DADSAS and Mundell Fleming a look behind the scene
Let us pause to look at what is going on beneath the surface of the DAD-SAS model as displayed in the p-Y diagram. The purpose of this interlude is to emphasize that whatever happens in the DAD-SAS model can be traced back to the Mundell-Fleming model, and vice versa. We look at the immediate response to an increase in money growth first, which moves the economy up along SAS j. The short-run response in DAD-SAS and IS-LM-FE representation In Figure 8.8 the economy is in equilibrium at point A....
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...
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...
Booms and recessions I the Keynesian cross
After working through this chapter, you will understand 1 The difference between steady-state income, potential income and actual income and what booms and recessions are. 2 How aggregate planned expenditure determines output and income in the short run. 3 How additional government spending may trigger additional private spending via the multiplier. 4 That economic decisions are often made on the basis of what people expect to happen in the future rather than on what they observe today. At 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....
The graphical ISLM model
Both the IS and the LM curves show combinations of interest rates and income levels that render the market under consideration in equilibrium. It is thus straightforward to merge the two curves onto one graph to obtain a model of the global economy thought to comprise a goods and a money market. Figure 3.9 does just that. There are many points in this graph on the IS curve that render a goods market in equilibrium, such as points A, B and C. And there are also many points on the LM curve that...
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...
Equilibrium in all three markets Equilibrium with graphs
We now know how to draw equilibrium lines for the money market, the goods market and the foreign exchange market in the i-Y plane. Each line yields interesting insights into a particular sector of the economy. But these are not yet sufficient to pin down a unique macroeconomic equilibrium -which is what we are primarily interested in and set out to identify. If the isolated discussion of individual markets only carried us so far, perhaps we can achieve progress by merging them. Let us construct...
Equilibrium income
The graphical representation of aggregate expenditure can now be used to determine equilibrium income. Figure 2.9 replicates the aggregate-expenditure line from Figure 2.8. This line has a positive intercept, depicting those components that are immune to income changes. Its slope is positive but smaller than 1, since individuals do not want to consume their entire income, but wish to save a small fraction of it. By contrast, the actual-expenditure line passes through the origin and has slope 1....
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...
Booms and recessions II the national economy
After working through this chapter, you will understand 1 What the national-economy Mundell-Fleming model is, and how it differs from the global-economy model. 2 How fiscal policy affects equilibrium income in the Mundell-Fleming model. 3 How monetary policy affects equilibrium income in the MundellFleming model. 4 How demand shocks in general, including those originating from abroad, affect equilibrium income. 5 The difference between comparative statics and adjustment dynamics. 6 How things...
Ca K Nx Ex Im xLYWorld x2R mLY m2R
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 m1 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 obtained by letting CA 0 in equation 4.2 and solving for Y. This yields All points that balance the current...
Back to ISLM enter the FE curve
The loose end remaining after the discussion of the goods market in Chapter 3 section 3.2 is the exchange rate. Left to market forces in a system of flexible exchange rates, currency prices tend to move about quite a bit - more than any other macroeconomic variable. While there may be market psychology and speculation involved, a number of strings attach the exchange rate to the set of variables we are focusing on in macroeconomics. This section identifies and formalizes these relationships....
The Mundell Fleming model under capital controls
In this book we assume that capital moves unhindered across borders. This describes the current situation quite well in industrial and many other countries. But there are still some countries, mostly in the developing world, that do not permit free movements of capital in and out. In Tanzania, for example, citizens need to submit proof of an import contract and obtain a permit if they want to acquire foreign currency. The purchase or sale of currency is usually not permitted for financial...
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...
