Macroeconomics:Imperfections, institutions, and policies

OXFORD

MACROECONOMICS

Imperfections, Institutions 8t Policies

Wendy Carlin David Soskice

Macroeconomics

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Macroeconomics:

Imperfections, Institutions,

and Policies

Wendy Carlin and David Soskice

OXPORD

UNIVERSITY PRESS

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OXfORD U N IV E R S IT Y PR ESS

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Fo r A ndrew a n d Niki

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■ PREFACE

1 Audience

T h is b o o k p ro v id es a w ide a u d ie n ce w ith access to m o d e m m a c ro e co n o m ic s . T h e co re

a u d ie n ce is u n d e rg ra d u a te s w h o alread y h a v e so m e b a ck g ro u n d in m a c ro e co n o m ic s . It

is also d esign ed fo r g rad u ate stu d en ts, a ca d e m ic e c o n o m is ts , a n d e co n o m ists w ork in g

in p o licy m a k in g a n d th e p riv a te se cto r w h o w a n t a n in tro d u c tio n to m a jo r ch a n g e s

th a t h a v e ta k e n p lace in m o d e rn m a c ro e co n o m ic s . K n ow led g e o f e c o n o m ic s h as b e co m e

in creasin g ly c e n tra l to co u rses in p o litical scien ce a n d p u b lic p o licy a n d th is b o o k w ill be

used th e re as w ell.

T h ro u g h o u t th e b o o k , w e e m p h asize th e ro le th a t im perfections p lay in lab o u r, p ro d u ct,

an d fin an cial m ark ets in sh o rt-, m e d iu m -, a n d lo n g -ru n m a c ro e co n o m ic s . Institutions

an d policies featu re h e a v ily in th e b oo k . By in stitu tio n s w e m e a n b o th th e b ro ad rules of

th e g a m e w ith in w h ich th e p layers in th e e c o n o m y o p e ra te a n d th e key o rg a n iz a tio n s.

C e n tra l bank s fu n c tio n a c c o rd in g to th e p rev ailin g m o n e ta ry p o licy fram ew o rk a n d set

m o n e ta ry p o licy ta k in g in to a c c o u n t th e b e h a v io u r o f th e p riv a te se cto r. E m p lo y ers an d

em p lo y ees o p e ra te w ith in a set o f lab ou r m ark et in stitu tio n s in w h ich u n io n s m a y bargain

o v e r w ages a n d w h e re th e re are rules g o v e rn in g h irin g a n d firing. Fin an cial m ark et in sti￾tu tio n s im p in g e o n in v e s tm e n t d ecisio n s b y firm s a n d o n th e b e h a v io u r o f h o u se h o ld s.

G o v e rn m e n ts im p le m e n t fiscal p o licy w ith in a fiscal p o licy fram ew o rk . T h e y also design

a n d im p le m e n t lab o u r m ark et, e d u ca tio n , in n o v a tio n , a n d co m p e titio n p o licies. Th e

large p layers in th e e c o n o m y m a y a c t strateg ically in th e ir o w n in terest a n d w e an aly se

th e m a c ro e c o n o m ic im p a ct o f th is.

2 What this book offers

• t o u n d e r g r a d u a te s s tu d y in g e c o n o m ic s

It is likely th a t y o u w ere a ttra c te d to e c o n o m ic s b ecau se it offers th e p ro sp e ct of

u n d e rsta n d in g big q u e stio n s a b o u t h o w th e w orld w orks. W h y h as in flatio n b een such

a m a jo r p ro b lem in s o m e co u n trie s at s o m e tim e s b u t n o w seem s v ery low a n d stab le in

m a n y c o u n trie s ? D o e x c h a n g e rates m a tte r for u n e m p lo y m e n t? W h y is a c o u n try like

th e UK th a t h ad p o o r m a c ro e c o n o m ic p e rfo rm a n ce tw e n ty y ears a g o p e rfo rm in g m u ch

b e tte r in re ce n t y e a rs? W h y are G e rm a n y a n d Ja p a n p e rfo rm in g so p o o rly ? W h a t are th e

likely c o n s e q u e n ce s fo r o th e r c o u n trie s o f a m a jo r hike in c o m m o d ity a n d oil p rices as

a c o n s e q u e n ce o f C h in a ’s rap id g ro w th ? H ow did so m e co u n trie s g et to be rich w h ile

o th e rs re m a in p o o r? W ill th e tra n sitio n e c o n o m ie s c a tc h up w ith th e rest o f th e E u ro p ean

U n io n ?

Ju s t as w h e n stu d y in g in d u strial e c o n o m ic s yo u e x p e c t to be able to d iscu ss c o m p e ­

titio n p o licy d e b a te s, o r, in lab o u r e c o n o m ic s, to p a rticip a te in d eb a te s a b o u t th e m in i￾m u m w age o r m ig ra tio n , in m a c ro e co n o m ic s y o u sh o u ld b e ab le to d iscu ss th e fo llow in g:

d e fla tio n in J a p a n , th e m erits o f e u ro m e m b e rsh ip for th e re c e n t a c c e ss io n c o u n trie s o f

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v iii PREFACE

th e EU , th e cau ses a n d c o n se q u e n ce s o f t h e USA’s w id en in g c u rre n t a c c o u n t d eficit, th e

likely co n se q u e n ce s for u n e m p lo y m e n t o f a n a cce le ra tio n o f p ro d u ctiv ity g ro w th , th e

ro le o f e d u c a tio n in e c o n o m ic g ro w th , a n d so o n .

T h is b o o k gives y o u a sy ste m a tic w ay o f th in k in g a b o u t q u estio n s like th e se . Y o u will

en d u p w ith a m o d e l th a t y o u c a n u se y o u rse lf to u n d e rsta n d m a c ro e c o n o m ic b e h a v io u r

an d p o licy issues in th e real w orld . In w h a te v e r job y o u g et, w h e th e r w o rk in g in a s ta rt￾up h ig h te ch c o m p a n y o r in a fam ily b u sin ess, in a v o lu n ta ry se c to r o rg a n iz a tio n , for

an in v e s tm e n t b an k , o r for th e m in istry o f fo reig n tra d e , y o u w a n t th e c o n fid e n ce to

be able to in te rp re t n a tio n a l a n d in te rn a tio n a l e c o n o m ic tren d s a n d th e p o licy d eb ate.

Such c o n fid e n ce is b u ilt in th is b o o k b ecau se it in te g ra te s th e d ifferen t c o m p o n e n ts o f

m a c ro e co n o m ic s a n d th e n sh o w s in C h a p te rs 17 a n d 1 8 h o w th e m o d e l c a n be u sed to

u n d e rsta n d a w h o le ra n g e o f p e rfo rm a n c e a n d p o licy issues in E u ro p e , Ja p a n , a n d th e

USA in th e last th irty y ears. Y o u m a y w a n t to tak e a lo o k a t th ese c h a p te rs b e fo re sta rtin g

o n th e rest o f th e b oo k .

G o in g b e y o n d co u rses in m a c ro e co n o m ic s , th e b o o k h as c o re m a te ria l fo r co u rse s in

th e e c o n o m ic s o f g ro w th , m o n e y a n d b an k in g , la b o u r e c o n o m ic s, th e e c o n o m ic s o f

u n e m p lo y m e n t, in te rn a tio n a l m o n e ta ry e c o n o m ic s, a n d th e e c o n o m ic s o f m o n e ta ry

in te g ra tio n .

• t o g r a d u a te s tu d e n ts in e c o n o m ic s

T h is b o o k is based o n th e m a in stre a m m o n e ta ry m a c ro m o d e l used in c u rre n t research

in u n iv ersities a n d c e n tra l b an k s. M o d ern m o n e ta ry m a c ro e c o n o m ic s uses w h a t is o ften

called th e 3 -e q u a tio n N ew K eyn esian m o d e l, w h e re th e th re e e q u a tio n s are

• th e /5 cu rv e

• th e P hillips cu rv e (P C ) an d

• a n o p tim iz in g m o n e ta ry p o licy ru le (M R).

Built a ro u n d th is c o re , th e b o o k p ro v id es y o u w ith a re fe re n ce b a ck to in tu itiv e a n d

less fo rm al e x p la n a tio n s o f th e 3 -e q u a tio n m o d e l a n d o f e a c h o f its c o m p o n e n ts . To

facilitate th e forw ard lin k age t o m o re a d v a n ce d tre a tm e n ts , w e sh o w in C h a p te r 15 h o w

th e m o d e l ca n be b u ilt u p fro m m ic ro fo u n d a tio n s w ith fo rw a rd -lo o k in g o p tim iz in g e c o ­

n o m ic ag e n ts w h o h a v e ra tio n a l e x p e c ta tio n s .

T h e b oo k also p ro v id es a rig o ro u s c o v e ra g e o f g ro w th th e o ry — b o th e x o g e n o u s an d

e n d o g e n o u s. T h e re is a c o m p re h e n s iv e c h a p te r o n th e S o lo w -S w a n m o d e l w ith an

a p p e n d ix th a t in tro d u ce s R am sey savin gs. W e e m p h a siz e th e c h a ra c te ris tic s o f stead y

states, h o w th e e c o n o m y m o v e s fro m o n e stead y s ta te to a n o th e r , a n d h o w th e m o d el

ca n be used to test e m p irica lly for w h e th e r e c o n o m ie s are c o n v e rg in g . D iag ram s a n d in tu ­

itive e x p la n a tio n s co m p le m e n t th e fo rm al d e riv a tio n s o f th e key results. W e p ro v id e a

u nified tre a tm e n t o f e n d o g e n o u s g ro w th m o d e ls a n d e x p la in h o w a sim p lified v e rsio n o f

th e S ch u m p e te ria n g ro w th m o d el w ork s. W e illu strate th e rich v a rie ty o f q u e stio n s a b o u t

g ro w th a n d in stitu tio n s th a t S ch u m p e te ria n m o d els ad d ress. T h ese c h a p te rs serve as a

sp rin g b o ard for g o in g o n to m o re te ch n ic a l an aly sis a n d p ro v id e a stim u lu s for th in k in g

a b o u t m a n y ap p lied q u e stio n s.

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PREFACE ix

• to graduate students in political science and public policy

T h is b o o k p ro v id es a se lf-co n ta in e d tre a tm e n t o f m o d e m m a c ro e co n o m ic s th a t is

accessib le to g ra d u a te stu d en ts o f p o litica l scie n ce a n d p u b lic p o licy w h o h a v e th e basic

m a th e m a tic a l co m p e te n c e s d escrib ed b elow . T h e a p p ro a c h in co rp o ra te s th e p resen ce

o f m ark et im p e rfe ctio n s a n d in clu d es co v e ra g e o f a w id e ra n g e o f p o licy in stru m e n ts.

It is d esig n ed to h ig h lig h t th e ro le in m a c ro e co n o m ic s o f d ifferen ces acro ss co u n trie s

in in stitu tio n s— fro m th e lab o u r m ark et to th e fin an cial sy ste m — a n d is well su ited for

th e stu d y o f e c o n o m ic p e rfo rm a n ce a n d p o licy w ith in sp ecific p olitical c o n te x ts . In th e

ch a p te r o n P o litica l E co n o m y , w e exp lain in d etail th e sta n d a rd to o ls o f an alysis th a t

are used in p o litical e c o n o m y a n d th e ir a p p lica tio n to w ell-k n o w n p ro b lem s in clu d in g

th e cred ib ility o f c e n tra l b an k s, p o litical b usiness cy cle s, th e role o f u n io n c o o rd in a tio n

o n w age b arg a in in g to solve co lle ctiv e a c tio n p ro b lem s, a n d v o tin g m o d els. T h is c h a p ­

ter in clu d es a se lf-co n ta in e d in tro d u c tio n to m u ch o f th e g a m e th e o ry th a t is n eed ed in

m a cro p o litical e c o n o m y .

• to p ro fe s s io n a l e c o n o m is ts

T h e ap p lied c h a p te rs o n p e rfo rm a n ce a n d p o licy in E u rop e, Ja p a n , a n d th e USA a n d o n

u n e m p lo y m e n t p ro v id e o v erv iew s o f re ce n t d e v e lo p m e n ts an d em p irical a n aly ses w ith in

th e fram ew o rk o f c o n te m p o ra ry m o n e ta ry m a c ro e co n o m ic s . W ith its e m p h a sis o n h o w

ce n tra l b an k s b e h a v e a n d , m o re b ro ad ly , o n in stitu tio n s a n d p o licies, th e b o o k c a n be

used as a refresh er fo r th o s e p arts o f m a c ro e c o n o m ic th e o ry th a t are m o st relev an t for

e c o n o m is ts w o rk in g o n real-w orld p ro b lem s. A lth o u g h w e d ev elo p th e 3 -e q u a tio n N ew

K eyn esian m o d e l as th e n ew c o re o f th e s h o rt- to m ed iu m -ru n m o d e l, w e sh o w h o w it

links to th e tra d itio n a l m a c ro w o rk h o rses su ch as IS/ L M a n d th e M u n d e ll-F le m in g m od el.

3 Approach

W e b egin fro m th e a ssu m p tio n th a t o u r first task is to p ro v id e a m o d el th a t ca n be used

to u n d e rsta n d m a c ro e c o n o m ic b e h a v io u r a n d p o licy issues. As w ell as b ein g plugged

in to th e real w o rld , th e b o o k is firm ly c o n n e c te d to c o n te m p o ra ry d e v e lo p m e n ts in

m a c ro e c o n o m ic s so it o p e n s u p access to m o re a d v a n ce d literatu re a n d co u rses.

3.1 The current consensus

C o n se n su s in m a c ro e c o n o m ic s h as o fte n b een elu sive bu t th e c o m m o n g ro u n d is m u ch

w ider n o w th a n h as b een th e case in p rev io u s d ecad es. A strik in g illu stratio n o f th is ca n

be fo u n d in th e titles o f tw o in flu en tial a rticle s p u b lish ed in th e late 1 9 9 0 s , w h ich argue

for a sim ilar m a in stre a m m o n e ta ry m a c ro m o d e l: ‘T h e N ew N eo classical S y n th esis an d

th e Role o f M o n e ta ry P o licy ’ a n d ‘T h e S cie n ce o f M o n e ta ry P olicy : A N ew K eyn esian

P e rsp e ctiv e ’. 1 W e like th e N ew K eyn esian label b eca u se w h ereas th e n eo classical asp ects

o f th e m o d e l are s ta n d a rd m e th o d o lo g ica l featu res o f c o n te m p o ra ry e c o n o m ic m o d ellin g ,

th e te rm ‘K e y n e sia n ’ refers to th e fact th a t su ch m o d els allow for ‘p ro lo n g e d d ep artu res

o f e c o n o m ic a c tiv ity fro m its o p tim a l level as a co n s e q u e n ce o f in sta b ility in ag g reg ate

sp e n d in g ’.-

1 Cioodt'riend and Kinj; 111,0 and < larida. Gali, and (iertler 11 Also W ood lord t200.ii.

: W oodford ( I W i .

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X PREFACE

T h e re is b ro a d a g re e m e n t th a t a fully s a tisfa cto ry m a c ro e c o n o m ic m o d e l sh o u ld be

b ased o n o p tim iz in g b e h a v io u r b y m ic ro a g e n ts, th a t in d iv id u al b e h a v io u r s h o u ld satisfy

ra tio n a l e x p e c ta tio n s , a n d th a t th e m o d e l sh o u ld allo w for w ag e a n d p rice rig id ities. T h e

3 -e q u a tio n (IS-PC-M R) m o d e l is th e b asic a n a ly tica l stru ctu re in m u c h o f c o n te m p o ra ry

m a c ro e co n o m ic s . T h e th re e e q u a tio n s are d eriv ed fro m e x p licit o p tim iz in g b e h a v io u r o n

th e p a rt o f th e m o n e ta ry a u th o rity , p rice setters, a n d h o u se h o ld s in im p e rfe ct p ro d u ct

a n d lab o u r m ark ets a n d in th e p re se n ce o f s o m e n o m in a l rigidities.

In th e m a in stre a m m a c ro m o d e l th a t w e p re se n t in th is b oo k :

• B usin ess cy cle s are d riv en b y sh ifts in a g g reg ate d e m a n d (a n d w e c o n tra s t th is w ith th e

Real B usin ess C y cle m o d e l in w h ich su p p ly sh o ck s d rive th e cy cle ).

• O u tp u t a n d e m p lo y m e n t a re a ffected b y flu ctu a tio n s in a g g reg ate d e m a n d b e ca u se o f

n o m in a l rigidities th a t p re v e n t w ages a n d p rices a d ju stin g rap id ly .

• T h e c e n tra l b an k is m o d elled as a ctiv e ly a d ju stin g t h e in te re st ra te in resp o n se to

sh o ck s to th e e c o n o m y so as to a c h ie v e its in flatio n ta rg e t.

• A ggregate d e m a n d flu ctu a tio n s sh ift th e e c o n o m y aw ay fro m th e eq u ilib riu m ra te o f

u n e m p lo y m e n t.

• T h e eq u ilib riu m ra te o f u n e m p lo y m e n t (ER U ) is th e o u tc o m e o f im p e rfe ctly

c o m p e titiv e lab o u r a n d p ro d u ct m a rk e ts— th e re is in v o lu n ta ry u n e m p lo y m e n t a t th e

ERU.

• Sup ply sh o ck s sh ift th e eq u ilib riu m rate o f u n e m p lo y m e n t (ER U ) a n d in stitu tio n a l

an d p o licy d ifferen ces acro ss c o u n trie s im p ly d ifferen t ERUs.

A lth o u g h th e 3 -e q u a tio n N ew K eyn esian m o d e l is th e basis for o u r s h o rt- a n d m ed iu m -

ru n m o d e l, w e aim to an aly se real-life e c o n o m ic p e rfo rm a n ce so w e in clu d e a rich e r

tre a tm e n t o f m a c ro e c o n o m ic p ro cesses th a n is o fte n th e c ase in th e fo rm al m icro fo u n d e d

N ew K ey n esian m o d els. E x a m p le s in clu d e th e fo llow in g:

• h o w in stitu tio n a l d ifferen ces in w age se ttin g affe ct m a c ro e c o n o m ic o u tc o m e s

• a n u m b e r o f m e c h a n ism s th ro u g h w h ic h m u ltip le eq u ilib ria c a n e m e rg e an d

h y steresis c a n o p e ra te , in clu d in g c o o rd in a tio n failu res an d c a p a c ity u tiliz a tio n effects

• h o w th e flow a p p ro a ch to th e lab o u r m ark et c a n b e in te g ra te d w ith th e w ag e- a n d

p rice -se ttin g m o d el

• e x p la n a tio n s for a cy clica l o r w eak ly p ro c y c lic a l real w ages

• p ro b le m s w ith u sin g a n in te re st ra te b ased m o n e ta ry rule

• th e role o f th e cre d it ch a n n e l for m o n e ta ry p o licy

• h o w im p e rfe ct in fo rm a tio n p ro d u ce s liq u id ity c o n s tra in ts in c o n s u m p tio n a n d

e n h a n c e s th e im p o rta n c e o f re ta in e d p rofits fo r in v e s tm e n t b e h a v io u r

• sh o rt- a n d lo n g -ru n effects o f fiscal p o licy a n d th e lo g ic o f fiscal p o licy rules

• th e in te ra c tio n o f ra tio n a l e x p e c ta tio n s in fin an cial m ark ets w ith slo w a d ju s tm e n t in

g o o d s m ark ets to p ro d u ce e x c h a n g e rate o v e rs h o o tin g

• cau ses a n d co n s e q u e n ce s o f s e g m e n ta tio n in in te rn a tio n a l g o o d s m ark ets

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PREFACE Xi

• sh o rt- an d m e d iu m -ru n an aly sis o f in te rd e p e n d e n t e c o n o m ie s , i.e. b e y o n d th e sm all

o p e n e c o n o m y m o d e l

• th e stra te g ic in te ra c tio n b etw een th e ce n tra l b an k a n d larg e w age setters a n d th e

co n se q u e n ce s for eq u ilib riu m u n e m p lo y m e n t.

In th e case o f e a ch v a ria tio n in in stitu tio n s, p o licy , o r b e h a v io u r, w e sh o w h o w th e

b asic IS-PC-M R m o d e l c a n b e m o d ified to in clu d e it.

3.2 How to study and teach the 3-equation model

T h is b o o k in tro d u ce s a n ew g rap h ical 'b aselin e' v e rsio n o f th e 3 -e q u a tio n (IS-PC-M R)

m o d e l, as its co re e le m e n t. In th e g rap h ical p re se n ta tio n o f th e IS-PC-M R m o d e l, th e IS

d iag ram is p la ce d v e rtica lly a b o v e th e Phillips d iag ram , w ith th e m o n e ta ry rule rep res￾en te d in th e la tte r a lo n g w ith th e Phillips cu rv es. T h e ag g reg ate su p p ly side is m o d ­

elled u sin g im p e rfe ct co m p e titio n an d th e Phillips cu rv es are derived ex p licitly fro m th e

b eh av io u r o f w ag e a n d p rice setters. T h e Phillips cu rv es are th e c o n s tra in t th a t th e ce n tra l

b an k faces w h e n d e cid in g h o w b est to set p o licy in resp o n se to a sh o ck to th e e c o n o m y .

T h e ce n tra l b an k ch o o s e s its preferred c o m b in a tio n o f o u tp u t a n d in flatio n a lo n g th e

Phillips cu rv e th a t it faces. It th e n uses th e IS cu rv e to ca lcu la te w h a t in terest rate it m u st

set so th a t a g g reg ate d e m a n d m o v es to th e d esired level.

T h e IS-PC-M R g ra p h ica l an alysis is p a rticu la rly useful for e x p la in in g th e o p tim izin g

b e h a v io u r o f th e c e n tra l b an k a n d for an aly sin g its re a ctio n s to a w id e v a rie ty o f d istu r￾b a n ce s to th e e c o n o m y . U sers c a n see a n d re m e m b e r read ily w h ere th e key relatio n sh ip s

c o m e fro m a n d are th e re fo re able to v a ry th e assu m p tio n s a b o u t th e p riv a te se cto r o r th e

b eh av io u r o f th e p o licy m ak er. Fo r e x a m p le , w e c a n see w h a t h ap p en s if th e ce n tra l b ank

is m ad e in d e p e n d e n t a n d is m o re averse to in flatio n th a n th e g o v e rn m e n t o r if w ages are

m o re resp o n siv e to u n e m p lo y m e n t (e.g . if w e w a n t to c o m p a re tw o co u n trie s, in o n e o f

w h ich u n io n s are im p o rta n t a n d in th e o th e r th e y are n o t).

In o rd e r to use th e g ra p h ica l m o d e l, it is n ecessary to th in k a b o u t th e e c o n o m ic s b eh in d

th e th re e key re la tio n sh ip s a n d th e p ro cesses o f a d ju stm e n t. O n e o f th e reaso n s IS-LM g o t a

bad n a m e is th a t it to o fre q u e n tly b e ca m e a n e x e rcise in m e c h a n ica l cu rv e sh iftin g . In th e

fram ew o rk p re se n te d h e re , in o rd e r to w ork th ro u g h th e a d ju s tm e n t p ro cess, y o u h a v e to

en g ag e in th e sa m e fo rw ard -lo o k in g th in k in g as th e p o licy m ak er. W e also e n co u ra g e th e

sk e tch in g o f th e tim e p a th s o f key v ariab les as th e e c o n o m y m o v es fro m o n e equ ilib riu m

to a n o th e r.

3.2.1 Why diagrams are essential

D esp ite th e d e v e lo p m e n t o f th e 3 -e q u a tio n (IS-PC-M R) m o d e l, H ick s’s fam o u s IS-LM

m o d e l o f 1 9 3 7 su p p le m e n te d b y F rie d m a n ’s e x p e c ta tio n s -a u g m e n te d Phillips cu rv e is

o fte n th e b asic m o d e l ta u g h t to u n d e rg ra d u a te s (o fte n referred to as IS-LM -AS o r IS￾L M -P C ). But w h ile it p ro v id es a b asic g en eral eq u ilib riu m m a c ro m o d e l, key c o m p o ­

n e n ts h a v e b een sid elin ed b y d e v e lo p m e n ts in e c o n o m ic th e o ry a n d p ra ctice , a n d th e

3 -e q u a tio n m o d e l h as su p erced ed it in g ra d u a te te a ch in g . U n d o u b te d ly th e lo n g e v ity of

IS-LM h as b een d u e to th e fact th a t its g ra p h ica l m e th o d p ro v id es stu d e n ts w ith an in te ­

g rated m o d e l th a t th e y c a n m a n ip u la te . A lth o u g h th e use o f e q u a tio n s in in te rm e d ia te

m a c ro e c o n o m ic s te x ts h as in cre a se d , d iag ram s re ta in a c e n tra l p lace. In o u r view , th is is

for g o o d re a so n . W h e n d e v e lo p in g a n u n d e rsta n d in g o f e c o n o m ic s, it is v e ry im p o rta n t

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xii PREFACE

n o t o n ly to u n d e rsta n d a b o u t eq u ilib ria a n d c o m p a ra tiv e sta tics b u t also to d iscu ss h o w

th e e c o n o m y m ig h t ad ju st fro m o n e eq u ilib riu m to a n o th e r. T o d o th is m a th e m a tic a lly

d iv erts a tte n tio n fro m e c o n o m ic s to m a th e m a tic a l m e th o d s. D iag ram s h elp to d e v e lo p

e c o n o m ic in tu itio n , i.e. th e y h e lp y o u to g et a feel for h o w th e e c o n o m y will re sp o n d to

d ifferen t sh o ck s an d p o licies w ith in a sy ste m a tic fram ew ork .

T h e b o o k is based o n th e a ssu m p tio n th a t d ifferen t read ers g a in d ifferen t in sig h ts from

m a th e m a tic a l, verb al, a n d g ra p h ica l re a so n in g . So th e b o o k m ak es use o f th e m all. O ur

view is th a t th e y re in fo rce e a ch o th e r, b u t it is q u ite possib le, for e x a m p le , to u se th e b oo k

w ith little em p h a sis o n th e eq u a tio n s.

3.3 Dealing with the open economy

An im p o rta n t c h a ra c te ris tic o f th e b o o k is th a t it offers a c o m p re h e n siv e a n d c o h e re n t

tre a tm e n t o f th e o p e n e c o n o m y . W e m o v e from th e M u n d e ll-F le m in g m o d el w ith fixed

p rices in th e sm all o p e n e c o n o m y to a n in te g ra te d a p p ro a ch to m e d iu m te rm in flatio n

a d ju stm e n ts an d th e n to in te rd e p e n d e n t e c o n o m ie s . A gain , w e m ak e use o f a c o re d ia ­

g ra m to p ro v id e a u nified o rg a n iz in g fram ew o rk for d ealin g w ith b o th th e o re tica l an d

applied q u estio n s.

3.4 How to use the model to answer new questions

O n c e th e o p e n e c o n o m y m o d el h as b een co v e re d , y o u w ill be ab le to use it to an sw er

q u e stio n s like th is o n e : w h a t is th e likely effect o f a c o u n tr y ’s in v o lv e m e n t in a w ar

a b ro a d ? T h e first step is to id en tify th e n a tu re o f th e sh o ck a n d th e n to w ork o u t th e new

sh o rt-ru n eq u ilib riu m a n d th e likely p ath o f a d ju s tm e n t to it. H ow w ill th e p riv ate se cto r

resp o n d an d sh o u ld p o licy be a d ju sted in th e ligh t o f th e sh o ck ? T h is is a n a g g reg ate

d e m a n d sh o ck : g o v e rn m e n t p u rch a se s rise a n d th is w ill p u sh e m p lo y m e n t a n d o u tp u t

u p. T h e c o n se q u e n ce s for in flatio n will d ep en d o n w h e re u n e m p lo y m e n t is relativ e to

th e eq u ilib riu m rate. T h is w ill also feed in to th e c e n tra l b a n k ’s d ecisio n a b o u t w h e th e r

m o n e ta ry p o licy sh o u ld be a d ju sted (C h a p te r 5 ). T h e parallel d e v e lo p m e n t o f th e sh o rt￾a n d m e d iu m -ru n m o d e l for th e o p e n e c o n o m y in C h a p te rs 9 a n d 1 0 allow s th e o p e n

e c o n o m y a sp e cts to be in c o rp o ra te d : e .g . w h a t is th e im p o rt c o n te n t o f g o v e rn m e n t w ar￾related p u rch a se s? T h e e x c h a n g e rate reg im e in p la ce w ill affect th e an aly sis o f th e sh o rt￾run im p a ct (h o w will th e e x c h a n g e rate react u n d e r flexib le ra te s?), w h e th e r co n s id e ra tio n

o f c e n tra l b an k b e h a v io u r is re le v a n t, a n d h o w in flatio n will re sp o n d . D ifferen t m e th o d s

o f fin a n cin g th e w ar-re la te d e x p e n d itu re m a y affect its im p a ct o n th e e c o n o m y a n d th e

d iscu ssio n o f ta x v ersu s b o n d b ased d eficit fin a n cin g in C h a p te r 6 is re le v a n t. N e x t, we

sh o u ld co n s id e r w h e th e r in v o lv e m e n t in th e w ar c o u ld h a v e m e d iu m -ru n co n s e q u e n ce s ,

i.e. for th e su p p ly -sid e o f th e e c o n o m y (C h a p te r 4 ). O n e lin e o f a rg u m e n t w o u ld follow

from th e asse ssm e n t th a t th e w ar m a y affe ct in te rn a tio n a l c o m m o d itie s ’ p rices, e.g . bv

in te rru p tin g th e su p p ly o f oil. T h is w o u ld p ro d u ce a n e g a tiv e e x te rn a l su p p ly sh o ck as

an aly sed in C h a p te r 11.

4 Prerequisites and technical level

W e a ssu m e read ers h a v e a fa m ilia rity w ith m a c ro e c o n o m ic s su ch as p ro v id e d b v a p rin ­

cip les co u rse . W e use alg eb ra a n d so m e sim p le ca lcu lu s b u t e x p la in th e m e th o d s a n d th e

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PREFACE x iii

resu lts v erb ally a n d g ra p h ica lly as w ell. W e in tro d u ce th e use o f logs a n d e x p o n e n tia l

fu n ctio n s a t th e b e g in n in g o f C h a p te r 1 3 , b ecau se th e y are u sed in th e th e o ry o f g ro w th .

C h a p te rs 15 a n d 1 6 a re d esign ed m o re for a g rad u ate a u d ie n ce a n d m o re m a th s is used.

H ow ev er, v erb al a n d g ra p h ica l e x p la n a tio n s are still p ro v id ed .

5 Chapter by chapter structure

C h a pter 1 p ro v id es m o tiv a tio n fo r th e m a in m o d els p resen ted in th e b o o k b y id en tify in g

a set o f key q u e stio n s in m a c ro e co n o m ic s . Sin ce th e b o o k a im s to sh o w h o w th e m od els

c a n be b ro u g h t to b ear o n co n te m p o ra ry p e rfo rm a n ce a n d p o licy issues, cro ss-co u n try

d ata is p re se n te d — b o th in re la tio n to th e sh o rt- a n d m e d iu m -ru n issues an d in te rm s of

g ro w th a n d th e w o rld d istrib u tio n o f in co m e .

PART 1 co n sists o f five ch a p te rs, w h ich p resen t th e s h o rt- an d m e d iu m -ru n m a cro

m o d el. C h a pters 2 a n d 3 set o u t th e b u ild in g b lock s o f th e m a c ro m o d els b e g in n in g w ith

ag g reg ate d e m a n d an d su p p ly a n d th e n in co rp o ra tin g in flatio n , th e Phillips cu rv e , an d

th e m o n e ta ry ru le. By th e e n d o f C h a pter 3 , th e IS-PC-MR m o d e l is in p lace. T h e m a in ­

stream m o d el o f b u sin ess cy cle s as flu ctu atio n s a ro u n d th e equ ilib riu m rate o f u n e m ­

p lo y m e n t d riv en b y ag g reg ate d e m a n d sh o ck s is co n tra ste d w ith th e real b usiness cy cle

m o d el. In th e real b u sin ess cy cle m o d e l, su p p ly sh o ck s p ro d u ce b usiness cy cles a n d o v e r

th e co u rse o f th e c y c le , th e flu ctu atio n s in e m p lo y m e n t reflect th e c h o ic e s m a d e by

w orkers re sp o n d in g to ch a n g in g o p p o rtu n itie s in th e lab ou r m ark et.

T h e m a jo r in s titu tio n a l a n d p o licy d e te rm in a n ts o f eq u ilib riu m u n e m p lo y m e n t are

an aly sed in C h a pte r 4 . T h ese in clu d e h o w w ages a n d prices are set u n d e r im p erfect c o m ­

p e titio n , th e in flu e n ce o n eq u ilib riu m u n e m p lo y m e n t o f g o v e rn m e n t p o licies, th e role

o f d ifferen t in stitu tio n a l a rra n g e m e n ts for w age settin g , e x p la n a tio n s for h ysteresis, an d

h o w th e flow a p p ro a c h to th e lab ou r m ark et c a n be in te g ra te d w ith th e m o d el o f w age

an d p rice s e ttin g to e n rich th e an alysis o f eq u ilib riu m u n e m p lo y m e n t. T h e c e n tra l b a n k ’s

m o n e ta ry p o licy ru le is d erived as a n o p tim a l p o licy rule in C h a pt e r 5 a n d th e p rob lem s

o f in fla tio n b ias a n d tim e in c o n s is te n c y are e x p la in e d . In C h a pter 6 , th e m a c ro e co n o m ic

roles o f fiscal p o licy a re p re se n te d : th e p ro v isio n o f a u to m a tic stab ilizers, th e use o f dis￾c re tio n a ry p o licy to c o m p le m e n t m o n e ta ry p o licy in stab ilizatio n , a n d th e req u irem en t

to m a in ta in a su sta in a b le b u rd en o f p u b lic d eb t.

PART 2 h as tw o c h a p te rs th a t deal w ith c o n s u m p tio n , in v e s tm e n t, m o n e y , a n d fin an ce.

T h e aim is to sh o w h o w sta n d a rd m icro fo u n d e d m o d els in flu en ce th e in te rp re ta tio n of

th e IS, th e LM , a n d th e MR. In C h a pter 7 , th e re is a m o re d etailed an aly sis o f c o n s u m p tio n

an d in v e s tm e n t b e h a v io u r. In e a ch case th e o p tim iz in g b e h a v io u r o f fo rw ard -lo o k in g

h o u se h o ld s o r firm s is used to d eriv e resp ectiv ely a c o n s u m p tio n a n d a n in v e stm e n t

fu n ctio n , w h ic h a re c o m p a re d w ith th e sim p le m a c ro e c o n o m ic fu n c tio n s u sed in PART 1.

In C h a pt e r 8 , th e re is a m o re d etailed an aly sis o f th e d ifferen t kinds o f assets in th e

e c o n o m y a n d th e ro le o f in fo rm a tio n p ro b lem s in e x p la in in g th e e x iste n c e a n d ro le o f

fin an cial in stitu tio n s.

In PART 3 , a n in te g ra te d m o d e l for th e an aly sis o f th e o p e n e c o n o m y is d ev elo p ed .

C h a pte r 9 is c o n c e rn e d w ith th e sh o rt-ru n an aly sis o f a sm all o p e n e c o n o m y . It p resen ts

th e tra d itio n a l M u n d e ll-F le m in g m o d el a n d in co rp o ra te s fin an cial o p e n n e ss b y a ssu m in g

p e rfe ct c a p ita l m o b ility a n d asset su b stitu tab ility in th e fo rm o f th e u n co v e re d in terest

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Xiv PREFACE

p a rity c o n d itio n . P rice s e ttin g in th e o p e n e c o n o m y , e x c h a n g e ra te o v e rs h o o tin g , a n d th e

im p lica tio n s o f d ro p p in g th e assu m p tio n s o f a sm all e c o n o m y , p e rfe ct c a p ita l m o b ility ,

a n d p e rfe ct asset su b stitu tab ility are e x a m in e d . C h a pte r 1 0 e x te n d s th e m o d e l fro m th e

sh o rt to th e m e d iu m ru n b y in tro d u c in g th e an aly sis o f in flatio n . W e use a c o re o p e n

e c o n o m y d iag ram to sh o w th e g o o d s m ark et eq u ilib riu m (i.e. th e o p e n e c o n o m y IS), th e

su p p ly side (i.e. th e eq u ilib riu m rate o f u n e m p lo y m e n t in th e o p e n e c o n o m y ), a n d th e

trad e b a la n ce . T h is g rap h ical a p p ro a c h allow s us:

(1 ) to a n a ly se th e co n tra stin g sh o rt-ru n resp o n ses o f th e sm all o p e n e c o n o m y u n d e r

fixed a n d flexible e x c h a n g e rates to a g iv en fiscal o r m o n e ta ry p o licy c h a n g e or

ag g reg ate d e m a n d sh o ck ;

(2 ) to sh o w th a t th e m e d iu m -ru n eq u ilib riu m w ith c o n s ta n t in flatio n fo llo w in g a given

sh o ck is in d e p e n d e n t o f th e e x c h a n g e rate reg im e.

C h a pte r 1 1 sh o w s th e v e rsa tility o f th e g ra p h ica l a p p ro a c h b y lo o k in g a t ag g reg ate

d e m a n d , e x te rn a l trad e a n d e x te rn a l su p p ly sh o ck s in th e o p e n e c o n o m y . It also e x te n d s

th e IS-PC-M R m o d el to th e o p e n e c o n o m y sh o w in g h o w a n in fla tio n -ta rg e tin g ce n tra l

ban k resp o n d s to a n a g g reg ate d e m a n d sh o ck . C h a pter 1 2 g o e s b e y o n d th e ty p ica l sco p e

o f a m a c ro c o u rse b y lo o k in g a t th e an aly sis o f in te rd e p e n d e n t e c o n o m ie s .

In PART 4 , th e re are tw o c h a p te rs o n g ro w th th a t p ro v id e a th o ro u g h tre a tm e n t of

b o th e x o g e n o u s a n d e n d o g e n o u s g ro w th m o d els. C h a pte r 1 3 c o n c e n tr a te s o n th e theory'

a n d e m p irics o f th e S o lo w -S w an m o d e l o f e x o g e n o u s g ro w th a n d th e issues su rro u n d in g

co n v e rg e n c e . C h a pt e r 1 4 p ro v id es a n in tro d u c tio n to a ra n g e o f e n d o g e n o u s a n d S c h u m ­

p ete ria n m o d els o f g ro w th . W e c o m p a re d ifferen t ch a n n e ls th ro u g h w h ich e n d o g e n o u s

g ro w th m a y o p e ra te — k n o w led g e sp illovers fro m th e a c c u m u la tio n o f p h y sica l ca p ita l,

in v e s tm e n t in h u m a n c a p ita l, a n d in v e stm e n t in R&D. W e sh o w h o w th e S ch u m p e te ria n

m o d e l c a n h elp us to u n d e rsta n d h o w in stitu tio n s affect g ro w th , b o th in c o u n trie s a t th e

w orld te c h n o lo g y fro n tie r a n d in p o o r co u n trie s.

PART 5 co n sists o f tw o ch a p te rs: th e m icro fo u n d a tio n s o f th e N ew K eyn esian m o d el

in C h a pt e r 1 5 a n d a c h a p te r o n p o litical e c o n o m y . C h a pter 1 5 p ro v id es a sy ste m a tic

m icro fo u n d e d tre a tm e n t o f th e key featu res o f th e N ew K ey n esian m o d e l. W ith in th e

sa m e fram ew o rk , w e in v e stig a te several m o d e ls th a t p ro d u ce m u ltip le m e d iu m -ru n

u n e m p lo y m e n t eq u ilib ria. T h ese in clu d e m o d e ls o f h y steresis p ro ce sse s, a n d m o d els in

w h ich w ork ers v a lu e n o t o n ly c o n s u m p tio n a n d leisure b u t also fairn ess, w h ich results

in th e e x iste n c e o f a ran g e o f eq u ilib riu m e m p lo y m e n t rates. C h a pter 1 6 is o n P o litical

E co n o m y . T h is fo cu ses o n th e u se o f g a m e th e o ry to a n a ly se g o v e rn m e n t a n d ce n tra l

b a n k b e h a v io u r. B o th ch a p te rs are se lf-co n ta in e d in th e sen se th a t th e y d o n o t assu m e

p rio r k n o w led g e o f sp ecific m o d e ls o r te ch n iq u e s , o th e r th a n sim p le ca lcu lu s. All o f th e

g a m e th e o ry n e e d e d for C h a pter 1 6 is p ro v id e d in th e c h a p te r.

T h e b o o k fin ish es u p in PART 6 w ith tw o ap p lied ch a p te rs. A lth o u g h re fe re n ce is m ad e

th ro u g h o u t th e b o o k to e x a m p le s o f p a rticu la r h isto rica l ep iso d es a n d to e m p irica l e v id ­

e n c e , th e aim o f PART 6 is to sh o w h o w th e m o d e ls in th e b o o k c a n be u sed in a su stain ed

e x p lo ra tio n o f p e rfo rm a n c e a n d p o licy . C h a pte r 1 7 tak es th e p erio d fro m 1 9 9 0 a n d uses

th e m o d els to p ro v id e a n in te rp re ta tio n o f m a jo r p e rfo rm a n ce a n d p o licy issues in a set

o f OHCD e c o n o m ie s : fro m G e rm a n u n ifica tio n , th ro u g h th e c re a tio n o f EM U , to B ritish

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PREFACE XV

e c o n o m ic p e rfo rm a n ce , th e US b o o m , a n d th e Ja p a n e se d o ld ru m s. C h a pter 1 8 focu ses

o n a key p e rfo rm a n ce p ro b le m — th a t o f u n e m p lo y m e n t— a n d sh ow s th e usefulness o f

th e m o d els in h e lp in g to u n d e rsta n d th e e m p irica l p a tte rn s a n d w id ely cite d e m p irical

stu dies. T h e ap p lied c h a p te rs d o n o t rely o n th e m o re a d v a n ce d m a te ria l in PART 5.

O n a few o c c a s io n s m o re d ifficult m a te ria l is p re se n te d th a t m a y be skipped w ith o u t

loss o f c o n tin u ity . T h ese se ctio n s are in d ica te d b y a n asterisk.

Tw o kinds o f exercises are p ro v id ed a t th e en d o f e a ch c h a p te r— a set o f so -called c h e c k ­

list q u estio n s th a t test for u n d e rsta n d in g o f th e key c o n c e p ts in th e c h a p te r b y fo cu sin g

o n c o m m o n co n fu sio n s a n d m isu n d erstan d in g s a n d a se co n d set o f exercises, so m e o f

w h ich are o p e n -e n d e d q u e stio n s for d iscu ssion an d o th e rs are p ro b lem s. Fu rth er m aterial

is availab le o n th e b o o k ’s w eb site an d w e e n co u ra g e o th e r in stru cto rs t o p ro v id e te a ch in g

m aterial related to th e b o o k th a t c a n be m ad e availab le to all o n th e w eb site. Th is b oo k

ca n be used as a co re te x t in a n u m b e r o f d ifferen t co u rse s a n d so m e illu strativ e e x am p les

are p ro v id ed b elow .

Chapters

1 M o tiv a tio n for M a c ro e c o n o m ic M odels

2 A ggregate D e m a n d , A ggregate Supply, a n d B usin ess C y cles

3 In flatio n , U n e m p lo y m e n t, a n d M o n e ta ry Rules

4 L ab ou r M ark ets a n d Supply-Side Policies

5 M o n e ta ry P o licy

6 Fiscal P olicy

7 C o n s u m p tio n a n d In v e stm e n t

8 M o n e y a n d F in a n ce

9 T h e O p en E co n o m y in th e S h o rt Run

10 In flatio n a n d U n e m p lo y m e n t in th e O p en E co n o m y

11 S hock s an d P o licy R esp on ses in th e O p en E co n o m y

12 In te rd e p e n d e n t E co n o m ie s

13 E x o g e n o u s G ro w th T h e o ry

14 E n d o g e n o u s a n d S c h u m p e te ria n G ro w th

IS N ew K eyn esian M icro fo u n d a tio n s

16 P o litical E co n o m y

17 P e rfo rm a n ce a n d P o licy in E u ro p e, th e USA, a n d Ja p a n

18 U n e m p lo y m e n t: In stitu tio n s, S h o ck s, a n d Policies

Possible course structures

Intermediate macroeconomics

C o re m a c ro e c o n o m ic m o d e l: Chapters 1 -4

M o n e ta ry an d fiscal p o licy : Chapters 5 , 6

C o n s u m p tio n , in v e s tm e n t a n d m o n e y : Selective use o f Chapters 7, 8

O p en e c o n o m y : Ch apters 9 (except section 6), 10, 11

R eferen ce to a p p lica tio n s : Chapters 17, 1H

In tro d u c tio n to g ro w th th e o ry a n d facts: C h apter 1 section 2 a n d selective use o f C h a p ter 13

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