New classical macroeconomics
New classical macroeconomics has a lot in common with monetarism. When displayed in an AD-AS diagram it looks deceivingly similar to the monetarist diagram with its distinction between a positively sloped short-run AS curve and a vertical long-run AS curve. But it goes one step further. It criticizes the assumption of adaptive expectations as too Figure 4 Demand and fluctuations have a surprise effect on income, but a lasting effect on prices. Classical dichotomy is violated only by surprises....
Hysteresis
Let us discuss the benchmark case of hysteresis first. Consider a reduction in money growth under flexible exchange rates. The DAD-SAS model then reads p m _ b Y _ Y_ 1 DAD curve 15.13 p pe A Y - Y_ 1 SAS curve with hysteresis 15.12 In Figure 15.18 the economy is in the initial equilibrium at m-Hl and Y . In period 1 the central bank reduces the money supply growth rate to m-LO. Figure 15.18 Under hysteresis and the specific kind of adaptive inflation expectations assumed here, the SAS curve...
Recommended reading Akw
The issues touched on in this chapter are the focus of much recent and current research. Examples of the many recent papers worth reading are Paul Collier and Jan W. Gunning 1999 'Why has Africa grown slowly ', Journal of Economic Perspectives 13 3-22, who distinguish between 'policy' and 'destiny' factors that caused slow growth in Africa over the past three decades. Alan B. Krueger and Mikael Lindahl 2001 'Education for growth Why and for whom ', Journal of Economic Literature 39 1101-36....
Technology change in Malaysia the return of the Solow residual
Real business cycle RBC models propose that the main driving force behind macroeconomic fluctuations is technology shocks. Before arguing that such shocks are impossible to measure, making the RBC model virtually immune to empirical testing, remember Chapter 9 on the basics of economic growth. There we had used the growth accounting equation to obtain an estimate of technological change, which we called the Solow residual The equation states that the part of income growth that cannot be...
Key terms and concepts Ypn
classical dichotomy 453 comovement 447 countercyclical movement 447 intertemporal optimization 459 intertemporal substitution of consumption 464 intertemporal substitution of labour 470 marginal rate of substitution 462 marginal revenue 450 New Keynesian economics 474 procyclical movement 443 real business cycles 453 sticky prices 449 stylized facts 443 16.1 For the USA and various other industrial countries nominal interest rates are procyclical. They fall during recessions and rise when the...
How well does the model explain the data
Whether we are happy with equation A.3 depends on how well it explains the variations in turnout. This explanatory power of the equation is measured by the coefficient of determination. Figure A.6 provides a hypothetical illustration of what the coefficient of determination does. The coefficient of determination, denoted by R2, measures the share of the variation in the variable you want to explain that is actually being explained by your estimation equation. The variation of your endogenous...
Household behaviour intertemporal choices
Households have to decide not only how to allocate time between work and leisure, and split income between consumption and saving today or this year . They also have to make a plan for these same decisions tomorrow or next year . Of course, today's decisions cannot be made independently of tomorrow's. This is most obvious in the case of consumption if I consume less and save more today, I will be able to consume more tomorrow. But it also applies to leisure time by working more today I may be...
The macroeconomic equilibrium
We have developed all the building blocks of our graphical real business cycle model. Let us look at how these pieces fit together to determine a macroeco-nomic equilibrium. Figure 16.14 This graph shows the long-run equilibrium of the real business cycle model. The firms' supply of goods slopes upwards due to intertemporal substitution of labour. Households work more today when the interest rate is high. The two components of aggregate expenditure are downward-sloping. For a given capital...
Empirical merits and deficiencies of the Solow model
Empirical work based on the Solow growth model usually proceeds from the assumption that, in principle, the same production technologies are available to all countries. Thus all countries should operate on the same partial production function and experience the same rate of technological progress. This leaves only two factors that may account for differences in steady-state per capita incomes. The first is the savings or investment rate. The higher a country's rate of investment, the larger the...
Fixed exchange rates Mtv
Equation A7.11 is the AD curve under fixed exchange rates. Taking first differences yields the DAD curve under fixed exchange rates. p e pW--L Y Y 1 -1-A YW -AG Again, the position variables of the FE curve, iW and ee do not show here because we assumed the IS curve to be vertical, that is, investment is independent of the interest rate. A common phrase cautions that you may not see the wood for the trees. Perhaps you feel a bit like this having worked through all this material. If so, the...
Key terms and concepts Oet
AD curve 175 AD-AS model 182 aggregate demand curve 174 demand-side equilibrium 174 expected price level 174 fiscal policy 186 long-run equilibrium 185 monetary policy 188 short-run equilibrium 185 7.1 When deriving the AS curve in Chapter 6 we assumed that real rigidities say, in the form of monopolistic trade unions cause involuntary unemployment at normal employment levels. Now consider an economy in which no such real rigidities exist. Normal employment is determined by the point of...
The production function and growth accounting Production function
At the core of any analysis of economic growth is the production function. We draw again on the production function we made use of when studying the labour market in Chapter 6. Real output Y is a function F of the capital stock K in real terms and employment L Y F K, L Extensive form of production function 9.1 Figure 9.3 The 3D production function shows how, for a given production technology, output rises as greater and greater quantities of capital and or labour are being employed. As a...
Booms and recessions I the Keynesian cross
After working through this chapter, you will understand 1 The difference between steady-state income, potential income and actual income and what booms and recessions are. 2 How aggregate planned expenditure determines output and income in the short run. 3 How additional government spending may trigger additional private spending via the multiplier. 4 That economic decisions are often made on the basis of what people expect to happen in the future rather than on what they observe today. At the...
Liquidity traps and Japans prolonged recession
Japan's long economic slump experienced during the second half of the 1990s baffled many observers. While the real money supply increased by almost 40 between 1996 and 2000, income rose by a barely observable 3.2 . So contrary to what we have learned from this chapter's analysis, monetary policy in this case does not really seem to have an effect on income worth talking about. Does this mean the IS-LM model is of no help in trying to understand Japan's recent slump One might be tempted to think...
Fixed exchange rates 1
Under fixed exchange rates the first step is the same. If the money supply is increased via the purchase of domestic bonds by the central bank, the LM curve shifts to the right. And again, the increased liquidity tends to drive the interest rate down. As investors get rid of domestic bonds and throw domestic currency on the market, the exchange rate cannot respond. Instead, the central bank is called upon as the 'buyer of last resort'. It is required to take Figure 5.3 Flexible exchange rates....
The graphical ISLM model
Both the IS and the LM curves show combinations of interest rates and income levels that render the market under consideration in equilibrium. It is thus straightforward to merge the two curves onto one graph to obtain a model of the global economy thought to comprise a goods and a money market. Figure 3.9 does just that. There are many points in this graph on the IS curve that render a goods market in equilibrium, such as points A, B and C. And there are also many points on the LM curve that...
AE cY I G NX
It shows that aggregate spending is not independent of income, but increases as Y rises. The aggregate expenditure line in Figure 2.8 shows how AE relates to Y and also breaks up aggregate expenditure into its four components. Figure 2.8 Aggregate or planned or desired expenditure varies with income. The graph stacks four demand categories. It starts with I, G, and NX, which are all considered independent of income. That makes these lines horizontal. Consumption spending increases with income,...
Monopolistic trade unions
Another institutional feature which causes labour markets in many industrial countries - and particularly in a host of European economies - to Maths note. If you are unfamiliar with hyperbolas, suppose w 5 L. Use a pocket calculator to compute the real wages for all L from 1 to 10. Plot these values in a w-L diagram and you have a hyperbola. deviate from the ideal classical scenario, is the prominent role of trade unions in the wage negotiating process. Wages are set in a collective negotiating...
What if spending plans change
The derived unique equilibrium income depends on planned spending. An important question to follow from this is, how does equilibrium income change if one of the actors involved revises spending plans Assume that the government raises expenditure by AG. Then income obviously also rises by AG. But this cannot be the end of the story. Households Figure 2.9 The Keynesian cross contains two lines. The 45 line measures actual expenditure which always equals income. At points above this line, desired...
Insiders and outsiders
As before, let workers be represented by a monopolistic trade union. Let the economy be in the same equilibrium that we identified in the preceding section. Now, however, assume that the trade union only cares about employed members, the insiders. Union members who are out of employment, be it voluntarily or not, are outsiders. In many countries, only employed trade union members can exercise active membership rights, such as voting about whether to accept a bargaining settlement between union...
List Of Case Studies And Boxes
1.1 Germany's current account before and after unification 12 2.1 Income vs leisure time in France and the USA 42 2.2 How to pay for the war Great Britain in 1940 50 3.1 Liquidity traps and Japan's prolonged recession 82 4.1 Italy's current account before and after the 1992 EMS crisis 100 5.1 The 1998 Asia crisis 122 6.1 Ford's focus an experiment in efficiency wages 161 7.1 International evidence on the quantity equation and the AD curve 189 8.1 Quantity equation, Fisher equation and...
Equilibrium in all three markets Equilibrium with graphs
We now know how to draw equilibrium lines for the money market, the goods market and the foreign exchange market in the i-Y plane. Each line yields interesting insights into a particular sector of the economy. But these are not yet sufficient to pin down a unique macroeconomic equilibrium -which is what we are primarily interested in and set out to identify. If the isolated discussion of individual markets only carried us so far, perhaps we can achieve progress by merging them. Let us construct...
When do firms invest
Capital costs are the costs of financing the purchase of capital goods. They equal the interest payment for a loan, or the interest foregone because money was invested and not lent out. the revenue generated by a project as a percentage of the invested funds. The motive behind investment is to make profits. Profits accrue as the difference between the gross returns generated by a project relative to the invested funds and the capital costs, i.e. the costs of financing the acquired capital...
Monetary policy
By adding the money market to our model we introduced a second policy option for governments and central banks - monetary policy. Monetary policy comprises central bank action geared towards steering the money supply. This can happen directly, by purchasing or selling bonds or foreign currency. It can also happen indirectly, by setting interest rates and inducing the market to hold liquidity in the desired amount. Here we use monetary policy as a synonym for direct control of the money supply....
Equilibrium income
The graphical representation of aggregate expenditure can now be used to determine equilibrium income. Figure 2.9 replicates the aggregate-expenditure line from Figure 2.8. This line has a positive intercept, depicting those components that are immune to income changes. Its slope is positive but smaller than 1, since individuals do not want to consume their entire income, but wish to save a small fraction of it. By contrast, the actual-expenditure line passes through the origin and has slope 1....
Time to pause we have come a long way
The AD curve, the graphical image of demand-side macroeconomic equilibria, is an admittedly complex concept with a deep foundation that stretches over several chapters. Before we proceed to combine the AD curve with the AS curve to obtain the most sophisticated model of booms and recessions discussed in this book, let us pause, step back and recall what we achieved so far. Figure 7.7 reminds us of the main concepts and how they fit together. We had chosen two kinds of perspectives. Initially,...
Efficiency wages
So far we have assumed that labour productivity depends only on the amount of capital with which labour is combined, but not on the received wage. Efficiency wage theory questions this assumption. Various arguments are advanced as to why the work effort, or efficiency, as it is called in the context of these theories, and hence given a specific amount of capital labour productivity may increase with the real wage. These are as follows Nutrition. This basic idea has played a major role in...
The equilibrium price level
The AD curve identifies the level of aggregate demand obtaining at different price levels. Yet if we do not know prices, we cannot determine the level of aggregate demand. The AS curve identifies aggregate supply at different price levels. Again we cannot identify aggregate supply until we know the price level. What helps here is that in equilibrium aggregate demand must equal aggregate supply. Graphically, therefore, the equilibrium price level is where Figure 7.9 This graph emphasizes key...
Income vs leisure time in France and the USA
In 1997 GNP in the United States of America stood at 7,783 billion while GNP in France was 1,542 billion. This is a preliminary, raw comparison of incomes, however, which does not take into account a number of factors. One very important factor is that one US dollar does not buy the same amount of goods in all countries - its purchasing power is not the same. Adjusting for differences in purchasing power, on a common measure French GNP is worth only 1,302 billion. This means that when French...
Macroeconomics
Visit the Macroeconomics, second edition Companion Website at www.pearsoned.co.uk gartner to find valuable student learning Macroeconomic tutorials with interactive models, guided exercises, and animations, plus an interactive road map connecting key concepts and models A data bank with macroeconomic time series for many countries, along with a graphing module Extensive links to valuable resources on the web, organized by chapter Self assessment questions to check your understanding, with...
Fiscal policy in the ISLM model
We are now equipped to refine our understanding of fiscal policy as set out in Chapter 2. Fiscal policy comprises all policy measures related to the government budget. At the aggregate level this amounts to government spending and raising government revenue by levying taxes. As we saw when we discussed the goods market in section 3.2, the IS curve moves to the right or up when the government increases spending. The same thing happens when the government reduces taxes. The reason is that at any...
The algebra of the IS curve
An equation for the IS curve is obtained by substituting equations 3.5 , 3.6 , 3.7 and 3.8 into the goods market equilibrium condition Y C I G EX - IM. Since we would like to obtain an equilibrium condition which can be shown on the i - Y surface along with the LM curve obtained above, we solve the equilibrium condition for i. This yields 1 c mi x2 m2 I G xiY i -- -1 Y -2 R - 1 The negative coefficient in front of Y shows that the curve slopes down. This simply reflects Chapter 2's result that...
The circular flow model revisited terminology and overview
We begin by building up some terminology and clarifying key concepts. For that purpose we revisit the circular flow diagram from Chapter 1 see Figure 2.5 . In an attempt to develop an expression for the total spending or total demand which comes back to domestic firms, note that households receive gross income Y top left-hand corner . Payment of taxes reduces this to disposable income Y T. After removing savings from the loop we obtain what is left for consumption, i.e. C Y T S. Because of the...
Booms and recessions II the national economy
After working through this chapter, you will understand 1 What the national-economy Mundell-Fleming model is, and how it differs from the global-economy model. 2 How fiscal policy affects equilibrium income in the Mundell-Fleming model. 3 How monetary policy affects equilibrium income in the MundellFleming model. 4 How demand shocks in general, including those originating from abroad, affect equilibrium income. 5 The difference between comparative statics and adjustment dynamics. 6 How things...
The money market the interest rate and the LM curve
A flow variable is measured over a period of time. Examples are income, consumption and exports. A stock variable is measured at a point in time. Examples are the money supply, the number of workers and the capital stock. The notion of a money market, in which supply and demand interact, may sound odd. It appears plausible that the central bank controls the supply of money by printing and issuing coins and bills. It seems less straightforward to imagine a well-defined demand for money. People...
CA K NX EX IM xLYWorld x2R mLY m2R
Figure 4.4, panel a , shows the current account as a function of income and the interest rate. While the interest rate has no impact on the current account i is missing from equation 4.2 , CA deteriorates with a factor m1 as income rises. For given world income and real exchange rate, only one income level exists which balances the current account. An algebraic expression for this is obtained by letting CA 0 in equation 4.2 and solving for Y. This yields All points that balance the current...
Minimum wages
In most industrial countries governments feel compelled to restrict or guide market forces in the labour market by implementing some sort of minimum wage legislation. The noble intentions of such legislation are undisputed. But a look at our labour market diagram reveals unintended side effects Figure 6.10 . Of course, as long as law-makers fix the minimum wage below w , it remains ineffective. Employers will voluntarily raise wages to w and expand employment to L , as in the classical case. As...
Bp Ca Cp Or 041
The balance of payments is always zero because of double-entry bookkeeping, as stated above. Therefore, any entry in one of the accounts must be accompanied by an equivalent entry of opposite sign in the same account or one of the other two accounts. Let us look at what this means in practical terms. To do so consider a stylized world with only two countries, Britain and Sweden. Suppose Britain wants to import one Volvo S60 vehicle from Sweden that costs 300,000 kronor. To obtain the 300,000...
Back to ISLM enter the FE curve
The loose end remaining after the discussion of the goods market in Chapter 3 section 3.2 is the exchange rate. Left to market forces in a system of flexible exchange rates, currency prices tend to move about quite a bit - more than any other macroeconomic variable. While there may be market psychology and speculation involved, a number of strings attach the exchange rate to the set of variables we are focusing on in macroeconomics. This section identifies and formalizes these relationships....
The MundellFleming model under capital controls
In this book we assume that capital moves unhindered across borders. This describes the current situation quite well in industrial and many other countries. But there are still some countries, mostly in the developing world, that do not permit free movements of capital in and out. In Tanzania, for example, citizens need to submit proof of an import contract and obtain a permit if they want to acquire foreign currency. The purchase or sale of currency is usually not permitted for financial...
Money supply vs interest control in a changing world
In Box 3.2 we concluded that it does not really matter whether the central bank uses the money supply or the interest rate as a policy instrument. This is true in a world that does not change. A second look at this issue is required, however, in a world of change and uncertainty. Suppose the central bank has two options announce a money supply target at the beginning of the year, and stick with it, no matter what happens, or, announce an interest rate target and stick with it. Further, suppose...
Italys current account before and after the 1992 EMS crisis
In open-economy models of the macroeconomy the exchange rate provides the key link between the monetary sector and the goods market. Changes in policy variables, such as the money supply or the interest rate, affect the exchange rate which, in turn, affects, imports and exports and, hence, income. Whether the assumed effect of the real exchange rate on imports, exports and, hence, the current account does indeed have an impact in the real world is often difficult to judge and may require the...
The ISLMFE model in a different dress
The IS-LM-FE model comprises three markets which determine three endogenous variables. Under flexible exchange rates these are i, E and Y. When we reduced the 3D graph of this model shown in Figure 4.7 to two dimensions we chose to show i and Y on the two axes, thus relegating E to an invisible role in the background. While this is the traditional choice, we may just as well have chosen to show i and E on the two axes, or E and Y. You often find the latter display in current textbooks, with the...
The algebra of ISLMFE equilibrium
The three markets discussed in this chapter constitute the IS-LM-FE model. Algebraically, the model consists of three equilibrium conditions These are the IS, LM and FE curves already discussed. If they look unfamiliar, it is because equations 3.2 and 3.9 have been rearranged so as to show, along with 4.8 , the three endogenous variables of the model on the left-hand side. The equilibrium values of R, Y and i are relatively easy to obtain because the model is recursive, meaning that equilibrium...
Fixed exchange rates Pgi
Under fixed exchange rates, equilibrium income is obtained by substituting the FE curve i zWorld into 4.9 and solving for Y Y m2 X2 R -b-i.World -1- G J 1 c mi 1 c mi 1 c mi R is now a policy variable controlled by the government. It can raise output via the multiplier The money supply is endogenous, that is, outside government or central bank control. Fiscal policy is effective and raises output via the multiplier which is exactly the one we had already obtained in Chapter 4 letting taxes be...
Endogenous and exogenous variables
The IS-LM-FE model provides a good opportunity to illustrate and re-emphasize the distinction between endogenous and exogenous variables, and to show how institutional arrangements change the nature of a variable. A model always comprises exogenous variables - their values are determined outside the model, and endogenous variables - to describe their behaviour is the very purpose of the model. A model may have an arbitrary number of exogenous variables. But it can only explain as many...
Forecasting the US dollar in 2004 an exercise in predicting exchange rates
In 2004 many analysts expected the US dollar to continue its slide. Obstfeld and Rogoff 2004 predicted that the dollar might lose another 20-40 of its end-of-2004 value of 1.30 to the euro. How do economists arrive at such numbers Exchange rates are very difficult to forecast - in the short run. It is a bit like a layman forecasting tomorrow's temperature. Without help from weather satellites we probably have to concede that tomorrow being a warmer day is just as likely as tomorrow being...
Income determination a second look
Disposable income is that part of income left to households after the payment of taxes. says by how much taxes rise if income rises by one unit. The average income tax rate gives the share of taxes on income on average, that is T Y. In equation 2.11 the marginal and the average income tax rate are the same. Now that we understand the basic concepts of equilibrium income and the multiplier we move on to a more realistic scenario. This perspective includes more plausible behavioural and...
I Working with graphs part II
I do not recommend learning the slopes of equilibrium curves like LM by heart. Neither do I advise memorizing which factor shifts the graph which way. As long as the economic reasoning behind some market equilibrium is understood, slopes and shifts of curves can, in most cases, be worked out by simple thought processes. Algebra or calculus is not necessary. For example, take the LM curve to demonstrate the nature of the thought process. Suppose you forgot how the graph slopes in the i Y diagram...
Human behaviour in the circular flow
In a state of equilibrium, desired and actual expenditure must be equal. In order to understand what individuals do desire to spend, we first look at the four components that constitute aggregate expenditure. Let all but one of the expenditure categories be autonomous, that is independent of income or other variables. We may even keep these autonomous spending variables fixed Equation 2.4 defines net exports EX IM as NX. As a reminder we state that net exports are a good first approximation for...