CHAPTER 1

Motivation for macroeconomic models

[This is a draft chapter of a new book - Carlin & Soskice (200x)1].This book aims to provide models that can be used to understand a wide range of macroeconomic

behaviour and policy issues and to explain how different countries perform and how performancechanges over time. We use two broad kinds of models: one is an integrated model for analyzingthe output- unemployment- ination- exchange rate nexus of problems and the other is used foranalyzing growth. The choice of models is motivated by their usefulness in framing key questionsthat face macroeconomists. The questions include:

How is output and employment determined? Why does ination occur and when should we worry about it? How does government policy affect ination and unemployment? Why is unemployment higher in some countries than others? How do trade, international financial markets and exchange rates affect employment and

ination? Why are some countries rich and others poor? Why are some countries catching up to the leaders and others not?

To understand how episodes of high unemployment or runaway ination can occur requires usto model the wage- and price-setters in the economy as well as the government. Countries differwidely in how their labour markets are organized how important are these differences for ex-plaining patterns of unemployment? Governments differ in how they manage economic policy. Inmany countries, monetary policy has been hived off from the government and delegated to an inde-pendent central bank. A dozen European countries have dispensed with a national monetary policyaltogether by joining the European Monetary Union. In some countries, unions and employers or-ganizations are involved in macro-economic policymaking. How would we expect these differencesin institutional arrangements to inuence performance?

In the analysis of growth, some models emphasize the role of the accumulation of capital bothphysical capital and human capital. Others highlight the importance of innovative entrepreneurialactivities. To account for the vast differences in the success with which countries have raised livingstandards, the role of economic policy and institutional arrangements for promoting investment andentrepreneurial activity needs to be addressed.

In the rest of this chapter, we put some esh on the bones of the questions posed above byfirst setting out in a schematic way how to model the short to medium-run macroeconomy. Wemotivate the key components of the model with empirical data showing cross-country trends in thekey variables. In the second section, we do a parallel exercise for the long-run analysis by presentingsome stylized facts and sketching how to model growth.

1. Output, unemployment and inationThe aim of this section together with Chapters 2 and 3 is to set out a macroeconomic model

for short to medium run analysis that is both reasonably simple and reasonably realistic. It has tobe realistic if it is to provide a framework for analyzing real-world macroeconomic problems. The

1 cWendy Carlin & David Soskice (2004). We are very grateful to Philippe Aghion, Steve Dowrick, Andrew Glyn,Georg von Graevenitz, Cameron Hepburn, Massimo Di Matteo, Nicholas Rau, and Sara Lemos for their help and advicebut we are responsible for all errors. Matthew Harding has provided excellent research assistance with this chapter.

1

2 1. MOTIVATION FOR MACROECONOMIC MODELS

simplicity of the model is essential if users are to be able to see how to apply it themselves to novelsituations. The model is a simple version of the New Keynesian model that is used in contemporarycentral banks and in modern monetary macroeconomics. This so-called 3-equation model consists ofthe curve that models aggregate demand, the or Phillips Curve that represents the imperfectlycompetitive supply side of the economy and the or monetary rule that captures the behaviourof an ination-targeting central bank.2

The overview seeks to show in a simple way how the different bits of short and medium-runmacroeconomics fit together to inuence the level of output and the rate of ination. In the twochapters that follow, we present the bare bones of a closed economy model without providing mi-croeconomic foundations. We give a basic rationale for the main features of macroeconomic be-haviour on the demand and supply sides of the economy. This provides us with the tools for findingout what happens to output, unemployment and ination when the economy is affected by a shockor when the government changes its policies.

The model that we set out in this section and in the next two chapters will allow us to begin toanswer questions like these:

what is the impact on the economy of changes in consumer confidence due to a collapse inthe stock market?

what is the impact on output and ination of changes in government policy such as changesin taxation or government expenditure or a change in monetary policy or in employmentregulation?

if the internet and globalisation affect product market competition, what would we expectto be the macroeconomic impact?

how do institutions like unions or an independent central bank affect ination or unemploy-ment?

What do we mean by impact on the economy or macroeconomic implications? We mean theimpact on output, employment, the price level and ination. Our basic model must therefore provideus with the means to answer the following questions:

: Q1. How is the actual or current level of output and employment in the economy deter-mined?

: Q2. What determines the level of employment in the economy at which ination is stable?We call this the medium-run equilibrium level of employment.

: Q3. How and why does the economy tend to adjust from its current position towards themedium-run equilibrium and what factors inuence the speed and smoothness of adjust-ment?

Once we have a systematic way of answering these three questions, we can tackle a wholerange of disturbances to the economy and assess the policy options available to the governmentor the central bank. There is, however, an important caveat. The real-world economies that we areinterested in are open ones because they trade with other countries and are connected to internationalfinancial markets. This means that it is often unrealistic to use a closed economy model when dealingwith an applied problem. On the other hand, we can easily lose sight of the wood for the trees if toomany facets are introduced at once. The model is extended to the open economy in Chapters 4 to 6.

1.1. Assumptions and terminology. Before we begin, it is useful to clarify some assumptionsand terms. On a first reading, the significance of all the distinctions that are drawn here may not beapparent. But reference back to this section may prove useful when reading through the overview ofthe model.

One special feature of macroeconomics is that the behaviour of a number of different kinds ofeconomic actor or agent such as households, firms, governments, unions, central banks has to

2This is the basic analytical structure of Michael Woodfords seminal book Interest and Prices published in 2003and, for example, of the widely cited paper The New Keynesian Science of Monetary Policy by Clarida, Gali andGertler published in the Journal of Economic Literature in 1999.

1. OUTPUT, UNEMPLOYMENT AND INFLATION 3

be taken into account simultaneously. Individuals make decisions to enter the labour force, to saveand to spend. They respond to job offers, to the interest rate, to changes in their current income leveland in the value of their accumulated wealth. Firms alter levels of production as demand for theiroutput uctuates, they set prices and make investment decisions. Firms may also set wages or do sothrough joint negotiations with workers or with unions. Both households and firms will be sensitiveto government tax, spending and interest rate policy. And their behaviour will reect not only thecurrent state of economic variables but also how they expect the level of these variables such asthe interest rate, the tax rate or wages to move in the future.

In macroeconomics, the aggregate supply side refers to the supply of goods and services. Thesupply side consists of:

the factors of production, which are labour and capital and are supplied by workers andfirms

the technology through which the inputs of labour and capital are transformed into output the way in which the incomes (wages and profits) that workers and firms receive are deter-

mined.The aggregate demand side refers to the aggregate or economy-wide demand for goods

and services. The aggregate demand for goods and services consists of consumption demand investment demand demand stemming from the government.

Consumption demand refers to the expenditure by individuals on goods and services spendingis on both durable products such as a music system or a sofa and on non-durable products such as aconcert or a loaf of bread.

Investment demand refers to expenditure on capital goods (machinery, equipment and buildings).Most of the additions to the total amount (or stock) of machinery, equipment and buildings in theeconomy reect the investment expenditure by firms, where investment also includes the building upof inventories of materials or of finished goods. But new housing and spending by the governmenton machinery, equipment and buildings (e.g. infrastructure such as roads or new school buildings)are also part of total investment.

Government spending on salaries (e.g. teachers, police) and purchases of goods (e.g. hospitalsupplies, ammunition for the army) and of services (e.g. contract cleaning and waste disposal)constitute government demand.

Because the real-world economy is complex, it is necessary to make many simplifying assump-tions when building a macroeconomic model. One method of simplifying is to think of some kindsof decisions and changes in economic variables taking place in the short run, others in the mediumrun and yet others in the long run. Although there are no hard and fast rules about how the short,medium and long run should be defined, we shall often use the following distinctions.

We think of the short run as the period during which output and employment can change butbefore prices and wages respond to the changes in output and employment. The logic and empir-ical basis for this assumption of wage and price stickiness is investigated further in Chapter 13 onwage and price-setting. But meanwhile, all of our attention in the short-run analysis is on the de-terminants of the level of output and employment, assuming that wages and prices are given. Whenwe say prices and wages are given, this is a way of referring to two short-run situations. Moststraightforwardly, it means that prices and wages are fixed the terms sticky and rigid are used in-terchangeably with fixed. Assuming that prices and wages are given can also refer to the situationin which prices and wages are rising by a constant amount each year e.g. by 2% per annum. Inboth of these cases, the key assumption is that in the short run the level of wages and prices or therate of change of wages and prices does not respond to changes in the level of output. This assump-tion means that in the short-run analysis, the focus is on the role of aggregate demand in determiningthe level of output and employment. The short run should be thought of in terms of months ratherthan years.

4 1. MOTIVATION FOR MACROECONOMIC MODELS

We think of the medium run as the period during which wages and prices can respond to changesin output and employment. For the most part, we continue to assume (as for the short run) that thecapital stock of the economy and the labour force are fixed. This means that the total amount ofmachinery and equipment is fixed and so is the level of technology. We do not investigate changesin the population growth rate or allow for migration. This means that the central component of thesupply side is the labour market i.e. the deployment of the existing labour force on the existingcapital stock in the economy. In the medium-run analysis, therefore, our attention is focused on thebehaviour of wage and price-setters: at what level of output and employment will wage and price-setters be in equilibrium in the sense that there is no upward or downward pressure on wages orprices?

We shall see that it is reasonably straightforward to incorporate in the medium-run analysis aninvestigation of the consequences of changes in technology such as changes in productivity growth.But to investigate the causes of productivity growth and why it might change, we need to extendthe analysis to the long run. We turn our attention to this in the second section of this chapter,which introduces growth theory. In the long-run analysis, we allow for growth in the population, inthe physical capital stock (machinery and equipment), human capital stock (skills of workers) andimprovements in technology.

At various points in the book, we make reference to the case of perfectly competitive markets.But we often work with a more general model with market imperfections. We interpret market im-perfections very broadly to include not only the exercise of market power but also the consequencesof the lack of complete information, such as the inability of employers to observe how hard a workeris working. For some questions we shall see that both models work in essentially the same way, butfor other questions the results are different.

In this introductory section, we aim to provide a birds eye view of how the different bits of short-and medium-run macroeconomics fit together. We focus on macroeconomic outcomes in terms ofoutput, unemployment and ination and on the role of government fiscal policies (i.e. spendingand taxation) and monetary policies. The aim here is to convey the general idea rather than to setout every step of the argument. The details are provided in the next two chapters. When workingthrough the detail, it may be useful to return to the overview to see the bigger picture.

1.2. Fluctuations in output and employment. One concern of macro-economists is with thecauses and consequences of short-run uctuations in economic activity. By short-run, we meanyear-to-year or quarter-to-quarter uctuations. Fig.1 shows the quarterly growth rate of output forthe United States since the end of World War II. Booms with strong growth of output and recessionswith sharp contractions are evident. The figure also shows a comparison of annual growth ratesof output for the United States and France from 1981 to 2003. A similar pattern of booms andrecessions is revealed for both countries, but it is also clear that the phases of growth and contractiondo not always coincide for these two economies.

In the short run, the level of output in the economy depends on the level of aggregate demand forgoods and services. The standard model is a useful starting point for understanding thefactors that inuence the level of aggregate demand and hence the level of output and employmentin the short run. As we shall see, it is reasonable to assume that prices and wages are given inthe short run. This means that we can concentrate on how quantities (i.e. output and employment)adjust to changes in the demand for goods and services. As we noted above, it is convenient in amacro model to look at the factors that determine aggregate consumption expenditure (by thinkingabout the inuences on the spending and savings decisions of consumers) and aggregate investmentexpenditures (by identifying the determinants of the decisions of firms to change their stock of capitalequipment). The government is a direct source of aggregate demand through its purchases of goodsand services. The government authorities (including the central bank) have an indirect inuence overthe level of aggregate demand by their choice of tax rates and the interest rate.

1. OUTPUT, UNEMPLOYMENT AND INFLATION 5

1980 1985 1990 1995 2000

0.0

2.5

5.0

7.5

An

nu

al

gro

wth

rate

s o

f GD

P % France USA

1945 1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000

0.0

2.5

5.0Qu

arte

rly

gro

wth

rate

of G

DP

% USA

FIGURE 1. Quarterly growth rate of GDP for the United States GDP, 1945:1to 2003:1 and annual growth rates of GDP for France and USA, 1981 to 2003.Source: U.S. Dept of Commerce: Bureau of Economic Analysis: National Accounts Data,INSEE and EIU

1.3. Unemployment: international comparisons. Economists and policy makers are inter-ested in what determines output and employment not only in the short run but over longer periodsas well. We focus on the latter by looking at the trends presented in Fig.2. Two questions ariseimmediately: why do different countries appear to have different unemployment rates and why arethere persistent trends in unemployment in some countries?

The top panel of Fig.2 shows the monthly unemployment rate for the US from 1948 to 2003.The lower panel shows the annual unemployment rate for the United States and the average for thefour large European economies (Germany, France, the UK and Italy) from 1960 to 2003. There hasbeen a trend of rising unemployment from the 1970s to the 1990s in Europe, which is reected bythe data for the big four European economies. There is a striking difference between the evolutionof European and US unemployment. The idea of a roughly constant medium-run equilibrium un-employment rate looks more plausible for the United States than for Europe. In the United States,unemployment uctuates a lot but it appears to have uctuated around a rate of about 6% since the1960s. European unemployment was well below that of the US until the 1980s.

Fig.3 shows the unemployment rates for France, Germany, Italy, Japan, Sweden, the UK andthe US for the same time period (using the US as a comparison benchmark in each picture). All ofthese countries exhibit significant variability in their unemployment experience over the past fourdecades. The UK followed the same trend rise in unemployment as much of Europe (France, Ger-many, Italy) from the early 1970s to the early 1980s. But since then, there has been a downwardtrend that was interrupted but not halted by the recession of the early 1990s. By contrast in Sweden,there was very low unemployment to the end of the 1980s followed by a dramatic jump in unem-ployment to the European average in the early 1990s. Japan has exhibited extremely low levels ofunemployment compared to the other countries until the early 1990s, while recent years have seena fairly strong ascending trend. These charts show changes in unemployment that persist over time

6 1. MOTIVATION FOR MACROECONOMIC MODELS

1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000

5.0

7.5

10.0

Unem

plo

ymen

t Rat

e in

%

US Unemployment Rate

1960 1965 1970 1975 1980 1985 1990 1995 2000

2.5

5.0

7.5

10.0

Un

empl

oym

ent R

ate

in

%

EUR=Average unemployment rate for F, G, I and UK

EUR US

FIGURE 2. Monthly unemployment rate for the US 1948:01 to 2003:04 and com-parison of the unemployment rates for the US and Europe 1960 to 2003. Source:Federal Reserve Economic Data: St. Louis Fed and U.S. Bureau of Labor Statistics: ForeignLabor Statistics. Note: Germany is West Germany before 1991 and United Germany from1991.

and big differences across countries. They motivate the notion of a medium-run unemploymentrate, in which changes over time and differences across countries are associated with variations insupply-side structure.

1.4. Modelling medium-run unemployment. We begin by contrasting how the aggregate sup-ply side is presented in the competitive model and in the more general model with market imper-fections. Many readers will be familiar with competitive models from their knowledge of microe-conomics. In a competitive model of the labour market, we say that the labour market clears. Thismeans that the real wage (i.e. the value of the wage in terms of the goods that can be bought withit) adjusts so that the demand for labour by firms is equal to the supply of labour by individuals. Atthe market clearing real wage, firms are in equilibrium in the sense that at the prevailing real wage,it would not be profitable for firms to employ any more labour. Conversely if they employed lesslabour, then they could increase their profits by raising employment. At the market clearing realwage, there is also an equilibrium from the point of view of workers. At the prevailing real wage,more labour will not be supplied equally if less labour was supplied, workers would be better off ifthey supplied more.

The only kind of unemployment that exists in the competitive equilibrium is voluntary unem-ployment. If workers derive more utility (i.e. happiness, pleasure) from being unemployed giventhe existing real wage than they would from working then they choose not to work and this is vol-untary unemployment. The unemployed would prefer the leisure and no wage as compared with thealternative of working and receiving the prevailing real wage. The voluntarily unemployed may besearching for a job offering better wages and or conditions.

1. OUTPUT, UNEMPLOYMENT AND INFLATION 7

1960 1965 1970 1975 1980 1985 1990 1995 2000

5

10Germany USA

Italy

1960 1965 1970 1975 1980 1985 1990 1995 2000

5

10

Un

empl

oym

ent r

ates

for

som

e o

f the

majo

r ec

on

om

ies

in

%

France USA

Sweden

1960 1965 1970 1975 1980 1985 1990 1995 2000

5

10Japan USA

UK

FIGURE 3. Unemployment rates for some of the major OECD economies, 1960to 2003. Source: U.S. Bureau of Labor Statistics: Foreign Labor Statistics. Note: Germanyis West Germany before 1991 and United Germany from 1991.

We shall call the rate of unemployment that corresponds to the market clearing level of employ-ment in the economy (i.e. when labour supply is equal to labour demand) the competitive equilibriumrate of unemployment.

1.4.1. Imperfect competition model. In contrast to the competitive model, we use a more generalmodel in which the equilibrium in the labour market does not necessarily coincide with marketclearing. One important consequence is that that there can be involuntary unemployment even atequilibrium. In the competitive model, wages and prices emerge through the process of marketclearing, i.e. they are the prices at which the supply of labour equals the demand for labour. Forexample, in a perfectly competitive product market, each firm faces the market price and choosesits level of output where its marginal cost is equal to the market price. By contrast, in the imperfectcompetition model, we can talk of wage-setters and price-setters. If there is imperfect competitionin the product market, this means that prices are set by firms and firms earn supernormal profitsbecause they have some market power. This means that the price is set by the firm above the level ofits marginal cost: the difference between the price and the marginal cost is the profit the firm makes.

With imperfect competition in the labour market, money wages will be set by employers or byunions or by both through negotiation. The real wage for an individual will depend both on theoutcome of wage-setting in the firm where they work and on the outcome of price-setting across theeconomy. At any given level of employment, the real wage consistent with wage-setting behaviour inan imperfectly competitive labour market will typically be higher than that in a perfectly competitivelabour market. Why is that? One explanation is that in a unionized work-place, the collectivebargaining power of employees will normally result in a wage that is higher than the minimum anemployee would be prepared to work for.

What is meant by equilibrium in the labour market in the imperfect competition model? It meansthat wage and price setters in the economy are in equilibrium, in the sense that at the current realwage and level of employment, they have no incentive to change their behaviour. There is one level

8 1. MOTIVATION FOR MACROECONOMIC MODELS

of employment and rate of unemployment at which both wage and price-setters accept the prevailingreal wage. This is the imperfectly competitive equilibrium rate of unemployment. We shall see thatimperfections in the labour or product market have the effect of raising unemployment above the ratein a competitive equilibrium. Although this is consistent with the fall in UK unemployment from the1980s as union power declined and the markets became more competitive, it does not square withthe low unemployment in highly unionized Sweden up to the 1990s. We shall need to enrich themodel to account for such facts.

1.5. Ination. Imagine an economy that has constant ination. In terms of our discussion sofar, such an economy is in a medium-run equilibrium, which we shall call the equilibrium rate ofunemployment or . If we now suppose that aggregate demand rises, output and employmentwill rise in the short run and unemployment will be pushed below the . Eventually, we wouldexpect wage- and price-setters to react to this. This is because with fewer unemployed workersavailable, workers will be in a stronger bargaining position in the labour market and real wages willhave to rise to satisfy their aspirations. Hence, the current real wage in the economy is now lowerthan the real wage with which wage-setters will be satisfied. As a result, wage-setters raise moneywages in an attempt to achieve the higher expected real wage. But if wages go up, then price-setterswill not be in equilibrium. Higher wages raise costs for firms. To maintain their profits, firms willtend to raise their prices. An increase in aggregate demand that raises output and employment abovethe equilibrium level therefore leads to a rise in ination.

This immediately raises the question of whether there is a lasting trade-off between ination andunemployment: can the lower unemployment and higher ination be sustained by the governmentsetting its policy to achieve this? The discussion of the labour market suggests that this is unlikely.The fact that there is no lasting trade-off does not depend on whether the labour market is competi-tive. In a competitive labour market, if employment is higher than the level at which labour supplyand demand are equal, the real wage will either be too low to maintain this level of employmentfrom the labour supply side or too high for such employment to be profitable for firms (i.e. fromthe labour demand side). With wage- and price-setting agents, there is a parallel result. We can seethis by extending our earlier example. Unemployment is below the and ination has gone up.Are wage- and price-setters in equilibrium? They are not: since ination has gone up, the livingstandards of workers (i.e. their real wages) have been reduced below the level they will accept in theconditions of a tight labour market. At the next opportunity, wage-setters will therefore raise moneywages by more and ination will rise further.

Fig.4 shows the ination rate for France, Germany, Italy, Japan, the UK and the US. The firstpanel shows the monthly series of changes in the consumer price index for the US covering mostof the 20th century. A particularly striking element is the relative smoothness of the series after1950 compared with the large episodes of ination and deation in the pre-war period. As with theunemployment data, there are striking differences between the countries and also interesting patternsover time. One feature that shows up clearly is the generally low level of German ination ascompared with both the United States and Italy. Especially in Italy, but also in the United States,France and the UK, there are two low-ination eras at the beginning and the end of the forty yearperiod. In between there is more than a decade of high and variable ination, with Italian inationhitting rates of 20% p.a. in the mid 1970s and again in the early 1980s. One is led immediatelyto ask why the high ination era was so much more pronounced in Italy than in Germany, why didination rise so high and what brought about the reduction in ination from the mid-1980s and itsconvergence with German ination by the end of the 1990s. Japan presents an equally fascinatingchallenge as we ponder the economic reasons behind its ination experience, which reached levelsover 20% p.a. in the 1970s and is currently well into negative figures.

1.6. Ination and monetary policy. Monetary policy is set in many different ways. In somecountries and historical periods, monetary policy was directed to reducing unemployment in others,

1. OUTPUT, UNEMPLOYMENT AND INFLATION 9

1920 1930 1940 1950 1960 1970 1980 1990 2000

0

50

100US Inflation %

1960 1970 1980 1990 2000

0.00

0.05

0.10

0.15

0.20 Italy USA Japan

1960 1970 1980 1990 2000

0.00

0.05

0.10

0.15

0.20 Germany UK France

FIGURE 4. Monthly ination in consumer prices for the US, 1913:02 to 2003:04and ination rates for some OECD economies, 1960 to 2003. Source: OECD.

it was oriented to an ination target. Countries have also switched between fixed and exible ex-change rate regimes and we shall see in Chapter 9 that this is a change in monetary policy regime.Here we choose the approach to monetary policy using now by many central banks as a way ofillustrating the interconnection between the aggregate demand and supply sides of the economy andpolicy.

Suppose that the central banks policy is to set the interest rate so as to steer the economy to alow target rate of ination. In response to a surge in ination, we would expect to see it put up theinterest rate. This would produce a fall in aggregate demand as investment spending responded tothe increase in the interest rate (i.e. in the cost of borrowing). The cut-back in investment would leadin turn to lower aggregate demand and a fall in output. Unemployment would go up and inationarypressure would diminish.

Fig.5 provides a schematic overview of the short and medium-run macro model. In the lefthand side, the role of aggregate demand and aggregate supply are summarized. The componentsof aggregate demand determine the level of output and employment in the short run. The structuralfeatures of the economy on the supply side determine the medium-run equilibrium rate of unemploy-ment ( ). In the third panel, the implications for ination are shown: if actual unemployment isequal to the , then ination will remain constant. With unemployment below the , ina-tion is rising and vice versa for unemployment above the . An increase in ination above thecentral banks target will trigger a rise in the interest rate a fall in ination will trigger an easing ofmonetary policy with a lower interest rate. In the right hand panel, the reaction of the central bankto ination rising above or falling below the ination target is shown. The looping arrows depict thefeedback from the central banks monetary policy rule to aggregate demand. This illustrates howa central bank uses a monetary policy rule to hold ination close to a low target value. A glanceat Fig.4 highlights, however, that we shall need to investigate why episodes high ination and ofdeation such as those depicted there occur.

10 1. MOTIVATION FOR MACROECONOMIC MODELS

ation and raises the interest rate.This dampens aggregate demand.Employment falls and the economymoves toward medium runequilibrium employment.

Monetary authority targets in-

moves toward medium runequilibrium employment.

ation and lowers the interest rate.This raises aggregate demand.Employment rises and the economy

Monetary authority targets in-

Aggregate demand

Aggregate demand

determines

ACTUALEMPLOYMENT

ination is:

rising

falling

constant

determines

is equal to

less than

greater than

MEDIUM-RUNEQUILIBRIUMEMPLOYMENT

Aggregate supply

determines

Central Banktargets

low ination rate

FIGURE 5. Schematic view of the short and medium run model

1.7. Summary. We can summarize the key results that we shall derive in detail in the next twochapters as follows.

(1) Levels of employment and output in the short run are determined by the level of aggregatedemand in the economy.

(2) There is a unique medium-run equilibrium rate of unemployment at which ination is con-stant (the ). At this rate of unemployment, the expected real wage that arises fromwage-setting decisions is equal to the real wage that results from the price-setting deci-sions of firms. Institutional and structural features on the supply-side of the economy willdetermine the equilibrium rate of unemployment.

(3) In general, there is involuntary unemployment at the equilibrium rate of unemployment inthe sense that there are workers prepared to work at the existing real wage who cannot getjobs. In the special case of perfectly competitive markets, there is no involuntary unem-ployment.

(4) If the level of aggregate demand produces a rate of unemployment below the , inationwill be rising. If unemployment is above the equilibrium rate, ination will be falling.

(5) We shall see that if policy-makers are targeting ination, then the economy will tend toreturn to equilibrium unemployment following an unexpected rise or fall in aggregate de-mand. The speed with which the economy returns to the equilibrium will depend on howwell markets and institutions in the economy work and on the decisions of policy-makers.

2. Economic Growth2.1. The world income distribution. There are just two periods in world history during which

there was a sustained growth in living standards. The first occured in China between the 8th and the12th centuries, taking living standards to a level not attained in Europe until the 18th century. Thesecond phase of sustained growth is a very recent phenomenon and began in Europe. A sustainedincrease in living standards started in Europe sometime after 1500, but it was initially very slow.During the first two centuries it averaged only about 0.1% per annum, which translates into a 22%increase in income per capita over the entire period. Economic progress slowly gathered momentumaveraging 0.2% per annum during the 1700-1820 period, while from the early 19th century it began

2. ECONOMIC GROWTH 11

to grow by about 1% per annum, allowing for a doubling in the standard of living in 70 years. Growthrates that consistently reached above 1% per annum were only recorded after 1870. Yet the centuryand a quarter of sustained growth since then has had spectacular effects, transforming life for peoplein the countries that have stepped on to the growth elevator and creating a yawning gap between thehaves and the have nots.

The dramatic increase in world inequality is illustrated by the fact that in 1900, average incomeper head in poor countries was about half that in the rich ones rich ones now have average per capitaincomes 25 times higher than poor ones. The Chinese experience demonstrates that the initiation ofa growth process does not entail its continuation indefinitely: China entered the post second worldwar period as one of the worlds poorest countries.

Figure 6 uses the Penn World Tables 6.13 to look at the distribution of average per capita incomeacross the countries in the world in 1960 and 2000. GDP per head of the population is measuredat constant prices and at Purchasing Power Parity (PPP) adjusted exchange rates to enable averageliving standards to be compared across countries. In Fig.6, country averages of GDP per capita aremeasured relative to the United States, i.e. the US = 1. In 1960 the worlds poorest country, Tanzania,had an average per capita GDP level of $382 per annum (i.e. just above $1 per day), while Chinaswas $682 and the United States had per capita GDP of $12,273. Today, Tanzania is still the worldspoorest country at $482 per capita GDP while the United States enjoys $33,293 per capita GDP4.Other examples of current GDP per capita levels are : United Kingdom $22,190 per capita, Romania$4,285 per capita, China $3,747 per capita and Uganda $941. Average growth in the United Stateswas about 1.75% per annum. If growth rates in the US since 1960 had been one percent lower, andthus comparable to those achieved by India or Pakistan, it would have only reached about a fourthof its current GDP levels and its economic performance would have been roughly similar to that ofMexico or Greece. If on the other hand the US had enjoyed growth rates only one percent higherthan the actual ones, its GDP per capita levels would have been almost four times higher than theyare now5. These examples give us a glimpse both into the extent of inequality increase over the pastfour decades and the phenomenal power of the growth engine, which allowed some Asian economiesto increase their incomes by a factor of six within one generation.

Figure 6 shows on the left the frequency distributions of the average GDP per capita of thecountries of the world in 1960 and 2000, where average GDP per capita is measured relative tothe US (=1). It is immediately obvious that the vast bulk of countries are to be found with levels ofaverage income way below that of the US. The so-called kernel distribution in the right-hand panel isa different method of using the same information presented in the histograms on the left.6 Lookingat the right hand panel, we can see the way the world income distribution has changed between1960 and 2000. First we notice a bimodal trend, meaning that it now looks as if it has two peaksat the ends, while in 1960 it only had one. We also notice that the distribution in 2000 is slightlywider than it was in 1960. These are signs that over time as some countries have become richer andothers poorer, the world has become increasingly more clustered between rich and poor countries7.A different question is what has happened to the distribution of income across the peoples of theworld, rather than across the countries of the world. In the past twenty years, some of the most

3The Penn World Tables and the supporting documentation describing the method of analysis and data gatheringprocess can be accessed at http://pwt.econ.upenn.edu/

4In fact the United States only comes in second and Luxemburg is the worlds richest country with $43,989 percapita GDP.

5G-M Angeletos (2003) Economic Growth, mimeo, Department of Economics, MIT.6It was derived by first plotting the different values of relative income in the form of a histogram as shown in the

panel in the left hand side of Fig. 6. The method of kernel smoothing effectively averages and connects points that areclose-by to generate an estimate of the distribution which is smooth and makes more use of the underlying informationthan does a histogram.

7C.I. Jones (1997) On the Evolution of the World Income Distribution, Journal of Economic Perspectives 11(3),19-36

12 1. MOTIVATION FOR MACROECONOMIC MODELS

0.00 0.25 0.50 0.75 1.00 1.25

10

20

30

Income Distribution 1960

Income Distribution 2000

0.00 0.25 0.50 0.75 1.00 1.25 1.50

10

20

30

40

50

-0.25 0.00 0.25 0.50 0.75 1.00 1.25 1.50

0.25

0.50

0.75

1.00

1.25

1.50

1.75

2.00

2.25Relative to US=100

1960 2000

FIGURE 6. The world income distributions in 1960 and 2000 (by country). Ker-nel density estimates of the world income distribution in 1960 and 2000 using realGDP per capita at constant prices USD and relative to US=1.00. Source: PWT 6.1

populous countries such as China and India have grown faster than the rich countries and this hashad the effect of pulling large numbers of people out of poverty.

This hints at powerful changes that occured over the past four decades as the world witnessedboth growth miracles and growth disasters, coupled with a profound tranformation of the politicallandscape and the collapse of many African economies under the burden of the AIDS epidemic.Theextent of economic inequality between todays world economies becomes even more striking whenwe are reminded that in the developing world over 790 million people do not have enough food toeat and 1.3 billion people do not have access to safe drinking water. Almost half of the worldspopulation survives on less than $2 a day. In Asia the number of people living in poverty, on lessthan $1 a day fell from 420 million to around 280 million even when taking into account the financialmeltdown of the late 1990s. In Eastern Europe on the other hand the number of people living on lessthan $1 a day has increased by a factor of twenty8.

Today most of the OECD countries together with some of the Asian economies find themselvesat the top of the worlds income distribution. In 1960 however we witness Latin American countrieslike Argentina, Uruguay and Venezuela in the top 25 percentile of the income distribution, none ofwhich are to be found at the top of the distribution in 2000. Similarly, some Asian countries likeChina, India, Indonesia and Pakistan that were in the bottom 25 percentile of the distribution in 1960were able to escape poverty through economic growth. Differences in economic growth rates haveranged from 6% p.a. for Taiwan to -1.8% p.a. for Zambia and have dictated the winners and losersof the last few decades.

In Figure 7 we plot the relative per capita incomes of the worlds economies in 1960 and 2000against the 45 degree line. Points that lie relatively close to the diagonal represent countries thathave seen very little change in relative living standards over the past few decades. Points that lie

8For a more advanced treatment of economic inequality including many recent trends and global facts the WorldDevelopment Report 2000/2001: Attacking Poverty compiled by the World Bank is a most useful guide.

2. ECONOMIC GROWTH 13

0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 1.0 1.1 1.2

0.2

0.4

0.6

0.8

1.0

1.2

GDP/capita relative to US in 1960

GD

P/ca

pita

rela

tive

to

US

in

2000

FIGURE 7. Scatter plot of relative incomes per capita in 2000 and 1960. Source:PWT 6.1

above the diagonal represent countries that have experienced positive relative rates of economicgrowth. The plot also shows that within the cluster of points in the lower left corner, representing thepoor countries of the world, many have experienced a deterioration in their relative position. Onlyvery few countries that have had relatively low incomes per capita in 1960 have seen a significantimprovement in their living standards, and can thus be identified as growth miracles. These formthe loose cluster of points to the left of the 45 degree line and include most of the Asian economiesbut also Botswana, Mauritius, Cyprus and Romania. Countries represented by points to the extremeright of the 45 degree line correspond to economies that have seen a deterioration of their relativeposition over the past few decades and are thus labelled as growth disasters. Notable examplesinclude Chad, Iraq and Venezuela.

Given the varied performance of countries as shown in Figure 7, we naturally face the questionof what the prospects are for the evolution of the income distribution in the future. Specifically,is there any hope that the worlds poorest economies will catch up with the worlds richest ones?We construct Figure 8 by plotting the growth rate in per capita GDP over the period 1960 to 2000against the log value of per capita GDP in 1960. This plot is a simple example of an attempt toexplore the concept of economic convergence and corresponds to an old economic hypothesis thatcountries which start off poor ought to grow faster and thus catch up with their richer cousins. If thecountries that are initially poor are to catch up, there should be a negative relationship in the graph,with countries on the left hand side (poor at the outset) having high growth rates (located at the top)and vice versa for countries that are initially rich. We have also plotted the best fit line correspondingto the sample regression and we observe a small positive slope. However, we should note that thereis a high dispersion of points across the surface of plot, and indeed if we perform a statistical test weobtain the result that the slope parameter is not significant from a statistical point of view. Thus, wecannot confidently conclude that there is divergence on the basis of this data, but there is clearly nosign of convergence across countries.

14 1. MOTIVATION FOR MACROECONOMIC MODELS

However, if we were to perform the same analysis on subsamples of the data set, such thatthe countries that we include are relatively similar in terms of their economic, social, political orhistorical experience we will obtain a strong negative relationship between the growth rate of incomeand the initial starting position, thus confirming the convergence hypothesis. In Chapter 13 we shallexplore these ideas further by distinguishing between the concepts of unconditional and conditionalconvergence.

6.00 6.25 6.50 6.75 7.00 7.25 7.50 7.75 8.00 8.25 8.50 8.75 9.00 9.25 9.50

-0.5

0.0

0.5

1.0

1.5

2.0

GDP/capita 1960

Gro

wth

rate

of G

DP/

capi

ta,

1960

-20

00

FIGURE 8. Is there cross-country convergence? Scatter plot of growth rates ofGDP between 1960 and 2000 against the initial level of GDP in logs. Source: PWT6.1

2.2. The stylized facts of economic growth. Early empirical work on economic growth by anumber of economists such as Nicholas Kaldor, Simon Kuznets and William Baumol uncovered anumber of robust facts about the process of economic growth facts that were deemed stable enoughacross countries and time to be used as the cornerstone of modern economic growth theory. Theyhave been used as a guide to inform model building but also as a test of consistency for any newmodel that had to justify its existence by how its theoretical results would fit these stylized facts.Over the years, growth theory has attracted a large number of talented economists and both ourtheoretical understanding of the engine of economic growth and our collection of empirical factshas grown significantly. Here we shall note the classic stylized facts of economic growth that haveguided economists over the past half-century, while augmenting the list with some of the newerempirical findings due to economists such as Robert Barro, Robert Lucas and Paul Romer. As welearn the mechanics of both exogenous and endogenous growth theory in Chapters 13 and 14 andthen explore the micro-foundations of growth by looking at models of innovation in Chapter 14, weshall return to this section to verify our understanding of economic growth by explaining to whatextent our models fit these stylized facts:

(1) Large discrepancies between both levels and growth rates of per capita income persistacross countries and across time.

(2) In the long run economies exhibit a balanced growth path, that is output per capita andcapital per capita grow at roughly constant positive growth rates over time.

2. ECONOMIC GROWTH 15

(3) The real rate of return to capital is approximately constant over the long run, while realwages grow at a rate close to that of output per head. From 2. and 3. it follows that the ratioof capital to output shows no trend over time and the shares of capital and labour in totalincome stay roughly constant.

(4) High investment rates in both physical capital and formal education are very closely relatedto high living standards.

(5) Technological progress associated with product market innovation is the main driving forcebehind the long-run growth of living standards in the leader country (or countries).

(6) Low population growth is associated with high living standards.(7) Sound economic policies by the government in terms both of stabilization policy (fiscal

and monetary policy) and the regulatory framework of the economy may have a significantimpact on economic growth rates.

(8) Political, social, institutional and historical factors affect the long-run economic perfor-mance of an economy and are associated with differences in growth rates across countries.Such factors help to predict which countries have converged to high levels of GDP percapita and which countries have not.

2.3. Growth and diminishing returns to factor accumulation. Once we understand the styl-ized empirical facts of economic growth we can try and formulate theoretical models. One place tobegin is to focus on what determines the level of output per worker. In our discussion of the shortand medium run, we focused on a single factor of production, labour. We assumed that the amountof capital equipment available to the worker was fixed. When we move to the long run, we wouldexpect differences in levels of output per worker across countries to depend on the amount of cap-ital equipment available. As we shall see, human capital should also be included. Human capitalrefers to abilities and skills that people can acquire. The term human capital is used to highlightthe analogy with physical capital: investment only takes place if current consumption is sacrificedand resources are devoted to acquiring capital goods instead. Similarly, resources and time must bedevoted to the accumulation of human capital through education, training or learning on the job. Inaddition to the quantity of factors of production available per worker, both technology and efficiencywill matter as well.

The first formal theory of economic growth was developed simultaneously in 1956 by RobertSolow (in the US at MIT) and Trevor Swan (in Australia) and it focused on systematizing the role offactor accumulation in growth. The capital stock had grown dramatically during the first half of thetwentieth century and provided the empirical backdrop to this modelling. The essence of the Solow-Swan model was that a countrys level of output per head would be increased by investment in raisingthe capital equipment per worker. In moving from a low level of capital per worker to a higher levelof capital per worker, output per worker would be growing. However, although more investmentwould raise the level of output per worker (and hence living standards), the model predicts that moreinvestment would only raise the growth rate of living standards temporarily. Why? The answer lieswith the assumption that there are diminishing returns to physical investment. Having one computerwill improve your output having two may raise your average output by facilitating back-ups andallowing you to continue working when the first one crashes but it is unlikely to double your output.

Suppose the economy has had a particular level of output per head for some time. Suddenly, abigger share of income is devoted to investment and this is maintained forever. The Solow-Swanmodel predicts that more capital-intensive techniques of production will be adopted. Output perworker will go up. But with each increase in capital-intensity, the bonus in terms of higher outputper worker diminishes. But why can the higher investment share not pay for a continuously risingcapital-intensity? The reason is that part of the capital stock disappears every year through depreci-ation so that eventually the feeble improvement in output will not generate sufficient extra savingsto keep raising the capital intensity. After some time, the economy will therefore come to a newequilibrium and the level of output per worker will once more remain constant.

A number of issues are raised by this result.

16 1. MOTIVATION FOR MACROECONOMIC MODELS

The model itself cannot account for the persistent growth of living standards. The Solow-Swan model can be amended by including a particular kind of technical progress: if tech-nology is improving year on year without using up any resources, we can say that there isexogenous technical progress. In that case, the initial situation described above would beone in which output per head rises at this constant, exogenous rate. When investment goesup, there is a period during which output per head rises faster than the rate of exogenoustechnical progress because of the increase in capital intensity that is taking place. Even-tually, the economy will return to the original rate of growth, but with living standards ata higher level than would have been the case in the absence of the shift to higher invest-ment. However, the steady growth of living standards is not explained by any economicmechanism inside the model and this seems unsatisfactory.

The model helps to explain why there should be a positive relationship between output perhead and capital per head. But does it predict correctly by how much a rise in capital perhead will raise output per head? As we shall see in more detail in Chapter 13, it does not.

This question, in turn, focuses attention on(1) whether human as well as physical capital needs to be included as a factor of production

in the growth model(2) whether all countries have access to the same technology and(3) whether even if they do, the technology can be used efficiently.

If human capital is included alongside physical capital in the Solow-Swan model, the predictionsof the model better match some of the stylized facts. Indeed the Solow-Swan model augmented bythe inclusion of human capital provides a powerful starting point for thinking about the determinantsof the growth of countries that have caught up with the productivity leader. The US came out of thesecond world war as the undisputed world leader in output per capita. But by the mid 1980s, morethan a dozen countries in Europe plus Australia, New Zealand, Canada and Japan had substantiallynarrowed the gap. Levels of human and physical capital per head had become similar to those inthe US. But the Solow-Swan model is less successful in providing an explanation for the failureof lots of other countries to converge toward the living standards of the rich ones. And it cannotcontribute to the explanation of persistent growth of output per head in the productivity leader sincethe only source in the Solow-Swan model is exogenous technical progress, which by definition isnot explained.

2.4. Growth and constant returns to factor accumulation. Dissatisfaction with the role ofexogenous technical progress in the Solow-Swan model motivated a new approach to growth theory.The key was recognition that it was the assumption of diminishing returns to the accumulation ofcapital physical and/or human that prevented persistent growth of living standards in themodel. The mechanics of creating endogenous growth is straightforward: drop the assumptionof diminishing returns to the accumulation of capital and replace it with an assumption of constantreturns. If the benefits to growth from higher investment do not diminish then it seems intuitivelyplausible that if the economy devotes a higher share of income to investment, this raises the growthrate permanently. This transforms a process of exogenous growth in the Solow-Swan model into oneof endogenous growth.

In our example of the two computers, the idea of diminishing returns to the accumulation ofcapital is an attractive one so the challenge for proponents of endogenous growth is to come upwith explanations for why returns to factor accumulation might not diminish. One inuential ideafocuses on human capital and argues that acquiring more education and training allows us to learnmore. If the link between our existing human capital and our ability to learn more is sufficientlystrong, then endogenous growth is possible: spending more time in education can raise the growthrate permanently. However, one might think that investing in education would eventually come upagainst the limits of human capacity. Perhaps more promising is the notion that higher investment ininnovative activities (e.g. research and development) could allow for the continuous improvement inproductivity.

3. CONCLUSION 17

As we shall see in Chapters 13 and 14 although there is a sharp theoretical difference between theSolow-Swan model of exogenous growth and the more recent theories of endogenous growth, oncethe Solow-Swan model is extended to include a broader concept of capital than simply buildings andmachinery, many of the empirical predictions of the two sorts of model are similar. The so-calledaugmented Solow-Swan model predicts that countries with lower levels of GDP per capita will growfaster than the countries at the technological frontier and will therefore eventually converge to thericher ones. But if convergence is very slow because the returns to the accumulation of physical plushuman capital diminish much more slowly than do the returns to physical capital alone, this processwill look quite similar to endogenous growth.

By modelling how technology is transferred from technology leaders to laggards, both kinds ofgrowth model can be brought closer to explaining real world problems. One important idea is thatpoor countries can only take advantage of the technology used in more advanced countries if theyhave sufficient human capital. This helps to explain why some countries have been able to catch-upand others have not.

2.5. Innovation and incentives: Schumpeterian growth. To go further in understanding growthit is necessary to look more closely at the incentives for innovation. The Austrian economist JosephSchumpeter, writing early in the 20th century, argued that innovations could sustain long-run growthand that institutions are important for creating the appropriate incentives for firms to engage in in-novative activities. Why is investment in innovations different from investment in physical capital?The answer is that ideas are different from fixed capital: once an idea has been developed, my useof it does not prevent you from using it too. By contrast, if I am using my computer, you cannot useit simultaneously. Because ideas are non-rival in this way, there has to be some method of creatingan incentive for firms to invest time and resources in producing the innovation: if not then they willnot be able to recover the costs incurred. Patents are a formal method of ensuring a period of monop-oly for the innovating firm but other more informal methods of retaining secrecy about innovationsare also common. In the Schumpeterian model, countries can be trapped with low levels of GDPper capita because the institutional structures are not conducive to taking advantage of spilloversin innovation from rich countries. This is investigated further in Chapter 14. Extensions of theSchumpeterian model allow us to investigate the implications for innovation and growth of productmarket competition, of how financial markets are organized, and of other structural and institutionalcharacteristics of the economy.

3. ConclusionThis chapter is a taster for what is to come. It hints at the way tractable models can help us to

make sense of the big questions of macroeconomics. The book is organized into six parts. In part1, there are five chapters that cover the short and medium-run macro model, including the analysisof labour markets and institutions, monetary policy and the behaviour of central banks, and fiscalpolicy. In part 2, there are two chapters, one on consumption and investment, and the other on moneyand finance. Part 3 extends the analysis to the open economy. Chapters 9 to 11 set out the short andmedium-run analysis for a small open economy and Chapter 12 extends the analysis to considerinterdependent economies. Part 4 presents the models of economic growth: Chapter 13 focuseson exogenous growth theory and Chapter 14 looks at models of endogenous and Schumpeteriangrowth. In part 5, there is a chapter on the micro-economic foundations of macroeconomic modelsand a chapter on how to model government behaviour using the tools of political economy. Finally inpart 6 are two chapters that illustrate how the macro models can be used to analyze performance andpolicy in the advanced economies over the past 15 years (Chapter 17) and to analyze unemployment(Chapter 18).