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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