Brown University

ECON 1210

Lectures Notes: Intermediate

Macroeconomics

Christian Roessler
Spring 2011
Contents
1 Sizing Up the Economy 2
1.1 Macroeconomic Issues . . . . . . . . . . . . . . . . . . . . . . 2
1.2 Measurement of Aggregate Output . . . . . . . . . . . . . . . 3
1.3 GDP Facts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10
2 Long-Run Growth 12
2.1 Aggregate Production and Productivity . . . . . . . . . . . . . 12
2.2 The Solow Model . . . . . . . . . . . . . . . . . . . . . . . . . 14
2.3 Saving . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17
2.4 Innovation: the Romer Model . . . . . . . . . . . . . . . . . . 20
2.5 Quantifying the Role of Technology . . . . . . . . . . . . . . . 24
3 Frictions 27
3.1 Income Inequality and Unemployment . . . . . . . . . . . . . 27
3.2 Natural Rate of Unemployment . . . . . . . . . . . . . . . . . 30
3.3 Money . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 33
3.4 The Aggregate Price Level . . . . . . . . . . . . . . . . . . . . 37
3.5 Costs of Ination . . . . . . . . . . . . . . . . . . . . . . . . . 40
3.6 Ination and Interest Rates . . . . . . . . . . . . . . . . . . . 42
4 Short-Run Fluctuations 43
4.1 Cyclical Component of GDP . . . . . . . . . . . . . . . . . . . 43
4.2 Investment-Saving Equilibrium . . . . . . . . . . . . . . . . . 46
4.3 Multiplier Eect . . . . . . . . . . . . . . . . . . . . . . . . . . 48
4.4 Fed Policy . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 52
4.5 Interest Rate Targeting and the Money Supply . . . . . . . . . 59
4.6 Aggregate Demand and Supply . . . . . . . . . . . . . . . . . 62
4.7 Real Business Cycle Theory . . . . . . . . . . . . . . . . . . . 69
4.8 The Financial Crisis of 2008 . . . . . . . . . . . . . . . . . . . 79
4.9 The Fed Response . . . . . . . . . . . . . . . . . . . . . . . . . 83
5 Public Finance 88
5.1 Tax Revenue . . . . . . . . . . . . . . . . . . . . . . . . . . . . 88
5.2 Budget Decits and the Federal Debt . . . . . . . . . . . . . . 91
5.3 Entitlement Programs . . . . . . . . . . . . . . . . . . . . . . 97
1
6 The International Dimension 102
6.1 Relationship between Budget Decit and Trade Decit . . . . 102
6.2 Exchange Rates vs. Ination and Interest Rates . . . . . . . . 106
6.3 Exchange Rate Regimes . . . . . . . . . . . . . . . . . . . . . 111
6.4 Business Cycle in an Open Economy . . . . . . . . . . . . . . 113
6.5 The Asian Crisis of 1997 . . . . . . . . . . . . . . . . . . . . . 115
1 Sizing Up the Economy
1.1 Macroeconomic Issues
Some facts we want to explain: US GDP per capita now fty times
higher than Ethiopias; divergent trends in the unemployment rate be-
tween US and Europe. Ination in wealthy countries was high in the
seventies, dropped in the eighties; US trade decit and budget decit
have tended to increase.
US GDP per capita has been increasing at roughly 2% on average, but
there are uctuations (notably Great Depression)
Long-run trend dominates short-run uctuations, 15-fold increase in
GDP per capita for US between 1870 ($ 2,500) and 2004 ($ 37,000)
Nobel laureate Robert Lucas, in 1987, calculated how much consump-
tion people would be willing to give up each year in order to have
smooth consumption (essentially a full insurance), rather than the vari-
able pattern of consumption that we observe in practice.
This exercise involves assuming a level of risk aversion (which can be
inferred, for example, from the interest rate people require in order
to save when income is expected to increase in the future - saving
more means more uneven, i.e. "riskier," consumption). But even for
the highest measures of risk aversion, the price people would pay on
average to eliminate business cycles is tiny - Lucas estimates 0.06% of
income, or $ 30 for someone earns $ 50,000 per year.
Is this plausible? The value of such insurance would seem much higher
when people stand to lose all their income by becoming unemployed
(rather than just the standard deviation in consumption, which is about
2
1.5%). Of course, unemployment insurance osets this potentially dev-
astating loss.
Elements of a model: exogenous (given) vs. endogenous (determined).
Could refer to values of variables, functional forms etc. Exogenous
values also called parameters, may be interested in comparing outcomes
of the model for dierent values.
Example: demand, supply functions are exogenous, price is endoge-
nous. Alternatively: preference relations, technologies are exogenous,
demand and supply functions are endogenous.
Distinction between long run (what happens inequilibrium, with all
variables fully adjusted) and short run (some variables are xed, for
example the price and supply of labor).
1.2 Measurement of Aggregate Output
Simon Kuznets got the 1971 Nobel for inventing Gross Domestic Prod-
uct, aggregate measure of all goods (including physical products and
services) created within a countrys borders in a given year (note this
is not the output of the countrys citizens: excludes citizens abroad,
includes foreign nationals living here).
GDP aggregates the value-added from each productive activity in the
economy to arrive at the total value produced.
For example, value-added from car assembly is the factory cost of the
car less the procurement cost of the individual parts. Then the dealer
adds value when the car is sold above factory cost; the dierence be-
tween the nal purchase price and the factory cost is the value-added
from selling.
GDP is equal to the value of all expenditures:
G11 = C +1 +G+`A
where C are consumer spending, 1 is the value of investments (primarily
by rms), G is government purchases, and `A is net exports (domestic
products bought by foreigners, less foreign products bought by local
residents).
3
For the US, the largest component (about 70%) is consumption spend-
ing on nal goods and services (not used in the production of further
goods and services). The next largest components (respectively about
15% and 20%) are investments in buildings (oce and residential),
equipment and inventory as well as government outlays on schools,
highways, research and defense. The smallest component (negative
5%) is net exports (the trade balance): since imports recently exceed
exports in the US since the mid-1970s, this entry is negative.
Note that business expenditures on intermediate goods are not included
anywhere in the expenditure approach, so there is no double counting.
Investment goods are by denition not used up in production.
Transfer payments are not included, e.g. stock purchases and welfare
benets, since these simply shift wealth (do not create anything new)
and are used by recipients to make purchases, which are recorded in
other categories.
There was a large increase in consumption, at the expense of invest-
ment, during the Great Depression, and a large reduction in both con-
sumption and investment during WW II, as the government expanded
defense spending.
The expenditure shares have been fairly stable since WWII, but note
the increasing trend in consumption, which is matched by a decrease
in net exports (and, to a lesser extent, government purchases).
GDP is also equal to the aggregate income of the economys resources,
namely capital and labor. This consists of prots on the one hand, and
salaries and benets on the other.
But not all business income that is generated is received in the form of
prots. Firms use up and replace capital (and therefore charge depre-
ciation against their prots). They must also pay certain taxes to the
government that do not come out of prot. Income must be generated
to cover these additional expenses, and this income should be counted.
Note that gross salaries and prots include taxes that will be paid
"directly" out of earned income to the government. But there are
also indirect taxes, such as the sales tax which businesses collect from
4
consumers, which is not counted under either salaries or prots. These
must be added in, since they reect value the economy created.
Moreover, some income must be reinvested in order to maintain the
capital stock. Again, the business income that covers depreciation is
value that we should count.
An important fact is that the share of labor (i.e. salaries and benets)
in total income is roughly constant at 2/3. If resource markets are
competitive, this means labor contributes about 2/3 of the value the
economy creates, and production functions we use in modeling should
reect this.
Compensation of employees is actually only a little more than half of
GDP in 2005. But have to keep in mind that prots include compensa-
tion for business owners labor, which needs to be separated out when
measuring labor and capital shares.
The national income identity
1 = C +1 +G+`A
says that total income 1 must equal total expenditure (and both equal
GDP). An identity is true by denition - any deviations in practice
reect measurement errors or incorrect accounting.
Some of the omissions in GDP are what is produced outside the market
(cooking and cleaning at home, volunteer work) and the exhaustion of
natural resources (oil, clean air). This can be an issue in comparing
GDP across countries, where some have a large informal sector or grow
on depletion of resources, pollution or unhealthy lifestyles.
When we look at total output of an economy, we have to literally ag-
gregate apples and oranges - quantities of products and services that
cannot be directly compared. What does it mean that a million cars
and three million hours of hospital care were provided in a year? Has
total output increased or decreased if the number of cars goes down
and the number of hours of care goes up?
GDP solves this by weighting quantities by prices - supposedly they
reect the value of the products and services.
5
This isnt quite correct, even with perfectly competitive markets. What
is true is that prices reect the marginal value of products and services,
i.e. the value of the last unit sold. They contain no information about
the value of non-marginal units. (Think about pain reliever - its cheap,
but clearly worth much more than its price to some individuals!) How-
ever, such information would be dicult or impossible to obtain, so
weighting units by prices is the best we can do.
Prices are quoted in terms of money, which varies in supply and there-
fore can become more abundant or more scarce. More on this later, but
two reasons why it becomes more abundant is that the Fed constantly
releases more bills into circulation and that a given bill might get spent
more often in a given year.
Abundant money - more bills chasing the same quantity of goods -
means that goods get on average more expensive. In comparing GDP
over time, we must account for ination to isolate the change in value
that is created.
Distinguish between nominal GDP (total value of nal goods and ser-
vices, weighted by their current prices) and real GDP (nominal GDP
adjusted for change in the average price level). Various approaches to
adjusting for ination.
One idea is to keep prices constant: to compare GDP at two dierent
times, t and t +1, use either the prices at time t or at time t +1. This
was the traditional way to measure real GDP in the US until the 1990s.
Fixing at time t prices,
`G11
t
= 1G11
t
=
n

i=1
j
i
t

i
t
where j
i
is the price of good i, and
i
is the quantity of good i (here
we are using the expenditure approach to GDP). Holding prices xed,
we have
1G11
t+1
=
n

i=1
j
i
t

i
t+1
.
6
Implicitly, at time t the price level is 1, but it may change by time t+1.
`G11
t+1
=
n

i=1
j
i
t+1

i
t+1
= 1
P
1G11
t+1
where
1
P
=

n
i=1
j
i
t+1

i
t+1

n
i=1
j
i
t

i
t+1
is the price index. This is a so-called Paasche price index, based on
quantities consumed at time t + 1. (In general, a Paasche index holds
a variable constant at its nal level.)
Note that changes in nominal GDP from t to t +1 can be driven either
by changes in prices or by changes in real GDP.
The increase in real GDP is
:
P
=
1G11
t+1
1G11
t
=
1
1
P

n
i=1
j
i
t+1

i
t+1

n
i=1
j
i
t

i
t
.
Fixing at t + 1 prices, we have
1G11
t
=
n

i=1
j
i
t+1

i
t
and
`G11
t+1
= 1G11
t+1
=
n

i=1
j
i
t+1

i
t+1
.
Now
`G11
t
=
1G11
t
1
L
=
n

i=1
j
i
t

i
t
and
1
L
=

n
i=1
j
i
t+1

i
t

n
i=1
j
i
t

i
t
is the price index. This is a Laspeyres index, based on quantities con-
sumed at time t. (In general, a Laspeyres index holds a variable con-
stant at its initial level.).
7
The increase in real GDP according to this denition is
:
L
=
1G11
t+1
1G11
t
=
1
1
L

n
i=1
j
i
t+1

i
t+1

n
i=1
j
i
t

i
t
.
Problem is, in comparing across longer periods, have to keep holding
prices constant (for example, at the level of 1960 when comparing real
GDP in 2010 to 1960). This may give an unrealistic picture, since
some prices change greatly over time. This became especially clear in
the early 1990s, as computer prices fell rapidly, even from year to year.
Hence national income accountants began to adjust the price index
gradually, using a Fisher, or chain-weighted, index:
1
C
=
_
1
L
1
P
.
If the Fisher index is bechmarked to time t,
`G11
t
= 1G11
t
=
n

i=1
j
i
t

i
t
`G11
t+1
= 1
C
1G11
t+1
=
n

i=1
j
i
t+1

i
t+1
and therefore the increase in real GDP is
:
C
=
1G11
t+1
1G11
t
=
1
1
C

n
i=1
j
i
t+1

i
t+1

n
i=1
j
i
t

i
t
=
_
:
P
:
L
.
If the Fisher index is bechmarked to time t + 1,
`G11
t
=
1G11
t
1
C
=
n

i=1
j
i
t

i
t
`G11
t+1
= 1G11
t+1
=
n

i=1
j
i
t+1

i
t+1
and again
:
C
=
1G11
t+1
1G11
t
=
1
1
C

n
i=1
j
i
t+1

i
t+1

n
i=1
j
i
t

i
t
=
_
:
P
:
L
.
8
The reason its called chain-weighted is that, for multi-year periods, say
2008 to 2010, we would calculate 1
C
=
_
1
L
1
P
rst for 2009 to 2010,
an average of prices xed at the 2009 and 2010 levels, then calculate 1
C
for 2008 to 2009, an average opf prices xed at 2008 and 2009 levels.
So its a moving average, like a chain.
The price indices are called GDP deators, since they are used to ad-
just nominal GDP for ination to recover real GDP, which is what we
ultimately care about.
When we compare GDP across countries to see how well o the average
citizen is, it is also important to hold prices xed. Exchange rates are
determined by many factors and do not necessarily reect the prices
of consumer goods. So, we might compare GDP by keeping prices
constant at the level of US prices in a given year.
Laspeyres and Paasche are names from index theory that refer, respec-
tively, to holding something xed at the initial level (Laspeyres) vs.
nal (Paasche). But when we calculate real variables in macro, that
something might refer either to prices or quantities, and thats how the
usage of the terms can be confusing or seemingly contradictory.
In calculating ination, we factor out any increases in quantities and
implicitly x them at some level. If real GDP is dened in terms of
nal prices (a Paasche index), quantities are eectively xed at the
initial level, and in that sense the price index is Laspeyres. If real GDP
is dened in terms of initial prices (a Laspeyres index), quantities are
implicitly xed at the nal level, and in that sense the price index is
Paasche.
To see this, you only need to realize that, with the Paasche denition
of real GDP, real GDP is equal to nominal GDP in the nal period,
so the price level is one. When you work out the growth in the price
index, its a function of nominal vs. real GDP in the initial period,
which is based on initial quantities. So the price level is a Laspeyres
9
index:
`G11 =
n

i=1
j
i
t+1

i
t
= 1 1G11. 1G11 =
n

i=1
j
i
t+1

i
t
1
t
=
`G11
t
1G11
t
=

n
i=1
j
i
t

i
t

n
i=1
j
i
t+1

i
t
. 1
t+1
=
`G11
t+1
1G11
t+1
= 1
1
t+1
1
t
1
t
=

n
i=1
j
i
t+1

i
t

n
i=1
j
i
t

i
t

n
i=1
j
i
t

i
t
.
1.3 GDP Facts
Theres been little change in wealth for two-thousand years, since the
emergence of agriculture and cities, then a dramatic rise from the 18th
century, spread unequally across countries (from roughly $500 per per-
son to $30,000 per person in the richest countries).
Evidence of conversion: wealthier US states in 1880 grew slower than
poorer states, e.g. the West (wealthy due to mining boom) had markedly
slower growth than the South (initially poor due to civil war).
Within the Northeast, relatively poor Maine and Vermont caught up
with relatively rich Massachusetts and Rhode Island.
On average, half the dierence in wealth was eliminated every 35 years.
Quantitatively very similar observations for regions in Western Eu-
rope from 1950, while the rate of convergence is slower across OECD
countries since 1960 (dierences halve every 70 years) and there is no
tendency of conversion when we look at all countries of the world from
1960.
Growth rates from 1960-2000 versus wealth relative to US in 2000:
higher growth rates were actually associated with higher initial wealth.
Empirically, we have conditional convergence: poorer countries grow
faster if they are otherwise similar. Most important characteristics
(that correlate with higher growth, given current wealth) are: rule of
law / property rights protection, openness to international trade, low
share of government consumption purchases in GDP, high saving rate,
low population growth, better education and health.
10
As mentioned before, US average growth rate per capita has been
around 2% for a long time. Total GDP grew even more, but so did
population.
Detrended uctuations (cyclical component of real GDP) has standard
deviation of about 1.7%. (I.e. growth is on average 1.7% above or
below trend of 2% at any given time.)
Can also look at cyclical components of items in real GDP (i.e. their
deviations from trend) as it relates to cyclical component of GDP.
Low standard deviation relative to real GDP (half): consumption of
non-durables and services, net exports. High standard deviation rela-
tive to real GDP (three to ve times): consumption of durables and
gross private investment. Similar standard deviation: government pur-
chases.
Thus much of volatility comes from behavior of investment, broadly
dened.
Correlation coecient co (A. 1 ) ,
_
c: (A) c: (1 ) is a normalization
of the covariance 1 [(A 1 (1 )) (1 1 (1 ))], a measure of whether
variables tend to be large / small at the same time or not (i.e. to
what extent they move together or in opposite directions, or are not
systematically related). Falls between 1 and 1.
Variables that move in the same direction as real GDP are procyclical,
variables that move in the opposite direction are countercyclical. Vari-
ables that do not systematically move with or against real GDP are
acyclical.
Procyclical: consumption, investment. Countercyclical: net exports
(more is imported in boom periods). Acyclical: government purchases.
Thus, the big story in uctuations is that investment expands in good
times, contracts in bad times, and this accounts for most of the expan-
sion and contraction in real GDP.
Employment and average worker hours are procyclical, hence we see
unemployment and underemployment when investment and real GDP
contract.
11
Output per worker and output per worker hour are procyclical (the rst
more so than the second), i.e. worker productivity is higher in booms
and hours expand at a greater rate than employment.
So it seems that investment expands in response to an increase in worker
productivity (sources of which are not clear). Formalizing these rela-
tionships is the focus of one approach to uctuations (real business
cycles, where shocks to labor productivity are taken to be exogenous).
Another (Keynesian) takes as its starting point uctuations in demand
(which appears to have less empirical support, but oers more guidance
to policy).
2 Long-Run Growth
2.1 Aggregate Production and Productivity
Cobb-Douglas production function:
1 = 1

.
Interpretation of c and ,: elasticity of output with respect to inputs,
J1
J1
1
1
= c1
1
1

1
1

= c
J1
J1
1
1
= ,1

1
1
1
1

= ,.
Note that
J1
J1
1
1
=
`11 1
1
and
J1
J1
1
1
=
`11 1
1
.
Since `11 = : (marginal product of capital equals the price of cap-
ital) and `11 = n (marginal product of labor equals the price of
labor) in competitive factor markets, we have c = (: 1) ,1 and
, = (n 1) ,1 , i.e. c and , correspond to the income shares of capital
and labor. Since these are empirically 1,3 and 2,3, it is reasonable to
set c = 1,3 and , = 2,3.
12
Then we have constant returns to scale (scaling all inputs by factor `
scales output by factor `):
(`1)
1=3
(`1)
2=3
= `
1=3
`
2=3
(1)
1=3
(`1)
2=3
= `
1=3+2=3
1
1=3
1
2=3
= `1
1=3
1
2=3
= `1.
On the other hand, marginal products of each individual factor is di-
minishing:
`11 =
J1
J1
=
1
3

_
1
1
_
2=3
is declining in capital, and
`11 =
J1
J1
=
2
3

_
1
1
_
1=3
is declining in labor.
Note that marginal products increase in as well as the quantity of
the other factor.
Per capita GDP is
=
1
1
= 1
1=3
1
2=3
1
=
_
1
1
_
1=3
= /
1=3
.
Suppose is constant across countries, then the only source of dif-
ferences should be capital stocks per person. From the size of capital
stock per person relative to the US (data from 2000) we can predict
GDP per capita relative to the US (i
1=3
where i is /
i
,/
US
). The pre-
dicted dierences in GDP per capita tend to fall short of the actual
dierences. So seems to be a signicant source of dierences too.
Large dierences in capital stock per person translate into smaller dif-
ferences in predicted GDP per capita because of diminishing `11.
There is a positive relationship between predicted and actual GDP,
but the t is far from perfect (i.e. deviates strongly and systematically
from the 45 degree line, along which predicted and actual GDP would
be equal).
13
The implied value of , which can be interpreted either as total factor
productivity (TFP) if we trust the model, or as the residual (deviation
from reality) if we dont.
Dierences in put countries on dierent growth trajectories as /
increases. If China had the same TFP as the US, the it would lie on
the high path, but as estimated, its lower TFP puts it on the low path.
Calculating TFP for dierent countries and mapping against GDP per
capita, we see that wealthier countries tend to have higher TFP.
How important is relative to /? Comparing
i
,
US
to /
i
,/
US
empir-
ically (where TFP is imputed so as obtain the correct GDP per capita,
given the capital per person), we nd that
i
,
US
is typically twice as
large as /
i
,/
US
, so it accounts for 2,3 of the dierences in GDP per
capita. You could either say that most of the dierences are attribut-
able to productivity or unexplained, which really amounts to the same
thing.
What might account for dierences in ? As the empirical results I
mentioned in the previous lecture suggest, dierences in growth can be
linked to dierences in rule of law / enforcement of property rights,
government policy on things like spending and trade barriers ("institu-
tions"), or health and education ("human capital"). Another possible
factor would be dierences in technological know-how.
2.2 The Solow Model
Solow model endogenizes the size of the capital stock in a dynamic
model. Capital accumulates if investment exceeds depreciation:
1
t+1
= 1
t
+1
t
o1
t
.
Depreciation is a constant that is typically thought to be around 10%
or slightly lower. In dierence notation,
1
t
= 1
t+1
1
t
= 1
t
o1
t
.
The capital stock keeps increasing while investment is greater than de-
preciation, but depreciation also increases (since its a xed percentage
14
of an increasing quantity) - if investment is constant, the addition to
the capital stock gets smaller and smaller.
We have no government or trade in this model, so expenditure on GDP
is
1
t
= C
t
+1
t
.
In this context the expenditure equation is referred to as the resource
constraint.
Let
1
t
= :1
t
.
i.e. a constant fraction of output is saved and invested (where :
[0. 1]). Then
C
t
= (1 :) 1
t
.
Production function at time t is
1
t
= 1
1=3
t
1
2=3
.
For the moment, think of and 1 as xed parameters.
Starting level of capital 1
0
at time 0 must be positive - why? (Else
nothing ever gets produced and accumulated.)
Capital accumulation is driving everything, we want to express it as a
function of the present capital stock (or of 1
t
, which depends directly
on 1
t
):
1
t
= 1
t
o1
t
= :1
t
o1
t
.
For given constants and 1, as well as : and o, we can now work
out the size of the capital stock at any point t by starting from 1
0
and adding net investment 1
1
, 1
2
and so forth. The interesting
question is: will capital forever increase in this fashion?
Since 1
t
is concave in 1
t
(increasing at a diminishing rate) and o1
t
is
linear in 1
t
(increasing at a constant rate) a point 1

will eventually
be reached where :1
t
= o1
t
, i.e. saving just osets depreciation. But
then 1
t
= 0 (net investment is nil), so the capital stock does not
grow any further and will stay xed at that level.
15
If 1
t
1

initially, depreciation exceeds investment, and the capital

stock declines.
Thus, for a given production function, saving and depreciation rate,
regardless of what they are, the capital stock is xed in the long run.
We say the system is in its steady state, once 1

has been reached,

and because the steady state is reached regardless of the initial level of
capital 1
0
, we say that it is (globally) stable.
Since 1

has the property that 1

= 0, i.e. 1
t+1
= 1
t
, we have
:1

t
o1

= 0
and, substituting for 1

and rearranging,
:1
1=3
1
2=3
o1

= 0
and
1

=
_
:
o

_
3=2
1.
At 1

, output is 1

, the associated steady-state level of production.

Note that ouput grows while capital is below its steady-state level and
then ceases to grow. Similarly, in the steady state, investment is xed
at :1

, consumption at (1 :) 1

. similarly.
We have
1

= 1
1=3
1
2=3
=
_
_
:
o

_
3=2
1
_
1=3
1
2=3
=
_
:
o
_
1=2

3=2
1.
Per capita output in the steady state is therefore

=
1

1
=
_
:
o
_
1=2

3=2
.
It increases in the productivity parameter and in the saving rate.
16
2.3 Saving
What determines the saving rate? The return to investment is xed
here by c = 1,3 (remember, this is the elasticity of output with re-
spect to capital). Somewhere in the background, though not explicitly
modeled, you can imagine a market where savers lend funds or rent out
capital to rms, and if that market is competitive, the price of capital
will be its marginal product, so this is what savers get.
People have to decide whether they want to consume immediately or
wait till later and benet from returns to investment. Diminishing
returns to capital means MPK is high when the capital stock is small,
and MPK is low when the capital stock is large. So there is a strong
incentive to save when investment is currently low and a weak incentive
when investment is currently high.
The saving rate is likely to be positive but not one. Ultimately, time
preference determines the precise level. The more patient consumers
are, i.e. the more output they are willing to set aside so that more
can be produced in the future, the higher will the saving rate be. This
preference / cultural explanation is frequently given for the high saving
rates in Asia relative to Western countries.
Capital-to-output ratios (1,1 ) against saving rates for dierent coun-
tries in 2000: positive relationship is predicted by the steady state
equation :1

= o1

or
1

=
:
o
and borne out by the data.
To quantify the role of saving in explaining dierences in GDP per
capita, notice that high-saver countries like Japan had about a 30%
saving rate, whereas low-saver countries like Ethiopia saved around
5%. So, except for the most extreme cases, saving rates vary at most
be a factor of 6.
Since the Solow model implies that

E
=
_
s
J

_
1=2

3=2
J
_
s
E

_
1=2

3=2
E
=
_
:
J
:
E
_
1=2
_

E
_
3=2
.
17
and :
J
,:
E
- 6, while

J
,

E
- 45, we have

E
=
(

J
,

E
)
2=3
(:
J
,:
E
)
1=3
-
12.6
1.8
= 7.
But, even though this dierence in productivity is not much dierent
from that in saving, its implied impact on GDP per capita is much
larger:
(
J
,
E
)
3=2
(:
J
,:
E
)
1=2
=

J
,

E
:
J
,:
E
-
45
6
= 7.5.
Hence it appears that most of the dierences in GDP per capita must be
attributed to dierences in productivity, rather than saving behavior.
Moreover, the Solow model implies that long-rung growth is not possi-
ble through capital accumulation alone - eventually, the economy set-
tles down to a steady state. Higher saving implies that the steady state
GDP per capita is higher (and perhaps grows faster during the tran-
sition, depending on how far the initial GDP is from the steady state
level). However, it cannot change the fact that there is no growth once
capital has reached its steady state level.
Eect of an increase in the saving rate on the steady state: igher saving
and investment at all levels of capital implies steady-state capital 1

increases.
As a result, steady-state GDP 1

also increases. Transition dynam-

ics: when the saving rate increases, there is at rst a sharp increase
in GDP (since the capital stock is far below its new steady-state level,
and therefore investment far exceeds depreciation), followed by dimin-
ishing increases (as depreciation approaches the level of investment)
and ultimately stagnation.
An increase in the depreciation rate causes steady-state capital to fall.
Steady-state output decreases, at rst rapidly as depreciation far ex-
ceeds the level of investment, then more slowly and ultimately the
system comes to a rest point again.
18
Since
1
t
1
t
= :
1
t
1
t
o
= :
1
t
1
t
:
1

(recall 1

= :1

o1

= 0), we have
1
t
1
t
= :
1

_
1
t
,1
t
1

t
,1

t
1
_
= :
1

_
_
1

t
1
t
_
2=3
1
_
.
which implies that the growth rate of the capital stock increases in
1

t
,1
t
, i.e. the distance from the steady-state level of capital (note
that 1

,1

is just a constant).
Similarly, GDP and GDP per capita grow faster when they are farther
from their steady-state levels.
Current OECD countries that were poorest in 1960 tended to have
the highest growth rates. Why is this not really convincing evidence?
(OECD is a non-random sample: we are looking at the richest countries
today and conclude that those that were poorest in 1960, but ended
up being rich today, had high growth rates. There is a selection bias -
what about countries that were poor in 1960, but did not make it into
the OECD?)
No such correlation when we expand the set of countries beyond the
OECD. Similar growth rates for poor and rich countries suggests that
many countries were close to their steady states in 1960 and grew for
other reasons than catch-up, i.e. they experienced steady-state growth
that was unrelated to their level of wealth.
Growth experience of the Philippines to that of Korea: Philippine in-
vestment rate was nearly constant since 1950, much like the US, so it
may have been near its steady state initially. Korea saw constant in-
vestment from 1950 to 1960, and then a big increase right up to 2000,
thus in 1960, its steady state appears to have shifted.
19
Once in steady state,

=
_
:
o
_
1=2

3=2
can only grow if there is growth in one of the parameters (:, o or ).
In the steady state, where MPK (and therefore the interest rate) is
constant, saving could only change due to changes in time preference.
We do not have a good story for this or for a persistent decline of
depreciation. So the implication of the Solow model is that economists
must focus on changes in productivity to explain sustained long-run
growth.
Note that

does not depend on 1, therefore population growth cannot

lead to growth in GDP per capita. Equivalently, if everything else is
constant, GDP grows exactly at the rate of population growth.
Suppose a poor country like Ethiopia receives aid in the form of ma-
chinery. Will this contribute to long-run growth? (No, if Ethiopia is
in steady state, this will only lead to a temporary increase in GDP;
because depreciation exceeds future investment, the capital stock will
dwindle down and eventually go back to the old level, as does GDP.)
2.4 Innovation: the Romer Model
Its clear that we need to focus on total factor productivity to explain
long-term growth, but how can we model productivity growth? Paul
Romers insight was to treat "ideas" as another input in the production
function, with some unique properties, and to model the creation of
ideas through division of labor into production and research.
Ideas are non-rivalrous goods: once produced, they can be used over
and over again. Thus, if represents the stock of ideas in the Cobb-
Douglas function, it makes sense that there are constant returns to
scale with respect to 1 and 1 (rather than all three factors): we can
double 1 and 1 and double output without increasing at all. Its
like building another plant that follows the same blueprint as the rst.
But then we have increasing returns to scale with respect to 1, 1 and
:
(`) (`1)
1=3
(`1)
2=3
= `
2
1
1=3
1
2=3
= `
2
1.
20
We now imagine that the economy can produce goods 1 as well as ideas
. Labor has to be allocated to these two sectors. 1
Y
is the amount
of labor the economy uses to manufacture 1 , and 1
A
is the labor that
is involved in creating , where
1 = 1
Y
+1
A
.
Hence we have two production functions:
1
t
=
t
1
1=3
t
1
2=3
Y
and

t
=
t+1

t
=
t
1
A
.
Ideas being non-rivalrous, they can simultaneously contribute to the
production of goods and of new ideas, so
t
shows up in both produc-
tion functions. What is key to the Romer model is that there are no
diminishing returns to ideas in either production function. Ideas lead
to further ideas at the same rate in perpetuity. These ideas add the
same amount of productivity in the goods sector in perpetuity.
Unlike in the Solow model, it is not clear whether a steady state, where
the capital stock stops growing, exists. Therefore, we focus on a solu-
tion where the capital stock grows at a constant rate instead - called
a "balanced growth path" (steady state is a special case where the
constant growth rate is zero).
If capital stock grows at a constant rate, then
1
t
1
t
= :
1
t
1
t
o
is constant, and thus 1
t
,1
t
is constant, which implies
1
t
1
t
=
1
t
1
t
.
The quickest way to calculate the growth of a function is by taking the
time derivative of its natural log
J ln 1
t
Jt
=
1
1
t
J1
t
Jt
=
1
t
1
t
.
21
Applying this to the production function, we have
1
t
1
t
=
J ln 1
t
Jt
=
J
Jt
_
ln
t
+
1
3
ln 1
t
+
2
3
ln 1
Y
_
=

t

t
+
1
3
1
t
1
t
.
Substituting 1
t
,1
t
= 1
t
,1
t
, we can solve for
1
t
1
t
=
3
2

t
.
Note that output grows faster than productivity - the reason is that the
capital stock keeps expanding as productivity increases (more output
is produced and available for investment at a constant saving rate, so
investment always stays ahead of depreciation). So part of the increase
in output comes from productivity growth, and part comes from posi-
tive net investment. (Recall: we are dening a balanced growth path
solution as one where net investment is proportional to 1
t
, which is
only possible here if net investment is positive.)
Since ideas grow at the rate

t
= 1
A
.
we have
1
t
1
t
=
3
2
1
A
=
1
t
1
t
.
So the capital stock and output are now growing at a rate that increases
in the productivity of the idea-generating sector and the amount of
labor that is involved in research.
The stock of ideas at time t, assuming an initial level
0
, is

t
=
0
_
1 +

t

t
_
t
=
0
(1 +1
A
)
t
.
(It would be
1
=
0
(1 +q) at time 1,
2
=
1
(1 +q) =
0
(1 +q)
2
at time 2, and so forth, where q =
t
,
t
.)
22
Similarly for capital:
1
t
= 1
0
_
1 +
1
t
1
t
_
t
= 1
0
_
1 +
3
2
1
A
_
t
.
Therefore,
1
t
=
t
1
1=3
t
1
2=3
Y
=
0
1
1=3
0
1
2=3
Y
(1 +1
A
)
t
_
1 +
3
2
1
A
_
t=3
along the balanced growth path.
Romer argued that, because of the positive externalities inherent to
the production of ideas, rms engaged in research could not absorb the
full benets in prots and therefore would tend to employ less than
the ecient amount of the labor. (I.e. only very benecial and prof-
itable ideas would be created, because the fraction of the value that
researchers could pocket would be large enough to justify the costs.
Other ideas might have a positive value for society, but are not prof-
itable to develop.)
Nevertheless, the Romer model delivers permanent growth. And it tells
us that incentives for research (i.e. to raise 1
A
), e.g. through patent
protection, are a vehicle for long-run growth.
We need to qualify this nding a bit: knowledge is likely to spill over
from the most advanced countries to others, so it may not make sense
for the latter to invest in research. Growth in all countries is then
driven by knowledge creation in the most advanced countries, and it is
they who must ensure the incentives are in place.
In the basic Romer model without capital accumulation, adjustment to
the equilibrium level of capital is not an issue, so the economy is never
in transition. (This is a simplication, not a substantive assumption.
We could explicitly model capital stock dynamics.) The growth rate
adjusts instantaneously when parameters change.
An increase in population (more of 1
A
and 1
Y
) raises productivity and
output growth.
23
An increase in the fraction of workers assigned to idea generation (more
of 1
A
, less of 1
Y
) leads to an initial reduction in output (since the labor
is taken out of goods production), but eventually to an increase, as
productivity growth increases from research. Why not assign all labor
to research? (Because then output jumps to zero, since manufacturing
requires labor too. The more we cut output at time t, the more growth
the economy needs to get back to the old level. If people want some level
of consumption now, they cant neglect production even temporarily.)
An increase in the saving rate : leads to transition dynamics as in the
Solow model, i.e. rapid initial growth as the capital stock adjusts (in-
vestment far exceeds depreciation). But now the economy does not
end up in a no-growth steady state, it goes back to the constant bal-
anced growth, the "normal" growth rate, once increasing depreciation
and diminishing returns to capital return the economy to a state where
productivity improvements are the sole source of growth again.
2.5 Quantifying the Role of Technology
If we allow that, in principle, all factors in the production function
could be growing (i.e. 1
t
=
t
1
1=3
t
1
2=3
Y t
, where 1
Y
now has a time
subscript), GDP per capita can be written as follows:

t
=
1
t
1
t
=
t
_
1
t
1
t
_
1=3
_
1
Y t
1
t
_
2=3
=
t
/
1=3
t
j
2=3
t
.
where j
t
= 1
Y t
,1
t
denotes the fraction of labor allocated to manufac-
turing goods and services.
The growth rate of GDP divides into factor growth rates as follows:

t
=
J ln
t
Jt
=

t

t
+
1
3
/
t
/
t
+
2
3
j
t
j
t
.
This equation can be used to determine the relative contributions of
the factors to GDP growth: just plug in the observable growth rates
of GDP, capital per (non-research) worker and growth in the share of
non-research labor, and the remainder is productivity growth.
24
The decomposition for the US, rst for the 1948-2002 period and then
for three subintervals. Note how GDP per capita (or, more precisely,
per hour) dropped temporarily from 1973-1995, then picked up again.
This pattern is mimicked by productivity, and to a lesser extent cap-
ital per worker - they fell and then recovered to an extent. From the
numbers, its apparent that productivity changes played the key role.
1973 is of course associated with the explosion of crude oil prices that
was triggered by the Yom Kippur war between Israel and its neighbors
Syria and Egypt. The initial attack on Israel occurred on October 5,
1973, and OPEC (which had already been founded in 1960, mostly
by Arab countries) responded to support for Israel from the United
States and other western countries with an embargo (i.e. a cut in oil
production for export). This quadrupled the price of crude oil by 1974.
The Iranian revolution at the end of the decade and the subsequent in-
vasion by Iraq further reduced the crude oil supply and led to another
tripling of oil prices by 1981. The US government instituted price con-
trols that caused domestic producers to also cut back their production
and led to a shortage. When they were lifted, consumers had to face
the reality of permanently higher oil prices.
Over time, consumers invested in more fuel-ecient cars, insulation for
home etc.; oil companies in non-OPEC countries increased exploration
eorts and oil production. This ultimately reduced prices, despite
OPECs eorts to maintain them through the mid-1980s. However,
OPEC had become suciently inuential to sustain oil prices above
the 1970 level. They spiked up again in the early 1990s, after Iraqs
invasion of Kuwait started the rst Gulf War. (More recently, the crude
oil price went through cycles where it tended to hit lows during major
crises, such as Asia at the end of the 1990s and September 11, rising in
between to meet the increased demand from the growing economies in
Asia and elsewhere.)
There would have been an impact on productivity on many levels, but
most directly productivity as we use it here comes in part from the
availability of resources other than capital and labor - such as energy.
In other words, if energy is needed to produce goods and services, and
its in short supply, capital and labor cant generate as much output.
25
The production function changes, and the only place where that can be
accounted for with Cobb-Douglas is
t
. Hence, it is not surprising that
the rising oil price - which reected a relative oil shortage - coincided
with low productivity measures and lower growth.
Another reason to believe that the productivity slowdown of 1973-1995
had to do with oil is that it also occurred in other advanced economies
- the main exception being the UK, which started to extract North Sea
oil in the early 1970s (and deregulated its economy under the Thatcher
administration during part of this period).
Computers appeared in the 1980s: the rst PC in 1981, the rst Mac
in 1984. By the late 1980s, fax and e-mail were part of our lives. So
why did productivity not recover until the mid-1990s? Experience with
other technologies has shown that it takes time, after the initial appear-
ance, for the technology to improve and for businesses to learn how to
apply it. Adoption involves an initial diversion of resources: infor-
mation must be gathered, choices made between competing platforms,
employees must be trained, processes adjusted and optimized.
Harvard economist Dale Jorgensen studied the impact of IT technolo-
gies on productivity growth in-depth, and he estimates that it already
accounted for most of the TFP growth that did happen in 1973-1990
(in other words, there would have been no growth at all, had it not been
for the advent of computer). Between 1990 and 1995, it accounted for
all TFP growth (in fact, TFP would have grown at a slightly negative
rate otherwise), and afterwards - when TFP growth picked up again -
IT was responsible for two thirds of that growth (and the rest is ba-
sically investment in hardware, which is attributed to capital). So it
took time for the full impact to be felt, but IT is what got us out of
the productivity slowdown and into the mid-1990s economic boom.
This corresponds quite closely to the "ideas" Romer had in mind: the
ever-improving chip designs and software kept making capital more
productive, and therefore rms accumulate machinery more rapidly
and produce more value that is partly reinvested. Software is a classic
example of something that is essentially non-rivalrous and makes it
easier to create more and more advanced software.
26
People who work in software programming or chip design are the "re-
search labor" of the Romer model. Think about whether software rms
are able to appropriate all the value they create for society. One issue
is piracy - its hard to protect a good that can be so easily transferred.
Then there is competition between software developers - it constrains
the prices they might charge. As a result, the industrys protability,
while high, is probably far from its actual social value, and that means
that some applications for which there might be adequate demand can
never repay their development costs and are therefore not undertaken
- too few "research jobs" are created.
3 Frictions
3.1 Income Inequality and Unemployment
Growth is about what happens to the GDP of a country. This is an im-
portant measure of overall well-being, but how this value is distributed
also matters. A large part of GDP is paid out in wages to employees,
and as we know wages can dier very substantially. What causes these
dierences?
Even as the supply of college-educated workers in the US and elsewhere
is growing, the return to college education (in terms of additional ex-
pected lifetime income) has been increasing since the 1960s. Its hard to
put an exact number on this return, since we would have to account for
self-selection (more talented people getting an education - they would
not necessarily earn the same without their college degree as those who
actually start working after high school). But its clear that the divide
between low- and high-skill labor income is widening.
Some popular explanations are IT revolution that creates a larger de-
mand for educated workers, and globalization, which has contributed
to the demand for high-end service exports from countries like the US.
In any case, these developments imply a more unequal income distrib-
ution, which subtracts from the social value of GDP growth. It is no
accident that welfare systems are expanding, i.e. some of the additional
wealth is used to address inequality.
27
In growth theory, the labor force is fully employed, since we are looking
at the long run, where prices (such aswages) are fully exible and
markets have ironed out any shortages or surpluses.The long run is an
analytical device - what would happen if we could keep various things
constant, so that we can isolate the eects of capital accumulation and
productivity change. In reality, we live in the short run, where some
people are always unemployed.
Employment in the US over time vs. GDP (recession intervals). Over
the post-war period of economic growth, there has been continuous net
entry into the labor force, as women increasingly sought careers. The
social transformation underlying this phenomenon in the US began in
World War II, when women were needed as workers while men were
drafted for military service overseas. Note how temporary reductions
in GDP (recessions) coincided with reductions in employment.
Involuntary unemployment carries signicant costs beyond the loss of
output. This is because an increase in the unemployment rate does not
aect everyone the same: it entails a dramatic drop in the quality of
life for a small subset of the population, and we all face a personal risk
of being aected.
Both the resulting inequality in incomes and the risk are costly from a
social perspective. This has to do with the way incomes translate into
utility, i.e. actual preferences. If we are risk averse, marginal utility
of income is diminishing. Inequality means that the poor, who have a
relatively high marginal benet from income, have too little. Moreover,
if income is risky because we might get unemployed, it is less valuable
in utility terms. So what causes unemployment?
A person is ocial unemployed if (i) currently available to work, (ii)
actively looking for jobs within the past four weeks. Most unemploy-
ment spells are brief, a few weeks or months - on average, 25% of the
unemployed nd a job each month. About 20% of the unemployed tend
to be long-term unemployed: out of a job for more than six months.
US civilian population (16 and older) in 2005: those in the labor force
(employed and unemployed) account for about 2/3 of the population;
those not in the labor force (not looking for a job) for about 1/3.
28
In 2005, unemployment was at about 5%, which is on the low side his-
torically (close to 10% in 1982, 25% during the Great Depression). Of
course, now were back at almost 10%, which is very much on the high
side. European economies traditionally have much higher unemploy-
ment, and this dierence has to be explained.
Wages are determined by supply (from prospective workers) and de-
mand (from prospective employers) in the labor market. Generally,
supply is higher and demand is lower at higher wages.
Income taxes shift labor supply in (workers demand higher pay). Else,
they are likely to exit the labor market, in which case they should not
be counted as unemployed (since they are no longer actively looking).
However, in Europe where unemployment benets last longer and after-
tax wages are substantially lower than in the US, there is a greater
incentive to keep looking "reluctantly," i.e. be ocially unemployed
but unwilling to accept some of the available jobs.
European legislation that makes it dicult to re people, and raises
non-wage expenses to the employer, reduces labor demand. With labor
supply xed, this is another factor that increases unemployment.
Wage rigidity refers to the tendency of wages to remain xed as de-
mand conditions change. This is what underlies the Keynesian theory
of uctuations, which can certainly explain labor surplus (unemploy-
ment). But these rigidities are quite controversial as an assumption.
One has to keep in mind that we are talking about real wages - to keep
them xed, nominal wages have to actually increase (assuming there is
some ination). It is not clear what would cause nominal wages to rise
during recessions.
A possible reason is union power (since traditionally union workers are
more dicult to re, unions might have a smaller incentive to protect
jobs than to protect incomes of the employed). So greater wage rigidi-
ties may be another reason why Europe sees higher unemployment, in
particular during recessions.
29
3.2 Natural Rate of Unemployment
A recent focus in labor economics on "normal unemployment" that
arises from transitions in and out of jobs as the sectoral allocation of
labor changes (industries rise and fall, people look for careers elsewhere)
led to the distinction between a long-term trend in unemployment and
cyclical uctuations that are driven by booms and recessions.
The trend is determined by (i) the frequency with with jobs get cre-
ated and destroyed over industry lifecycles, forcing workers to search
for new jobs (frictional unemployment) and (ii) systemic constraints
and incentives that cause people to remain unemployed (structural un-
employment). Most of the dierence between the US and Europe is
traditionally structural: labor laws, unemployment benets.
Relative to the US and Japan, the unemployment rate in Europe (France,
Germany, Italy and the United Kingdom) rose dramatically and per-
manently after the productivity slowdown of the early 1970s. Note how
uctuations are closely correlated between the US and Europe, but the
long-term dierence in unemployment rates persists.
Change in the hours work per person, relative to the US: from 1970-
1974 to 1993-96, all other countries had experienced a relative reduc-
tion, and all European countries worked fewer hours. Some of this may
be due to lifestyle preferences, but a good part is likely to reect lower
labor demand for structural reasons.
Together, frictional and structural unemployment make up what is
called the natural rate of unemployment. This is calculated as the
ten-year moving average (a period long enough to cancel out the busi-
ness cycle). A reduction in unemployment benets is an example of
a policy that is expected to lower the natural rate of unemployment,
regardless of the state of business cycle.
The actual unemployment rate is the natural rate plus the cyclical
component, which is positive in a recession and negative during a boom.
The microeconomics of unemployment. Workers have, and jobs require,
dierent skills and characteristics, therefore the labor market needs to
match the right workers with the right jobs. This takes time and leads
30
to temporary (in most cases) unemployment when someone loses a
job (say because the rms needs or workers preferences change, or
previous matches turn out to be poor).
Denote the fraction of the labor force that is employed by c, the fraction
that is unemployed by n (so c + n = 1). The job-separation rate o is
the percentage of employed individuals who lose their jobs in a period
(say 1% of c). The job-nding rate c is the percentage of unemployed
individuals who accept jobs in the same period (say 9% of n).
Then
c = cn oc = 0
if
n =
o
c +o
since c = 1 n. (With o = 0.01 and c = 0.09, we would have 10%
unemployment.)
n is the natural rate of unemployment. Not surprisingly, it increases in
the job-separation rate, for a given job-nding rate; and it decreases in
the job-nding rate, for a given job-separation rate. We can think of
job separation as driving frictional unemployment and job nding as
reecting structural unemployment (low c indicates not many jobs are
being created, or few individuals are accepting oers).
Business cycles can temporarily change o and c: for example, a re-
cession is likely to increase job separation as labor demand from rms
falls, while decreasing job nding. This would increase unemployment.
After the recession ends and labor demand is back to the old level, un-
employment drops (c 0) because n has increased and c decreased
relative to the natural levels. Still, it takes some time for the old un-
employment rate to be restored.
Job separation rates tend to be higher for younger employees, which
can be explained in that they have had less time to nd an optimal
match. This means that a younger employee is more willing to leave a
job and also that a rm is more likely to lay o a younger employee.
Seasonal and other temporary jobs often require less experience, and
31
this may also account for higher job separation among younger em-
ployees. Because of this, we see more unemployment among young
people.
The job-nding rate is aected by policies such as minimum wage and
unemployment insurance. Minimum wage legislation causes some jobs
to disappear and therefore permanently reduces the number of job of-
fers, increases unemployment. A more subtle eect of minimum wage
is that, in the teenage labor market where it matters most (McDonalds
etc.), higher wages bring new workers into the labor market (middle-
class kids) who displace the more disadvantaged groups (minority kids)
that were willing to work for low pay. So no only do minimum wages
increase unemployment, they also cause jobs to be less eciently allo-
cated.
Unemployment benets encourage job seekers to turn more oers down.
Suppose there is a distribution of job oers the job seeker is likely
to get at any given time. If pay determines the value of a job (a
simplication, but a harmless one), there will be a threshold level ^ n,
so that a particular job seeker will accept jobs that pay more than this
level and reject jobs that pay less.
The threshold will lie somewhere above n
0
, the level of unemployment
benets. Rejecting an oer n means that the job seeker foregoes earn-
ing of n n
0
in the current period, in order to attract a better oer
n
0
n. Just how high the threshold is will depend on the (known)
distribution of jobs out there, the better the oers you can expect, the
higher your standard for acceptance. It also depends on n
0
, the higher
n
0
, the smaller are the wages foregone by continuing to search.
What happens if unemployment benets (n
0
) increase? Then you are
guaranteed a better income, n n
0
declines for all oers. You should
increase your threshold, since you are exposed to a smaller risk (po-
tential income loss). With the higher threshold, you are less likely to
accept oers and likely to be unemployed longer. Thus, better and
longer-lasting benets imply more unemployment.
32
3.3 Money
One aspect of GDP that we have not explicitly modeled is that it in-
cludes many dierent goods, and that individual workers tend to spe-
cialize in producing a few specic things that they have a comparative
advantage at. In fact, the division of labor contributes greatly to the
productivity of modern economies, as Adam Smith already emphasized.
But this is only possible if goods can easily be traded. Money replaces
barter to eliminate the need for a "double coincidence of wants": that,
in order to purchase a good from someone, you need to have a good
of similar value that they desire and will accept in exchange. When
a commodity in xed supply, such as gold coins or certain types of
printed paper, is universally accepted in trade, it acts as a promise
from the whole economy (rather just one individual) to deliver goods
in the future.
A further advantage of coin or paper money is that, unlike most goods,
it is almost innitely divisible, so that its easy to exchange goods for
a quantity of money of similar value. Thus, money greatly facilitates
exchange and increases the value that production can generate because
it allows for a more ecient allocation of consumption goods through
trading.
Early forms of money had intrinsic value: e.g. coins were made from
precious metals, gold being the most common. Later, governments
issued more convenient paper currency, but promised to exchange it
for gold etc. at a xed rate at the bearers request.
In the 20th century, countries began to abandon the gold standard
and paper currency became "at" money (at means "by decree" -
the government simply declares the paper to be "legal tender"). This
is possible because, over time, a mutual expectation has evolved that
paper bills will be accepted for purchases. We accept our salary in
dollars as long as we believe the grocer will accept dollars for food.
The grocer accepts dollars as long as she can pay her employees in
dollars.
We now insert money in a little general equilibrium model to see how it
aects the price level. In this economy, there are two individuals who
33
each specialize in the production of a good and then trade.
Person 1 supplies A units of the rst good to the market and has
preferences represented by
n
1
(r
1
.
1
) = r
1=2
1

1=2
1
.
1s budget constraint
j
x
r
1
+j
y

1
= j
x
A
reduces to
j
y

1
= j
x
(A r
1
) .
we can substitute for
1
and write the utility function in terms of one
variable:
n
1
(r
1
) = r
1=2
1
_
j
x
j
y
(A r
1
)
_
1=2
.
Maximizing with respect to r
1
, we have rst-order condition
Jn
1
(r
1
)
Jr
1
=
1
2
1
r
1=2
1
_
j
x
j
y
(A r
1
)
_
1=2

1
2
j
x
j
y
r
1=2
1
1
_
px
py
(A r
1
)
_
1=2
= 0
==
r
1
=
1
2
A.
Then

1
=
j
x
j
y
(A r
1
) =
1
2
j
x
j
y
A.
Person 2 supplies 1 units of the second good to the market and has
preferences represented by
n
2
(r
2
.
2
) = r
1=3
2

2=3
2
.
2s budget constraint
j
x
r
2
+j
y

2
= j
y
1
reduces to
j
x
r
2
= j
y
(1
2
) .
we can substitute for r
2
and write the utility function in terms of one
variable:
n
2
(
2
) =
_
j
y
j
x
(1
2
)
_
1=3

2=3
2
.
34
Maximizing with respect to
2
, we have rst-order condition
Jn
2
(
2
)
J
2
=
1
3
j
y
j
x
1
_
py
px
(1
2
)
_
2=3

2=3
2
+
2
3
_
j
y
j
x
(1
2
)
_
1=3
1

1=3
2
= 0
==

2
=
2
3
1.
Then
r
2
=
j
y
j
x
(1
2
) =
1
3
j
y
j
x
1.
The market for 1 clears,
1 =
1
+
2
=
1
2
j
x
j
y
A +
2
3
1.
at relative prices
j
x
j
y
=
2
3
1
A
.
(The same conclusion would be reached if we set r
1
+ r
2
= A and
solved for j
x
,j
y
. This is known as Walras law: if one market clears,
then so must the other.)
The price ratio solves the general equilibrium model in the sense that,
any prices in this proportion clear the markets for both goods. We
cannot pin down both prices: the usual practice is to declare j
y
the
price of the "numeraire" (reference good) and just assume that its
j
y
= 1. The "price level" is meaningless, since an increase in j
x
and j
y
would, on the one hand, make things more expensive but, on the other,
provide more income to 1 and 2; they could still aord (and would still
choose) exactly the same quantities. Nothing happened in real terms.
But this is a barter economy, where we assume direct trades (
1
for r
2
)
are possible. Now suppose when 1 wants to buy
1
from 2, 2 will only
accept money, and likewise 1 will only accept money for r
2
.
Say, both 1 and 2 have just enough money to purchase what they wish,
i.e. the money supply is
` = j
y

1
+j
x
r
2
= j
y
(1
2
) +
j
x
j
y
j
y
(A r
1
) =
2
3
j
y
1.
35
Note that j
y

1
+j
x
r
2
is GDP in this simple economy; assuming that r
1
and
2
, the quantities that 1 and 2 keep for themselves, are not traded.
We have
j
y
=
3
2
`
1
and
j
x
=
2
3
1
A
j
y
=
`
A
.
Now the prices are both pinned down by the further constraint that is
imposed by the money market equilibrium(money supply equals money
demand, i.e. GDP). Prices are increasing in the money supply and
decreasing in A and 1 . The latter reects that more goods "chasing"
the same amount of money must get cheaper - there just isnt enough
currency to purchase them otherwise.
What would happen if 1 and 2 sold all their produce to "the market"
and then bought back what they wish to consume? Now GDP is j
x
A+
j
y
1 , and money supply and demand are equal if
` =
j
x
j
y
j
y
A +j
y
1
=
5
3
j
y
1.
implying
j
y
=
3
5
`
1
and
j
x
=
2
5
`
A
.
Prices have dropped (specically, the price level; relative prices remain
the same). Why? Essentially for the reason we just gave: there are
now more goods traded, so at a given money supply the prices must
come down.
Finally, what if money is initially not allocated in the right quantities?
Say 2 has all the money. In order to sell
1
to 1, 2 must lend money to
1. Lets suppose 1 charges an interest rate : for this (well learn later
how the interest rate is in fact determined).
36
Eectively then, 1 pays (1 +:) j
y
for each unit of 2s good: every dollar
has to be borrowed and repaid with interest. Since r
1
is not sensitive
to j
y
(a special property of demand functions that arise from Cobb-
Douglas utility), we can simply multiply j
y
by 1 + : everywhere. So 1
will consume r
1
= A,2 and

1
=
1
2
1
1 +:
j
x
j
y
A.
2 receives extra income and gets to consume
2
= 21,3 and
r
2
=
1
3
(1 +:)
j
y
j
x
1.
This means that (with everything traded)
j
y
=
3
5
1
1 +:
`
1
and
j
x
=
2
5
1
1 +:
`
A
.
Hence a higher interest rate is associated with a lower price level. In
general, this is true because the interest rate represents a cost of holding
money - the better the terms at which it can be lent out, the less money
is demanded. At xed supply, this means the price level at which money
supply equals demand drops.
3.4 The Aggregate Price Level
So far we expressed the equilibrium in the market for money as ` =
G11 (money supply equals money demanded in order to purchase the
GDP at current prices). Aggregating the various outputs and prices,
we can write nominal GDP as 1 1 , where 1 is the price level.
What we neglected so far is that a dollar bill might be spent several
times over in the relevant period, eectively increasing the money sup-
ply. The frequency with which currency is spent on average is called
"velocity" and denoted by the letter \ . We have therefore
`\ = 11
(where, in the previous example, we implicitly assumed \ = 1).
37
Can velocity be measured? Well, we can measure GDP, and the Fed
knows (roughly) how much currency it has in circulation (some money
gets destroyed or lost each year). According to the formula, velocity is
simply 11,`.
If we view velocity and output as independent of the money supply, we
have the quantity theory of money: the price level is mainly determined
by how much money the Fed prints. Everything except the price level
is exogenous, but ` is a matter of policy. (It is exogenous in the sense
that the model does not explain how the policy is determined. We will
consider the question later on.)
We can calculate the rate of ination, i.e. the growth in the price level
1
t
1
t1
1
t1
.
from the equilibrium equation: since
1
t
=
`
t
\
1
t
.
we have
1
t
1
t
=
J
Jt
(ln `
t
+ ln \ ln 1
t
) =
`
t
`
t

1
t
1
t
(because ln \ is a constant, its time derivative is zero).
As we discussed earlier, there are various ways to dene the aggregate
price level. One might aggregate the value of all goods in the economy
and compare it to a base year (or a moving average): these are GDP
deators. Or one might focus on a selected set of goods that are relevant
to a particular agent.
Examples are investment or export goods, but the best-known of these
is the consumer price index (CPI), which compares the prices of a
"typical" basket of consumption goods over time. (The CPI keeps
quantities xed at the initial level, so it is a Laspeyres index.)
In the US, we had relatively high rates of ination in the 1970s, and
sustained moderate rates around 3% since then.
38
This is reected in the CPI benchmarked to the year 2005. It doubles
in the 1970s, then grows more slowly.
According to the quantity theory, we get ination when the growth in
the money supply outpaces growth in real output. This conclusion de-
pends on real GDP 1
t
being in fact unrelated to 1
t
, an idea known as
the "neutrality of money." While it makes intuitive sense, since incen-
tives to produce should only depend on relative prices (not the price
level), there may be imperfect adjustment to an increase in the money
supply in the short run: businesses need some time to gure out that
there is more money around and prices should increase. In that case,
relative prices could be (temporarily) aected, and then also what is
produced.
Generally, the money supply includes "highly liquid assets." There are
various denitions of what that includes, depending on the standard
of liquidity. The strictest would be what we conventionally think of as
currency - i.e. dollar bills in circulation.
The "monetary base" is currency plus the reserves that commercial
banks are required to hold with the Federal Reserve Bank (to cover
withdrawals from bank accounts). Although reserves arent actually
in circulation, they can be drawn on immediately if needed and paid
out to people as cash. In fact, the Fed will provide short-term cash
to banks at the "discount rate" (set as part of its management of the
money supply) so that they can maintain their reserves when they run
short.
M1 is the monetary base plus demand deposits, which are accounts
that, while not actually cash, can immediately be converted into cash,
such as when you draw on your checking account with a debit card.
M2 is M1 plus savings and money market accounts (i.e. bank deposits
with some withdrawal limitations, but this does not include time de-
posits). Savings accounts yield a xed interest rate. Money market
accounts are accounts with commercial banks or money market funds
that are invested in the money market and pay an interest rate tied to
the going money market rate. While a savings account imposes some
costs on withdrawals (you may have to go to the bank or transfer funds
39
online), a money market account typically gives convenient access to a
portion of your funds (it may let you write checks, but only in limited
amounts).
The money market trades securities that banks, government (municipal
paper, treasury bills) and corporations (commercial paper, repurchase
agreements) issue in order to manage their cash ows. For example,
a town needs to pay its employees while waiting for tax receipts. It
might issue municipal paper to raise the cash immediately. A trading
company pays a supplier with a bankers acceptance (bank guarantee
to pay a certain amount at a certain date, i.e. upon receipt of the
goods). Because these instruments are repaid quickly and backed by
anticipated earnings, they are considered very safe and interest rates
are similar.
Ination in the US against the rate of (M2) money growth: the rela-
tionship is positive, as predicted by the quantity theory, higher money
growth is associated with higher ination. The same is true across
countries, for the average money growth and ination rates from 1990
to 2003.
3.5 Costs of Ination
German hyperination: in 1919, a loaf of bread cost 25 Pfennige (the
equivalent of "penny"; one dollar was worth about ve Mark at the
time); four years later, the loaf of bread cost 80 billion Mark (the
equivalent of dollars; by then, a dollar was worth one trillion Mark).
Two episodes from the time: a German lawyer bought a 20-year life
insurance policy in 1903 and, when it came due in 1923, used it all
to purchase one loaf of bread. A German cook received a one-dollar
tip from an American tourist: he decided to start a trust fund for his
family.
Ination progress so quickly that people were paid every day and would
immediately buy whatever was sold, or had relatives stand by to do it
for them. You bought a cup of coee at one price, and by the time you
ordered another, the price might have doubled.
40
Reasons included that Germany abandoned the gold standard in 1914
on the eve of World War I in order to nance the war machine. After
the war, Germany had massive reparations to pay to France, leaving
the government scrambling to nance its normal operation, and on top
of it, unfolding political unrest (murder of the foreign minister) un-
dermined faith in the state. A spiral began where citizens sought to
convert currency into real assets and increasingly bartered, so the de-
mand for money dwindled. The central bank printed money to nance
the government. The value of money dropped, and the more prices
increased, the more money had to be printed. Once ination was fully
underway, it was self-reinforcing and seemingly nothing could stop it.
In 1923, the central bank introduced a new currency that was backed
by real goods (i.e. it stood in a xed proportion to output by farms
and factories and was independent of government needs). But people
had lost their savings, and the extreme experience of the hyperination
was blamed by some for a culture that had become demoralized and
passive in the face of "fate," giving birth to the Nazi regime. (Thomas
Mann: "The market woman who without batting an eyelash demanded
100 million for an egg lost the capacity for surprise. And nothing that
has happened since has been insane or cruel enough to surprise her.")
Other hyperinations occurred during times of trouble, such as Yu-
goslavia and Russia during transition from socialism in the early 1990s,
Latin America during the debt crisis in the 1980s, Hungary after World
War II in the 1940s, and the confederate states during the American
civil war.
Hyperinations are usually dened as increases in the price level at a
monthly rate exceeding 50%. All hyperinations are associated with
money printing. This yields immediate cash for the government, but
the growing prices devalue citizens savings. In this sense, it is like a
hidden tax on money holders. The temptation for governments to raise
revenue in this manner is why countries like the US and Germany have
traditionally emphasized central bank independence.
While the costs of hyperination are obvious, even moderate levels of
ination cause problems: businesses rely on being able to roll over loans
(i.e. get a new loan in order to pay o old loans). Rising interest rates,
41
associated with ination, can make this dicult. They can also catch
home owners o guard who have variable-rate mortgages, and whose
incomes may not be growing at the rate of ination.
In general, ination benets those who have long-term debts at xed
rates, and it harms creditors, because it devalues debt. Creditors in-
clude banks and employees with pensions. Without ination-adjusted
("indexed") interest rates (which only came into use after the expe-
rience with high interest rates in the 1970s), the value of what they
initially paid out (as loans or deposits into the pension system) might
even exceed the value, in real terms, of what they get back.
3.6 Ination and Interest Rates
The nominal interest rate can be decomposed into the rate of ination
and the real interest rate. Suppose you borrow an amount r
0
and agree
to repay r
1
, a year later.
The implicit (nominal) interest rate is i such that (1 +i) r
0
= r
1
, so
i =
r
1
r
0
1.
But what is repaid in real terms is r
1
,1
1
, where 1
1
is the eventual price
level (assuming it is benchmarked to the present, so that 1
0
= 1). In
real terms, the interest rate is : such that r
0
+:r
0
,1
1
= r
1
,1
1
, so
: =
r
1
r
0
1
1
.
(We have to divide :r
0
by 1
1
since it is received in the future, when
the price level has changed to 1
1
.)
Hence
: =
_
r
1
r
0
1
_
(1
1
1)
= i :
where
: =
1
1
1
0
1
0
= 1
1
1
is the rate of ination.
42
The nominal interest rate i is the interest you would actually pay on a
loan (assuming default risk is negligible). If this is xed, at some level,
then the real interest rate (what your payment is worth in terms of
goods) depends on the rate of ination: it falls when ination is higher.
This is why ination enriches debtors at the expense of creditors.
In general equilibrum, the real interest rate is the marginal product of
capital (reects the cost of renting capital). This is another version of
money neutrality: in the long run, after full adjustment, the nominal
interest rate will simply increase with the rate of ination. But in the
short run, when adjustment is imperfect and ination is not always
predictable, the real interest rate can be sensitive to ination.
4 Short-Run Fluctuations
4.1 Cyclical Component of GDP
At any given point in time, the economy is in the short run - i.e. real
output is not necessarily the long-run capacity (what growth theory
predicts), but rather uctuates around it while adjusting to some cur-
rent shock.
Trend line of real GDP ("potential output"), determined by the econ-
omys capacity to produce if resources are optimally allocated, contrasts
with a curve that depicts the measured real GDP ("actual output"),
which is more volatile. Actual output can be detrended (i.e. poten-
tial GDP

1 at each point in time subtracted), so that we isolate the
deviation, the cyclical component (or "short run component")
~
1 .
The cyclical component is dened by
1
t
=

1
t
+
~
1
t
.
where 1
t
is observed real GDP (deated nominal GDP).
There are various techniques for detrending real GDP, called "lters."
All involve averaging real GDP growth over a period of time, so that
temporary deviations are "ltered out."
43
The most popular is the HP-lter (Hodrick-Prescott), which picks the
smoothed (trend) series

1
1
.

1
2
. .... 1
T
such that the function
T

t=1
_
1
t

1
t
_
2
+`
T1

t=2
_

1
t+1

1
t

1
t

1
t1
__
2
is minimized for some `. The parameter ` weights deviations from
the trendline (captured by the rst term) against changes in the trend
growth (captured by the second term), i.e. it determines how the dual
objectives of "good t" and "smoothness" of the trend line are bal-
anced. (The HP-lter is often applied to the logarithms of the 1
t
series.
GDP data are available quarterly, and in that case the suggested value
for ` is 1600.)
The solution to the minimization problem can be stated in matrix no-
tation as

1 = [1 +``
0
`]
1
1.
where

1 =
_

1
1
.

1
2
. .... 1
T
_
is the vector of trend values, 1 = (1
1
. 1
2
. . . . . 1
T
)
are the observed GDP data, 1 is the identity matrix (where all non-
diagonal entries are zero, and diagonal entries are 1), and ` is a special
matrix (starting with the identity matrix, replace each zero immedi-
ately to the right of a diagonal entry with 2, and the zero immediately
to the right of that entry, i.e. two positions from the diagonal entry,
with 1). For example e.g.
_

1
1

1
2

1
3

1
4
_

_
=
_

_
_

_
1 0 0 0
0 1 0 0
0 0 1 0
0 0 0 1
_

_
+`
_
_
_
_
_

_
1 0 0 0
2 1 0 0
1 2 1 0
0 1 2 1
_

_
1 2 1 0
0 1 2 1
0 0 1 2
0 0 0 1
_

_
_
_
_
_
_

_
1
_

_
1
1
1
1
1
1
1
1
_

_
(where the superscript 1 refers to matrix inversion).
As previously remarked, when we compare actual output against the
long run trend, uctuations do not seem severe (between -5% and +5%
of real GDP), except at times like the Great Depression, but much of the
cost lies in individual exposure to extreme events like unemployment.
The dierence,
~
1
t
, is - roughly speaking - positive in a boom (when
GDP temporarily exceeds long-run capacity) and negative in a reces-
sion. In practice, whether the economy is in an ocial recession or not
44
is determined by the Business Cycle Dating Committee of the NBER,
a panel of prominent macroeconomists. They take various indicators,
such as employment and output in leading sectors, like wholesale, re-
tail and manufacturing, into account. As a simple rule of thumb, a
recession is called when real GDP has been below potential for about
a year.
A regularity of short-run uctuations is that ination falls during a
recession.
The positive relationship between changes in ination and the cyclical
component of output is reected in a stylized fashion by the Phillips
curve, named after a New Zealand economist who rst noticed it. Ex-
plaining it is one of the tasks of macroeconomic theory.
Comparing ination growth and detrended output growth over time
in the US, we can see the Phillips curve in the data: for every per-
cent increase in ination, the detrended output grows by about 2%.
The correlation is far from perfect, but the tendency is something our
modeling will have to reect.
One way to rationalize this relationship is as follows: suppose people
expect a certain amount of ination each year, and wages tend to grow
accordingly. Now, due to some shock (e.g. an increase in money supply
growth), goods prices rise faster than anticipated. Then rms nd their
prot margin increasing and may expand production. If the economy
were in equilibrium, wages would have risen, and the relative prices of
goods and labor would be unaected. But, for a while, wages might
fall in real terms, and it becomes feasible for rms to pay workers for
overtime and expand output beyond long-run capacity. I.e. the price
increase triggers a boom in production.
On the other hand, suppose ination slowed (because of a decrease
in money supply growth). Then wages rise in real terms, and rms -
unable to raise prices for their output, but stuck with increasing wages
- want to scale back production, lay o people. Then the economy
might enter a recession.
Another regularity of short-term uctuations is the negative relation-
ship between output and unemployment. Over time in the US, a 1%
45
increase in cyclical unemployment (the dierence between actual unem-
ployment and the natural rate) has been associated with a 2% reduction
in the short-term component of GDP.
This is known as Okuns law (after a member of the Council of Eco-
nomic Advisors during the Kennedy administration).
Unemployment and ination aect the livelihoods and life satisfaction
of voters. Not surprisingly, they can help predict the outcomes of presi-
dential elections in the US. Predicted popular vote shares of the incum-
bent based on a model by Yale economist Ray Fair (which mainly uses
ination and unemployment, but controls for incumbency advantage)
are quite close to the actuals.
4.2 Investment-Saving Equilibrium
The Phillips curve captured that an unexpected increase in ination is
associated with an increase in cyclical GDP. We saw previously that
higher ination reduces the real interest rate that lenders earn and
borrowers pay. Now we make the connection by modeling the negative
relationship between the real interest rate and cyclical GDP.
This relationship is called the IS curve, for investment = saving. If we
rearrange the national income identity,
1
t
= C
t
+1
t
+G
t
+`A
t
.
to
1
t
= 1
t
C
t
G
t
`A
t
and add and subtract taxes 1
t
, we have investment on the left and
saving from various sources on the right:
1
t
= (1
t
1
t
C
t
) + (1
t
G
t
) + (`A
t
) .
Namely, 1
t
1
t
C
t
is saving by consumers (after-tax income not
consumed), 1
t
G
t
is government saving (tax revenue not spent), and
`A
t
is saving by foreigners (imports net of exports, which must cor-
respond to domestic assets held by foreigners).
46
That investment will equal saving in this sense is true because the
national income identity must hold. The IS curve reects that the
national income identity implies a negative relationship between the
real interest rate and cyclical output.
Dividing by the potential output 1 , we have
1
t
1
=
C
t
1
+
1
t
1
+
G
t
1
+
`A
t
1
.
We treat C
t
,1 = c
C
, G
t
,1 = c
G
and `A
t
,1 = c
NX
as exogenous.
Investment becomes more attractive when the real interest rate 1
t
is
small relative to the marginal return to capital : that businesses must
pay on loans. Hence, let
1 = c
I
1 / (1
t
:) 1.
Thus,
~
1
t
=
1
t
1
1
=
C
t
1
+
1
t
1
+
G
t
1
+
`A
t
1
1
= c
C
+c
I
/ (1
t
:) +c
G
+c
NX
1
= c / (1
t
:)
where c = c
C
+c
I
+c
G
+c
NX
1.
This is the IS curve in its algebraic form: note that cyclical output
~
1
t
decreases in the real interest rate 1
t
and increases in c (the spending
propensity in the various sectors) as well as : (the marginal return to
capital).
Note that, when 1
t
= :, i.e. the real interest rate is the marginal return
to capital (as it would be in the long run), output is at its potential
(since deviations of 1
t
from : are the only source of change here), so
we must have
~
1
t
= c = 0.
Since the IS curve reects
~
1
t
at each value for the real interest rate 1
t
,
any changes in the real interest rate involve movement along the curve.
The important thing to keep in mind is that the relationship has not
changed in this case, the curve is still in place.
47
If c (spending propensity) or : (marginal return to capital) increase,
~
1
t
is higher at any interest rate. The curve, i.e. the values of
~
1
t
at
dierent 1
t
, has shifted out.
Examples include: an invention (raises :), an increase in consumer
or investor condence (raises c through c
C
or c
I
), a new government
initiative (raises c through c
G
) and an increase in exports due to an
economic boom abroad (raises c through c
NX
).
Conversely, the IS curve might shift in if a new computer virus reduces
the marginal return to capital, consumers and businesses anticipate
slower growth, the government cuts spending and foreign economies
are faring poorly and import less.
Changes in potential output do not directly aect the IS curve, if they
are neutral with respect to c and :. Though we can think of events that
would shift both potential output and the IS curve, we must identify
how they alter c or :. For example, a new management approach might
make the economy more productive and increases the marginal return
to capital. Potential GDP increases for the rst reason, and the IS
curve shifts for the second.
4.3 Multiplier Eect
In the derivation of the IS curve, we have treated the spending propen-
sities (c) as exogenous, i.e. uncorrelated with the state of the economy
~
1
t
. This seems a bit unrealistic, and we will take a closer look at the
issue in this lecture. Specically, if they depend on
~
1
t
, what happens
to the IS curve?
Milton Friedmans permanent income hypothesis says that consumers
will base their spending not on their current income, but on the net
present value of their expected lifetime income:
T

t=0
,
t
n
t
.
where n
t
is income at time t, and , is the discount factor.
48
Note that ,n
1
is the time-0 value of n
1
, ,n
2
is the time-1 value of n
2
,
so , (,n
2
) = ,
2
n
2
is the time-0 value of n
2
... In general, ,
t
n
t
is the
current (time-0) value of receiving income n
t
at time t.
Individuals who are risk-averse (exhibit diminishing marginal utility
of income) will want to smooth their consumption over time, since
it is welfare-improving to allocate a dollar from times when they are
relatively wealthy to times when they are relatively poor.
Hence, students and retirees overspend relative to their current incomes
(students "borrow" from their parents, retirees live down their savings
and benets), professionals underspend (save, e.g. through programs
like retirement contributions). This implication of the permanent in-
come hypothesis is known as the life-cycle theory of consumption.
If consumption stands in a xed proportion to expected lifetime in-
come, then it should not be responsive to short-term uctuations, and
therefore c
C
= C
t
,1 would be approximately constant.
In reality, consumption smoothing is a bit more intricate: you cant
foresee every event that aects your future income, such as promotions,
winning the lottery etc. Hence, your expected lifetime income, and
therefore consumption, will in fact uctuate when you learn something
new about what your future looks like. But the logic of the permanent
income hypothesis implies that, at each time, consumption choices are
based on your best current forecast of lifetime income - any future
changes in consumption are in response to "surprises." Technically,
this means that consumption is a "random walk" (a stochastic process
where the expected value in the next period is the same as the current
value).
Moreover, risk averse consumers will engage in "precautionary saving"
to insure themselves against adverse events. Even someone who is
poor relative to expected future income would therefore not necessarily
borrow to consume. Others, who might wish to borrow, cannot do so
because banks will not lend to them if they have no collateral to oer
and future income is uncertain.
Even if income were perfectly predictable, consumption smoothing does
not imply that spending on consumption will be constant, since e.g.
49
the availability of time varies over ones lifetime. Once you retire, you
can more easily cook yourself, so you can maintain a given standard
of eating without the expense of going to restaurants all the time.
Anticipating this change in resources (time), your income might have
to be higher while you are working and earning, in order to keep your
consumption smooth.
If you think about these points carefully, you will notice that they all
imply that consumption is somewhat sensitive to short-term uctua-
tions in GDP: higher current income is likely to increase your estimated
lifetime income, reduce the "worst case scenario" and preference for in-
surance, relieve borrowing constraints, and perhaps cause you to work
overtime so that you will spend more on services. The fact that the
government nds it necessary to mandate some saving (retirement ac-
counts) moreover suggests that individuals dont necessarily conform
perfectly to the incentive to smooth consumption. We will build the
dependence of consumption on short-term GDP into the model shortly.
Investor income is exposed to progressive taxation (higher income is
taxed at a higher rate). This provides an incentive to smooth receipts
by maintaining a relatively stable investment volume.
But there are also reasons why investment might uctuate with GDP:
if rms have less cash on hand, they must borrow more in order to
undertake investments, and this involves paying risk premia that arise
from moral hazard (borrowers have an incentive to take excessive risk)
and adverse selection (rms that have private knowledge that they are
at risk are more likely to nance investment with debt rather than
equity). Thus, the cost of borrowing is usually substantially higher
than the risk-free real interest rate, and in a downturn, when incomes
are low and funds must be sourced in the capital market, investing is
less attractive, even if the real interest rate does not change.
Government spending is, to some extent, constrained by the tax rev-
enue, which would suggest that it is fairly stable. On the other hand,
government can borrow in the bond market on attractive terms, and
may want to use scal policy to stimulate the economy in a recession,
or cool it during a boom.
50
However, since additional government spending must be nanced through
loans that will necessitate higher future taxes, it lowers consumers
expected lifetime income and investors expected returns. Thought
through to its conclusion, this suggests that scal policy cannot af-
fect total spending in the economy - since consumers and investors will
scale back their spending in response to higher government spending,
in anticipation of future tax increases. Economists refer to this idea as
"Ricardian equivalence." In practice, Ricardian equivalence does not
appear to hold perfectly: the eects of scal expansion are tempered,
but not fully cancelled, by reductions in consumer and investor spend-
ing.
Net exports reect economic conditions overseas, which are correlated
with domestic GDP. Hence imports and exports are likely to move
together, but shocks arising from resource prices, government policy
etc. will make the relationship imperfect and net exports somewhat
responsive to
~
1
t
.
So what if the fraction of GDP that is spent on consumer, investment,
government and overseas purchases varies with the short-term uctu-
ations in the economy? Suppose that they actually take the following
form:
C
t
1
= c
C
+r
C
~
1
t
1
t
1
= c
I
+r
I
~
1
t

/ (1
t
:)
G
t
1
= c
G
+r
G
~
1
t
`A
t
1
= c
NX
+r
NX
~
1
t
.
Let c = c
C
+ c
I
+ c
G
+ c
NX
1 and r = r
C
+r
I
+r
G
+r
NX
. Then
~
1
t
=
1
t
1
1
=
C
t
1
+
1
t
1
+
G
t
1
+
`A
t
1
1
= c +r
~
1
t

/ (1
t
:)
=
1
1 r
_
c

/ (1
t
:)
_
.
51
We recover our original IS equality
~
1
t
= c / (1
t
:) if we let
c =
c
1 r
and
/ =

/
1 r
.
The term 1, (1 r) is the famous "multiplier." It reects the domino
eect of an increase or reduction in spending propensity: if a downturn
causes
~
1
t
to fall by 1%, everybody spends r cents less of each dollar
they receive in income. This causes
~
1
t
to drop by another r% (total
1 + r). But for each of these additional r%, everybody lowers their
spending again by r%, so there is a further reduction in
~
1
t
by r
2
%,
and so forth. Overall
~
1
t
falls by 1 + r + r
2
+ r
3
+ %, and this is a
geometric series, so it can be written as 1, (1 r).
The way to think of the multiplier is as follows: "one persons cutback
in spending is another persons loss of income, which induces another
cutback in spending." If you decide to put another dollar aside because
times are bad, that means the grocer has a dollar less and may ulti-
mately need to cut sta, which forces the laid o employee to spend
less, and so forth.
Of course, it works opposite when there is an exogenous increase in
~
1
t
: the economy actually expands by a greater amount because the
additional income is spent several times over.
While the multiplier does not really aect the qualitative logic of the
IS curve, it magnies volatility
~
1
t
(greater c) and makes investment
more sensitive to the real interest rate (greater /). If a decrease in
~
1
t
causes the some of the economys agents to reduce their spending, then
~
1
t
decreases further, triggering another round of spending reductions
and another decrease in
~
1
t
... Clearly, this mechanism amplies any
change in
~
1
t
that the real interest rate might induce.
4.4 Fed Policy
The Federal Reserve Systemconsists of 12 regional federal reserve banks
and the federal reserve board of governors. There are seven governors,
52
appointed by the president to 14-year terms, including the chair (whose
term is four years), currently Ben Bernanke. The Federal Reserve Bank
controls the money supply and can therefore lend unlimited amounts.
It can use this power in order to eectively set interest rates, since it
is able to lend any amount at the desired interest rate to commercial
banks, or to borrow.any amount at the same rate. (Managing the
interest rate is only one of the Feds roles. It also auctions government
securities in order to raise cash for the treasury.)
For example, if the target rate is lower than the current interest rate,
the Fed wants to increase the money supply: by oering to buy bonds
(and thereby releasing new currency to borrowers), or by lowering the
reserve requirement and / or the discount rate.
If the target rate is higher than the current interest rate, the Fed tight-
ens the money supply by issueing bonds (thereby taking the currency
of lenders out of circulation), or by raising the reserve requirement and
/ or the discount rate.
Banks borrow from each other when their reserves with the Fed tem-
porarily fall below the required level (a bank in need of a loan will look
for a bank with excess reserves). This might happen when Bank A
attracts additional deposits while Bank B lost some deposits. Bank A
needs to increase its reserve account with the Fed by 10% of the new
deposits. Bank B could lower its reserve account by 10% of the lost
deposits. It might cash those reserves in for currency (which it could
then loan to anybody), or it might lend its excess reserves to Bank A
in the "federal funds market."
The interest rate on such short-terminterbank loans is called the federal
funds rate. (If needed, banks can also borrow from the Fed at the
discount window, but they tend to be cautious about it, since the Fed
will monitor them, especially if they seem to need help repeatedly.)
The Fed targets a particular federal funds rate through open market
transactions (sales and purchases of bills and bonds). Interest rate
policy is set by the Federal Open Market Committee within te Fed,
which has twelve members: the governors, the president of the New
York Fed, and four other presidents of regional Feds that rotate.
53
Here is how an open market operation might work. At any given time,
the private sector holds a quantity of US treasury bills and government
bonds of dierent maturities. The Fed also holds some of this debt.
If the Fed wants to raise the interest rate, it will tighten the money
supply by selling some of its government securities, say three-month
treasury bills, to banks.
In practice, it will use a repo ("repurchase agreement") with one of
18 banks ("primary dealers"): the bank buys the bills for a specied
period of time (typically, one day to a week) and agrees to resell them
(at a higher price) to the Fed at the end of the period. Essentially, the
bank loans money to the Fed: the dierence in the sales and repurchase
price reects the interest rate that the Fed is implicitly paying.
The bank that purchases the bills will have a reserve account with the
Fed. The Fed debits the reserve account for the price of the bills. If the
bank did not have sucient excess reserves, it falls below its reserve
requirement at this point and will most likely borrow in the federal
funds market to make up the dierence. Hence the Feds sale of T-bills
led to an increase in demand for federal funds, and therefore upward
pressure on interest rates in the federal funds market.
Similarly, if the Fed wants to lower the federal funds rate, it purchases
government securities from banks (through a reverse repo, with an
agreed date on which it sells them back) and credits their reserve ac-
counts. The excess reserves reduce demand and increase supply in the
federal funds market, which puts downward pressure on the interest
rate.
Once the Fed is borrowing at a particular interest rate, this is the
minimal rate at which banks will loan out money, since there would be
no point in setting a lower rate in the open market: they could lend
those same funds to the Fed (we will see in the next lecture how this
works exactly) and earn a higher interest rate. (One has to qualify this
statement a bit, since loan terms dier. However, if the expectation is
that the Feds target rate will persist for some time, banks can get the
same rate for a longer period by rolling loans over, hence the eect of
changes in the target rate should show up in the whole term structure
of commercial interest rates.)
54
It also means that all banks can obtain loanable funds at the same
cost, and competition should ensure that they charge relatively similar
interest rates on their loans. Interest rates on business and consumer
loans will generally be higher than the Feds target rate, since they
must include service charge and risk premia and account for the loan
period for the bank to stay viable. Nevertheless, the real interest rates
that borrowers pay are largely determined by the federal funds rate. In
this sense, the Fed controls the (nominal) interest rate.
Federal funds rate over time in the US: normally falls during recessions
(reecting how the Fed uses the interest rate to counteract the business
cycle) - except in the early 1980s, when Fed chairman Paul Volcker was
combating ination and intentionally induced a recession.
Since there is very little risk involved in federal funds transactions,
and volumes are large (the service component is negligible), the federal
funds rate is essentially the real interest rate plus ination.
Recall the Fisher equation: the (risk-free) nominal interest rate i
t
is
the sum of the real interest rate 1
t
and the rate of ination :
t
. Hence
the real interest rate is
1
t
= i
t
:
t
.
If an increase in the nominal interest rate is always accompanied by
a corresponding increase in ination, the Fed has no control over the
real interest rate, it would be stable. In the present context, we assume
that ination is in fact xed in the short run (any upward or downward
pressures induced by Fed policy take time to materialize - people do not
immediately adjust their expectations about the future rate of ination
and continue to raise prices at the same rate for a while).
One way to justify this idea is that people do not observe all prices at
the same time. If I run a business and I see demand for my products
increase, there are two possibilities: a positive demand shock that is
specic to my industry, or an overall price increase. In the rst case,
I want to expand output (even if I notice that my costs have gone
up proportionately), since my prot has increased in real terms (from
j c 0 to (1 +) j (1 +) c = (1 +) (j c) per unit). In
the second case, my prot is unchanged (the extra (j c) merely
55
compensates for ination). So there is temporary confusing about the
source of the price increase, and it would then be rational for rms to
cautiously expand production (and reduce it later if they discover the
price increase was universal).
If ination is momentarily xed, then the Fed eectively controls the
real interest rate through the nominal target rate. The monetary policy
"curve" horizontal to reect that the interest rate is exogenous to short-
run GDP, it is whatever the Fed decides it should be.
An increase in the real interest rate shifts the line up..
Example of how the Fed might ght a recession. A housing market
bubble comes to an end, and consumers and investors reduce their
spending, fearing an economic downturn. This shifts the IS curve in
(left panel). The interest rate is unaected, since that is set by the
Fed, but cyclical GDP declines.
The Fed responds by lowering the target rate, inducing a reduction in
the real interest rate (right panel). We move along the new IS curve to
- if the interest rate cut is properly targeted - the old level of cyclical
GDP.
Behind this is a spending increase by investors in response to the lower
rate at which they can now borrow. In practice, it takes 6 to 18 months
for a rate cut to make itself felt, and the Fed often cuts the interest
rate repeatedly - rst cautiously, then more boldly - to gure out just
how much is needed.
If the Fed sets interest rates in order to steer cyclical GDP, what is the
eect on ination? The Phillips curve described how ination increases
with cyclical GDP. Expressed as a function,
:
t
= o +:
e
t
+
~
1
t
.
where o is an exogenous shock to ination and :
e
t
is the expected rate of
ination, i.e. the price increase that people anticipate at the beginning
of the period, before they observe the actual rate of ination :
t
. For
example, it seems reasonable that :
e
t
= :
t1
; people believe that, absent
any unforeseen shocks, the previous rate of ination will persist. (There
56
are other theories as to how these expectations are formed; this one is
referred to as "adaptive expectations.")
Hence, with adaptive expectations,
:
t
= :
t
:
t1
= o +
~
1
t
.
When uctuations in GDP cause deviations from the expected rate
of ination, we speak of "demand-pull" ination. Specically, during
a boom ination increases, and during a recession ination decreases.
The rationale lies in how rm-level pricing responds to changes in de-
mand. If the economy is contracting, rms have trouble selling their
output and therefore increase prices by less than the typical rate. If
the economy is expanding, and rms are approaching capacity as they
ll their many orders, they raise prices faster than typical.
An increase in
~
1
t
leads to a movement along the Phillips curve and
:
t
0 because of "demand-pull" ination. Notice that
~
1
t
= 0
(no uctuations), absent a shock, leaves the rate of ination constant:
:
t
= 0.
If o increases, perhaps due to a positive oil price shock or an increase
in wages negotiated by a large union, the Phillips curve shifts upward,
and we get "cost-push" ination. Makes sense because any ination
that does not involve a change in
~
1
t
cannot be attributed to changes
in demand (
~
1
t
includes the demand from each agent in the economy).
A notable success of Fed policy was the ending of the "Great Ination"
of the 1970s. This sustained ination through the 1970s was partly
caused by the rise in oil prices we have already discussed.
But it is now also attributed to a misguided monetary policy. The
Fed wanted to thwart what they perceived as a coming recession by
stimulating the economy. It did not recognize that potential output,
not cyclical output, was in decline (the productivity slowdown, caused
by the permanently reduction in oil supply after OPEC got active).
By keeping GDP above trend, i.e.
~
1
t
0 (mistakenly believing that
~
1
t
= 0), the Fed allowed ination to keep growing. (This relationship
was also not clearly understood at the time, the Philipps curve used to
57
have ination, not change in ination, on the y-axis, so that a sustained
boom would have left ination constant. The experience of rising ina-
tion despite little growth in GDP, "stagation," was a puzzle that led
to the reexamination of the Phillips curve.)
When Paul Volcker became chairman of the Fed in 1979, he faced a
decade of high ination. By raising interest rates, the Fed induced a
reduction in cyclical output, i.e. a recession (moving from point A to
point B in the diagram). The contraction would have come from falling
investments.
Banks raised their prime lending rates (for the most creditworthy clients)
from under 5% in 1979 to 19% in 1981. Housing purchases dropped as
mortgage rates rose to over 20%. With these drastic reductions in in-
vestment spending, income in the economy fell (including for consumers
who are, ultimately, the recipients of returns to investment), and rms
responded to lower demand for their products with price cuts.
In the Phillips curve diagram, we have the eect of cyclical output on
ination: we can see that the recession (which was the worst since the
Great Depression) caused the rate of ination to fall.
What happened to the real interest rate, real GDP and ination dy-
namically. Soaring oil prices delivered an external shock to ination.
Initially, 1
t
might have been at the marginal product of capital : (left
panel) and GDP on trend (middle panel), but ination was high be-
cause of the shock (right panel). (This isnt quite historically accurate,
the economy was probably above trend, and 1
t
below the true mar-
ginal return to capital : during the Great Ination, causing ination
to grow.)
At time 0, Volcker raised 1
t
above :, which caused GDP to fall below
trend, and this induced the slowdown in ination. At time t

, oil priced
had eased and expected ination was lower (since people knew the Fed
was committed to reigning in ination), so 1
t
could be lowered back to
:, so that GDP jumped back to trend. Absent any inationary pressure
from output, ination remained low.
This does not yet explain why the lower rate of ination became sus-
tained into the present. But for this we have the quantitative theory
58
of money: responsible management of the money supply (keeping it at
the rate that is necessary to maintain prices given output growth) will
keep ination constant, if there are no further inationary shocks that
require a response like the one we just discussed (OPEC only raised oil
prices "once," so it was a permanent shock to prices, but a temporary
shock to ination).
Development of GDP and employment through the 2001 recession,
which was brought about by the burst of the dot-com bubble (and,
at the tail end, aected by the September 11 attacks). The interest-
ing, and as yet not fully explained, aspect of the recession is that the
subsequent recovery was associated with a continued increase in unem-
ployment.
Just like stagation caused macroeconomists to rethink the Phillips
curve, the "jobless recovery" has called the current version of Okuns
law into question. It is important to keep in mind that these are "em-
pirical laws," not logical theories. They are accepted only until we run
into contrary evidence.
4.5 Interest Rate Targeting and the Money Supply
The federal funds rate that Fed policy targets is in reality determined
by the supply and demand for money faced by commercial banks. The
money supply is the side the Fed can directly control.
The money demand curve slopes down: money holdings decrease in the
nominal interest rate, which is the opportunity cost of keeping currency
on hand, rather than invested in an interest-bearing asset. The nominal
interest rate is such that money demand equals the money supply, hence
it is determined by the demand for liquidity (unless the Fed intervenes
and adjusts the money supply through open market operations).
Recall that, according to the quantity theory of money,
` =
11
\
.
With money supply, price level and output xed in the short run, the
only thing that can change in response to the nominal interest rate is
59
the velocity of money: people want to keep less currency in their wallets
if the return on savings and money market accounts is higher, so each
bill gets spent less often. The nominal interest rate that we see in the
short run is the one where the (xed number of) bills in circulation
cover the (xed) cost of the produced goods.
Tightening the money supply makes money more scarce. The result is
a higher interest rate and decreased velocity. This is how the Fed can
raise the interest rate through monetary policy.
With interest rate targeting, the money supply is horizontal at the
nominal interest rate the Fed is setting. It will adjust in whatever
direction is necessary to establish this interest rate.
The Fed used to target the money supply (M1), rather than the inter-
est rate. Even if the relationship between the money supply and the
interest rate were perfectly predictable, a problem with such a policy
is that the growth in checkable deposits (the largest component of M1)
is not so easy to manage. The Feds open market operations directly
aect the monetary base (it credits and debits banks reserve accounts).
While a greater stock of reserves would allow the commercial banking
system to make additional loans, that would create additional deposits,
the precise change in M1 depends on consumer choices as to how they
want to hold their money.
An open market operation has a "money multiplier" eect: as a banks
reserves with the Fed increase by an amount A, it can loan out 90%
of A, and if those 90% are deposited with another bank, that bank
can loan out 81% (90% of 90%) of A, and so on. Ultimately (if every-
thing gets re-deposited and nothing is held as currency), deposits in the
nancial system increase by A,0.1 = 10A. Conversely, if the Fed tem-
porarily sold securities and debited reserves by A, checkable deposits
would decrease by a multiple of A.
However, if each borrower decided to keep 10% of the loan in cash, then
only 81% of A (the 90% less 10% of it) is deposited with the second
bank, which needs to keep 8.1% on reserve, and only 65.52% (72.8%
less 10% of it) reaches the third bank, etc. The multiplier is in this
60
case
0.9 (1 0.1) + (0.9 (1 0.1))
2
+
= (0.9)
2
+ (0.9)
4
+
=
1
1 (0.9)
2
- 5.
i.e. only half. Since the interest rate is easily and instantaneously
observable, the Fed can target it with more precision.
When the Fed wants to change the interest rate, it most commonly
engages in open market transactions: it buys and sells treasury bills
and bonds to adjust the currency in circulation. In principle, the Fed
has two other options: it could alter the reserve requirement, allowing
commercial banks to loan out more of their funds, or the discount rate,
making it cheaper to replenish reserves.
Since a reduction in the discount rate would make it less costly for banks
to fall below their reserve requirements, it would encourage them to
keep fewer excess reserves and lend more money. This would increase
supply in the federal funds market and lower the federal funds rate.
Conversely, raising the discount rate would increase the federal funds
rate, by decreasing supply in the federal funds market as banks keep
larger reserves.
However, unless the Fed intends to compete directly with the federal
funds market and become a large-scale lender to commercial banks,
the discount rate is not as eective a tool as open market operations:
currently, banks use it as a last resort and borrow almost exclusively
from other banks.
Even though the reserve requirement has been stable for a long time
now, the Fed can use (and has in the past used) it to manage the
interest rate. Currently, nancial institutions must hold 10% of their
checkable deposits in reserve (3% if they have less than $ 50 million in
checkable deposits)
If the reserve requirement were lowered, commercial banks could loan
out a larger fraction of their deposits, so they would be willing to pay
a higher interest rate on accounts to their customers (at a given federal
61
funds rate). This will encourage individuals to hold more money in
checkable deposits, so it ultimately reduces the monetary base and
increases M1.
The federal funds rate would fall because bank balances are less likely to
fall beneath a lower reserve requirement, and if they did, other banks
would have more funds available to loan out on a short-term basis.
Conversely, raising the reserve requirement would increase the federal
funds rate, by increasing demand and decreasing supply in the federal
funds market.
Reserve requirements have a secondary role to play as "insurance"
against sudden increases in demand for currency (bank runs), so the
Fed is reluctant to lower them as a monetary policy instrument.
4.6 Aggregate Demand and Supply
Monetary policy rule: a principle the central bank uses to determine
what the money supply should be. It might be tied to cyclical GDP
~
1
t
or the rate of ination :
t
or cyclical unemployment, depending in the
central banks objectives.
The Fed primarily tries to manage the rate of ination. Recall from
the Phillips curve that cyclical GDP is related to changes in the rate of
ination, so by keeping ination stable, the Fed is implicitly also reign-
ing in the business cycle. In a boom, ination is higher than expected
(i.e. prices grow faster than usual), lowering the rate of ination back
to a target rate depresses output growth.
The Feds monetary policy rule might be described as follows:
1
t
: = :(:
t
:) .
where : is the target rate of ination. The parameter : describes how
sharply the Fed will adjust the interest rate 1
t
if ination :
t
deviates
from the target rate.
By substituting for 1
t
: in the IS curve equation,
~
1
t
= c / (1
t
:) = c /:(:
t
:) .
we have
~
1
t
as a function of ination.
62
This is referred to as the aggregate demand (AD) function, since it is
a downward-sloping relationship between overall output and the price
level. Actually, in our approach, a change in the price level, but tra-
ditionally Keynesian analysis links the interest rate to the price level,
not ination, to derive the AD curve. This connection can be made via
the quantity theory of money: 1 = `,1 .
The AD curve slopes down because, when ination :
t
rises, the central
bank responds by raising the interest rate 1
t
, which reduces investment
and thereby
~
1
t
.
Recall that, at
~
1
t
= 0 we have c = 0 (which is to say, c
C
+ c
I
+ c
G
+
c
NX
= 1). Thus, :
t
= : means
~
1
t
= 0.
A change in the rate of ination, due to some price shock, would induce
a movement along the AD curve to a lower cyclical GDP. Any other
change (spending propensity c, target ination rate : etc.) would imply
a shift.
Higher : means that the Fed ghts unintended ination more aggres-
sively (by raising or lowering the target interest rate more). In this
case, the AD curve gets atter: a given change in :
t
creates a greater
change in
~
1
t
under the policy rule.
In the last lecture, we introduced a function for the Phillips curve:
:
t
:
t1
= o +
~
1
t
(this assumes adaptive expectations, :
e
= :
t1
).
This implies
~
1
t
=
1

(:
t
:
t1
)
o

.
Because output increases in the price level (more directly, change in
the price level), the Phillips curve in this form is called the aggregate
supply (AS) curve.
The AS curve slopes up. When ination increases, rms produce more,
given our maintained assumption that prices change unevenly, and in
particular nal goods prices initially rise faster than business costs
(wages, intermediate goods).
Recall that, at
~
1
t
= 0 we have o = 0 (no shocks to ination). Thus,
:
t
= :
t1
= :
e
(ination is as expected) means
~
1
t
= 0.
63
Here, a change in :
t
is a movement along the AD curve, and a change
in :
t1
constitutes a shift. Thus, a movement along the curve in the
current period implies a shift in the next.
In this context, :
t
= :
t1
(and the absence of demand or price shocks,
c = 0 and o = 0) is the denition of the steady state. Thus, from the
AS curve,
~
1
t
= 0 in the steady state, and, from the AD curve, :
t
= :
(which means that :
e
= :
t1
= :, i.e. the target level of ination is
expected).
Overlaying the AS curve on the AD curve, they intersect in steady state
at :
t
= : and
~
1
t
= 0. I.e., in the absence of shocks, the Feds target
interest rate will be attained and GDP will be at potential.
In predicting the dynamics induced by a shock, it is important to keep
in mind that the economy will eventually, after temporary shocks have
subsided, return to steady state. Note that only two things can change
the steady state: (1) the central bank might adjust : (so the new
steady state is at
~
1
t
= 0 and the new :), or (2) permanent "shocks"
might alter the denition of
~
1
t
(which is relative to potential GDP),
but this would not aect AD-AS analysis (since we are only talking
about deviations from potential GDP, we do not need to know what
potential GDP is).
Consider a shock to the ination rate, i.e. o 0. This shifts the AS
curve up: now ination is higher at any level of GDP. But the impact
on
~
1
t
is softened by the monetary policy response, which is reected in
the move along the AD curve: the Fed will raise the interest rate and
discourage investment, forcing
~
1
t
to fall. The equilibrium changes from
A to B.
What happens next? Even though the shock is temporary, there is an
increase in expected ination, so :
t
increases at any
~
1
t
(and the AD
curve shifts out again) relative to the initial AD curve, but by less than
before. (Since the actual rate of ination :
t1
after the policy response
was less than what it would have been purely on account of the shock,
so the increase in :
t1
is smaller than o.). The short-run equilibrium
changes from B to C.
64
The same pattern continues. Since the rate of ination has declined,
:
t
< :
t1
, there is a further shift inward in the next period as :
e
falls.
In this fashion, the rate of ination continues to decline (and
~
1
t
grad-
ually recovers) toward the target rate (and potential output).
It takes time for the economy to adjust after the temporary shock;
typically, monetary policy will not immediately return the economy to
its steady state. As in the principle of transition dynamics in growth
theory, convergence toward the steady state is strongest initially, when
the economy is at its farthest from it. Later, interest rates adjust more
gradually, and the eect on
~
1
t
is less pronounced.
Note that, even though the book relates this to stagation experience of
the 1970s, that was triggered by a change in potential output, whereas
here we are looking at a short-term deviation from trend. A change in
the long-term trend would not shift the AS curve relative to the AD
curve,
~
1
t
would remain zero at the expected rate of ination.
Consider an attempt to set a new target rate of ination within the
AD-AS framework. This is what Volcker implicitly did in the early
1980s.
Since : enters positively into the AD equation
~
1
t
= c /:(:
t
:), a
decrease would shift the AD curve in: at any level of ination, cyclical
output
~
1
t
will be reduced (since the Fed is taking a more aggressive
stance against ination). Initially, the equilibrium changes from point
A to B, moving down the AS curve because falling ination means nal
goods prices drop faster than costs of production, so rms scale back
their output. The economy is in recession.
But as ination starts to drop, the expected rate of ination :
e
= :
t1
also changes from period to period, and we see successive downward
shifts of the AS curve,
~
1
t
= (:
t
:
t1
) , o,. Eventually, the AD
curve will be at the point where :
0
(the new target rate of ination) is
associated with potential output,
~
1
t
= 0. During transition, ination
drops gradually and output gradually recovers.
Earlier we considered a one-time supply-side shock to ination and
found that it left the interest rate ultimately unchanged. What if the
65
shock persists for some time? (If the demand shock were permanent, it
would amount to a one-time inationary shock, which we have already
considered.)
Suppose c increases in the AD equation, perhaps due to a boom in
Europe. Then net exports increase beyond their long-run level, and
~
1
t
0 at the current interest rate :
t
. This implies a shift up of the AD
schedule, and the economy moves from A to B to higher output and a
higher ination rate.
For GDP to transition back to potential,
~
1
t
= 0, the AS curve must
shift up as well, which implies a new equilibrium at C, where
~
1
t
= 0
but :
t
:. How does this happen? Initially, the rise in ination is
unexpected and moderated by the fact that rms expand their output
(while input prices arent keeping up). But over time, everyone adjusts
their expectations of the ination rate upward. As input prices catch
up, rms scale back their output at every level of ination - that is, the
AS curve goes through a series of upward shifts.
Now the economy is at potential but the ination rate diers from
the target. Specically, the equation for the AD curve tells us that
:
t
= : +c, (/:) since c /:(:
t
:) =
~
1
t
= 0.
When the shock ends, AD shifts back to its old place. Unexpected
deation leads the economy into a recession, since rms see their output
prices drop faster than their costs. So
~
1
t
is reduced at any given level
of ination: the AS curve shifts in. Eventually, the economy returns to
the original steady state.
What we are left with, after the temporary shock to demand, is the
boom-recession cycle in between the departure and return to steady
state. As we have previously discussed, these uctuations are costly
to the economy, since they are. for example, associated with cyclical
unemployment. If the central bank had not adjusted the interest rate
according to its monetary policy rule (movements along the AD curve),
the swings would have been more severe.
Since we have been presuming that Fed policy follows the rule 1
t
: =
:(:
t
:) in targeting the federal funds rate, we should stop to see
whether we can verify this in the data. Of course, the observable federal
66
funds rate is a nominal rate, but we can apply our theory to nominal
interest targeting via the Fisher equation:
i
t
= 1
t
+:
t
= :(:
t
:) +: +:
t
.
The ination rate :
t
is observable, the marginal return to capital :
is usually taken to be 2%. For the policy parameters, : = 2% and
: = 1,2 have been suggested as providing a good approximation to
Fed behavior.
This is a simple version of the Taylor rule for targeting the nominal
interest rate, named after John Taylor, who suggested it. The full
Taylor rule also takes deviation from potential output into account,
i
t
=
1
2
(:
t
0.02) + 0.02 + :
t
+
1
2
_
ln 1
t
ln

1
t
_
so that the Fed ghts both inations and cyclicality in GDP. With
these values for the (simple) Taylor rule, we get a reasonably good t
to the actual federal funds rate.
Ination rates have fallen since the 1980s in developed countries through-
out the world. This is support for the assumption that monetary policy
reacts to the rate of ination. Some central banks (not the US Fed)
announce ocial ination targets these days.
When the central bank exercises "discretionary" policy, i.e. takes ad
hoc decisions to target what appears to be the best interest rate, it can
introduce "time inconsistency" (deviating from previously announced
policies, say in order to create unexpected ination in a recession).
Ultimately, such behavior (or even just the possibility of it) increases
uncertainty in the economy, and adjustment to a new policy target
takes longer.
By acquiring a reputation for following a particular policy rule, central
banks can inuence expectations about the ination rate and achieve
faster adjustment. In the model so far, people predicted - rather naively
- that the previous rate of ination will persist, no matter what. They
should use the best information available (including the central banks
track record and announcements) in forming such views.
67
Even though we have a theory that "perfectly" predicts the changes
in the ination rate induced by a shock, we are arguing that people in
the economy are "surprised" by these changes, which is what causes
output to increase according to the AS curve. Why dont they learn
some macroeconomics? Money could be made in the stock market if
you buy when the economy starts to expand and sell when it contracts.
Sellers of intermediate goods could raise their prices in anticipation of
increased demand during a boom. Workers could demand intermittent
pay raises while their labor is in short supply.
To some extent they do: think about industries that pay bonuses based
on rm performance - these schemes implicitly adapt the real wage to
the business cycle. Suppliers are certainly not systematically blind
to foreseeable events, they do try to maximize their prots and raise
prices when they can. These are the kinds of conceptual issues modern
macroeconomics is trying to sort out.
In what became known as the "Lucas Critique," Robert Lucas made
this point in 1976. Rational expectations - the idea that people act
on the best forecast possible from a statistical point of view - has be-
come widely accepted as a standard that economic modeling should
meet (even if economists privately argue over whether individuals are
indeed approximately rational). Adaptive expectations are therefore
an oversimplication.
When the central bank has a strict policy of implementing a certain
target level of ination through its management of the interest rate,
the rational expectation would be for the interest rate to remain close
to target.
If a lower target rate is announced, the ADcurve shifts in (since : enters
positively), but the AS curve immediately shifts out (because :
e
= :
replaces :
t1
, which enters negatively). In theory, the ination rate
adjusts immediately, and there is no recession (unlike with adaptive
expectations).
This is why macroeconomists today support a predictable and con-
sistent Fed policy, with explicit targets - with approximately rational
expectations, this will minimize the cyclical variations in GDP that the
68
economy has to go through when the Fed intervenes. And it will keep
ination stable in the rst place, since everyone acts on the assumption
that the Fed will restore the target rate of ination swiftly, so there is
little pressure for unexpected price increases.
4.7 Real Business Cycle Theory
The main empirical problem with the Keynesian approach is that it
suggests labor productivity falls during a boom (rms hire more labor
time because wages do not keep up with output prices, so the marginal
product of labor declines), which is contradicted by the data. The main
alternative model xes this aw, but is analytically much more dicult.
The natural extension of the Solow-Romer model to short-term be-
havior is a so-called real business cycle model. In this model, prices
still adjust perfectly, so ination has no real eects. In fact, money is
not needed in order generate short-term uctuations in real variables.
The uctuations arise from productivity shocks that might reect any-
thing from natural disaster to oil discovery, from tax increases to new
business practices and inventions, from foreign wars to growth miracles
overseas. Its a catch-all concept, and that is a strength as well as a
weakness.
While we can t many scenarios into the model and do not need to im-
pose assumptions like price rigidity, the productivity shocks themselves
remain unexplained, and government (which does not even feature in
simple real business cycle models) is mostly powerless against down-
turns. Policy makers have been hesitant to adopt these models for such
reasons, yet they form the basis for much of modern macroeconomic
research.
As usual, the economys output is given by the Cobb-Douglas produc-
tion function
1
t
=
t
1
1=3
t
1
2=3
t
.
In the long run, productivity
t
may be determined by Romer-style
idea generation, but in the short run, we now think of

t
= c
zt
as driven by a shock.
69
In the real business cycle literature, .
t
is typically specied as an au-
toregressive process of the form
.
t+1
= j.
t
+
t+1
.
which is at each point in time a normally distributed random variable:

t+1
~ ` (0. o
2
). Such models ultimately produce the best t with the
data, but they do not have closed-form solutions. In calibrating this
kind of process to the data, shocks are found to be quite persistent: a
reasonable value for j is about 0.95, so that much of a shock in period
t carries over to period t + 1.
For our purposes, we will consider a process
.
t+1
=
2
3
ln
_
1
(c
zt
)
3=2
+
t+1
_
that is a random walk with drift: the expectation of .
t+1
is positive
and increasing one-for-one in .
t
.
E.g. suppose the distribution of
t+1
(conditional on .
t
) is as follows:
Pr (
t+1
= 0) = 1,2 and
Pr
_

t+1
=
1
2
1
(c
zt
)
3=2
_
= Pr
_

t+1
=
1
2
1
(c
zt
)
3=2
_
=
1
4
.
Then
1
t
[.
t+1
] =
1
4
_

2
3
ln
_
1
2
1
(c
zt
)
3=2
__
+
1
2
_

2
3
ln
_
1
(c
zt
)
3=2
__
+
1
4
_

2
3
ln
_
3
2
1
(c
zt
)
3=2
__
= .
t
+
1
3
ln
2
_
3
.
The constant reects technological progress.
The representative agent is assumed to act according to instantaneous
utility function
n(C
t
. 1
t
) = ln C
t
,1
t
.
where C
t
is individual consumption and 1
t
is time worked. Note that
the marginal utility from consumption is diminishing, which entails a
preference for consumption smoothing.
70
If labor supply is indivisible (i.e. you either have a job and work 9-5
or you dont have a job and thus work no hours), you can think of , is
reecting the probability of being employed in a given period (where, if
you were unemployed, you would receive unemployment benets equal
to the market wage). In that type of economy, everyone is paid the mar-
ginal product of labor, and however many people are actually needed
to work are selected by lottery, the others get to take a nap. The im-
portant thing is that the representative agent dislikes working if income
(consumption) is given.
The representative agent is innitely lived (e.g. we care equally about
our childrens welfare as about our own) and maximizes expected utility
over time:
1
t
_
1

t=0
,
t
n(C
t
. 1
t
)
_
.
subject to the budget constraint
C
t
+1
t+1
= 1
t
+ (1 o) 1
t
.
In more elaborate real business cycle models, we may have nancial
assets, money, government spending etc.
At any point in time, there are three independent choice variables (C
t
,
1
t
and 1
t+1
). Why is 1
t
not a choice variable? (Its determined by
consumption and previous saving and work eort, which x 1
t
). In a
graduate class, you would learn how to solve this problem by dynamic
programming methods. But, with a little care, we can treat it as a
Lagrangean:
(C
t
. 1
t
. 1
t+1
) = 1
t
_
1

t=0
,
t
_
ln C
t
,1
t
+`
t
_
c
zt
1
1=3
t
1
2=3
t
+ (1 o) 1
t
C
t
1
t+1
__
_
.
To simplify notation, dene the marginal returns to labor and capital:
n
t
=
J1
t
J1
t
=
2
3
1
t
1
t
=
2
3
c
zt
_
1
t
1
t
_
1=3
:
t
=
J1
t
J1
t
=
1
3
1
t
1
t
=
1
3
c
zt
1
_
Kt
Lt
_
2=3
=
1
2
1
Kt
Lt
n
t
.
Note that they are sensitive to the shock .
t
.
71
We have rst-order conditions
(1)
J
JC
t
=
1
C
t
`
t
= 0 == `
t
=
1
C
t
(2)
J
J1
t
= , +`
t
n
t
= 0 == `
t
= ,
1
n
t
(3)
J
J1
t+1
= ,
t
`
t
+1
t
_
,
t+1
`
t+1
(:
t+1
+ 1 o)

= 0 == `
t
= 1
t
[,`
t+1
(:
t+1
+ 1 o)] .
plus the budget constraint (which can be thought of as a fourth rst-
order condition, where we dierentiate by `
t
). It can be written as
follows:
(4) 3:
t
1
t
+ (1 o) 1
t
= C
t
+1
t+1
.
Note that the realization of the random element .
t
, and therefore 1
t
,
is known at time t; we have 1
t
[1
t
] = 1
t
and 1
t
[C
t
] = C
t
. But in the
rst-order (3) condition for 1
t+1
we must dierentiate two terms: 1
t+1
appears in
,
t
_
ln C
t
,1
t
+`
t
_
c
zt
1
1=3
t
1
2=3
t
+ (1 o) 1
t
C
t
1
t+1
__
as well as in
1
t
_
,
t+1
_
ln C
t+1
,1
t+1
+`
t+1
_
c
z
t+1
1
1=3
t+1
1
2=3
t+1
+ (1 o) 1
t+1
C
t+1
1
t+2
___
.
The latter includes 1
t+1
= c
z
t+1
1
1=3
t+1
1
2=3
t+1
, which is not known at time
t (since the realization of the shock .
t+1
has not been observed yet).
Hence we must retain the expectation operator in this case.
From (1), (2), (4):
(1), (2) C
t
=
1
,
n
t
(4) C
t
= (3:
t
+ 1 o) 1
t
1
t+1
.
hence
1
t+1
= (3:
t
+ 1 o) 1
t

1
,
n
t
.
This is the equation of motion for the capital stock, familiar (in slightly
dierent form) from the Solow model.
72
It reects the budget constraint, as well as intertemporal substitution:
a higher rate of return to capital increases capital accumulation, but a
higher wage today increases consumption and reduces capital accumu-
lation.
From (2), (3):
n
t
=
1
,
1
1
t
_
1
w
t+1
(:
t+1
+ 1 o)
_.
This relationship is known as an Euler equation. It reects how the
representative agent takes into account howcurrent choices aect future
quantities (n
t+1
and :
t+1
). This is where rational expectations are built
into the model, unlike in Keynesian analysis. Once we understand this
relationship, we can predict the motion of the capital stock and how
it will react to a shock (to n
t
and :
t
). Then we will also know what
happens to labor and GDP.
We set up a real business cycle model and derived two optimality con-
ditions for the representative agents choices. One is the motion of the
capital stock,
1
t+1
= (3:
t
+ 1 o) 1
t

1
,
n
t
.
the other is the Euluer equation,
n
t
=
1
,
1
1
t
_
1
w
t+1
(:
t+1
+ 1 o)
_.
The marginal return to capital and labor had the form
n
t
=
2
3
c
zt
_
1
t
1
t
_
1=3
:
t
=
1
3
c
zt
1
_
Kt
Lt
_
2=3
=
1
2
1
Kt
Lt
n
t
.
We are assuming a shock
.
t+1
=
2
3
ln
_
1
(c
zt
)
3=2
+
t+1
_
.
73
with 1
t
[
t+1
] = 0.
The expectation of .
t+1
is 1
t
[.
t+1
] = .
t
+ c, where c.is a constant
that depends on the distribution of
t+1
(conditional on .
t
). The key
point is that this process entails persistence of a shock
t
,= 0, unlike
the standard real business cycle, where shocks eventually vanish. We
will see in a moment that persistence leads to counterfactual results
(and thus it becomes clear why the real business cycle literature goes
through the trouble of working with models that have no closed-form
solutions).
Suppose (subject to verication) that the capital-labor ratio depends
on the shock in the following way:
1
t
1
t
= (rc
zt
)
3=2
.
where r is a constant. Then
n
t
=
2
3
r
1=2
(c
zt
)
3=2
:
t
=
1
3
1
r
.
We can now rewrite
1
t
_
1
n
t+1
(:
t+1
+ 1 o)
_
=
1
2
1 + 3r (1 o)
r
3=2
1
t
_
1
(c
z
t+1
)
3=2
_
.
Rearranging the equation for .
t+1
, and taking the expectation, yields
1
t
_
1
(c
z
t+1
)
3=2
_
= 1
_
1
(c
zt
)
3=2
+
t+1
_
=
1
(c
zt
)
3=2
.
Substituting these expressions into the Euler equation, we can deter-
mine the value of r:
n
t
=
2
9
1
,
r
3=2
1 + 3r (1 o)
(c
zt
)
3=2
and
n
t
=
2
3
r
1=2
(c
zt
)
3=2
.
74
imply
r =
1
3
,
1 , (1 o)
.
Since this is a constant, we have veried the assumed functional form
for 1
t
,1
t
.
Substituting for the marginal products in the motion of the capital
stock,
1
t+1
= (3:
t
+ 1 o) 1
t

1
,
n
t
=
_
1
r
+ 1 o
_
1
t

2
3
1
,
r
1=2
(c
zt
)
3=2
.
Notice that 1
t+1
is reduced by an increase in productivity .
t
.
Writing 1
t
as
1
t
= c
zt
1
_
Kt
Lt
_
2=3
1
t
=
1
r
1
t
.
we have
1
t+1
=
1
r
1
t+1
=
1
r
__
1
r
+ 1 o
_
1
t

2
3
1
,
r
1=2
(c
zt
)
3=2
_
=
_
1
r
+ 1 o
_
1
t

2
3
1
,
1
r
1=2
(c
zt
)
3=2
(since 1
t
= r1
t
by the same token). Again, 1
t+1
falls when productivity
.
t
increases.
Lets try to understand the strange behavior of GDP in this model.
A kind of potential GDP can be isolated by keeping capital and labor
constant in the absence of a new shock, i.e.
t+1
= 0 and so .
t+1
= .
t
.
The capital stock is constant (at given .
t
) if
1
t+1
=
_
1
r
+ 1 o
_
1
t

2
3
1
,
r
1=2
(c
zt
)
3=2
= 1
t
.
hence
1
t
=
2
3
1
,
r
1=2
1
x
o
(c
zt
)
3=2
=

1
t
.
75
(Since the capital to labor ratio is determined by .
t
, labor is implicitly
also constant if capital is.)
We see that potential GDP

1
t
=
1
r

1
t
=
2
3
1
,
r
1=2
1 ro
(c
zt
)
3=2
.
is increasing in productivity .
t
.
What is going on? Consumption, which from the rst-order conditions
of the Lagrangean problem was
C
t
=
1
,
n
t
=
2
3
1
,
r
1=2
(c
zt
)
3=2
.
increases in .
t
as one would expect. Since the representative agents
utility is concave in consumption, she wants to smooth consumption
over time. Given that a positive shock permanently increases expected
productivity, consumption is permanently higher (at least, that is the
plan at time t: unexpected negative shocks later on could reverse this).
Since
1
t
1
t
= (rc
zt
)
3=2
.
labor eort is
1
t
=
1
(rc
zt
)
3=2
1
t
.
which is decreasing in .
t
(of course, 1
t
is xed at time t, it does not
change in response to .
t
).
Why would individuals work less when they become more productive?
The reason is that the productivity increase (in this oversimplied ver-
sion of a real business cycle) is permanent, so the representative agent
expects to be able to produce more with less eort now and in the
future. Since labor enters negatively into the utility function, she takes
advantage of the positive shock by raising consumption a bit and re-
ducing work hours a bit.
76
Think about how this conclusion would change if the shock only had
a temporary eect on productivity. Then it would make sense to work
more today, when time spent working yields more output than tomor-
row. This seems more realistic: employment and hours worked increase
when labor productivity is high (which is typically the case during a
boom).
Since a positive shock makes the representative agents labor more pro-
ductive, she can maintain a suciently high long-run output with a
smaller capital stock. The saving rate in our model is
:
t
= 1
C
t
1
t
= 1
1
,
n
t
r
1
1
t
= 1
2
3
1
,
r
3=2
(c
zt
)
3=2
1
1
t
.
This decreases in .
t
. Similarly, gross investment
1
t
= 1
t+1
(1 o) 1
t
=
1
r
1
t

2
3
1
,
r
1=2
(c
zt
)
3=2
and net investment
1
t+1
1
t
=
1 or
r
1
t

2
3
1
,
r
1=2
(c
zt
)
3=2
decline in .
t
.
Hence, the representative agent here divests over time in response to a
productivity increase: she works less, but permanently consumes more
- this can only come at the expense of capital accumulation. Over
time, the increase in consumption is funded less from new production
and more by running down the capital stock.
Again, it does not accord with reality that investment falls when labor
productivity rises. If productivity increases due to a positive shock were
temporary, the representative agent would use periods of high produc-
tivity to work more, save more and thereby perpetuate the increase in
wealth through capital accumulation. This would smooth the increase
in consumption over time.
77
The present model shares with the Keynesian model the mistaken impli-
cation that labor productivity is countercyclical. In Keynesian analysis,
this was because sticky wages made it protable for businesses to hire
more workers (or make them work longer, lowering marginal productiv-
ity) when there was unexpected ination (resulting in a boom). Here,
the productivity increase is primary, but the anticipation of higher fu-
ture productivity induces people to work and save less, causing GDP
to fall below potential.
Clearly, real business cycle models with temporary shocks are needed
to mimic the basic facts of macroeconomic uctuations: labor produc-
tivity, hours worked, investment and consumption are all procyclical.
Moreover, they should - and can - reect that investment is more
volatile than consumption. Keynesian analysis achieves this through
monetary policy, which is designed to expand and contract investment.
In real business cycle theory, the Fed cannot easily do this, because real
interest rates are taken to be independent of ination (nominal interest
rates adjust fully and quickly to any predictable change in ination).
Thus, investment volatility must arise from the optimal reaction of
the representative agent to productivity shocks, i.e. from consumption
smoothing.
You might ask yourself how proponents of real business cycles would
explain the empirically observed Phillips curve, which links booms to
ination. After all, real business cycles do not allow for temporary
misalignment in prices, which explains the Phillips curve in Keynesian
analysis.
More sophisticated real business cycle models do include money and
government. Although they maintain "money neutrality" - that the
price level cannot cause changes in real GDP - they are consistent with
the possibility that changes in real GDP cause changes in the price
level, directly or as a result of Fed policy.
During a boom, the quantity theory of money predicts that, with con-
stant money supply, prices decrease. (But, unlike Keynesians, real busi-
ness cycle theorists expect all prices to adjust fully, instantaneously.)
Because demand for loans (by businesses and consumers) grows (as a
78
result of higher productivity and expected future incomes), there is up-
ward pressure on the real interest rate. If the Fed seeks to stabilize
the interest rate, it has to expand the money supply, which might push
the economy into ination, and this would imply the Phillips curve
relationship.
However, the primary eect is in the wrong direction, and it is not clear
why the Fed would overreact to deationary pressure, nor is interest
rate stabilization (rather than ination and business cycle smoothing)
consistent with the Feds actual policy stance. This is one of the prob-
lems of real business cycle theory: it does not have a very plausible
explanation for the Phillips curve, which is clearly observable in the
data.
4.8 The Financial Crisis of 2008
Crises that hit Latin America, East Asia and Russia in the 1990s depre-
ciated foreign currencies against the dollar and reduced demand for US
products. As a result, developing countries held increasing amounts of
US currency (paid by US rms for goods imported to the US or in ex-
change for foreign currency that was needed to pay for imports). These
dollar reserves did not sit idly in a vault somewhere, but were loaned
back to the US economy in one way or another. They contributed to
record low interest rates in the United States.
As a result, credit was in ample supply and nancial institutions relaxed
lending standards for businesses as well as individuals. As debt became
cheaper and more readily available, businesses, especially nancial in-
stitutions, increased their leverage. Leverage refers to the ratio of debt
to equity (equity is the net worth of the rm: assets minus debt).
High leverage implies that small percentage changes in the value of
investments translate into large amounts relative to the rms equity.
Hence, a modest loss on all investments might wipe out any positive
net worth. Normally, such losses are not supposed to happen because
nancial institutions hold diversied portfolios that are calculated to
yield predictable gains. But when an event causes many investments to
go bad at the same time, the rm can no longer pay o its short-term
debt, unless it nds an unsuspecting lender.
79
Thus, increasing leverage made the survival of nancial institutions
(and other businesses) more sensitive to such an event. Moreover, since
many nancial institutions hold signicant debt of other nancial in-
stitutions, the failure of one could quickly lead to the failure of others,
a condition known as "systemic risk." Essentially, each bank was not
only relying on the wisdom of its own investment decisions, but on
those of all other banks as well.
Fannie Mae and Freddie Mac are companies operating under govern-
ment charter that purchase mortgages from banks, pool them and resell
them to investors (including banks). Their role is to increase liquidity
in the primary mortgage market (i.e. for the institutions that originate
the mortgages). At a premium, they guarantee principal and interest,
and these guarantees were perceived in the nancial community to be
implicitly backed by the government.
In the mid-1990s, the Clinton administration had paved the way for
so-called subprime mortgages: home buyer loans for relatively high-
risk borrowers. Fannie Mae and Freddie Mac were encouraged to
buy lower-quality mortgages, which gave banks an incentive to issue
such mortgages, given that they could resell them and avoid the risk.
(The governments objective was to increase home ownership for poorer
Americans at a time when defaults did not seem to be a big threat.)
In the decade prior to 2006, house prices tripled on average as new
buyers entered the market, and by 2006 a fth of new mortgages were
subprime.
What caused the housing market bubble to burst? If we look at the
development of the federal funds rate, we see that the Fed sharply raised
the target interest rate starting in 2004, to ght inationary pressures.
This cooled the demand for new mortgages and brought house prices
down.
Many of the new mortgages carried low introductory interest rates that
were xed ("teaser rates"), followed by a high variable interest rate a
few years later. When interest rates increased, subprime borrowers,
who could barely aord their mortgages, were suddenly in trouble.
Moreover, falling house prices meant in some cases that the home was
80
now worth less than the value of the outstanding mortgage. As home
owners defaulted and their houses went back on the market, prices fell
further, causing even more homes to be vacated. This downward spiral
explains why house prices dropped so dramatically.
Like Fannie Mae and Freddie Mac, banks "securitize" mortgages (and
other types of debt, such as credit card debt) by bundling themtogether
to create a new instrument that is sold to investors at a discount. If
the loans perform, the proceeds are paid to the investors, who are
basically betting against default (counting on the portfolio eect that
the number of individual defaults will be predictable and small). Many
buyers of such mortgage-backed securities are other banks.
The fact that banks were so heavily invested in mortgages, many of
which were subprime, caused additional problems when it became clear
that many mortgages were in danger of default. Interbank lending is
normally at a slight premium over the T-bill rate (which is considered
almost riskless). By 2007, banks perceived a greater risk in lending to
each other, since one bank could not know exactly how much of another
banks assets was invested in subprime mortgages, and therefore what
its short-term default risk really was.
The spread between the interest rate on three-month interbank loans
(LIBOR is the London Interbank Oered Rate) and the interest rate on
T-bills grew from less than half a percent to, eventually, almost 3.5%.
This greatly increased the cost to banks of falling below their reserve
requirements (in which case they would have to borrow in the interbank
market) and forced them to issue fewer loans to consumers and busi-
nesses - a phenomenon that became known as the "liquidity crisis" or
"credit crunch." The sudden high cost or unavailability of loans wors-
ened defaults on mortgages as well as businesses, both of whom depend
on being able to cover short-term uctuations in income by borrowing
from commercial banks.
The S&P 500 stock price index fell by almost 50% between 2007 and
2009, reecting a risk evaluation in response to the liquidity crisis as
well as a huge increase in the price of oil: the price of a barrel went from
about $20 in 2002 to $140 in July 2008, a six-fold rise in real terms.
81
This development had very dierent causes (increase in demand for oil
and other basic commodities from growing economies like China and
India, and speculation on that), but further undermined the viability
of businesses across industries, increased the need for credit while it
was tight, and ultimately devalued investor portfolios.
In September 2008, it became clear that major nancial institutions had
so many non-performing assets on their books that they were worthless
and could no longer repay their short-term debts: Lehman Brothers
collapsed, AIG was bailed out, Merrill Lynch had to be sold to Bank of
America. Fannie Mae and Freddie Mac were taken over by the federal
government.
By 2009, GDP was belowtrend and continued to fall sharply for another
year. Somewhat earlier, in 2007, the unemployment rate began to climb
from under 5% toward 10%. By either measure, decline in GDP or rise
in unemployment, the 2009 recession is far worse than typical recessions
in the US since 1950. This table is based on April 2009 values, before
the recession reached its trough.
Note the drop in consumption, which suggests people expect income
growth to slow in the long run or face binding wealth constraints that
force them to adjust their standard of living. Usually, consumption
continues to grow during recessions, since it should be based on per-
manent income.
But this is not an ordinary recession that arises from normal demand
or productivity shocks (depending on which theory of uctuations you
subscribe to). It has its origin in a breakdown of the nancial system, so
we should compare it to other crises that were associated with failures
of nancial institutions - the Great Depression, the Asian crisis in 1997,
etc.
Comparing with average changes in economic variables, from start to
nish, for 20th century nancial crises around the world. The large
drops in asset prices (housing and stocks) are typical, as are severe
reductions in output, employment. Governments greatly increase their
debt in ghting these crises.
82
As capital markets are increasingly interlinked, banks and investors
hold foreign assets, it is not surprising that the current nancial cri-
sis is global in scope, aecting developed and developing economies
alike. This means, unfortunately, that reductions in consumption lead
to reduced demand for exports, which exacerbates the decline in GDP.
In summary, what caused the crisis were nancial innovations, such
as subprime mortgages, that took advantage of overabundant credit
and poor monitoring (non-transparent risks of securitized instruments,
the government shouldering risk through Fannie Mae and Freddie Mac,
which it implicitly backed). Sooner or later, inated asset markets had
to implode; the immediate trigger was probably the Feds decision to
raise interest rates. High leverage of nancial institutions increased
sensitivity to such events and created systemic risk.
Oil price increases coincided with these developments, slowing produc-
tivity The global nature of capital markets exposed other economies
to the crisis and, by pulling them down alongside the US, worsened the
recession further.
4.9 The Fed Response
How can we understand the Fed and US government response to the
crisis within our short-run model? The reduction in asset values and
liquidity translates into a reduction in aggregate demand: at any in-
terest rate, consumers would buy fewer products and businesses would
invest less money; in addition, because of the global dimension of the
crisis, foreigners could aord fewer exports.
Normally, the Fed would want to cut the federal funds rate in order to
induce ination and stimulate the economy. It would do so by borrow-
ing government debt in the open market from banks at very low in-
terest, thereby increasing the money supply. Indeed, the federal funds
rate basically went to zero, which provided the needed short-term cash
to nancial institutions.
However, this does not mean that banks will automatically lend at
low rates to commercial customers. When there is heightened default
risk, they demand a higher risk premium or may decline to lend at
83
all. (This scenario is called a "liquidity trap," money is available but
remains trapped in the bank vaults.) The actual real interest rate faced
by borrowers becomes 1
t
+j
t
, where 1
t
is the risk-free rate (managed
by the Fed) and j
t
is the risk premium.
Troubled businesses are especially in need of long-term loans. The
wedge between the rate on ten-year treasury bonds and ten-year cor-
porate BAA-rated bonds was increasing, causing the latter to increase
even as the former fell. (On the Standard & Poors scale, investment
grade bonds are bonds with at least a BBB- rating. Bonds with lower
ratings than that are "junk bonds.")
What happens when the interest rate reduction targeted by the Fed is
insucient to bring the risk-adjusted interest rate down. The economy
slides farther into recession to point D (panel b) instead of C (panel
a). Once the federal funds rate reaches zero, the Feds hands are tied,
it cannot reduce interest rates further.
Recall that the IS curve
~
1
t
= c /
_
1
IS
t
:
_
and the monetary policy rule
1
MP
t
: = :(:
t
:)
together constitute the aggregate demand curve.
Now, in the IS curve, 1
t
refers to the interest rate at which businesses
can borrow (it drives the investment component of GDP). In the MP
rule, 1
t
refers to the interest rate the Fed targets: the (largely) risk-
free federal funds rate. If investors face a risk premium, then 1
IS
t
=
1
MP
t
+j
t
. Hence the monetary policy can be rewritten as
1
IS
t
: = j
t
+:(:
t
:) .
Then the AD curve has the form
~
1
t
= c /j
t
/:(:
t
:) .
84
and we can see that an increase in the risk premium reduces
~
1
t
at
every rate of ination. The reduction in investment comes on top of the
demand reductions caused by the asset devaluation (which are reected
in c).
In the AD-AS diagram, the downward shift of the AD curve triggers a
series of downward shifts in the AS curve
~
1
t
=
1

(:
t
:
t
)
o

leading to an ever lower rate of ination while the increased risk premia
(and asset devaluation) persist.
The problem is that, when the ination rate is already low initially, a
further drop might lead to deation. Deation is costly because, with
imperfectly adjusted prices, it causes output prices to fall more slowly
than input prices and therefore leads to layos, further reductions in
demand, more layos etc., the deationary spiral. Since the Fed cannot
push the nominal interest rate below zero (you wouldnt leave your
money in the bank if you had to pay interest on your deposits), it cannot
eectively ght a real interest rate that is rising above the nominal rate
due to deation (recall the Fisher equation i
t
= 1
t
+:
t
, in other words
1
t
_ i
t
if :
t
_ 0).
Given the limitations on managing liquidity through the interest rate,
the Fed took extraordinary measures. It started loaning money directly
to the private sector (previously, the Fed only held public debt), e.g.
through the purchase of commercial paper This injects cash into the
economy where it is needed and where commercial lenders perceive too
much risk or uncertainty to play this role.
How did the Fed come up with the money to do this? For the most part,
it didnt print it. Instead, the Fed oered interest on federal reserve
accounts. In other words, it attracted deposits from banks far in excess
of the ocial reserve requirement (which banks where, of course, happy
to supply, since it seemed too risky to loan the money to the private
sector). These excess reserves where then channeled into the economy
via private debt purchases.
85
Compare the Feds balance sheet in 2007 and 2009. Note the (private-
sector) loans that appear under assets in 2009, and the large increase
in reserves under liability. The Fed also borrowed funds from the trea-
sury that the treasury had raised from the public by issuing new debt
(these obligations to the treasury are entered under treasury accounts).
Overall, Fed assets and liabilities more than doubled.
Composition of non-government debt held by the Fed since 2008. Cen-
tral bank liquidity swaps are instruments through which the Fed pro-
vides dollars to foreign central banks (in exchange for foreign currency)
over a period of time. The other items are loans to the US private sec-
tor and US banks (term auction credit refers to direct loans the Fed
auctions o to nancial institutions).
The crux to this strategy is that the Fed can lend money to the private
sector on better terms than commercial banks because partly controls
the systemic risk. Where a commercial bank needs to charge a high
risk premium (or deny loans) to stay viable in a risky economy, the
Fed is reducing the risk by the very act of purchasing the debt, and it
hopes that it can ultimately save many of the borrowers and get the
debt repaid. If this does not happen, then the Fed will be left with
negative equity that has to be covered through either direct or indirect
taxation (printing money) in the future.
In addition to the Feds interest policies and loans, the government
took actions designed to clean up the portfolios of nancial institutions
(the Troubled Asset Relief Program, or TARP) and increase demand
(the stimulus packages). TARP took assets o the books of rms and
nancial institutions that were in trouble and thereby allowed them to
liquidate those assets at full value, rather than the heavy discounts the
private sector would demand, given the associated risks. The sellers of
these assets were able to repay their short-term debt and survive.
To the extent that nancial institutions are bailed out (their "toxic,"
i.e. nonperforming, assets are bought above value), there is a poten-
tially large long-term cost, because nancial institutions will expect
similar rescues in the future. Since they will fully benet from the
upside of a risky investment, but believe they can share failures with
the public (since the government uses taxpayer money to subsidize the
86
losses), they have an incentive to take excessive risk even against better
judgement. The debate about whether banks should be allowed to fail
weighs the costs of an even more severe liquidity crisis against the costs
of perpetuating bad incentives.
The stimulus packages reect the Keynesian logic that recessions that
originate with demand shocks can be xed if the government increases
spending enough to oset temporary reductions in consumer and in-
vestor spending. The idea is that this will induce increases in ination
that lead rms to hire and expand output.
Classical economic reasoning that does not acknowledge sticky prices
disagrees with this view. Rational expectations imply that people fore-
see correctly that increases in government spending today must be -
nanced with tax increases in the future, hence decreases permanent
income. Therefore, consumers would cut back their own consumption
(which has in fact happened in the current crisis, as we have seen).
The 2008 stimulus, which involved tax credits for low- and middle-
income earners, raised current incomes and was expected to raise con-
sumer spending. This has not occurred, consistent with the permanent
income hypothesis: people realized that the increase in income is tem-
porary and therefore saved it, smoothing consumption over time. In
the graph, the spike in disposable income (after the disbursements) did
not lead to an increase in personal consumption expenditures.
It is impossible to know what would have happened if nancial in-
stitutions had been allowed to collapse. The immediate eect would
likely have been sharp. While the Fed has avoided unraveling, it faces
a dicult challenge to regulate the system in a way that discourages
excessive risk-taking despite a demonstrated willingness to bail failing
banks out at the expense of the public.
The eect of the recent, much larger stimulus packages remains to be
seen. Whether they work depends on whether prices are indeed sticky,
i.e. wages are slow to adjust to increasing ination. Eorts to increase
consumer spending via tax credits appear not to have succeeded, which
gives some validation to the rational expectations hypothesis.
87
5 Public Finance
5.1 Tax Revenue
The major sources of income for the federal government are currently
personal income taxes and social insurance contributions, followed by
corporate prot taxes, then customs and excise duties, and nally
money creation by the Fed (newly printed money is used by the trea-
sury for its purchases).
Historically, the government used to be nanced almost entirely by
customs and excise duties before World War I, until corporate and
personal incomes taxes were established, respectively, in 1909 and 1913.
Their shares in total revenue rose to 25% and 40% by the end of World
War II. While the share of personal income taxes has remained fairly
constant since then, the shares of corporate and customs / excise taxes
have been declining.to about 10%.
Unemployment insurance and social security started on a small scale in
1936 and 1937 as part of FDRs "new deal." Today, social and health
insurance contributions make up more than 40% of tax revenue, and
the share continues to increase.
State and local tax revenues are about half the size of federal income
State and local governments used to rely primarily on the property
tax, but at this point sales taxes, local income taxes and federal aid
(transfers for social programs like welfare, medical care, transportation,
education etc.) are roughly equally important sources of income, each
accounting for about a fth. The remainder includes local school and
prot tax, social insurance levies and revenues from toll and such.
Any tax that is tied to income (as virtually all taxes are in one way or
another) ultimately discourages income-generating activities, such as
work and investment, and encourages leisure and consumption. (The
idea behind the earned income tax credit, which supplements incomes
of the working poor, was to make their marginal tax rate negative, to
discourage voluntary unemployment. Introduced in 1996 under Clin-
ton, the EITC indeed raised work hours among this group.) In some
cases, taxes direct people away from legal activities, that are reported
88
and taxed, toward the black market (or at least informal exchange),
where no taxes are paid. This is why tax increases, other things equal,
reduce measured GDP and the tax base.
A long-standing debate is over the point where tax increases will result
in a reduction in tax revenue. In theory, it is clear that the point exists
where the tax base shrinks so much that the increase in percentage does
not translate into an absolute increase. In fact, every tax increase leads
to a smaller incremental increase in tax revenue. This relationship is
known as the Laer curve and played an important role in motivating
the Reagan tax cuts of 1981.
Specically, an increase in the tax rate from t to t
0
implies a decrease
in the fraction of the marginal return (to work or capital, depending
on what is taxed) that the taxpayer gets to keep, from 1 t to 1 t
0
.
If t 0.5, the percentage reduction in 1 t exceeds the percentage
increase in t if the tax rate is raised. Depending on how responsive,
for example, labor supply is to wages, the tax revenue might rise or fall
in response to a tax increase, and the higher the initial tax rate, the
more likely it is to fall.
Most economists believe that the tax rates we see in practice are not
high enough to cause tax revenue to fall. However, when Reagan came
to power, marginal tax rates were signicantly higher than now, 70%.
The Reagan administration lowered taxes across the income spectrum,
expecting an increase in revenue. So what happened? (Even the facts
are still hotly debated and frequently in misleading ways.)
The initial Reagan tax cut reduced the maximum marginal tax rate on
personal income from 70% to 50%, and later in 1986 to 28%. (Reagan
also eliminated tax loopholes, raised the corporate tax rate and so-
cial security contributions during his presidency, but one overall eect
was a signicant tax cut for high-income earners.) Overall, tax revenue
declined and the debt soared in the early 1980s.
However, if we focus on the top range of the income distribution, the
picture is dierent. Those with adjusted gross income over 200K paid
23% more in 1984 than in 1981. The economy was booming over this
period, so an absolute increase in tax collection is not so surprising.
89
Yet, the share in tax revenue of those in the top 0.5% of the income
distribution also rose from 14% in 1981 to 18% in 1984. (After the
further tax cut in 1986, it climbed again temporarily, but this can be
attributed to the increase in the capital gains tax rate that followed
in 1987, which caused the wealthy to make planned asset sales. Later,
the share fell back to about 18%, so this tax cut did not change their
relative contribution.)
What we can conclude is that low and middle income brackets were
certainly not on the declining portion of the Laer curve, they paid
lower taxes absolutely and relatively as a result of the Reagan cuts.
The highest income bracket appears to have been close, but it may
have paid lower taxes, had it not been for the boom and the closing of
loopholes. The Clinton administration later raised marginal tax rates
at the top to over 40%, and the tax revenue from the richest 0.5%
increased as a result. Perhaps tax revenue is maximized at a marginal
tax rate somewhere between 40% and 50% in the US. (In Sweden,
where the top marginal tax rate was temporarily at 80% in the early
1970s, tax revenues were actually below the maximum, and a series of
reductions showed that the maximum occurred at a marginal tax rate
of about 70%.)
Even though politicians debate whether or not the eect of a tax in-
crease on revenues is negative, it should be emphasied that maximizing
the tax revenue is not a reasonable goal. Being on the downward-
sloping portion of the Laer curve would be blatantly inecient (higher
taxes reduce output and do not even increase tax revenue). On the
upward-sloping portion, tax increases may still reduce output notice-
ably while yielding little in extra tax revenue.
The progressive character of most taxes (i.e. the wealthy pay more in
absolute terms, and mostly also in percentage terms) means that they
redistribute income from the wealthy to the poor. (This is certainly
true for money spent on welfare programs, but also more generally, to
the extent that everyone has the same access to goods provided by the
government, such as defense and transportation.) If the wealthy save
more than the poor (because their marginal utility from consumption
is smaller), this redistribution lowers saving and, via the interest rate,
90
investment. (The income tax is most progressive and therefore has the
greatest eect on saving.)
5.2 Budget Decits and the Federal Debt
In recent years, the government has more or less consistently spent
more than it took in. 2005 US government spending (federal, state,
local combined) was more than $15,000 per person.
Federal spending accounted for 20% of GDP in 2005. Health care,
social security and defense were the largest items. There is a budget
decit - expenditures exceed revenues.
Budget decits must be nanced by borrowing (the federal government
issued more than $1,000 per person in bonds in 2005), and debt must
eventually be repaid, at which point the government has to run a budget
surplus. If it does not reduce spending, it must raise taxes in the future.
If we think of G as government spending in this context (not just "pur-
chases," as in the discussion of GDP; the main dierence is that spend-
ing also includes transfer payments), the budget constraint for the gov-
ernment at time t is
1
t+1
= (1 +i
t
) 1
t
+G
t
1
t
(where 1
t
are borrowed funds at time t, 1
t
is tax revenue, i
t
is the
nominal interest paid on bonds). In principle, the government might
also print money to nance its operations, but this is like an implicit
tax and is not a sustainable strategy in the long run.
Above, we see that new debt (1
t+1
) must be incurred if the budget
surplus (1
t
G
t
) is not large enough to over interest obligations on the
outstanding debt (1
t
).
Applying this equation repeatedly, and supposing that the budget decit
and the nominal interest rate stay the same through time, we have
1
t+2
= (1 + i) 1
t+1
+G1
= (1 + i)
2
1
t
+ (1 + 1 +i) (G1)
91
and
1
t+3
= (1 + i) 1
t+2
+G1
= (1 + i)
3
1
t
+
_
1 + 1 + i + (1 + i)
2
_
(G1) .
i.e. in general:
1
t+n+1
= (1 + i)
n+1
1
t
+
n

k=0
(1 +i)
k
(G1)
= (1 + i)
n+1
1
t
+
(1 +i)
n+1
1
i
(G1)
by the geometric series identity:

n
k=0
r
k
= (1 r
n+1
) , (1 r).
Rearranging, we have
(1 +i)
n+1
1
i
G+ (1 + i)
n+1
1
t
=
(1 +i)
n+1
1
i
1 +1
t+n+1
.
This says that the present value of future government spending and
interest obligations has to equal the present value of future taxes and
borrowing.
If G consistently exceeds 1, we need 1
t+n+1
_ (1 +i)
n+1
1
t
, which
becomes ever larger over time (as : increases).
How large will creditors allow the outstanding debt to become before
the government needs to start paying it down? When US and foreign
investors are no longer willing to lend to the US government (at present,
US debt is owed about equally to domestic and foreign citizens), the
debt must be paid o by running a budget surplus - or by printing
money.
The incentive to do the latter can create a dangerous cycle, where
lenders anticipate seignorage that leads to ination. If they require
a higher interest rate to compensate, which forces the government to
print more money, the expectation of ination can be a self-fullling
prophecy, and ultimately we may get a hyperination.
92
Hence, lenders will be cautious of governments that have trouble ser-
vicing their debt through tax revenues. An important criterion of cred-
itworthiness is how large debt is as a share of GDP, i.e. the tax base.
(Much in the same way as your bank will consider your annual income
in determining your credit line.)
Decits were very large during World War II, as the government -
nanced the war eort. Then budget decits and surpluses alternated
until the 1970s, at which point the federal government began to run
lasting decits (with the exception of a brief interval in the late 1990s,
the second termof the Clinton administration). However, because GDP
has been increasing over time, the debt to GDP ratio has not risen at
the same pace and remains at about 40%.
In the US and other advanced economies, the debt to GDP ratio tends
to increase during wars and recessions and decrease during peace-time
booms. In recessions, we see both an increase in debt-nanced gov-
ernment spending and a decrease in output; the opposite is true for
booms.
Compared to other major economies, the US debt-to-GDP ratio is not
especially large.
It might be argued that growth in GDP is a consequence of investments
being made by the current generation into science, infrastructure etc.
so that future generations can be better o. Perhaps it is appropriate
that our wealthier descendants shoulder some of the expenses by paying
higher taxes.
However, many economists believe that an increase in government spend-
ing, which is not necessarily productive, actually "crowds out" private
investment. Borrowing by the government is in direct competition with
borrowing by the private sector and raises the interest rate.
On the other hand, the permanent income hypothesis would suggest
that budget decits cause people to reduce consumption, since they
know they will be taxed higher someday. This means the decit would
be oset by increasing private saving.
93
This is what economists call Ricardian equivalence. Consider a rep-
resentative agent who receives income from wages, which are equal to
output 1
t
, and from interest on government bonds 1
t
. He spends this
income on taxes 1
t
due to the government, consumption C
t
, and gov-
ernment bonds held into the next period 1
t+1
. Hence, he faces budget
constraint
1
t
+C
t
+1
t+1
= 1
t
+ (1 + i) 1
t
in each period.
Since
1
t+1
+C
t+1
+1
t+2
= 1
t+1
+ (1 + i) 1
t+1
.
this implies.
1
t+1
=
1
1 +i
(1
t+1
1
t+1
C
t+1
1
t+2
) .
Recursively,
C
0
= 1
0
1
0
+ (1 + i) 1
0
1
1
= 1
0
1
0
+ (1 + i) 1
0
+
1
1 +i
(1
1
1
1
C
1
1
2
)
= 1
0
1
0
+ (1 + i) 1
0
+
1
1 +i
_
1
1
1
1
C
1
+
1
1 +i
(1
2
1
2
C
2
1
3
)
_
.
.
.
=
1

t=0
1
(1 +i)
t
(1
t
1
t
)
1

t=1
1
(1 +i)
t
C
t
+ (1 + i) 1
0

1
(1 +i)
1
1
1
or
1

t=0
1
(1 +i)
t
C
t
=
1

t=0
1
(1 +i)
t
(1
t
1
t
) .
if 1
0
= 0. This says that the present value of consumption must equal
the present value of disposable income.
The governments budget constraint is:
1
t
+1
t+1
= G
t
+ (1 + i) 1
t
.
since income from taxes and bonds issued must equal spending G
t
and interest payments on outstanding bonds. Combining this with
94
the representative agents budget constraint (which can be written
1
t
+1
t+1
(1 +i) 1
t
= 1
t
C
t
), we get
1
t
C
t
= G
t
and thus
1

t=0
1
(1 +i)
t
G
t
=
1

t=0
1
(1 +i)
t
1
t
.
the present value of government spending must equal the present value
of taxes.
Alternatively then,
1

t=0
1
(1 +i)
t
C
t
=
1

t=0
1
(1 +i)
t
(1
t
G
t
) .
The timing of consumption does not depend on the timing of taxes or
government spending. Suppose the representative agents preferences
correspond to instantaneous utility n(C
t
) = ln C
t
, so that he wants to
maximize intertemporal utility
1

t=0
,
t
ln C
t
.
Since C
t
= 1
t
1
t
+(1 +i) 1
t
1
t+1
according to the personal budget
constraint,
1

t=0
,
t
ln C
t
=
1

t=0
,
t
ln (1
t
1
t
+ (1 + i) 1
t
1
t+1
) .
which has rst-order condition (with respect to 1
t+1
)
,
t
1
C
t
+,
t+1
1 +i
C
t+1
= 0.
or
C
t+1
= , (1 +i) C
t
.
95
The consumption sequence is now determined by the intertemporal
budget constraint:
C
0
= 1
0
1
0
1
1
C
1
= , (1 +i) (1
0
1
0
1
1
)
C
2
= ,
2
(1 +i)
2
(1
0
1
0
1
1
)
.
.
.
C
t
= ,
t
(1 +i)
t
(1
0
1
0
1
1
) .
The value of 1
1
is determined by the governments budget constraint,
which yields
1
1
= G
0
1
0
+ (1 + i) 1
0
= G
0
1
0
.
so
C
t
= ,
t
(1 +i)
t
(1
0
G
0
) .
The interpretation of this consumption rule, which does not depend
at all on taxes and future government spending, is quite simple: a
government decit creates a future tax liability for the representative
agent, but it also increases the representative agents wealth today
(either substitutes for planned consumption or reduces taxes), and the
agent invests this additional wealth in a bond that nances the decit
and earns interest from which future taxes are paid.
In this fashion, consumption decisions are completely uncoupled from
scal decisions. Consumption does not increase in response to a tax
reduction or an increase in government spending, nor is overall (public
and private) investment aected. If the government dissaves (issues
new bonds), the private sector saves (purchases the bonds). Hence
there is no crowding out.
Incidentally, this does not mean that the government cannot raise out-
put by reducing taxes. Lower taxes imply higher marginal after-tax
income from working or investing, so they encourage productive activi-
ties. But if taxes are raised again in the future, there is a corresponding
drop in output as people work and invest less.
96
The empirical evidence that more government spending is associated
with less private investment is mixed. While the investment and bud-
get surplus series are positively correlated (suggesting crowding out),
the trend toward sustained decits is not reected in investment - there
is no systematic drop in private investment (consistent with the per-
manent income hypothesis).
During the major wars, WWI, WWII, the Korean and Vietnam wars,
sharp increases in government spending were accompanied by very no-
ticeable reductions in private investment (crowding out). Israel expe-
rienced a large budget decit in 1984 followed by a balanced budget in
1985. Again, private saving rose suddenly when the decit appeared
and dropped just as quickly when the decit disappeared again, keeping
national saving nearly constant.
One may also be worried that the current generation is making selsh
consumption choices, living o future tax revenues, that reduce living
standards tomorrow relative to ours. (Unfairly, future generations can-
not vote on current spending.) But the strongest indication of that
would be a rising debt to GDP ratio, which so far has not occurred
over long periods of time.
5.3 Entitlement Programs
The earliest known welfare state was the Islamic caliphate of the 7th
century. The rst modern welfare system was introduced by Bismarck
in Germany in the late 19th century. In the United States, social
security commenced during the rst Roosevelt presidency. While the
Islamic welfare state was created in a time of unprecedented prosperity,
the German and American programs were reactions to severe economic
crisis and uncertainty (both episodes were in their day known as "Great
Depressions").
The Islamic caliphate was established by the prophet Muhammad in the
7th century. Its capital was Medina in western Saudi Arabia. Muham-
mads rst successor (caliph) subdued the tribes on the Arab penin-
sula and recommitted them to the Islamic faith. Under the second and
third caliphs, Umar and Uthman, the remainder of the Middle East
97
and Egypt were conquered, and a ourishing market economy devel-
oped after the introduction of currency (the dinar), debt instruments,
and property rights to land, which could be bought and mortgaged by
anyone.
The Quran requires Muslims to practice charity by giving zakat (2.5%of
their unused wealth) to the needy. Non-muslim citizens of the caliphate
had to pay jizya, a form of tribute, and could freely practice their
lifestyles and religions in exchange. As a result of the military suc-
cesses, receipts multiplied, and Umar founded a central treasury to
house them. The treasury began to collect zakat, jizya and other taxes
on land, imports and spoils and administered the provision of income
to the poor, elderly and disabled. After victories in war generated large
surpluses, a system of allowances, based on religious merit, was intro-
duced. Hence, the riches the caliphate amassed through warfare and
from taxes on the wealth of increasingly prosperous citizens created a
demand for public insurance that was met through this earliest form of
the welfare state.
Bismarck was prime minister of Prussia from 1862 until 1890 and rst
chancellor of the unied German empire, which he had engineered mil-
itarily and diplomatically, from 1871 to 1890. The Long Depression
(known at the time as "the Great Depression") began in 1873 with the
Vienna Stock Exchange crash, at the tail end of an industrial boom,
which was fueled further by cheap capital from the reparations imposed
on France at the conclusion of the Franco-Prussian war in 1871 and con-
dence in the new industries, such as railroads, all of which led to an
investment bubble. The crash ushered in a period of deation until the
end in 1879. The Long Depression was an unprecedented event, the
longest depression in history and the rst international crisis.
By the end of the 1870s, Bismarck was increasingly concerned with a
swell of support for the socialist movement and introduced both anti-
socialist laws and social programs to stem the tide. In 1883 and 1884,
health and accident insurance for workers were enacted, in 1889 pen-
sions and disability insurance followed. Employers or the government
(which taxed land and property) contributed to each type of insurance.
Bismarck even considered establishing unemployment insurance, but it
did not actually appear in Germany until 1927. These programs were
98
in fact responible for a signicant decline in German emigration to the
United States in the 1880s.
The Great Depression began, in the United States, in September 1929
as stock prices headed downward toward the "Black Tuesday" crash on
October 29, 1929. A gradual recovery began in 1933, helped along by
Roosevelts New Deal policies and rearmement following the outbreak
of World War II, but was interrupted by another recession in 1937 after
the government raised taxes to control its ballooning debt. The rst
New Deal, i.e. laws passed directly after Roosevelts election in 1932,
regulated the economy more tightly and introduced stimulus programs.
The second New Deal brought on Social Security in 1935 and measures
aimed at generating employment and promoting unions, most of which
were revoked by a conservative congress in 1938 when the economy was
back on track.
The Social Security Act of 1935 provided for retirement and unem-
ployment benets, nanced in equal parts through a payroll tax on
workers and employer contributions. These were collected for the rst
time in 1937 and were meant to build up a reserve from which re-
tirement benets would be paid beginning in 1942 (a so-called "fully
funded" system). A 1939 amendment advanced the payouts to 1940,
turning the system into a "pay-as-you-go" scheme (where the payments
of the current working generation are used to fund benets for the cur-
rent retired generation), in response to concerns that the reserve would
withdraw too many funds from the economy. The rst recipient, Ida
May Fuller of Vermont, paid a total of $25 into the system until she
retired in 1940, and had drawn $23,000 in benets by the time she died
at the age of 100.
The Social Security Act of 1965 added health insurance for the el-
derly (Medicare, which is funded by an additional tax) and the poor
(Medicaid). Still under the Johnson administration, another signicant
expansion of benets was passed in 1972. In unadjusted dollars, bene-
ts rose steadily from $35 million in 1940 to over $650 billion in 2009,
roughly a 1,800-fold increase, while nominal GDP grew about 140-fold
over the same period, and the number of beneciaries increased 200-fold
from under 250,000 to over 50 million. The share of welfare payouts in
GDP rose 130-fold from 0.035% to 4.6%. Because the social security
99
tax is a percentage of income (federal payroll taxes are typically 7.65%
of wages for both employee and employer, i.e. 15.3% in total), and
moreover payouts in excess of certain levels are taxable since 1983, it
is clearly redistributive.
Even though social security is nanced by contributions, people work
ever fewer years relative to the period over which they expect to collect
retirement benets (due to increased life expectancy and longer educa-
tion). The child birth rate has also declined: all in all, there are more
and more old people per young adults who are working and paying
into the system. Hence, government spending on social security is on
a predictable path of growth.
But the bigger problem is health care. Increasing availability of, and
demand for, expensive treatments is continually raising the cost of cov-
erage. Of course, the increasing life expectancy is another complication,
since more people qualify for Medicare for longer periods.
Social security and health care have expanded (and are projected do
continue expanding) drastically as a share of GDP, accounting for much
of the growth in federal spending. Meanwhile, tax revenues, as a per-
centage of GDP, have remained roughly constant.
Much of the growth in entitlement spending is projected to come from
health care, rather than social security.
Health care spending has also been increasing in other advanced economies,
although somewhat less so than in the US.
The alarming scal picture hides some ner points. Perhaps it is nat-
ural that individuals choose to spend an increasing portion of their
income on health care, given longer life expectancy. Unlike other con-
sumption goods, health insurance is so essential that it is provided
publically, rather than privately, for those who are at risk of not being
able to aord it. In this sense, the increase in government spending
merely reects a change in consumption patterns, and it makes sense
to cover it through higher taxes.
A less optimistic view would point to the special problems associated
with health care provision (doctors may have poor incentives to pre-
scribe moderated and less costly treatments) and attribute rising costs
100
at least in part to ineciencies. The focus would then be on designing
a better health care market, and public administration of health care
is conceivably one of the reasons why incentives are distorted, so that
the decit could be reduced through privatization (and any increases
in health care costs would show up in private spending, not in higher
taxes).
The Health Care Reform Act that was passed in the US in 2010 aims
to cut costs in various ways. By requiring coverage for everyone, pre-
ventive health care is supposed to be universally accessible and lower
long-run treatment costs. Part of the increase in insurance costs from
covering the formerly uninsured is oset by reductions in Medicare pay-
ments (some of which are now absorbed by providers out of their sav-
ings from no longer having to treat uninsured patients) and levies and
taxes on drug manufacturers, insurance companies (for high-premium,
so-called "cadillac plans") and high-income earners.
Except for the doubtful savings from expanded preventive care, and the
implicit penalty on cadillac plans, none of this works against the rise
in health care costs, however. The basic issues are malpractice laws
(doctors have an incentive perform too many tests and treatments),
asymmetric information (patients cannot well determine what is essen-
tial) and intransparent costs (arising from the multitude of providers
and complicated billing practices). Since patients cannot accurately de-
termine needs and costs when they make choices, providers have little
reason to compete on price.
It may be inherently dicult to enable patients to make more informed
choices regarding their health care, so solutions probably need to focus
on the incentives of providers. Ultimately, doctors should be rewarded
for treatment outcomes, rather than treatment costs, so that they nd
it in their interest to monitor costs themselves. As our knowledge of
how to measure health improves, it becomes easier to evaluate outcomes
and understand the price-quality trade-os, so that price competition
between providers of comparable services will hopefully become feasi-
ble.
101
6 The International Dimension
6.1 Relationship between Budget Decit and Trade
Decit
About half of the US public debt is held by foreigners. The sustain-
ability of the debt is therefore closely related to the demand for dollars
overseas. To understand this demand, we need to take a closer look at
the net exports part of GDP.
There are several reasons why trade has become more important. Freight
charges, both at sea and airborne, have dropped sharply, as have long
distance communication costs (e.g. via telephone). In 1930, a three-
minute call from New York to London cost $250!
Taris have also been cut and quotas lifted through international nego-
tiations under the umbrella of the World Trade Organization (WTO).
Average tari on manufacturing goods was 14% in the early 1960s, but
only 4% in 2000.
The share of export and imports in GDP has increased steadily since
the 1970s, and since the 1980s imports have risen faster than exports.
Currently, imports account for 15% of GDP and exports for about
10%. Hence, there is a trade decit (negative net exports) of 5% of
GDP. Since the 1990s, the trade decit has been rapidly growing.
Since the trade balance must be zero worldwide, this means that that
the rest of the world runs a trade surplus. Major trading partners
are shown in this graph: the blue bars measure these countries trade
surplus as a share of US GDP. (Note: these do not directly reect the
share of the US trade decit the country accounts for. We are looking
here at the trade surplus with the rest of the world.) China and Japan
run the biggest trade surpluses, followed by France and Germany. The
UK has a trade decit, like the US.
Note that even Chinas trade surplus is much smaller than the US
trade decit. This contrasts with the fact that exports and imports
are a larger share in most countries GDP compared to the US. The
dierence is that other countries (inlcuding China) import closer to the
102
amount that they export, whereas the US imports much more than it
exports.
How should we evaluate a trade decit - is it a bad thing? Trade occurs
voluntarily: it makes the trading partners better o. In that sense, it
must be a good thing. It exploits comparative advantage - just like
individuals in the US economy are better o specializing in productive
tasks, so do countries benet from doing what they can do better of
more cheaply than other countries.
Clearly, you would not want to have to make every good you consume
yourself - you can live much more comfortably by learning a profession
and acquiring goods with the income it generates for you. Similarly, it
would be inecient for every country to produce everything.
This is even true when one country can produce every good at lower
cost - maybe because its workers are more educated - it is still in that
countrys interest to specialize in what it does best. What matters is
the opportunity cost of producing a good, which is the best alternative
use of the resources.
If I need three hours to make r and two hours to make , and you need
two hours to make r and one hour to make , your opportunity cost
of producing r is greater than mine, since you can make two units of
for each unit of r and I can only make 1.5 units of for each unit
of r. At the same time your opportunity cost of producing is lower
than mine, since you can only make half a unit of r for each , while I
can make two thirds of unit of r. So I should specialize in r and you
should specialize in .
Each country has a comparative advantage at something, regardless of
how productive it is. Hence there should absolutely be trade. (Notwith-
standing certain adjustment costs that can arise when trade opens up
and workers have to be reallocated to new sectors. Those costs are con-
centrated among a few, and they engage in political advocacy for trade
barriers, while the benets from lower prices and higher consumption
are spread over the whole population. However generally it is safe to
say that the overall benets from trade exceed the costs; and as jobs in
an importing industry move overseas, more valuable jobs are created
in an exporting industry.)
103
A trade decit arises when trade is unbalanced, and while it reects
optimal consumption choices, there is certainly a cost.
When US rms import goods, one of three things must occur. (1)
The importer may be required to pay in foreign currency and therefore
needs to exchange dollars. Or the importer might be allowed to pay
in dollars, and then the supplier would either (2) exchange the dollars
into foreign currency or (3) acquire a US asset, such as a bond, stock
or piece of real estate.
In case (1) and (2), somebody accepts dollars in exchange for foreign
currency. Either there is a corresponding demand for dollars from rms
abroad that wish to import US goods, or - if the US has a trade decit
- the dollars remain in the hands of foreigners. They will invest those
dollars in US assets. Either way then, a trade decit is matched by
a transfer of real or nancial US assets to foreign owners. If they run
trade decits with the US in the future, they can sell those assets o
and use the dollars to pay for imports in excess of exports.
This is precisely whats been happening: a lot of West Coast real estate,
in particular, belongs to Chinese citizens. Half of the public debt is
owed to foreign citizens all over the world.
Of course, someday, foreigners will want to use the income from dollar-
denominated assets to increase their consumption, i.e. to purchase US
goods. At that time, the US will have to run a trade surplus. A trade
decit today is an implicit commitment to export more than you import
in the future and accept a reduction in consumption then.
From the point of view of the permanent-income hypothesis, a trade
decit would thus make sense for a country that expects its consump-
tion to increase relatively quickly, while a trade surplus should occur
when a country expects slower than typical consumption growth.
If we look at the fastest-growing economies between 1980 and 2000,
this relationship is not borne out at all. Of the top six, only Mauri-
tius had a trade decit on average during this period. For some reason
that might have to do with time preferences or government policies,
fast-growing economies like China show greater restraint in their con-
sumption relative to the US.
104
Using the national income accounting identity,
1 = C +1 +G+`A.
we can make a direct connection between a trade decit and the outow
of assets from the US. Since 1 C 1 (private saving) and G 1
(government saving) together constitute domestic saving o, we have
`A = (1 C 1) (G1) 1 = o 1.
In other words, a positive trade balance implies that the countrys
residents save more than they invest domestically (and are therefore
net investors overseas), whereas a negative trade balance means that
the country is receiving investments from abroad.
Net saving is also called the "current account" balance (this includes,
besides net domestic saving o1, net income from foreign investments,
i.e. interest earned abroad by domestic residents minus interest paid
to foreign residents). The "capital account" balance is the resulting
change in asset ownership: foreign assets acquired by domestic residents
minus assets acquired by foreigners. The current account and capital
account balances add to the balance of payments, which must be zero.
In the US private investment was recently roughly equal to private
saving. If 1 = 1 C 1, then `A = (G1). I.e. the current
account decit tracked the budget decit, a phenomenon sometimes
referred to as the "twin decits."
While domestic investment has uctuated around 15% of GDP, not
showing a long-term trend, the budget and trade decits have risen
together after 2000. The relationship between the current account and
the capital account implies that the US is currently paying for the
budget decit with assets that are being transferred to foreigners.
In the mid-1980s, the US ceased to be a net creditor in the world capital
market and accumulated an increasing net debt through regular trade
decits that were counterbalanced by asset transfers (remember this
includes debt instruments like bonds, but also property such as stock
and real estate).
105
6.2 Exchange Rates vs. Ination and Interest Rates
Imports and exports respond to cost dierences in goods across coun-
tries, which are, at the most fundamental level, reected in the real
exchange rate. The pound-to-dollar real exchange rate is
111 =

UK

US
.
where
US
is the quantity of a good that a dollar buys in the US, and

UK
is the quantity of the same good that a dollar buys in the UK if
the dollar is exchanged for pounds at the prevailing nominal exchange
rate.
To reconcile this denition of the "real" exchange rate with the notion
of "real" GDP, remember that real GDP is nominal GDP (GDP at
current price) adjusted for ination, i.e. changes in the overall price
level. If we had only one good, then real GDP would be output of the
good at a price that is held constant over time, so that all variation
is due to changes in output. In fact, we might as well hold the price
constant at 1 and equate real GDP to physical output (this is not
possible when there are multiple goods, hence the actual denition of
real GDP is more complicated than that).
So the pound-to-dollar real exchange rate is the number of goods a
pound can buy relative to the number of goods a dollar can buy. The
nominal exchange rate is the price of dollars in terms of the face value of
another currency, unadjusted for ination in that country. The pound-
to-dollar nominal exchange rate reects how many pounds a dollar can
buy, where the value of a pound in terms of goods (its "purchasing
power") might be uctuating.
A related concept are the "terms of trade": a countrys export price
index divided by its import price index. These are average prices for
xed baskets of export and import goods from a common base year.
Roughly, the terms of trade tell us how much the US needs to export
to pay for what it imports - but unlike the real exchange rate, this has
units of dierent goods in the numerator and denominator.
Let 1
US
be the US price (in dollars), 1
UK
the overseas price (in pounds)
and 1 the nominal exchange rate of pounds per dollar. (To keep things
106
consistent, we will always dene nominal exchange rates as foreign cur-
rency per dollar, not the other way around.) Then
US
is equal to
1,1
US
(e.g. if a unit costs $2, one dollar buys half a unit). Extending
that logic to the UK,
UK
is equal to (1,1
UK
) 1, since you would get
1 pounds for a dollar and 1,1
UK
units per pound. Hence
111 =
1
US
1
UK
1.
At given price levels, the nominal exchange rate therefore determines
the real exchange rate, and we can predict that a higher nominal ex-
change rate would reduce US exports and increase US imports, since
traders can get more units of the same good in the UK than in the US
for a given dollar outlay.
We might also expect that arbitrage must eventually balance
UK
and

US
, i.e. the real exchange rate must tend toward 1. This situation is
what economists call "purchasing power parity": a dollar buys the same
quantity of goods in all countries. It is an example of the "law of one
price": valued in dollars at the current exchange rate, things should cost
approximately the same everywhere.(after adjusting for freight costs,
taris and dierences in tax, and absent trade restrictions).
How does arbitrage lead to purchasing power parity? If 11
US
1
UK
,
then the good costs more pounds in the US than in the UK, and some-
one could make money buy shipping it from the UK to the US. Even-
tually, this would increase supply in the US, and decrease supply in the
UK, to a point where the price (denominated in either currency) is the
same. Similarly, if 11
US
< 1
UK
, shipping the good from the US to the
UK is protable and should bring the price down in the latter. Thus
11
US
= 1
UK
.
and it follows that 111 = 1.
We should keep in mind that the absence of arbitrage opportunities
(purchasing power parity) does not imply that there is no reason to
trade. Trade arises from comparative advantage and causes the good
to be supplied by the least-cost producer to other countries with higher
opportunity costs. This is consistent with a single world price. But if
107
there is a temporary dierence in prices between countries, we should
expect additional trade ows from where it is relatively cheap to where
it is expensive - until the real exchange rate is back at 1.
In the long run, the quantity theory of money (`\ = 11 ) applies,
and the price level in each country is pinned down by the money sup-
ply, which is a matter of local central bank policy. Under purchasing
power parity, the nominal exchange rate is the only free variable that
can bring the demand and supply for tradable goods into equilibrium.
In a single-currency area like the US, price dierences arent sustain-
able. In a world with multiple currencies, there can be multiple prices
denominated in their respective currencies, but the nominal exchange
rate (in the long run) must be such that prices are the same in terms of
a single currency like the dollar. It balances world demand with world
supply for goods whose relevant market is global and for currencies
used to purchase these goods.
Since purchasing power parity implies that
1 =
1
UK
1
US
.
we would expect that the nominal exchange rate correlates with ina-
tion rates. An increase in the US money supply expands the relative
supply of dollars and, other things equal, should bring the price of down
- depreciate the dollar. According to the quantity theory, it raises prices
in the US, hence decreases 1
UK
,1
US
for any tradable good we choose
to consider, so the nominal exchange rate indeed falls.
What is the connection between ination and the market for dollars?
As prices rise in the US relative to the UK, arbitrageurs seek to source
from the UK and therefore want to exchange dollars for pounds. This
reduces the price of the dollar - it will buy fewer pounds.
The yen tended to appreciate against the dollar since the 1970s (a
dollar bought fewer and fewer yens over time). Over much of that
period, the Japanese ination rate was below the US ination rate, but
the relationship is not perfect.
The Economists Big Mac index regularly compares the price of a Big
Mac across countries in dollar terms (at the given exchange rate). There
108
is substantial variation. Why? A burger is not a tradable good - to a
large extent, its cost is determined by the local price of produce and
labor. And at least labor cannot easily be shipped.
The Big Mac is one case where the law of one price will not hold.
What are others? (Mainly services, goods that are customized for each
country - such as instructions in the local language - and branded /
unique goods where the seller can control distribution and price dis-
criminates across countries, e.g. fashion is much cheaper in the US
than elsewhere.) We must also bear in mind that taris and taxes
make a dierence: e.g. higher sales tax and corporate prot tax in-
crease the price sellers must charge in order to earn the same return as
in other countries.
Trade in goods is not the only thing that aects exchange rates. De-
mand for currency also arises from trade in nancial assets, and given
the instantaneous operation of, and information ow in, nancial mar-
kets, arbitrage there is more immediate. It also accounts for the bulk
of currency trade, which is more then twelve times of world GDP in
value.
A key part of this market is debt denominated in foreign currency. If in-
terest rates increase in the US, bonds and other debt instruments in the
US become more attractive investment assets. But they cost dollars,
and foreigners who want to purchase them must rst acquire dollars
in the foreign exchange market. The demand for dollars increases, and
the dollar appreciates as a result.
This leads us to another form of the law of one price: interest paid
on a dollar in the US must be worth the same as interest paid on the
equivalent of a dollar in the UK:
(1 +i
US
) 1 = (1 + i
UK
)
1
1
0
1.
On the left, we have the return in the US: one dollar invested pays back
the dollar with interest i
US
. On the right, we have the return that is
available to the US investor in the UK: she exchanges the dollar for 1
pounds, earns interest i
UK
on these and changes them back into dollars
at the future exchange rate 1
0
.
109
The equation simplies to
i
UK
i
US
= (1 +i
US
)
1
0
1
1
-
1
0
1
1
.
Any positive dierence between the UK and US nominal interest rates
must correspond to the capital gain the investor can realize from an
appreciation in the dollar over the period. This relationship is referred
to as nominal interest rate parity. (There are some reasons why it
need not hold exactly: risk premia, dierences in taxation of interest
payments, restrictions on capital ows ...)
In the long run, when purchasing power parity leads to full adjustment
in exchange rates, we must have 1
0
= 1 and i
UK
= i
US
. In fact,
when currencies buy the same quantities of goods everywhere, nominal
interest rate parity implies real interest parity. But how might investors
expect the nominal exchange rate to vary in the short run, so that
nominal interest rates would dier from country to country?
Perhaps investors anticipate a change in monetary policy in the future
that alters the rate of ination. A future increase in the US nominal
interest rate will slow ination and cause the long-run exchange rate
to rise, in accordance with purchasing power parity. Hence, investors
expect a capital gain from buying the US asset with cheap dollars today
and changing more valuable dollars back tomorrow. To compensate
those who invest in the UK asset, the UK interest rate must be higher
today.
In combination with nominal interest rate parity, purchasing power
parity (1 = 1
UK
,1
US
) yields
1
0
1
1
=
1
0
UK
,1
0
US
1
UK
,1
US
1 =
1
0
UK
,1
UK
1
0
US
,1
US
1 =
1 +:
UK
1 +:
US
1
(note that 1
0
US
,1
US
= 1 +(1
0
US
1
US
) ,1
US
= 1 +:
US
), and thus the
growth of nominal exchange rates reects the ination rates.
Arbitrage in nancial assets determines the nominal exchange rate in
the short run. In the long run, the trend of the nominal interest rate
also reects arbitrage in goods that takes longer and is less perfect, due
to the inherent informational and physical barriers. I.e. we get nominal
110
interest rate parity in the short run and a tendency toward purchasing
power parity in the long run (which means that international dierences
in exchange rates ultimately reect dierences in ination rates).
In the long run, real interest rates around the world approach parity.
This implies that the real interest rate in an integrated world is ul-
timately determined by the global return to capital :, since domestic
residents have access to the global capital market both for lending and
borrowing purposes and would arbitrage away any local dierences in
the price of funds. The global return is determined by the global de-
mand and supply of capital, which depend on investment opportunities
and the desire for consumption smoothing.
Some examples where countries borrowed on the world credit market
to smooth their consumption are Poland after harvest failures in 1978-
1981 and Mexico when oil was discovered in the early 1970s. The
United States in the 19th century and Brazil during its boom in the
1970s borrowed in order to nance their high levels of investment in a
rapidly growing economy. In each case, substantial debt was amassed.
On the other hand, many of the industrialized countries were until
recently net lenders (including the US until the 1980s). Besides the
East Asian economies that apparently discount future income less than
Western countries, oil-producing nations like Saudi Arabia are creditors
in order to preserve their nite income into the future.
Events in a small country like Poland will only have a negligible eect on
the world capital market, so its real interest rate is beyond its control.
A large economy like the US, however, does aect the real interest
rate. The real interest rate is somewhat procyclical (and the current
account somewhat countercyclical) in the US, reecting that investment
demand exceeds saving in a good business climate.
6.3 Exchange Rate Regimes
Through the 19th century up until World War I, the major currencies
like the British pound were on the gold standard (or a gold and silver
standard in the case of the US until 1879, when it switched to gold
only). I.e. countries maintained gold reserves and oered to trade
111
domestic currency for gold at a xed price. You could literally walk
into a bank and purchase or sell a bar of gold at a price that remained
stable. This served as assurance that paper money indeed had a value.
One implication is that the exchange rates between dierent currencies
also had to be stable: after all, you could always buy gold in one country
at a xed price and resell it in another at a xed price, no one had an
incentive to trade currency at anything other than the implied ratio.
One result of World War I was that this regime fell apart as countries
had to resort to printing money. Since they did not have enough gold
reserves to sell for all the currency that came into circulation, they could
no longer oer to trade gold at a xed price and therefore abandoned
the gold standard.
Ination was rampant in the aftermath of World War I, we already
talked about the German hyperination. In 1944, as World War II came
to close, a meeting took place in Bretton Woods, NH, with the goal
to restore stability to exchange rates. The US committed to trade US
dollars for gold at a xed rate ($35 per ounce) with other central banks,
thus guaranteeing the stability of the dollar. Other major currencies
were pegged to the dollar, i.e. they committed to trade their currency
for the dollar at a xed rate.
Bretton Woods fell apart in the 1970s, when price increases in the US
devalued the dollar in real terms and the Fed was running its gold
reserves down as central banks around the world wanted to exchange
dollars for gold (probably because they anticipated a nominal devalu-
ation). Since then, countries have used various exchange rate regimes
at the same time, including voluntary pegs to major currencies like the
dollar and limited or full oats.
The purest form of a peg is a currency board, as practiced by Ar-
gentina in the 1990s. It requires the central bank to hold enough dol-
lars to exchange all outstanding domestic currency at the proclaimed
rate (else, speculators might "attack" by buying dollars in the hope
that the domestic currency will be devalued, so that it can be bought
back cheaply). (What eventually forced Argentina to give up the peg
was mounting government debt, to the point where it defaulted, after
a depreciation of Brazils currency led to a large trade decit.)
112
Once the currency is pegged, the central bank loses the option to pursue
other objectives through monetary policy, since the money supply must
be adjusted to maintain the exchange rate. This can be a good thing,
if the central bank wants to assure citizens that it will not print money
to nance government debt and thereby create ination. But it also
renders it powerless to respond to recessions.
Capital controls, as practiced by China in the 1990s, limit the amount
of trading and therefore require fewer dollar reserves. (You could only
buy dollars from the Bank of China at the time, and only up to a
certain amount.) But capital controls prevent a country from taking
full advantage of the nancial system, which can channel funds to their
most ecient uses. For China, this is perhaps less of a problem because
of its very high domestic saving rate that can fund the investment
opportunities.
Many central banks today commit not to a xed rate, but to a band
within which they allow the exchange rate to uctuate. If the band
applies to the dollar exchange rate, they usually adjust their interest
rates in the same direction as US interest rates, hence will typically
follow Fed actions. But they reserve discretion to deviate on a small
scale to manage the domestic business cycle.
6.4 Business Cycle in an Open Economy
In the long-run, exchange rates reect price levels in accordance with
purchasing power parity. Hence they depend on how much currency the
central banks issue relative to the economys output. This makes no
dierence to relative prices and economic decisions. In the short run,
however, exchange rates can uctuate as we have seen, to maintain
nominal interest parity.
How do exchange rates enter into our short-run analysis? An increase
in the real interest rate makes dollar-denominated assets more valuable.
Hence the exchange rate appreciates, both in nominal and in real terms
(given sticky ination), and net exports fall as imports get cheaper (and
exports more expensive from the point of view of foreigners).
113
Our model should therefore account for the fact that net exports de-
pend negatively on the real interest rate. More specically, if the long-
term fraction of GDP spent on net exports is c
NX
, net exports should
decrease when the domestic real interest rate exceeds the world real
interest rate. (Recall that, in the long run, it is equal to the world real
interest rate.) Thus:
`A
t
1
t
= c
NX
/
NX
(1
t
1
W
)
= c
NX
/
NX
(1
t
:) +/
NX
(1
W
:) .
The IS equation can now be rewritten
~
1
t
= c / (1
t
:)
where
c = c
C
+c
I
+c
G
+c
NX
+/
NX
(1
W
:) 1
and
/ = /
I
+/
NX
.
The IS curve has exactly the same form and shape as before; only the
denitions of the parameters have changed (and therefore the types of
shocks that can change them). Now the relationship between short-run
output and the real interest rate is negative not only because investment
falls when the interest rate increases, but also because the currency
appreciates and net exports fall.
When the money supply is tightened overseas and the interest rate in-
creased, the parameter c now increases, shifting the IS curve out, i.e.
~
1
t
is higher at each 1
t
. The reason is that the pound appreciates, and
therefore American goods become cheaper for UK residents, which in-
creases US exports (at the same time, imports from the UK become
more expensive and decline). Thus, the `A
t
component of GDP ex-
pands. (Assuming the interest rate increase does not also depress the
UK economy and reduce demand for imports there ...).
In the AS-AD diagram, the AD curve (which combines the IS curve
with the monetary policy rule) shifts out and induces an increase in
ination and a temporary boom, point 1. The Fed raises the interest
114
rate in the process to discourage investment and avoid overheating. As
expected ination increases, rms see their costs increase faster and
want to produce less at any given actual rate of ination, so that the
AS curve shifts in, point C. At this point, the Fed lowers the interest
rate to avoid a deep recession, and this increases ination further.
When the shock vanishes (because interest rates in the UK have fallen
back to their old level), the ADcurve shifts back to the old level, causing
a recession, point D. Now, ination is dropping and the AS curve shifts
out as expected ination falls over time, so that costs slow and rms
want to produce more at any given ination rate. Eventually, the old
equilibrium is reestablished.
6.5 The Asian Crisis of 1997
In the nal lectures, we take a closer look at the Asian growth miracle
and the Asian crisis of the late 1990s. The discussion will touch on
many of the issues we have encountered in growth theory, short-run
analysis and international macroeconomics. While we will identify the
shocks that activated the Asian crisis in the summer of 1997, the focus
is on why the Asian economies could not eectively respond.
Taking an aerial view rst, we consider the place of the crisis years
in the long run growth history of Asia, and identify the main threads
in the story we will explore in some detail. Then, we follow three
major developments of the 1990s that rendered the Asian economies
vulnerable to macroeconomic disruption and discuss why. Finally, we
chronicle the events of the crisis itself and consider the policy issues
and options that arose.
The growth of the East Asian economies since the 1960s (with a few ex-
ceptions, where political arrangements were unfavorable) was an episode
without parallels. Never had a single country, much less a group of
countries, grown so much in so little time. Over 40 years (1960-1999),
the US economy expanded by a factor of 3.5 (which is remarkable in
itself), but many East Asian economies were between 10 and 20 times
wealthier than 30 years earlier!
115
In the scheme of things, the Asian crisis was a small dent (and almost
didnt aect China at all) but it was also the rst such setback: even
the oil crises didnt stop the region from expanding . . . And for a group
of countries thats used to high positive annual growth rates, swinging
into the negative for two years was certainly perplexing and disturbing.
A shaken condence in the future (more cautious consumption, more
risk-conscious investment) added to the real costs (corporate and bank
failures, a signicant increase in unemployment).
Compared to the other recent currency crisis, that of Mexico in 1994
and 1995, Asias was also more serious in two ways: it spread through
the region and beyond. Mexicos crisis was not contagious (Latin Amer-
ican countries maintained their pegs): the peso depreciated in real
terms against the currencies of export competitors, improving the cur-
rent account quickly. While Mexico beneted from a vigorous US econ-
omy (the main export market), and recovered fully after nine months,
the global environment was less friendly at the end of the 1990s (US
slowing, Japan stagnant, EU weak), oering no such boost to Asia.
Among economists, an old debate about the feasibility of saving our-
selves rich was rekindled. On one side were those who said Asia had
blindly and unproductively invested for years, and was now paying the
price in the form of bankruptcies and defaults. On the other side, opti-
mists argued that Asia was merely undergoing a structural transition,
and that speculation had blown the problems out of proportion. We
have, thus, a long-term and a short-term argument, with dierent im-
plications: one says, Asia was on the wrong track with its development
strategy of encouraging massive investments; the other says, Asias suc-
cessful expansion came to a temporary halt due to a charred psyche and
some necessary corrections.
The fact is that Asia did regain strength in 1999 and 2000, but the re-
gion soon labored under a new global malaise that had largely unrelated
reasons: the weak electronics market, the US slowdown, the terrorist
attack. But before we dismiss too rashly the Alwyn Youngs and Paul
Krugmans (who had predicted an Asian slip in the early 1990s, based
on low estimates of productivity growth, especially for Singapore), lets
consider how troublesome the long-term picture is.
116
An economy cannot grow forever in per capita terms (given saving
and labor force participation rates) unless there is some kind of e-
ciency improvement. The capital stock (per eective worker) will only
grow until a steady-state is reached, where capital is just suciently
productive to replace itself, making up for depreciation and the capi-
tal requirements of labor force entrants. Alwyn Young published two
articles with such melodramatic titles as A Tale of Two Cities and
The Tyranny of Numbers, which attracted much publicity, and where
he calculated that Singapore had virtually no productivity growth for
decades. Its one of those results that strike everyone as funny (after
all, does the excellent public transport network not add to eciency?;
dont Singaporeans have computers?; doesnt Singapore have excellent
schools?), but that have to be addressed anyhow.
One explanation is that Youngs technique imputes productivity change
into his factor contributions (he basically subtracts labor force and
capital stock growth from output growth and calls the rest productivity
growth, but he weights labor force growth according to the wage rate,
which rises with productivity). Another objection is that he just used
weird data, and his results havent often been replicated in follow-up
studies (they sometimes nd that Singapore ranks among the economies
with the highest eciency growth).
Generally, it would be wrong to speak of a single Asian development
model. Some countries in the region invest like theres no today (Tai-
wan, Singapore, Korea, Japan); some are primarily catching up through
education (China, Indonesia); some are doing a bit of both and dont
look so dierent from the US in this respect (Hong Kong, Thailand).
But the typical return to capital (by the crude measure of the capital-
output ratio) is indeed far below that in the US. Even though I dont
believe that Asia had insignicant productivity growth, Im sympa-
thetic to the idea that there has been overinvestment in the region,
with relatively low returns as a consequence. If we calculate the in-
cremental capital-output ratio (by how much the capital stock grew
with each 1% increase in output), and compare the 1987-1992 aver-
age with the average for 1993-1996, we get additional conrmation for
the hypothesis: most Asian countries capital stocks are becoming less
productive.
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You might ask: why are investors still investing? There are several
explanations: (1) The government is a big investor in some of these
countries, and the government isnt necessarily guided by returns. (2)
A lot of investments ow into projects that dont contribute to future
output, but hold potential for lucrative reselling (think residential prop-
erty and stocks). (3) It has been argued that there is signicant reverse
causality from GDP growth to investment. Investors form exuberant
expectations about prospects in an economy that has been doing well in
the past. Lets not forget that there is much uncertainty about returns
in practice and that practitioners do use simple rules of thumb.
As we proceed to a medium- and short-run view of the crisis, lets keep
in mind that a tradition of overinvestment in Asia may have lowered
the real returns to economic activity despite what most people were
perceiving at the time. This would increase rms exposure during a
downturn and limit the amount of debt they can shoulder.
While the conditions that led to the crisis were not identical around
Asia, the trigger was in all cases an unexpected currency depreciation,
increase in the real value of international debt, defaults that spread
from rms to banks, further depreciation as investors tried to sell their
local assets, and the cycle over again, several times.
Why had rms and banks been able to borrow until they were not
resilient to shocks? Thats where my opening point about systemic
aws comes in. This is what the Asian crisis, and any crisis, is primarily
about. In many Asian countries, the nancial sector lacked incentive
to monitor because (1) governments seemed willing to support ailing
banks and conglomerates and (2) central banks were committed to xed
exchange rates. Investments in the region appeared essentially risk-free
and could be justied even if nominal returns were relatively low.
Why did currencies suddenly depreciate? Exchange rates are prone to
uctuate in response to sentiments, and sentiments tend to build and
collectively overreact to real events. (Sounds irrational, but it really
isnt in an environment characterized by uncertainty.) And a central
bank can only stem a limited amount of pressure on a currency . . .
The initial spark was a minor capital ow out of Thailand in response to
an everyday event (well get to specics later), but as the central bank
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stepped in to support the baht, it became clear that its depleted forex
reserves could not sustain the peg (to the US dollar) in the event of a
major movement. The perceived risk caused just such a major move-
ment, and Thailand had to give up the peg. Then attention shifted to
other regional economies, like the Philippines, Indonesia and Malaysia
(and a bit later Korea) that seemed to have some of the same problems,
and by then the sheer magnitude of the capital ow reversals unhinged
every one of the targeted currencies. Even intact economies like Singa-
pore, Hong Kong and Taiwan eventually experienced pressure as their
currencies had undergone real appreciation relative to those of their
competitors in export markets.
While this is how the crisis came to fruition, I want to emphasize
the fundamental misalignments that had, over years, nourished the
prospect of a crisis. We look at medium-term developments of the
1990s now that set the stage for July 1997.
Through the 1990s, Asian economies were overheated. Factual evidence
comes from high ination rates. In a period during which US prices
rose by 20%, Chinese and Philippine prices doubled, and those of other
Asian economies (except depressed Japan) tended to rise faster, by
multiples.
Rapid money growth powered these expansions in an ironic race against
rising prices (to avoid a liquidity crunch). Malaysian ination was
relatively low only because of price controls. In fact, large-scale public
infrastructure projects fueled overheating in the Malaysian economy in
the mid-1990s. (The price controls were a factor in Malaysias widening
current account decit: if the exchange rate is xed and regulations
cause a domestic shortage, imports close the gap.)
A consequence were deteriorating trade balances due to rising imports
and also weakening exports. Exports suered from (1) the Japanese
slowdown: stagnant till 1995 and growing briey in 1996, Japan was
back in a slump in 1997 after an increase in the consumption tax
Japan received 30% of regional exports; (2) the electronics sector down-
turn in 1996: demand for semiconductors, a major export item of re-
gional economies, fell signicantly; (3) the increasing weight of China in
Asian exports: a 50% nominal devaluation of the RMB in 1994 implied
119
a sharp real depreciation and large trade surpluses at the expense of
Asian competitors; (4) worsening terms of trade (more on that later).
The seeming lack of exchange rate risk also enticed private foreign
investors to buy high-interest Asian bonds and seemingly high-yield
Asian equity. Particularly in Thailand and the Philippines, interest
rates were signicantly higher than abroad (for example in the US),
driven ultimately by unrealistic expectations of capital gains in prop-
erty and equity markets.
Driven by import demands and readily nanced by capital inows,
current account decits in Korea, Indonesia, Malaysia, and especially
Thailand surged above 5% of GDP. These countries saw the most dras-
tic currency depreciations in 1997 (and the won and baht were under
attack from 1996).
Importers need dollars, which they acquire from banks, and if exporters
and foreign investors dont supply enough dollars to banks, banks bor-
row oshore. This amounts to a reduction in the countrys net foreign
assets (as the banks are selling domestic debt nancial assets to for-
eigners), in line with the external balance requirement that net export
equal net foreign investment.
Not surprisingly, an increase in foreign-currency denominated debt ac-
companied the trade decits of the 1990s. In Indonesia and Thailand,
debt exceeded the combined value of forex reserves and annual exports.
Well have more to say about the nature of that debt later on, but will
focus for the moment on the conditions under which a current account
is thought to be sustainable. (Of course, if economists think it unsus-
tainable, so will investors over short or long, translating into actual
speculative attacks and collapse.)
Current account decits are acceptable and healthy at an early stage
of development if the economy is growing on a solid foundation and
creates the wealth from which to repay the debt in the future. Ideally
a developing country would import investment goods that contribute
to growth in export sectors.
A bad sign would be that a current account decit coincides with a
reduction in domestic saving. In this case, foreign investment eec-
120
tively nances current consumption and does not provide the means
for repayment. This is what led to the Mexican peso crisis in 1994:
Mexico was unable to meet its short-term interest obligations because
the foreign loans had been used unproductively. The data show that
something like it happened in Thailand in the 1990s. In some other
Asian countries, forced saving (such as CPF contributions in Singa-
pore) prevented the problem.
Another bad sign is usually that a current account decit coincides
with persistent scal decits. The reason is, again, that government
spending goes mostly into consumption (public services), not invest-
ment. The Latin American debt crisis in 1980 was primarily caused
by budget decits nanced abroad but Asian governments (except
Chinas) ran surpluses in the 1990s.
The good news is that what Asia borrowed tended to get invested. The
bad news is that returns were low by the 1990s (for reasons we have
already touched on) and that a good deal of investment took place in
non-traded sectors (construction and internal services). Troubled Ko-
rean and Indonesian companies borrowed abroad to nance marginally
protable operations and projects of dubious quality. Thailand and
Malaysia, especially, sustained speculative bubbles in the real estate
and equity markets with foreign capital.
We have already alluded to the serious current account decits this
behavior created in aggregate. But to appreciate the extent of the
problem, lets not forget that capital inows were much greater than
current account decits (which are just the net inows). For instance,
Koreas current account decit in1996 was $ 23 billion, but gross inows
were $ 41.3 billion - the rest was oset by outows, which tend, however,
not to come back during a crisis.
In addition, debt structure was unfavorable. Short-term obligations
(debt service plus short-term debt) exceeded foreign reserves in Korea,
Thailand, Indonesia, and the Philippines, implying substantial default
risk in the event of a shock. Asias high current account decits in the
1990s were a matter of concern as they created short-term debt that
did not nance productive, forex-generating activities. In fact, they
supported speculation and marginal (often high-risk) projects that were
121
unlikely to contribute to debt repayment. Which raises the question:
why did lenders supply funds for such purposes?
Until the 1990s, state banks dominated most Asian credit markets,
and private nancial institutions were strictly regulated (excepting the
sophisticated banking sectors of Singapore, Hong Kong and Taiwan).
By the 1990s, this arrangement had become an obvious constraint on
growth, and governments began to implement nancial liberalization
policies, that is they made private credit more freely available.
To give a specic example, Indonesia had ve state-owned banks in
1980, which handled 80% to 90% of all credit. Private start-ups that
emerged after reforms in 1988 and 1989 overtook the state banks in
market share as early as 1994.
Private credit and bank lending seems to have run ahead of devel-
opment especially in Malaysia and Thailand, where nancial depth
exceeded that of the US by 1997 and private sector liabilities continued
to expand at full steam up to the time of the crisis.
Formerly restricted or non-existent nancial institutions were suddenly
thrown into the hot water that were Asias buoyant economies, and
the private sector clamored for funds to invest in risky enterprises like
property and stock market speculation. Banks ignored much of the risk
for two reasons: (1) Competitive pressure; for the newcomers, it was a
struggle to survive, and they needed clients. (2) There was a real or
perceived commitment of governments to bail out technically bankrupt
rms. As NYUs Nouriel Roubini put it, the market operated under
the impression that return on investment was insured.
To provide the coveted funds, banks themselves borrowed from abroad.
Here, too, they accepted an unusual amount of risk: they would typi-
cally not hedge against exchange rate uctuations. Banks saw no need
to hedge (pay premium forward rates), since the currencies were cred-
ibly pegged by their governments.
Moreover, banks and rms were highly leveraged and susceptible to
bankruptcy. Banks had typically a lot more foreign liabilities than as-
sets; often more than 50% of the debt was short-term, foreign-currency
denominated, and unhedged. Thai banks, in particular, had more than
122
eight times as many foreign liabilities as assets toward BIS (Bank of
International Settlements) aliates. (The ratio exceeded ten toward
all banks). Taiwan was the only Asian country whose banks were in-
ternational net creditors.
To get a sense of corporate exposure, consider some aggregate statistics
of the thirty biggest Korean chaebols on the eve of the crisis. They had
a median debt-to-equity ratio of ve at the end of 1996 (compared to
a ratio of one which is typical for US companies), and a dismal median
return on sales of 0.1% (even though 1996 was still a decent year for
Korea).
Such hazardous debt structure at the rm and bank level underscored
the danger of the current account decits. Newly liberalized banks were
exposed to exchange rate and cash ow risks, and many of their clients
were excessively leveraged and unprotable. Asias premature nancial
system in the 1990s, characterized by distorted incentives, funded the
bubble economies and steered them to the edge of crisis.
Now it remains to be explained whether and why governments failed to
intervene. The quasi-xed exchange rate regime is at the heart of this;
it was a blessing during years when Asia grew in the productive, export-
oriented sectors, since it provided stability and security for investors.
It was a curse in the early 1990s.
Let me begin with an overview of the specic exchange rate systems
then in use around Asia. We have essentially four or ve types, with
moderate to no exbility. Hong Kong had a currency board, that is the
peg to the US dollar was xed by law, and monetary policy automati-
cally defended it at all times. Malaysia, Thailand, and the Philippines
pegged their exchange rates to a basket of currencies, but the US dollar
had so much weight that we might call it an implicit peg to the US
dollar. In practice, the ringgit and the baht moved in a narrow range
around a xed value to the US dollar between 1990 and 1997, and the
same is true for the Philippine peso between 1995 and 1997.
Indonesia and Taiwan targeted a xed real exchange rate against the US
dollar. Since Indonesia and Taiwan had higher ination than the US in
the 1990s, this means that their currencies depreciated nominally to the
123
dollar (the rupiah by 26% and the new Taiwan dollar by 16% from 1990
to 1997). China and Korea maintained fairly constant exchange rates
against the US dollar at most times, but made occasional adjustments
as macroeconomic conditions require. China devalued by a full 50%
in 1994, since it had experienced rapid ination, but afterwards the
renminbi was stable. The won was allowed to depreciate against the
dollar by 14% in the early 1990s, and another 10% at the end of 1996.
Singapores policy came closest to a oat. The Singapore dollar ap-
preciated by 18% between 1990 and 1997. With the exception of Sin-
gapore, Asian currencies were therefore explicitly or eectively tied to
the US dollar; the Hong Kong dollar, ringgit, baht and peso, especially,
would move closely with the US dollar in nominal terms.
Such a quasi-xed exchange rate regime has some attractive features for
a developing economy: (1) It keeps ination near the world level. Sup-
pose local prices rose faster than American prices. Arbitrageurs could
then import US goods (without having to pay a currency premium),
forcing local prices down. (2) It imposes scal discipline. Suppose
the local government tried to run a budget decit and nance it by
having the central bank print money. The increase in money supply
depreciates the currency, so the central bank must reduce the money
supply through bond issues. Hence budget decits will be nanced by
borrowing from the private sector, not by seignorage.
But the obvious downside of a xed exchange rate is that central banks
must surrender their autonomy in managing the money supply and
subject monetary policy to the defense of the currency. This implies,
for instance, that central banks had little power to ght overheating
ahead of the Asian crisis.
There is another hidden caveat that is of some importance in practice.
Controlling ination is a motivation in xing the exchange rate. But
information barriers, taris, and transportation costs usually prevent
complete price convergence. We have already seen that Malaysia, Thai-
land, and the Philippines continued to have higher ination than the
US. A country that starts out with high ination and then pegs usu-
ally experiences real appreciation (since the nominal exchange rate is
xed, but the price level remains somewhat higher). At the same time,
124
excess ination keeps nominal interest at a premium, prompting capi-
tal inows. The current account worsens, and more capital injections
are required, accumulating more debt until investors lose condence
in the countrys ability to service the debt and maintain the peg, at
which point the central bank must sell reserves to defend the currency.
Clearly a crisis scenario.
Unfortunately, the US dollar itself gained in real terms against Eu-
ropean, Japanese and Asian currencies from the second half of 1995,
appreciating the pegged currencies in its wake. Real appreciation, with
rather than against the dollar, was a key development that shares re-
sponsibility for the crisis. After nominal depreciation against the yen
and mark in the rst half of the decade, the dollar gained 56% on
the yen between spring and summer 1995. The peso and the ring-
git, but also the Hong Kong and Singapore dollars, appreciated be-
tween 15% and 25% in the 1990s, largely because of the US dollar
movements. Countries with eectively xed exchange rate regimes
(Malaysia, Philipppines, Thailand, Hong Kong) tended to undergo
much greater real appreciation.
Since the real exchange rate is reected in the price of exports, countries
with more overvalued currencies generally experienced greater deterio-
ration in their current accounts. China and Taiwan, whose currencies
depreciated in real terms, had current account surpluses. Korea suf-
fered large and increasing current account decits despite real depre-
ciation of its currency. Circumstances were a bit unique here recall
that the chaebols borrowed for survival, and Korea was hit especially
hard by bad export markets.
The crisis, with its watershed nominal and real devaluations, was there-
fore a necessary correction to adjust the current account positions of
many Asian economies. Nominal exchange rates (to the US dollar) later
depreciated by 42% in Thailand, 37% in Indonesia, 26% in Malaysia
and 28% in the Philippines between end of 1996 and the beginning of
September 1997.
Once this correction was underway in some economies, others had to
follow suit because their currencies had now appreciated greatly, in real
terms, against those of regional export competitors. The Korean won,
125
for example, which depreciated by only 8% nominally against the US
dollar between December 1996 and end of September 1997, appreci-
ated in nominal (and real) terms by 34%, 29%, 20%, and 18% against
the currencies of Thailand, Indonesia, the Philippines and Malaysia,
respectively. The result was a drastic loss of competitiveness and
pressure on the won to fall further.
The previously useful policy of pegging the currency had turned mali-
cious in the 1990s, leaving central banks powerless to stie the bubble
and causing a disastrous real appreciation against many of the worlds
currencies as the dollar began to surge in 1995. This exacerbated prob-
lems, since the weak, risk-exposed and debt-laden corporate sector was
dealt a competitive disadvantage in the face of already dwindling ex-
port markets. Recall that banks had lent heavily to these rms and
had accumulated foreign-currency denominated debt in order to do so.
I think the scope of the diculties is now apparent. Lets see what
happened in the summer of 1997.
On July 2, 1997, Thailand devalued the baht by 20% and asked for IMF
assistance. What momentous event had set the avalanche in motion?
Well, avalanches arent triggered by momentous events; one small dis-
turbance inicts another, and then turmoil builds until the whole fragile
system crumbles and collapses. Same with an economic crisis. The mo-
mentous events - those that undermined the system - happened long
before.
Thailand capitulated to a rumor: investors thought that the Japanese
central bank was about to raise interest rates, and they sold some baht
assets to acquire yen assets. The Thai central bank had to step in and
buy baht, in order to defend the peg. Thats when Thailands central
bankers and foreign investors were alerted to the fact that, owing to
huge current account decits in the recent past, dollar reserves had
shrunk to a minimum and were too small to support the current peg
much longer. Investors moved more foreign currency out of the country,
in anticipation of a devaluation, which forced the central bank to give
up the peg a self-fullling prophecy.
At dierent points during the crisis, Thailand and Korea ran down
their forex reserves to almost half the level of 1996. Malaysia suered
126
considerable depletion as well. Investors were wary now and looked for
other devaluation candidates in the region, who were running out of
reserves. Capital started moving out of the Philippines, and on July
11, the Philippine central bank had to devalue the peso and ask for
an IMF package. In the next weeks, as the full picture of the regions
problems came into view and investor sentiments turned gloomier, the
slide of the baht, peso, ringgit and rupiah accelerated.
On August 14, Indonesia gave up all pretense of supporting its currency
and let it fall freely, collecting $ 40 billion in IMF support over the next
months (despite bad blood and battles over policy). The rupiahs de-
scent continued for months because of political uncertainty (concluding
with president Suhartos resignation amid riots in May 1998). In Jan-
uary 1998, the country suspended service of its foreign debt.
In September, Singapore and Taiwan gave way to pressure for depreci-
ation (Taiwan switched to a oat). By October, the baht, peso, ringgit,
rupiah, Singapore dollar and New Taiwan dollar had on average depre-
ciated by 40%. Late October saw the panic spread to the Hong Kong
stock market, which lost a quarter of its value in four days, because
investors anticipated devaluation. A few days later, Western stock
markets fell through the oor: the Dow Jones saw the largest one-day
loss ever (554 points) as rm performance was expected to suer from
investment losses in Asia and low-cost import competition.
Another chapter opened when, on November 17, the won collapsed and
Korea requested and got a $ 60 billion bail-out package from the IMF.
Three months later, after foreign banks demanded immediate repay-
ment of short-term loans, and conglomerates and nancial institutions
drowned in a wave of defaults, Korea negotiated a $ 24 billion debt
roll-over with a creditor consortium. In the course of the crisis, only
Hong Kong and China avoided devaluation; the rupiah suered the
most dramatic decline, losing more than 80% of its value.
At this point, I might clarify what I mean by a crisis. It is, in my de-
nition, a situation where the going policy cannot be maintained without
outside help, or the market has to be restrained. Thus I classify Thai-
land, Philippines, Indonesia, and Korea, who sought IMF assistance,
127
and Malaysia, who implemented capital controls, as economies in crisis
in 1997.
Having let the events pass before our minds, well endeavor to explain
them briey. I think it presents itself as no coincidence that the collapse
originated in Thailand: this was the country with the most severe
current account decit, the thinnest reserves and most perilous foreign
debt structure among its commercial banks; in short, this economy was
most vulnerable to a shock, even of a small magnitude.
The baht crisis spread next to similarly indebted and structurally weak
economies in the region: Philippines, Malaysia and Indonesia. You
might have expected to see Korea on this list, and Korea had some
of the worst problems. But one problem Korea did not have: a xed
exchange rate. In mid-1997, investors were concerned with devaluation
and what their assets were worth. The won had already depreciated in
late 1996, and this adjustment probably spared Korea for a few months.
In the fall of 1997, the currencies of Singapore, Taiwan, Hong Kong
and Korea came under pressure for a dierent reason. These countries
were linked to the crisis-struck economies by competition in export
markets. The massive devaluations among their competitors translated
into equally massive real appreciation and loss of competitiveness.
In the context of contagion and pressure for depreciation, Hong Kong
got in trouble because its currency was so rigidly xed, and investors
feared that in trying to defend the peg, Hong Kong might deplete its
reserves and face a crisis as well. Hong Kong was, however, successful
in avoiding devaluation at the price of a recession, as we shall see.
In the case of Korea, real appreciation added to its many structural
problems and pushed corporations and banks into default. The sharp
collapse of the won in November and December burdened the other
currencies with new real appreciation that was not sustainable given
the shaky nancial conditions around the region.
Depreciation cycles continued through November and December, each
setting the stage for yet another round, until the injections of IMF
money and agreements on debt roll-overs began to limit the damage and
restore some condence among investors. Meanwhile, depreciation had
128
disastrous eects on the regions frail businesses: their external debt
multiplied in real terms and foreign creditors, nding their exposure to
the region much too risky, insisted on collecting short-term debt that
their clients expected to roll over. Firms and their banks collapsed
in domino fashion. Japanese nancial rms had lent heavily in Asia,
facing very low interest rates at home. Thus the Asian disease crept
into the Japanese economy as well, and lenders collapsed, worsening
Japans macroeconomic woes.
Baht, won and ringgit recovered somewhat in early 1998. The post-
crisis adjustments suggest that investors had been overly cautious and
thus exacerbated the situation. Their behavior can be accounted for:
(1) Information asymmetry: when negative disclosures about asset po-
sitions of countries and businesses take investors by surprise, they sus-
pect more skeletons in the closet and pull out. Lets call it collectively
probing the limits and guring out how bad things really are. But
across-the-board refusals to roll over loans forced viable borrowers into
bankruptcy, and pegs that might have been sustainable broke down
due to investor skepticism. (2) The policy calculus: when and where
businesses failed, and government bail-outs seemed likely, investors ex-
pected an increase in ination (due to seignorage to fund the bail-outs),
which raised expected real exchange rates and perceived overvaluation
further.
This is the time to consider the role of the IMF in bringing the crisis
to closure. Im sure you are at least faintly aware that a lot of criticism
was lodged against the IMF at the time so you might expect that
there was a dierence of opinions about how to ght the crisis.
Maybe a more accurate way of stating it is that there werent any pain-
less cures and that disagreements persist about which was least painful.
The IMF had a particular philosophy: it didnt just want to address the
symptoms; the IMF wanted to x the system that had produced overly
risky debt structures and overvalued currencies. IMF critics tended to
advocate more gradual solutions that would give struggling businesses
time to recover.
But, to begin at the beginning, why could Asian central banks not
ght the pressure on their currencies alone? I see two reasons: (1) In
129
a way, they didnt want to, because the cost of maintaining the peg
would have been recession. (2) Once investors stampeded out of Asia
and depreciation became self-reinforcing, a de facto guarantee of forex
supplies, as IMF intervention provided, was the only way to restore
condence and halt the crisis.
To understand why the price of defending the peg was a recession, lets
revisit the idea of interest parity. Arbitrage in nancial assets will en-
sure that expected returns on assets, in terms of a given currency, are
equal everywhere. If the exchange rate is nominally pegged, but in-
vestors begin to expect a devaluation, the only way to restore expected
returns on local nancial assets to parity with US assets is to raise local
interest rates. The central bank can raise interest rates by contracting
the money supply (selling bonds), but a consequence is a reduction in
investment spending and economic activity. Hong Kong alone followed
this route: the monetary authorities drastically tightened the money
supply, saving the peg, but steering the economy into recession.
Asian central banks were reluctant to raise interest rates because it
would have complicated the position of heavily indebted rms further:
they would have had to renance at greater expense, and the recession
would have further deteriorated earnings. Initially, some central banks
took the opposite route: they sterilized forex market interventions (i.e.
the sale of reserves, which has the eect of reducing the money supply)
by buying bonds to the keep interest rates low and the currency pegged.
But this just prompts further demand for foreign currency, given that
returns on local assets remain as low as before, so that the rationale for
the initial outow persists. As the central bank continues to sell and
sterilize, it depletes foreign reserves without any improvement. Asian
central banks soon gave that strategy up.
Instead, Thailand and Malaysia implemented capital controls to delink
onshore and oshore money markets (so that the central banks could
inject money, lowering interest, but not the exchange rate), which was
largely ineective, as capital controls usually are. If people really want
to move their money out of a country, they manage to do so somehow.
The result of loose montary policies, which were corrected much too
late, was a further depreciation of the currencies and increased real
130
value of the private external debt. The IMF was the last resort as
currencies plummeted and forex reserves vanished, but the IMF does
not regard its rescue packages as grants. They are loans, and the IMF
expects to be repaid. Therefore the IMF requires borrowers to take
such steps as it believes to be conducive to a current account surplus.
I have argued that Asias defunct nancial systems were partially to
blame for the crisis, and the IMFs reform programs, which were ne-
gotiated together with the loan amount with each country, addressed,
besides scal, monetary, and external imbalances, the nancial and reg-
ulatory architecture. Typical features of these reform programs were
scal discipline (low budget decits), contractionary money supply to
raise interest rates and avoid capital outows and banking sector re-
structuring (e.g. foreclosure of ailing banks and increased reserve re-
quirements).
Especially the IMFs stipulations to raise interest rates and let banks
fail (without government deposit insurance) were controversial, since
they spelled bankruptcy for heavily indebted corporations and carried
signicant social costs (rise in unemployment, bank runs in Indonesia).
The main alternative proposition was to control capital outows (as
a remedial measure) and capital inows (as a preventive measure, to
limit future current account decits). Supporters argue that, while
barriers to capital ows are permeable in the long run, they can promote
healthy debt practices in the short run (limiting foreign liabilities) and
aid in rebuilding the nancial sector. China installed successful capital
controls during the Asian crisis. Its central bank was able to lower
interest rates and maintain macroeconomic prowess (the only major
Asian economy to avoid a recession in 1997/1998) without depreciating
its currency. Paul Krugman thinks, this is why China evaded the crisis
despite having had many of the usual structural problems.
What is the best way to deal with a crisis, once it is underway, remains
a hotly debated topic. The eventual goals in Asia were clear: xing
the nancial system and the current accounts. The IMFs approach
to strengthen returns to local assets by raising interest rates, and
thereby ush out mismanaged corporations and banks was economi-
cally and socially disruptive, but quickly improved structures and put
131
the Asian economies back on a healthy growth track, as history has
shown. Capital controls appear to be a more friendly solution for
the short term, as long as they can be made eective. However, they
have the decided disadvantage of undermining investor condence in
the market in the future. No one likes the prospect of having his or her
returns temporarily conscated as the government sees t.
In choosing an appropriate policy mix, much would appear to depend
on the particular circumstances of the economy in question. But none
will be costless; past negligence in creating a solid nancial architecture
and good economic fundamentals must be paid for when a crisis strikes.
I hope we have given some sensical explanations for Asias crisis, and
yet an inconspicuous (you might say random) incident, a mere rumor,
got the train of events rolling. Yet there is no doubt that the bub-
ble economy of the 1990s, given too much latitude by weak nancial
systems that looked to the wrong incentives, drove Asia into the neigh-
borhood of a crisis, piling up current account decits and excessive
debt. There also is no doubt that quasi-xed exchange rates, that dis-
couraged risk management through hedging and, appreciating with the
dollar, had grown out of line with fundamentals, pushed Asia to the
brink of devaluation and a debt crisis.
What I am getting at is that the eruption of the crisis on July 2, 1997,
was not inevitable, and in that sense there is a random element. But:
shocks will come, and the shock that was to push Asia over was bound
to come, given the lack of resilience. In this sense, and I think it is the
more important sense, the crisis was no accident.
Economies that left the market some room to adjust fared consider-
ably better than those which stuck to pegged currencies. Singapore
and Taiwan permitted currency depreciations; of course, their nancial
systems were also healthier than most in the region, but so was Hong
Kongs, and Hong Kong suered severely in maintaining its currency
board.
Indonesia and Korea, which also preserved some nominal exibility, had
structural problems and current account decits of such magnitude that
they could not escape the crisis once it unfolded around them. Thai-
land, Malaysia and the Philippines were the prototype crisis economies
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overinvested in unproductive sectors and deeply indebted to foreign
creditors, they had pegged, overvalued currencies and a loose money
supply for too long.
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