Samenvatting: Macroeconomics: a European text

Deze samenvatting is geschreven in collegejaar 2012-2013.

Chapter one Introduction

Unemployment, inflation, stock markets, economic growth, interest rates and foreign exchange rates, these are subjects we hear about daily. Economic themes tend to dominate the news on television and newspapers.

Macro economics is the study of these economy-wide phenomena. The study is useful because the movements in interest rates, rate of inflation and exchange rates for example affect the well-being of all consumers.

Important measures of the economic well-being of a nation is its output and income. We will discuss the GDP, the gross domestic product in chapter two. In the long run we will look to the trend of the gross domestic product. In the short run we will see ups and downs fluctuations. These ups and downs are called business cycles.

A lot of countries have an increasing GDP per capita. But some countries face serous setbacks, due to wars and famines. We will discuss reasons why economies grow or stagnate in chapter three.

A important phenomenon associated with the business cycles is unemployment. Unemployment is the fact that people are searching for work, but cannot find it. It can also be the case when the economy is growing rapidly. The unemployment rate is the ratio of the number of unemployed workers in a country to the size of the labor force in the country. The labor force consists of people who have a job or are actively looking for a job. So not young people who are not yet working, old people who are retired or those who do not wish to work.

The output of an economy, the GDP, is the result of work effort by people combined with equipment: machines, buildings and other structures. Labor and capital are the technical names given to the two most important factors of productions (the input of the economy).

The share of income in manufacturing goes to labor is called the labor share.

There is an inverse relationship between labor share and the stock price index. Because when the labor share is high, there is less available for firms’ owners, so t he stock prices are depressed.

Inflation is the rate of change of the average price levels. The inflation rate is usually stated in terms of percentage change per year. In the case of hyperinflation, the inflation is very high. It describes situations when the monthly inflation rate exceeds 50 percent.

The rate of capacity utilization measures the degree to which companies use available equipments. It is a good indicator of cyclical conditions. The inflation rate in procyclical. The inflation rate tends to rise in periods of high growth and declines in periods of slow growth. In contrast unemployment is countercyclical.

The real economy concerns t he production and consumption of goods and services and the incomes associated with productive activities. The financial or monetary economy deals with trade assets.

Every country engages in trade, exporting and importing goods and services from other countries. One measure of a country’s openness or exposure to the influences of the rest of the world, is the ratio of its exports to the GDP of the country.

For a long time, economists paid little attention to movements of the GDP around its trend. It was believed that properly functioning markets would deliver the best outcome. This principle was called “laissez-faire”.

Laissez-faire was opposed by proponents of interventionism. This principle advocated government support for particular markets and industries. This includes subsidies and protection from foreign competition.

Macroeconomics boils down to separating events into two categories: those that affect demand for goods and services and those that affect the supply of those goods and services.

The demand side relates to spending decisions by economic agents (households, firms and governments agencies).

Two demand management instruments are fiscal and monetary policy. Fiscal policy affect the volume of national spending by governments expenditures or taxes. Monetary policy is directed at influencing interest and exchange rates.

The supply side relates to the productive potential of the economy. The productivity of labor and capital, the choice of hours worked by households and the efficiency with which resources are allocated in generating nation’s output, all influence the aggregate supply.

Exogenous variables: Variables we do not try to explain and hold as fixed.

Endogenous variables: Variables to be explained using economic principles and models.

Macroeconomics proceeds by making simplifying assumptions. We need the assumptions in order to see through the vast complexity of an economy.

Positive economics refrains from value judgments, but normative economics takes a further step and passes judgments or makes policy recommendations.

Chapter two Definitions and accounts

The gross domestic product, GDP, is defined for a particular are (usually a country). It is also defined over a time interval (usually a year). So the GDP is a flow variable. It is not a variable defined to a particular pint in time. So it is not a stock variable.

The GDP is generally considered to be the most important indicator of an economy’s health. A positive movement in the GDP constitutes an improvement in the national well-being.

While GDP represents the collective income earned within a country. Not all of it will end up in the hands of individuals. What households actually receive to spend or save is called personal disposable income.

The gross domestic product (GDP) can be defined in three equivalent ways:

• as the flow of final sales (so not the intermediate sales)

• the flow of value added

• the flow of factor incomes

A firm creates value by transforming raw materials and unfinished goods into products that they can sell in the market. You can compute it for a firm by the revenue minus the price of the raw materials and unfinished goods.

The gross domestic product can also be obtained by multiplying the quantities and prices of products sold. Because the nominal GDP measures the final sales at market prices, an increase in the level of product prices leads to an increase in GDP.

This is even the case if quantities sold are constant.

The Real GDP is computed by pricing current output at with constant prices, corresponding to a base year.

So you can obtain the real GDP by multiplying the new quantities sold and the old price of the base year.

A way to measure the price level is using the GDP deflator. The GDP deflator is the ratio of the nominal GDP to the real GDP.

GDP deflator = nominal GDP / real GDP

Inflation is approximately equal to the difference between the nominal GDP and the real GDP growth rates.

GDP deflator inflation = nominal GDP growth rate – real GDP growth rate

An alternative measure of inflation based on an average prices with fixed weight, called price index. Price indexes use constant-weights baskets of goods and services. An example is the consumer price index (CPI). This is based on a basket of goods consumed by a representative or average individual.

The difference between the price index and the GDP deflator inflation is usually not very large. But it can becomes large if the prices of import products changed relative to output produced domestically.

If the price of an important import product of consumers increases relative more than the products produced domestically, the CPI increase at a faster rate than the GDP deflator.

To measure the GDP is costly, time consuming and the results are often imperfect. A big part of the economic activities are unmeasured, such as household activities and underground economy. This problem is larger in development countries, where a lot of activities are unpaid, so unregistered.

But year-on-year comparisons, such as annual growth rates, are less affected by measurement problems.

Flows

The gross domestic product is equal to the sum of consumption C, investment I, government spending G and the current account CA or X - Z. You can also interpret it is income to the households. This income is taxed by the government, which also transfers money to households and firms by government purchases, subsides etc. What left, the private income, can be saved S or spent C. The private sector borrows money to invest. Investment is the purchases of new equipment. Productive equipment, including structures, is referred to as physical capital. The balance S – I is the private sector’s net saving behavior.

Y = C + I + G +CA

The national spending, sometimes called absorption is the sum of C + I + G

CA = E-Z

The current account is export minus the import, also called the net exports.

At the same time, GDP is equal to consumption, plus the savings of the private sector plus net taxes (gross taxes less public transfers received by the private sector)

Y= C + S + T

This fallows that the current account surplus is equal to the surplus of the government plus the surplus of the private sector.

CA = (T – G) + (S – I)

Net private savings = S – I

In the process of producing GDP, the production equipment is subjected to war and tear and obsolescence. So this depreciation should be subtracted from the GDP. Subtracting depreciation from the GDP gives us the net domestic national product, the NDP.

Key accounting identities

C + S + T = C + I + G + X – Z

(S – I) + (T – G) = (X – Z)

The balance of payments is a record of current account transactions and their the financial account.

The current account is the sum of merchandise, invisibles and transfer accounts. The surplus or deficit of the current account must be matched by an equal and opposite sum of private long-term capital, short-term financial errors and omissions and official intervention accounts.

When the monetary authorities want to maintain the value of their country’s exchange rate, they have to intervene on exchange rate markets to match any possible balance of payments imbalance. In contrast, the exchange rate floats freely when the monetary authorities refrain from intervening. In this case all adjustment for balance of payments equilibrium occurs within the private sector, as a result of changes in the market determined exchange rate.

Balance of payments

All items in the balance of payments must add up to zero. Current account surpluses must be matched by net financial outflows, for example. Because the country is lending to the rest of the world. Current accounts deficits imply borrowing from abroad. So in this case, financial capital is flowing into the country.

Two accounts perform balancing act:

• financial account

• official account

The financial account indicates the balance of purchaser of net sales of foreign assets by private domestic residents. The official account indicates net transactions performed by the monetary authority.

When residents have sent more money abroad than they received, through either commercial transactions (current account) or financial transactions (financial accounts), or combination of both, the monetary authority can intervene. In this case the monetary authority should sell their foreign exchange reserves (the foreign currencies that they have) to get the domestic currency in return. This action is called the foreign exchange market intervention.

Because the information of the balance of payments come from difference sources and there can be mistakes, the balance of payments has a errors and omissions account. This balancing item is necessary to arrive at zero at the bottom of the table.

CA + FA + Off = 0

FA = financial account

Off = official interventions

Chapter three The cause of economic growth

This chapter discuss three of the four main causes of economic growth. Those are:

• The growth of the capital stock

• The growth of the population

• Technological process

(Innovation, quality of education and size of a country)

We will use the Solow growth model to discuss the causes.

Economic growth refers to a steady expansion of the gross domestic product over a period of a decade or longer. Growth theory is concerned with economic growth in the steady state. The steady state is the situation in which the output and the capital grow at the same pace and also remain in constant proportion to labor in effective terms. So the capital-output ratio is neither rising or falling. In this situation there are no business cycles.

This approach reflects the stylized facts.

The stylized facts are:

• Output per capita and capital intensity keep increasing. *

• The output of capital is trendless

• Hourly wages keep rising

• The rate of profit is trendless

• The relative shares of the gross domestic product going to capital and labor are trendless.

* If labor input in man-hours (L) increase more slowly than capital (K) and the output (Y), the production process becomes more capital intensive. So (K/L) will increase and the ratio (Y/L) will also raise.

The aggregate production function shows that output grows when more inputs, capital and labor, are used. Next to it, the technological progress increases the effectiveness of the inputs.

The capital stock is the sum of productive equipment and structures. It is accumulated through investment, which is financed by savings of households and firms. A firm can increase their productive capacity by purchasing capital goods. In this case the firm will raise his output, which then raises future savings and investment, and so on.

Marginal productivity is the amount of new output per unit of incremental capital. You can imagine that when a firm brings more and more capital in the production process, without increasing the labor amount, the increases in output will become smaller and smaller. This principle is called diminishing marginal productivity. This principle applies also to the labor input. Increasing the employment hours will raise the output. But the additional output of an extra labor-hour will decrease.

If the input of capital and labor will increase in the same proportion:

• the output can raise in the same proportion. Constant returns to scale

• the output can raise more than the proportion. Increasing returns to scale

• the output can raise less than the proportion. Decreasing returns to scale

In the case of constant returns to scale we can write the production function in the following intensive form:

y = f(k)

Where y = Y/L and k = K/L

To get the intensive for you have to divide the production function by the effective labor.

When the savings are a stable proportion of output, the steady state capital stock is determined by the net effect of savings and the depreciation of capital.

The assumption that the marginal productivity of capital declines, implies that the output, and therefore the savings, grow less than proportionately to the stock of capital. This is different from depreciation, which rises in proportion to capital. Eventually, the size of the capital stock exhausts the potential of savings to raise it further.

If the investment exceeds depreciation, the capital stock will rise. If the investment is smaller than the depreciation, the capital stock will shrink.

When the investment is less than the depreciation, the capital labor ratio must decline. It will increase if the investment exceeds the depreciation.

Without the population growth and technological change, the steady state is characterized by zero output and capital growth.

Adding population growth provides will not result in an increasing of the standards of living (measured as output per capita). But is only does increase the output growth.

The higher the rate of population growth, the lower the sustainable steady-state capital labor ratio.

The production function with technological progress is:

Y = F(K, AL)

AL refers to the effective labor. Because we introduce technological progress (A), we can produce more output with the same equipment.

The effective labor grows for two reasons:

• More labor (L)

• Greater effectiveness (A)

Permanent growth in per capita output and capital is possible by technological progress.

Savings is deferred consumption. Consuming less today and saving more is putting income aside for later consumption. And consumption is responsible for economic satisfaction. So the best that can be achieved, is consumption as high as possible.

The golden rule is looking for the situation in which consumption in the steady state is as high as possible. In the complete Solow model, you can find it where the marginal productivity of capital is equal to the rate of depreciation plus the rate of population growth and the rate of technological change.

MPK = δ + n + a

The steady state consumption in the steady state case is given by:

c = y - sy = f(k) – (δ + a +n)k

(In the case without population growth and technological process, you have to delete the “n” of population growth and the “a” of technological process)

An economy is dynamically efficient when the consumption in the steady state can be raised in the future only at the expense of lower consumption today. This is the case, to the left of k*. It is dynamically inefficient when current and future steady state consumption can be raised. This is the case to the right of k*.

In the first case, a dynamically efficient economy, the capital stock is lower than the golden rule level, calling for additional accumulation. In a dynamically inefficient economy, the capital stock is above the golden rule level.

In the Solow model, savings does not affect the steady state growth rate, but only the level of output per capita.

Removing the assumption of diminishing marginal productivity allows output to grow forever. This is even the case if there is not population growth and technological change. It implies that changes in savings and productivity can have permanent growth enhancing effects. This is the basis of the theory of endogenous growth.

Chapter four Theory and policy of economic growth

The main factors that drives the economic growths are:

• The initial GDP (negative effect)

• Education

• Life expectancy

• Fertility rate (negative effect)

• Government consumption (negative effect)

• Rule of law

In chapter three we discussed population growth, capital accumulation and technological. Note that neither capital accumulation nor population growth can explain continuing advances in standards of living.

In the Solow model, population growth and capital accumulation cannot sustain economic growth on their own. The reason is that capital and labor are subject to the law of diminishing marginal returns.

When a country wants economic growth, it is important that they accumulate physical and human capital rapidly. Adopting new technologies is important as well.

A high gross domestic product has a negative effect on the economic growth. Because the higher the initial GDP, the less it subsequently grows. This is the convergence hypothesis. It says that countries starting from a low GDP per capita should accumulate capital per capita faster than wealth economies and thereby eventually catch up.

Human capital, is people’s knowledge. The more the knowledge, the more positive effect it will have on the GDP. Better-trained and educated workers tend to be more productive. Furthermore more productive means higher incomes. Raising the population’s schooling by one year is found to speed up the growth of the GDP by 1,2 percent a year.

So countries which invest more in education and training tend to be better off in the long run. Next to it, human capital increases the marginal productivity of other factors.

A one-year increase in the expectancy of life at birth raises an average growth of 4,2 percent of the GDP. The effect is likely to come through the investment in human capital and work effort. The effect of life expectancy is less important in rich countries, because the retirement limits the lengths of active lifetime. In contrast to the poorest countries, few people ever reach the retirement age.

Fertility (the average number of children a woman) has two effects on the economy:

• capital widening as in the Solow model

• time spent by mothers on take care of their children instead of economic production.

An survey has found out that it has a negative effect on average.

Reducing public consumption by 10 percent of the GDP raises growth by 1,4 percent. This measure exclude productive spending. The negative effect probably is due to the high public employment, which tends to be inefficient and invite corruption. Next to it acts disincentive to savings, investment and innovative activity, because of the tax collection.

Public infrastructure contributes directly to production. This is a productive public spending. So it has a positive effect on the economic growth. Growth may be held back for lack of adequate infrastructure, because of excessive taxation.

Human capital and infrastructure are also subject to the law of diminishing marginal returns, like capital and labor. So if we use these two factors more, we will get the same idea as the Solow model: countries with the same savings rates and technology will converge to the same steady state. This need not be the case. Because an investment of a firm may have beneficial effects on others. This makes it possible for the growth to be driven endlessly bye the accumulation of production factors. Knowledge can be the secret behind endless growth.

Public goods are generally identifiable when they are either non–excludable or non-rivalrous. Non-excludable means that the consumer of a good cannot legally or physically prevent others from consuming it at the same time. Non-rivalrous means that that t he consumption of a good by the one does not affect others’ ability to enjoy it.

Knowledge is unlikely to face diminishing returns. Because it is impossible to imagine all the uses that can be made of any piece of knowledge, we will never be sure that we spend enough on its production. If we want to encourage privately funded supply of knowledge, we need to imagine ways of making it profitable. This means that we have to reduce its excludability. This is possible with patents. But the side-effect of monopoly is that it allows firms charge much more than the development cost. Patents hinder the full exploitation of useful knowledge. So also the economic growth. Poor countries cannot invest enough in human capital, which in turn hinders growth. This suggests the poverty traps.

The law of a country has also effect on the economic growth. Lasting, credible property rights are precondition for investment in physical as well human capital. It is easy to see why property rights are precondition for a long-run economic growth. If investors cannot be sure they will own their investments, they will not invest there.

The average growth due to the “bad” and “good” laws of countries is 2,9 percent positive.

Next to law systems, an stable peace environment is also important for the economic development. Taxation behavior and the legimate scope of government should be directed towards establishing stability and continuity.

The openness to international trade and economic growth are positively related. Countries which have large trade exposure tend to have faster GDP growth rates. Two reasons are the transfer of knowledge and competition. Competition encourage firms to innovate.

Kuznets observed in the 1950s that the inequality in a country first grows as the country’s average income rises. But it will declines when the income level reaches a high level. This can be presented in a Kuznets curve.

Chapter five The labor market

Households have two options in the labor market: working (more) and income or (more) leisure. They will trade off leisure against working. When they work, they get income and can consume with it. So in other words they will trade off leisure against consuming.

An indifference curve shows how readily a household is willing too substitute consumption for leisure, holding the its level of satisfaction (utility) constant. So a curve shows options with the same utility. Curves further out from the origin correspond to higher levels of utility.

The marginal rate of substitution shows how much consumption a person will give up for an additional unit of leisure.

The price of an hour leisure is the opportunity cost: he amount he will get by one hour working. For this reason the price of leisure is called the real consumption wage. You can measure this also by:

Nominal wage W/Consumer price index P = Real wage w

To find the optimal choice of between consumption and leisure is like the way you learned in de course of micro-economics. First, you should draw the budget constraint (I). In this case the slope of the budget constraint is equal to –w. You can maximizes the utility by choosing the highest possible indifference curve (U) without violating the budget line. The optimal choice is when the slope of the indifference curve is equal to –w, the slope of the budget constraint.

Consumption

Leisure Work

Leisure

If the price of leisure rise (in the case of when the wages rises), a lot of people will choose to work more. So they will take less leisure, work harder and consume more. This is the substitution effect. But some people can also choose for work less in this case. They earn more than enough they think, so they will take more leisure and they can also enjoy more consumption. This is the income effect.

If the substitution effect of leisure and consuming dominates, so the labor supply is relatively elastic, an increase in income will induce more labor supply.

It will supply less labor if the income effect dominates, in stead of the substitution effect.

There will be no change if the supply of labor is inelastic and the two effects offset each other.

In the short run, individual labor supply seems to be inelastic. When the income of someone reached a certain high level, he will wish more leisure and more consumption. So in the long run the supply of labor is more likely to be backward bending, when the income increases.

Aggregate labor supply is more responsive to real wage changes than that of individual households in the short runs, as real wage increases draw new individuals into labor force. This is also the reason that the aggregate labor supply curve is flatter and the individual supply curve is steeper.

Because the substitution effect dominates, the household labor supply curve is upward sloping.

The demand side of the labor market consists of firms. The available technology and capital stock affect the demand of labor. Firms hire labor to the amount where the marginal productivity of labor is equal to the real wage.

In the case of an improvement in the technology or an increase in the capital stock, the demand schedule will shifted outwards.

The equilibrium of employment and wage level are given by the intersection of the demand and supply graph. Improvements in technology or an increase in the capital stock will be reflected in higher wages, if the labor supply is inelastic. If it is elastic, it will result in higher employment.

The labor force is the part of population that is either working or unemployed.

Ls = L + U

So the labor force excludes young people in school, people who not looking for a job and the retired.

The unemployment rate u is given by:

u = U/Ls

Voluntary unemployment exists when the equilibrium real wage is too low to persuade all workers to give up leisure.

Involuntary unemployment occurs when an individual is willing and able to work at a given wage (the social minima wage, which is higher than the equilibrium wage), but cannot find a job.

Not voluntary unemployment arises when real wages do not decline to clear the market so that not all labor supplied by households is hired.

The existence of involuntary unemployment must be explained by real wage rigidity. The wages cannot decline because of laws and regulations. There are people who are willing to supply labor under the minimum wage. But they cannot supply, because it is forbidden for firms to pay that wage, that is below the minimum wage. Because those people are less productive than the minimum wage, they are unemployed.

So individuals may be willing to work for much lower wages than the equilibrium wage. But they may not be able to underbid in the market. This is the sense in which real wages are downwardly rigid.

Labor unions care about the real wages and the employment. In determining their target wage, they ask higher wagers than if the labor market were perfectly competitive. Actually, they do not regulate the demand side.

While the resulting unemployment rate is voluntary for unions, it may be involuntary for individuals. The supply curve with unions are given by the collective labor supply.

Negotiations taking place at intermediate levels of centralization deliver higher real wages and more unemployment than very centralized or decentralized wage negotiations wage negotiations.

Firs cannot easily monitor work effort or wish to elicit lower turnover or improve worker quality. So they offer efficiency wages. This an reason why real wages may be set above market-clearing level.

The government is also active at the labor market. An example of an intervention of the government is the minimum wage law. Minimum wages are designed to protect workers. But it can actually cause unemployment. Despite this, the government sees it as an guarantee of a socially acceptable minimum income for those who want to work.

The labor market consists of considerable amount of flow between different states. Examples of the states are: employment, unemployment, not in the labor force. An important course that result in frictional unemployment is searching for a job. Equilibrium unemployment will result in structural unemployment.

The government can affect the efficiency of job search by policies. The efficiency of job search can vary across individuals and countries.

Unemployment benefits are made to make unemployment more bearable. But it provides disincentives to quickly fining a job. So it also increase the frictional unemployment.

Programs like, training and relocation subsidies are able to reduce frictional unemployment.

The change of unemployment is given by:

∆U = sL – fU

S is the separation rate. This is the fraction job quitters/losers of the total existing jobs L.

f is the finding rate. f is the fraction of unemployed who find a job.

The separiation rate has tow components:

• Structural (is linked to the ease with which firs dismiss workers)

• Cyclinal (refers to the fact that during recessions the probability of losing a job rises)

Frictional rate of unemployment:

Uf = Uf/N = s/(s + f)

Equilibrium unemployment is never zero or entirely voluntary. This is because of distortions and regulations in the labor market.

It can take a long time before real wages actually adjust to their long-run values. Real wages are slow to adjust to disequilibria, if only because they fulfill many other roles.

Actual employment is below and actual unemployment is above the equilibrium when the real wage is above the equilibrium level.

The labor market institutions have effect on the speed of adjustment. So the actual and equilibrium unemployment can differ for some time. This deviations tend to be associated with fluctuations of the economy associated with business cycles.

Chapter six Borrowing and lending

Households can borrow money and lend money. So their budget constraint is fundamentally intertemporal. The budget constrain incorporates current and future spending and the current and future income. Future spending and incomes are discounted using the interest rate. This is the interest rate which household can borrow and lend.

The slope of the budget constraint is given by – ( 1+r). So when the rate of interest increases, the slope will become steeper. The intersection of the budget constraint with the x-axis and and y-asis gives the maximum amount that can be spent today and tomorrow.

Maximum amount today is given by (present discounted value):

Y1 + (Y2 / (1 + r))

Maximum amount tomorrow:

Y1(1 +r) + Y2

When the income rises the budget constraint will shift parallel to the older budget constraint. It will only rotate if the interest changes.

Wealth is the sum of:

• current income

• discounted future income

• inherited assets

• less debts

The intertemporal budget constraint requires that the present value of spending be less than or equal to wealth.

The use of valuable resources to produce more goods later is called investment. (Also fixed capital formation).

The investment decision depends on the amount of output with the equipment. This is given by the production function F(K). This function faces also the principle of diminishing marginal productivity.

Investing means saving and not consuming. When firms invest, they forgo current consumption. They will get output in the future back, if they done well. The profitability of investment depends on the rate of interest and the technology, which provide the amount of output. The interest is the opportunity cost of capital that investors use to invest in physical capital. This is because they can also use the money to invest in financial capital, and earn the interest. Investing in physical capital means that they are not able anymore to save it and get interest back.

If the net return from investing (V) is positive, the firm should invest. (Investing amount = K)

V = (F(K)) / (1 + r)

The Modigliani – Miller Theorem means that it does not matter whether a firm uses debt or equity to finance the investment plans.

It is possible to add budget constraints together. Adding, or consolidating, the budget constraints of firms and households together, gives the budget constraint of the private sector. Corporations provide their shareholders with a means of increasing their wealth.

The government incomes is given by the taxes (T). The spendings of the government is given by G. The primary deficit is given by G1 – T1. This is the amount by which non-interest expenditures exceed the revenues and the interest payments rgD1.

For the government to obey its intertemporal budget constraint, the sum of the present value of primary budget surpluses is equal to the initial outstanding debt. It has a slope of –(1 +rg). The budget line passes through the origin.

The government budget constraint:

D1 = (T1 – G1) + (T2 – G2)/(1 + rg)

=

D1 + G1 + (G2)/(1 + r) = T1 + (T2)/(1 + r)

Tax reductions today imply tax increases later. This is also the case conversely. This means also that government spending today, less spending later means. The public sector intertemporal budget constraint implies this.

The Ricardian equivalence proposition asserts that the private sector internalizes the public sector budget constraint. Public dept is not considered as private wealth.

Taxes do not affect the private budget constraint. If the private sector face the same interest rate as the government. Public dissaving is matched one for one by private saving. This is also the case conversely.

The Ricardian equivalence is unlikely to hold. This is because individuals expect that some current public debt will be repaid after they die. Another reason is that private interest rates exceed the rate at which the government borrows. Many households face borrowing constraints. There are some evidences that the private sector internalizes a part of government debt, yet.

The national budget constraint is the aggregation of the private budget constraint and the public budget constraint. Present value of primary current account deficits cannot exceed the nation’s net external wealth. The national budget constraint also implies that higher primary current account deficits today will require primary current account surpluses in the future.

Chapter seven The demand side of the private sector

The GDP consist of consumption, investment, government purchases and the net exports of goods and services. These components are the demands for goods and services of households, firms, the government and foreigners. Their sum is called the aggregate spending or aggregate demand.

The aggregate demand is driven by different motives. In general, private consumption is much more stable than investment.

Consumption

In the economy rational consumers will smooth consumption over time. People dislike highly variable consumption patterns. They will borrow in bad years and save in good years. Consumption is driven by:

• wealth

• the present discounted value of current and future income

• the initial net asset holdings.

You can find the optimal consumption by drawing a budget constraint and indifference curve. The optimal consumption is the point that the slope of the indifference curve is equal to the budget constraint. The slope of the budget constrain is equal to –(1+r).

When a is on his budget constraint he spends his total wealth in the course of two periods:

C1 + (C2/(1+r)) = Y1 + (Y2/(1+r))

The slope of the indifference curve shows the willingness to swap consumption tomorrow for consumption today, holding the utility constant. It also shows the willingness to substitute.

Income changes

In most cases, income typically increases during lifetime. So rational consumers typically borrow when they are young and pay it back later.

The permanent income is that income, if constant, would deliver the same present value of income as actual expected income path. The life cycle consumption is equal to it.

When the income changes temporary, the consumption of today and tomorrow will increase. Consumption today increases less than the windfall, if the consumer save some to spread over time. A temporary increase is accompanied by a permanent, but smaller, increase in consumption.

In contrast to it, a permanent increase in income is absorbed in a permanent increase in consumption of the same size.

If consumers expect an increase of income in the future, they will borrow now, to consume more today. So the consumption will increase today and tomorrow in this case.

Changes in consumption must be unpredictable. This is known as the random walk theory of consumption.

In the aggregate, temporary disturbances are met by current account imbalances to reduce the need to adjust consumption abruptly, in the case when individual consumption smoothing. Imbalances means national saving or dissaving.

Contrary, permanent disturbances lead to immediate consumption adjustment rather than borrowing or lending. From the fundamental identity of macroeconomics, the PCA is equal to the GDP less domestic spending:

Primary current account = Y – (C + I + G)

Uncertainty about future incomes and the inability of banks to assess individual future prospects prevent households borrow money to consume against future expected income. This is an imperfection of financial market. As result, current disposable income affects the aggregate consumption function.

Interest changes

Changes in the real interest rate have a lot effect on the current consumption. Lenders tend to increase consumption when the interest increases. The borrowers tend to decrease consumption, because borrowing money to consume becomes more expensive.

In the aggregate, higher interest are likely to reduce consumption by reducing wealth.

The effect of the interest rate on consumption works through two channels:

• It increases the cost of goods today relative to tomorrow

• It reduces the value of wealth

Consumers who cannot obtain a credit in spite of future earnings potential are said to be credit rationed.

Income and consumption

The consumption function relates aggregate consumption wealth and disposable income. (Both positively.)The link between consumption and disposable income is stronger than the link between consumption and wealth. This is because not everyone can borrow. Another reason is that wealth is more volatile than disposable income.

So consumption depends on wealth and disposable income:

C= C(Ω,Yd)

Investment

Investment goods are not intended for consumption. They include machines, office furnitures, computers, buildings and cars, for example. All these goods are enable the production of goods and services in the future.

The optimal capital stock equates marginal productivity of capital to the marginal cost of capital. He marginal productivity is the amount of extra output that can be obtained with an extra unit of capital. It is equal to the slope of the production function. The marginal cost of this case is equal to (1+r). This is also the opportunity cost. When the real interest rate declines and when technological gains raise the marginal product of capital, the optimal capital stock will increase.

When the investment exceeds the capital depreciation, the capital stock will increase. When the investment is lower than the depreciation, the capital stock will decrease. Investment is driven by the interest rate. This is also the case of optimal capital stock.

The accelerator mechanism links investment to changes in output. This is both a mechanical relationship and a credit rationing symptom. (In the long run the output per amount capital is constant.)

Tobin’s q is the ratio of the market value of installed capital to the replacement cost of installed capital. It is an approximation of the marginal return of investment to the marginal cost of capital. When the capital stock has reached its optimal level of stock, this ratio is equal to the unity.

When the ratio Tobin’s q is larger than the unity, the stock is below its optimal level. In this case the firm will benefit from more investment.

The numerator of Tobin’s q is the market value of installed capital. This is priced in the stock market. In setting this price, stock markets have to look forward. This mirrors how firms take into account expected future earnings when they make decisions concerning investing.

Firms do not acquire their optimal capital stock immediately. This is because of the various installation cost.

Rather, firs spread investment over time. In this way they gradually bringing capital up to the optimal level.

The present discounted return to investment exceeds the marginal cost of capital. This is because it has to compensate for the installation cost. Firms will further invest until the present value of return (at the margin) equals the marginal cost of investment ( the sum of borrowing and installation cost).

The investment function states that aggregate investment depends upon:

• real interest rate (negatively)

• GDP growth

• Tobin’s q

The investment function is:

I= I(r,∆Y,q)

Chapter eight Real rate of exchange

In this chapter we will see the effects of the real exchange rate on the primary current account.

Definition real exchange rate 1

The real exchange rate gives the price of domestic goods in terms of foreign goods. There are a variety price measure unities that can be used:

• Export price index

• CPI

• WPI

• GDP deflator

• Labor cost

To compute the real exchange rate you can also use the external terms of trade, the ratio of domestically produced exports to foreign-produced import prices. Another one is the internal terms of trade, the ratio of non-traded to traded goods prices.

So the real exchange rate can be used to double-deflate the nominal exchange rate and address different quotation. A convenient definition is the ratio of non-traded good prices to traded good prices.

You can calculate the real rate with the following formula:

σ = SP/P*

S is the nominal exchange rate in British terms. P is the domestic price and P* is the price abroad.

Exchange rates can be quoted in two ways:

• British terms: $1.5 per 1£ from the view of UK residents or $1,1 per €1 from the perspective of European Monetary Union.

• European terms: CHF 1,6 per $1 for Switzerland, for example.

The nominal and real exchange rates tend to fluctuate in tandem. This is because the nominal exchange rates are volatile, but the prices tend to be sticky.

The nominal and real exchange rate move together when the domestic and foreign price levels change b y the same percentage.

If inflation pushes foreign prices faster than domestic prices, the real exchange rate decreases, depreciates.

It is also possible that the nominal exchange rate appreciate without the real exchange rate changing. This is the case when inflation is lower at home than abroad, while the nominal exchange rate rising at a rate equal to the difference in the two inflation rates.

The effective exchange rate

The effective nominal and real exchange rates are weighed average of a country’s exchange rates to the rest of the world (in practice the main trading partners). So it is the exchange rate of your currency to the rest of the world. Each partner country receives a weight representing its importance in trade for a particular country. Then you should calculate the average rate for all countries with the weights.

Effects on current account

The real exchange rate has effect on the primary current account The real interest rate and the primary current account have a negative relation. A decrease in the real exchange rate, also called a depreciation, will improve the primary current account. It will be cheaper for the rest of the world to import products of this country. Relatively lower non-traded good prices encourage producers to shift to the traded good sector away from the non-traded sector. So it will encourage consumers to buy traded goods in stead of non-traded goods.

The definition of the real exchange rate 2

The real exchange rate can also defined as the ratio of price of non-traded and traded goods.

σ = Pn/Pt

Pn is the price of non-traded goods in the domestic currency and Pt is the price of traded goods in the domestic currency.

Because the price on traded goods is under pressure from world trade competition, the pric must be take as given. In this case the real exchange rate is:

σ = SPn/Pt*

When trade is relatively free, traded goods cannot differ much in price and quality. Non-traded goods is purely local.

As given by the formulas above, the real exchange rate represent an internal term of trade. It is the price ratio of the two categories of domestically produced goods. It measures how many traded goods must be offered to obtain one unit of locally goods. When non-traded goods are costly, the real exchange rate will appreciate relative to a situation in which they are cheaper.

Optimal production
In a efficient production process, producing more of one good implies producing less of the other. If you applied this to tradable and non-tradable goods, you get the following production possibilities frontier PPF.

Traded goods

non-traded goods

The production possibilities frontier summarizes maximal combinations of different goods that an economy can produce with the available resources. The PPF shifts outwards over time, because the inputs will increase and because of the technological progress. The PPF has a negative slope because we cannot produce more of one good without producing less of the other one. It is bowed out because the sacrifice of traded goods for additional unit of non-traded goods increases with the quantity of non-traded goods already produced.

The price line R of traded and non-traded goods is given by the real GDP:

• Real GDP = Yt + σYn with σ = Pn/Pt

• Nominal GDP = PtYt + PnYn

This price line has a slope of σ. When the slope of the production possibilities frontier is equal to the slope of the price line, the production is optimal, and the GDP is maximal.

It is also possible to draw the indifference curve for consumers with the trade-off of the traded and non-traded goods. When the slope of the indifference curve is equal to the slope of the PPF, the highest satisfaction is attained. The slope is also the equilibrium relative price of the two goods, which is the equilibrium real exchange rate.

Production of non-traded goods must be equal to the consumption non-traded goods. Note that the primary current account is the difference between the production of traded goods and the spending on traded goods.

The nation’s budget constraint affect the primary current account in the long run. So the equilibrium real exchange rate depends on the inherited net external position of the country in the long run. A country that accumulates large external indebtedness, for example, will tend to have depreciating real exchange rates.

On the other hand, countries with large external asset position will tend to have an upward real exchange rate, also called appreciation.

The nation’s intertemporal budget constraint can be written as:

PCA1 + PCA2/(1+r) = - F1

PCA2 = -(1+r)(F1+PCA1) = -F2

Disturbances that affect a country’s structure (productivity, tastes, other relative prices) also change the equilibrium real exchange rate. But this is seldom the case.

An increasing in productivity and wealth will cause appreciation in the real exchange rate. This is especially the case in the traded goods sector. This is also the reason that price levels measured in common currency are lower in poorer countries. If a country accumulate capital, import advanced technology and become more productive their economy under go a systematic transformation. The result is a continuing appreciation of the real exchange rate, also called the Balass-Samuelson effect.

Chapter nine Money and its demand side

The definition of money has been an issue of dispute for a long time, and difficulties have been compounded by the newest technologies, like computers and the internet.

Money is a means of payment. It is an asset that is generally accepted. The definition of money leaves some room for interpretation. This is important, because in today’s world it is possible to pay without cash money.

In the nineteenth century people use commodity monies, like gold, silver and other things to serve as money. In today’s world, the low cost, ease and speed of converting one type asset into another have blurred conventional distinctions between money and related forms of wealth (like cheques, credit cards, prepaid phone cards and foreign currencies).

When central banks first began issuing paper money two centuries ago, they committed themselves to exchange these banknotes against gold on demand. Today, the gold backing is no longer explicit.

Money is a public good. Because it is easily recognized and generally accepted, it generates benefits for the community. This is the reason why the government has to issue and guarantee money. Money has to be creditworthy, in this way money could circulate as a means of payment without any difficulty.

Four attributes of money are:

• a medium of exchange (double coincidence of wants: person A wants product B’ and person B sells that product, but person B does not want the product of person A, so they cannot change their product.)

• a store of value

• a unit of account

• a standard for deferred payment

Definitions

Currency in the hands of the public (households, firms and the government) and the sight deposits (bank accounts that are payable on demand) are together the monetary aggregate.

M1 = currency in circulation + sight deposits

Sight deposits at banks have three main characteristics:

• the interest paid is either nil or much lower than that offered by other assets

• they may be converted into cash on demand at the issuing bank

• cheques can be written or bank transfers can be made against them

Because the interest of sight deposits are low, a lot of banks offer more attractive accounts t that bear interest but cannot drawn on with cheques. These accounts are often easily transferred into regular sight deposits. Because the ease these assets very similar to sight deposits. Recent innovations in payment technologies have provided a convenient means of shifting low interest sight deposits (M1) to better remunerated accounts (M2) This is a reason for another definition:

M2 = M1 + time (or savings) deposits at banks with unrestricted access.

An broader measure takes also longer term and possibly restricted access, foreign currency deposits and deposits with non-bank institutions into account. This is called M3:

M3 = M2 + larger, fixed-term deposits + accounts at non-bank institutions

(beyond currency and M1, all other definitions are arbitrary and vary from country to country)

If money bears no interest (or low interest), it is dominated by other assets.

Its desirability stems from its unique ability to resolve the double coincidence problems of wants and of information asymmetry.

Money is simultaneously an asset of the private non-banking sector. So money is a liability of the banking system. Deposits are a liability of commercial banks. Currency is a liability of the monetary authority, the central bank.

The sectors

A balance sheet is a snapshot of an entity’s financial status. This consist of assets, listed on the left side, and liabilities, listed on the ride side. The difference between the assets and the liabilities is the net worth.

We consider three big players:

• Central bank

• Commercial banks

• Non banking sector (households, corporations and the government)

Sight deposits are backed by three types of asset:

• banks hold some currency and deposits with the central bank

• banks may own government debt

• banks hold debt of households and firms

Demand

If we speak about demand for money, we mean demand for real money. To analyze things, agents look at the purchasing power of money. So the real value not the nominal or face value. The real value of money can be represented as:

Real money stock = M/P

M is the nominal stock of money and P is the consumer price index.

When the nominal stock increases exactly by the same proportion as the price level, the real money stock remains unchanged. If the money supply and the price level were to double, there would be no effect on the real economy, if all other things being equal. This property is called the neutrality of money.

The demand for money depends on:

• The volume of transactions (approximated by the real GDP) (positively)

• The nominal interest rate (negatively)

• Transaction cost (positively)

M/P = P(Y,I,c)

M is then nominal stock of money, P is the price level, Y is the real GDP, I is the nominal interest and c is the average cost of converting other forms of wealth into money.

The velocity of money measures how many times on average a unit of money is spent during the measurement period:

V = PY/M

V = Y/ P(Y,I,c)

An increase in the price level, unexpected, has no effect on the real demand for money. It only affect the nominal demand of money. The nominal demand for money will increase in proportion with the increasing of price level.

The principle that a low-inflation country will have an appreciating currency is called the relative purchasing power parity.

The result of inflation is an decreasing purchasing power of money. Agents will reduce their real demand for money if they expect inflation. This effect is captured by the nominal interest rate. The nominal interest rate is the sum of the expected rate of inflation and the real interest rate.

The real in interest rate:

r = i – πe

r is the real interest, i, the nominal interest and πe the expected inflation.

The relationship i = r + πe is called the Fisher principle or the Fisher equation.

Equilibrium in the money market occurs rapidly through changes in the bond prices and interest rate, in the short run. In the long run the equilibrium of the money market is achieved through changes in the price level and the rate of inflation.

Parity holds in the long run, in the case of the absence of real disturbances and relative purchasing power. The rate of nominal exchange rate depreciation is equal to the inflation differential then.

Chapter ten Monetary policy

Objectives and instruments

The central bank is the banker’s bank. So it is the bank of commercial banks, which supply most of the money. The control of the process rests solely with the central bank. The main aim of central banks it to achieve price stability. This means a low and stable inflation and a low rate of money growth. There are central banks that also try to stabilize employment and output. In pursuing their aims, the central banks define one or more targets. To meet these targets they have some instruments of monetary policy at their disposal.

A particular difficulty that has arisen in the recent decades is that the central bank can only control the M1 M2 or wider monetary aggregates indirectly, through interest.

Inflation is the main objective, but the central banks cannot control it directly. We saw that inflation is determined by the growth rate of money (the confrontation of real money demand with a nominal supply). The central bank has to match the supply of money today with its ultimate, long-run impact on inflation.

Because central banks cannot control it directly, they have targets. Targets are intermediate objectives which are closely related to the ultimate inflation objective. Those are more easily controlled by the central banks.

There are three important targets:

• Rate of growth of monetary aggregates (M1, M2, M3, M4, etc.)

• The exchange rate

• Stabilize or fix market interest rates or exchange rate

The demand for nominal money therefore depends on the price level P# and the real money demand.

Md = P# P(Y,I,c)

When the central bank operates with an interest rate instrument, it has to give up the possibility of controlling the money supply.

Money creation

As financial intermediaries, commercial banks collect funds from depositors and lend them to other customers. These commercial banks are allowed to lend more than they receive from savers. So they can create money. Other financial intermediaries, such as savings banks, brokers and stock markets, are not allowed to create money. Non of them may legally lend more than they have received in deposits. Commercial banks make profit when they make sure that the asset side of the balance sheet is earning a good rate of return. They make profit as long as the interest on the loan exceeds the cost of managing the deposits.

The central banks, which commercial banks can use to settle claims against each other, and may also serve as a clearing house of cheques or transfers written on accounts of depositors.

Direct money creation by the central banks involves only cash (banknotes and coins) and bank reserves held by commercial banks at the central bank.

The most of the money stock is created by commercial banks. So the control of money supply by the central bank is only indirect. The key instrument of the central bank is the reserve ratio. Bank reserves can be thought as the money that commercial banks use to conduct transactions among themselves and with the central bank. This is imposed by regulation or self-imposed by commercial banks themselves.
 

This ratio establishes a link between the bank reserves of the monetary base (this is liability of the central bank and bank deposits), a component of the money stock. The reserves is also for to meet everyday withdrawals by customers.

The sum of currency in circulation and commercial bank reserves is the monetary base, or also called the M0. The central bank can only control M0.

The bank reserves is a fraction of deposits. The money multiplier is the multiplicative factor of the fraction. Whenever a bank makes a loan to a customer, it creates a new deposit, and it need to hold a fraction of it at the central bank. So an increase in the monetary base and in bank reserves means much larger increase in deposits. The multiplier establishes a stable link between the money base and the wide monetary aggregates. (The M1, M2,M3, and M4) So the public’s money demand results in a derived demand for the monetary base. This demand is expressed on the money market.

Monetary multiplier = M2/M0 = 1/ ((cc + rr(1-cc)

cc is the proportion the public wises to hold and rr is the fraction of deposits in bank reserves.

Central banks carry out open market intervention to provide commercial banks with money base. Central banks decide a quantity to supply. They can also supply whatever quantity is demanded to deliver the desired rate of interest on the market.

Another instrument that the central bank has, is the required reserve ratio.

The most targets of the monetary policy are:

• money growth

• expected inflation

• exchange rate

In the money market or the open market the commodities traded are deposits at the central bank The players are the central bank, financial and non-financial institutions. The central bank is the sole producer of base money. Because the commercial banks know that they ultimately need reserves to grand credit to the customers, they regard the interest rate charged as their primary indicator of monetary condition. They tend to pass the interest on to their own customers. If reserves available on the market exceed participant needs, the interest rate declines.

The central bank is committed to intervene on the exchange markets, if the exchange rate is fixed. There is a link between the money supply and the foreign exchange market interventions. A way to break the automatic link is sterilization.

The central bank can assist the government in financing of the government’s expenditures in three ways:

• lend it directly to the government

• it usually remits most if not all of its seigniorage profits

• by allowing inflation to rise, it creates an inflation tax which lowers the burden of the public debt. (when the latter is not indexed)

More and more number of central banks have been made independent of their government. This is be cause the monetary financing op public spending is a permanent temptation.

In the way of independence central banks are allowed to refuse to jeopardize their price stability objective.

Sometimes the independence means that the central bank may not lend directly to the government. It is also possible that there is a limit on such loans.

To establish the standard of payment, the central bank ultimately guarantee the value of money. The variety of regulations and the lender-of-last-resort function can do this. Bank deposits are guaranteed through insurance schemes and understanding that the central bank will create sufficient monetary base in the case of failure of the bank.

Sometimes the guaranteeing is only up to a certain level. The central bank may impose on banks constraint designed to reduce their vulnerability, in return.

Chapter eleven Relations with the demand side, the output and the interest rate

In this chapter we will see why there are business cycles (periods of growth and low unemployment followed by periods of slow or negative growth and rising unemployment). To give a short answer: business cycles originate in interactions between goods market, financial market and the labor market. All these markets are subjected to various disturbances. These disturbances can come from home or abroad, some can related to the government’s imposed tax or spending. Or it is also possible that it is a result of the policy of the central bank.

We will first take a look at the Mundell-Flleming model, this is an extension of the IS-LM model to the open economy. You can see it as a small open-econmy version of the Keynesian model. The Mundell-Fleming model describes the simultaneous equilibrium of following markets:

• The domestic money market

• The market for goods and services.

• The international financial markets.

• This model adopts the Keynesian assumption that prices are sticky. So the output is driven by the demand side.

Demand of goods

The demand for domestically produced goods and services can be given by:

Y = C + I +G + PCA

The consumption (C) can be given by:

C = (Ω,Y-T) Y-T represents the disposable income

The investment can be given by:

I = I(I,q) q respresents Tobin’s q

PCA = X – Z (The export minus the import)

Import can be given by:

Z = Z(A,σ)

A is the absorption and σ the real exchange rate

The export function is:

X = (A*, σ)

A* is the foreign absorption and σ is the real exchange rate.

Absorption are the factors: wealth, disposable income, Tobin’s q, real growth and the interest rate.

Note that in the case of export the real exchange rate is negatively related to the export and in the case of import positively.

When the income and output in the rest of the world expand and the real exchange rate depreciates, the primary CA will improve. The PCA is negatively related to domestic real income, positively related to the foreign income and negatively to the real exchange rate.

The current account worsens when the domestic gross domestic product and absorption rise at home.

The desired demand function can be given as:

DD = C(Ω,Y-T) + I(I,q) + G + PCA(Y,Y*, σ)

So the GDP (Y) has a positive effect on the consumption, but is negatively related to the PCA. Theory and evidence tells that the effect on consumption dominated.

When we draw the DD-line, we will see that it is flatter than the 45°-line. This is because:

• A part of our spending falls on imported goods

• Consumers save a part of their income

• A part of our income is taxed away

When we put the desired demand on the Y-axis and the output on the x-axis and we draw the DD line and the 45°-line, we will find the goods market equilibrium and the equilibrium GDP, at the intersection. The DD line is upward sloping because more income (production) means a higher demand

The DD curve will shift upwards when a variable changes, like increasing government expenditures, decrease in the interest rate, reduces in taxes etc. This means that more demand. The multiplier mechanism means that more demand will result in more output, and more output means a higher income. And hence an new round of demand increases. This principle is also known as the Keynesian demand multiplier. This multiplier process can be dampened by leakages in the income-demand chains. Examples of leakages are imports, savings and taxes, as mentioned above.

IS curve

The IS curve shows the combinations of nominal interest rate and real GDP that are consistent with the goods market equilibrium. A high interest rate reduces the domestic demand and output. This is why the IS curve is downward sloping.

The slope of the IS curve is flatter:

• when the sensitivity of consumption and investment to changes in interest rates are more sensitive.

• when the multiplier is large

We have a excess supply when the point is above or on the right of the IS curve. We observe an excess demand when the point lies below and on the left of the IS curve.

Changes of exogenous variables result in a shifting IS curve. We will observe a move along the IS curve when a endogenous variable changes.

LM curve

In contrast to the IS curve, the LM curve is the combination of income and interest rates for which the domestic money market is in equilibrium.

A high GDP level result in more demand for money. This is why the LM curve is upward sloping. A high interest rate is necessary in this case. In this way you can bring money demand back, which reduces the domestic demand for goods and services.

If the demand money demand is very sensitive to output, the LM curve is very steep. In this case the money case is not very sensitive to the interest rate. So the LM curve is steeper, the more sensitive money demand is to output and the less sensitive it is to the interest rate.

We have a excess demand when the point is above or on the right of the LM curve. We observe an excess supply when the point lies below and on the left of the LM curve.

Changes of exogenous variables result in a shifting LM curve. We will observe a move along the LM curve when a endogenous variable changes.

International capital flows

The interest rate parity condition is reflects by the BP line:

i = i*

This condition shows the working of the international financial market. The international financial market equalizes returns on similar assets.

In the case of limited international capital mobility, the interest rate parity condition does not always hold. This can be the result by capital controls.

When you bring the three schedules together, it permits one to study the general macroeconomic equilibrium, when all three markets are simultaneously in equilibrium.

The domestic interest rate is tied to the financial conditions of the world, when a country’s financial markets are well intergraded. A third equilibrium condition requires the domestic interest rate to be equal to the world rate of return, under the conditions of complete capital mobility.

Output and interest under fixed and floating exchange rate

In the case of fixed exchange rate, demand disturbances affect domestic GDP. Monetary disturbances (including fiscal policy), have no effect on the real GDP, in this case.

The exchange rate is set exogenously and the supply of money becomes endogenous. The LM curve moves to meet the BP and IS schedules.

In the case of freely floating exchange rate, the economy is shielded from demand disturbances. In this case the monetary policy is effective. The exchange rate is endogenous and the central bank is able to set money supply exogenously. The IS curve moves to meet the BP and LM schedules.

The central bank can control money supply or exchange rate. It is not possible to control both. You can also say that monetary and exchange rate policies are just two side of the same coin.

In the case of fixed exchange rates, the central bank controls the exchange rate and must give up the control of supply of money. In the case of flexible rate regime, it retains control of money supply. The exchange rate will be determined by the market in the latter case.

The choice of the regime of an exchange rate involves trade-offs. Different countries choose difference forms of regime. The choice of an exchange rate regime can depend on circumstances.

Chapter twelve The general equilibrium with labor and changing prices

In this chapter we will go further with the theory of chapter eleven. We will discuss the difference between the sticky price version, the Keynesian model and the flexible price version, the neoclassic model.

This chapter presents the neoclassical synthesis, the view that the Keynesian model is acceptable in the short run while the neoclassical model is better for the log run.

As we saw in chapter eleven, the IS curve shows the sets of real gross domestic product and the interest rates, which are in equilibrium in the goods market, given the price level. The IS curve is downward sloping.

The LM curve shows the sets the real gross domestic product and the interest rates, for which the money market is in equilibrium.

To reduce the complexity, we assume in this chapter that the economy is closed. So we haven’t got the BP line.

The model with labor market

The supply and demand of labor depends on the real wage. When the supply and demand of labor are equal, the labor market is in equilibrium. In this case there is no involuntary unemployment, from the perspective of the collective bargaining parties. In the production function, it is possible to see, what the level of output (Y) is, when the labor market is in equilibrium. You can draw the vertical line of that level of output together with the IS and LM curve. This vertical line of the labor market is the S curve.

In the case when the goods market, labor market and the money market clear simultaneously, the general equilibrium of the economy is achieved. This is the intersection of the IS, LM and S curve. The role of the price level determines how and whether the general equilibrium is achieved.

Prices

Prices are fully flexible and move to maintain equilibrium in each market, assumes the neoclassics. The output of the economy is determined and there is no collectively involuntary unemployment, under this assumption. The price level adjustments has effect on the supply of real money and the LM curve. It drives the LM curve to pass through the intersection of the supply-determined output schedule and the IS curve.

When the three schedules do not intersect each other in the same point. The price level adjusts and affects the real value (M/P) of a given stock of nominal money supply. This will result in a shift in the LM curve until it passes through the point where the supply and IS curve intersect. In the case of excess supply, a reduction of the price level is needed. So the LM curve shifts to t he right. Conversely, in the case of excess demand, the price has to increase and the real money supply has to decrease. This will result in a shift of the LM curve to the left.

Dichotomy and money neutrality

Real and nominal variables do not affect each other, when the price level is flexible, In this case the economy is dichotomized. The absence of real effects of the nominal money changes is monetary neutrality. Money has only effect on prices and other nominal variables.

Sp the neoclassical assumption that all prices are flexible leads to the very important conclusion that the nominal and real variables do not affect each other.

Two results follow:

• Real variables (like, the employment, real GDP, real exchange rate and relative prices) are unaffected by the level of money supply.

• Changes in the money supply affect all nominal variables (those denominated in terms of the domestic currency) by the same proportion

In contrast to the neoclassical assumption, the Keynesians assumes that the prices and wages are not flexible. They also assume that the output is determined by the demand side of the economy. The general equilibrium occurs at the intersection of the IS and LM curves, in this case. In this theory it is possible that the output differ from the production capacity. The result of this is a disequilibrium on the labor market. This means involuntary unemployment.

The principle that money does not affect the real side of the economy is called monetary neutrality.

When the price level adjusts immediately in order to maintain the economy in general equilibrium, the principle of classical dichotomy holds. In this case the nominal variables do not have effects on the real variables.

The classical dichotomy and monetary neutrality principles do not apply, because of the sticky prices. Money matters for the real side of the economy.

It is possible to use the same graphical apparatus to analyze the flexible and sticky price cases. In the case of sticky prices, the GDP is demand determined and firms adjust output. In the case of flexible prices, the GDP is supply determined and prices adjust.

To analyze the economy in the long run, the assumption that prices are flexible is a useful and good way. In the short run full price flexibility is less likely.

The theory of Keynesian that the output adjust to achieve the goods market equilibrium and that the prices are sticky is a convenient short cut for the analyzing the short run determination of the interest rate and the gross domestic product.

Chapter thirteen Supply and inflation

In this chapter we will look to the supply side of the economy. So we have to analyze prices, so even the production costs. We will see that prices drive wages and wages drive prices. The outcome of the analysis is accounting of the factors that add up to a full explanation of inflation. The analysis is summarized in the aggregate supply curve.

In the most developed countries the inflation has declined considerably. It stabilize around two percent. In Japan inflation even become negative. This phenomenon called deflation.

Phillips curve

The Phillips curve shows the trade off between unemployment and inflation. When the inflation is high the unemployment is low. In contrast, when the inflation is low the unemployment is high. The output rises to meet the increase in demand. But in the process, it would generate a higher rate of inflation.

The Phillips curve vanished from the late 1960s to the late 1980s. Note the inflation-unemployment trade off, the inflation and unemployment rose in the mid 1970s and early 1980s. This phenomenon is called stagflation.

Growth in the nominal wages also called wage inflation.

Okun’s law

The deviation of the real gross domestic product from its trend is called the output gap. The law of Okun suggests that the output gap and the unemployment as deviation from its equilibrium level systematically move in opposite directions. So there is an inverse relationship between output and unemployment.

During an expansion firms will increase their production. So more labor is required. In this way unemployment will decline.

Okun’s law can represented as:

U-U̅ = -g(Y-Y̅)

U is the unemployment rate and U̅ is the equilibrium unemployment rate. g stands for a parameter of Okun (g=1/3, a one percent drop in the unemployment rate was associated with three percent increase of the GDP above the trend). The output gap is represented as the deviation of the real GDP (Y) from its trend growth path (Y̅).

Money illusion is, if people act on increases in their own prices or wages without taking increases in all other prices into account.

Prices and mark ups

In the case of perfect competition, the price of the products are equal to the marginal cost. Firms which operate in perfect competitions are price-takers. Others are price setters. They are able to set a mark up above the nominal production costs.

Firms set their prices with a mark up. They set a mark up over the production costs. To analyze the inflation we should know how the prices are set.

P = (1 + θ)MC

MC is the marginal cost and θ is the mark up percentage above the marginal cost.

Nominal wages are set as a mark up on the nominal price level.

There are two categories of production costs:

• Labor costs

• Non-labor costs

Unit costs in euros =

Total costs in euros/number of units produced

or

unit labor costs + unit non labor costs

Wages

Nominal unit labor costs

= total labor costs/output (WL/Y)

= gross hourly wages/ average labor productivity (W/(Y/L))

Real unit labor costs

= labor share of output = sl

=wage bill/nominal GDP = (WL)/(PY)

The labor costs will increase when the wages and the other costs that are related to labor increase faster than the productivity of labor. The most important source of cost changes of products are the labor costs.

Wages are set through negotiations that acknowledge three main factors:

• productivity gains

• state of business cycle

• core inflation

The state of business cycle reflects the relative bargaining strength of employers and employees.

The nominal wages are determined by the expected price level (Pe):

W/Pe = F(U)= 1-bU

The price level can be given with:

P = (1+θ)(1-bU)Pe

Augmented Philllips cuve

The inflation can be given with:

π = π̅ - b(U-U̅)

π̅ is the core inflation.

Core inflation has the backward- and forward looking aspects. The wage contracts attempts to protect wages from future inflation and to catch up on past inflation. So core inflation captures the rate of inflation agreed upon during wage negations. It must be related to the actual rate of inflation.

The actual rate of inflation is describes by inflation accounting, which responds to:

• demand pressure transmitted from the labor market to goods market

• occasional supply shocks

• core inflation

The Phillips curve existed for century but disappeared in the 1960s and the early 1970s and in the periods of the oil crisis 1973-1974 and 1979 and 1980. The explanation that the Phillips curve disappeared in those periods is because of the inflation.

So the Phillips curve should be corrected with the core inflation and the supply shocks (s).

π = π̅ - b(U-U̅)+s

The long run

Unemployment will returns to the equilibrium level, in the long run. The real gross domestic product cannot stray away from the productive potential of the economy for ever.

The aggregate supply schedules and the Phillips curve are vertical in the long run. The growth and real rigidities determine the GDP. The money growth and the unemployment determine the inflation. There is also no trade off between inflation and unemployment. So the economy is dichotomized.

Aggregate supply

By using Okun’s law, it is possible to transform the Phillips curve (that describes the supply side) into an aggregate supply. The aggregate supply can be found by substituting the Law of Okun in the Phillips curve. You will get:

π = π̅ + a(Y-Y̅)+s

It is possible to see in the supply curve that an increased output will result in inflation increases, because the production costs rise faster than the anticipated, or than is reflected in core inflation. The aggregate supply curve has a positive slope in the short run, in contrast to the curve of Phillips and Okun.

The position of the short run Phillips curve is determined by the core rate of inflation and the equilibrium unemployment rate. The core rate of inflation and GDP trend determine the position of the aggregate supply curve. The short run schedules will shift when there is a change in one of these variables. In the long run the aggregate supply curve is vertical.

So the following things will cause a shift of the aggregate supply curve:

• Core inflation

• Long run unemployment

• Long run GDP

• Supply shocks

Chapter fourteen Aggregation of demand and supply

In this chapter we will see how the aggregate demand curve is derived. Next to it we will analyze the aggregate supply and aggregate demand. This is another form of the IS-LM model, we discussed some chapters before this. The IS-LM model shows the relations between the output and the interest. In this chapter we will use the AS-AD curves that gives the relations of output and inflation. So in this chapter we adopt the principle of purchasing power parity (PPP). The PPP asserts that the real exchange rate is constant. This is not acceptable for the short run of course, but it is an good rule of thumb for the long run.

The macro economy is analyzed as the interplay of aggregate supply and aggregate demand. When the output returns to its growth rate. This framework emphasizes the difference between the long and short run.

Fixed and flexible exchange rate

To draw the aggregate demand curve, you have to use the IS-LM model, in the case of fixed exchange rates. The aggregate demand curve is plotted with the inflation on the y-axis and the output (Y) in the x-axis. When inflation increase, it will reduces the country’s external competitiveness. So the IS curve will shifts leftward. The output (Y) is less than before the shift of the IS curve. So an increasing inflation will reduce the output. In this way you can draw the AD line.

The aggregate demand curve of the short run has a negative slope. An increase in inflation above the foreign rates erodes external competitiveness, under fixed exchange rate. This will result in a reducing demand for the domestic goods.

In the contrary, under flexible exchange rate, for a given growth rate of the nominal money supply, an increase in the inflation rate lowers the rate of growth of the real money stock. So this will result in a contractionary effect on the aggregate demand. Using the IS-LM model to derive the aggregate demand curve under flexible exchange rates, the LM curve will shift to the left because of a higher inflation rate. So in this case too, the aggregate demand curve is downward sloping, but this is because the LM curve.

Exogenous changes in demand which shift the IS curve will also shift the aggregate demand of the short run in the same direction.

In the long run output is at its trend growth level, the output gap is zero. The inflation is equal to the foreign inflation rate. This two aspects are in the case of a fixed exchange rate.

Long run inflation is determined by the growth of the nominal money supply, under flexible rates.

Policies

In the long run fiscal expansion has no effect. The monetary authority can only set the money growth rate under flexible exchange rate. It is possible to use repeated devaluations or revaluations to achieve some independence under fixed rates.

Fiscal policy has effect on the aggregate output and demand under fixed exchange rates. These effects are temporary. The budget constraint of the government prevents a permanently expansionary fiscal policy and the output of the economy must be back on trend, in the long run. So monetary expansion and fiscal expansion have only impact in the short run.

The output level will be raised by a fiscal expansion initially at the cost of a higher rate of inflation. As the unavoidable retrenchment of fiscal policy occurs and core inflation rises, the demand returns to trend output, over time.

Fiscal policy is ineffective under a flexible exchange rate, in the long run and short run. The monetary policy is ineffective under fixed exchange rates, in the long run.

A monetary expansion raises inflation and output initially, in the case of flexible exchange rates. The inflation will continues increasing and eroding the real supply of money. This will leads that the output will go back to its trend growth path, over time.

The expected appreciation of a currency base on another one, is equal to the interest differential between the two countries.

(Se – S)/S = i abroad – i home country

Appreciation own currency = interest differential

The output will lower and the inflation will raise by a adverse supply shock. The demand management policies cannot deal with the supply shock. So this will result in a fall in income at the cost of more inflation. It is also possible that the inflationary impact reduces at the cost of more unemployment and a deeper fall in the output. The supply shock is caputerd by the exogenous shock variable s in the aggregate supply function:

π = π̅ + a(Y-Y̅)+s

When the shock is unfavorable s>0.

When the exchange rate is sticking to peg under a fixed exchange rate regime or is freely floating, disinflation required reducing the rate of monetary growth. Disinflation is costly concerning the lost of unemployment (above equilibrium) and lost output.

The cost of disinflation can be reduce by a faster core inflation. This is why credible institutions can convince wage negotiators that the disinflation policy is serious.

Inflation targeting strategy is an approach that requires that they announce the inflation rate that they intend to achieve and that they explicitly and publicly tie their actions to target. One measure of output cost of disinflation is the sacrifice ration. It compares the cumulated increase in the rate of unemployment with the reduction in inflation achieved during a period.

Chapter fifteen Fluctuations

Economies tend to grow over time. But they will grow with fluctuations in the long term trend, so in a unsteady manner. Cyclical fluctuations of five to ten years’ durations are called business cycles. It is seldom that those cycles deviate more than five percent of the output from average. In modern industrial societies, they are yet assigned considerable significance.

Recessions are when the economies are stagnating. The contrast of it are booms.

Business cycles, the fluctuations, are the result of fluctuations in other macroeconomic variables. The most of them are coincident. But some of lead and some are lag.

The stylized facts

The real GDP growth fluctuates in a irregular manner but it is recurrent. The average cycle length is five to eight years.

The amplitude of business cycle fluctuations is small measured relative to the GDp and growth process.

Government consumption is acyclical and the components of private expenditures are procyclical.

Some variables systematically lead GDP over the cycle (capacity utilization, real money balances, stock prices and inventories) systematically lag behind. Others, interest rates for example are coincidence.

Investment is more volatile and consumption less volatile than GDP. The export and the import are highly variable. The government purchases are acyclical.

Burn Mitchell diagrams are diagrams that give a visual summary of the average behavior of macroeconomic variables over a typical business cycle. (measured in relation to their respective values of cyclical peak)

The parts of the gross domestic product exhibit various degrees of volatility. This is why that the economic forces behind them are not the same. Private consumption is smoother than investment, for example, and for small open economies, exports and imports are more volatile than for big countries.

Interpretations of business cycles

There are two theoretical approaches to study business cycles:

• deterministic cycles

• stochastic cycles

Robertson lag: The consumption function links current spending to current income and wealth. It may take time in transforming into effective action.

Lundberg lag: The behavior of firms initially supply additional demand by running down inventories. (Output does not rise immediately to meet increases in demand)

Consumption in period t responds to income with a Robertson lag:

Ct = ao + a1Yt-1

a0 and a1 are positive constants with a1 represents the marginal propensity to spend out of income with a< a1<1

Investment behaves to the accelerator principle in the following way:

It = bo + b1(Yt-1 - Y t-1)

b0 and b1 are positive

Yt = (ao + bo) + (a1+ b1) Yt-1- b1 Yt-2

Explosive: When consumption and investment react strongly to the GDP of the past.

Damped: Economic exhibits cycles that die out over time.

Cycles represent the accumulation of shocks over time, is the more modern and widely accepted view.

Purely random shocks (also called impulses) are transformed into more regular fluctuations by the impulse propagation mechanism. The existence of lags in response of some key variables to their determinants is crucial to the mechanism.

Sticky price

The AS-AD framework is one example of an impulse propagation framework. This framework rests on the assumption that prices are sticky in the short run. It rest on lags in response of core to actual inflation and of demand to GDP. This view underlines the distinction between the shocks of supply and demand.

An alternative to the sticky price interpretation of business cycles is the real business cycle (RBC) theory. Exogenous productivity shocks are the impulses that are propagated through two main channels:

• The intertemporal substitution of leisure

• The capital accumulation

The two different interpretation of the business cycles have good things as well bad things. The AS-AD framework falls short in explaining the procyclical interest rates and the procyclical productivity. So it can account for the apparent short run rigidity of nominal prices and real wages and for high variance of employment.

The real business cycle theory falls short to account for the high fluctuations in the employment, despite the acyclical or mildly cyclical behavior of the real wages. The biggest problem of the real business cycle theory is that its assumes that fluctuations represent the best response to a changing environment, that cannot be improved upon for the society. And it assumes also that prices are perfectly flexible.

Chapter sixteen Fiscal policy

The government is an important agent in our economy. The government in Europe spend close to a half of the GDP. The other halve is leaving for the public sector. This chapter looks at the economic function of the government and how they fulfil their tasks. We focus on two economic functions of the government:

• micro economic function: Provision of public goods and services and income distribution

• macro economic function: stabilizing aggregate activity.

Seigniorage is the unique privilege based on the monopoly right to create legal tender of the central bank.

Economic welfare

The most important purpose of fiscal policy is to provide people in the country public goods and services. The boundary between what has to be produced publicly and what privately is not very clear.

The redistribution of income and the alleviation of inequities that are generated by the market mechanism is another function of fiscal policy. But the redistribution can also result in inefficiencies.

Productive efficiency is the optimal use of available productive resources. This is achieved when each factor of production is paid its marginal productivity. The result of this can be very unequal distribution of income and wealth.

Equity and fairness is often seen as requirement for society be cohesive and stable. Equity and efficiency often work against each other. There is a equity-efficiency trade-off.

The government can reduce inequalities, an example of a solution is progress income taxation.

Fiscal policy is also used to offset temporary or cyclical fluctuations. To do this, the government has to running deficits in bad years (financed by borrowing) and running surpluses in good years. The government can repay the debts by the surpluses.

The three main benefits of countercyclical fiscal policy are:

• private income maintenance

• tax smoothing

• private consumption smoothing

The fiscal policy can step in and support private consumption smoothing in bad years, because some citizens cannot borrow on their own.

Fiscal policy can also be used to stabilize demand when prices and wages are not perfectly flexible. It can be done indirectly through taxations by reducing fluctuations in private sector incomes or directly through government investment.

Parliament set public spending levels and the tax rates, when they vote on the budgets. During an expansion tax receipts increase. This will result in a surpluses. In contrast to this, during a recession tax receipts will decline that will result in a deficit. It is a automatic stabilizer. In this way you can see that a budget can use for stabilization. So it is countercyclical.

It is difficult to interpret changes in the budget, because of the operation of the automatic stabilizer. The cyclically adjusted budget balance provides a way of disentangling the endogenous response to the business cycles fluctuations from exogenous discretionary actions of the government.

Deficit financing

It is necessary to keep on borrowing merely to service existing debt, when the primary budget is balances and the debt is positive. So indebtedness in an explosive process that is inherently. The real interest rate gives rate that the real debt is accumulates at.

To finance the deficit, the government must borrow and issue new debt ∆B, in the absence of monetary:

∆B: G – T + rB

Primary balance deficit Debt service Total budget deficit

The government must run a primary budget surplus that is equal to the interest charge, in the case when they want to stabilize the level of the real debt, in the absence of real growth and money financing. When the government waits, the larger the debt and the interest burden will be. This will result in a larger required primary budget surplus.

Stabilizing the ratio of debt to the gross domestic product is a less stringent condition than stabilizing the level of the debt, in the case of a growing economy. The primary surplus that is required is proportional to the difference between the real GDP growth rate and real interest rate. This can be negative (permanent primary deficits) and smaller than the real interest rate.

The debt burden can be reduces by monetary financing because:

• money growth can lead to inflation, so the real value of nominal debt will decline.

• seigniorage provides resources directly to government (free of charge).

The account can be rewritten, since the real value of seigniorage is ∆M0/P:

∆B + ∆M0/P = G-T + RB

New debt seigniorage primary deficit Interest payment

Stabilizing public debt

Unexpected inflation can only be the reason of collecting inflation tax. Because, the nominal interest rate rises (which protects lenders), when this is not the only reason.

Debt can also stabilized by defaulting, next to spending cuts, increasing tax and resorting the money finance. This way can hurts the reputation of the government, because it is a drastic form of taxation. A default will redistributes income in the opposite direction.

Debt stabilization or reduction implies only income redistribution within a country, when the public debt is held by residents. Stabilization requires a net transfer by residents to other countries, when the public debt is held by foreigners.

Chapter seventeen Demand management

Demand management policies can smooth fluctuations and business cycles. But the recent economic principles and experience suggest caution.

Since the publication of “The General Theory” a fierce debate has raged between Keynesians and Neoclassics. The theory of Keynes is a short run theory and looks at the demand side. The latter group defend the classical framework of flexible prices and rely on the inherent self-corrective nature of the economic system. They initially put much emphasis on the role of money and monetary developments. They do not spend much time on the usefulness of fiscal policy.

The degree to which actual prices and markets achieve efficient allocation of the available resources and optimal satisfaction of individual needs, is the thing that Keynesians and Neoclassics mostly disagree on. Keynesians consider that economies can suffer from persistent underutilization of the available resources and that the markets suffer from a host of imperfections. Neoclassics consider that markets are closer to perfection than the government and that market clearing is a good approximation.

The rational expectations hypothesis posits that people do not make systematic errors. They may underestimate future inflations and then overestimate, but on average they get it right.

Policy lags

In the debate of Neoclassics and Keynesians, uncertainty plays a important role. For the Neoclassics, this means that policy mistakes are as likely to make matters worse as they are to improve them. Uncertainty means for Keynesians, that private decisions are taken imperfect future conditions’ knowledge. So neoclassic favour rules, the Keynesians want discretion in policy-making.

Recognition lag: The time it get takes to discover that some policy intervention is called for.

Decision lag: The time the government need to formulate policy.

Implementation lag: As ministries must originate and parliaments must pass legislation.

Effectiveness lag: The time policy takes to produce their effects.

Expectations

The Lucas critique implies that policies that look good given the past may turn out to deliver very different outcomes from those desired. The actions of private agents are driven by less by the current behavior of the government perceptions of its general rules of conduct, called the policy regime. Changes in regime policy may alter the behavior abruptly, but limited policy changes may not have effect on the private behavior. This is because expectations crucially shape private behavior.

Policy often suffer from poor credibility. The policy that plans, will become less good at a later stadium. Time inconsistency arises when the policy that looks optimal today, become less desirable later. So time inconsistent policies are not credible. Politicians have a powerful incentive to renege on promises once the private sector has acted in the belief that the promises will be carried out.

Two ways of making time inconsistent policies credible are:

• Legally binding reputation: Reputation requires that the government refrain from actions even if they are, at this moment desirable.

• Legally binding rules: Rules invariably restrict policy activism and discretion.

Because of the time consistency problems, monetary policy is a fragile instrument. This is the reason why central banks seek rules that establish credibility. This means independence. In the most cases independence means lower inflation rates.

Politics

Government care mainly about being re-elected, instead of well meaning, in the reality. Citizens have different opinions and interests. So some government will use economic policy for aims with relations to re-election. Electoral business cycles will be the result. The partisan business cycle represents the cycles due to the change of parties that cause policy changes.

Expansionary policies being introduced before the elections can be a form of political business cycles. Corrective contra-policies will take place after the elections. The result of alternation of government that represent the interest of their constituencies are partisan business cycles.

Chapter eighteen Supply policy

In chapter seventeen we discussed the demand side policies. A complementary policy to the demand side management is to increase the productive potential of the economy. Policy measures which raise the long run or potential GDP are known as supply side policies.

Market efficiency

Demand side policies, are short run policies. In contrast to the demand side policies, supply side policies do not imply a short run trade-off between inflation and unemployment. The supply side policy has to increase the economic growth and the output permanently at any given level of inflation.

Market clearing level will be reached under competition. Competition will bid up and down prices until they reach the market clearing level.

Some are convinced that markets are naturally efficient. In this case there is no need for interventions of the government. This is the laissez-fair view.

Other believe that there are market failures. Interventions are needed. But it is only justified if two conditions are met:

• They should be limited to clearly identified market failures

• They would be targeted directly at the market failure to avoid creating additional distortions of their own.

Firms strive to acquire a premier position in the market at the expense of t here rivals. Thereby earning substantial profits aptly called economic rents.

Measures which increase competition and thereby economic output are generally referred to as competition policy. Forms of competition policies are: monopolies, collusion in the form of cartels, for example.

When the market imperfections can be removed, it is possible to enhance the productivity and overall output in the economy. An important principle of supply side policy, is that the markets has imperfections.

Failures

The three market failure’s main sources are:

• increasing returns to scale

• externalities

• asymmetric information

The result of increasing returns to scale can be a economy with only monopolies. Some of the monopolies are natural, others are state ownership. More and more state monopolies are privatized. A form a regulations by the government in the privatized monopolies are the interventions.

Externalities will take place when a economic activity of someone affect others. This can be positive as well negative. Positive externalities is the effect that the benefits to the society of the action is not being recognized. So the economic activity will undertake less than is desirable to the society.

Negative externalities is the effect of an activity that the one does not recognize the cost of it to the society. So the person will undertake too much of this economic activity than is desirable to the society.

Government interventions is need in the case of non-pecuniary externalities. Once property rights are ascertained, pecuniary externalities are solved.

When an action of somebody are not known to others, asymmetric information will take place. The result can be inefficient outcomes. To solve this problem, it is possible to design regulations for it.

Goods market

Non-rival and non-excludable public goods tend not privately provided. It is possible that the government provides these goods. Examples are human capital (education), law and order, health (medical goods).

Tax can be very inefficient, because it drives a wedge between the price that producers receive and the price that the consumers pay. In this way taxes can reducing the demand and the supply. But taxation is necessary, because of the government spending and operation.

The Ramsey principle of public finance states that efficiency is achieved by spreading taxes as widely as possible and by taxing most heavily those goods with the most inelastic demands and supplies.

The supply side considerations consist of limiting the public spending to the production of goods and services that cannot privately provided. This is because of the operation of the government, which uses resources with alternative uses in the private sector.

It is a difficult question to say what the best size of the government is, so there is much debate about it.

Firms and industries are often subsidized by the government. Reasons for subsidizing those firms and industries are protecting them. But the subsidizing or state ownership remove the incentive to compete and ultimately cost jobs. Because of these effects, the response of it in the supply side is to cut down the subsidies and increase the privatization.

Labor market

A important problem of the supply side is the structural unemployment. This is the result of distortions in the labor market. Causes of this structural unemployment are the interventions of the government and the private agents.

A crude indicator of the efficiency of job matching in a given labor market is the extent to which jobs openings (vacancies) and job seeking, unemployed workers coexist at the same time in a labor market.

The extent of mismatch in the labor market is summarized by the Beveridge curves.

Some solutions that can eliminate structural unemployment are:

• active labor policies

• labor relations

• social safety net reduction

• better management of labor taxation

• severance regulations

The welfare trap is the result of safety net programmes that induce people to remain unemployed or stay out of the labor force. The productive potentioal of the economy is reduced due to such programmes.

Reforms of the labor market or controversial and highly politicized. This is because of the reforms beneficiaries are usually in the minority. So their interests are difficult to protect. Broad-based reforms almost always require take and give of the involved parties. Reforms require time to have a measurable effect in the case conflictual or consensual.

Chapter nineteen International finance

The asset market

Assets are different from normal goods in the goods market. Unlike goods and services which bought for consumption and perishable in some sense, assets are durable. Next to it assets have no storage costs.

The future and the risks determine the price in the asset market. Corporations and household can decide whether they save or borrow without to gather the whole array of uncertain information that have effects on their future, in this way. Savers who are willing to bear risk can save at the minimum cost.

Most of the transactions on the financial markets correspond to trade among intermediaries. Financial intermediaries intervene on behalf of their customers.

In large and good organized markets, the financial assets are traded easily. The assets are durable and cheap to store. The demand and supply of the asset stock are continuously balanced by financial markets. So not only the flow increments to the stocks that are created in the period. Returns among similar assets (similar risk level and maturity) must be equalized, for the stocks to be held voluntarily.

Risk can be reduced, but cannot fully eliminated. The way to convince people to bear risk is to offer a compensation to them. This is called the risk premium.

Interest parity condition

A feature of efficient financial markets, is the no-profit condition. In the case without risk-taking, it takes a form arbitrage. The covered interest parity condition is an example of arbitrage. The interest parity condition means that a higher domestic interest rate is matched by a forward exchange rate premium, when capital is internationally mobile.

The no-profit condition means that the expected returns are equalized up to a risk premium. This is the reward for agents who bear risk and is risk-averse. This is the case in the presence of undiversifiable risk. The uncovered interest condition is an example of the no-profit condition. The uncovered interest condition means that an expected depreciation of the exchange rate should be compensated with a higher interest rate, when capital are internationally mobile.

A forward contract is a contract that the investor can sign to eliminate all risk, at the beginning of the year to sell (1+i*)St euros against pounds at the end of year, for example. Such forward contract specify the exchange rate at which this sum will be converted from euros to pounds. It is the one-year ahead forward exchange rate (Ft). This rate implies a delayed delivery of the currency. The spot rate (St) implies immediate delivery. Because the forward contract eliminates all exchange risk, the investment is said to be covered or hedged. The covered interest parity condition can be written as:

(1 + i) = (1 + i*)St/ Ft

i* = i - (Ft – St)/St

interest rate UK interest rate EU Forward premium

When all available information are gathered and treated to the point where prices reflect fully what is known and the risks attached to any single asset, markets are efficient. Except speculative bubbles and noise trading, the evidence efficiency market is mostly favorable.

The uncovered interest parity (UIP) condition can be written as:

(1 + i) = (1 + i*)(St/t St+1)

Return in UK = expected return in Euroland

i = i* - (St+1 – St)/St

interest in UK interest rate EU expected appreciation of sterling

The uncovered interest parity condition can be rewritten to accommodate risk aversion by allowing for a risk premium that the British investor will requite to hold the euro denominated assets:

i* = i + (St+1 – St)/St + ψt

Interest rate EU interest rate UK expected appreciation of sterling risk premium

The risk premium can vary over time. It is possible to define it as a function of the uncovered interest parity condition:

Ψt = (i*-i) - (St+1 – St)/St

Market makers are usually big financial institutions that have an interest in keeping the market liquid all the times. This means that every desired operation can be carried out instantly. The market makers needs to be compensated for both the service and the risk. This is the bid-ask spread. This also happens to foreign exchange market. There is a lower bid price for those who want to sell the foreign currency and a higher ask price for buyers. The difference of it is the market maker’s profit.

The real interest are equal worldwide, if the purchasing power parity condition and the interest parity condition hold. Real interest equalizing is only a medium to long run proposition, because the PPP holds at rates at best in the long run.

The associated rates on interest converted at annual rates, map out what is called the term structure of interest rates.

Today’s interest rates and the expected exchange rate in the next period determines the exchange rate of today. These variables are also used in the uncovered interest parity condition. So exchange rates are forward looking variables.

All information that is known today about the future is reflected in the value of exchange rate of today. The exchange rate of today is linked to other present and future interest at home and abroad. The link takes a form of a chain of the present and future uncovered interest parity conditions. New information and revisions of expectations about the future, will result in changes in the exchange rate primarily.

Real factors that drive the long run real exchange rate are present in nominal exchange rate of today. The long run exchange rate is “the indicator” of future expected exchange and relates it to the current value. So the long and short run views of the exchange rate not inconsistent.

The behavior of the exchange rate closely resembles a random walk. This is because of the forward looking principle and new information arrives randomly. This is why it is difficult to see the link between the exchange rate and its fundamentals. The fundamentals are typically considerably less volatile. Their future expected values are present by the market’s expectations.

When the money stock increases, the exchange rate will depreciate, in the case of sticky prices in the short run. This will overshoots its long run value. Overshooting shows that persistent deviations of real exchange rates from their equilibrium values, or misalignments, are possible, even with rational expectations. If all other variables are unchanged the increase of the money stock will result in changes in the price level and the exchange rate in the same proportion, in the long run.