Ebook Macroeconomics Manfred gartner (3rd edition) Part 1

(BQ) Part 1 book Macroeconomics Manfred gartner has contents Macroeconomic essentials, booms and recessions, money, interest rates and the global economy, exchange rates and the balance of payments, booms and recessions, enter aggregate supply,...and other contents.

Macroeconomics is aimed at courses in intermediate macroeconomics,

applied macroeconomics, and on the European economy.

manfred gärtner is Professor of Economics at the University of

St Gallen, Switzerland.

Visit www.pearsoned.co.uk/gartner for a sophisticated, up-to-date, companion website

including interactive macroeconomic models equipped with guided exercises, state of the

art data analysis and display, multiple choice quizzes and more.

What’s new

Macroeconomics of the global economic and financial crisis

theme in the business cycle chapters, featuring several case studies and boxes Concepts

that drifted to the edge of intermediate macroeconomics curriculums in recent years, such as

Monetary policy rules

LM curve, Chapter 3, Money and Interest Rates, has been thoroughly re-written to discuss the

implications of monetary policy rules, such as the Taylor Rule, that many central banks have

adopted The chapter shows how the two approaches relate, offering instructors the option to

emphasise one or the other in later chapters

Extended bridge towards graduate macroeconomics

bridge towards graduate macroeconomics, with Chapter 16 offering a serious introduction to

the New Keynesian and Sticky Information Phillips Curves, and Chapter 17 introducing the real

Glossary and notes on Nobel laureates

terms has been added to the book, as has a new appendix titled Economics Nobel prize winners

contributed to the concepts and models that form the backbone of this textbook

Macro economics

Visit the Macroeconomics, third edition, Companion Website at

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material including:

exer-cises and animations, plus an interactive road map connectingkey concepts and models

coun-tries, along with a graphing module

● Extensive links to valuable resources on the web, organized bychapter

instant grading

● Index cards to aid navigation of resources, plus chapter maries, macroeconomic dictionaries in several languages, andmore

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Macro economicsTHIRD EDITION

Manfred Gärtner

University of St Gallen, Switzerland

Pearson Education Limited

Edinburgh Gate

Harlow

Essex CM20 2JE

England

and Associated Companies throughout the world

Visit us on the World Wide Web at:

www.pearsoned.co.uk

First published as A Primer in European Macroeconomics 1997

Revised edition published as Macroeconomics 2003

Second edition Macroeconomics published 2006

Third edition Macroeconomics published 2009

© Prentice Hall Europe 1997

© Manfred Gärtner 2003, 2006, 2009

The right of Manfred Gärtner to be identified as author of this work has been asserted

by him in accordance with the Copyright, Designs and Patents Act 1988.

All rights reserved No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording or otherwise, without either the prior written permission of the publisher or

a licence permitting restricted copying in the United Kingdom issued by the Copyright Licensing Agency Ltd, Saffron House, 6–10 Kirby Street, London EC1N 8TS.

All trademarks used herein are the property of their respective owners The use of any trademark in this text does not vest in the author or publisher any trademark ownership rights in such trademarks, nor does the use of such trademarks imply any affiliation with

or endorsement of this book by such owners.

ISBN: 978-0-273-71790-4

British Library Cataloguing-in-Publication Data

A catalogue record for this book is available from the British Library

Library of Congress Cataloging-in-Publication Data

Printed by Ashford Colour Press Ltd, Gosport

The publisher’s policy is to use paper manufactured from sustainable forests.

FOR DAVID, CHRIS, KAI,DENNIS AND LOU

Guided tour of the book xiv

2 Booms and recessions (I): the Keynesian cross 34

3 Money, interest rates and the global economy 64

4 Exchange rates and the balance of payments 99

5 Booms and recessions (II): the national economy 124

7 Booms and recessions (III): aggregate supply

8 Booms and recessions (IV): dynamic aggregate

12 The European Monetary System and Euroland at work 330

16 Sticky prices and sticky information: new perspectives

17 Real business cycles: new perspectives

Appendix C: Economics Nobel prize winners

B R I E F C O N T E N T S

Guided tour of the book xiv

3.2 Aggregate expenditure, the interest rate and the

C O N T E N T S

Recommended reading 121

5.3 The algebra of monetary and fiscal policy in the

8 Booms and recessions (IV): dynamic aggregate

Contents xi

Appendix: The two-country Mundell–Fleming model 356

16 Sticky prices and sticky information: new perspectives

16.1 Reality checks: business cycle patterns and the

16.3 The Phillips curves and monetary policy rules

17 Real business cycles: new perspectives on

Contents xiii

Visit www.pearsoned.co.uk/gartnerto find valuable online resources.

Companion Website for students

● Macroeconomic tutorials with interactive models, guided exercises and animations, plus an interactive road map connecting key concepts and models.

● A data bank with macroeconomic time series for many countries, along with a graphing module.

● Extensive links to valuable resources on the web, organized by chapter.

● Self-assessment questions to check your understanding, with instant grading.

● Index cards to aid navigation of resources, plus chapter summaries, macroeconomic dictionaries in several languages, and more.

quently used definitions are gross domestic

prod-domestic product sums up what is being produced national product is the term for all income received

it results from production at home or abroad This these days.

Which of these two measures of income is the proper one in a specific context depends on geographic region or the material well-being of a book, the geographic region, say the UK, France, appropriate measure of income is GDP In a few effects and the motives behind globalization, we are affected, and thus cast an eye on GNP.

In the real world, the distinction between GDP and GNP is not seriously relevant for most coun- than a handful of countries for which the differ- what may be attributed to measurement error At bourg, with a GNP that falls short of GDP by a ering taxes aggressively in competition with other 1980s, Ireland succeeded in attracting foreign firms taking pace As a consequence, a substantial part of puters, laboratories and more – belongs to foreign- earnings generated with this capital go to resi- Ireland’s GDP, but not in its GNP.

The opposite applies to Switzerland Here GNP exceeds GDP by 8% This is because a substantial

part of Switzerland’s savings has been invested come generated by these investments – interest Switzerland’s GNP, but is not included in its GDP Figure 1.9 compares the absolute levels of GDP and GNP for the selected group of countries The barely visible, and we may not make a serious mis- other: say, if the other is not available Even for the two income aggregates appears less dramatic

in Figure 1.9 than it did in Figure 1.8.

GNP–GDP (%)

–20

IRL P A NL E D GER DK GR USA F N S JP UK CH

–15 –10 –5 0 5 10

Gap GNP–GDP, in % of GDP, 2004

Figure 1.8

0 10 20 30 40 50

GDP

IRL P E D GER DK GR USA F N S JP UK CH

GDP and GNP, 2004

Figure 1.9

78Money, interest rates and the global economy

Working with graphs (part II)

I do not recommend learning the slopes of memorizing which factor shifts the graph which some market equilibrium is understood, slopes and

equilib-by simple thought experiments Algebra or lus is not necessary.

calcu-For example, take the LM curve to demonstrate

the nature of the thought process Suppose you and how it shifts when the money supply increases.

Here is a way out.

The slope of a curve

1 Pick an arbitrary point A in the i/ Y plane

As-sume that A is an equilibrium, i.e a point on LM.

information, you are free to position the LM

2 Move horizontally from A to B With i being the

same at A and B, but Y being larger at B, the

de-A Thus, as we are holding the money supply

money In other words, B is not on LM!

3 Starting from B, work out in which direction i

has to move in order to restore equilibrium As

reduce money demand via higher opportunity will have risen just enough to re-establish equi- librium.

4 Now that we have two points A and C on the LM

curve, we have identified the curve’s slope In and C.

How does the curve shift?

1 As before, pick an arbitrary point A in the i/Y

plane Assume that it is an equilibrium point,

i.e it lies on LM See Figure 3.10.

2 Assume that the money supply has been

in-creased Since the old money supply equalled ply of money.

3 Holding i constant, work out whether Y has to

rise or to fall in order to raise money demand

swer is, obviously, that Y has to rise So the

at B.

4 As we could have started from any other point

on the old LM curve and obtained the same the entire LM curve has shifted to the right into the position of the new LM curve.

LM curve

Supply < demand Supply = demand

Supply = demand

Raising the interest rate re-establishes equilibrium Raising income creates excess demand

A is initially an equilibrium Raising income raises money demand;

establishes new equilibrium at point B

1

2

Figure 3.10

108 Exchange rates and the balance of payments

The current account tracks net exports of goods and services These we

already know from the above analysis of the goods market.

(4.2) Figure 4.4, panel (a), shows the current account as a function of income and the interest rate While the interest rate has no impact on the current

account (i is missing from equation (4.2)), CA deteriorates with a factor

as income rises.

For given world income and real exchange rate, only one income level exists which balances the current account An algebraic expression for this is ob- tained by letting in equation (4.2) and solving for Y This yields

Current account equilibrium (4.3) All points that balance the current account lie on a vertical line in the plane, as shown in Figure 4.4, panel (b) As indicated in the graph, this line shifts as its positioning parameters change For example, if the real exchange rate goes up, meaning that the home currency depreciates, ex- line, where there was by definition, we now face the dise- quilibrium situation Imports, which are too small at this new real exchange rate and the initial level of income, can only rise up to the now

to the right to find a new current account equilibrium: after a real tion a new equilibrium with can only be found to the right of the initial line Therefore, a real depreciation moves the line to the right By analogous arguments we find that an increase in world income moves to the right as well The text in the white boxes summarizes these results.

Current account CA

0

Interest rate i

Line shifts left as

Here the current account

is balanced (CA = 0)

Rworld ↑ Line shifts right as

R↑

Yworld ↑

Figure 4.4The current account worsens as rising income raises imports The interest rate does not affect CA The rent account equilibrium line, therefore, projects as a vertical line onto the i–Y plane An exchange rate depreciation

cur-or a rise in wcur-orld income moves the CA plane up, shifting the CA⫽ 0 line to the right.

Note Economists rarely work with 3D graphs They are used here and below to show where the 2D graphs

on the right of Figure 4.4 come from If you have no problem understanding the 2D graph you can ignore the 3D version.

Maths note One euro invested at home grows period If invested abroad it grows to (1 + i World )(1 + (E e +1 ⫺ E)>E).

Setting this equal to (1 + i ) and subtracting 1 from both

Equation (4.4) simplifies this

by ignoring the involved exchange rate gain on the small under normal circumstances.

+iWorldEe+1 -E

i = iWorld

+

Ee +1 -E

What to expect

Bullet points at the

start of each chapter

show what the reader

can expect to learn,

and highlight the core

coverage.

Key terms

Key terms and concepts

in each chapter are

Boxes

Boxes in each chapter

present useful guidance

to the reader and

illus-trate the concepts.

Margin notes

Helpful tips and guidance appear in the margins, giving maths reminders, examples, rules, empirical notes and reality checks.

Enter aggregate supply

After working through this chapter, you will understand:

1In more detail the meaning of potential incomeor output.

2How wages and employment are determined in the labour market.

3How regulations, trade unions, and other labour market tics, or demographic features, may give rise to involuntary unemploy- mentwhich persists in the long run.

characteris-4Why aggregate outputproduced by firms may temporarily exceed or fall short of the level of potential output produced in equilibrium (or the long run).

What to expect

By now we have a good understanding of aggregate demand: that is, of what ing of aggregate supply, the treatment of which so far has been, well, rather level of output was when we discussed money in the circular flow model in Chapter 1 There we considered two extreme cases of the aggregate supply

(AS) curve, the line that indicates how much output firms produce at ent price levels For easy reference, Figure 6.1 replicates these two versions.

differ-ployed in Chapters 2–5 in the context of the Keynesian cross, the IS-LM

extreme Keynesian aggregate supply curve It assumes there is slack and the presence of one or more production factors in abundance Then how much any level of output that is demanded But then the price level never changes!

changes in the form of inflation are the rule rather than an exception? Quite obviously, a horizontal aggregate supply curve cannot be the whole story.

Panel (b) in Figure 6.1 shows a vertical aggregate supply curve Firms

sup-ply potential output Y* no matter what the price level is This curve is

gener-ally referred to as the classical aggregate supply curve, for reasons that will become evident in a moment The drawback here is that, unless we assume change, but never income This is clearly at odds with real-world observations vertical aggregate supply curve cannot be the whole story either.

C H A P T E R 6

The extreme Keynesian aggregate supply curveis horizontal, stating that, at the current price, firms are ready

to produce any output that

is demanded A refined Keynesian aggregate supply curve will be introduced later.

The aggregate supply curve

shows the total quantity of goods and services supplied by all firms in the economy at different price levels.

The classical aggregate supply curveis vertical, stating that firms produce only one output Y*, no matter how high prices are.

Chapter summary59 CHAPTER SUMMARY

■ A country’s income at a given point in time is determined by the income, and the deviation of income from potential income The latter is called the business cycle.

steady-■ In the circular flow model there exists one equilibrium level of income at apart from all other feasible income levels is that firms will try to set pro-

■ An increase in autonomous expenditure, such as government purchases, This multiplier effect occurs because the exogenous spending increase raises higher.

■ When the multiplier is large, small changes in government expenditure or recessions.

■ Factors that reduce the size of the multiplier are high marginal income tax rates and a high marginal propensity to import.

■ Consumption does not depend on current income only, but, more tantly, on expected future income.

impor-■ Multiplier effects apply fully only if consumers consider observed income changes to be permanent.

■ The multiplier becomes much smaller if observed income changes are sidered transitory.

con-■ Investment rises when expected future income rises and/or when the interest rate falls.

actual expenditure 40 aggregate (planned) expenditure 40 average income tax rate 49 boom 35 business cycle 35 capital costs 56 consumption function 49 disposable income 49 equilibrium income 47 government purchases 43 import function 49

Keynesian cross 45 marginal income tax rate 49 marginal propensity to consume 44 multiplier 48 net taxes 43 permanent income 58 potential income 35 rate of return 56 recession 35 steady-state income 35 transitory income 58

Key terms and concepts

60Booms and recessions (I)

France

6,000

2,000 4,000

1991 as given in Figure 2.19.

Add your guess of the paths of steady-state

Two US economists, Arthur F Burns and Wesley typical business cycle lasts between six and thirty- two quarters.

(c) Does this agree with your findings?

2.3Consider an economy with the following data not coincide with actual investment):

(a) Is this economy’s circular flow in equilibrium

in the sense that firms do not have to change inventories involuntarily?

(b) Translate the above data into a diagram with demand on the vertical axis and income on the horizontal axis.

Add the assumption (c) Draw the aggregate-expenditure and the actual-expenditure lines Identify demand-determined income in equilibrium

in your graph and analytically.

(d) What happens to equilibrium income if government expenditure increases by 500 units? Show your result in a graph and verify

4,000 7,000

6,000 5,000 8,000 10,000

Figure 2.20

328 Endogenous economic policy

Models of political business cycles are surveyed in Manfred Gärtner (1994) ‘Democracy, elections, and macroeconomic policy: Two decades of progress’,

European Journal of Political Economy 10: 85–109.

The empirical evidence is reviewed in Bruno S Frey and Friedrich Schneider (1988) ‘Politico-economic models of macroeconomic policy: A review of the em-

pirical evidence’, in Thomas D Willett (ed.) Political

Business Cycles: The Political Economy of Money, Inflation, and Unemployment, Durham and London:

Duke University Press, pp 239–75.

Applications to US presidential elections are cussed in Ray C Fair (1996) ‘Econometrics and

dis-presidential elections’, Journal of Economic tives 10(3): 89–102.

Perspec-Recommended reading

RECENT RESEARCH

The economy and US presidential elections

Ray C Fair (1996, ‘Econometrics and presidential

elections’, Journal of Economic Perspectives 10(3):

89–102) offers a non-technical update of earlier

efforts to explain the Democratic Party’s share by economic variables and what he calls incumbency variables His new equation reads as follows:

A P P L I E D P R O B L E M S

The economic variables highlighted in the equation all have a significant influence on the incumbent’s re-election prospects: if income growth speeds

up by 1 percentage point, his vote share rises by

1 percentage point, his vote share falls by 0.83 percentage points There is an added bonus to high income growth For each quarter in which it exceeds 2.9%, which represents good news, the vote share rises by 0.99 percentage points The equation explains 96% of the variation in the Democratic Party’s vote share It predicts the winner in 17 out of the 20 presidential elections since 1916 correctly The

use of the I dummy variable serves to turn effects on

the Democratic vote share around when a Republican sever the link between inflation and good news, and the vote during the world wars.

WORKED PROBLEM

Who wanted the euro? (part I)

Journalists and politicians closely monitored public attitudes towards the single European currency.

Table 11.3 gives the result of one such opinion poll

I -0.034 (1.26) Democrats are in White House (I = 1); Republicans are in White House (I = -1)

I * d 0.047 (2.09) d = 1 if world war went on during last 15 quarters; else d = 0 g3 * I 0.0065 (8.03) income growth during last 3 quarters (g3)

p15 * I * (1 - d)-0.0083 (3.40) inflation during last 15 quarters (p15)

n * I * (1 - d) 0.0099 (4.46) number of last 15 quarters with good news (meaning g 7 2.9).

DPER 0.052 (4.58) Democratic President is running (DPER = 1);

Republican President is running (DPER = -1)

DUR -0.024 (2.23) number of consecutive terms in office by incumbent party (negative for

Republicans)

R2 =0.96; 20 presidential elections 1916–92

Applied problems63

consumption almost perfectly The marginal

propen-sity to consume is found to be 0.71 The t-statistic of

486.5 renders this coefficient highly significant.

It can be argued that parts of consumption ing cannot be adjusted to changing income immedi- ately: your summer vacation that has been booked since the previous autumn; high car maintenance costs that can only be reduced by selling the car at a loss; your second daughter who insists on taking ballet lessons just like her older sister, and so on To allow for such adjustment lags we may suppose that

spend-only desired consumption C* is related to income,

that is If desired consumption drifts away from actual consumption, the response

of actual consumption only closes a fraction a of this gap Formally we may write Substituting the above explanation of desired con- sumption for in the partial adjustment equation

this equation yields

The autoregressive coefficient (the one in front of ) carries a t-statistic of 6.31, render-

ing it highly significant The coefficient of disposable income is also significant, but smaller than in our first estimate above Note, however, that it represents the product Since is estimated at 0.78, we may compute , which barely differs from the previous estimate So while the long-run

by another , one period later

on So while the partial adjustment version of the consumption function estimates the same overall response of consumption as the simple version, it sug- gests that the response is spread over a longer span

of time.

YOUR TURN

Consumption function in first differences

One thing to note in the above study of Italian sumption functions is that both consumption and dis- posable income show a clear upward trend during problem Regressing two heavily trended variables

con-on each other may give a statistically significant sult, although the two have nothing to do with each other (a classic example is the negative correlation between the number of telephones and the number

re-of storks during the first half re-of the 20th century)

In an attempt to alleviate this problem we may compute first differences on both sides of the con- sumption function to obtain Please check whether this formulation is supported by the data.

¢C = c1 ¢(Y - T )

0.22 * 0.22 * 57,000 = 2,758.8L 0.22 * 57,000 = 12,540L

To explore this chapter’s key messages further you are encouraged to use the interactive online module found at

www.pearsoned.co.uk/gartner

Chapter summary

Each chapter ends with a bullet-point summary which highlights the material covered in the chapter and can be used as

a quick reminder of the main issues.

Key terms and concepts

A list at the end of each

chapter of all the key

terms and concepts, for

quick reference.

Exercises

Exercises at the end of each chapter are geared towards the chapter’s central ideas and consolidate the acquired knowledge.

recom-mended reading section,

directing the reader to

ad-ditional printed and

elec-tronic sources in order to

gain an alternative

per-spective, or to pursue a

topic in more depth.

Companion website references

A web reference is given at the end of each chapter, guiding the student to useful and relevant interactive resources on the companion website to support their learning.

Guided tour of the book xv

7.1 International evidence on the quantity equation and the

8.2 Quantity equation, Fisher equation and purchasing power

10.1 National incomes during the Second World War, east and

17.1 Technology change in Malaysia: the return of the Solow residual 496

Boxes

2.1 Actual income, potential income and steady-state income:

L I S T O F C A S E S T U D I E S A N D B O X E S

List of case studies and boxes xvii

4.2 Forecasting the US dollar in 2004: an exercise in

10.1 An illustration of the income and distribution effects

What makes this book unique?

This text reverses the usual priorities in intermediate macroeconomics tion Here, the ultimate goal is not to simply to teach general macroeconomictheories, models and concepts, with real-world applications thrown in formotivation and excitement; rather, students work through this book towards

instruc-an understinstruc-anding of the macroeconomic issues instruc-and challenges facing theglobal economy and individual countries Macroeconomic concepts are taughtonly as they serve this end

What is new in the third edition?

Whenever possible, graphs, tables and information in general were updated.Countless explanations have been improved, case studies brought up to date

or replaced, and new exercises added Beyond that, major innovations in thisnew edition are:

being prepared while this millennium’s first global economic crisis, putably the harshest in generations, unfolded and gained momentum In theSpring of 2009, the jury is still out on how far incomes will plummet andhow long the downturn may last But as experts in many trades are trying

indis-to come indis-to grips with what has happened, and what is yet indis-to come, it isbecoming increasingly clear that current events will have a lasting impact onhow we teach macroeconomics Curriculums will not have to be scrapped.Textbooks will not have to be rewritten But the startling speed at whichdemand and employment are receding, and the sheer magnitude of change,has gravely tarnished belief in the self-healing power of the markets Thiscalls for a revitalized interest in what can go wrong in financial and goodsmarkets, and when and how the government should step in to augment pri-vate demand when it is lacking Acknowledging this, the text’s business cyclechapters use the events of 2008–2009 very much as a running theme thatfeatures in several Case Studies and Boxes Key concepts that are given newemphasis – concepts that had drifted to the edge of, or even off the radar of,

intermediate macroeconomics curriculums in recent decades – are liquidity

traps, market psychology and risk premiums in various guises A related

con-cept that must be taken seriously, and makes an appearance, is deflation,

with all the negative repercussions it may generate for the real economy

markets, where supply and demand interact in an explicit fashion and

match on the LM curve, it now acknowledges that recent years have seen many central banks adopt monetary policy rules Chapter 3 has been thor-

oughly rewritten to lay out in detail how the two approaches are related,

P R E FA C E

thus offering instructors the option to emphasize one or the other in laterchapters.

struggle with the gap between what they learned in intermediate nomics and the models that graduate macroeconomics rely upon The text’sconcluding chapters try to bridge this gap, with Chapter 16 offering a seri-

macroeco-ous introduction to the New Keynesian and Sticky Information Phillips

Curves, and Chapter 17 introducing the real business cycle approach Here

also, empirical facts taken from current research are evaluated to explainthese concepts Nevertheless, these chapters do stray from the book’s guid-ing philosophy, in that they focus on theory more than on issues And sincethey include the book’s most demanding sections, they may certainly beskipped in courses where a majority of students do not plan to proceed tograduate school

of searching for explanations in the main text, a comprehensive Glossary of

all relevant technical terms has been appended to the book Another newAppendix, ‘Economics Nobel prize winners and earlier giants’, introducesstudents to the names and work of the greatest minds that have contributed

to the concepts and models that form the backbone of this textbook

Content

The text’s main body comprises 17 chapters Chapters 1–9 are fairly tional in content, amounting to a streamlined, no-frills introduction to themacroeconomic concepts that are useful for discussion of contemporarymacroeconomic issues in the world economies Essential macroeconomic con-cepts are introduced in the context of the circular-flow-of-income model Stu-

conven-dents are then led via the Keynesian cross, the IS-LM, the Mundell–Fleming

model and the aggregate demand-aggregate supply model to a fully dynamicaggregate demand-aggregate supply framework for analysing short- andmedium-term macroeconomic issues Chapters on the supply-side topics ofunemployment and growth round out this predictable set of tools

Chapters 10 and 11 extend the toolbox into areas that most intermediatemacroeconomics textbooks barely mention in passing The first refines andextends the Solow growth model (introduced in Chapter 9) for a discussion

of human capital and poverty traps, and concludes with a first glimpse atendogenous growth Under the heading ‘Endogenous economic policy’, Chap-ter 11 then shows that politicians may steer the economy along courses notconsidered desirable from society’s point of view, and discusses how institu-tions should be structured to reduce this risk

Chapters 12–15 explore issues at the heart of European and global tary and economic integration All major topics are addressed in these chap-ters: inflation, monetary unions, budget deficits and the public debt, andunemployment

mone-Chapters 16 and 17, thoroughly expanded for the third edition, offer asneak preview of what students might expect in macroeconomics courses atthe Masters level They also make a serious effort to motivate students andexplain why current macroeconomic research has moved beyond the work-horse models of intermediate macroeconomics to study the potential of

Preface xxi

macroeconomics models with explicit microfoundations – of the business-cycle mould, or with sticky prices and information To this end, stu-dents learn about the co-movement of macroeconomic variables, and whysticky prices or sticky information may perform better than sticky wages inexplaining empirically observed patterns They also grasp the intuition behindreal-business-cycle dynamics, without the elaborate formal apparatus thatusually comes with it

real-Learning features

The book has a user-friendly design, featuring margin notes and definitionsthat emphasize important concepts Exercises geared towards each chapter’scentral ideas consolidate the acquired knowledge An extensive and innova-tive use of graphs facilitates access and enhances learning success Every chap-ter contains one or more Case Studies that apply core concepts to recentexperiences in Europe and in other parts of the world And all chapters featurelinks to our elaborate online material that includes interactive graphical ver-sions of the book’s key models, guided exercises, online tests, macroeconomicdata, and much more

What courses does the book accommodate?

The organization of the book gives instructors various options:

■ Primarily, the text is designed for courses in undergraduate or intermediate

macroeconomics that on the one hand insist on providing a sound

theoreti-cal foundation, but on the other also want to make a point of emphasizing

applications in the form of Case Studies or even, if so desired, elementary

statistical work

■ The book’s first half can also be used for a self-contained short course in

macroeconomic theory whenever time does not permit working through a

voluminous 600–900-page macroeconomics text which has become thestandard

Applied macroeconomics Such courses may be organized around an

appro-priate selection from the several dozen Case Studies and empirical tions Conveniently, as deemed necessary, students can be referred to therequired theoretical tools in the same textbook

applica-■ Finally, the book accommodates European studies courses that can be

or-ganized around the applied topics discussed in Chapters 12–15 Here also,should it be necessary to freshen up or expand previously acquired theoret-ical knowledge, such material is readily available in the same textbook

Prerequisites

Ideally, students should approach this book with a Principles of economics course

under their belt The formal mathematical requirements are mild: anythingclose to the most basic mathematics training in high school should do In fact,most of the formal manipulations are optional and either shown in marginnotes or in separate sections that supplement graphical arguments

I am quite confident, though, that the book can also be adopted and usedsuccessfully if a principles course is missing and algebraic manipulations areavoided altogether Dozens of Case Studies, some brief, some rather elaborate,provide ample ammunition for keeping up motivation, and the big payoffwaits in the later chapters of the book.

Finally, and though it may sound frivolous: I believe that the book is evensuited for self-study The acquired knowledge will definitely be more fragileand lack depth compared with what can be achieved under the guidance of anexperienced instructor But it should provide an up-to-date first foundationfor informed discussion of today’s national and global macroeconomic issues

Acknowledgements

This brings me to the people I want to thank for their contributions to ever merits this text may have In the very first place, these are my students,who amaze me time and again Most of all, teaching teaches the teacher Stu-dents’ questions and curiosity constantly force me to refine explanations, and

what-in the process very often make me understand thwhat-ings better myself

It has been a joy to work with the professionals at Pearson Education, towhom I owe a big ‘thank you’ They helped and guided me, with unmatchedskill and great patience, in preparing this thoroughly extended third edition,and brought the book into its final shape: Georgina Clark-Mazo (senior editor),Linda Dhondy (proofreader), Pauline Gillett (editorial administrator), RobinLupton (editorial assistant), Ellen Morgan (acquisitions editor) and ChrisBessant (copy editor)

More than any other book of mine, this one would not even be close to what

it is without the talents and the enthusiasm of the people working with me at theUniversity of St Gallen’s Institute of Economics This new edition owes morethan I can express to Susanne Burri She updated numerous graphs and tables,often with data for more than a dozen countries, scrutinized Exercises and CaseStudies, prepared most of the new Glossary, and, playing the devil’s advocate,challenging me on virtually everything I say between the front and the back cover

In the course of joint teaching ventures based on this textbook, Florian Jung fered criticism and many constructive suggestions that improved this edition Healso accepted the responsibility for proofreading along with Pascal Bischof,Hanna Köpper, Björn Griesbach, Andreas Kleiner and Thomas Seiler Frode Bre-vik performed the simulations reported in Chapter 17 And the interactive onlinematerial that augments the textbook continued to grow and shine thanks to theprogramming magic of Christian Busch and the maths skills of Frode Brevik I

of-am deeply indebted to all of them; and to Gudrun Forster, for unparalleled ministrative support and her eye for the big and the little things that contribute to

ad-a work ad-atmosphere which helps us ad-all deliver our very best

I have also benefitted from the reviews commissioned by Pearson tion Both those that offered applause and encouragement, and those thatwere more reserved, helped shape the book into a better teaching tool.The mere writing of a textbook may mostly happen at the desk But theenthusiasm, the creativity and the discipline that are essential for such a projectcome from beyond office doors In this respect I owe much more to my wifeLouise and to our sons Dennis, Kai, Chris and David than they can possiblyknow

Educa-P U B L I S H E R ’ S A C K N O W L E D G E M E N T S

We are grateful to the following for permission to reproduce copyright material:

Figure 9.2 from Penn World Tables, Figure 6.2; Figure 9.6 and Figure 12.1 from

Economics, 1st edn, Prentice Hall Europe (K Case, R Fair, M Gärtner and

K Heather 1999) Pearson Education Ltd; Figure 15.9 from Trade Unions in

Western Europe since 1945, 1st edn, Macmillan: New York (Ebbinghaus and

Vissner 2000) Macmillan; Figure 15.12 from http://www.wtrg.com/oil_graphs/oilprice1869.gif

In some instances we have been unable to trace the owners of copyright rial, and we would appreciate any information that would enable us to do so

mate-Macroeconomic essentials

After working through this warm-up chapter, you will know:

1 What macroeconomicsis all about, and how it relates to microeconomics

2 All you need to know about national income accounting, includinggovernment budgets and the balance of payments

3 What the circular flow modelis, how to use it and what its limitationsare

4 How moneyfits into the macroeconomy

5 Why economists need to use models, and why these simplified pictures

of the real world are useful

6 How to work with graphs

What to expect

1.1 The issues of macroeconomics

Economics is about how people use time and tools to produce what other

people want to buy – and about the sometimes intricate choices that must bemade and the things that can go wrong

The two major subdisciplines of economics are microeconomics and economics Microeconomics looks in great detail at how individuals makechoices – as consumers, as employees, as entrepreneurs, as investors, or even

macro-as politicians Macroeconomicslooks at the big picture, at the way things areand how they develop after we add everything up, in the whole economy or inlarge segments or sectors of the economy Of course, microeconomics andmacroeconomics cannot lead separate lives What happens in the macroecon-omy must be the result of all the individual decisions analysed and explained

in microeconomics This is why the search for the microfoundations of

macro-economics ranks high on today’s research agenda However, to model all the

choices of millions of different people and show how they interact to generatespecific macroeconomic outcomes is simply not feasible It probably never will

be Inevitably, at some point we have to resort to simplifications or abstractions:either by assuming, say, that all individuals are alike, which is what so-called

representative agents models of the macroeconomy do; or by postulating

rela-tionships between macroeconomic variables which are ad hoc in the sense that they only proxy the outcomes of individual choices, but nevertheless seem to

work well in many real-world situations

Microeconomicsstudies

individual entities such as

consumers or firms.

Macroeconomicsstudies the

whole economy from a

bird’s-eye perspective.

$905 or less

19 out of the last 24 winners

sub-The economies of China and India grow some 10% each year At such rates, income doubles in about seven years

New Zealand’s central bank governor is to be fired if inflation exceeds 2%

1 out of 10 Europeans is out of work

20% of Brazilians receive 70% of Brazil’s income

Figure 1.1 The map shows the huge differences that exist in the per capita incomes of the world’s nations in 2006 Other important macroeconomic variables and issues are reported in boxes: economic growth, unemployment, inflation, the distribution of income and the close link between the economy and politics.

Source: World Bank Key Statistics Online.

The foremost single measure of how an economy performs is the aggregatelevel ofincome Presenting the world at a glance, Figure 1.1 gives an overview ofthis variable by classifying countries according to income per capita, which istotal income divided by population Huge differences in per capita incomesexist At the high end are the industrialized countries with annual incomes perhead of $20,000 to $50,000 Lowest are a number of countries in sub-SaharanAfrica with average annual per capita incomes of barely $100 To make mattersworse, the world’s poorest countries do not seem to be growing very much – if atall In stark contrast, the Asian ‘tigers’ – Hong Kong, Singapore, South Koreaand Taiwan – have been growing at or near double-digit percentage ratesthroughout the 1980s and much of the 1990s Other Asian nations, China andIndia most notably, by far the world’s most populous nations, seem poised tocopy this miracle At such growth rates, incomes double in less than ten years

Incomes given in Figure 1.1 are nominal incomes, i.e incomes expressed in

currency (here US dollars) at current prices If you want to compare incomesbetween countries, nominal incomes may not be the best data to look at.Neither should we rely on nominal income as an indicator of how a country’sincome evolved over time

Measuring income growth over time in a single country is the simpler

prob-lem Note that nominal income is prices P times real income Y, that is Now consider that US nominal income per capita grew by 22% from

necessarily mean that US citizens could buy 22% more goods and services in

P2006 * Y2006 = $44,155

Y2002 = $36,126

P * Y

Incomeis revenue derived

from work and assets, such as

wages, interest, dividends and

profits.

Rule of 72 As a rule of

thumb, divide 72 by the

annual income growth rate

(in per cent) to learn in how

many years income doubles.

Example: 72/9  8.

1.1 The issues of macroeconomics 3

Table 1.1 Nominal and real income in 2006 The second column shows nominal income.

Because prices differ substantially between countries (third column), real income, the amount

of goods that income can buy, turns out quite differently, as shown in the fourth column.

2006 than they could in 2002 Possibly, the increase in nominal income mighthave been entirely due to a 22% rise in prices, with no real improvements in thepurchasing power of US incomes at all Of course, this has not really been thecase In fact, US prices rose by 12% from an index value of, say, 1 in 2002 to1.12 in 2006 To obtain 2006 real income (expressed in 2002 prices), we need todivide 2006 nominal income by the 2006 price level and multiply by 2002

So while nominal income rose by 22%, real income grew by only 9%

Similar issues, with one added complication, arise when comparing incomesbetween countries Noting that per capita income in 2006 was $39,424 in theUnited States but $48,080 in Switzerland would only permit a meaningfulcomparison of purchasing power if one dollar bought the same in Switzerland as

in the United States Although $10.23 buys four Big Macs at $3.41 each in theUnited States, you need $15.60 to buy the same (at $5.20 each) in Switzerland.This price difference may have two causes: at 6.30 Swiss francs Big Macs maysimply be expensive in local currency; or the dollar may be undervalued, mean-ing it takes too many dollars to buy a Swiss franc Our current knowledge doesnot put us in a position to sort this out All we know is that a dollar buysfewer Big Macs in Switzerland than in the United States, and that we need totake this into account when comparing Swiss income to US income

Table 1.1 summarizes our Big Mac example Column 2 shows that in 2006nominal income per capita in Switzerland was almost $10,000 higher than inthe United States In Poland it was less than a fifth of Switzerland’s Taking intoaccount the level of prices relative to the United States, the picture changessubstantially In Switzerland, $48,080 buys what only $36,522 buys in the

United States So Switzerland’s real income per capita is slightly lower than

America’s Prices in Poland are a little more than half as high as in the UnitedStates, and some 40% of what they are in Switzerland Therefore, in terms ofreal income, Poland performs much better than it seems to perform in terms ofnominal income

A statistical average, which is what income per capita is, is one thing The actual distribution of income may be quite another story In Brazil, to give one

example, the richest 20% of the population earn more than 60% of the nation’saggregate income The poorest 20% earn as little as 3% In Europe, high aver-age incomes conceal that almost one in ten of those who want to work do notfind a job Good unemployment insurance and social security have so far pre-

vented high unemployment from showing up in a deteriorating distribution of

income But welfare states are struggling and are quickly scaling down the role

of the government

Y2006 = (P2006 * Y2006)>P2006 * P2002 = 44,155>1.12 * 1 = $39,424

Empirical note.World-wide

the richest countries, with

15% of the population,

make some 80% of world

income The poorest

countries, with 57% of the

population, make 5% of

world income.

Nominal income (per capita, in $)

PY

Real income (in US purchasing power)

Y

Price level (relative to US price level)

P

Greece GR

Population 11.2 million

Unemployment 8.3% Inflation 3.0%

Finland FIN

Population 5.3 million Per capita GNP €33,912 Unemployment 6.9% Inflation 1.6%

Germany D

Population 82.3 million

Unemployment 8.4% Inflation 2.3%

Denmark DK

Population 5.4 million

Unemployment 3.8% Inflation 1.7%

Non-members of the European Union

In the United States the results of eighteen out of the twenty-two tial elections preceding 2008 could have been predicted simply by looking athow the economy was doing, as measured by key indicators such as incomegrowth and inflation This implies a close link between macroeconomic per-formance and all the other (and, you may argue, more important) things inlife, not only because all these other things typically cost money, but because aprecondition for being in power – and thus being able to realize one’s dream,ideology or vision, in whatever field – is a satisfactory economic performance.New Zealand’s government made the headlines in the 1990s by putting aclause in the employment contract of its central bank governor that threatenshim with the sack if he allows inflation to exceed 2% annually This reflects a

presiden-serious concern for inflation, the rate at which prices grow Many other nations

share this concern, which points to inflation as a third important variable inthe macroeconomic context

The world abounds with economic challenges and puzzles These differfrom one part of the world to another, and they must be viewed in the context

Figure 1.2 The map provides 2006 data on the countries of Western Europe that formed the European Union at the turn of the millennium, or that had completed negotiations before choosing not to join GNP is a measure of a coun- try’s total income Country names are followed by shorthand abbreviations that are used in the text.

1.1 The issues of macroeconomics 5

Figure 1.3 This map provides basic 2006 data on recent and prospective EU members and some other countries for reference.

Romania RO

Population 21.6 million

Unemployment 6.4% Inflation 4.9%

Cyprus CY

Population 0.8 million

Unemployment 3.9% Inflation 2.2%

Poland PL

Population 38.1 million Per capita GNP €8,061 Unemployment 9.6% Inflation 2.6%

Hungary HU

Population 10.1 million

Unemployment 7.4% Inflation 7.9%

Croatia HR

Population 4.4 million Per capita GNP €8,441 Unemployment 9.6% Inflation 3.2%

Slovak Republic SK

Population 5.4 million

Unemployment 11.1% Inflation 1.9%

of different institutions, cultures and historical backgrounds Despite this, a set

of macroeconomic principles and concepts exists which can, applied wisely, bebrought to bear on a variety of different issues This book sets out to assemblesuch a basic macroeconomic tool-kit While it focuses on and emphasizes what

is needed to understand and discuss the experiences and prospects in one part

of the world, the European Union and its neighbours, the perspective is global,

as indicated by the range of issues, case studies and data

The European Union grew out of economic and political integration efforts

that started half a century ago After the turn of the millennium it comprisesthe twenty-five member states shown in blue in Figure 1.3 Figures 1.2 and 1.3also provide some basic information on the member states’ economies, theeconomies of Norway and Switzerland, whose governments had embarked on

GDP as a measure of total output or income

How do modern economies measure total income

(or output)? Usually it is done by means of a

con-cept called gross domestic product (GDP) Nominal

GDP evaluates all final goods and services

pro-duced in a country at current market prices If 100

pizzas and 5 Alfas are produced in a given calendar

year at prices of €10 and €30,000, respectively,

Impor-tant things to watch out for are the following:

■ Only count final products If Alfa Romeo buys

tyres from an external supplier to put on its cars,

you would not want to count tyres twice – once

when Alfa Romeo buys them and again when

consumers buy an Alfa, the price of which, of

course, includes the cost of tyres As indicated,

one way to avoid double counting is by

includ-ing final products only Another way is to count

only the value added at each stage during the

production process.

■ Only count current production If the original

Alfa owner resells her car next year, this

obvi-ously does not represent output and income

generated during that period.

GDP increases, first, if more pizzas and/or Alfas are

being produced, and second, if prices rise Table 1.2

illustrates these two possibilities.

In 2007 nominal GDP is €151,000 Real GDP

does not evaluate output in terms of current prices, but in prices in a given year In terms of what nominal GDP buys in 2007, real GDP in 2007

of course is also €151,000 In 2008 nominal GDP has risen to €182,000 Since prices are the same as

in 2007, real GDP has also risen to €182,000: the buying power of nominal GDP is at what €182,000 would have bought in 2007 Finally, in 2009 nomi- nal GDP is at €244,000 But the increase is only due

to price increases Production quantities are the same as in 2008 This leaves real GDP unchanged

at €182,000.

Sometimes total income is also measured as gross

national product (GNP) The difference between

the two concepts is that GDP refers to incomes generated within the geographical boundaries of

a country, no matter by whom Instead, GNP ures the incomes generated by the inhabitants of a country, no matter in what country So if a Spaniard living in Barcelona owns Lufthansa stocks, the annual dividends she may receive are included in Germany’s GDP, but in Spain’s GNP For most coun- tries the difference between GDP and GNP is small.

meas-We will usually think of GDP when talking about total income or output.

Table 1.2 An illustration of nominal and real GDP

Nominal GDP (in e)

Real GDP in prices of 2007

1.2 Essentials of macroeconomic accounting 7

1.2 Essentials of macroeconomic accounting

The focal point of macroeconomics is the level of income Incomes are paidout to factors of productionthat are employed by firms to produce goods andservices This output is then put on the market for people to buy The twomajor things that can go wrong in this process are as follows:

■ Firms may not use all available production factors to produce output, thus

leaving factors idle in the form of unemployment or slack.

■ People may not want to buy all that is being produced, that is demand may

fall short of output.

Economists have analysed economies very much in terms of these two ures: underutilization of production factors and/or insufficient (or excessive)demand These will also be major themes in subsequent chapters of this book,

fail-as they lie at the heart of most prominent macroeconomic issues such fail-as employment and inflation

un-Before embarking on our task to assemble a set of macroeconomic tools andconcepts for analysing these and other macroeconomic issues, we need to clarifysome essential terminology and techniques

The circular flow of income and spending

We start by looking at how economists measure income, and at how theydivide it into useful components to facilitate subsequent efforts to understandwhat determines income and what makes it change For this purpose we em-ploy a preliminary stylized picture (or ‘model’) of the economy: the image ofcontinuous circular flows This model, which we begin to build in Figure 1.4,identifies the key actors (or sectors) of an economy, and then proceeds todescribe and measure the interaction between them

Factors of productionare

all resources used in the

production of goods and

services: labour, capital goods

such as machines, and natural

resources such as oil.

Figure 1.4 The circle shows that households furnish firms with production factors such

as labour, and receive goods and services produced by firms in return (Please excuse

us for describing something that flows around four corners as a circle!)

Firms Households

Labour Income

Goods

Spending

Figure 1.5 The outer circle shows that the inner real flow of labour and goods is financed by a monetary flow of income payments from firms to households and of households’ spending on the firms’ goods.

Suppose there are only two actors, households and firms In an economy without money – economists call this a barter economy – households and

firms interact through a continuous flow of real transactions Householdsfurnish firms with labour (and usually also capital goods like machines and

buildings, or land) Firms use these factors of production, or resources, as

they are also called, to produce goods (and services) These goods flow back

to the households, constituting compensation for having supplied the factors

of production

It would not be very efficient if pizzerias were to compensate pizzaiolos withthe margaritas and calzones they baked, and if Alfa Romeo were to pay em-ployees with a brand new Alfa 147 every six months In modern economies,firms pay households with money for using the factors of production This re-lieves pizzaiolos of a tedious search for Alfa Romeo workers with just the rightcraving for pizza Therefore, in the upper half of Figure 1.5, an appropriateamount of euros, pounds or kronas flows back to the households, completingthis transaction In the lower half, households spend their money incomes onthe goods produced and put on the market by the firms So in the end thecounter-clockwise circular flow of real transactions between households andfirms remains intact It is now complemented by an outer circle flowing clock-wise which records the payments streams that compensate for the goods receivedand for the labour provided

The outer circle has an important advantage over the inner one: it is easier

to measure, since all transactions are denominated in the same measuringunits This is not true for the inner circle Typically, both the factors of pro-duction and the goods produced are very heterogeneous and cannot simply beadded up Economists therefore focus on the outer circle of income and spend-ing to measure aggregate economic activity

An important point to note is that one person’s spending – flowing fromright to left in the lower part of the outer circle – is another person’s income,received after completion of the upper part of the outer circle So all spending

1.2 Essentials of macroeconomic accounting 9

must add up to the same amount to which all incomes add up Total production

or aggregate output, the value of all goods and services produced by firms,may therefore be measured either by adding up all incomes, or by adding upall expenditures

Figure 1.5 provided a very simple first picture, and there are a number ofcomplicating factors For example, consumers may not, and typically do not,spend all their income As Figure 1.6 illustrates, if households save €20 out of

an income of €100, only €80 arrives at the firms in demand for their goods.The €20 leak out of the circular flow system On the other hand, the firms’

products are not only bought by consumers The pizza place may buy an Alfa

and offer home deliveries Such investment demand is typically not paid for

out of current income (in fact, firms have no income) but is financed by

bor-rowing money from banks In this light, investments take the form of injections

into the income circle

Figure 1.6, with its focus on bringing savings and investment into the ture, illustrates how the basic circular flow model may be adapted to take intoaccount complications that arise in reality We now take a big step and intro-duce all those leakages and injections that will play prominent roles in the re-mainder of this book First, income received by households may not arrive atthe firms as demand for three main reasons:

pic-1 People save We have noted this point already If people save part of their

income, their consumption expenditures fall short of what they have

pro-duced and received as income Saving may thus be viewed as a leakage of

income out of the circular flow system

2 Governments levy taxes The taxes that governments levy on citizens are a part

of income which is prevented from turning into demand – another leakage

3 People buy foreign goods Income earned at home which is used to buy

goods produced in a foreign country constitute a third leakage of incomefrom the domestic circular flow system

The expenditure approach

measures aggregate output

as the sum of all spending The

income approach adds up all

incomes instead.

Saving

Imports

Exports Investment

Injections

Leakages

Government expenditure

Total income Total expenditure

measurement error Data for Britain in 2002 are (in £billion):

and G = 450.4 Total income, the width of the stream, was 1,079.3.

1 Firms invest As noted, firms build or buy new production facilities, new

machines, distribution networks and so on These investments are typicallyfinanced via credit from banks or credit markets in general

2 Government spending Government spending on such things as public

con-sumption, infrastructure or transfers paid to households or firms represents

an injection from the outside into the income circle

3 Foreigners buy our goods If residents of foreign countries decide to buy

do-mestically produced goods, this represents a last injection of demand intothe circular flow

Figure 1.7 depicts the improved circular flow of income that allows for these six categories of leakages and injections.Note that we build on the outer,

clockwise flow of income and spending introduced in Figure 1.5 and refined inFigure 1.6 For the sake of clarity we will now refrain from identifying firmsand households in the circle (To include them would complicate the picture

Note In economics the term

investment describes

purchases of capital goods.

This differs from the popular

use of the word which calls

purchases of financial assets

(say, stocks) out of savings

’(financial) investments’.

Transfersare payments from

governments to individuals or

firms that do not involve

goods or services, such as

welfare payments or housing

subsidies.

1.2 Essentials of macroeconomic accounting 11

since, for example, both firms and households buy imports which would tail separating out their respective imports.)

en-Leakages of spending are shown in the upper part of the ‘circle’, injections

of spending in the lower part Only if the sum of all leakages equals the sum ofall injections does total expenditure (measured at the end of the lower leg ofthe circle) exactly match total income (measured at the outset of the upperleg) But wouldn’t leakages match injections only by pure chance? The answer

is no Quite the contrary: in the end, when we add everything up, leakages and

injections always match Why is that?

Suppose that initially, with the amount of investment planned by firms,injections would fall short of leakages Then spending tends to fall short ofsupplied output, and firms must add unsold output onto their existing stock

of inventory Whether they like it or not, they are forced to ‘demand’ thatpart of output themselves which they cannot sell In the opposite case, if de-mand exceeds output, either firms must draw down their existing inventory,

or, if that is not feasible, that part of demand which exceeds supply remainsunsatisfied

Now let investment not only be the purchase of machines, but also the dition to stocks of inventory (which are classified as capital goods) Then theforced changes of inventory described in the previous paragraph always ren-der investment just high or low enough to make injections equal to leakages

ad-So the bottom line is that, if investment is understood to include inventory

changes, the leakages and injections always balance, and the following

equa-tion holds at all times:

(1.1)Note that we have paired each leakage with an injection so as to yield a mean-

the interactions between the domestic economy and the government sector;

are net imports, the country’s balance of trade in goods and serviceswith the rest of the world

As we shall see in subsequent chapters, the circular flow identity is anextremely effective gadget in any trained economist’s tool-box But it canalso be very misleading if used in an uninformed way, that is withoutresolving the ambiguities in cause and effect that are often present inmacroeconomics

One example of such uninformed use would be to rearrange equation (1.1)

so as to yield

(1.2)and then conclude that in order to raise what is perceived to be insuffi-cient investment by 10 billion, all the government must do is raise taxes by

10 billion

A look back at Figure 1.7 reveals that this recommendation naively assumes

that increasing the tax leak leaves all other leakages and all injections except I

unaffected, thus forcing investment to rise with taxes Without an economic

CASE STUDY 1.1 Measuring income: gross domestic income vs gross

domestic product

Income is a key variable in any economy, both as

proposed in our theoretical models, and as

mea-sured in reality In our models we simply call it

ag-gregate income, or output, and stick the label Y

onto it In reality, it can be measured in a number

of ways The two most important and most

fre-quently used definitions are gross domestic

prod-uct (GDP) and gross national prodprod-uct (GNP) Gross

domestic product sums up what is being produced

within the geographical borders of a country Gross

national product is the term for all income received

by the inhabitants of a country, no matter whether

it results from production at home or abroad This

is why it is often called gross national income (GNI)

these days.

Which of these two measures of income is the

proper one in a specific context depends on

whether we are modeling economic activity in a

geographic region or the material well-being of a

group of people In most models introduced in this

book, the geographic region, say the UK, France,

Europe or China, takes centre stage Then the

appropriate measure of income is GDP In a few

instances, though, such as when we talk about the

effects and the motives behind globalization, we

need to look at how people rather than regions

are affected, and thus cast an eye on GNP.

In the real world, the distinction between GDP

and GNP is not seriously relevant for most

coun-tries, as Figure 1.8 shows In Europe, there is less

than a handful of countries for which the

differ-ence between GDP and GNP is much larger than

what may be attributed to measurement error At

one end, Ireland stands out, in addition to

Luxem-bourg, with a GNP that falls short of GDP by a

whopping 15% The reason is well known By

low-ering taxes aggressively in competition with other

European countries for foreign capital since the

1980s, Ireland succeeded in attracting foreign firms

and capital investment from abroad at a

breath-taking pace As a consequence, a substantial part of

the Irish capital stock – machines, buildings,

com-puters, laboratories and more – belongs to

foreign-ers, or has been bought with foreign capital The

earnings generated with this capital go to

resi-dents of foreign countries, and are thus included in

Ireland’s GDP, but not in its GNP.

The opposite applies to Switzerland Here GNP

exceeds GDP by 8% This is because a substantial

part of Switzerland’s savings has been invested abroad, in countries such as Ireland The capital in- come generated by these investments – interest earnings, dividends, rents or profits – adds to Switzerland’s GNP, but is not included in its GDP Figure 1.9 compares the absolute levels of GDP and GNP for the selected group of countries The message is that for most countries the difference is barely visible, and we may not make a serious mis- take by using one of the measures instead of the other: say, if the other is not available Even for Switzerland and Ireland, the difference between the two income aggregates appears less dramatic

in Figure 1.9 than it did in Figure 1.8.

GNP–GDP (%)

–20

IRL P A NL E I D GER DK GR USA F N S B JP UK CH

–15 –10 –5 0 5 10

Gap GNP–GDP, in % of GDP, 2004

Figure 1.8

0 10 20 30 40 50

GDP GNP

IRL P A NL E I D GER DK GR USA F N S B JP UK CH

GDP and GNP, 2004

Figure 1.9

1.2 Essentials of macroeconomic accounting 13

understanding of what determines the decisions of investors, consumers, porters and importers, other equally valid (or invalid) interpretations would

ex-be the following:

■ Raising taxes reduces savings by an equal amount (since equation (1.1)

investment unaffected

What sets these assertions apart is which variables are held fixed and which

ones we allow to change after we changed T Each version was arbitrary.

Without an understanding of how investment, savings, import and export cisions are being made, there is no way of telling what will actually happenafter a tax increase It is possible that several of the other leaks and injections

de-may change after T rises To complicate things further, even the width of the

circular flow stream, which measures the income level, may be affected by thetax increase

So if it is to be used in the context of economic analysis, the circular flowequation needs to be combined with thorough economic reasoning This will

be enlarged upon in subsequent chapters As it is, the circular flow identityonly provides a glimpse at some key structural properties of a country’seconomy

Actual numbers for the components of the leakages and injections bined in equation (1.1) and other related variables are assembled in the

com-national income accountsof a country Table 1.3 presents the sums involved,

EX = S - I + T - G + IM

IM = I - S - T + G + EX

S = I - T + G - IM + EX

National income accounts

report data for GDP and its

components.

Table 1.3 The circular flow identity in numbers (2006, as % of GDP) The data decompose

the circular flow identity for a set of industrial countries To permit comparability, gates are given in percentages of GDP The data report similarities and differences between countries Consider Italy and Japan, which run a similar government budget deficit In Japan this is easily financed by private domestic savings What sets the two cases apart is that Japan’s government runs up its debt against its own citizens only, while Italy also runs up debt against the rest of the world.

expressed as percentages of GDP While country experiences differ, there aresome common threads in the data:

■ Most countries still run sizeable budget deficits Governments spend morethan they receive

■ In the majority of countries private savings exceed private investment This

is one way of financing the government budget deficit (or syphoning off thenet injections coming from the government sector) Instead of savings beingpassed on to firms for investment spending, they go to the government forfinancing the deficit

■ About half of the countries shown here export less than they import Inthose countries the net injection from the private and government sectors

to other countries Other countries may appear to refrain from buying ourexport goods with all the money they receive for our imports from them, butinstead lend part of that money to our government and/or firms to financethe national deficit

Discussion of the twin deficits that were haunting the US economy in the1980s and 1990s and returned with a vengeance in recent years offers amplereal-world examples of uninformed use of the circular flow identity, which theabove stylized example attempted to discredit To some, the US budget deficitcauses the current account deficit, and therefore it has to be removed (based

im-port restrictions cause the current account deficit, which in turn forces the US

third view is that neither is true Rather, insufficient private savings in theUnited States drive the current account into deficit (based on

) Again, while there may be a grain of truth

in all three explanations, no judgement is possible before we understand howthe people who make up the economy make choices

Money in the circular flow

Figure 1.5 featured a counter-clockwise flow of real factors such as labour andgoods, and a compensating clockwise nominal flow of money income (evalu-ated at today’s wages) and spending (evaluated at today’s prices) We knowthat each flow is simply a mirror image of the other It seems plausible thathow labour is linked to income depends on the wage rate, and how goods relate

to spending depends on prices To sharpen our understanding of this we need

to introduce moneyinto the circular flow model How does money fit in?Consider the example given in Figure 1.10 Firms only employ one factor ofproduction – labour – to produce one good – cars Assume this economy pro-duces 6 cars annually, using 24,000 work-hours Assume 30,000 euros floataround in this economy, in notes and coins To keep the argument simple, letthere be no other money (such as bank accounts) Now if those €30,000 arebeing turned over (meaning that they flow from firms to households and back)

12 times a year, the firms’ cash registers add up a total of €360,000 Since thissum represents the payments for 6 cars, the price of a car is obviously

€60,000 On the other hand, over the course of a year €360,000 also arrive in

Countries run twin deficitsif

both the government budget

and the current account are in

deficit.

Moneyis anything that sellers

generally accept as payment

for goods and services.

1.2 Essentials of macroeconomic accounting 15

Figure 1.10Looking at the inner circle first, we assume that firms use 24,000 hours

of labour to produce 6 cars If €30,000 circulates 12 times a year, annual income and annual spending must be €360,000 Hence the wage rate must be €15 per hour and the price of a car is €60,000 Thus, given all the other factors, the supply of money determines goods’ prices and nominal wages.

the pockets of households as wage incomes, as compensation for 24,000work-hours So the hourly wage rate must be €15 per hour Nominal income

and spending equals €360,000, while real income and spending equals 6 cars.

Next, consider the following thought experiment – devised by an economistwho later won the Nobel prize Let a helicopter fly all over our imaginarycountry, and, little by little, scatter €3,000 in small notes What are the conse-quences? If by now €33,000 continue to circulate at the speed of 12 turnovers

a year, cash registers will count €396,000, as will wage earners As regardsprices, we consider two extreme cases

One possibility is that the number of work-hours used in the productionprocess remains at 24,000 hours This could be because we are operating atthe capacity limit, and this leaves output at 6 cars Then €396,000 of incomeand spending must be compensation for 24,000 work-hours and payment for

6 cars So the price of a car must have risen to€66,000, and the hourly wage rate

to€16.50 Workers have to work 4,000 hours to earn enough money to buy a

car, just as much as before the helicopter mission Putting this differently, nominal

Real income, income in terms of what it can buy, is unchanged at 6 cars.

As a second possibility, the increase of nominal spending to €396,000 mayinduce firms to increase output instead of raising prices At the original pricelevel, 6.6 cars can be sold This requires 26,400 work-hours, which, at thegoing wage rate of €15, produces €396,000 of income Workers still have towork 4,000 hours to make enough money to buy a car This leaves the realwage rate, the purchasing power of one hour’s work, unchanged at 0.00025

cars Economy-wide real income has increased by 10% to 6.6 cars.

The numerical example discussed here motivates the classical quantity equation

Quantity equation

It states that the money supply M times the velocity of money circulation V equals nominal income PY (where P is the price level and Y denotes real income).

M * V = P * Y

The numerical example

discussed here motivates the

classical quantity equation

It states that the money supply M

times the velocity of money

circulation V equals nominal

income PY (where P is the

price level and Y denotes

real income) In the

example, M increases from

unchanged In the second

case, Y rises from 6 to 6.6 at

an unchanged price level It

should be obvious that both

P and Y may rise, as long as

Goods: 6 cars

Spending: = C 360,000

The quantity equation

becomes

a theory of inflation, the

quantity theory of money,

by letting V be constant Then

the money supply determines

nominal income:

.

P * Y = V * M

M * V = P * Y