The SAS curve under fixed and flexible exchange rates
Let the world consist of Germany and Italy only when both still had their national currencies. German consumers purchase a basket of goods containing a share a of goods produced in Germany and a share 1 - a of goods produced in Italy. If the prices of these goods are PD and PI respectively, the German price index is P PD (EPI)1 -a. The l ira prices of goods produced in Italy need to be multiplied by the DM lira exchange rate to obtain their equivalent in marks. Taking logarithms of the price...
Who wanted the euro The role of government debt
In the mid-1990s not all 15 member states of the European Union welcomed the prospect of a single currency. At one extreme, 70 of Italians welcomed the euro while only 15 rejected it. At the other extreme only 25 of the Danish public wanted the euro while a hefty 60 did not. We saw in Case study 11.1 that part of this difference in attitudes can be attributed to different inflation experiences and, hence, different benefits from the price stability the ECB's monetary policy is expected to...
Key terms and concepts
(debt-to-income ratio) 383 deficit financing 381 deficit ratio (deficit-to-income ratio) 383 government budget constraint 382 government debt 398 debt 396 money financing 391 phase line 384 primary deficit 381 public debt 382 seignorage 395 14.1 Table 14.3 presents data on debt and GDP for a number of European countries in 1992. Compute the debt ratios and determine the level of debt that would just meet the Maastricht criterion of 60 of GDP. 14.2 Consider a country with a primary deficit rate...
Technology change in Malaysia the return of the Solow residual
Real business cycle RBC models propose that the main driving force behind macroeconomic fluctuations is technology shocks. Before arguing that such shocks are impossible to measure, making the RBC model virtually immune to empirical testing, remember Chapter 9 on the basics of economic growth. There we had used the growth accounting equation to obtain an estimate of technological change, which we called the Solow residual The equation states that the part of income growth that cannot be...
Household behaviour intertemporal choices
Households have to decide not only how to allocate time between work and leisure, and split income between consumption and saving today or this year . They also have to make a plan for these same decisions tomorrow or next year . Of course, today's decisions cannot be made independently of tomorrow's. This is most obvious in the case of consumption if I consume less and save more today, I will be able to consume more tomorrow. But it also applies to leisure time by working more today I may be...
Empirical merits and deficiencies of the Solow model
Empirical work based on the Solow growth model usually proceeds from the assumption that, in principle, the same production technologies are available to all countries. Thus all countries should operate on the same partial production function and experience the same rate of technological progress. This leaves only two factors that may account for differences in steady-state per capita incomes. The first is the savings or investment rate. The higher a country's rate of investment, the larger the...
Liquidity traps and Japans prolonged recession
Japan's long economic slump experienced during the second half of the 1990s baffled many observers. While the real money supply increased by almost 40 between 1996 and 2000, income rose by a barely observable 3.2 . So contrary to what we have learned from this chapter's analysis, monetary policy in this case does not really seem to have an effect on income worth talking about. Does this mean the IS-LM model is of no help in trying to understand Japan's recent slump One might be tempted to think...
Fixed exchange rates
Under fixed exchange rates the first step is the same. If the money supply is increased via the purchase of domestic bonds by the central bank, the LM curve shifts to the right. And again, the increased liquidity tends to drive the interest rate down. As investors get rid of domestic bonds and throw domestic currency on the market, the exchange rate cannot respond. Instead, the central bank is called upon as the 'buyer of last resort'. It is required to take Figure 5.3 Flexible exchange rates....
Monopolistic trade unions
Another institutional feature which causes labour markets in many industrial countries - and particularly in a host of European economies - to Maths note. If you are unfamiliar with hyperbolas, suppose w 5 L. Use a pocket calculator to compute the real wages for all L from 1 to 10. Plot these values in a w-L diagram and you have a hyperbola. deviate from the ideal classical scenario, is the prominent role of trade unions in the wage negotiating process. Wages are set in a collective negotiating...
Insiders and outsiders
As before, let workers be represented by a monopolistic trade union. Let the economy be in the same equilibrium that we identified in the preceding section. Now, however, assume that the trade union only cares about employed members, the insiders. Union members who are out of employment, be it voluntarily or not, are outsiders. In many countries, only employed trade union members can exercise active membership rights, such as voting about whether to accept a bargaining settlement between union...
List Of Case Studies And Boxes
1.1 Germany's current account before and after unification 12 2.1 Income vs leisure time in France and the USA 42 2.2 How to pay for the war Great Britain in 1940 50 3.1 Liquidity traps and Japan's prolonged recession 82 4.1 Italy's current account before and after the 1992 EMS crisis 100 5.1 The 1998 Asia crisis 122 6.1 Ford's focus an experiment in efficiency wages 161 7.1 International evidence on the quantity equation and the AD curve 189 8.1 Quantity equation, Fisher equation and...
Time to pause we have come a long way
The AD curve, the graphical image of demand-side macroeconomic equilibria, is an admittedly complex concept with a deep foundation that stretches over several chapters. Before we proceed to combine the AD curve with the AS curve to obtain the most sophisticated model of booms and recessions discussed in this book, let us pause, step back and recall what we achieved so far. Figure 7.7 reminds us of the main concepts and how they fit together. We had chosen two kinds of perspectives. Initially,...
The equilibrium price level
The AD curve identifies the level of aggregate demand obtaining at different price levels. Yet if we do not know prices, we cannot determine the level of aggregate demand. The AS curve identifies aggregate supply at different price levels. Again we cannot identify aggregate supply until we know the price level. What helps here is that in equilibrium aggregate demand must equal aggregate supply. Graphically, therefore, the equilibrium price level is where Figure 7.9 This graph emphasizes key...
Income vs leisure time in France and the USA
In 1997 GNP in the United States of America stood at 7,783 billion while GNP in France was 1,542 billion. This is a preliminary, raw comparison of incomes, however, which does not take into account a number of factors. One very important factor is that one US dollar does not buy the same amount of goods in all countries - its purchasing power is not the same. Adjusting for differences in purchasing power, on a common measure French GNP is worth only 1,302 billion. This means that when French...
The circular flow model revisited terminology and overview
We begin by building up some terminology and clarifying key concepts. For that purpose we revisit the circular flow diagram from Chapter 1 see Figure 2.5 . In an attempt to develop an expression for the total spending or total demand which comes back to domestic firms, note that households receive gross income Y top left-hand corner . Payment of taxes reduces this to disposable income Y T. After removing savings from the loop we obtain what is left for consumption, i.e. C Y T S. Because of the...
Money supply vs interest control in a changing world
In Box 3.2 we concluded that it does not really matter whether the central bank uses the money supply or the interest rate as a policy instrument. This is true in a world that does not change. A second look at this issue is required, however, in a world of change and uncertainty. Suppose the central bank has two options announce a money supply target at the beginning of the year, and stick with it, no matter what happens, or, announce an interest rate target and stick with it. Further, suppose...
Italys current account before and after the 1992 EMS crisis
In open-economy models of the macroeconomy the exchange rate provides the key link between the monetary sector and the goods market. Changes in policy variables, such as the money supply or the interest rate, affect the exchange rate which, in turn, affects, imports and exports and, hence, income. Whether the assumed effect of the real exchange rate on imports, exports and, hence, the current account does indeed have an impact in the real world is often difficult to judge and may require the...
The Islmfe model in a different dress
The IS-LM-FE model comprises three markets which determine three endogenous variables. Under flexible exchange rates these are i, E and Y. When we reduced the 3D graph of this model shown in Figure 4.7 to two dimensions we chose to show i and Y on the two axes, thus relegating E to an invisible role in the background. While this is the traditional choice, we may just as well have chosen to show i and E on the two axes, or E and Y. You often find the latter display in current textbooks, with the...
Endogenous and exogenous variables
The IS-LM-FE model provides a good opportunity to illustrate and re-emphasize the distinction between endogenous and exogenous variables, and to show how institutional arrangements change the nature of a variable. A model always comprises exogenous variables - their values are determined outside the model, and endogenous variables - to describe their behaviour is the very purpose of the model. A model may have an arbitrary number of exogenous variables. But it can only explain as many...
Working with graphs part II
I do not recommend learning the slopes of equilibrium curves like LM by heart. Neither do I advise memorizing which factor shifts the graph which way. As long as the economic reasoning behind some market equilibrium is understood, slopes and shifts of curves can, in most cases, be worked out by simple thought processes. Algebra or calculus is not necessary. For example, take the LM curve to demonstrate the nature of the thought process. Suppose you forgot how the graph slopes in the i Y diagram...
The Keynesian cross with income expectations
So what are the implications of this for our previous determination of equilibrium income in the circular flow and for the expenditure multiplier The first result, that a unique equilibrium income level exists and that a neat first attempt to determine it is at the point of intersection between the aggregate demand line and the 45 line in the Keynesian cross, remains intact. The multiplier, however, has lost some of its pervasiveness and must be handled with much more care. Figure 2.15 draws a...
Recommended reading
While much of the discussion in this and the next chapter derive from John Maynard Keynes's thinking, his writing is very heavy-going and reading it at this stage may confuse rather than enlighten. The graphical apparatus on which we rely has been introduced by John Hicks 1937 'Mr. Keynes and the Classics A suggested interpretation', Econometrica 5 147-59. Concepts such as the Keynesian cross and the multiplier are discussed extensively in almost every macroeconomics textbook. If you desire a...
