INSTRUCTORS GUIDE

Instructors Guide

to accompany

Macroeconomics: A European Text

Michael Burda

Charles Wyplosz

OXFORD 1997

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Michael Burda and Charles Wyplosz 1997

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INTRODUCTION

In this Instructors Guide to the second edition ofMacroeconomics: A European Text, we would like toshare with teachers our approach to teaching thesubject. More concretely, we review some of the mostimportant ways in which this book differs from othertextbooks on the market, and provide instructors withsome hints -- based on our experience -- in making thematerial digestible and even appealing to students. Eachchapter provides a short summary of the importantconcepts, as well as a short list of further reading whichmay help users of this textbook to obtain moreperspective on the strengths and weaknesses of ourapproach to teaching macroeconomics.

Lectures and readings

There is a big difference between what is said in classand what the students read in the textbook. This is whythe time spent in class and on the textbook should beseen as complements, not substitutes. We have foundthat lectures are best devoted to a limited number of theissues covered in the book, usually at a basic level.While it is important to make the material look as easy,clear, and interesting as possible in class, students canbe made responsible for a much larger range ofmaterial not covered in class. Those students who studythe book carefully before lectures -- hopefully themajority -- are rewarded in two ways: they can checkthat they have understood what matters and why, andthey have a chance of asking detailed questions.Following this recipe, each chapter can be covered in aclass lasting about 90 minutes, although Chapters 4, 10,11, and 13 are best spread over several lectures. Ofcourse, teachers who have more time might spendcommensurately more hours on all the material.

Examples, not proofs or literature reviews

What makes this textbook different is the large numberof examples drawn from all over Europe and elsewhere.Examples serve two purposes. First, they break the

usual monotony and offer a breather. Second, they offera reality check on the theory with which students aretrying to understand for the first time. The immediaterelevance of the theory has been, in our experience, animportant incentive for the students to retain what theyhave learned. This is why we have tried systematicallyto present an example whenever a new concept isintroduced or a new result is established. This is arecipe we have experimented with in class with greatsuccess. Students enjoy relating their own experiencesto the principles they learn. We strongly encourageteachers to present some of these examples in class(overhead projectors are great teaching devices) andtake the time to comment extensively on them. Theimproved quality of the transparencies supplied as anadd-on should make this option more attractive.

Of course, examples are not proofs. Yet it is ourbelief that it is inappropriate to submit theories toformal analysis in an introductory textbook. Informalinference and introspection can generate many of thepropositions and theories that we present, which to ourminds represent a consensus view of macroeconomicsin the 1990s. We intentionally shield the student at thislevel from the nuances of the empirical (andeconometric) literature; we feel that our presentation ofmacro is relatively well-established in the literature andare confident that the facts will continue to besupported by further research. In the forefront was ourconcern not to reinforce the familiar stereotype of two-handed economists unwilling to take a stand.

Topics

A shorter course may limit itself to the first fifteenchapters, possibly skipping Chapter 7 which, likeChapters 18 and 19, deals with exchange rates whileChapters 20 and 21 cover special topics. For an evenshorter course the teacher may want to focus on thebasics and accordingly drop Chapters 15 to 17. Oldertexts typically cover growth (Chapter 5) and labourmarkets (Chapter 6) at a much later stage. Nowadaysthis is hardly acceptable. Since the real economyoccupies a central role in our presentation it is essential

Instructors Guide Introduction

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to establish long-run growth and labour markets at theheart of macroeconomics. Similarly, we understandbetter now how dangerous it is to separate too cleanlythe short run (business cycles) from the long run(economic growth). Yet, if hard pressed by a tightprogramme, a teacher could drop Chapter 5, and, as alast resort, Chapter 6.

Order

The preface to the textbook suggested two possibletracks: an aggregate demand/business cycles trackmoving quickly to the IS-LM and demand/supplyapproach familiar from previous popular textbooks; anda neoclassical/microfoundations track which movesslowly to equilibrium emphasising behaviouralrelationships first. In the end, it is a matter of taste.

Yet we encourage teachers to cover at least Chapter3 early on. The IS-LM analysis is very useful butstudents should understand that it is a short runapproach, not only because of price and wage rigidity,but also as a result of intertemporal budget constraints.It is our experience that students quickly grasp andretain the particularly useful message that mostmacroeconomic choices (consumption and spending,investment, budget imbalances) are fundamentallyintertemporal, that intertemporal budget constraintsbite, and that with forward-looking financial marketsthey bite relatively quickly.

Changes from the first edition

The second edition is different from the first in anumber of significant ways. Obviously, we haveupdated and streamlined tables and figures and havetried to add more current examples. Second, we addedsome new exercises and deleted other which were toodifficult or repetitive. Third, we edited and revisedmost of the chapters significantly -- examples beingChapters 4, 7, and 11 (old Chapter 10). Fourth, we haveswitched the order of Chapters 5 and 6, reflecting adesire for more continuity.

Most significantly, we have added two new andimportant chapters, responding to many demands frominstructors:

Chapter 10 is the much-sought after integration ofthe real parts of the macroeconomy with the monetarysector in the usual classical (flexible price) but alsoKeynesian (fixed price) analyses. Rather than calling ita "closed economy detour" we prefer to think of it as

the global economy context, highlighting determinantsthe world rate of interest, inflation, output, etc.

We are particularly excited about our survey ofbusiness cycles, Chapter 14. Not only is this anopportunity to apply the AS-AD model and explain adurable feature of capitalist economies, but also anopportunity to highlight two very different ways oflooking at the world. This treatment parallels that ofChapter 10: the AS-AD, sticky price variantcorresponds to the Keynesian short-run analysis, whilethe real business cycle view parallels the classical flex-price analysis. To motivate discussion, we providesome "stylised facts" on the cycle -- some of which wethink are not well-known -- using the reference cyclemethodology of Burns and Mitchell, and consideringaverages over a number of OECD countries. Ourconclusion is agnostic, meaning that the both views ofthe business cycle have merits and difficulties.

Mathematics

Wherever the students level permits, we encourageteachers to use maths in class. Most chapters have amathematical appendix which offers the backbone ofthe material covered in the main text. It is primarilydesigned for classroom use when possible.

On the other side, if the students are not at ease withmathematics, there is a real danger of their focusingmost of their learning efforts on the formalizationinstead of grasping the underlying economic meaning.This is especially true of introductory macroeconomicscourses. In such cases, mathematics is better assignedas optional reading.

Exercises

Each chapter (with the exception of the first and lasttwo) contains roughly twenty exercises. A first group,labelled theory, directly relates to the materialpresented in the text. These exercises are designed tocheck the understanding of key results; sometimes theyoffer extensions. A second group, labelled applications,is meant to train the students to translate concepts andresults into useful tools. These applications aresometimes ambiguous, with more than one acceptableanswer, just like real life. Teachers may use them toexpose students to the limitations of a social science.Within each group, exercises are normally presented inorder of ascending difficulty.

Instructors Guide Introduction

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The second edition of Macroeconomics: A EuropeanText contains a number of important changes which areaimed at improving pedagogy as well as streamliningand unifying content. In addition to describing thesechanges, the accompanying Instructors Guide offers acomplete set of solutions to both the theoretical andapplied exercises at the end of each chapter. We hopethat this improvement will make teaching with the booka more convenient and pleasurable experience.

Acknowledgements, present and future

In preparing the guide, we have kept in mind thereactions of early users of the textbook. Their questionshave reminded us that what is clear and simple to oneperson may be problematic to another, which makesteaching challenging and fun. In addition to the scoresof contributors mentioned in the acknowledgements, weare particularly grateful to Simon Burgess for hishelpful review in the Economic Journal of May 1994.Successive waves of students at INSEAD, Berlin andGeneva continue to tell us how they like and dislike theexercises and have led us to rethink a great many ofthem. We continue to receive helpful comments andsuggestions from both colleagues and students and willcontinue to exploit them in future editions of thetextbook and this guide.

Michael Burda and Charles Wyplosz

CHAPTER 1

WHAT IS MACROECONOMICS?

This chapter corresponds to the very first lecture,maybe just fifteen minutes if the schedule is tight.Advance reading by the students is desirable, but notindispensable. We see this chapter as both a motivatingintroduction to the subject matter and a declaration ofintent. In this introduction we make it clear that, in ourview, it is important to take time early on to lookcarefully at some macroeconomic data. This activityconveys the message that macroeconomics is aboutexplaining facts and that these facts are given byaggregated data. The danger exists, however, that eagerstudents will want to explain everything immediately.For that reason the lecturer should avoid an overload ofdata which may be dizzying or even discouraging.

We begin with this is what I shall talk about: itpresents the key concepts of macroeconomics: (real)GNP, growth, and cycles; factors of production andincome distribution; inflation; the link between the realeconomy and financial markets; and, of course,openness. No precise definition is offered, as the solepurpose is to appeal to intuition and stimulate interest.Section 1.2 moves from issues to the social role ofmacroeconomics. It is designed to alert the student tothe broad implications of what he is about to study. Wehave chosen to claim that policies inspired bymacroeconomic theory have altered the shape ofbusiness cycles, because we believe that this is the case,but we know that it is controversial. Even thestaunchest anti-Keynesians and real business cycletheorists would agree that the behaviour of prices haschanged since World War II (Fig. 1.5) and lay theblame on (bad?) macroeconomic policy! The tone changes in Section 1.3, which stresses thatmacroeconomics is not a description but an analysis ofthe facts. The distinction between exogenous andendogenous variables is introduced early on toemphasise that we work with models. We find it usefulto warn that while macroeconomics is a scientific field-- in its rigour and the methods that it uses -- it isnevertheless plagued or blessed with the particulardifficulty of dealing with social phenomena. This is thetime, we feel, to refute the newspaper allegations thateconomists chase irrelevant theories.

CHAPTER 2

MACROECONOMIC ACCOUNTS

Objectives

There is no short cut: students must know the bareminimum about national income accounting before theycan study macroeconomics. We have clearly chosen thelight touch with respect to accounting, but this drymaterial can be effectively used to paint the big pictureboth efficiently and rigorously. The presentation can bestructured around the flow diagram in Fig. 2.2, whichmaps out the flow of goods and services in themacroeconomy. The large circle represents how incomeflows from producers to customers and back toproducers. The smaller circles correspond to the threesectors of the economy: the private sector, thegovernment, and the rest of the world. This sectoralbreakdown of the economy is the backbone of the book.

Students should understand that what comes in isnot the same as what goes out because any of the threesectors can be out of balance, with the imbalancematched by a build-up or draw-down of (net) assets.Imbalances arise when one sector attempts to spendmore, or less, than it earns. Despite the fact that totalbalance requires that the three sector imbalances cancelout as shown in (2.7), intertemporal budget constraintsimply restrictions for each sector in the future. Playingup this result exposes students to the concept of marketequilibrium and to the distinction between ex ante andex post behaviour as well as preparing for the nextchapter (intertemporal balances).

GDP and related concepts

Like the rest of the industrialized world, we nowemphasise GDP over GNP. This required us to reworkmany of the definitions, but with little loss along theway. The first two definitions of GDP -- total spendingand total factors income -- serve later on to clinch theconcept of general aggregate equilibrium. This is why itis essential to stress this point over and over again.Students typically like to discuss ad infinitum about theunderground economy and other limitations of GDPdata. They should be told early on that aggregate data

are inaccurate but that most of the time we use them tomeasure growth rates, not levels. The margin of error isreduced with growth rate as long as distortions do notvary systematically.

The next important distinction is nominal versusreal. Having defined deflators it is natural to contrastthem with price indices. Another more importantdistinction, between GDP and GNP, is often too subtleto grasp at first blush. Just mentioning it early onshould suffice as we shall return to it more formally inChapter 3. On the other hand, the concepts factorincome and factors of production recur frequently andit is useful to stress them early on.

The circular diagram

It pays to work carefully through the diagram, becauseit leaves students with a good insight flow tounderstand the accounting terms. It is best to start fromthe left where GDP is shown and ask students whathappens to sellers incomes.

As we pass the bifurcation between consumptionand saving on the right of the large circle, we movefrom the incomes breakdown of GDP (Y=C+S+T) to thespending breakdown (Y=C+I+G+X-Z). It is worthshowing the two relationships at this stage and later onto derive the identity as (I-S)+(G-T)+(X-Z)=0, notingwhat it implies for the three circles.

The diagram misses out a few connections or detailswhich may be brought to the students attention (asproposed in some exercises):- corporate and personal savings (and therefore

private income and private disposable income) arenot distinguished. Corporate savings may berepresented explicitly by a pipe going to the privatesector circle and originating where national incomeis written: after the bifurcation we would havenational disposable income.

- trade in assets is not shown. Each sectors imbalanceis financed somehow, but the diagram does not sayby whom. Our view was that with a fully integratedworld capital market, it really doesnt matter.

Instructors Guide Chapter 2

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Additional pipelines would be necessary -- perhapsin another colour -- to illustrate thiscounterbalancing flow of assets. These would allhook up with the world capital market whichallocates world savings and investment. Thelogistics of the current diagram are already quitedaunting, and we have decided to leave it be at thisstage.

Balance of payments

In the same way as for national income accounts, thechallenge is to make accounting interesting. It isrelatively easy to do so, emphasising that the currentaccount is the pivotal concept: it separates out real(trade in goods and services) from financialtransactions ones (trade in assets). As is well known,the distinction between trade in goods and services andtrade in assets is not completely airtight, but it is veryimportant to stress the distinction early on. It leadsdirectly to stressing that, because the current accountrepresents the net external lending or borrowing of thenation, the lower part of the balance of payments,private and official financial transactions, simplymatches the current account, hence (2.9). This is thetime to recall the identity Y = C+I+G+CA and show thatCA = Income - Spending.

It is also useful to signal early on the differencebetween fixed and flexible exchange rate regimes byexplaining the role of official interventions and of themonetary authorities. As the residual ex ante overallimbalance, official interventions show what themonetary authorities have done to prevent the price ofdomestic currency -- the exchange rate -- from movingall the way until the overall account is balanced ex ante.

CHAPTER 3

INTERTEMPORAL BUDGET CONSTRAINTS

Objectives

This chapter provides students with an understanding ofintertemporal trade and its graphical representation.The chapter can be extended, according to theinstructors preferences, to include more detaileddiscussions of bond prices and interest rates as well asother aspects of intertemporal budget constraints.

Two-period diagrams are used throughout as asimplifying but intuitive device. The main drawback ofthis approach is that it rules out second periodinvestment because the economy ends afterwards.Intentionally, we do not delve into the associateddifficulties. These are discussed in more detail below.

This is one chapters where mathematics is reallyessential; most instructors will agree that the simplealgebra of discounting should be part of everyonestool-kit.

An important distinction is introduced for the firsttime here, which the instructor will should be familiarwith for the inevitable questions which arise. This is thedistinction between overall public or external deficits orsurpluses versus primary deficits or surpluses, whichexclude interest payments or more generally investmentincome receipts. This distinction will prove helpfulwhen, later on, debt service will be shown to be a majorsource of instability.1

Motivation

A good way of starting is to recall the circular flowdiagram of the previous chapter (Fig. 2.2) and point outthat one task of macroeconomics is to study therelationship between output, inflation, interest andexchange rates, to imbalances in the three circles. Thenthe accounting identity which shows the link betweenthe imbalances:

CA = (S - I) + (T - G)

1 It is also one reason why the IS-LM model is a short-runanalysis.

makes it clear that each term refers to net saving, i.e. ashift of resources over time.

Constraints and optimisation

This chapter sets out budget constraints but refrainsfrom dealing with preferences or optimal behaviour. Analternative is to teach consumption in one shot -- that iscombining constraints and optimal choice, followed byinvestment and the current account. This functionalapproach is possible by pairing the correspondingsections of Chapters 3 and 4:

- Consumption: Sections 3.3 and 4.2- Production and Investment: Sections 3.4 and 4.3In our view, there are good reasons for separating

constraints and behaviour. First, the very notion ofintertemporal trade is hard to grasp when firstintroduced. Limiting this first contact to constraints is away of reducing complexity. Second, showing thesimilarities and differences between the three sectorsconstraints has great pedagogical appeal. Third, theaggregation of sectors offers a natural link with nationalaccounts, and extends neatly to the foreign sector(current account). Finally, it allows us to give a nearlycomplete and yet relatively simple treatment ofRicardian equivalence without studying the relevantbehavioural assumptions.2

Varying the level of difficulty

Since the chapter starts with accounting and ends at thefrontier (Ricardian equivalence), the teacher must takea decision on how far to go. This in turn may haveramifications for material which can be treated later on.

For a short course, focusing on essentials meansusing the two-period diagram to explain that the interestrate is a relative price and to show graphically what is a

2 What is lost is mainly the whole question of bequests andaltruism across generations. One exercise (TheoreticalExercise 6) provides an opportunity to introduce the idea.

Instructors Guide Chapter 3

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present value; this is applied to the consumer, the firm,and the government but consolidation is not shown(skip Sections 3.4.4, 3.5.2, 3.5.3, 3.5.4 and 3.6.).

For longer courses and/or advanced audiences, onekey issue the instructor must decide is how extensivelyto treat Ricardian equivalence. One possibility is to justpresent the consolidation of accounts in successivelogical steps (Sections 3.4.4, 3.5.2 and 3.6) and leave itat that. Another is to state the equivalence proposition(Section 3.5.3) and explain in a few words why it mayfail to hold in practice.

Full treatment implies using the material presentedin the more demanding Section 3.5.4. We take themiddle-road view that Ricardian equivalence is aninteresting theoretical idea with mixed empiricalsupport.3

Two-period Crusoe

Irving Fisher introduced Robinson Crusoe to economicsin his pioneering work on intertemporal aspects ofeconomic decisions. Since then, there have been twocategories of textbooks which present the topic: thosewith Robinson, and those without. We think the Crusoemodel represents an important and robustmicrofoundation of macroeconomics, and is the sourceof much useful intuition about the subject. We havetoned down the parable in deference to those who mayfind the device too simple or even offensive. No doubt,there are two categories of teachers, those who useRobinson and those who dont.

With Fishers two-period framework almost all thatmust be understood in an introductory course can bepresented compactly with two periods (present andfuture). In addition it prepares the students for thinkingin terms of short and long run. This is why, throughoutthe text, we interpret the first period (today) as the shortrun and the second period (tomorrow) as the long run.It is a trick which works almost all the time4. Someindications of its shortcomings are given below.Appendices to this and other chapters show thetransition from the two-period case used in the text toan infinite horizon.

The intertemporal budget constraint

For both the consumer and the government, the budgetconstraint is a line whose slope is given by the grossmarket interest rate (1+r). It is a technology whichallows resources today to be converted into resourcestomorrow. For the firm which has access to a 3 Two references are Barro (1974) and Bernheim (1987).4 A good reference is Frankel and Razin (1987).

productive technology, an alternative means ofconverting resources today into resources tomorrow, isthe production function. The desirability of thistechnology is determined by how well it stacks upagainst the opportunity cost of resources today versustomorrow (the market interest rate). Making this clearand simple is the real challenge of this chapter.

Net wealth of the consumer can be read in terms oftodays consumption on the horizontal axis of the two-period diagrams. (It can also be read in terms oftomorrows good as well on the vertical axis, but this issuppressed to avoid confusing students.) The value ofthe firm can also be read -- in terms of tomorrows good-- as the vertical distance between the productionfunction F(K) and the cost-of-borrowing line OR in Fig.3.5.

Note that we assume the absence of existingproductive capital (fruit-bearing trees) so thatinvestment today and capital stock tomorrow areidentical. This makes the presentation simpler butunrealistic. Box 3.3 alerts students to this fact andChapter 4 will extend the model appropriately. (Inaddition, the planting season restricts Crusoe fromplanting coconuts he could borrow in the financialmarkets, a point that the smartest students will quicklypick up!).

The discussion of the production function at thisjuncture will give the instructor an opportunity toremind students of the distinction between physicalinvestment (expanding the productive capital stock) andfinancial investment (swapping existing assets).

Consolidation

The consolidation of the private sector -- consumersand firms -- requires that we flip the productionfunction around the vertical axis. Indeed in Fig. 3.7investment is read off the horizontal axis from right toleft in contrast with Fig. 3.4. In Fig. 3.7 it is worthemphasising the fact that the production rise above BBindicates that productive technology raises wealth, thelast term in the second line of (3.9). Of course, theoptimal level of investment can be deduced from Fig.3.7, but this task is left for Chapter 4.

Consolidation in the two-period framework withinvestment in both periods

It was assumed that there is no productive capital tostart with, so that investment today and the capital stocktomorrow are identical. An alternative presentation isas follows. Endowments are the outcome of

Instructors Guide Chapter 3

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previously accumulated capital -- trees in existence attime 0:

Y1 = F(K0) and Y2 = F(K1).

Resources available for consumption in both periodsare now:

C1 = F(K0) - I1 and C2 = F(K1).

In present value terms:

C1 + C2/(1+r) = Y1 - I1 + Y2/(1+r).

Although there is no second period investment (end ofthe world) so that I2=0, it is correct and more general,therefore, to write:

C1+I1 + (C2+I2)/(1+r) = Y1 + Y2/(1+r).

It can then be shown that (3.20) is just the consolidatedbudget constraint of the nation by recalling the twobudget constraints:- private sector:

C1+I1 + (C2+I2)/(1+r)= Y1-T1 +(Y2-T2)/(1+r)+rF0.

which is (3.9) modified in two ways: 1) I2 has beenadded; 2) if Y is GDP and not GNP, we need to add theincome earned on net foreign wealth F0.- public sector

G1 + G2/(1+r) = T1 + T2/(1+r).

which is (3.11) with rG = r.

Adding up these two equations gives:

C1+I1+G1 +(C2+I2+G2)/(1+r)= Y1+Y2/(1+r)+r F0.

which is (3.23). Note that Y=C+I+G+PCA since Y isGDP. So the last equation can be rewritten as:

PCA1 + PCA2/(1+r) = - F0.

or assuming that interest is paid at the end of the periodas in (3.21)

PCA1 + PCA2/(1+r) = - (1+r)F0.

If we want Y to represent GNP, then it includes thereturn on net foreign assets and F0 disappears in theprivate sector budget constraint as well as in theconsolidated account. Now, however, Y=C+I+G+CA(see (3.22) and we have:

CA1 + CA2/(1+r) = 0.

Ricardian equivalence

Some teachers may be surprised that the issue ofRicardian equivalence is taken up before consumer

preferences and behaviour. Our intention was twofold.First we wanted to use the equivalence principle as aconvenient application of the intertemporal budgetconstraint without taking a stand on its ultimateveracity. Second, we thought it important to stress thatRicardian equivalence indeed arises first and foremostfrom budget constraint considerations: once theaggregate private sector realises that it will pay futuretaxes, the solvency of the government implies thatpurposeful and rational private agents will take note ofthis fact.

The discussion which follows then allows to focuson a number of points that students may remember.These are: the deeper meaning of consolidation (ex postit is just a matter of accounting while ex ante it carriesthe strong implication of equivalence); the differencebetween interest rates faced by the public and privatesectors and the income effects associated with publicborrowing; the notion of credit constraints;distortionary taxation; the disconnectedness oftaxpaying generations; and uncertainty stemming fromthe mortality of taxpayers.

References

Barro, Robert (1974) Are Government Bonds NetWealth?, Journal of Political Economy, 82: 1095-117.

Bernheim, Douglas (1987) Ricardian Equivalence: AnEvaluation of Theory and Evidence, NBERMacroeconomics Annual, 2: 263-303.

Frenkel, Jacob, and Razin, Assaf (1987), FiscalPolicies and the World Economy, The MIT Press,Cambridge, Mass.

CHAPTER 4

DEMAND OF THE PRIVATE SECTOR

Objectives

The student should finish Chapter 4 equipped with aconsumption function and an investment function.Given a level of output and government purchases,these two functions are the primary determinants of theprimary current account. The strategy is to begin withfirst principles and then to inject realism. Teachersimpatient to go to the IS-LM analysis faster may skipthis chapter -- and return later -- provided that theyoffer justification for the behavioural relationships (4.4)and (4.7) or (4.23), as well as the primary currentaccount function of Chapter 7.1

This chapter is probably the most difficult to teach.The big stumbling block is the q-investment function.In response to many suggestions, the second edition hasbeen modified in a number of ways to make thiscomplex material more palatable, even to students witha limited knowledge of microeconomics.

Consumption

There is no major difficulty in shifting from the intra-temporal apparatus of standard consumption theory tothe intertemporal interpretation. Students only need tobe warned that consumption today or tomorrow reallyrepresents a basket of goods.

Impressing students with the central result that theconsumption function, in theory, depends on wealthalone, is justified by the principle of consumptionsmoothing -- a principle which does not generally applyto other components of national expenditure, such asinvestment, government spending, or exports. Yet it ishealthy to follow up by pointing out the well-knownlimitations of this elegant theory: borrowingconstraints, uncertainty about future income and ratesof interest. It is also helpful for the short run IS-LM

1 Chapter 11 now begins with a quick motivation for theprimary current account (net export) function, so this is lessimportant than was the case with the first edition.

analysis to derive results which will justify a Keynesianconsumption function.

The distinction between permanent and temporarychanges in income is not only a good way for studentsto check their understanding, it is also an important toolof analysis. The examples provided are designed toillustrate the importance of this distinction.

The role of the real interest rate in the consumptionfunction is usually more difficult for students to grasp.It often helps to start by asking whether saving (themirror image of consumption) should increase ordecline when the real interest rate rises. Details may beskipped if time is short.2

Net wealth

The emphasis on endowment may leave the impressionthat wealth is just the present value of earned incomes.It is important to remind students that in general,financial assets and liabilities inherited from the pastalso enter in .

Physical investment

In the first edition we pushed the q-theory ofinvestment for a number of reasons, which we stillconsider valid. First, is the only one consistent with theintertemporal forward-looking approach adopted in thistext and by modern macroeconomics. Second, itestablishes a clean link between aggregate demand andthe stock markets. Finally, even though empiricalsupport for the q-theory is not as strong as one mightlike, empirical support for the alternative (that the real

2 Users of the first edition will no doubt note that Box 4.4 hasdisappeared. Many found it too advanced for anundergraduate text; others found the distinction made bySummers (1981b) and others to be uninteresting. On theother hand, some found it useful for sorting out the channelsby which interest rates influence consumption. Toaccommodate these demands, we have introduced Figure 4.9and the accompanying text.

Instructors Guide Chapter 4

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interest rate is the prime determinant of investment) iseven weaker. The sad truth is that the only theorywhich works well empirically is the accelerator, but weknow this has as much to do with the limitations of thedata as with those of theory.3

The treatment of investment was arguably thehardest part of the first edition. We have now changedit to allow for a modular treatment of interest rates(Sections 4.3.1 and 4.3.2) and the accelerator (Section4.3.3) for those instructors who would like to omitTobins q. For those who would like to offer a "babyversion" of the q-theory, we offer Section 4.3.4. Theharder underlying economics -- which still derive fromthe two-period model and are intact from the firstedition -- is laid out in Section 4.3.5.

With this new structure, it is possible to teachinvestment in four steps, with increasing degree ofdifficulty. First, use microeconomic principles to findthe (long-run) optimal capital stock as a function of thereal interest rate.4 Second, provide a simple justificationfor the investment accelerator.5 Third, define Tobins qand link investment to the market value of capitalalready installed (in place). Finally (optionally)introduce costs of adjustment to obtain the q-investmentfunction.

Deriving Tobins q

It is the final step which is hardest to digest. There aremany reasons: installation costs are hard to makeintuitive and students often find it hard to believe thatinvestment moves slowly to the optimal capital stock(especially in the absence of uncertainty); implicitly atleast this is not a two-period analysis;6 and what ismeant by the marginal return on investment -- the fullstream of expected returns on a marginal increment tothe capital stock -- often appears obscure. In presentingthis material, it is essential that students understand theimportant differences between Fig. 4.14 and 4.18: in

3 For an extensive survey of the empirical evidence, seeChirinko (1993).4 Recall that, because the second period is the last, all capitalis lost at the end, hence MPK=1+r and not MPK=r whencapital remains in place (possibly depreciated in which casethe rate of depreciation must be subtracted). This is stressedin Boxes 4.6 and 4.7 in the second edition.5 In the long run the optimal capital stock is in place andMPK=1+r. With a homogeneous production function, MPKis a function of the ratio K/Y so K/Y=g(r). In the special caseof a Cobb-Douglas production function we obtain the simplelinear relationship (4.12) in the text.6 Alternatively, we cut today into smaller sub-periods (as isexplicitly shown in the Appendix). This is needed torepresent the fact that we do not jump straight ahead to theoptimal capital stock because it is costly to do so in one leap.

the second panel of Fig. 4.18 the horizontal axisrepresents investment, not the capital stock; the verticalaxis is discounted back to today.

Ways to make this difference clear:- recall magnitudes: that the capital stock is

considerably larger than annual investment (K/Y isabout 3, I/Y is about 0.2). What we explain in step 2is the (small) addition to the existing capacity ofproduction.

- stress that investment represents new bets on thefuture, while the optimal capital stock is the sum ofmany more decisions which turned out, on average,to be correct (otherwise the capital stock wouldhave been depreciated away).

Installation costs are less intuitive for students andoften appear too insignificant to justify the centre stagethat they are often given. One way to clarify the idea isthat the representative firm is an approximate stand-infor the economy; although individual firms do notrecognise these installation costs, the economy as awhole behaves as if this were the case (because ofpecuniary or nonpecuniary negative externalities, short-run decreasing returns in the investment goods sector,etc.).

One way to stimulate students interest is thefollowing sequence of points:- define Tobins q as the ratio of the value of installed

capital to that of un-installed (or replacement)capital. Thus q is a relative price in the same waythat 1/(1+r) is the price of coconuts tomorrow interms of coconuts today.

- observe that the value of installed capital (and allother forms of capital, for that matter) is determinedby stock markets. Why does a firms value oftenexceed the replacement cost of its capital? (Whycant Daimler-Benz be reproduced merely by buyingde novo all the physical equipment which comprisesit?)

- note that the present value of expected dividendpayments (plus realisable capital gains at sellingtime) is the market valuation of a firm, hence thenumerator in Tobins q.

- finally note that when Tobins q is larger than unityit pays to install capital -- all at once!This all leaves the students with some intuition for

investment. It also poses a puzzle. The intuition is thatthe larger q is the stronger are the incentives to invest.The puzzle is: how can q remain above unity? Theanswer is: installation costs.7

7 Some instructors might prefer to stress time-to-buildconsiderations, which would require a multiperiod setting totreat adequately. For a nice review of the q-theory ofinvestment in a multiperiod setting, see Summers 1981a).

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The next step is to show why investment dependsupon q, represented on the vertical axis when the costof new capital is unity. Maybe the hardest part is toconvince the students that 1 on the vertical axis is theprice of capital in terms of consumption goods. It ispossible, in fact, to start the graphical exposition withthe nominal cost of new capital on the vertical axis.What corresponds to point A is not q, but the nominalexpected return on investment.

A short-cut -- recommended for shorter courses --consists of Section 4.3.4. and restates the q-theoryexactly as Tobin (1969) originally did. Firms can raisemoney on the stock market to buy new equipment.Once installed, though, equipment is worth more to thefirm because it is combined with previously installedcapital and the firms labour force. The ratio of thevalue of installed capital to new equipment, Tobins q,is thus a measure of how desirable it is to borrow andinvest, hence I=I(q). Tobins q, on the other hand,depends on expected future returns from the newlyinstalled capital, i.e. future MPKs.

The primary current account

The PCA function is now postponed until Chapters 7and 11. At this point we motivate that to a large extentit can be understood from the national income identity:

PCA = Y - C - I - G

given the consumption and investment functions. Thusit is simply derived from previous results, which will beinadequate later on when two goods and relative pricesare introduced. More theorising on this function isprovided in Chapter 7.

The interpretation of the current account as nationalsavings can be repeated at this juncture. The reaction ofthe current account of an economy of consumptionsmoothers in response to investment booms (Spain inthe 1980s), sudden increases in government spending(wars), or changes in terms of trade (Fig. 4.6) will be torespond in the same direction. The irrationality ofrunning persistent primary current account surpluses (atleast from the consumers point of view) can bejustified using the theory presented in this chapter. Aquick look at Fig. 3.16 will remind students that highsurplus countries have also seen periods of currentaccount deficits and will see them again in the future(for example, Germany as a consequence of unification,and probably in Japan as consumers begin to enjoymore consumption and leisure).8

8 For more on the current account in an intertemporalcontext, see Sachs (1981) or Frenkel and Razin (1987).

References

Chirinko, Robert (1993) "Business Fixed InvestmentSpending: A Critical Survey of Modeling Strategies,Empirical Results, and Policy Implications," Journal ofEconomic Literature 31, 1875-1911.

Frenkel, Jacob, and Razin, Assaf (1987), FiscalPolicies and the World Economy, The MIT Press,Cambridge, Mass.

Sachs, Jeffrey D. (1981) The Current Account andMacroeconomic Adjustment in the 1970s, BrookingsPapers on Economic Activity, 81/1: 201-68.

Summers, Lawrence H. (1981a) Taxation andCorporate Investment: A q-Theory Approach,Brookings Papers on Economic Activity, 81/1: 67-140.

Summers, Lawrence H. (1981b) Capital Taxation andAccumulation in a Life-Cycle Model, AmericanEconomic Review, 71: 533-44.

Tobin, James (1969) A General Equilibrium Approachto Monetary Theory, Journal of Money Credit andBanking, 1: 15-29.

CHAPTER 5

EQUILIBRIUM OUTPUT AND GROWTH

Objectives

As we stress in the introductory chapter, economicgrowth may well be the most important topic inmacroeconomics. Over periods of a decade or more, theaverage persons well-being is more closely linked toissues of growth in per capita output and income than tobusiness-cycle fluctuations. Thanks to recent work atthe frontier, these issues are now firmly rooted in therealm of macroeconomics, where they belong; yetdespite the revival of the Solow (1956) model inspiredby the newer empirical work summarised in Barro andSala-i-Martin (1995), considerable ignorance remains.A mixture of enthusiasm and caution sets the tone ofthis chapter. The Maddison data serve to catch thestudents eye while the Solow decomposition, and itsmysterious residual, reminds us that the residualtechnical progress still explains a large part of growth.

That growth is presented early on in the bookfollows from the real-nominal dichotomy which is laterstressed in Chapter 10. It is more natural, in our view,to elucidate a long run toward which the economygravitates. The chapters objectives are simple. First,motivate economic growth as an equilibrium process(Section 5.2) resulting from growth or accumulation offactors of production working through the productionfunction. Second, demonstrate using the Solowdecomposition just how much (or little) of growth canbe accounted for in this way. Third, introduce theKaldor stylised facts as a guidepost for viable growththeories (and introduce the notion of a stylised fact ingeneral, which will help in Chapter 14, among otherplaces). Next, introduce the Solow model of balancedgrowth and point out the importance of technologicalchange in this model. Finally, take the student to thefrontier of the field in the discussion of what technicalprogress really is.

General equilibrium

Section 5.2 sits a bit uncomfortably at the beginning ofthis chapter and can be skipped if time is short. It doesserve two important functions. First, after a chapterlinking output and capital (Chapter 4) it meets the needfor bringing output, capital, and labour together in aform of general macroeconomic equilibrium.1 Second,it introduces the aggregate production function, thework-horse of both growth theory and analysis of theeconomys supply side. Fig. 5.1 is meant to symbolisethat we now operate in three dimensions rather thansub-spaces.

In addition, this section is used to introduce someconcepts which will be needed later on: returns to scaleand technological change, in particular. While someteachers may find it a bit too dry to sustain theiraudiences interest, it is important to define theaggregate production function and explain what returnsto scale mean for the macroeconomy.

This section also fills an important gap: Section5.2.2 provides a quick account of the determination ofthe world interest rate in the long run. The kissingtangency in Fig. 5.4 is a classic. It will be taken up inmore detail again in Chapter 10 (Figure 10.7).

The Solow decomposition and balanced growth

The Solow decomposition is a central organisingframework for the material of the chapter. One way tolook at it is as just an exercise in accounting and theearly part of the chapter takes this approach. Once werealise that the residual accounts for only about half ofgrowth performance, the attention shifts from

1 In swapping the order of the labour and growth chapters inthe second edition, we are forced to downplay thehouseholds decision to work, implicitly assuming completelyinelastic labour supply. Later in Chapter 6 this omission isamended. As a result, we treat labour as a fixed input to theproduction process and derive the labour demand curveinformally from the MPL=w rule.

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accounting to analysis. An alternative approach is toderive the decomposition rigorously from a generalproduction function with the usual attributes. Equation(5.6) is the cornerstone of this chapter and deservesspecial emphasis in the classroom. It is also useful tofix students ideas about the magnitudes involved: thenormal rate of growth of countries, the contribution ofinputs, and the size of the residual.

Following tradition, we focus on balanced growth,which occurs when particular ratios of economicinterest are constant. Balanced growth paths can bethought of as a subset of steady-state growth paths, inwhich all variables are growing at constant but notnecessarily equal rates. We chose, as Kaldor did, tofocus on the relative stability of K/Y (the US is the mostoutstanding example). It is important to explain tostudents that especially for countries like Germany andJapan which lost considerable capital stock in the war,K/Y increasing can be consistent with a transition to asteady state value. The balanced growth condition,combined with constant returns and the Solowdecomposition, generates a tight link between economicgrowth, population growth, and technical progress.

We do not pretend that this standard choice isobvious. In fact, the data shown in Tables 5.6 and 5.7should remind the student that stylised facts areregularities, not iron laws. Countries vary in many waysthat are not captured by the model. The stylised factsare useful in that they impose restrictions on theaggregate production function, which in turn lead to anemphasis on the role of total factor productivity indetermining per capita growth.

Bringing in theory

Balanced growth is the accepted way of putting morestructure on the analysis. The distinction betweenbalanced growth and steady state deserves perhapsmore emphasis than it receives in the text. Balancedgrowth paths are a restricted subset of steady-stategrowth paths which requires that some selectedvariables grow at the same rate.

The next step is the Solow model, which has apedagogical elegance which is seldom found in ourfield. We derive the model in the usual way, althoughleaning more heavily on the diagrams than on themaths. The key result, of course, is the invariance ofgrowth with respect to the savings rate -- a difficultresult to explain but nevertheless one of centralimportance. As promised, an appendix with this andother elementary formal aspects of growth theory hasbeen included in the second edition.Limitations and Extensions

Later in the chapter we note that all is not well with thesimple two-factor growth model: high savers seem togrow faster than low savers (despite the fact thatsavings rates do not affect steady-state growth in theSolow model); and that poor countries fail to catch upricher countries. A good pedagogical approach forhighlighting these issues is to propose the convergencehypothesis: that GDP per capita convergeasymptotically so that per capita income levels in poorcountries should catch up to those in richer ones (Figure5.13). The fact that convergence seems to occur onlyamong the wealthier countries invariably generatesmuch interest.

Three resolutions of these difficulties are thenproposed, leaving the reader free to choose among, oraccept all three extensions.2 First, it is shown that oncehuman capital is added as a third factor to the aggregateproduction function both facts can be explained. Therehabilitation in Mankiw et al. (1992) has given newlife to the neoclassical, constant returns approach togrowth. Second, the same is true if one adds publicinfrastructure.3 Finally, endogenous growth, the theorydeveloped in the late 1980s, gives a role to increasingreturns to scale and externalities and also allows us toaccount for the role of saving and the absence ofconvergence.

It may therefore be useful to close the presentationby suggesting extensions of the two-factor model.Human capital is the most frequently and successfullymodelled third factor. Further additions may includenatural resources or public infrastructure, that can beincorporated into the Solow decomposition. Some of

2 This agnosticism is motivated by the fact that, at the time ofwriting, the verdict on endogenous growth was still out.Writing this guide in late 1996, we are unsure about wherethe empirical literature on growth is taking us (for a criticalreview see Solow (1994)). On the empirical side (see Levineand Renelt (1992)), three results seem important: 1)investment in human capital is positively associated withgrowth (Mankiw et al. 1992); 2) public infrastructure alsoseems to matter; 3) convergence of per capita income seemsto occur within regions of a country (Barro and Sala-i-Martin1991) at roughly 2% per year, when the steady state to whichthe local economies are converging is appropriatelycontrolled for. Externalities and returns to scale may explainthe distribution of activities within a country -- the newdiscipline of economic geography -- but may be less usefulfor national growth performance.3 These two explanations must be combined with the idea ofconditional convergence. Technically, if one is willing toadmit out-of equilibrium behaviour, conditionalconvergence may also account for the positive association ofgrowth rates and savings rates (countries with higher savingsrates have a higher steady state to which they converge, willaccumulate capital at a faster rate, and will therefore growmore rapidly as in Figure 5.13).

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the exercises at the end of the chapter drive home thispoint.

Feldstein-Horioka

Why introduce the Feldstein-Horioka puzzle in achapter devoted to growth? The answer is that ourtextbook is dedicated to the open economy, and as suchneeds to confront this fascinating fact.4 In textsdevoted to the closed economy, the link between savingand growth is assumed since saving (public and private)equals investment (public and private) by definition. Inthe open economy, this link can be broken byinternational borrowing or saving. Yet it survives, asFeldstein and Horioka showed. In a sense, the solutionto the puzzle might have to do with sovereign risk (nocountry can sustain growth solely on foreign capitalwithout being tempted to confiscate it in the end andavoid repayment) or the high correlation of permanentinvestment opportunities across countries in the longrun (as opposed to transitory ones, to which optimallysmoothed consumption would respond with current-account fluctuations).

References

Barro, Robert J. and Sala-i-Martin, Xavier (1995)Economic Growth, New York: McGraw Hill.

Feldstein, Martin and Horioka, Charles (1980)"Domestic Saving and International Capital Flows,"Economic Journal, 90: 314-29.

Levine, Ross and Renelt, David (1992), A SensitivityAnalysis of Cross-Country Growth Regressions,American Economic Review, 82: 942-63.

Mankiw, N. Gregory, Romer, David, and Weil, David(1992), A Contribution to the Empirics of EconomicGrowth, Quarterly Journal of Economics, 107: 407-38.

Solow, Robert M. (1956), A Contribution to theTheory of Economic Growth, Quarterly Journal ofEconomics, 70: 65-94.

______ (1994), Perspectives on Growth Theory,Journal of Economic Perspectives, 8: 44-54.

4 The reference is Feldstein and Horioka (1980).

CHAPTER 6

LABOUR MARKETS AND EQUILIBRIUM UNEMPLOYMENT

Objectives

This chapter explains unemployment in the long run:why does the rate of unemployment fluctuate around alevel which is far from small in most countries, and hasrisen considerably in Europe over the last two decades?

One effective way we have found to teach thischapter is first to propose a standard demand andsupply analysis, in which all unemployment is theoutcome of voluntary choice. The paradox of how tointerpret the unemployment which we observe arisesimmediately, and the teacher then proceeds to unearththe sources of involuntary unemployment.1

The central message is that labour is a veryparticular commodity: once we take into account whatmakes it particular, the paradox disappears. Given themany different reasons why labour is special, thechapter does not offer an all-encompassing theory ofunemployment. Instead it looks at each explanation oneby one, leaving the reader to add them up, and allowingthe instructor leeway to stress his or her own preferred(or locally relevant) cause. Many of these aspects havebeen removed from Chapter 6 and can now be found inChapter 17 (supply side).

Controversial distinctions

We have chosen to separate out actual (i.e. observedand quoted in newspapers) unemployment into twoparts: equilibrium and cyclical. While this accords wellwith intuition and current econometric practice, it maybe at variance with the recent flow approach tounemployment or with recent developments of thedisequilibrium view.2 The same applies to the

1 Some might argue that the distinction is largelymeaningless, i.e. that all unemployment has an involuntaryelement; for a convincing case, see Lucas (1978) orPissarides (1989). We take a neutral stand.2 Two references are C. Pissarides (1989, 1990) and C. Beanand J. Drze (eds.) (1991). The text presents the flow view inSection 6.4, and part of the disequilibrium view in Section6.3.

distinction of equilibrium unemployment betweenfrictional and structural. We find these distinctions veryhelpful in the classroom and, we hope, roughly correct.

Approach

It is thus fruitful for the teacher to remember that theresults are ultimately summarised in (6.7)

Equilibrium = Frictional + Structuralunemployment unemployment unemployment

This distinction refers to the two classes of reasons whythe demand-supply framework is inadequate:- static causes of unemployment, i.e. reasons why

wages are prevented from clearing the market. Thisis interpreted as the cause of structuralunemployment.

- dynamic causes of unemployment, i.e. reasonswhich increase the inflow into unemployment orslow down the process of job take-ups. This isinterpreted as the determinants of frictionalunemployment.

Static causes of unemployment

- Trade union theory (see Booth, 1995, for a recentreview) relies on the distinction between individuallabour supply decisions and the outcome ofcollective bargaining. The trade-union mediated"collective labour supply curve" (wage-offer curve)cannot be to the right of the individual supply curvebecause trade unions cannot force workers to workmore than they wish. It is further to the left themore the trade union values real wages relatively tojobs. A good illustration is to show the effect ofincreased labour supply (demography, immigration,entry of women into the labour force) as a shift ofthe individual supply curve -- possibly matched by ashifting labour demand curve as the result of capitalaccumulation or technological change. If the trade

Instructors Guide Chapter 6

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union does not change its wage offer schedule,involuntary unemployment can increase.3

- efficiency wages (see Katz, 1986, for a survey) canbe introduced to justify rigid real wages.

- minimum wages is a straightforward example ofwage rigidity.

- regulations and taxes may be represented asdrawing a wedge between supply (both individualand collective) and demand: they both increase thecost of labour to the firm without raising net after-tax workers income. If net after-tax real wages areshown on the vertical axis, the demand curve shiftsdown: employment declines as real wages fall.

Static causes of unemployment

The dynamic considerations of Section 6.4 are noteasily cast in the demand-supply framework. This iswhat may make this part hard to convey in class. Table6.5 which presents unemployment flows, as well as thestandard diagram in Fig. 6.18, signal the change ofapproach. These flows include those who are fired orwhose firms go bankrupt (more important in Europe),as well as those who enter unemployment from thelabour force or quit into unemployment (lessimportant). The magnitudes shown in the table areconvincing evidence that gross movements are nottrivial, and are part of the mechanism by which thestock relationships, which form the core of the analysis,are maintained. For more evidence in the Europeancontext see our paper (Burda and Wyplosz 1994).

Off-the-curve equilibria

Many interesting results occur when either workers areoff their individual (or even collective) supply curves orfirms are off their demand curves. This is one way ofcapturing the popular wisdom that unemployment ispainful and that firms suffer because of redundancies orunfilled vacancies. Bargaining models in which neitherfirms nor workers are on their demand and supplycurves are not discussed in the text but may be worthexploring (for a review see Booth, 1995).

3Andrew Oswald has rightfully pointed out that monopolistsdo not have "supply curves"; by calling the outcome a"collective labor supply curve" we try to avoid pinning themechanism on a monopoly union. The term "wage offercurve" used in the first edition may be preferred by thepurists. It should also be that the slope of the curve willgenerally depend on the nature of the shock; only ifeverything is linear will all shifts to labor demand result inthe same collective labor supply schedule.

Facts and institutions

There is hardly any other branch of macroeconomicswhich is so intertwined with local institutions andtraditions. The text emphasises this point in variousways: the choice of topics (the flow approach is highlytied to institutional aspects including benefits),discussions of the effects of national institutions (e.g.collective bargaining structures), and by examples(contrasts between European and US labour markets isa natural way of illustrating the issue). Teachers profitfrom drawing on their own national experiences foralternative examples.

Numbers

Students want to know how high equilibriumunemployment actually is (so do a lot of policy-makers!). There are few good estimates around,unfortunately, and those that exist do not alwayscoincide. References are the studies in Bean and Drze(1991) or various studies by the OECD and IMF (whichare really estimates of the NAIRU studied in Chapter12). Table 6.8 produces some unpublished OECDestimates which, as always, should be sold as estimatessurrounded by the usual bands of statisticalimprecision.

Economics and politics

Markets are not perfect and economists must deal withthat as best they can. This is especially true for labourmarkets. There is however a serious risk that students,frustrated by the persistence of high unemployment inEurope, will react to the material with sweepingconclusions: ban or restrict trade unions, or abolishminimum wages, slash unemployment benefits, etc. Itis the teacher's responsibility to remind them thateconomics is just one component of a larger socialgame. Indeed, such conclusions can make sense from anarrow economic viewpoint (efficiency wages, forexample). But political science and sociology also havemuch to say about the unemployment phenomenon, andthey may contradict economic reasoning, which meansthat civil order and social harmony have a price. In theend, we economists can even explain why economicprinciples should not be followed too closely!

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References

Bean, Charles and Drze, Jacques (1991)Unemployment in Europe, Cambridge, Mass., MITPress.

Booth, Alison (1995) The Economics of the TradeUnion, Cambridge, UK: Cambridge University Press.

Burda, Michael and Wyplosz, Charles (1994) "GrossWorker and Job Flows in Europe," European EconomicReview, 38:1287-1315.

Katz, Lawrence (1986), 'Efficiency Wage Theories: APartial Evaluation', NBER Macroeconomics Annual, 1:235-76.

Lucas, Robert E. Jr. (1978) 'Unemployment Policy,'American Economic Review Papers and Proceedings,68: 353-357.

Pissarides, Christopher (1989), 'Unemployment andMacroeconomics', Economica, 56: 1-14.

____________ (1990) Equilibrium Unemployment,London, Basil Blackwell.

CHAPTER 7

THE REAL EXCHANGE RATE

Objectives

So far it has been implicitly assumed that there is justone good in the world; this chapter introduces a second.This step is necessary to give content to the question:what is the role of the real exchange rate -- anintratemporal price -- for an open macroeconomy? Italso allows us to deal with a number of ideas andresults normally overlooked in textbooks which mostlyfocus on the closed economy: why do price levels differacross countries? What are the terms of trade? Couldthere be a link between growth and inflation (theBalassa-Samuelson effect)?

Because of its central importance in the openeconomy, Chapter 7 has been modified and updated ina number of ways. The real exchange rate is used sofrequently that, we now begin Section 7.2 with athorough discussion of both the concept and itspractical implementation and measurement. Weproceed then to motivate heuristically the primarycurrent account function: how the real exchange rate --still loosely defined as the price of foreign goods interms of domestic goods -- positively influences thecurrent account (surplus). The use of the notationPCA(,...) is meant to signal both that everything elseis held constant and that more is to come. As before, wefirmly establish that the exchange rate is measured inEuropean terms (how many units of domestic currencyor goods are required to purchase one unit of foreigncurrency or goods).

Next we take one way of looking at the realexchange rate and explore it more deeply, namely thereal exchange rate as the relative price of traded goodsin terms of nontraded goods. Users of the first editionwill notice the shift in emphasis away from a seconddefinition used more extensively in the first edition,namely the relative price of imports in terms ofexports.1

1 Feedback from users signalled difficulties with the notion of"exports" versus "exportables" so we ended up putting theexports/imports distinction into a Box 7.3. This frees up

Following the general strategy of first anchoring thelong run, Section 7.4 derives the equilibrium realexchange rate as that necessary to balance theintertemporal budget constraint. It begins with theobservation that a countrys intertemporal budgetconstraint imposes a steady-state restriction on theprimary current account and suggests that onemechanism by which the intertemporal budgetconstraint is obeyed is via reallocation of productiveresources towards goods that can be exported (ratherthan a reduction of absorption).

Following this line, the long-run equilibrium orfundamental real exchange rate is defined as the onewhich balances intertemporal trade. Two examples ofthis approach in the literature for infinite horizonmodels are Sachs (1982) and Dornbusch (1983)(although the latter addresses somewhat differentissues); a more recent application to an interestinghistorical episode which stresses the exports/importsdistinction is Wyplosz (1991).

Position of the chapter

This chapter is placed at the end of the sections dealingwith the real economy. As such it can be seen as anextension of what precedes it, and is consistent with ourtreatment of the real economy, microeconomicfoundations, and intertemporal budget constraints. Itmay, however, be taken up at different stages in acourse. For example, it could as well fit betweenChapters 18 and 19 in a course on internationalmonetary economics. The order of topics could be: theexchange rate: institutions and markets (Chapter 18),the exchange rate in the long run (this chapter), and theexchange rate in the short run (Chapter 19). In thatcase, before starting Chapter 11 and the open economytreatment of the IS-LM model, the teacher shouldremember that Chapter 7 defines the nominal and realexchange rate in section 7.2.1.

teaching time to focus on difficult issues raised in Section7.4.

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The long-run budget constraint and the equilibriumreal exchange rate

Sections 7.4 conveys a simple message alreadyemphasised in Section 3.6: in the long run the primarycurrent account ceases to be a choice variable. Inpractice, because most developed countries net externalpositions are relatively small the steady-state primarycurrent account is close to balance (the highly indebtedcountries reached a debt at the peak of about 40% oftheir GDP implying a debt service to GDP ratio ofabout 5%).2

Students are often surprised, even sceptical, whenpresented with this conclusion. Fig. 7.1 shows thatGermany can run current account deficits -- data for the1990s show that this can repeat itself -- while Italy canalso have surpluses! Additional long term data can befound in Maddison (see references in the textbook). Wefind it easy to convince the students that in the longrun, on average, the primary current account must besmall.

The novelty is that a new relative price - the realexchange rate - supplies an economy with an additionaldegree of freedom for meeting the nationalintertemporal budget constraint. A real appreciationreduces the production (and consumption) ofnontradable goods in favour of tradables.3 The realexchange rate thereby becomes endogenous, and theteacher can follow up with Section 7.4 and theconclusion that in the long run, on average, the realexchange rate or "competitiveness" must be such thatthe primary current-account imbalance is smallenough, hence motivating the equilibrium realexchange rate. The rewritten version of Chapter 7stresses this even more by postponing the discussion ofthe equilibrium real exchange rate until the end.

References

2 In addition, growing countries can afford even lowercurrent-account imbalances if the objective is to stabilise thenet external position as a proportion of GDP.3 Arguing from the perspective of Box 7.3, it could alsoinvolve a shift in resources away from the production ofimportables towards exportables, as well as a decrease in theconsumption of importables.

Dornbusch, Rudiger (1983), Real Interest Rates, HomeGoods, and Optimal External Borrowing, Journal ofPolitical Economy, 91: 141-53.

Sachs, Jeffrey D. (1982), The Current Account in theMacroeconomic Adjustment Process, ScandinavianJournal of Economics, 84: 147-59.

Wyplosz, Charles (1991), A Note on Exchange RateEffects of German Monetary Union,Weltwirtschaftliches Archiv, 127: 1-17.

CHAPTER 8

MONEY AND THE DEMAND FOR MONEY

Objectives

This chapter is standard. It reviews the definitions andfunctions of money and prepares for the next chapterwith a presentation of consolidated balance sheets (Fig.8.1). The money-demand function is not derived fromfirst principles: it is simply presented and motivated bythe transactions approach, recognising the dependenceof demand on opportunity cost of holding money, thenominal interest rate.1 The Appendix derives theinventory theory of money demand in the tradition ofBaumol and Tobin.

The chapter is somewhat innovative in twodirections, buttressing an otherwise descriptive andinstitutional chapter with central analytical results.First, the chapter discusses money-market equilibrium,assuming an exogenously set real money supply(Section 8.6). The student is thus exposed early on tothe equilibrating role of the interest rate.2

Second, a long run interpretation locks in theprinciple of homogeneity of degree 1 in nominalmagnitudes, here between money, prices and thenominal exchange rates. It also provides the firstopportunity to present the Fisher principle. In contrastto the first edition, the second edition postponesdiscussion of the concepts of dichotomy and monetaryneutrality to Chapter 10, in which all major markets ofthe economy can be considered simultaneously.

What is highlighted and what is de-emphasised

1 More formal models (cash-in-advance or money-in-the-utility function) would increased the level of complexity wellbeyond that of an introductory text. See Blanchard andFischers (1989) textbook for a nice derivation of the mostuseful approaches.2 The assumption is, of course, that the central bank can fixthe real money supply. This cannot be true in a world withflexible prices, as Section 8.7 makes clear, so an instructormust either assume a given (but perhaps not fixed) pricelevel, or derive the demand for money in nominal terms.

We emphasise a number of well-known ideas andresults that do not always get attention in macrotextbooks. First, we stress that money has aspects of apublic good -- namely its acceptability in transactionsvis--vis unknown or unpredictable trading partners.Furthermore, an individuals use of money makes itmore valuable for others by increasing thisacceptability. Confidence sustains the value of money,and the lack of it can undermine the stability of bankingsystems. Second, care must be taken to distinguishcarefully between nominal and real variables affectingmoney demand. Third, the nature of market clearingdepends on the time horizon. In the short run (given aprice level), real balances are given so the nominalinterest rate clears the money market. In the long run,the price level and the inflation rate are endogenous,and are determined by the level of real activity and therate of growth of the money supply chosen by themonetary authority.

On the other side, we pay relatively little attentionto some features which often figure prominently inother textbooks. First, we gloss over details concerningmonetary aggregates and institutions. Although moreinformation is provided in Chapter 9, we do not spendmuch time on the definitions of money because theyvary from country to country and even over time withina particular country. Teachers may want to elaboratethese aspects using a supplementary, perhaps national-based text. Showing and explaining a central-bankbalance sheet is a good use of classroom time. Second,we do not spend much energy on the concept ofvelocity. While a number of teachers use this concept,we feel it easily confuses students, who tend to give it alife of its own. We prefer to emphasise the fact that it isnothing more than a transformation of the demand formoney and stress the role of nominal interest rates andconversion costs.3

3 Velocity is shown in (8.2) to be a function of real GDP, theinterest rate, and the technology of money or liquidityservices (captured by parameter c).

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The effects of price on money demand

Students often find it difficult to separate out the twoeffects of price increases on money demand. Fig. 8.3attempts to clarify the issue. The first is a level effectwhich works through the fact that money demand is ademand for real cash balances. Nominal moneydemand can be written as M=PL: ceteris paribus, thereis a one-to-one effect of an increase in the price levelon nominal money demand or, equivalently, no effecton real money demand. The second effect is the rate ofgrowth effect. The Fisher effect implies that an increasein the inflation rate increases the nominal interest rateby the same amount; real money demand declinesbecause the cost of holding money increases. Nominalmoney demand increases over time, but not quite as fastas the price level, so real balances decline. Theexamples shown in Fig. 8.12 may seem to weaken thelatter argument: it is a good occasion to remind studentsthat the Fisher principle involves expected (ex ante),not actual (ex post) inflation. Such a discussion servesas a lead-in for future discussions on the credibility ofmonetary policy.

References

Blanchard, Olivier J. and Fischer, Stanley (1989),Lectures in Macroeconomics (Cambridge, Mass.: MITPress), 4, esp. 4.1-4.3.

Goldfeld, Stephen M. (1990), The Demand for Moneyin Friedman and Hahn, eds., Handbook of MonetaryEconomics (Amsterdam: North Holland).

CHAPTER 9

THE SUPPLY OF MONEY AND MONETARY POLICY

Objectives

There are three good reasons for dealing with moneysupply after money demand and money marketequilibrium. First, an understanding of the equilibratingrole of the interest rate in the money market greatlyhelps the exposition of open-market operations.Second, openness and international capital movementsprofoundly affect monetary policy via the interest rate.Third, if the mechanics of money supply gets relativelyless emphasis, it is because monetary policy in mostEuropean countries emphasises interest rate orexchange rate policy as well as bank regulatory aspects.

Indeed, a key difficulty of presenting monetarypolicy to students living in an open economy is thatthey know that foreign interest rates are the centralconstraint. This is why this chapter de-emphasises themoney multiplier and stresses the linkage betweenmonetary policy and exchange-rate policy, establishingthe link between a money-market intervention and anexchange-market intervention. While a full resolutionof this issue will have to wait until Chapter 11 and theopen-economy version of the IS-LM model, studentsare ready to think about these issues.

Another aspect of monetary policy often saved forlater receives here a special early treatment: monetaryfinancing of budget deficits and independence of thecentral bank. This issue is paramount in severalEuropean countries and has been given a centraltreatment in the discussions surrounding monetaryunion in Europe. Presenting the idea early on isadvisable, despite details provided later in Chapter 15.

Overall, the instruments available to the monetaryauthorities can be presented quickly in a summaryform. Similarly, teachers short of time may skip thebalance-sheet approach which is very useful but time-consuming. One important change in this edition is arewriting of the parts of Section 9.3 to reflect theincreasing importance of open market operations inEuropean monetary policy -- as well as the prospect ofa European Central Bank by the year 2000. We see thisbank -- to the extent it becomes a reality -- as operating

in a manner similar to the Bundesbank and have addedBoxes 9.3 and 9.4 to highlight these issues.

Different national institutions, yet the same process

Because monetary institutions differ from country tocountry, the chapter adopts a neutral presentation of themoney-supply process: it does not go into nationalspecifics and instead focuses on common elements.1

For instance, reserve-holding behaviour is central tolegal reserve requirements, yet reserve holding may ormay not be regulated in the particular country understudy. Similarly, the relationship between central andcommercial banks also differs across countries, and thishas important policy implications. For example, Fig.9.7 studies three approaches: i) a strict monetarycontrol as practised in the US in the early 1980s; ii)strict interest rate control as currently practised in manysmaller European countries as well as the UK andFrance; iii) the newer hybrid approach targeting a shortterm interest rate with open market policy, either viaauctions of reserves (via repos as in Germany) ordealings in Treasury securities (as in the US).

Yet, it is useful to emphasise the crucial role ofbank reserves, be they voluntary or regulated. Again,using the balance sheets introduced in the previouschapter can be an effective way of presenting in onestep the two main aspects of money supply: the money-multiplier process and the effective control of moneysupply.

In doing so, the text introduces two multipliers: thereserves multiplier (the ratio of M1 or any other moneyaggregate to banks reserves) in Section 9.2.2.1, and themonetary-base multiplier (the ratio of M1 or any othermoney aggregate to the monetary base M0) in Section9.2.2.2. In our view the latter is a more effective, and

1 Those interested in delving into national detail might wellconsider a historical approach which outlines how theinstitutions arose. For an excellent treatment, see Goodhart(1990).

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less misleading, way of presenting the two concepts ofmultiplier and control.2

Step-by-step multiplication versus aggregate effect

Section 9.2.3 deals in great detail with the moneymultiplier. In principle, the one-step aggregate effectpresented earlier should suffice in terms ofmacroeconomics. Yet students often correctly suspectthat there is more going on among banks. The step-by-step presentation fills that gap. Yet it can be quite time-consuming in class, and impossible to stop once started.One way of dealing with this is simply to refer curiousstudents to the full treatment in the text and stick to theone-step approach represented in Fig. 9.2.

Policy dilemmas

Students often note that, according to the principles,central banks should be able to control money supplyeffectively and yet they often miss their pre-announcedtargets. This provides a good lead-in: teachers shouldnot be afraid of telling students that central banks maywell have several objectives: long-run price stabilitywhich calls for the control of money growth; a shorter-run preoccupation with the business cycle which can beaddressed by varying the interest rate; and very short-run exchange-rate targets -- even under a flexibleexchange rate regime central banks care about the valueof the currency. More often than not, these objectivesstand in conflict with each other, creating a dilemmafor the monetary authorities and leading tocompromises. Several examples of this problem arepresented in the text (a more recent example ismonetary policy in Germany after unification and theUK after the EMS crisis of September 1992).

Regulations

While not traditionally presented in macroeconomictexts, the regulatory aspects of central banks meritsome attention, especially in Europe. Two examplesmight convince the sceptical teacher. The CookeRatios presented in Section 9.6.3 are widely believed tohave been the main source of monetary stringency inthe early 1990s, in the USA, Europe, and Japan. Tworeasons have been presented and may be discussed inclass with the help of press reports, especially in Japanand France.3 First, it takes time for banks to build up

2 A useful reference here is Brunner and Meltzer (1990).3 See also Theoretical Exercise 9.

their capital base to the levels required by the ratios;second, with the fall in house prices, a number of bankcustomers have failed to keep up payments on theirloans leaving banks with collateral -- such as houses --which are worth less than their book values, thuseroding the asset side of the banks balance sheets.4

The other example is the issue of lender of lastresort treated in Section 9.6.2. There is no agreementon whether or how this function should be performedby a future European Central Bank. The GermanBundesbank seems to oppose making commitments forfear of entering into a commitment to create money.The Bank of England is less reticent, probably havingbeen more sensitised to the risk of instability in its(much more developed) financial markets. This is greatmaterial for classroom discussions or examinationquestions.

References

Brunner, Karl and Meltzer, Allan (1990), MoneySupply in Friedman and Hahn, eds., Handbook ofMonetary Economics, (Amsterdam: North Holland).

Goodhart, Charles A., (1990), The Evolution of CentralBanks (Cambridge, Mass., MIT Press).

4 The recent collapse of Barings and enormous reportedtrading losses of Metallgesellschaft and Sumitomo haveimportant implications for the banking sector. Students mayneed to be told that banks are virtually always involved whenbusinesses suffer losses or go bankrupt.

CHAPTER 10

OUTPUT, EMPLOYMENT, AND PRICES

Objectives

This chapter stitches together the patchwork of theprevious nine chapters into the general equilibriumframework most commonly used in macroeconomics.The centerpiece of the chapter is the so-calledneoclassical model, which assumes perfectly flexiblenominal prices and fixed output, given factorendowments. It is the product of the first three sections,culminating in Figure 10.6. In an effort to be balanced,we conclude the chapter with the fixed price, variableoutput version of the model, which can be understoodusing the same IS and LM curves developed inpreceding sections and is meant to provide a steppingstone for the Mundell-Fleming analysis of Chapter 11(previously Chapter 10).

Key concepts introduced in this chapter are:macroeconomic general equilibrium (an extension tothe discussion of Chapter 5); the IS-LM diagram, whichis presented for the first time; the concepts of monetaryneutrality and dichotomy; and the Keynesianassumption and its implications.

The return of the closed economy

A number of users of the first edition will be relieved atthe addition of this chapter. Initially, we were confidentthat deriving the open economy IS-LM model from theoutset would be a straightforward exercise. In the end,many users as well as our own experience convinced usthat the closed economy version was necessary, notbecause the closed economy is particularly relevant(especially in the European context) but because it isthe most suitable means of drawing together the looseends of the previous chapters. (Chapter 11 retains theemphasis of the Mundell-Fleming open economy modeland the regime-dependency of fiscal and monetarypolicy.) We thought that students deserved a last look atthe long run, stressing the value of the classicalframework for understanding long run trends, whilecontinuing to think about these issues within theconfines of the two-period model.

One interesting application of the closed economymodel is to motivate more fully the long rundetermination of the world real interest rate. Figure10.7 (Box 10.1) adds flesh to the bones of the firstattempt in Figure 5.4 and shows how "crowding out"can occur in a purely classical framework, even if thereis Ricardian equivalence, when the governmentincreases its claim on resources. This may besupplemented by analyses of related changes, such asan increase in the economys endowment today, whichwould tend to decrease the interest rate in equilibrium,versus a "technology shock" (an increase in marginalproductivity at any particular capital stock), whichwould tend to increase the interest rate.

Structure

Although the analysis is classical as in Patinkin (1948)or Sargent (1987: Chapter 1), it begins with thetraditional "Keynesian cross" or 45 line diagram usedto interpret demand-determined cyclical fluctuationsand in deriving the IS schedule.

Next comes the derivation of the IS and LMschedules. They are derived ceteris paribus, i.e. withoutreference to other constraints on output and interestrates. Derivation of the aggregate supply side occurs ina natural way and provides the first explicit linkbetween the labour market (Chapter 6) and equilibriumoutput (which figures importantly in Chapter 12 and13).

Both IS and LM schedules are derived in thestandard way, but with the exception of Figure 10.12they are not "moved around"; that chore is left forChapter 11. In this sense Chapter 10 is a treatment ofthe theoretical issues, and should be understood by thestudent as a preparation for the "action" in subsequentchapters.

Finally these curves are integrated in a six-paneldiagram that will be familiar to some and new to many.We think it will provide a crystallisation point for themany ideas of previous chapters -- in a single picture.This diagram allows the instructor to illustrate the key

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propositions of monetary neutrality and dichotomy, aswell as the failure of these when prices are not fullyflexible.

Equilibrium

A central concept in this chapter is the idea ofmacroeconomic equilibrium. Equilibrium is introducedearly on as a state in which no forces exist which wouldmove the economy away from that state. Of course,equilibrium is always defined with reference to achoice of exogenous and endogenous variables and wehave tried to use the development of the chapter toconvey this distinction. One example is the Keynesiancross diagram, which we decided to leave in for thosewho like to emphasise it. Given the nominal interestrate i, the desired demand curve can be thought of as inequilibrium with output, assuming that output issupplied elastically. Similarly, the IS and LM curvesintersect to give a level of output and interest ratesgiven that this is supplied -- leaving open either aclassical or Keynesian interpretation.

Deriving the IS and LM