER PROBLEMS

PPP method: 800/5000=0.16 2.

3.

a.

Y=63

b.

Y doubles.

c.

Yes.

d.

Y/N=(K/N)1/2

e.

K/N=4 implies Y/N=2. K/N=8 implies Y/N=2.83. Output less than doubles.

f.

No.

g.

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.

h.

Yes.

a. b. c.

True.

False.

Uncertain – earlier evidence suggested this was false but more recent evidence suggests it may be true.

False.

True.

False.

True.

d. e. f. g.

Dig Deeper 4.

5.

a.

Y/Y = .5 (K/K) growth rate of output = 1/2 growth rate of capital

b.

4% per year

c.

K/Y increases.

d.

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.

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ANSWERS TO END-OF-CHAPTER PROBLEMS ❖ 157

Explore Further 6.

Real GDP per Capita ($2005), PPP adjusted Source: Alan Heston, Robert Summers and Bettina Aten, Penn World Table (PWT) Version 7.0, Center for International Comparisons of Production, Income and Prices at the University of Pennsylvania, August 2011.

a.

10 Richest Countries (in the data sample) in 1970 Brunei 59124 Switzerland 25963 Bermuda 25686 Luxembourg 22788 Bahrain 22311 United States 20480 Sweden 19143 Bahamas 19067 Netherlands 19050 Australia 18165 Canada 17966

b.

10 Richest Countries (in the data sample) in 2008 Qatar Luxembourg United Arab Emirates Macao Norway Kuwait Bermuda Singapore Brunei United States

149950 89814 56414 53103 51094 50621 50458 49987 45542 43326

The composition of countries did change somewhat. c-d.

Macau had the largest proportional growth. Macau is the location of massive gambling industry serving southern China – all built since 1970.

There are 160 countries with observations for both 1970 and 2008. 19 (by my count) of these countries had negative growth over the period. The number may vary depending on the end point when you do this question. The main point to notice is that negative growth is rare.

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158 ❖ ANSWERS TO END-OF-CHAPTER PROBLEMS

e

7.

8.

Answer will vary with the country you look at.. Often a civil or external war is a major issue. One very low value is Somalia, a country wracked by war over the past decades.

Another very low value is found in Zimbabwe, a country where there was a hyperinflation and some very challenging governance issues.

a.

Japan tended to converge to the United States in the earlier period, but not in the recent periods.

b.

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 some time ago.

Instead, output per person remains substantially higher in the United States.

Output per person in the United States ($41,102) was substantially higher than Japanese real output per person ($31,958) in 2009 (from Table 10-1). There may be more recent data in the Penn World Tables.

b.

There was substantial convergence for the France, Belgium, and Italy until the last two decades.

c.

Argentina, Chad, Madagascar, and Venezuela have not converged to the United States.

In fact, they have grown steadily poorer relative to the United States.

CHAPTER 11 Quick Check 1.

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.

2.

a. b. c.

True, in a closed economy, and if saving includes public and private saving.

False.

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 steadystate 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.

d.

Uncertain. See the discussion of the golden-rule saving rate.

e.

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

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ANSWERS TO END-OF-CHAPTER PROBLEMS ❖ 159

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. f.

h.

3.

Uncertain. The U.S. capital stock is 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, 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 longrun level of output per worker. Finally, since the evidence suggests 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. Chapters 19 and 23 explore further reasons in an open economy and in an economy with a public sector deficit why increasing the savings rate could be beneficial.

Dig Deeper 4.

5.

a.

K/N=(s/(2))2; Y/N=s/(4)

b.

C/N=(1-s)Y/N=s(1-s)/(4)

c-e.

Y/N increases with s. C/N increases until s=0.5, then decreases.

a.

This would likely lead to a higher saving rate, so output per worker and output per person would be higher in the long run.

b.

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.

6.

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.

7.

a.

Yes.

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160 ❖ ANSWERS TO END-OF-CHAPTER PROBLEMS

8.

9.

b.

Yes.

c.

Yes.

d.

Y/N = (K/N)1/3

e.

In steady state, sY//N = K/N, which, given the production function in part (d), implies K/N=(s/)3/2

f.

Y/N =(s/)1/2

g.

Y/N = 2

h.

Y/N = 21/2

b.

K/N = (0.15/.075)2 = 4 Y/N= (4)1/2=2

c.

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.

a.

Substituting from problem 7 part (e) implies K/N=1.

b.

Substituting from problem 7 part (f), Y/N=1.

c.

K/N=0.35; Y/N=0.71

d. t t+1 t+2 t+3

K/N 1.00 0.90 0.82 0.75

Y/N 1.00 0.97 0.93 0.91

Explore Further 10.

a.

For 2009, the national saving rate was approximately 10.0%.

In steady state, K/N = (0.100/0.075)2 =2.82, and Y/N=(2.82)1/2 =1.33.

Note that savings were exceptionally low in the crisis due to the very large public sector deficit

b.

For fiscal year 2008, the budget deficit (including the off budget items) was 10.0% of GDP. (We’ll use the fiscal year budget deficit with the calendar year saving rate.)

Eliminating the deficit increases the national saving rate to 20.0% (10.0% + 10.0%). As a result, in steady state, K/N = (0.200/.075)2=7.11, and Y/N=(7.11)1/2 =2.67. Steady-state output per worker increases by about 100%. Note this is a function of the enormous deficit in the crisis.

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ANSWERS TO END-OF-CHAPTER PROBLEMS ❖ 161

CHAPTER 12 Quick Check 1.

2.

a.

Most technological progress seems to come from R&D activities. See discussion on fertility and appropriability in Chapter 12-2.

b.

This proposal would probably lead to lower growth in poorer countries, at least for a while, but higher growth in rich countries. It is unclear whether it would lead to higher growth in the world overall.

c.

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.

d.

Presumably, this proposal would lead to a (small) decrease in the fertility of applied research and therefore to a (small) decrease in growth.

e.

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.

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.

False.

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, rapid growth in China has been due to both increases in technology and increases in capital.

f. g. h.

i.

3.

a.

The economic leaders typically achieve technological progress by generating new ideas through research and development.

b.

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.

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162 ❖ ANSWERS TO END-OF-CHAPTER PROBLEMS

c.

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.

a.

Probably affects A. Think of climate.

b.

Affects H and possibly A, if better education improves the fertility of research.

c.

Affects A. Strong protection tends to encourage more R&D but also to limit diffusion of technology.

d.

May affect A through diffusion.

e.

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.

f.

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).

g. 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 5(c).

5.

a.

i. ii. iii. iv. v.

K/(AN) = (s/(+gA+gN))2 = 1 Y/(AN)= (K/AN)1/2=1 gY/(AN) = 0 gY/N= gA=4% gY= gA+gN=6%

b.

i. ii. iii. iv. v.

K/(AN) = (s/(+gA+gN))2 = 0.64 Y/(AN)= (K/AN)1/2=0.8 gY/(AN) = 0 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. c.

i. ii. iii. iv. v.

K/(AN) = (s/(+gA+gN))2 = 0.64 Y/(AN)= (K/AN)1/2=0.8 gY/(AN) = 0 gY/N= gA=4% gY= gA+gN=10%

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ANSWERS TO END-OF-CHAPTER PROBLEMS ❖ 163

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).

6.

7.

a.

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 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.

b.

A permanent reduction in the saving rate has no affect 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.

a.

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%

b.

c.

GDP deflator Year 1=1; Year 2=3960/3300=1.2 inflation=20%

d.

Real GDP/Worker Year 1 = 3000/100=30; Year 2 = 3300/110=30 Labor productivity growth is zero.

e.

Year 2 Real GDP (Year 1 Prices)=10(100)+13(230)=3990 output growth=3990/3000 – 1 = 33%.

f.

GDP deflator Year 1=1; Year 2=3960/3990=0.992 inflation=0.992/1 – 1 = -0.8%

g.

Real GDP/worker=36.3 in year 2. Labor productivity growth is 36.3/30=21%.

h.

This statement is true, assuming there is progress in the banking services sector.

Explore Further 8.

a.

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.

gK – gN = 3(gY – gN) – 2gA

c.

gY – gN

gA

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gK – gN

164 ❖ ANSWERS TO END-OF-CHAPTER PROBLEMS

U.S. France Japan UK

1.9% 1.9% 1.8% 2.1%

1.3% 1.6% 2.1% 1.6%

3.1% 2.5% 1.2% 3.1%

They makes sense in that these economies continue to increase the capital per worker. This has to be the case so that capital per effective worker does not fall. Note that capital per effective worker does appear to be falling in Japan.

CHAPTER 13 Quick Check 1.

2.

3.

a.

u = 1-(1/(1+m))(A/Ae)

b.

u = 1-(1/(1+0.05)) = 4.8%

c.

No. Since wages adjust to expected productivity, an increase in productivity eventually leads to equiproportional increases in the real wage implied by wage setting and the real wage implied by price setting, at the original natural rate of unemployment. Thus, equilibrium can be maintained without any change in the natural rate of unemployment.

a.

Reduce the gap, if this leads to an increase in the relative supply of high-skill workers.

b.

Reduce the gap, since it leads to a decrease in the relative supply of low-skill workers.

c.

Reduce the gap, if it leads to an increase in the relative supply of high-skill workers.

d.

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.

a.

False. Productivity growth is unrelated to the natural rate of unemployment. If the unemployment rate is constant, employment grows at same rate as the labor force.

False.

True.

True.

True.

True.

False.

False

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

4.

An increase in labor productivity has no effect on the natural rate of unemployment, because the wage ultimately rises to capture the added productivity. The increase in the wage also implies that an increase in labor productivity has no permanent effect on inflation. From the price setting equation, P=(1+ m)W/A. If the wage (W) increases by the same proportion as productivity (A), the price level will not change.

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ANSWERS TO END-OF-CHAPTER PROBLEMS ❖ 165

Dig Deeper 5.

a.

P = Pe(1+)(Ae/A)(Y/AL) The new variables are technology variables, A and Ae. An increase in A has two effects. i.

For a given level of Y, an increase in A reduces Y/A, which implies a reduction in N and in increase in u. The increase in u tends to reduce W and therefore to reduce P. This is the effect that tends to increase the actual rate of unemployment in the short run.

ii.

To the extent that Ae lags behind A, Ae/A falls. In effect, workers do not receive as much of an increase in wages as warranted by the increase in productivity.

This is the effect that tends to reduce the actual and natural rates of unemployment for a time.

The effects in (i) and (ii) both shift the AS curve down, so output increases in the short run. The effect on short-run unemployment depends on the relative strength of the effects in (i) and (ii).

6.

7.

b.

AS shifts down. Given Ae/A=1, only effect (i) is relevant.

c.

In this case, effects (i) and (ii) from part (a) are relevant. Compared to part (b), the AS curve shifts down further.

a.

W/P=F(1-N/L,z)

b.

Labor supply slopes up. As N increases, u falls for given L, so W/P increases.

c.

MC=W/MPL so W/P=MPL/(1+m)

d.

Labor demand slopes down. As N increases, the MPL falls, so W/P falls.

e.

An improvement in technology increases the MPL, so the labor demand curve shifts right. The real wage increases when technology improves.

Technological change has led to a reduction in agricultural employment, but evidently has had no effect on the natural rate of unemployment.

Explore Further 8.

a.

For a given markup, the real wage grows at the rate of technological progress. Clearly, there has been technological progress since 1973.

b.

1973: $9.26; 2010: $8:90 Thus average private earnings per hour have fallen.

c.

The real wage of low-skill workers has fallen markedly, which suggests that the relative

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166 ❖ ANSWERS TO END-OF-CHAPTER PROBLEMS

demand for low skill workers has fallen markedly. It suggests that private sector jobs have a larger proportion of the low skill jobs.

9.

d.

Other benefits, particularly health care benefits, might be missing from this calculation.

a.

Projections for job decline from 2010-2020 Some examples: Shoe machine operators and tenders – perhaps foreign competition Postal Service Mail Sorters – technological change

b.

Projections for job growth from 2010-2020 Some examples: Home health aides, personal care aides – aging of the population. There were many other health-related jobs on the list likely related to population aging.

In the set posted in 2012, there did not seem to be an obvious increase in jobs in a technology-intensive area.

CHAPTER 14 Quick Check 1.

a.

No. If the nominal interest rate were negative, nobody would hold bonds. Money would be more appealing since it could be used for transactions and would earn zero—as opposed to negative—interest.

b.

Yes. The real interest rate is negative if expected inflation exceeds the nominal interest rate. Even in this case, the real interest rate on bonds (which pay nominal interest) exceeds the real interest rate on money (which does not pay nominal interest) by the nominal interest rate.

c.

A negative real interest rate makes borrowing very attractive and leads to a large demand for investment.

d.

Answers will vary.

2.

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

True.

True.

True.

False.

True.

False.

True.

True. The nominal interest rate is always positive.

False. The real interest rate can be negative.

3.

a.

Real. Nominal profits are likely to move with inflation; real profits are easier to forecast.

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ANSWERS TO END-OF-CHAPTER PROBLEMS ❖ 167

4.

b.

Nominal. The payments are nominal.

c.

Nominal. Car lease and car loan payments are usually stated in nominal terms.

a.

The discount rate is the interest rate. So, in case (i), the EPDV is $2,000(1-0.25) under either interest rate, and in case (ii) the EPDV is (1-0.2)$2,000 under either interest rate.

b.

The interest rate does not enter the calculation. Hence, you prefer (ii) to (i) since 20%<25%.

Note that the answer to part (a) does not imply that saving will not accumulate. By retirement, the initial investment will have grown by a factor of (1+i) 40 in nominal terms and (1+r)40 in real terms. As long as r is positive, the purchasing power of the initial investment will grow.

Moreover, this problem assumes that the tax rate you will pay upon retirement (25%) is higher than the tax rate you pay when you establish the IRA (20%). This assumption may be false for some taxpayers.

5.

6.

7.

a.

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

b.

3.60%; 4%

d.

5.48%; 8%

a.

The Fisher hypothesis is that in the medium run, changes in inflation are reflected onefor-one in changes in the nominal interest rate. In other words, in the medium run, changes in inflation have no effect on the real interest rate.

b.

Support.

c.

The line should not go through the origin, because the real interest rate is positive: when inflation equals zero, the nominal interest rate is positive.

d.

No. Even if monetary policy does not affect output or the real interest rate in the medium run, it can be used in the short run.

a.

$V=$100/0.1=$1000

b.

Since the first payment occurs at the end of the year, $V = $z[1- 1/(1+i)n]/[1-1/(1+i)] - $z.

10 years: $575.90; 20 years: $836.49; 30 years: $936.96; 60 years: $996.39

c.

i = 2%: PV of consol=$5000; 10 years: $816.22; 20 years: $1567.85; 30 years: $2184.44; 60 years: $3445.61 i = 5%: PV of consol=$2000; 10 years: $710.78; 20 years: $1208.53; 30 years: $1514.11; 60 years: $1887.58

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168 ❖ ANSWERS TO END-OF-CHAPTER PROBLEMS

Dig Deeper 8.

a.

The IS shifts right. At the same nominal interest rate, the real interest rate is lower, so output is higher.

b.

The LM curve shifts down because the increase in money growth leads to an increase in the real money stock. The increase in expected inflation has no effect on the LM curve, because money demand depends on the nominal interest rate, not the real interest rate.

c.

Output increases. The nominal interest rate is higher than in Figure 14-4. Whether the nominal interest rate is lower or higher than before the increase in money growth is ambiguous. Thinking in terms of the money market equilibrium, the increase in the nominal money supply tends to reduce the nominal interest rate, but the increase in nominal money demand (because of the increase in output) tends to increase the nominal interest rate.

d.

Output is higher than in Figure 14-4. Reasoning from the IS relation, the real interest rate must be lower, since no exogenous variables in the IS relation have changed. (In other words, while the nominal interest rate may increase relative to Figure 14-5, it increases by less than the increase in expected inflation, so the real interest rate decreases.)

Explore Further 9.

Answers will vary depending upon when the website is accessed.

CHAPTER 15 Quick Check 1.a.

2.

The LM curve shifts down unexpectedly. There isan unexpected fall in the interest rate and an unexpected increase in output. Both of these changes lead to an increase in the stock price. b.

There is no change in the stock price.

c.

The effect on the stock price is ambiguous. Unexpected expansionary fiscal policy means the interest rate is higher than expected (after the expected expansionary monetary policy) but so is output. The interest rate effect tends to reduce the stock price; the output effect to increase it

The yield is approximately the average of the short-term interest rates over the life of the bond. a.

5%.

b.

5.25%

C. 5.5% 3.

a.

(1+i)n=$F/$P 1+i =($F/$P)1/n

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ANSWERS TO END-OF-CHAPTER PROBLEMS ❖ 169

i =(1000/800)1/3-1 = 7.7%

4.

b.

5.7%

c.

4.1%

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

False.

True.

True.

False.

True.

True.

False.

Uncertain/False. Some of the increase in the stock market was probably justified. But most economists believe that there was a bubble in the stock market as well. A stock market correction followed.

Dig Deeper 5.

6.

a.

See Figure 14-5 in Chapter 14.

b.

Initially after the increase, the yield curve will slope down out to one-year maturities, then slope up. After one year, the yield curve will slope up. After three years, the yield curve will be flat.

Let r be the real interest rate, g the growth rate of dividends, and x the risk premium. The price is given by the following expression.

Q=1000/(1 + r + x) + 1000(1 + g)/(1 + r + x)2 + 1000(1 + g)2/(1 + r + x)3 . . . = [1000/(1 + r + x)][1 + (1 + g)/(1 + r + x) + (1 + g)2/(1 + r + x)2 + . . .] = 1000/(r + x - g)

7.

a.

$50,000; $20,000

b.

$10,000; $7692.31

c.

$16,666.67; $11,111.11

d.

The stock price increases when the risk premium falls. A fall in the risk premium is like a fall in the real interest rate.

a.

An inverted yield curve implies that the expected future interest rate is lower than the current interest rate. These expectations could arise from a belief that the IS curve is going to shift to the left in the future, say because future investment is expected to fall. If the IS curve shifts left in the future, output will fall.

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170 ❖ ANSWERS TO END-OF-CHAPTER PROBLEMS

b.

Given the Fisher effect, a steep yield curve probably implies that financial market participants believe that future inflation will be substantially higher than current inflation.

Explore Further 8.

Answers will vary.

9. The yield curve will be very flat and yields-to-maturity will remain close to zero for a large number of years. The number of years will depend on how long an “extended period” is believed to be by the public.

10.

Answers will vary. However in general, the larger the movement in stock prices on the day of the announcement, the more likely whatever announcement was made was unexpected.

11.

a.

b.

Inflation was highest in early 1980. The 12-month inflation rate peaked at 14.6% in March and April of 1980.

d.

A positive spread means that expected future interest rates are higher than current interest rates.

A declining spread means that the expected increase in future short-term interest rates is falling. The one-year T-bill rate increased from 7.28% to 12.6% between January 1978 and January 1980, but the spread declined from 0.9 percentage points to –1.46 percentage points over the same period. Financial market participants were not expecting short-term interest rates to continue to increase. Indeed, by the end of the 1970s, the negative spread indicates that short-term interest rates were expected to decline in the future.

The Fed can reduce the growth rate of money. The nominal interest rate increases in the short run, but falls in the medium run.

e.

There spread declined by almost one percentage point in October 1979. The decline is consistent with expectations of lower inflation in the future.

f.

The one-year interest rate fell.

g.

During the rate cut in the recession, spreads went up, as short-term rates declined. But long-term rates did not increase, which suggests that inflation expectations did not increase. Instead, the increase in spreads is consistent with the expectation that the antiinflationary policy would continue with high short-term interest rates after the recession.

This is indeed what happened.

CHAPTER 16 Quick Check 1.

The EPDV of purchasing the machine is /(r+) = $18,000/(r+0.08) a.

Buy. EPDV=$138,462>$100,000

b.

Break-even. EPDV=$100,000

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ANSWERS TO END-OF-CHAPTER PROBLEMS ❖ 171

c.

Do not buy. EPDV=$78,261<$100,000

2.

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

False.

False.

False.

False.

False.

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.

3.

a.

(1-0.25)(1+1.05+1.052)$40,000=$94,575

b.

$194,575

c.

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.

d.

Consumption could increase by $2,000 annually.

e.

Benefits imply extra annual consumption of 0.6(1.052)$40,000(7/10)=$18,522.

a.

$44,000(1-0.4)36-$40,000(1-0.4)38=$38,400

b.

$44,000(1-0.3)36-$40,000(1-0.3)38=$44,800

4.

Dig Deeper 5.

6.

a.

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.

b.

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.

c.

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.

d.

The uncertainty leads to higher saving by consumers in the first period of life.

a.

EPDV of future labor income = $30. Consumption=$10 in all three periods.

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172 ❖ ANSWERS TO END-OF-CHAPTER PROBLEMS

7.

b.

youth: -5; middle age: 15; old age: -10

c.

Total saving =n(-5+15-10)=0

d.

0 – 5n + 10n = 5n

a..

youth: 5; middle age: 12.5; old age: 12.5 The consumer cannot borrow against future income when young.

b.

0 + 12.5n - 12.5n = 0

c.

0 + 0 + 12.5n = 12.5n

d.

By allowing people to borrow to consume when young, financial liberalization may lead to less overall accumulation of capital.

Explore Further 8.

a-c.

Between 1960 and 2010, consumption accounted for 65% of GDP on average and investment for about 16%, so consumption is about four times bigger than investment.

Relative to average changes, movements in consumption and investment are of similar magnitude, which implies investment is much more volatile than consumption. This is the type of data used to construct Figure 16-5.

9.

a.

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.

h.

In thinking about consumption, we are thinking about the decisions of individuals.

Hence it does make sense to look at per capita (per person) changes.

c.

There appears to be positive relationship between the variables, but it is not tight.

d.

There are many values of the level of consumer confidence when there is zero growth in per capita income.

e.

Most of the time (but not always) the index falls.

f.

There were very large declines in the level of the index of consumer sentiment from 2007 to 2008 that persisted into 2009. .

CHAPTER 17 Quick Check 1. 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

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ANSWERS TO END-OF-CHAPTER PROBLEMS ❖ 173

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 future by themselves. They can rely on the predictions of experts on television or in the newspapers. Essentially, rational expectations rules 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.

2.

a.

The IS curve shifts right.

b.

The LM curve shifts right.

C. 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) tends to reduce real interest rates in the future. The fall in the expected future interest rate tends to shift the IS curve to the right. Third, the fall in future real interest rates could lead to an increase in investment in the medium run and to an increase in output in the long run. The increase in expected future output tends to shift the IS curve to the right. The net effect on the IS curve is ambiguous. Note that the model of 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). d. The IS curve shifts to the left.

3.

a.

Higher real stock prices led to an increase real wealth directly, which tended to increase consumption. Moreover, the hype about the New Economy, combined with increasing stock prices, may have led to favorable expectations about future labor income, which would also tend to increase consumption.

b.

Subsequent declines in the stock market decreased wealth and may have led consumers to revise (downward) expectations about future labor income, effects that would tend to reduce consumption.

4.

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

False.

False. The IS curve gets steeper.

False.

True/Uncertain. Consumers can rely on forecasts by others, but somebody has to do it.

False.

True.

False.

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 shortrun effects. a.

The effect on current output is ambiguous. The tax cut in the future will lead to a boom in the future. Output and the real interest rate will increase. The increase in expected future output tends to shift the IS curve to the right; the increase in the expected future real interest rate tends to shift the IS curve to the left. Finally, the fall in expected future

©2013 Pearson Education

174 ❖ ANSWERS TO END-OF-CHAPTER PROBLEMS

taxes tends to increase expected future after-tax income (for any given level of income).

This effect tends to shift the IS curve to the right. b.

This means that the Fed will increase the interest rate in the future (shift the LM curve to the left in the future). The expected interest rate will increase more, which tends to shift the IS curve to the left, but there is still the effect of lower expected taxes on current consumption. The effect today on output is still ambiguous, but more likely to be negative than in part (a).

c.

Future output will be higher, the future interest rate will not increase, and future taxes will be lower. The IS curve definitely shifts to the right in the current period, and current output increases.

Dig Deeper 6.

7.

a.

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 gets more positive on the day of the announcement.

b.

No.

c.

Compared to original expectations, the nominee is expected to follow a more expansionary monetary policy. The yield curve will get less positive on the day of the announcement.

d.

Financial market participants had known Bernanke was a potential replacement and seemed pleased by the choice. The stock market rallied on the day of his nomination.

Interest rates had been rising before his nomination, and continued to rise afterwards, but spreads did not change much. Bernanke promised to pursue Greenspan’s policies, and market participants seemed to believe him.

a-b.

See the discussion in the text.

c.

The gesture seemed to indicate that the Fed supported deficit reduction, and was willing to conduct expansionary monetary policy in the future to offset the direct negative effects on output from spending cuts and tax increases. A belief that the Fed was willing to act in this way would tend to increase expected future output (relative to the case where the Fed did nothing) and to reduce expected future interest rates. Both of these effects would tend to increase output in the short-run.

Explore Further 8.

a.

The interest rate will increase in the short run, and increase even further in the medium run. The yield curve will get more positive.

b.

The spread increased over the period.

5-Year Yield minus 3-Month Yield

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ANSWERS TO END-OF-CHAPTER PROBLEMS ❖ 175

August 2002: January 2003: August 2003: January 2004:

1.64% 1.86% 2.4% 2.22%

CHAPTER 18 Quick Check 1.

Domestic Country Balance of Payments ($) Current Account Exports Imports Trade Balance Investment Income Received Investment Income Paid Net Investment Income Net Transfers Received Current Account Balance Capital Account Increase in Foreign Holdings of Domestic Assets Increase in Domestic Holdings of Foreign Assets Net Increase in Foreign Holdings Statistical Discrepancy

Foreign Country Balance of Payments ($) Current Account Exports Imports Trade Balance Investment Income Received Investment Income Paid Net Investment Income Net Transfers Received Current Account Balance Capital Account Increase in Foreign Holdings of Domestic Assets Increase in Domestic Holdings of Foreign Assets Net Increase in Foreign Holdings Statistical Discrepancy 2.

25 100 -75 (=25-100) 0 15 -15 (=0-15) -25 -115 (=-75-15-25)

80 (=65+15) -50 130 (=80-(-50)) -15 (=115-130)

100 25 75 (=100-25) 15 0 15 (=15-0) 25 115 (=75+15+25)

-50 80 (=65+15) -130 (=-50-80) 15 (=130-115)

a.

The nominal return on the U.S. bond is 10,000/(9615.38)–1=4%.

The nominal return on the German bond is 6%.

b.

Uncovered interest parity implies that the expected exchange rate is given by E(1+i*)/(1+i)=0.75(1.06)/(1.04)=0.76 Euro/$.

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176 ❖ ANSWERS TO END-OF-CHAPTER PROBLEMS

3.

c.

If you expect the dollar to depreciate, purchase the German bond, since it pays a higher interest rate and you expect a capital gain on the currency.

d.

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.

e.

The uncovered interest parity condition is about equality of expected returns, not equality of actual returns.

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

True.

False.

False.

False.

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.”

This statement is True.

False.

g.

Dig Deeper 4.

5.

a.

GDP is 15 in each economy. Consumers will spend 5 on each good.

b.

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.

c.

No country will have a zero trade balance with any other country.

d.

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.

a.

The relative price of domestic goods falls. Relative demand for domestic goods rises.

The domestic unemployment rate falls in the short run.

b.

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.

c.

The real wage falls.

d.

Essentially, a nominal depreciation stimulates output by reducing the domestic real wage, which leads to an increase in domestic employment.

Explore Further

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ANSWERS TO END-OF-CHAPTER PROBLEMS ❖ 177

6.

a.

World saving essentially equals world investment, as must be true logically.

b.

In 2010, U.S. saving was 11.6% of GDP, but U.S. investment was 15.9% of GDP. The United States financed the difference by borrowing from abroad.

The Advanced Economies country list (in 2010) where Income, Net is positive is the United States, Germany,France, Japan, United Kingdom. These are the Advanced Economies where GNP is larger than GDP.

c.

7.

8.

a.

Considering the evidence through February 2011, the yen generally appreciated against the dollar throughout this whole period. The most rapid appreciation was the mid 1980’s to the mid 1990s. 1985 to mid-1995, when it reached its strongest value against the dollar. Since mid-1995, the yen has fluctuated against the dollar, albeit within a relatively broad range. Most recently there has been further appreciation of the yen (depreciation of the dollar)

b.

Depreciation of the yen.

c.

The recent appreciation does not help the Japanese recovery.

a.

The sum of world current account balances should be zero. In 2008, the sum was positive, which implies literally that the world as a whole was borrowing. Obviously, this cannot have been true.

b.

In 2010, the United States was the world's biggest borrower by far. Europe was also a borrower. The economies of the Middle East and some developing economies in Asia were other large lenders; the economies of central and eastern Europe were large borrowers.

i.

In 2010 both Europe and the United States were borrowing. The savings of the other advanced economies was less than total borrowing by the United States. Thus the U.S. was borrowing from other, non-advanced economies.

d.

The projections in the October 2011 World Economic Outlook suggested no qualitative change in the answers to parts (a) through (c). Trade flows have fallen during the crisis, but the pattern of borrowing and lending remains more or less the same, although the Euro area is projected to begin running a current account surplus within the next few years.

CHAPTER 19 Quick Check 1.

2.

a.

There is a real appreciation over time. Over time, the trade balance worsens.

b.

The currency appreciates at the rate of -*.

a.

The share of Japanese spending on U.S. goods relative to U.S. GDP is (0.13)(0.23)=2.99%.

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178 ❖ ANSWERS TO END-OF-CHAPTER PROBLEMS

3.

b.

U.S. GDP falls by 2(.05)(.029)=0.3%.

c.

U.S. GDP falls by 2(.05)(0.13)=1.3%.

d.

This is an overstatement. The numbers above indicated that even if U.S. exports fall by 5%, the effect is to reduce GDP by 1.3%.

a. b.

False.

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.

True.

False. Econometric evidence suggests that a real depreciation does not lead to an immediate improvement in the trade balance. Typically, the trade balance improves six to twelve months after a real depreciation.

True.

False.

c. d. e.

f. g.

4.

Answers follow the model in the text.

Dig Deeper 5.

6.

a.

There must be a real depreciation.

b.

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.

a.

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.

b.

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.

c.

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

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ANSWERS TO END-OF-CHAPTER PROBLEMS ❖ 179

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.

7.

8.

d.

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.

e.

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).

a.

The ZZ and NX lines shift up. Domestic output and domestic net exports increase.

b.

Domestic investment will increase because output increases. Assuming taxes are fixed, there is no effect on the deficit.

c.

NX=S-I+T-G. Since the budget deficit is unchanged, and I and NX increase, S must increase.

d.

Except for G and (for our purposes) T, the variables in equation (19.5) are endogenous.

An exogenous shock such as an increase in foreign output can affect all of the endogenous variables simultaneously.

a.

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*]

b.

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.

c.

When government purchases increase by one unit, net exports fall m1Y= m1/(1-c1-d1+m1). Note that the change in output is simply the multiplier.

d.

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.

e. small economy (m1=0.5) large economy (m1=0.1) f.

Y 1.1 2

by

NX 0.6 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.

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180 ❖ ANSWERS TO END-OF-CHAPTER PROBLEMS

Explore Further 9.

a.

Current Account Balance = NI+NT+NX=National Saving - I.

c.

These answers use nominal GDP shares, obtained from Table B1 in the Economic Report of the President. Gross private investment has fallen since 1980 from 17% to 12% of GDP in 2012, this is a decline of 5 percentage points. Net exports have become a larger negative value, moved from -0.5% to -3.5%. Thus savings must have fallen even more than investment.

d.

1981-1990 1991-2000 2001-2010

 Investment (% of GDP) -1.2% -2.1% -2.2%

NX (% of GDP) -1.4% -1.0% -4.0%

These values are differences between the average values of I/GDP and NX/GDP for the decade in question minus the values of I/GDP and NX/GDP in 1980. We are thinking of net exports in 1980 as roughly zero. Thus compared to 1980, in the 1980s, investment fell, net exports fell so savings fell more. The same is true in the 1990s. In the 2000s, compared to 1980, investment had fallen by 2.2 percentage points and the trade deficit grown to an average of 4% of GDP. Thus national saving rates had dropped a lot. e.

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. f. Since the Current Account deficit = Trade Deficit + NI (net investment income) + NT (net transfers) The gap between the trade deficit and current account deficit is partly filled by NI, net investment income from abroad. The value of NI as a percent of GDP fell for many years from 1980 values of around 1% to less than 0.5% in the 2000’s. There was a recovery of this value in the last few years – 2008 and 2009 as interest rates paid on US debts to foreigners fell to near zero in the crisis. This value represents the gap between GDP and GNP.

CHAPTER 20 Quick Check 1.

a.

The IS curve shifts right, because net exports tend to increase. increases.

b.

The IS curve shifts right, because the increase in i* tends to create a depreciation of the domestic currency and therefore an increase in net exports. Domestic output increases.

The interest parity line also shifts up.

c.

A foreign fiscal expansion is likely to increase Y* and to increase i*. A foreign monetary expansion is likely to increase Y* and to reduce i*.

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Domestic output

ANSWERS TO END-OF-CHAPTER PROBLEMS ❖ 181

d.

2.

a.

b.

A foreign fiscal expansion is likely to increase home output. A foreign monetary expansion has an ambiguous effect on home output. The increase in Y* tends to increase home output, but the fall in i* tends to reduce home output.

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 net exports, but the increase in output tends to reduce net exports.

3.

The appropriate mix is a monetary expansion to lessen the value of the currency (and thereby to improve the trade balance) and a fiscal contraction to prevent output from increasing.

4.

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

False.

True.

True.

True.

Uncertain. If expected appreciation of the yen is greater than or equal to the interest rate in other countries, than foreign investors will hold yen bonds.

False. The money stock will change in response to shocks (including policy shocks) so that the home interest rate equals the foreign interest rate.

Dig Deeper 5.

6.

a.

An increase in Y* shifts the IS curve to the right. The incipient rise in the home interest rate creates a monetary expansion as the home central bank purchases foreign exchange to prevent the domestic currency from appreciating. So, the LM curve shifts right.

Output and net exports increase.

b.

The interest parity line shifts up, and the LM curve shifts left as the central bank sells foreign exchange to prevent the domestic currency from depreciating. Output falls, which leads to an increase in net exports.

c.

A fiscal expansion in the Leader country, which increases Y* and i*, reduces domestic output, if the effect of Y* on domestic output is small. A monetary expansion in the Leader country, which increases Y* and reduces i*, increases domestic output.

a.

The IS curve shifts to the left. Output falls, the interest rate falls, and the currency depreciates. The currency depreciation tends to increase output by increasing net exports.

Therefore, the exchange rate movement dampens the effect of the fall in business confidence.

b.

The IS curve shifts left and the LM curve shifts left (because the money supply falls) as the central bank sells foreign exchange to prevent the domestic currency from depreciating. The fall in output is greater than in part (a).

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182 ❖ ANSWERS TO END-OF-CHAPTER PROBLEMS

c.

When the exchange rate is flexible, movements of the exchange rate tend to dampen the output effects of IS shocks. The currency depreciates when the IS curve shifts left and appreciates when the IS curve shifts right.

Explore Further 7.

8.

a.

Et=Eet+1(1+it+x)/(1+i*t+1)

b.

The IS curve slopes down as before, but with the result in part (a) substituted for the nominal exchange rate in the NX function.

c.

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 depreciates. Note that the output effect, by itself, tends to reduce net exports. But in this case, output increased because net exports increased.

d.

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.

e.

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 February 25, 2012, the dollar was expected to appreciate 2.42% against the pound, 18.24% against the yuan, 1.81% against the Canadian dollar and depreciate by 0.49% against the Euro and 9.47% against the yuan.

c.

If significant real depreciation of the dollar is required, the results of part (b) imply that U.S. inflation needs to be enormously lower than foreign inflation by a substantial margin for all of these countries. For example, if very little is possible through a nominal depreciation over a 10-year horizon, then U.S. inflation must be around 2 percentage points lower than inflation in other countries in every year. Differences in annual inflation of this size seem unlikely to happen for an entire decade.

d.

Perhaps the relatively strong demand for dollar assets, irrespective of the interest rate or expected depreciation, has slowed the depreciation of the dollar that might have been expected to result from the enormous U.S. current account deficit. Clearly this was the case in the first few months of the global crisis, as the dollar appreciated strongly, despite the fact that the crisis originated in the United States.

CHAPTER 21 Quick Check 1.

a.

The expected exchange rate is E. The home interest rate is i*.

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ANSWERS TO END-OF-CHAPTER PROBLEMS ❖ 183

2.

b.

The expected exchange rate is less thanE. The home interest rate is greater than i*.

c.

The domestic interest rate returns to i*, because expected depreciation is zero.

d.

Devaluation per se does not lead to higher interest rates. Fear of devaluation does.

a.

The home real interest rate equals the foreign real interest rate minus expected real appreciation of the home currency. When the home currency is expected to appreciate in real terms, foreign bonds must offer a real interest rate higher than the home real interest rate to compensate international portfolio investors for the expected loss in the real value of the foreign currency. When the home currency is expected to depreciate in real terms, home bonds must pay a real interest rate higher than the foreign real interest rate.

b.

According to uncovered interest parity, 10%=6%-expected nominal appreciation, which implies that expected nominal appreciation equals -4% per year. In other words, expected depreciation is 4% per year.

c.

According to real interest parity, 10%-6%=(6%-3%) - expected real appreciation, which implies that expected real appreciation equals -1% per year. Therefore, expected real depreciation is 1% per year.

d.

You would purchase the domestic bond because the foreign bond will pay less interest than the domestic bond, and the domestic currency is expected to gain in value relative to the foreign currency.

3.

a.

True. Britain returned to the gold standard where the exchange rate implicit in the gold standard parity found the pound appreciated above the level consistent with full employment.

The required real depreciation had to take place through a reduction in nominal wages. b.

True. c.

False. d.

False. e.

False.

4.

b.

The AD curve shifts right in the short run. The AS curve shifts left in the medium run. In the medium run, output is unchanged, but the price level is higher.

c.

Consumption is unchanged in the medium run.

d.

The real exchange rate appreciates, since the price level rises. As a result of the real appreciation, net exports fall in the medium run.

e.

The domestic interest rate equals the foreign interest rate, i*. The nominal interest rate is unaffected by government spending. Since expected inflation is constant, the real interest rate is also unaffected. Investment is unchanged in the medium run.

f.

In a closed economy, an increase in government spending reduces investment in the medium run.

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184 ❖ ANSWERS TO END-OF-CHAPTER PROBLEMS

g.

The statement is true. Under fixed exchange rates, the interest rate is tied to the foreign interest rate. Since the interest rate does not change, there is no mechanism for government spending to crowd out investment.

Dig Deeper 5.

6.

7.

a.

The domestic interest rate equals the foreign interest rate before and after the devaluation.

b.

The expected exchange rate falls toE. The UIP curve shifts up.

c.

The IS curve shifts right, because the devaluation tends to increase net exports. The interest rate would increase with no change in the money supply.

d.

The money supply must increase. Otherwise, the increase in the interest rate (see part (d)) that would prevent the currency from depreciating all the way to the new level, E.

In order to reduce the value of the currency to the new level, the central bank must sell domestic currency and accumulate foreign exchange, which leads to an increase in the money supply. The LM curve shifts right.

e.

Output increases.

f.

Fear of further devaluation will increase the expected exchange rate above E and increase the interest rate above i*. These effects will tend to reduce the increase in output. If the initial devaluation creates a strong enough fear of further devaluation, the devaluation could lead to a fall in output.

a.

In the medium run, the price level rises by 10%.

b.

The real exchange rate is EP/P*. If P rises by 10%, E falls by 10%. There is a 10% depreciation of the currency in nominal terms.

c.

Eet+n falls by 10%.

d.

E falls by 10%.

e.

E falls by more than 10%. By interest parity, i-i* equals expected depreciation. If i falls below i* in the short run, then there is expected appreciation. This can only happen if E falls by more than 10% in the short run. So, E falls by more in the short run than it does in the medium run.

a.

Eet+1 falls.

b.

The UIP curve shifts up. The domestic interest rate must increase to maintain the fixed exchange rate.

c.

The money supply falls as the central bank sells foreign exchange to buy its own currency. The LM curve shifts left.

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ANSWERS TO END-OF-CHAPTER PROBLEMS ❖ 185

d.

Output falls and the interest rate rises. The government might choose to abandon the fixed exchange rate to avoid the fall in output, even if initially the government had no intention of devaluing. Self-fulfilling crises are possible.

Explore Further 8.

The answer is given in the comments after part (c). The exchange rate is many times more variable than the interest rate differential.

CHAPTER 22 Quick Check 1.

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

g.

False.

True/Uncertain.

False.

False.

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 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 pre-commitment. 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?

False.

2.

Answers will vary, but there is some discussion of this issue in the text.

3.

New Zealand wants to eliminate fears that the central bank might try to reduce unemployment below the natural rate with expansionary monetary policy and higher inflation. See Chapter 25 for a discussion of inflation targeting.

4.

a.

Inflation will increase in the fourth year.

b.

The President should aim for high unemployment early in the administration, to reduce inflation before the fourth year.

c.

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.

Dig Deeper

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186 ❖ ANSWERS TO END-OF-CHAPTER PROBLEMS

5.

The payoffs should be symmetrical, as written below. The table presented in the text leads to the same equilibrium, however.

Welfare Cuts

6.

Yes

No

Defense

Yes

(R=1, D=1)

(R=-2, D=3)

Cuts

No

(R=3, D=-2)

(R=-1, D=-1)

a.

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.

b.

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.

c.

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.

a.

et=0.5(D + R)

b.

The unemployment rate will be less than the natural rate. Inflation will be higher than expected.

c.

The unemployment rate will be greater than the natural rate. Inflation will be lower than expected.

d.

The results fit the evidence in Table 24-1 if one looks at the first two years of each administration, and not just the first year.

e.

The unemployment rate will equal the natural rate, because π = πe. There will be high inflation.

Explore Further 7.

Answers will vary.

CHAPTER 23 Quick Check 1.

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

True.

False.

False.

False.

False.

False

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ANSWERS TO END-OF-CHAPTER PROBLEMS ❖ 187

2.

g. h. i. j.

False False True False

a.

If money growth = 25%, 50%, 75%, seignorage=162.5, 325, 487.5.

b.

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.

3.

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.

4.

a.

Interest payments are 10% of GDP, so the primary surplus is 10%-4%=6%.

b.

Real interest payments are (10%-7%)*100%=3% of GDP. So the inflation-adjusted surplus is 6%-3%=3%.

c.

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%.

d.

The change in the debt to GDP ratio = (3%-2%)*100% - 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.

Dig Deeper 5.

a.

The IS curve shifts right. Output rises. The government finances the extra spending by borrowing.

b.

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 3). 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

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188 ❖ ANSWERS TO END-OF-CHAPTER PROBLEMS

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.

6.

e.

Statement (i) is false. Statement (ii) is true.

a.

The new interest rate is 10%+0.5*20%=20%. So assuming that expected depreciation was previously zero, the domestic interest rate increases from 10% to 20%.

b.

The real interest rate increases from 3% to 13%. The high real interest rate is likely to decrease growth.

c.

The official deficit increases from 4% to 14% of GDP. The inflation-adjusted deficit increases from –3% (a surplus) to 7% (a deficit).

d.

In the first year, the change in the debt ratio = (13%-0%)*100%-6%=7%. It goes up very quickly.

e.

In this example, the worries were self-fulfilling.

Explore Further 7.

g.

a.

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%.

b.

In 10 years, the debt to GDP ratio rises to 93%.

c.

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).

d.

After 10 years, the primary deficit must fall to zero to maintain the debt-to-GDP ratio of 50%.

e.

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.

f.

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.

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ANSWERS TO END-OF-CHAPTER PROBLEMS ❖ 189

CHAPTER 24 Quick Check 1.

a.

The unemployment rate will remain equal to the natural rate.

b.

It is unlikely that the central bank will be able to hit its target every period. There will be surprises, and there are lags and uncertainty in policymaking.

b. Changes in the natural rate will make it more difficult for the Fed to hits its target. It will be harder to distinguish changes in the actual rate of unemployment from changes in the natural rate of unemployment.

2.

3.

4.

a.

i. r=4%-0%=4%; ii. r=14%-10%=4%

b.

i. r=4%(1-0.25)-0%=3%; ii. r=14%(1-0.25)-10%=10.5%-10%=0.5%

c.

Given the deductibility of nominal mortgage interest payments, inflation is good for homeowners in the United States.

a.

Demand for M1 falls while demand for M2 is unchanged. People shift funds from checkable deposits to time deposits.

b.

Demand for M1 increases as people transfer funds from money market funds to checking accounts. Demand for M2 remains unchanged.

c.

There is a shift in the composition of M1 (and consequently M2) as people hold more currency and make fewer trips to the bank while holding smaller checking account balances.

d.

The demand for M2 increases as the benefit of holding government securities falls.

a. b. c. d.

False.

False.

False.

False. Evidence suggests that people have money illusion, when would seem to imply that inflation would distort decision making.

True True. The capital gains tax is not indexed to inflation.

False False

e. f. g. h.

Dig Deeper 5.

b.

The IS curve slopes down, and the MP relation slopes up.

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190 ❖ ANSWERS TO END-OF-CHAPTER PROBLEMS

c.

An increase in government spending shifts the IS curve right, so output and the real interest rate rise.

d.

The MP relation shifts up. Output falls and the real interest rate increases.

6.

Discussion question.

7.

a.

The MP relation shifts up. Output falls and the real interest rate increases.

b.

Since Y<Yn, e falls. Inflation tends to returns to its target level.

c.

The MP relation shifts down. Output increases and the real interest rate falls.

d.

Since Y>Yn, e rises. Inflation tends to move away from its target level. A value of a<1 makes no sense as part of the policy rule, because inflation would tend to move away from its target level.

Explore Further 8.

Answers will depend upon current Fed policy.

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