Type:
Solution Manual
Macroeconomics A European Resource: Perspective Edition:
4th Edition
Author(s):
Olivier Blanchard Alessia Amighini Francesco Giavazzi
Instructor’s Manual Macroeconomics Fourth edition
Olivier Blanchard Alessia Amighini Francesco Giavazzi
Contents 1: A Tour of the World
01
2: A Tour of the Book
07
3: The Goods Market
12
4: Financial Markets: I
17
5: Goods and Financial Markets: The IS-LM Model
23
6: Financial Markets II: The Extended IS-LM Model
28
7: The Labor Market
34
8: The Phillips Curve, the Natural Rate of Unemployment, and Inflation
40
9: From the Short to the Medium Run: The IS-LM-PC Model
45
10: The Covid Economic Crisis
49
11: The Facts of Growth
51
12: Saving, Capital Accumulation, and Output
54
13: Technological Progress and Growth
60
14: The Challenges of Growth
64
15: Financial Markets and Expectations
67
16: Expectations, Consumption, and Investment
71
17: Expectations, Output, and Policy
76
18: Openness in Goods and Financial Markets
79
19: The Goods Market in an Open Economy
84
20: Output, the Interest Rate, and the Exchange Rate
89
21: Exchange Rate Regimes
94
22: Should Policymakers be Restrained?
99
23: Fiscal Policy: A Summing Up
103
24: Monetary Policy: A Summing Up
107
25: Epilogue: The Story of Macroeconomics
111
Answers to End-of-Chapter Problems
115
iii .
CHAPTER 1. A TOUR OF THE WORLD I.
MOTIVATING QUESTION
What is macroeconomics? The chapter does not provide an explicit or formal answer. Instead, it takes you on an economic tour of the world. At the beginning of 2020, the world population was hit by a serious pandemic caused by COVID-19, a new coronavirus that forced entire countries into quarantine and stopped production in many sectors. The world economy had just been hit by a disastrous economic crisis in 2008, the deepest since the Great Depression in 1929. World output growth, which typically runs at 4–5% a year, was negative in 2009. Since then, growth has turned positive, and the world economy has largely recovered. But the crisis, now known as the Great Financial Crisis, has left several scars, and some worries remain. Today, however, the pandemic will cause an even deeper recession. The chapter also provides an overview of the three main economic powers of the world: the United States, the Euro area, and China. The chapter concludes with a list of other regions of the world and macroeconomic issues of growing importance. A working definition of macroeconomics at this point is the study of output, unemployment, and inflation, terms that will be defined precisely in Chapter 2.
II.
WHY THE ANSWER MATTERS
This chapter attempts to provide students an incentive to master the theoretical material that follows in the remainder of the text. The implicit promise is that the theoretical model developed in the text will allow students to make sense of the various macroeconomic issues that continue to impact countries around the world.
III. KEY TOOLS, CONCEPTS, AND ASSUMPTIONS 1.
Tools and Concepts
Chapter 1 does not provide any analytical tools. However, it does force students to confront some basic data and introduces data sources for various regions of the world. In addition, the chapter introduces and defines the concepts of output, growth, the unemployment rate, and the inflation rate. A more precise definition of these terms follows in Chapter 2. Chapter 1 mentions in passing the terms standard of living, productivity, and purchasing power parity. All of these terms and concepts will be explored in later chapters in the text.
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 Pandemic of 2020
A serious recession begun in the world in 2020, with few precedents in history. In just four months, the pandemic caused by the COVID-19 virus spread from the Chinese city of Wuhan throughout the world. This is an event that will mark this century, as last century was marked by the 1-1 .
‘Spanish’ flu of 1918, a virus that caused more deaths than the First World War. Recessions caused by a pandemic are different. They are not produced by any imbalance in the economy, but rather by an exogenous and unexpected shock, the diffusion of a virus. This shock affects the economy in three ways. First, by breaking the production chains. Second, to slow the spread of the virus, most countries have chosen to limit the mobility of people and many – all those who cannot work remotely – have stopped working, as vividly shown in Figure 1.2. Intermediate goods and workers, as we shall see in the next chapters, are essential factors of production, without which companies cannot produce. Their disappearance has therefore represented a ‘supply shock’, i.e. a shock that has limited production (more on this in Chapter 9). There is a third factor: the closure of factories and shops, and the associated fall in family incomes – since not all workers receive unemployment benefits – has caused a sudden slowdown in consumption. The “supply shock’ has therefore been accompanied by a ‘demand shock’, that is a fall in consumption.
2.
The Crisis
Included in the 8th edition of the textbook is a discussion around the major macroeconomic crisis that occurred in 2008. Figure 1-7 outlines the output growth rates for the world economy, the advanced economics and for the other countries separately since 2000. From 2000 to 2007 the world economy had a sustained expansion. Annual average world output growth was 4.5%, with advanced economies growing at 2.7% per year, and emerging and developing economies growing at an even faster 6.6% per year. By 2008, the world, advanced and emerging economy output growth rate began to decline marking the beginning of the macroeconomic crisis. In 2010, growth in advanced economies turned positive and has remained positive as of 2019. Highlights of the Macroeconomic Crisis: • • • •
• •
•
• •
U.S. housing prices, which had doubled since 2000, started to decline in 2007. A number of mortgage loans originated during the earlier expansion were to high-risk borrowers which were increasingly unable to make mortgage payments. Declining housing prices caused the mortgages to exceed the market value of the homes thus creating an incentive to default. Banks that originated the loans often bundled, packaged and repackaged the loans into new securities and then sold them to other banks and investors. The holdings of securities, instead of mortgages by banks, added complexity that made it impossible to appraise the value of these derivative financial obligations. The complexity of the value of the securities and the quality of the assets made banks reluctant to lend to each other. September 15, 2008, a major bank, Lehman Brothers, went bankrupt creating borrowing issues and asset valuation problems for other banks. Within weeks the whole financial system was in jeopardy. Figure 1-2 shows how the financial crisis became an economic crisis with the collapse of stock prices indicated in the three stock price indexes (for the United States, Euro area and emerging economies). By the end of 2008, stocks had lost half or more of their value from the previous peak. The decline in housing prices and the collapse in stock prices lead to a decline in consumption of goods and services. Businesses’ concerns over sales and continuous decline in housing prices caused a sharp reduction in investment along with a decline in the building of new homes.
1-2 .
•
• •
• •
3.
Despite strong actions by the Fed, including a cut in interest rates, and the U.S. government which cut taxes and increased government spending, both demand and output continued to decline in the U.S. A decline in the U.S. imports along with U.S. banks needing to repatriate funds from other countries moved a U.S. crisis into a world crisis. By 2009, average growth in advanced economies was −3.4%, by far the lowest annual growth rate since the Great Depression. Growth in emerging and developing economies remained positive but was 3.5 percentage points lower than the 2000–2007 average. Table 1-1, shows by 2018, economic growth in the U.S. was positive but still not at pre-crisis levels. Tables 1-1 and 1-2 show consistently high unemployment rates for the United States and Euro area since the beginning of the crisis. However, U.S. unemployment rates improved dramatically and are down to 3.7% as of 2018.
The United States
The recovery from the financial crisis started in the United States in June 2009. Since then, output growth had been positive until the COVID-19 pandemic broke and growth abruptly turned negative. In the United States, the 1990–2007 average rate of growth of the economy was 3.0%. In contrast the rate of growth during the crisis (2008–2009) was −1.3%. However, by 2018 the U.S. economy was growing at an annual rate of 2.9%. Beginning in June 2009, the U.S. economy continued to expand and is currently in the longest expansion on record. U.S. unemployment rates increased from a pre-crisis average of 5.4% to an average of 6.8% over the period 2010–2017. However, by 2018 the U.S. unemployment rate was down to 3.7% as firms began to add employees. One of the primary economic issues facing the U.S. is the current Federal Reserve policy of extremely low interest rates which have been necessary to propel growth. Figure 1-10 shows the federal funds rates from 2000–2019 which highlights this policy. Until the end of 2015, the Fed remained near the zero interest rate bound and it was not possible to lower rates much to stimulate growth if deemed necessary. However, by early 2019, the rate was up to 2.4%. This rate is still low by historical standards and continues to limit the Fed’s ability to respond to another recession. The low rates also push investors to take excessive risks in search of higher returns. Another macroeconomic issue is the low productivity in the U.S. Table 1-2 shows that productivity growth is significantly lower in all sectors of the economy relative to the 1990s. Slow productivity growth can decrease the real earnings power of workers and lead to an increase in income inequality. Since 2000, the real earnings of workers with a high school education or less have decreased. Policy makers need to change this trend and one mechanism to accomplish this goal is higher productivity growth.
4.
The Euro Area
Figure 1-12 displays a map the EU17 that uses the Euro as a common currency along with the 2018 output of the Euro area’s output for the countries of France, Germany, Italy and Spain. Table 1-3 shows that over the 1990–2007 time period right before the crisis, the Euro Area together experienced positive but relatively low growth. The Euro Area also experienced low inflation and continued high unemployment. The crisis caused growth to decline to negative 2.0% over the 2008–2009 period while the unemployment rate averaged 10.6% over the 2010–2017 time period. Some Euro Area countries, such as Greece and Spain, continue to struggle with unemployment rates exceeding 15%, even in 2018.
1-3 .
The issues facing the Euro area are: • •
How to reduce unemployment. How to function effectively as a common currency area.
How to reduce unemployment The debate over remedies for high unemployment in Europe is characterized by two polar views. According to the first view, high unemployment is the result of the financial crisis and the sudden collapse in demand. The suggested remedy is to allow demand to recover on its own and reduce the unemployment rate. According to the second view, high unemployment is a result of rigid labor market institutions, particularly with respect to worker protection such as generous unemployment insurance policies that reduce the incentive to find work. Thus, the suggested remedy is to restructure labor market institutions—in fact to model them after the institutions in the United States. The United Kingdom has followed this approach, evidently with some success in reducing the unemployment rate. Some economists, however, remain skeptical that the U.K.’s approach is the right model for Europe. These economists point out that low unemployment rates occur in many European countries that provide generous social insurance for workers. The way forward, the skeptics argue, is to study the details of worker protection policies in places where such policies have been consistent with low unemployment, and to apply the lessons to other European economies. How to function effectively as a common currency area The Euro offers political and economic benefits. Politically, the adoption of a single currency provides a strong symbol of European unification after the wars of the 20th century and before. Economically, the Euro has eliminated exchange rate uncertainty among participating countries, and thus may facilitate trade and contribute to the economic development of Europe as, perhaps, the largest economic power in the world. On the other hand, the adoption of a single currency has eliminated the discretion of each country individually to use monetary policy to stimulate output and reduce unemployment. Countries that participate in the Euro have a common monetary policy, in the same way that states in the United States have a common monetary policy. This situation creates the possibility of policy conflicts when some countries are in recession and others are in an economic boom. The chapter points to the recent policy conflicts among Euro members. Highlighting the issue are deep recessions of countries including Italy, Ireland, Portugal, and Greece, that are unable to individually decrease their interest rates, or depreciate their currency. These problems have prompted some economists argue that they should drop out of the Euro. Others argue that such an exit would be both unwise, as it would give up on the other advantages of being in the Euro, is extremely disruptive, and could lead to even deeper problems for the country that exits. In a referendum held on 23 June 2016, Great Britain voted in favour of exiting from the European Union, the so-called Brexit. Until December 2020, the UK remained in a ‘transition period’ during which London continued to apply European regulations and pay its share of contributions to the EU budget. During the same period, the UK and the EU have negotiated a treaty that defined their relationship after December 2020.
5.
China
China’s economy commands the attention of macroeconomists because of its exceptional growth over the last three decades. Since 1980, China’s output has grown at roughly 10% a year. Table 1-4 shows that the 2008–09 crisis has had little effect on the Chinese economy. While, Chinese exports slowed down during the crisis it was nearly fully offset by a major fiscal expansion by the Chinese government. The result was sustained growth of demand and, in turn, of output. However, China’s economic growth rate is falling and was only 6.6% in 2018.
1-4 .
Although official Chinese statistics are not as accurate as in richer countries, research suggests that there is no clear bias in the numbers. In other words, high growth in China is a fact, and not an artifact of poor statistics. China has achieved high growth through rapid accumulation of capital (investment rates exceeding of output) and fast technological progress. The latter achievement is in part a result of the Chinese government’s strategy of encouraging foreign firms—which are typically more productive than Chinese firms—to produce in China. The government has also encouraged joint ventures between foreign and Chinese firms. Such joint ventures allow Chinese firms to learn from more productive foreign firms. Although China’s success seems to provide a model for other developing countries to follow, questions remain about the operational lessons to draw from China’s experience. In most other cases, the transition from central planning to a market economy has been accompanied by a large decline in output. Some argue that the slow pace of China’s transition—thirty years and still incomplete—was an important factor in China’s success. Others argue that the political control of the Communist party during the transition has enabled better protection of property rights for firms, thereby creating incentives for investment.
V. PEDAGOGY 1.
Points of Clarification
Chapter 1 mentions in passing that an annual growth rate of 10% means output will double in about 7 years. The “rule of 70” tells us how long it takes for an amount to double in value so instructors may wish to mention it here. Also, the text does not use logarithms, although it does use graphs on logarithmic scales. Instructors who wish to use logarithms in the course can use the rule of 70 as a way to reacquaint students with the use of the natural logarithm.
2.
Alternative Sequencing
i.
The 2020 Pandemic Crisis. Indeed, instructors could use the Covid crisis as the running example to introduce most the material. The 8th Edition features a streamlined organization where an early and continuous examination of the global crisis provides an integrated framework to think about the short, medium run, and long run. Output, the Unemployment Rate, and the Inflation Rate. Output, the unemployment rate, and the inflation rate are not defined precisely until Chapter 2. Some instructors may prefer to cover the definitions from Chapter 2, and possibly the discussion of why macroeconomists care about these variables, before discussing the material in this chapter.
ii.
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 Federal Reserve should do with regard to interest rates. Students should develop alternative opinions based on illustrative newspaper quotes or student answers.
VI. EXTENSIONS 1.
The Rest of the World
The Tour of the World presented in this chapter focuses attention on the United States, Europe, and China. Economic events in other regions are discussed only briefly at the end of the chapter. Current economic events in some of these regions are discussed at various places throughout the text. However, instructors may wish to devote more time to these regions at the outset, especially if the course will consider the open 1-5 .
economy. Looking Ahead, section 1-6, contains a number of other important macroeconomic issues that you may want to discuss in class.
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 income inequality in the section on the U.S. economy. In subsequent editions, including the current edition, income inequality is discussed in Chapter 14. Instructors may wish to raise this issue in the introductory discussion of the U.S. economy. It may be beneficial to point out that higher productivity growth is one way to address income inequality.
VII. APPENDICES Appendix 1: Where to find the numbers? This appendix provides numerous sources of economic data on the Internet. Economic growth, inflation rates, unemployment rates and countless other macroeconomic and microeconomic data are available for almost every nation. Examples include FRED, OECD stat, and the World Economic Outlook Database.
Appendix 2: What do macroeconomists do? Some of the students may wonder what they can do with a degree in economics. Those earning an undergraduate degree will probably work in the private sector helping the organization assess the economic situation. If you want a job at the IMF or World Bank you will probably have to get a Ph.D. The same holds true for jobs in higher education.
1-6 .
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; output as the GDP and the unemployment rate as the percentage of the labor force not working. The text defines the inflation rate in two ways: the percentage change in the GDP deflator and the percentage change in the CPI. The link between output and the standard of living is implicit in the chapter. Economists care about the unemployment rate because the unemployed suffer, particularly if they remain unemployed for long periods of time, and because the unemployment rate provides an indicator of whether the economy is growing too fast or too slowly (concepts that will be defined precisely later in the book). Inflation has three main effects: it redistributes real income away from those who receive fixed nominal income, it distorts relative prices to the extent that some nominal variables do not adjust, and it creates uncertainty about relative price levels.
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. ii.
Chapter 2 introduces index numbers. The chapter defines formally the basic macroeconomic concepts of nominal and real gross domestic product (GDP), GDP growth, the GDP deflator, the unemployment rate, the consumer price index (CPI), and the inflation rate, as well as associated concepts such as valued added, intermediate inputs, the labor force, and the participation rate. All of these concepts are defined in the usual manner. The chapter distinguishes the short run, the medium run, and the long run in the manner described above in Part I. The distinction establishes the basic theoretical framework for the book.
iii.
IV. SUMMARY OF THE MATERIAL 1.
Aggregate Output
The text considers a closed economy until Chapter 18, so output is equated with gross domestic product (GDP). Output has three equivalent definitions: (1) the value of final goods and services produced during 2-7 .
a given period, (2) the sum of value added during a given period, and (3) the sum of labor and capital income and indirect taxes. Using the first definition, nominal GDP is output valued at current prices. Real GDP is output valued at constant prices. If the economy produced only one good—say, SUVs—and this good were unchanged over time, one could measure real GDP by simply counting the number of SUVs produced each year. Alternatively, one could multiply the number of SUVs by some constant price—say, the price in some base year. Thus, in the base year, real and nominal GDP would be the same. In practice, the construction of real GDP involves two complications. First, since the economy produces many goods, one must decide how to weight the value of the output of each good to produce aggregate real GDP. The text notes that the United States has adopted a technique—chain weighting—that allows the relative price of goods to change over time. The appendix to Chapter 2 discusses the construction of GDP and chained indexes in more detail. Second, the quality of similar goods changes over time. Economists who construct GDP try to account for quality change in goods through hedonic pricing, an econometric technique that estimates the market value of a good’s characteristics—speed, durability, and so on. The growth rate of real (nominal) GDP is the rate of change of real (nominal) GDP. Periods of positive GDP growth are called expansions; periods of negative growth, recessions.
2.
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.
3.
The Inflation Rate
The inflation rate is the growth rate of the aggregate price level. Since there are many goods produced and consumed in an economy, constructing the aggregate price level is not trivial. Macroeconomists use two primary measures of the aggregate price level. The first, the GDP deflator, is the ratio of nominal to real GDP. Since nominal and real GDP differ only because prices in any given year differ from the base year, the GDP deflator provides some measure of the average price level in the economy, relative to the base year. By construction, the GDP deflator equals one in the base year. Since the choice of base year is arbitrary, the level of the GDP deflator is meaningless. The rate of change of the GDP deflator, however, is meaningful; it is one measure of inflation. Measures with arbitrary levels but well-defined rates of change are called index numbers. The GDP deflator is an index number.
2-8 .
An alternative measure of the price level is the Consumer Price Index (CPI)—another index number. In the United States, this measure is based on price surveys across U.S. cities. The prices of various goods are weighted according to average consumer expenditure shares in the United States. The construction of the CPI and the construction of real GDP involve similar problems. One can also measure inflation as the rate of change in the CPI. The relationship between inflation measured from the GDP deflator and inflation measured from the CPI is very close, but not perfect. The differences arise because the two price indexes apply to different baskets of goods. GDP measures production of final goods, so inflation calculated from the GDP deflator provides a measure of the percentage change in the aggregate price of final goods produced in an economy. The CPI, on the other hand, measures the price of a representative basket of private consumption, so inflation calculated from the CPI provides a measure of the percentage change in the price of the domestic consumption basket. Domestic consumption includes goods imported from abroad, and domestic production includes final goods used for purposes other than domestic consumption. Economists care about inflation because it can distort relative prices, produce uncertainty about relative prices, and redistribute income. Inflation distorts relative prices because some nominal variables do not adjust immediately to the rise in the aggregate price level. Inflation redistributes income because some transactions involve fixed nominal payments. For example, some retirees receive fixed nominal incomes. Inflation may be costly, but there are also economic problems associated with deflation (negative inflation). For example, some of the costs of inflation would also apply to deflation. Moreover, deflation limits the ability of monetary policy to affect output. Consideration of the costs of inflation and the costs of deflation seems to suggest that there is an optimal rate of inflation. Most economists favor a stable inflation rate somewhere between 1 and 4%.
4.
Output, Unemployment, and the Inflation Rate: Okun’s Law and the Phillips Curve
There are two relationships that connect the three main dimensions of economic activity. The relationship between unemployment and output is described by Okun’s law. American economist Arthur Okun found that when output increases unemployment falls and vice versa. Intuitively this relationship makes sense because higher output in general requires employing more workers. Figure 2-5 highlights this relationship. The second relationship was identified by economist A.W. Phillips and is shown graphically as the Phillips curve (see Figure 2-6). Phillips discovered that inflation tends to increase as unemployment falls This finding also seems intuitive given that as economic activity increases, and most people are working, the remaining potential workers must be paid higher wages to get them off the couch. In addition, firms will begin sniping employees from other firms by paying higher wages. The net result is an increase in inflation while unemployment falls.
5.
The Short Run, the Medium Run, and the Long Run
Macroeconomists view the economy in terms of three time frames. In the short run—a few years or so— demand for goods and services determines output. In the medium run—a decade or so—the level of technology and the size of the capital stock determine output. Since these variables change slowly, it is a useful simplification to assume that they are fixed in the medium run. Finally, in the long run, technological progress and capital accumulation are the primary determinants of output growth. Changes in a nation’s education system, the quality of government, or savings rate are examples of long run factors that affect economic output.
2-9 .
6.
A Tour of the Book
The remainder of the book can be divided into three sections: “Core” material (Chapters 3-14), extensions to the Core, and concluding chapters on macroeconomic policy and the state of macroeconomic thinking. The Core is organized around the three time frames. It discusses how output is determined in the short run in chapters 3 to 6. Chapters 7 to 10 develop the supply side and look at how output is determined in the medium run. Chapters 11 to 14 focus on the long run and looks at output growth. After the Core, there are two extensions: expectations (Chapters 15-17), and the open economy (Chapters 18-21). In chapters 22 to 24 the content goes back to monetary and fiscal policy issues. The final chapter (Chapter 25) focuses on the history of thought in macroeconomics. The book is constructed so that the extensions can be addressed in any order after the Core. Indeed, most of the material in the extension chapters can be discussed without covering the growth section of the Core. In addition, much of the material in the policy chapters can be discussed immediately after the Core, without any of the extensions. Thus, there are a number of options for constructing a course around the text.
V. PEDAGOGY 1.
Points of Clarification
The use of subscripts to index time will be new for many students. A few minutes of clarification may be worthwhile at the outset.
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 real GDP and chain-type indexes is also presented in Appendix 1. Instructors may prefer to introduce the material from Appendix 1 immediately after Section 1 of this chapter.
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 7, which introduces the labor market and aggregate supply. A benefit of this approach is a more rapid advance to the Keynesian cross in Chapter 3. A cost is the need to say something about the aggregate price level in the LM curve in Chapter 6.
VI. EXTENSIONS 1.
GDP as a Measure of Welfare
The chapter discusses briefly why economists care about inflation and unemployment, but does not do the same for GDP. It is probably obvious that economists use GDP as a gross measure of aggregate welfare, but instructors may wish to point out that there are (at least) three limitations on GDP as a welfare measure. i.
Measured GDP values goods and services at market prices, since these reflect the relative values placed on them by consumers. However, some valuable things are not sold on markets, and their values thus have to be imputed, a process that undoubtedly introduces some errors. Two important services that do not have a market price are government services and owner-occupied housing. 2-10 .
ii.
iii.
Some goods and services not traded in markets are omitted altogether from the GDP calculation. For example, the value of leisure and the value of services performed in the household are not included in GDP. From a broader perspective, one might also cite civil liberties and other political “goods” as nonmarket goods produced by a nation, but not included in GDP. GDP does not account for the fact that some of a nation’s wealth is depleted in the process of producing it. NDP corrects this to some extent by subtracting the value of depreciated physical capital, but depletion of natural and environmental resources is still omitted. The Department of Commerce and others have experimented with adjustments to GDP to account for resource and environmental depletion, but there is no consensus among economists about the proper methodology.
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.
VII. APPENDIX The Construction of Real GDP and Chain-Type Indexes The chapter discusses real GDP and also mentions the real GDP in chained dollars. This appendix shows you how to construct the real GDP and then how construct a rate of change in the real GDP. It also extends the computations and shows how to link or chain the level of real GDP to a base year which is currently 2015. In the base year 2015 the nominal and real GDP are equal. Today any mention of the real GDP refers to 2015 euros. This practice provides economists with a measure of real economic output by removing the influence of inflation.
2-11 .
CHAPTER 3. THE GOODS MARKET I.
MOTIVATING QUESTION
How is output determined in the short run? Output is determined by equilibrium in the goods market, i.e., by the condition that supply (production of goods) equals demand. This condition always determines output, but in the short run, we assume that production adjusts automatically to output without changes in price. Thus, in the short run, output is effectively determined by demand. Moreover, in this chapter, investment is exogenous (and therefore independent of the interest rate), so there is no need to consider simultaneous equilibrium in the goods and financial markets.
II.
WHY THE ANSWER MATTERS
The determination of output is the fundamental issue of macroeconomics. This chapter introduces the topic through the Keynesian cross model, which considers the goods market in isolation. The Keynesian cross provides basic intuition about the building and solving of models, the determination of output, and the role of fiscal policy. The short-run, qualitative results generally survive in more complicated models. Chapter 4 examines the financial markets in isolation, and Chapter 5 combines the goods and financial markets to construct the demand side of the economy.
III. KEY TOOLS, CONCEPTS, AND ASSUMPTIONS 1.
Tools and Concepts
i. ii.
iv.
The chapter introduces functional notation. The chapter introduces modeling terminology: exogenous and endogenous variables, behavioral equations, identities, and equilibrium conditions. The chapter describes the Keynesian cross model (although it does not use this expression), and associated terms, such as the (marginal) propensity to consume, disposable income, and autonomous spending. The chapter introduces fiscal policy.
2.
Assumptions
i.
The text assumes that the economy produces a single good. This assumption is maintained throughout most of the formal work in the book. After introducing the national income identity, the text assumes a closed economy. This assumption is maintained until Chapter 18. For short-run analysis, the text assumes that production adjusts automatically to output without changes in price. This assumption implies that the price level is fixed. Instructors may wish to clarify this assumption before the price level is introduced in the discussion of the money market and the LM curve in Chapters 4 and 5. The assumption that the price level is fixed is maintained until Chapter 7. Within the short-run context, the critical assumption of this chapter is that investment does not respond to the interest rate. This isolates the goods market from the financial market. This assumption will be relaxed in Chapter 5.
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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. Write consumption as a linear function of disposable income (YD)
C = C (YD )
(3.1)
(+) The function C = C(YD) is called the consumption function. The positive sign below it indicates that consumption increases as disposable income increases. However, there is some level of consumption that would occur even if disposable income were zero. This consumption is called autonomous consumption and is represented by c0. The parameter c1, which represents the increase in consumption for every extra unit of disposable income, is called the (marginal) propensity to consume. Assume that households do not consume every dollar of additional income, but save some, so that 0 < c1 < 1. Given this new information we can expand the consumption function to the following linear function;
C = c0 + c1 (YD )
(3.2)
When we add the government sector and taxation to the model we see that consumers pay taxes (T) on income (Y). This addition expands the linear expression of the model to;
C = c0 + c1 (Y − T )
(3.3)
The two remaining components of consumption are government spending (G) and business investment (I) which in the next section we will hold constant.
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.
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(3.5)
The variable Y appears on both sides of this equation. On the LHS, Y represents production. On the RHS, Y represents national income. Chapter 2 explained why these two quantities are equal. The aim of this model is to determine the value of Y, an endogenous variable. To solve the model, it is necessary to write Y as a function of the exogenous variables, i.e., those determined outside the model. In other words, Y=
1 [c0 + I + G − c1T ]. 1 − c1
(3.8)
Equation (3.8) shows the algebraic solution and Figure 3-2 the graphical solution. In the graph, equilibrium occurs where demand (the ZZ curve) crosses the 45° line (i.e., the line along which Y = Z). Figure 3-2: Equilibrium in the Goods Market
Demand (Z), Production (Y)
Y=Z ZZ Demand Slope = c1 Equilibrium Point Autonomous Spending
45° Income, Y
Equilibrium income is the product of two factors: autonomous spending (the second term in brackets in equation (3.8)) and a “multiplier” (the first term in brackets). Assume that autonomous spending is positive,1 which (given that c1 < 1) will be true unless the budget surplus, (T – G), is very large. The multiplier, which depends on the value of the propensity to consume, arises because consumption is affected by income. Suppose there is an increase in autonomous consumption—say, because of an increase in consumer confidence. The initial increase in consumption because of the rise in c0 leads to an increase in income. The increase in income leads to a further increase in consumption, which leads to a further increase in income, and so on. Thus, the effect of the initial increase in consumer confidence is “multiplied.” The multiplier captures this effect. More formally, the multiplier can be described as the limit of a geometric series of fractional increases in consumption. A focus box on page 57 discusses the impact of the early stages of the financial crisis and consumer concerns over their future disposable income.
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.
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4.
Investment Equals Saving: An Alternative Way of Thinking About Goods-Market Equilibrium
Private saving is defined as disposable income minus consumption, or
S = Y − T − C. Using this definition, the equilibrium output condition (Y = C + I + G) can be expressed as I = S + (T − G ).
(3.10)
In a closed economy, investment equals private (consumer) saving (S) plus government saving (T − G). The quantity (T − G) is called the budget surplus. The quantity (G − T) is called the budget deficit.
5.
Is the Government Omnipotent? A Warning
The equilibrium output condition (3.8) seems to imply that the government, by choosing G and T, has absolute control over the level of output. The text stresses that this chapter provides only a first pass at the analysis of fiscal policy. Later chapters will make clear the many limitations on the ability of the government to control output through spending and taxation.
V. PEDAGOGY 1.
Points of Clarification
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. The Definitions of G and T. Government spending includes the purchase of newly produced goods and services, not total government outlays. In particular, transfers—such as Social Security payments, veterans’ benefits, and interest on the government debt—are excluded. Note also that government spending includes spending by all levels of government (federal, state, and local) and that some government spending pays for capital goods. The variable T is defined as taxes minus transfers and includes taxes minus transfers at all levels of government. Exports and Imports in GDP. Imports are subtracted from GDP on the expenditure side because the domestic spending categories C, I, and G include spending on foreign goods and services. To isolate spending on domestically produced goods and services, imports must be subtracted. Likewise, exports are added because they represent foreign spending on domestically produced goods and services.
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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.
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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. The focus box on page 68 introduces the “Paradox of Saving” which is also an interesting way to stimulate class discussion.
VI. EXTENSIONS 1.
Macroeconomic Models
Some instructors may wish to supplement the discussion of model building in the text by distinguishing a model’s structural form from its reduced form and by explaining the requirement that the number of equations equal the number of exogenous variables. A model’s structural form sets out the model’s postulates about behavior, definitions, and equilibrium conditions. A model’s reduced form expresses the endogenous variables in terms of the exogenous ones. The number of equations must equal the number of unknowns if the model is to provide a complete (not underdetermined) and coherent (not overdetermined) explanation of the phenomenon of interest.
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.
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CHAPTER 4. FINANCIAL MARKETS: I I.
MOTIVATING QUESTION
How is the interest rate determined in the short run? The interest rate is determined by equilibrium in the money market, i.e., by the condition that money supply equals money demand. Since the text abstracts from all assets other than bonds and money, equilibrium in the money market is equivalent to equilibrium in the bond market. In this chapter, nominal income is taken as given, so there is no need to consider simultaneous equilibrium of goods and financial markets.
II.
WHY THE ANSWER MATTERS
Investment is a function of the interest rate (as will be discussed in Chapter 5), so output is affected by the interest rate. In addition, the determination of the interest rate is intimately connected with monetary policy. This chapter introduces the simplest model needed to think about the determination of the interest rate and the role of the central bank. This chapter takes nominal GDP, which affects money demand, as given, so the financial markets can be considered in isolation from the goods market. Chapter 5 will address the joint determination of output and the interest rate in the short run. Chapter 9 will address the complexity of the financial system in light of the financial crisis. Chapter 24 will address some post-2008 crisis changes in monetary policy in advanced economies.
III. KEY TOOLS, CONCEPTS, AND ASSUMPTIONS 1.
Tools and Concepts
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The chapter defines stock and flow variables and distinguishes wealth (a stock) from income (a flow). The chapter introduces monetary policy and describes open market operations. The chapter makes use of balance sheets for the central bank and private banks. The chapter introduces various terms and concepts associated with the banking system. These include currency, deposit accounts, reserves, the reserve ratio, central bank money (high powered money, the monetary base), the federal funds rate and the refi rate, and the money multiplier.
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. 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.
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IV. SUMMARY OF THE MATERIAL 1.
The Demand for Money
Suppose the financial markets include only two assets: money, which can be used to purchase goods and services and pays no interest; and bonds, which cannot be used for transactions, but pay a positive interest rate i. Financial wealth equals the sum of money and bonds. 4-17 .
Financial wealth is a stock variable, i.e., a variable whose value can be measured at any point in time. An individual’s financial wealth changes over time by saving or dissaving, but at any given moment, financial wealth is fixed. Saving is a flow variable, i.e., a variable whose value is meaningful only when expressed in terms of a time period. Income is also a flow variable, as is recognized in ordinary speech. People speak of annual income or monthly income. At every moment, households must decide how to allocate their given financial wealth between money and bonds. Since financial wealth is fixed, the demand for bonds is known once the demand for money is known, and vice-versa. Accordingly, the chapter restricts attention to the demand for money. By assumption, money is needed for transactions. Although it is hard to measure the overall level of transactions in the economy, it seems reasonable to assume that the level of transactions is proportional to nominal income, denoted €Y. So, money demand should be proportional to €Y. On the other hand, allocating wealth to money comes at the cost of forgone interest on bonds. So, money demand should decrease with the interest rate. Putting these observations together, the chapter specifies money demand as
M d = €YL(i ), ( −)
(4.1)
where the function L decreases as the interest rate increases. A box in the text notes that most U.S. currency is held abroad by foreigners, so that factors beyond U.S. economic variables affect U.S. money demand. Nevertheless, the text does not include foreign variables in the specification of U.S. money demand.
2.
Determining the Interest Rate: I
Assume all money is currency, so there are no checking accounts or banks. Consider the supply of money to be fully in the control of the central bank, and take nominal income as given. Then, equilibrium in the money market occurs when the supply of money (M) equals the demand for money (Md) given in equation (4.1). Figure 4-2 illustrates this equilibrium point. An increase in the money supply shifts the vertical line to the right, resulting in a new equilibrium with a lower interest rate. In order to induce the private sector to hold more money, bonds must become less attractive (the interest rate must fall). An increase in nominal income (for a given money supply) shifts the money demand curve to the right and generates a new equilibrium with a higher interest rate. The increase in nominal income leads to an increase in the quantity of money demanded at the original interest rate. Since the supply of money has not changed, the interest rate must rise to reduce the quantity of money demanded and thereby offset the effect of the increase in income. How does the central bank control the money supply? Consider the central bank’s balance sheet. Currency held by the public constitutes the central bank’s liabilities. The central bank’s assets are any bonds that it owns. To increase the money supply, the central bank creates currency to purchase bonds, thus increasing assets (through the additional bonds) and liabilities (through the new currency created and exchanged for bonds). To reduce the money supply, the central bank sells bonds for existing currency, thus reducing assets (through the sale of bonds) and liabilities (through the reduction of currency held by the general public). Purchases and sales of bonds by the central bank are called open market operations.
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Figure 4.2 The Determination of the Interest Rate
The text also shows how bond prices and interest rates are related. Suppose a bond promises a payment of €F one year in the future. Call the current price of the bond €PB. Then, the interest rate (or rate of return) on this bond is given by
i = (€ F − € PB )/ € PB . We can solve this equation for the bond price:
€ PB = € F /(1 + i). Given fixed nominal bond payments, we show that the nominal interest rate and the bond prices are inversely related. For example, when the central bank purchases bonds through open market operations it increases the demand for bonds and tends to increase their price which, in turn, reduces the interest rate.
3.
Determining the Interest Rate: II
Now introduce banks into the model. Banks receive funds from depositors (individuals and firms) and allow their depositors to write checks against (or withdraw) their account balances. These deposit accounts are liabilities of banks. On the asset side, banks hold bonds, loans (which are claims against borrowers), and reserves of some of their deposits. Some bank reserves are held in cash and the rest in accounts at the central bank. Banks hold reserves in part to protect against daily excesses of withdrawals (in currency or check form) over deposits and in part because they are required to do so by the central bank. Additionally, in many countries including the United States, the central bank now pays interest on reserves. In the euro area, banks must hold a liquidity reserve determined in relation to the composition of their balance sheet. Until January 2012, banks had to hold a minimum of 2% of certain liabilities, mainly customers’ deposits, at their national central bank. Since then, this ratio has been lowered to 1%. Adding banks to the economy alters the central bank balance sheet only on the liabilities side. Central bank liabilities now consist of currency held by the public plus reserves held by banks. Central bank liabilities— the money the central bank has created—are called central bank money. 4-19 .
Now reconsider money market equilibrium in terms of central bank money (Hd). The demand for central bank money arises from two sources: currency held by the public and reserves held by banks. Since bank reserves depend on the amount of checkable deposits we can model this relationship by letting the θ (Greek lowercase letter theta) represent the reserve ratio. Recall from our original equation 4.1 that money demand is given by;
M d = €YL(i ) ,
(4.3)
The second component of money demand, bank reserve demand, can be modeled with the equation; H d = θ M d = θ €Y L (i )
(4.4)
Equilibrium in the money market can now be depicted as the point where the money supply controlled by the central bank (H) is equal to the money demand (Hd). We can rewrite this equation in the following manner; H = θ €Y L(i )
(4.6)
Graphically this equilibrium is presented in Figure 4-7. Now you can see that an increase or decrease in the money supply impacts the price of money (i.e. the interest rate). The specific interest rate targeted by the central bank is the policy rate.
4.
The Liquidity Trap
The central bank can choose a desired interest rate by changing the money supply. However, the central bank can push interest rates to zero which would limit further monetary stimulus. This condition is known as a zero lower bound. When the economy is in this position and monetary policy is no longer effective the economy is said to be in a liquidity trap. Increasing the money supply beyond this point has no impact on interest rates. Both households and banks absorb increases in the money supply when interest rates are zero so monetary policy loses its effectiveness. The Focus box on page 81 addresses the “Liquidity Trap in Action” as a result of central bank policy following the financial crisis.
V. PEDAGOGY 1.
Points of Clarification
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. Comparative Statics with Bond Prices. It may be useful to reconsider comparative statics in the money market in terms of bond prices. The text carries out this exercise for open market operations, but instructors could also do the analysis for an exogenous increase in national income. An increase in income shifts the money demand curve to the right, which leads to an increase in the equilibrium interest rate, as is evident from the graph. To tell the bond market story, note that at the initial interest rate, the quantity of money demanded exceeds the quantity supplied. In other words, households are attempting to sell bonds to acquire money. The pressure to sell bonds (effectively a shift to the left of the bond demand curve) reduces the bond price and hence increases the interest rate. The Central Bank Balance Sheet. It is probably wise to assume that many undergraduates have never seen a balance sheet of any kind. A few words of explanation would be useful. In addition, as a
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