INSTRUCTOR’S GUIDE - University of Bathpeople.bath.ac.uk/ecsjgs/Teaching/Intermediate...

INSTRUCTOR’S GUIDE

Instructor’s 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 Instructor’s 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

Instructor’s 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.

Instructor’s 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 Instructor’s 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 the’light touch’ with respect to accounting, but this drymaterial can be effectively used to paint the ’big picture’both 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 sector’s imbalanceis financed somehow, but the diagram does not sayby whom. Our view was that with a fully integratedworld capital market, it really doesn’t matter.

Instructor’s 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 theinstructor’s 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 everyone’stool-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 sectors’constraints 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.


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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 don’t.

With Fisher’s 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 gross’market’ 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 oftoday’s consumption on the horizontal axis of the two-period diagrams. (It can also be read in terms oftomorrow’s 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 tomorrow’s 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


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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 with’first 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 Ω.

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.


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interest rate is the prime determinant of investment) iseven weaker. The sad truth is that the only ’theory’which 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 omitTobin’s 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 Tobin’s qand link investment to the market value of capitalalready installed (in place). Finally (optionally)introduce costs of adjustment to obtain the q-investmentfunction.

Deriving Tobin’s 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 Tobin’s 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 firm’s value oftenexceed the replacement cost of its capital? (Whycan’t 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 Tobin’s q.

- finally note that when Tobin’s 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).


9

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 firm’s labour force. The ratio of thevalue of installed capital to new equipment, Tobin’s q,is thus a measure of how desirable it is to borrow andinvest, hence I=I(q). Tobin’s 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 consumer’s 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 person’s 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 thestudent’s eye while the Solow decomposition, and itsmysterious residual, reminds us that the residual’technical 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 theeconomy’s 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 theiraudience’s 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 thehousehold’s 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.


11

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: the’normal’ 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 converge’asymptotically’ 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).


12

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. Drèze (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


14

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 Drèze(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!


15

References

Bean, Charles and Drèze, 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(λ,...) 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 country’s 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.


17

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 andFischer’s (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-à-vis unknown or unpredictable trading partners.Furthermore, an individual’s 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 Money’in 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 bank’s 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 economy’s 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 schedules

Even when derived mathematically as in the Appendix,teachers should reinforce students’ intuition for whatthe IS and LM curves stand for, to prevent their beingused mechanically, and possibly incorrectly. We havefound that it is best to proceed in a heuristic mannerinitially. The text performs the ’what if’ exercise toderive the slopes of the schedule (going from A to C toB in Fig. 10.2 and 10.3). Second, ask what off-schedulepoints represent1 and how equilibrium can be restored(both Y and i can move and do the job; explain why andhow).

Chapter 11 provides detailed information about theslopes of the schedules, so this may be left out at thetime of the first presentation: the whole apparatus isoften hard to grasp and students should be led to focuson the essentials. Thus, asking what happens as onemoves along each schedule requires a more extensivedevelopment of the components of aggregate demand(especially the primary current account, which is notaddressed in Chapter 10).

A few stumbling blocks and helpful simplifications

Perceptive students always find problems with anyinstructor’s presentation, and we have written down a

1 This is the object of Exercise 3 in the theory section.

few of the short cuts we have taken in writing Chapter10 which may turn into stumbling blocks down theroad:

Two periods or one? This is the last time thetwo-period framework is mentioned in any significantfashion. The chapter completes the transition to theshort-run, suppressing subscripts and treating the entireanalysis as if it were "first period." This is a transitionalso for the next chapter, which is exclusivelyconcerned with the (Keynesian) short run. Observantstudents will ask: what happens if the potential outputof the economy changes? Clearly, teachers can finessethe point by focusing on temporary changes -- thoseoccurring in with no long-term implications for wealth,investment, and output. Longer run changes bring usback to Chapter 5.

"The fourth market." The classical model isusually thought of in terms of four markets: goods,labour, money and "bonds" -- where bonds mean allinterest-bearing alternatives to money. The bondmarket is usually ignored (an application of Walras’Law for a system of asset demands in equilibrium), andthis may cause some confusion among better students.It is important to stress that bonds and money aremarkets for stocks -- as opposed to markets for flows(goods and labour services both today and tomorrow).The short cut is invalid for the flow markets: sinceinvestment is occurring, there are goods tomorrow andlabour tomorrow as well. Difficult stuff best left for agraduate level course.

IS-LM, aggregate demand and equilibrium.Strictly speaking, our presentation of the IS and LMcurves yields the level of aggregate demand, but inFigure 10.6 we draw the demand for money defined atthe equilibrium level of output. In that sense the moneydemand curve in the upper right panel of Figure 10.6does not shift when the economy is out of equilibriumin the flexible price case.

The neoclassical assumption: price flexibility

While not particularly plausible in the short run, theidea that price-flexibility defines the long run and is ofcentral importance in macroeconomics.

In the model presented in this textbook, theassumption of price flexibility and that all nominalprices are indexed to the price level delivers theneutrality of money and the dichotomy proposition --that the real and nominal sides of the economy do notinfluence each other in a substantial way. It reinforcesthe intuition that, in the long run, increases in real


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output are only possible if aggregate supply makes itpossible. This point can be made effectively usingFigure 10.9.

The Keynesian assumption

It is important to warn the students of the problematicnature of the fixed-price assumption that underlies theIS-LM analysis. One idea is to announce that thischapter deals with the very short-run (a year, say),while the next one introduces inflation covering longerhorizons, all the way to the dichotomised long-run.Another is to treat it exclusively as a stepping stone

towards the more general AS-AD without anyparticular policy usefulness of its own.

References

Patinkin, Don (1948) "Price Flexibility and FullEmployment," American Economic Review, 38: 543-64.

Sargent, Thomas J. (1987), Macroeconomic Theory,New York: Academic Press, Ch. 1.

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CHAPTER 11

AGGREGATE DEMAND AND OUTPUT

Objectives

Following the closed economy IS-LM model, thepresent chapter moves to its open economy version, theso-called Mundell-Fleming model. The flexible priceversion is abandoned, i.e. the focus is decisively on theshort-run.

The opening-up involves two steps: introducing thetrade linkage (via the primary current function) and theinternational financial link (via a simplified version ofthe interest parity condition, further elaborated upon inChapter 19). The main goal is to derive the benchmark“Mundell-Fleming table” which depicts up the policyineffectiveness results. The second goal is to use thistable to help students think about intermediate cases.

The Mundell-Fleming table

The key difficulty of this chapter is that the exchangerate regime radically affects the working of the model:with full capital mobility monetary policy is ineffectiveunder fixed exchange rates while under flexible rates itis fiscal policy which fails to affect the economy.Consequently, we cannot just “open up” and show howthe results are modified. We have to separate out thetwo polar cases: full flexibility and perfectly crediblefixity of exchange rates. These are extreme cases,especially as they additionally assume full capitalmobility.

The result is Table 11.4, the chapter’s key result,which can be used to: 1) help the students grasp thedizzying variety of sharp results; 2) guide the student toless clear-cut cases (less than perfect capital mobilitywith an upward-sloping financial integration line),expected de- or revaluations (shift the financialintegration line); 3) discuss intermediary regimes(managed float) and the case of monetary union (in factthe permanently fixed exchange rate case).

The PCA function

Instructors familiar with the previous edition will noticethat the PCA function, previously introduced in Chapter4, has now been moved to the present chapter. ThePCA function is inherently “Keynesian” and is naturallyintroduced here. It is based on the traditional importfunction. For the sake of continuity with the micro-foundations, we start by modelling imports as afunction of total absorption, and then link up absorptionto the GDP. The end result is in fact the Keynesianmarginal propensity to import --although we don’t callit that in order to avoid “stuffing” students withconcepts which are not really essential.

The open economy IS and LM schedules

The IS and LM schedules have already been introducedin Chapter 10. They are derived again here. Repetitionis not only superficial, however. A second, slower,exposition of this essential tool of macroeconomicanalysis has pedagogical merit. In addition, the openeconomy versions differ from their closed economycounterparts; this justifies a careful treatment. Formathematically-oriented courses, much can be learnt bycontrasting the formulae in the Appendices to bothchapters.

Another advantage of this new exposition is thathere we take time to insist on the importance ofseparating out endogenous and exogenous variables.This is made possible as we now adopt the Keynesianassumption of fixed prices. This distinction is used toaddress one key difficulty that students face at thisstage: grasping when to move along the schedules, andwhen do the schedules shift.

The financial integration line

Teachers will know that in the Mundell-Fleming modelexpectations are omitted, or assumed to be static so thati = i* + a constant term. Later chapters, starting withChapter 13, will introduce more realism andcomplexity. In a first pass it is essential, we believe, tostick to this simplification, even if some alert students


26

suspect that it is not quite right. Going in the directionof introducing endogenous exchange rate expectationsis like opening Pandora’s box at this stage.

As with the IS and LM schedules, students shouldunderstand what is happening off this schedule, whydoes the economy promptly returns onto the schedule,and what shifts the schedule - including possiblyexpectations of appreciation or depreciation.

The financial integration schedule assumes fullcapital mobility and substitutability: then, and onlythen, are all assets perceived as identical. Of course,that is not a very realistic assumption, just abenchmark. Two interesting deviations may beconsidered.

The first case is that of full mobility but imperfectsubstitutability. Early models in the Mundell-Flemingtradition used to draw an upward sloping schedule toaccount for less than perfect substitutability.Subsequent research has tried to understand thecorresponding "exchange risk premium". It is hardlyplausible that an upward sloping schedule makes sense:the premium is believed nowadays to be small andhighly variable. This is why we do not follow the oldertradition, and instead tell the students to assume fullasset substitutability. Again, as a first order ofapproximation, it is perfectly acceptable. And there isno graphical second order of approximation.

The second case of less than full mobilitycorresponds to the existence of capital controls. Thesecontrols - presented in Chapter 19 and 21 - break thelink between domestic and foreign interest rates. Thereis no simple way of representing them graphically,certainly not with an upward sloping schedule. In theadvanced countries with developed financial markets,the best approximation remains the horizontal linebecause it is known that, given time, controls are easilycircumvented.

Policy mix

Sections 11.3.3 and 11.4.3 present how a fiscal-monetary policy mix operates. This may seem a littlebit like hair splitting. In fact, it is an excellent way ofchecking students’ understanding. It can easily be leftout of a busy classroom schedule.

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CHAPTER 12

AGGREGATE SUPPLY AND INFLATION

Objectives

This chapter derives the aggregate supply curve. Thisanalytical tool remains controversial; while mosteconomists would probably accept the notion of ashort-run aggregate supply curve and admit that theschedule becomes vertical in the long run,disagreements persist regarding the microeconomicfoundations. This is why we propose a fairly open-minded approach: inflation accounting in the traditionof Friedman and Phelps, with an eclectic view withrespect to the foundations. More strongly opinionatedteachers can choose to rationalise the aggregate supplycurve in terms of a specific model: Lucas’s monetary-misperceptions or error-extraction mechanism, theFischer-Taylor overlapping contracts, staggered pricesetting, or menu costs, for example.1

The proposed strategy starts with the following’fairy-tale’ presentation of the Phillips curve: it used toexist, it disappeared, but may have returned, and in anycase theory says it has to end up vertical. The inflationaccounting exercise is reasonable, and makes sense ofthe ’stylised fact’ of a short-run inflation unemploymenttrade-off which is nonetheless interrupted by detectablebreakdowns in the relationship. Most importantly itneed not take a stand on the source or nature of theunderlying nominal rigidities. This is followed by arehabilitation of the Phillips curve in its modified form.

To move from the unemployment-inflation space tothe output-inflation space we use Okun’s law. Okun’slaw is often less robust than a law should be -- andChapter 6 presents many reasons why. Still, we believethat Okun’s law ought to be in every student’s toolkit. Itmay be useful to warn students that employmentfluctuations typically lag behind those in output.

The Phillips curve as a ’stylised fact’

The Phillips curve is an important component of thischapter, and we recognize it as an important historicalstatistical regularity. What the students shouldremember from the chapter comes in two steps:

1 For a catalogue of sources of nominal rigidities whichmight lead to a less than vertical supply curve, see Blanchard(1990), or Romer (1995).

Everything else being equal, lower rates ofunemployment are associated with rising inflation. Thisis the Phillips curve, and it is indeed visible wheneverything else remains equal. But, in general,everything else does not remain equal. Inflationaryexpectations -- which enter the determination of coreinflation can and do change -- as well as theequilibrium unemployment rate itself, due to factorsthat often have nothing to do with the business cycle.

Price level or inflation?

In constructing the aggregate supply curve, theory oftenleads us to operate in the output-price space rather thanin the output-inflation space. A frequent strategy is tostart with the price level and then go to inflation; sometextbooks keep the discussion in the levels throughout.We have found that students are puzzled, if notconfused, by the change (they often have a hard timedistinguishing price levels from the inflation rate), butwant to know about inflation, which seems morerelevant politically and comparable internationally.Indeed, we must eventually be able to explain inflationbecause realistic steady states are ones in which pricesrise at a constant rate. This is why the textbook movesdirectly to inflation, at the cost of some short cutswhich at first glance may be less appealing to someinstructors, but which ultimately allow students todirect their energies to a smaller number of models.

Core inflation

The concept of core inflation is intentionally leftsomewhat vague in the main text. It is the component ofcurrent inflation which is not attributed to capacityutilization, tension in the labour market, or supplydisturbances. The term appears frequently in thefinancial press and seems to have assumed a meaningnot too different from ours (close substitutes areunderlying or trend inflation, but we steered clear of theterm ’inflationary expectations’, the term used inpopular macroeconomic textbooks from the lastdecade). Our loose treatment is partly due to the lack ofconclusive empirical evidence on the subject, partlydue to the role that nominal wage indexation, collectivebargaining, and other national institutions may play in


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its evolution. In the text we have tried to present a storyacceptable to the largest number of colleagues; teacherswith strong opinions will always stress whatever theybelieve is the most convincing approach.2

In developing the concept of core inflation we findit useful and convincing to tell students to think of whatis being bargained over in wage negotiations.Especially in Europe, negotiators explicitly assume arate of inflation to factor into wage settlements, andthey generally end up agreeing on a rather precisefigure. Because national institutions differ, it is notalways clear how much this figure corresponds to acatch-up on past inflation and how much it representsan attempt at guessing future inflation. Such aspects asthe frequency at which wage negotiations take place,whether wages are indexed, and how high and uncertainthe inflation rate is, seem to play important roles indetermining core inflation. To a large extent,disagreements largely centre around the relativeimportance of backward- and forward-looking elementsin the formation of core inflation.3

Dynamics

The presentation in Section 12.5.3 of the transitionfrom the short to the long run is intentionally sketchy.What is certain are both the starting point (point A inFig. 12.11) and the steady state under long-runneutrality of money (point Z). How we move from A toZ depends on the dynamics of the underlying modelwhich is not fully specified here, among other thingsbecause the model is incomplete -- the demand side ismissing and is introduced in Chapter 13. Even the post-policy change point (point B) depends on the relativespeed of the effects of monetary policy (the movementalong the short-run Phillips curve) and of the shifts ofthe Phillips curve. Most models will predict that theconvergence of inflation to point Z over time is notmonotonic, for the simple reason that as long as we arebelow point Z, inflation has not risen by as much as therate of money growth so the real money supply hasincreased. Since the real money stock must, in steadystate, return to its initial level, a period of higher

2 See Bruno and Sachs (1985) for a detailed discussion ofwage and price behaviour and the Phillips curve in OECDcountries.3 Autoregressive inflationary expectations are anotherpotential source of persistence in core inflation, although thisidea is not stressed in the text. Judging from the performanceof economic forecasters (whose view are often consulted incollective bargaining in Europe), it reasonable in our view toassume weak rational expectations, or that expectationalerrors are orthogonal to information available when theforecast was made. This puts the blame for non-neutrality ofmoney squarely on nominal price rigidities.

inflation is needed, so convergence will include pointsabove point Z.4

None of these complexities are mentioned in thetext because we believe that it is far too complicated.Even the appendix to Chapter 13, which presents aformal model, depicts dynamics in a simple fashion.Clever students, however, will often see the need toovershoot point Z during the convergence process.

Which space?

Section 12.6 constructs the aggregate supply curvesimultaneously in the two spaces: unemploymentinflation and output inflation. Since the chapter startswith the Phillips curve and ends up with the aggregatesupply curve -- most naturally represented in the outputinflation space -- it is unavoidable that a step be takenat some point from one space to the other.

This is time-consuming in class, though. Teacherswho are short of time may have to make a choice. Ouradvice, then, is to skip the Phillips-curve and Okun’s-law part and build up the aggregate supply curvedirectly in output-inflation space. In equations (12.7),(12.9), (12.10) and (12.11) this requires replacing thecyclical indicator (U-U) by (Y-Y) as in (12.12). All thereasoning goes through with this limited change.

References

Blanchard, Olivier J. (1990), ’Why does Money AffectOutput: A Survey’, in B. Friedman and F. Hahn, eds.,Handbook of Monetary Economics, (Amsterdam: NorthHolland).

Bruno, Michael, and Sachs, Jeffrey D. (1985), TheEconomics of World Stagflation, (Cambridge, Mass.:Harvard University Press).

Romer, David (1995) Advanced Macroeconomics, NewYork, McGraw-Hill.

4 Naturally, this is not exactly correct in a growing economy.With a sufficiently rapid real growth rate, steady state realmoney demand may rise fast enough to eliminate the need forhigher inflation.

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CHAPTER 13

AGGREGATE DEMAND AND AGGREGATE SUPPLY

Objectives

This is the central chapter which provides the synthesisof the macroeconomic model, which in some form oranother, is the common basis for dialogue betweenmacroeconomists of whatever direction or school.1 Asis customary, it presents the aggregate demand andsupply analysis. A key difference is, in line withChapter 11, that this chapter deals separately with fixedand flexible exchange rates, by-passing the closedeconomy and thus differing from presentations found inmost macroeconomics textbooks.

Having derived the aggregate supply schedule in theprevious chapter, the first order of business here is toderive the aggregate demand curve. It is done byintroducing inflation into the IS-LM model in a fairlyconventional manner.

Under fixed exchange rates, nominal money isendogenous and adjusts to inflation so that the moneysupply remains in line with demand. Inflation has short-run real effects on aggregate demand because, with afixed nominal exchange rate, it leads to a realappreciation. Under flexible exchange rates, nominalmoney growth is exogenous. Higher inflation means acontraction in the real money supply which, through theusual mechanisms, reduces aggregate demand.

In both cases the aggregate demand curve isdownward sloping. Yet, students should be remindedthat the mechanism at work is different. A carefulderivation of the demand schedule along the linessketched above is one way of driving the point home.Another way is to manipulate the AD and AS curves intandem with the IS-LM system when studying shifts inexogenous real spending or policy variables. This can,however, be a difficult exercise. Those who areinterested should refer to theoretical problem 14.3 andthe proposed answer.

1 We think that even real business cycle theories can becouched in terms of this framework, although it does notstress the sources of real fluctuations (i.e. productivity, laboursupply, or taste shocks). Empirical evidence that demand andsupply disturbances are both important for the USA can befound in Gali (1992).

Two-step reasoning: the short-run and the long-runanchor

A large component of this chapter is about dynamics,but dynamics is difficult and, by and large, beyond thelevel of this textbook.2 To circumvent the difficulty andstill allow students to understand the general directionof dynamic adjustment, the treatment focuses on twopoints in time, the short run and then the steady state.Filling the gap in between is done heuristically throughreasoned guess-work.

The short-run effect is found by asking whether thedisturbance affects the demand side, the supply side, orboth. Moving the corresponding schedule(s)accordingly gives the new temporary position. The longrun is found through a different reasoning: domesticinflation is determined by foreign inflation under fixedrates and by domestic money growth with flexible rates;output returns to its trend level, which in the meantimemay be higher. The dynamics can only be sketchedbecause the full dynamic behaviour is not completelyspecified but in most cases it involves gradualadjustments of the supply (and possibly demand)schedule until both curves pass through the long-runequilibrium point.3

The output gap

In the output inflation space the horizontal axisrepresents the output gap, not output itself. The reasonis practicality: with steady state growth output, the long

2 Graphically it requires the use of phase diagrams; moreimportantly, it requires a stand to be taken on the source (i.e.wages versus prices) and nature (overlapping contracts,misperceptions cum signal extraction, menu costs) ofnominal rigidities.3 In the notes to the preceding chapter this point isdeveloped. The position of the aggregate demand curve mayalso depend on output last period, which will complicate theanalysis considerably (for those who remember, Dornbuschand Fischer’s (1987) textbook took this tack in a linearframework).


30

run aggregate supply curve would move to the rightcontinuously, rendering the graphical analysiscumbersome and messy. Using the output gap getsaround this difficulty but creates a problem of its own.Some disturbances may have a permanent level effecton output, i.e. they change the trend growth path butnot the rate. In the output gap inflation space this mightgo unnoticed.

The way to capture this is somewhat complicated; asimpler alternative is to change the horizontal axis backto the level of output rather than the output gap (this isdone in Exercise 1 of Chapter 17).

Teachers might find a sketch of the solution to beuseful.4 Fig. 1a illustrates a once and for all drop intrend output which then resumes its old growth rate.Actual output is shown to recover its new trendgradually. In Fig. 1b this is shown as a leftward shift ofthe long-run aggregate supply line and the associatedshort-run supply schedule AS’. At the initial point A, asin Fig. 1a output is above its new trend growth path. If,for example, money growth is unchanged, long-runinflation remains the same and the long-run equilibriummust be at point B. The post-shock position is at pointC. Convergence will include shifts in both the demandand supply schedules. While the shifts of the supplyschedule are familiar, that of the demand schedule isnot. What happens though is that wealth (or permanentincome) falls (see Fig. 1a) so demand falls accordingly.If the downward adjustment in demand wereimmediate, the AD schedule would instantaneouslymove to its new position, passing through point B. Thevarious paths depicted in Fig. 1a are all possible,depending on the dynamics (as well as assumptionsabout the consumption function and other componentsof spending).

Using the AS-AD framework

Merely understanding the AS-AD framework is notreally sufficient. Since this is the single most importantand useful tool to be brought away from amacroeconomics course, it is essential that studentsrecognize how powerful it is for thinking about the realworld. The examples provided in Section 13.4 dealwith the most obvious cases. The model is alsoextensively used in the next chapter to provide aninterpretation of business cycles. Several exercises arealso designed to provide good practice. One recipe forhammering in the usefulness of the AS-AD model whenfirst exposed, is to identify a head-line economic issueat the time of teaching and provide an AS-AD

4 It might be used to provide an extension of the treatment ofthe oil shocks in Section 13.4.1 where this point isintentionally downplayed.

interpretation in class. This can be accompanied byrelevant press clippings.

Since the chapter is meant to be a synthesis ofprevious chapters, teachers should not hesitate to returnto earlier results (e.g. emphasising the role of labourmarkets in determining the speed of adjustment toshocks and possibly trend output). Later chapters aremainly devoted to doing just that but any time devotedto that effect is well spent.

An important issue in this regard is largelysidestepped: the empirical slopes of the AD and AScurves. This is clearly important for predicting theoutcomes of various shocks and policy interventions. Afew estimates exist (see Gali, 1992) but, in principle,simple reasoning can take us a long way. For example,in Japan, the near perfect harmonization of wagebargaining plus extensive profit sharing reducesnominal rigidities originating in labour markets to nearzero; those coming from the price-setting side remain,leading to a relatively steep AS curve. In the USA, asemi-open economy in which long-term nominalcontracts are important, explicit cost-of-livingadjustment is rare and where unions represent a minorfactor in wage determination, one would expect the AScurve to be relatively flat (Sachs, 1980). Europe, withannual but overlapping bargaining and a strong trade-union movement and often institutionalized inflationcompensation, is somewhere in between. In moreadvanced courses, instructors may also wish to stressthe endogeneity of the slope of the AS curve: it maydepend on the variability of inflation (Lucas, 1973) orthe level (Ball et al., 1988).

Figure 1a and 1b from chap. 12 of the Instructor’sGuide, 1/e here


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Interest parity

The financial integration line in the underlying IS-LMmodel can be troublesome because the interest paritycondition involves exchange rate expectations. In thefixed exchange rate case, it is simply assumed that theexisting parity is credible so that i=i*. With flexibleexchange rates, this is no longer a tenable assumption.The reasoning implicitly assumes that the financialintegration line does not move, which is actuallyincorrect. A full treatment is presented in Chapter 19.

As an example for advanced students, consider thecase of a monetary expansion under flexible exchangerates as in Section 13.3.3. The rightward shift of the ADschedule in Fig. 13.10 corresponds to a shift of the LMschedule met along a supposedly unchanged financialintegration line by a new IS which has moved rightwardto reflect the real depreciation. But as inflation risesalong the AS schedule (from A to B) it must be the casethat the exchange rate depreciated even more thanprices rose. Does it not affect the expected rate ofdepreciation and therefore the financial integrationline? One answer is the overshooting result (seeChapter 19 and references therein) which implies anexpected appreciation and a downward shift of thefinancial integration line. This provides the appealingresult that the domestic interest rate temporarily fallsafter a monetary relaxation. Over time, though, thefinancial integration line rises to reflect the fact that, inthe long run, a higher rate of money growth leads tomore inflation and a permanently higher rate ofdepreciation (or a lower rate of appreciation). Theunderlying IS and LM schedules both shift to the leftduring the transition to reflect the fact that risinginflation (AS moves up along the AD schedule) reducescompetitiveness and the real money supply.

References

Ball, Lawrence, Mankiw, N.Gregory, and Romer,David (1988), ’The New Keynesian Economics and theOutput-Inflation Tradeoff,’ Brookings Papers onEconomic Activity, 1: 1-65.

Dornbusch, Rudiger, and Fischer, Stanley (1987),Macroeconomics, 4th ed. (New York: McGraw-Hill).

Gali, Jordi (1992), ’How Well Does the IS-LM ModelFit Postwar US Data?,’ Quarterly Journal ofEconomics, 107: 709-38.

Lucas, Robert E. Jr. (1973), ’Some InternationalEvidence on Output-Inflation Tradeoffs,’ AmericanEconomic Review, 63: 326-34.

Sachs, Jeffrey D. (1980), ’The Changing CyclicalBehavior of Wages and Prices in the United States,1890-1976,’ American Economic Review, 70: 78-90.

Students can also be referred to existingmacroeconomic models. Most of them are built aroundthe AS-AD model. Instructors will be familiar with themodels in use in their own countries. At theinternational level, the IMF’s MULTIMOD has themerit of using rational expectations. It is presented in:

Masson, Paul (1990) MULTIMOD Mark II: A Revisedand Extended Model, IMF Occasional Paper.

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CHAPTER 14

BUSINESS CYCLES

Objectives

This chapter is new to the second edition. It presentsthe student with an exposition of: 1) the main empiricalfeatures of business cycles; 2) the role of pricestickiness in explaining cyclical fluctuations, thusintroducing the Real Business Cycle (RBC) theory.The other chapters mostly attempt to downplaycontroversies between the various schools of thought. Itis impossible to do so for business cycle theories.Instead, we use this chapter to illustrate the importanceof assumptions about the degree of price flexibility.Indeed, one way of presenting this chapter is that itprovides another exposition of the principles presentedin Chapter 13. The AS-AD framework is put to work to“reproduce” business cycles. Its flexible price versionis the backbone of our presentation of the RBC. Whileit is not completely possible to subsume the debate onbusiness cycles to the issue of price flexibility, doing sooffers continuity and coherence of exposition.

The strategy adopted here parallels that used in thegrowth chapter (Chapter 5), and the two arecomplementary as both deal with GDP growth, theformer focusing on the trend, the present one withfluctuations around trend. In both cases, we presentstylised facts, setting objectives for the theory to bedeveloped. Thus students know what to look for, andthey are given a motivation to work through thetheoretical material.

The stylised facts

We have resurrected the old Burns-Mitchell diagrams,which had fallen into some sort of disrepute followingthe attacks from the Cowles Commission in the earlypost-war period. This approach has enjoyed a revival,recently (Quah (1994), King and Plosser (1994)).Nowadays, we feel, economists are sufficiently wellequipped in rigorous statistical methods to studybusiness cycle regularities (e.g. spectral analysis) thatthere is little risk of being carried away by the nakedeye. In any case, the results that we brand as stylisedfacts are also well-established in the professional

literature (see some references at the end of thisChapter.

The procedure that we used to construct thesediagrams is described in Figure 14.3. Because we usestandardised data we only look at period since 1970,which limits the number of completed cycles and mayreduce the “generality” of the stylised facts that wewish to reveal. For this reason, we have decided to useaverages over several countries. We have not detrendedthe data mainly because we wish students to see therelative size of the growth trend and of cyclicalfluctuations. In the classroom, instructors may presentBurns-Mitchell diagrams which include theuncompleted cycle under-way: this allows a discussionabout the particularities of the current cycle which islikely to echo familiar debates in the media.

While presenting the stylized facts we find it soundto refer to the microeconomic principles developedmuch earlier (Chapters 2 to 6). At this stage, studentsoften think that “IS-LM is enough” and that themicroeconomic foundations have not be much used inthe subsequent chapters. The variability of componentsof aggregate demand offers a nice opportunity to reviveinterest for microeconomic principles and also toprepare the presentation of the RBC theory.

Deterministic versus stochastic cycles

Students are often told about either deterministic cyclesor about standard cycles (as presented in Box 14.1).We take a skeptical view about these rather mechanicalviews, partly on the basis of modern statistical analysis.The difference should not be overplayed. For example,Kondriateff cycles can be seen as stochastic cyclestriggered by major discoveries which turn out to occurat frequencies of 40-60 years.

More interesting is the generality of the impulsepropagation mechanism. Yet, the presentation is tricky.On the one hand it is important to show students hownoise is transformed into cycle-like fluctuations. Thiswill equip them with a healthy skepticism when itcomes to explaining month-to-month wiggles. On theother hand, we do not want to give the impression that“anything can be explained away”. Instructors may


33

want to emphasise that macroeconomics is preciselyuseful because it explains the nature of propagation.

We present a few lags (Robertson, Lundberg) asexamples of the more general fact that empiricalmacreoconomic relationship include various lags orvarious duration. What must be made clear to thestudent is that it is the presence of lags which makespropagation more than just transmission. This is whatthe multiplier-accelerator example is designed to show.This is just an example: real life is more complex, ofcourse, much like different wave-lengths interfere toproduce a rich visual or sound outcome.Mathematically, we just want to have differenceequations to produce dynamics. Wherever possible,instructors should spend some time presentingdifference equations, including the possibility ofgenerating cyclical responses. Box 14.2 and Figure14.10 provide some material to that effect.

Using AS-AD

Implicitly at least, the dynamic use of the AS-ADframework involves many lags. The result is a fairlycomplicated dynamic behaviour, as the Appendixshows. Accordingly, in the main text, we refrain frompretending to show the detailed evolution of the system.We posit the short-run effect, the long-run equilibrium,and sketch a few principles which can guide theanalysis of the transition. Students often want to seemore at this stage. It is not a good idea to attempt tostudy the details since the exercise is rather daunting(e.g., whether convergence is oscillatory or not dependson parameter values). Instructors are advised to stick tothe few principles that are unambiguous and show howthey help broadly map out the system’s evolution. Oneof us has had enormous success "simulating" live asimple Hicks-Samuelson model on white noise, using aspread-sheet program.

On the other hand, for technically advancedcourses, instructors may want to show the details: oneof the simplest possible AS-AD models is presented inthe Appendix and displays quite some richness (e.g. itshows when and why loops occur). Note that this modelassumes perfect foresight and sticky prices, unlike theSargent-Wallace models which rely on imperfectinformation to obtain deviations from full employmentequilibria.

Real business cycles

There are two ways of looking at the material presentedunder this heading. One is that it is possible to explainbusiness cycles even with purely flexible prices.Second, it shows how the macroeconomic implicationsof the principle of intertemporal substitution, largely

underplayed in the IS-LM and AS-AD analyses. Evenif they have doubts that RBC theory in and by itselfprovides a complete interpretation of business cycles,instructors may point out that these mechanisms can beat work in economies with sticky-prices.Another way of presenting the RBC theory is that itasserts that, given exogenous productivity shocks,economic agents are as well-off as they can be, giventhe circumstances. For this reason, no policy action canimprove their inter-temporal welfare: any benefitprovided by a temporary policy action will have to bemore than paid for later on.

RBC vs. sticky prices

Our intention here is to build up a solid basis for thedebate Keynesian vs. Classical economics whichappears in Chapter 16 (instructors should be aware thatthis topic is taken up explicitly later on). We attempt topoint out how data can be made the referee of thiscontroversy. This is why we display some additionalBurns-Mitchell diagrams at the end of the chapter.Three stylised facts presented there merit attention.First, real money is usually found to be a procyclicalleading indicator, which accords with sticky pricesmodels, but not easily with RBC theory. Second, aspredicted by the RBC, productivity is procyclical, whileit is expected to be counter-cyclical in sticky pricemodels. Third, real wages turn out to be acyclical, notprocyclical as expected in RBC models orcountercyclical as predicted by most Keynesianmodels.

Trends and cycles

For more technically-oriented courses, this chapterprovides an opportunity of discussing standardtreatments of macroeconomic time series. Here are fewideas of what can be done:- seasonality: time series like private consumption realmoney (not to mention output in agriculture) typicallyexhibit seasonality (Christmas shopping dominates).Procedures to deseasonalize include the use of movingaverages or the so-called X-11 Census method whichremoves estimated seasonal factors.- stationarity: students may be presented with thedefinition of stationarity (stable moments) and with thedifference between zero and first-order of integration,and to be told that most macroeconomic time series areI(1).- procedures can be discussed which separate trendsfrom cycles. They are briefly presented in theAppendix.


34

Additional literature

A simple and lucid presentation of the RBC theory is inMcCallum (1989). A critical review is in Summers(1986) (see text). King (1995) presents in a clear waythe modern methodology of business cycle research.Simkins (1994) offers a critical review.

Some of the references provided refer to debates on therole of price rigidities to explain historical episodes,and may be more informative than stylised facts alone.Students often enjoy (re)visiting the Great Depression:two classics are quoted in the text -- Kindleberger(1986) and Temin (1989). Additional readings tosuggest include Mankiw (1989) and Bernanke andParkinson (1991): they deal with the procyclicality ofproductivity during the Great Depression. Romer (1986)looks at long time series to challenge the view that realGDP has become more stable after World War II.

References

Bernanke, Ben and Parkinson, Martin (1991)“Procyclical Labor Productivity and CompetingTheories of Business Cycles: Some Evidence fromInterwar US Manufacturing Industries”, Journal ofPolitical Economy, 99: 439-59.

King, Robert G. (1995) “Quantitative Theory andEconometrics”, Federal Reserve Bank of RichmondEconomic Quarterly, 81: 53-105.

King, Robert G. and Plosser, Charles I. (1994) “RealBusiness Cycles and the Test of the Adelmans”,Journal of Monetary Economics, 33: 405-38.

Mankiw, N. Gregory (1989) “Real Business Cycles: ANew-Keynesian Perspective”, Journal of EconomicPerspectives, 3: 79-90.

McCallum, Bennett (1989) “Real Business Cycles”, in:R. Barro (ed.) Modern Business Cycle Theory, ChicagoUniversity Press, Chicago.

Quah, Danny (1994) “Measuring Some UK BusinessCycles”, unpublished, London School of Economics.

Romer, Christina (1986) “Is the Stabilization of thePostwar Economy a Figment of the Data?” AmericanEconomic Review, 76(3): 314-34.

Sargent, Thomas (1987) “Macroeconomic Theory”,Academic Press, New York.

Simkins, Scott P. (1994): “Do Real Business CyclesReally Exhibit Business Cycle Behavior?”, Journal ofMonetary Economics, 33: 381-404.

35

CHAPTER 15

FISCAL POLICY, DEBT, AND SEIGNIORAGE

Objectives

Thus far fiscal policy has been presented rathermechanically. This chapter plugs a number of holes leftover by the previous chapters’ preoccupation withreaching the AS-AD synthesis as fast as possible.

First, the chapter presents the welfare arguments forpublic spending. This is not really macroeconomics, sothe presentation is brief.

Second, the text returns to the early chapters’ focuson optimal intertemporal choices. This is used here toask when and how the government should use its taxingand spending powers to ease out cyclical fluctuations.Consumption smoothing plays a central role here andleads to tax and public-spending smoothing results.Attention is drawn to the fact that active fiscal policymust be based on market failures and some cases arediscussed, e.g. credit rationing or price and wagerigidities.

Third, the conventional automatic stabilizers arepresented. This allows us to draw attention to thepartial endogeneity of budget figures, i.e. thedistinction between discretionary and non-discretionaryspending.

Fourth, the explosive nature of the public-debtprocess is discussed in depth, since nationalindebtedness is a perennial favourite of policy-makersand politicians alike. Among other things, this allows afull treatment of the budget constraint in a growingeconomy and the link between the deficit, seigniorage,and inflation.

Use of the material

This chapter is a first opportunity to draw together anumber of results from previous chapters. It also offersbackground for discussing current issues. Now that thestudents understand the broad picture (the AS-ADframework) they can fully appreciate debates aboutfiscal policies, and press clippings may profitably bedistributed and discussed in class or in take-homeassignments. Of course, in shorter courses, most of the

material here may be presented in a more cursoryfashion.

Welfare

Because debates on the size and role of the governmentinvolvement are so highly politicized, the text adopts afairly narrow economic point of view. Usingcomparative data, as in Tables 15.2, 15.3 and 15.9, isoften a good way of escaping parochial debates. Morecomparative data on budgetary issues are available inOECD publications and provide the basis forinteresting class discussions.

Public debt

In principle, what matters are levels of net public debt.However, in Table 15.6 we present gross debts (as apercentage of GDP). Available net debt figures (e.g.from the OECD, like the gross figures that we use) takeinto account public holdings of state-owned firms andother commercial properties. Our choice is due to theserious limitations of net figures. First, the valuation ofstate properties is highly arbitrary (e.g. state ownedfirms are not priced on stock markets). Second, somestate assets include loans which may never be repaid infull. Third, these estimates overlook a number ofpotential and important assets and liabilities. Forexample, current retirement legislation implies futurepensions which will be quickly rising when the babyboom generation born after World War II reachesretirement age: these are unmeasured liabilities (Table15.4 elaborates on this point). Probably in recognitionof the limits of net debt figures, the Maastricht treatysets limits on gross, not net national debt.1

Debt dynamics

1 See Buiter et al. (1993) for details on the debt ceiling andthe debate over its necessity in a future European MonetaryUnion.


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The material in Section 15.4 is most easily presentedusing mathematics, as in the Appendix. The textattempts to avoid maths as much as possible and iswritten to be comprehensible to students with no propermaths background. Teachers may want to check that thetechnical difficulties are not a barrier to understanding.

An intuitive way of making the point on debtstabilization is to describe the evolution of the debt-GDP ratio as a race between the numerator (growing atthe rate of the public sector borrowing requirementdivided by the current debt stock) and the denominator(growing at the GDP growth rate). When the primarybudget is in balance, the numerator growth rate isdetermined by debt service, i.e. by the interest ratetimes the debt level.2 This is why it is essential tocompare the interest rate and the GDP growth rate:either the nominal interest rate versus the nominal GDPgrowth rate, or the real interest rate versus the real GDPgrowth rate.

Stabilising debts

European public debts have risen to high levels overthe 1980s, an evolution unheard of in peacetime. Thisis one reason why nearly everywhere debt reduction hasbecome the main objective of economic policy. Thepriority given to debt reduction is further reinforced bythe Maastricht Treaty (which is fully described inChapter 21). This has led to a new economics of fiscalstabilization. Instructors who wish to develop thisquestion can use two recent articles. Alesina and Perotti(1995) show which measures work (cutting spending onpublic employment) and which ones fail (cutting publicinvestment). Giavazzi and Pagano (1996) show that insome cases fiscal retrenchment can be expansionary (astrongly non-Keynesian effect), as may have been thecase in Ireland and Denmark in the late 1980s.

References

Alesina, Alberto and Perotti, Roberto (1995) ‘FiscalAdjustments: Fiscal Expansions and Adjustments inOECD Countries’, Economic Policy, 21:205-248.

Buiter, Willem H., Corsetti, Giancarlo, and Roubini,Nouriel (1993), 'Excessive Deficits: Sense andNonsense in the Treaty of Maastricht,' EconomicPolicy, 16: 57-100.

Giavazzi, Francesco and Pagano, Marco (1996) “Non-Keynesian Effects of Fiscal Policy Changes:

2 Of course, in reality the national debt is rarely financed atthe current short term interest rate, but rather at a wholespectrum of short and long maturities.

International Evidence and the Swedish Experience”,Swedish Economic Policy Review.

The May 1996 issue of IMF’s bi-annual publication,World Economic Outlook, focuses on fiscal policy. Itincludes a wealth of analyses and data which provideexcellent classroom material. See also the June 1996issue (No. 59) of the OECD Economic Outlook.

37

CHAPTER 16

THE LIMITS OF DEMAND MANAGEMENT

Objectives

This chapter is meant to be fun for both students andinstructors alike. It reviews old and highly popularmaterial -- the inevitable discussion of Keynesiansversus Monetarists -- as well as going over more recentand exciting research on the interaction betweenexpectations and policy. Like Chapter 15, it providesmany opportunities to apply results established inearlier chapters and to discuss current issues.

The main purpose of this chapter is to continue thetask of the previous one, namely to convey some of themore subtle aspects of macroeconomic policy and toremove some of the optimism conveyed by the AS-ADframework of Chapter 13. Chapter 15 hinted that fiscalpolicy is not as effective, even in the short run, assuggested by the AS-AD framework. Chapter 16 isintended to amplify this scepticism to governmentdemand policy in general.

The great debate

No macroeconomics course can be complete withoutsome discussion of the on-going debate betweenKeynesians and Monetarists. In the text, so far, thisdebate has been suppressed because we believe thatstudents should not be told that "economists disagreeabout everything" and therefore know nothing. This isboth untrue (we hope) and highly demotivating for thestudents (we know). We also think that classes shouldfirst be presented with a framework that they can under-stand and then shown which of its components arecontroversial.

In presenting the debate we have intentionallysuppressed discussion of issues which, we believe, havebeen resolved: the slopes of the IS and LM curves, theliquidity trap, whether or not the slope of the long-runPhillips curve is vertical. Rather we have cast thedebate in terms of the desirability of governmentinterventions. As many have pointed out, the centralissue is the rigidity of nominal wages and prices.Assuming the foundation of Chapters 6, 12, and 13have been well laid, this will be relatively easy for thestudent to grasp. In addition the chapter establishes a

link with policy-making which can be easily shownwith the AS-AD apparatus, and which relates directly tothe issue of voluntary versus involuntaryunemployment. Finally, it also provides a lead intoanother inevitable and related topic: the costs ofinflation.

Time and expectations

Section 16.3 presents the results which have soprofoundly changed the field of macroeconomic policyin the late 1970s. They all hinge on the importance forpolicy of expectations, and how policy andexpectations affect each other. This leads to theconcepts of reputation and credibility. The generalimplication is that the effectiveness of policy (demandmanagement) is further constrained by the fact thatpolicies are predictable; once they are predicted, theylose some or all of their effectiveness.

Students usually find it intuitive, and enjoy the ideathat the public tries to out-guess the authorities (and hasan interest in doing so!) and that the authorities, havingonce lost their ability to surprise the public, are betteroff bound by rules.

Political economy

Recent work has reduced the gap between economicsand political science. Technically, policy actions usedto be considered as the archetypal exogenous variables.The new literature endogenizes the behaviour of policy-makers -- by noting that they merely respond topolitical conditions which are themselves shaped byeconomics. Put in an extreme form, policy-making isreactive, not active. Because the literature is still in itsinfancy and shaped by US institutions we give only abrief summary.1

References

Alesina, Alberto (1988), ’Macroeconomics andPolitics’, NBER Macroeconomics Annual, 3: 13-62. 1 Readers interested in more details can see the surveys inNordhaus (1989) and Alesina (1988).

38

Nordhaus, William (1989), ’Alternative Approaches tothe Political Business Cycle,’ Brookings Papers onEconomic Activity, 2: 1-49.

39

CHAPTER 17

SUPPLY-SIDE AND UNEMPLOYMENT POLICY

Objectives

The two previous chapters showed the limits ofdemand-side policies. Supply-side policies have beenbelieved to be the response to disenchantment withdemand-side policies. Usually it means less governmentbut not always. The common idea is that everyeconomy contains pockets of inefficiencies which canbe rooted out either by more efficient functioning ofmarkets or by the state. This chapter organizes the ideaswhich lie at the heart of most of the supply-side policieswhich have been tried over the past decade or so.

By way of examples, we focus on two areas wherethe principles of supply-side policies are readilyapplicable: taxation and labour markets. This choice isobvious: tax reform is on the political agenda of manycountries in Europe while unemployment is arguablyEurope’s worst supply-side failure.

Micro- and macroeconomics

We call supply-side policies all those interventionswhich aim at improving an economy's overallefficiency or productivity. Because a large patchworkof policies falls under this rubric, the chapter starts byexamining the most common sources of inefficiency.This has the virtue of providing a unifying framework,strengthening the analytical content of the chapter, andestablishing links with previous results.

We start by a reminder of the principle of laissez-faire in economies characterised by perfectcompetition. This is used to motivate a review of themain sources of deviations from the perfect competitionparadigm. Here again the students will note that theborder between micro- and macroeconomics is fuzzy.Supply-side policies mainly draw the macroeconomicimplications of a variety of microeconomic principles.

A difficult chapter to teach

This is a difficult chapter to teach. It covers a lot of(mostly microeconomic) ground. It deals with a domainwhere there is still little empirical evidence available onwhich to judge the effectiveness of policies. Yet, it is

useful because it represents the evolution of policy-making and also because most of the issues arepolitically controversial.

For this reason, we have presented a large selectionof policy issues to motivate the theory. Hopefully, atthe time this class is taught, instructors will be able torefer to current policy debates and ask students toprepare relevant economic arguments. Alternatively,the chapter can be taught in reverse: starting with eithertax reform or unemployment as a policy issue, then askwhat principles are needed to think through the policyoptions, and thus come back to the principles expositedin Section 17.2.

Public goods and taxation

Section 17.3 returns to a theme already discussed inChapter 15: public goods are needed but the taxeswhich finance them are distortionary and are associatedwith welfare costs. While Chapter 15 used this idea tocaution against activist fiscal policies, the approachtaken here asks rather what are the public goods thatgovernments must provide and how they can beprovided in the most efficient way.

Most of the answers come from the literature onpublic finance (e.g. the principles of efficient taxation).The principles involved are mostly applied, however, tomacroeconomic concepts developed in earlier chapters-- savings, labour, capital accumulation -- thus closelyechoing the themes developed in the chapter on growth(Chapter 5).

Structural unemployment

Section 17.4 can be seen as a sequel to Chapter 6. Itcan be taught separately from the rest, if only todevelop the analysis of equilibrium unemployment thatwas only briefly exposited. Instructors who considerdropping this chapter could -- in our view, should --still use the material of this section, either on its own orwhen presenting Chapter 6.


40

The three curves

This chapter introduces three empirical curves. Each ofthem requires qualification but can be used to motivatetheoretical developments.

The Laffer curve easily attracts attention. Its logicseems inescapable and, for this reason, should beheavily qualified.1 Students typically see its relevanceand they recognize that the issue is being publiclydebated.

The Beveridge curve, an empirical regularity withrespectable microfoundations (see Blanchard (1991)),provides a possible pretext for the discussion ofinformation and a search in the macroeconomy.

The Calmfors-Driffill (1988) “hump-shape” curvehas also received some microfoundation, but itsempirical status is often debated. It is a very usefulinstrument to focus the student’s mind on labourbargaining, the role of trade unions and governments,the existence of labour strikes, etc.

Other avenues

One subject which has received little attention in thischapter but which can be developed alongside publicgoods, is the role of infrastructure investment andeducation. These topics were discussed in Chapter 5.While the evidence on the role of public investment incross-country growth performance is weak (Barro,1991), this line of thought is clearly behind theEuropean Commission’s plans to increase spending onhighways, roads, and bridges as part of a long termsupply-side policy to improve total factor productivity.The transformation of Eastern and Central Europe canbe seen in a similar light. Reference can also be madeto the literature on economic development and tostrategies applied in developing countries. The usualgrowth-literature papers citing the importance of humancapital (again Barro, 1991 or the references in Chapter5) can be used to motivate supply-side policies whichtarget improved education and training.

References

1 There is some evidence from the United States (Lindsey1987) that the behaviour of taxpayers changed after the taxcuts of the Reagan administration -- due less to increasedlabour supply than to increased income reporting and fewertax avoidance activities.

Barro, Robert (1991), 'Economic Growth in a CrossSection of Countries,' Quarterly Journal of Economics,106, May: 407-44.

Blanchard, Olivier J. (1991) “Two Tools for AnalysingUnemployment”, in: M. Nerlove (ed.) Macro-economics and Econometrics, IEA ConferenceVolume 99: 102-27, New York University Press, NewYork.

Calmfors, Lars and Driffill, John (1988), "BargainingStructure, Corporatism and MacroeconomicPerformance,"Economic Policy 6: 16-61.

Lindsey, Lawrence (1987), 'Individual TaxpayerResponse to Tax Cuts: 1982-1984', Journal of PublicEconomics, 33: 173-206.

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CHAPTER 18

FINANCIAL AND EXCHANGE MARKETS

Objectives

This chapter marks a transition between open-economymacroeconomics and a section devoted to thedetermination of the exchange rate. It has two mainpurposes: 1) to present key features of financial andexchange markets; 2) to develop the principle of marketefficiency.

Market institutions and instruments

The sections on financial and exchange markets aremostly descriptive. They can be left to reading at home,teachers simply summarizing the key points in class asthey are listed in the summary section. Depending onstudent interest, there may be no need to explain theseinstruments in detail.1 It may also be useful to checkthat students know how to compute a one-week or one-month yield at annual rate.

Market efficiency

Students must clearly understand the concept of marketefficiency: it rules out systematic, but not random andunpredictable gains. They should be able to distinguisharbitrage (no risk involved) from speculation (risktaking). The discussion on bubbles in Section 18.3.3.3may seem esoteric but it is worth going over for threereasons. First, it provides a check on students’understanding of arbitrage. Second, it illustrates clearlywhat is meant by ’fundamentals’. Third, it may be highlyrelevant to the early 1990s, which saw spectaculardeclines of stock and house prices in many countries. Inthe UK, Sweden, France, Finland, Japan, among others,banks have been nearly bankrupted as a result of theheavy losses suffered in real estate investments.

1 An exception is that of forward contracts which play animportant role in Chapter 19.

Further references

Several commercial banks publish booklets for theircustomers, designed to explain financial and exchangemarkets. These booklets are usually very simple andcontain many details on institutions and/or instruments.

The Bank for International Settlements in Baselpresents useful data in its Annual Report, especially onEuro-markets.

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CHAPTER 19

EXCHANGE RATES IN THE SHORT RUN

Objectives

The theory of exchange rate determination is bothdifficult and exciting. This chapter proposes anefficient short cut without giving up much substance.The challenge is to cover the material in a way that isclear and simple. We have proposed the followingsequence of topics:- Establish the tension between the ’long run’ view of

the exchange rate in Chapter 7 with the data, as wellas with Mussa’s stylised facts.

- Start with the interest parity conditions alreadypresented in Chapter 11. Then, by manipulating thiscondition, it is possible to show the essentials ofexchange rate determination: forward-looking,unpredictable ’jumping’.

- With a little bit more complexity and simply using agraphical apparatus, it is then possible to establishthe overshooting proposition and, at the same time,to link the short run, developed in this chapter, withthe long run as established in Chapter 7.1

Mussa’s stylised facts

Stating ex ante what is to be explained serves threemain purposes. First, it gives students a clear view ofwhere the lecture is leading. Second, students’ attentioncan be maintained by reminding them which stylizedfact is being explained each time a new result isachieved. Finally, it represents an anchor in a storm offairly complex material. Use of a transparency listingthe stylised facts and checking them, is advisable.

The interest parity relationships

Interest parity has been briefly introduced -- andextensively used -- earlier. Here it is explained in detailand with greater precision. The main difficulty when

1 If Chapter 7 has been skipped earlier, as is entirely possible-- see instructions in this Guide -- it must be covered beforeChapter 19.

presenting the parity relationships is to prevent studentsfrom being confused about when each one holds, andhow it all relates to forward premiums. The use ofdifferent symbols for different premiums and thesummary Table 19.3 are designed to clarify matters. Itshould be emphasised however that the risk premiaintroduced in (19.4) and (19.9) are really symbolicrather than derived from a proper theory, and that thereis no presumption whatsoever as to their sign. In factthey are known to be very unstable, both in sign andsize.2

It is also well worth going over the decomposition(19) of the forward forecast error between the riskpremium and the market forecast error. Note thatforecast errors are no proof of market inefficiency aslong as they are not systematically exploitable forprofit.

Forward looking exchange rate

Notice that all terms in the interest parity condition(19.15) are endogenous so that the whole exerciseconducted in Section 19.3 should not be interpreted asa theory of exchange rate determination. Yet repeatedsubstitutions yield an important intuition for theforward-looking nature of the exchange rate (as for allassets).

It is often difficult to make Fig. 19.5 understandableto students on the first try. There are two ways ofproceeding. The easy way is to say that when theinterest rate rises, capital flows in and the exchange rateappreciates. This is true of course but it misses thewhole idea that exchange rates are forward looking. Soit is worth confusing students a bit by observing that ahigher interest rate means that the exchange rate isexpected to depreciate: as long as the expected rate ofdepreciation equals the interest differential (plus a riskpremium factor, if applicable) there are no capital flowsat all. To understand what happens to the exchange rate

2 Some instructors may prefer to assume that the riskpremium is zero, and attribute deviations from UIP to the’peso problem’.


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now, there is no short cut: we must use theory to helpus pin down the nominal exchange rate in the long run(see below).

Time spent interpreting (19.19) is a goodinvestment. In particular, it is a good idea to point outvery early that the link between the short run (and theenormous amount of volatility) and the long run is thatthe long run exchange rate is always present in thebackground as captured by the ’mast’ or leading termEt+n+1.

Overshooting

The formal presentation of the ’Dornbusch model’ in theAppendix can easily be avoided, where necessary,thanks to the graphical apparatus developed in Section19.4. There are three key intuitions which must beestablished.

First it is price rigidity which forces an exchangerate to move ’too much’. Appealing to the principle ofphysics, that when there is excess pressure in a systemit must find one way or another to escape, is a usefulanalogy.

Second, note that the mix of highly volatileexchange rates and sticky prices implies that the realexchange rate, by and large, moves like the nominalexchange rate in the short run. This means that nominalfluctuations -- nominal interest rates pushing aroundnominal exchange rates -- have real effects via the realexchange rate. This is a key channel for transmission ofmonetary policy in open economies under flexible ratesas argued in Chapter 11 and after.

Third, the so-called fundamental determinants ofthe exchange rate mostly consist of expected futurevariables such as money and real aspects ofcompetitiveness. The past matters relatively little. Thisimmediately establishes a link, somewhat under-emphasised in the text, with the authorities’ credibilityin pursuing a particular set of policies. Note also thatthe overshooting result predicts that the exchange rateis likely to deviate frequently by a wide margin fromwhat is warranted by the equilibrium real exchange ratepresented in Chapter 7.

References

Dornbusch, Rudiger (1976), ’Expectations andExchange Rate Dynamics’, Journal of PoliticalEconomy, 1161-76.

Frankel, Jeffrey, and MacArthur, Alan (1988), ’Politicalvs. Currency Premia in International real InterestDifferentials’, European Economic Review, 32: 1083-114.

Frankel, Jeffrey, and Meese, Richard (1987), ’AreExchange Rates Excessively Variable?’, NBERMacroeconomic Annual, 2: 117-62.

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CHAPTER 20

THE INTERNATIONAL MONETARY SYSTEM

Objectives

In this chapter many of the earlier results are illustratedas the history of international monetary relationsunfolds. The gold and other metallic standards, whichoccupied centre stage for so long, bring home to roostmany of the important ideas of Chapters 8 and 9. Theissues underlying the Hume mechanism are simplyChapters 11 and 13 cast in a historic setting. The issueof credibility of policy (Chapter 16) is important forunderstanding the working of the gold standard: theoften cited increasing nominal rigidity in the worldeconomy may be an result of moving to a fiat moneystandard in which downward adjustment is no longerassumed to be necessary.

A section covers the standard debate on the choiceof an exchange-rate regime. Reflecting on why systemsemerge and collapse it is useful to think about currentissues such as the European Monetary System anddiscussions on monetary co-operation among the largercountries.

There are no exercises for this chapter.

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CHAPTER 21

POLICY CO-ORDINATION AND EXCHANGE RATE CRISES: THE EMS AND EMU

Objectives

A study of the EMS provides the background forcovering a number of analytical issues such as: policyco-ordination, balance of payments crises, the theory ofan optimum currency area. Like the preceding chapter,it offers a lot of data and experience to which theresults developed earlier can be applied. In the yearspreceding the launch of a monetary union, these areburning issues of independent interest for Europeanstudents.

This chapter has been entirely rewritten followingthe dramatic events of 1992-93. No doubt, the years1997-1999 will be historical for European monetaryintegration. As we wrote this chapter, we were painfullyaware that events will surprise us, one way or another.Instructors will fill the vacuum and correct unfulfilledspeculation on our part!

Teaching

This chapter is relatively easy to teach, and a niceconclusion of the course. European students know thefacts and the challenges. The chapter is structuredalong historical lines, which is a natural, but time-consuming, way of introducing the issues. Analternative is to select some topics and use them whileteaching the relevant principle. A list of topics is:- the Mundell-Fleming model under fixed exchangerate: the N-1 problem and German dominance (Section21.3.3)- the role of perfect capital mobility in the Mundell-Fleming model: the impossible trilogy (Section 21.3.5)- credibility: one reason for German dominance(Section 21.3.3)- the role of expectations: crises in the EMS (Section21.3.4)- the long-run real exchange rate (Chapter 7) and theoptimum currency area (Section 21.4.1)- balance of payments and mutual assistance (Section21.2.3)

Self-fulfilling speculative attacks

The crises of 1992-93 have revived interest inspeculative attacks. Box 21.2 presents the theory ofspeculative attacks and concludes that a currency whichpursues policies incompatible with a fixed exchangerate must eventually give up and float. Six currencieshave come under sharp attack during the autumn 1992.Only two of them conform to this view: the lira andsterling indeed have left the ERM and begun to floatafter a sharp (about 10%) depreciation. This has led tothe development of the theory of self-fulfilling attackswhich is briefly presented in Section 21.3.4. The paperby Obstfeld (1995) quoted in the text, as well asEichengreen, Rose and Wyplosz (1995), offer a fullertreatment.

Optimal currency area

It is now fashionable to research the conditions underwhich monetary union is feasible and welfare willimprove. Following Mundell (1961), the two criteriaseem to be a high correlation of regional supply anddemand shocks and/or a high degree of factor mobility.In the USA the latter seems to obtain either because ofnecessity or national culture (see Blanchard and Katz1992). This does not seem to be the case in Europe, norhas the integration of product and factor marketsremoved sources of asynchronization of disturbances inEuropean regions (von Hagen and Neumann (1994)),Decressin and Fatás (1995). The imaginative instructormight introduce some of the convergence discussionthat appeared in Chapter 5 'through the back door' aswell as arguments for and against a more federalEuropean tax and expenditure system.1

1 See Bean (1992) for a survey of the debate surroundingEMU.


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Future steps

The subject of this chapter will evolve quickly over thenext few years. Instructors will have to fill in the latestdevelopments and the economic principles needed toanalyze them. Here are a few markers which may, ormay not, turn out to be useful:

- not all countries will join the EMU. Whatarrangements will link those who are in and those whoare out? The simple Mundell-Fleming model will be ofhelp to judge the arrangement. Add the theory ofspeculative attacks to bring in some spice of realism.

- there are discussions of a “stability pact” constrainingbudget deficits for the countries after the EMU isformed (not just to get in). Here again Mundell-Fleming is useful: with a permanently fixed exchangerate (i.e. a currency union), fiscal policy is the onlydemand-management instrument left. Will countrieseasily give up this instrument? Will they negotiatesome form of mutual support? Will such a pact beforgotten as soon as it is accepted? Can sanctions beenforced?

- the new European Central Bank will be untested.What will be its credibility? This is a nice test of issuespresented in Chapter 16.

References

Bean, Charles (1992), 'Economic and Monetary Union',Journal of Economic Perspectives, 6: 31-52.

Begg, David, Giavazzi, Francesco, Spaventa, Luigi,and Wyplosz, Charles (1991), 'European Monetary

Union - The Macro Issues', Monitoring EuropeanIntegration, CEPR, London.Blanchard, Olivier J., and Katz, Lawrence (1992),'Regional Evolutions,' Brookings Papers on EconomicActivity, 1: 1-76.

Decressin, Jörg and Fatás, Antonio (1995) 'RegionalLabor Market Dynamics in Europe,' EuropeanEconomic Review, 39 (9):1627-1655.

Eichengreen, Barry, Andrew, Rose, and Wyplosz,Charles (1995) “Exchange Market Mayhem: TheAntecedents and Aftermath of Speculative Attacks”,Economic Policy, 21: 249-312.

Giavazzi, Francesco, and Giovannini, Alberto (1989),Limited Exchange Rate Flexibility: The EuropeanMonetary System, MIT Press, Cambridge, Mass.

Hagen, Jürgen von, and Neumann, Manfred J. M.(1994), 'Real Exchange Rates Within and BetweenCurrency Areas: How Far Away is EMU?', The Reviewof Economics and Statistics, 2:236-244.

Kenen, Peter (1969), 'The Theory of OptimumCurrency Areas: An Eclectic Approach', in R. Mundelland A. Swoboda (eds.) Monetary Problems of theInternational Economy, University of Chicago Press.

Mundell, Robert (1961), 'A Theory of OptimumCurrency Area' American Economic Review, 51: 657-65.

As a supplementary reading, or for the instructors’ owninterest, one might use:

Kenen, Peter (1995) Economic and Monetary Union inEurope, Cambridge University Press.

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