NILS GOTTFRIES UPPSALA UNIVERSITY, SWEDEN

MACRO ECONOMICS

palgrave

macmillan

List ofFigures List o/Tables List of Variables About the Author Preface Author's and Publisher's Acknowledgements

1 Introduction What is macroeconomics? Why do we use models? What data do we use?

THE LONG RUN 2 Production, Prices, and the Distribution of Income

What determines the long-run level of income and its distribution

3 Interest Rates and Investment Whatfactors determine investment?

4 Consumption and the Natural Rate of Interest Whatfactors determine consumption and the real interest rate?

5 Capital Accumulation and Growth Why are some countries richer than others?

6 Wage-Setting and Unemployment Why is there always unemployment in a market economy?

7 Money and Inflation in the Long Run What determines the long-run rate of inflation?

THE SHORT RUN 8 The Interest Rate and Production in the Short Run

What causes short-run fluctuations in production and employment?

9 Economic Activity and Inflation in the Short Run Is there a choice between low inflation and low unemployment?

ECONOMIC POLICY 10 Monetary Policy

How should the central bank react to news about the economy?

viii BRIEF CONTENTS

11 Fiscal Policy Are governmentfinances sustainable? How does fiscal policy affect economic activity? 288

(4) THE OPEN ECONOMY 12 Exports, Imports, and International Financial Markets

How doglobalized markets forgoods, services, and loans affect the economy? 323

13 The Open Economy in the Long Run Whatfactors determine the current account, the real exchange rate, and the long-run levels of income andforeign debt? 354

14 The Open Economy in the Short Run What roles do fiscal and monetary policies play underfixed and fioatingexchange rates? 378

15 Exchange Rate Systems and Monetary Union What are the advantages and disadvantages of fixed and floating exchange rates, and monetary union? 404

(5) BUSINESS CYCLES, POLICYMAKING, FINANCIAL MARKETS 16 Business Cycles

What are business cycles and why do they occur? 447

17 Institutions and Economic Policy How do institutions shape economic policy? 470

18 Financial Markets What roles do financial markets and institutions play? 490

Key Equations Index

525 529

CONTENTS

List ofFigures xix List ofTables xxv List of Variables xxvi About the Author xxviii Preface xxix Author's and Publisher's Acknowledgements xxxv

1 INTRODUCTION 1 1.1 The big picture 3

A macroeconomic model with microeconomic foundations 4 Why use an economic model when we can make the argument intuitively? 6 Using a model: an example 7 The short and the long run 9

1.2 Organization of this book 10 1.3 Macroeconomic data 12

National accounts 13 Output, value added, and GDP 13 Some important concepts in the national accounts 14 Many different measures of production and income 16 How much do different production sectors contribute to GDP? 16 Who gets the income? 16 Where do goods and services come from and how are they used? 19 Savings, Investment, and the current account 23 How can we compare incomes between countries? 26 How do we measure real growth of production? 28 How do we measure Inflation? 29

What have we learned? 30 Where do we go from here? 32 Exercises 32 Appendix 33

ix

CONTENTS

(?) THE LONG RUN

2 PRODUCTION, PRICES, AND THE DISTRIBUTION OF INCOME 43

2.1 Production 44

Production factors 44

The production function 44

Technological development 48 The Cobb-Douglas production function 49 The marginal product of labour 49

2.2 Goods markets and price-setting ^0 Monopolistic competition 50 The price elasticity of demand 51 The profit maximizing price 53 Price-setting in the Cobb-Douglas case 56 A simple pricing rule based on unit labour cost 57

2.3 The natural level of production 59 2.4 The real wage and the distribution of income 60

The real wage 60 The distribution of income 62

What have we learned? 64 Where do we go from here? 66 Exercises 66 Appendix 67

3 INTEREST RATES AND INVESTMENT 69 3.1 Nominal and real interest rates, and discounting 70

The price of money 70 The price of goods today in terms of goods next year 71 An approximate measure of the real interest rate 72 Nominal and real interest rates in the last 60 years 73

3.2 Investment -1, The desired capital stock and Investment 74 The long-run demand for capital 76 The short-run demand for capital 79 The Investment function 79

3.3 The accelerator effect and the volatility of Investment s()

3.4 Inventory and housing Investment j What have we learned? 83

Where do we go from here? 84

Exercises Appendix oc

CONTENTS xi

4 CONSUMPTION AND THE NATURAL RATE OFINTEREST 86 4.1 Consumption in a two-period model 88

The lifetime budget constraint 88 Intertemporal preferences 90 The interest rate and the planned consumption path 91 The effect of the real interest rate on consumption 93

4.2 Consumption in an infinite horizon model 94 Sustainable consumption 95 The consumption function 96 A specific consumption function 96 Expectations about future income 98 The marginal propensity to consume 100

4.3 Liquidity constraints, demographics, durable goods 100 Liquidity-constrained consumers 100 Demographic effects on consumption and saving 100 Durable goods 101

4.4 Aggregate demand and the natural rate of interest 102 4.5 The Fisher equation 104 What have we learned? 105 Where do we go from here? 107 Exercises 107 Appendix 108

5 CAPITAL ACCUMULATION AND GROWTH 112 5.1 Long-run adjustment of the capital stock for given

population and technology 113 Patience - a virtue? 116

5.2 Convergence 117 5.3 Population growth and technological development 120

The long-run rate of return in a growing economy 121 Explicit solutions for the long-run levels of capital and GDP 122 The ratio of capital to production and the savings rate 124

5.4 The Golden Rule 124 5.5 Why are some countries richer than others? 126

Differences in physical capital input 129 Differences in human capital 132 Access to technology 135 Natural resources 135 'Institutions' 136

5.6 Are poor countries catching up? 138 5.7 What determines technological development? 141 What have we learned? 144 Where do we go from here? 145 Exercises 145 Appendix 147

CONTENTS

161

WAGE-SETTING AND UNEMPLOYMENT 151 6.1 Stocks and flows in the labour market 1 52

Employed, unemployed, and outside the labour force 152 Unemployment as a percentage of the labour force 156 Flows 1^7

6.2 A model of turnover and the job-finding rate 1 J9 6.3 A model of wage-setting and unemployment 1 60

On-the-job search, turnover of workers, and wage-setting The natural rate of unemployment 164 The wage-setting equation 165 The natural level of employment and the real wage 166

6.4 Malching problems and search incentives 168 6.5 Wage bargaining and unions 170 6.6 Minimum wages and skill-biased technical change 174 6.7 Persistent high unemployment 176

Why do unemployment rates differ between countries? 176 Why is unemployment so much higher than it was in the 1960s? 178 Do temporary shocks have persistent effects on employment? 180

6.8 Long-term unemployment 181 What have we learned? 183 Where do we go from here? 185 Exercises 186 Appendix 187

MONEY AND INFLATION IN THE LONG RUN 189 7.1 The functions of money 190 7.2 Money and inflation in the long run 190 7.3 Alternative definitions of money 192

Monetary base 192 Ml 194 Broad money aggregates 194

7.4 Does money growth explain inflation? 194 7.5 Money demand 196

The interest rate and money demand 196 Inflation and real money holdings 197

7.6 Seignorage 199 7.7 Should we dislike inflation? 200

202 What have we learned? 200 202

Where do we go from here? 203 203 205

Exercises 203 203 205

Appendix

203 203 205

CONTENTS XÜi

THE SHORT RUN

8 THE INTEREST RATE AND PRODUCTION IN THE SHORT RUN 209 8.1 Goods market equilibrium and the multiplier effect 211 8.2 How the interest rate affects demand and production 214

The IS curve 215 The multiplier and the slope of the IS curve 216 The IS curve and the natural rate of interest 217

8.3 The money market and the interest rate 218 The LM curve 220

8.4 Equilibrium in the goods and money markets 221 8.5 Effects of exogenous shocks and policy in the IS-LM model 223

An increase in the money supply 223 A shock to aggregate demand with constant money supply 224 A shock to aggregate demand with constant interest rate 226

8.6 Does monetary policy really matter? 226 What have we learned? 230 Where do we go from here? 231 Exercises 231 Appendix 233

9 ECONOMIC ACTIVITY AND INFLATION IN THE SHORT RUN 235 9.1 Unemployment and wage Inflation 236 9.2 Unemployment and price Inflation 238 9.3 Inflation and the Output gap 240 9.4 Information delays, contracts, and staggered wages 241 9.5 Is there a choice between low Inflation and low

unemployment? 242 Assumption 1: The price level is expected to remain unchanged 243 Assumption 2: Wage setters expect Inflation to continue 243 Assumption 3: A strict and credible Inflation target 245

9.6 What does the data say? 246 What have we learned? 250

. Where do we go from here? 251 Exercises 252 Appendix 252

ECONOMIC POLICY

10 MONETARY POLICY 257 10.1 The objectives of monetary policy 257 10.2 How should the central bank react to shocks? 259

An exogenous increase in money demand 260 A demand shock 261

xiv CONTENTS

A cost-push shock An unexpected and permanent increase in productivity 264 An increase in the expected rate of inflation 264

10.3 Using macro data to set the interest rate 266 News about production 267

News about inflation 267 10.4 The Taylor Rule 268 10.5 Rational expectations 2/0 10.6 The rise and fall of inflation 2 /1 10.7 The Instruments of monetary policy 2, .5

The Interbank market for overnight borrowing 274 How the central bank lends and borrows to control the Interbank rate 274 Control over the interest rate and the demand for money 278 Reserve requirements 279 The Interbank rate and other interest rates 279

What have we learned? 281 Where do we go from here? 283 Exercises 283 Appendix 283

11 FISCAL POLICY 288 11.1 How large is the public sector? 289 11.2 Sustainable government finances 293

Are government finances under control? 296 11.3 Fiscal policy in the short run 300

Crowding out 302 11.4 Do lower taxes really make us richer? 303

Proof of Ricardian equivalence 304 Deviations from Ricardian equivalence 305

11.5 Fiscal policy and the business cycle 307 Policy lags 307 Automatic stabilizers 309 The structural budget deficit 311

11.6 Empirical evidence on fiscal policy 312 Effects of fiscal policy shocks 312 The stabilizing role of the government 313 Is there any evidence of active counter-cyclical policy? 313

What have we learned? 3^5 Where do we go from here? 3 j 6

Exercises 216 Appendix 318

(?) THE OPEN ECONOMY

12 EXPORTS, IMPORTS, AND INTERNATIONAL FINANCIAL MARKETS ,,, , 12.1 The small open economy 39 ^ 12.2 The real exchange rate o ,r

CONTENTS XV

12.3 Imports, exports, and aggregate demand 327 Goods market equilibrium in the small open economy 327 The effect of the real exchange rate on net exports 330 A look at the data 332

12.4 Savings, Investment, and the current account 337 12.5 The interest parity condition 339

The implications of interest parity under fixed and floating exchange rates 341

12.6 Globalization in the markets for goods and services and the financial markets 343

What have we learned? 346 Where do we go from here? 347 Exercises 348 Appendix 348

13 THE OPEN ECONOMY IN THE LONG RUN 354 13.1 Real and nominal interest rates in the open economy 355 13.2 The current account and the real exchange rate 356

The relation between the budget deficit and the current account deficit 360 Does a current account deficit lead to depreciation of the currency? 364

13.3 Investment and growth in the open economy 365 13.4 The current account and the long-run level of foreign debt 367 13.5 How integrated are world financial markets? 369 13.6 Should current account balance be an objective of policy? 371 What have we learned? 372 Where do we go from here? 373 Exercises 374 Appendix 374

14 THE OPEN ECONOMY IN THE SHORT RUN 378 14.1 The Mundell-Fleming model 379 14.2 A fixed exchange rate 380

How does a central bank fix the exchange rate? 381 Macroeconomic equilibrium with a fixed exchange rate 382 The effect of the real exchange rate on aggregate demand 385 Devaluation and revaluation 386

14.3 Monetary union 386 14.4 A floating exchange rate 387

Monetary policy with a floating exchange rate 390 Fiscal policy with a constant money supply 391 Fiscal policy and the central bank reaction to the shock 392 Exchange rate expectations and the importance of the exchange rate Channel 392 The roles of monetary and fiscal policy under fixed and floating exchange rates 393

xvi CONTENTS

399 401

14.5 Long-run adjustment with fixed and floating exchange rates

14.6 Evidence on the exchange rate Channel -396 What have we learned? 398 Where do we go from here? 399 Exercises Appendix

15 EXCHANGE RATE SYSTEMS AND MONETARY UNION 401 15.1 Fixed exchange rate systems 404

The gold Standard 404 The Bretton Woods system 405 The EMS, the ERM, currency baskets, and target zones 407 Speculation, exchange rate crises, and devaluation cycles 408 Deregulation of capital flows and the sustainability of fixed exchange rates 411

15.2 Floating exchange rates and inflation targeting III 15.3 The pros and cons of monetary union 411

Microeconomic aspects: efficiency and trade 416 Macroeconomic aspects: stability 419 Optimum currency areas 422

15.4 The fiscal framework in EMU 123 15.5 Ten years with the euro 126

Trade 426 Macroeconomic Performance on the union level 428 Macroeconomic developments in individual countries 430 Fiscal policy 433 The response to the debt crisis by the European Union 435 Conclusion 436

What have we learned? 436 Exercises 43g Appendix 439

(5) BUSINESS CYCLES, POLICYMAKING, FINANCIAL MARKETS

44' 16 BUSINESS CYCLES 16.1 The trend and the cycle

A linear trend The Hodrick-Prescott Alter 449 A stochastic trend Comparison of alternative measures How long do business cycles last?

16.2 Co-movement of macroeconomic variables 16.3 What drives the business cycles?

Shocks Amplification mechanisms

451 452 454 454 457 458 462

CONTENTS XVÜ

16.4 Should we care about business cycles? 465 What have we learned? 466 Exercises 467 Appendix 468

17 INSTITUTIONS AND ECONOMIC POLICY 470 17.1 Inflation bias 471

Solutions to the Inflation bias problem 474 Reforms of the institutional framework for monetary policy 476

17.2 Deficit bias 476 How serious is the problem of high government debt? 477 Reasons for deficit bias 480 Reforms of the framework for fiscal policymaking 481 Myopia and public Investments 485 Gross debt or net debt? 485 Dealing with an ageing population 485

What have we learned? 486 Exercises 487

18 FINANCIAL MARKETS 490 18.1 Debt and equity 491

Debt, equity, and risk 493 Why debt finance? 495 Debt, equity, and incentives to take risk 496

18.2 The financial accelerator 496 18.3 The stock market and Tobin's q 497

The stock market as a predictor of future economic developments 497 Tobin's q theory of Investment 500

18.4 Banks and other financial intermediaries 501 Banks as managers of credit 503 Banks as liquidity providers 503

18.5 Bank runs and banking regulation 505 Bank runs 505 Contagion and financial crises 506 Banking regulation 507

18.6 Recent developments in the financial industry 508 Wholesale financing 508 Quasi-banks 508 Securitization 508

18.7 The financial crisis in 2007-2009 509 Short-run crisis management 513 Measures to avoid future financial crises 516 Conclusion 517

xviii CONTENTS

18.8 Macroeconomic management of financial crises 517 Increases in margins charged by the banks 517 The zero lower bound on the interest rate 518

What have we learned? 520 Exercises 522 Appendix 523

Key Equations Index

525 529