Economic Principles I

MACROECONOMICS

Revision Notes
Contents
1. A review of the Aggregate Demand / Aggregate Supply Model: ........................................................ 2
2 Inflation and Unemployment ................................................................................................................ 9
3 ...Policy makers are impotent... (Sargent and Wallace 1976) ......................................................... 13
4 The Labour Market. ............................................................................................................................ 16
5. Monetary Policy: Ulysses and the Sirens........................................................................................... 17
6. Is there a Political Business Cycle?. .................................................................................................. 20
7. Fiscal Policy ....................................................................................................................................... 23
8. The Wide World Part I . ..................................................................................................................... 25
9 The Wide World Part II ...................................................................................................................... 32
10 Consumption and Investment ........................................................................................................... 34
11. Economic Growth I (Solow-Swan aka Exogenous aka Neoclassical Growth Theory): ....... 36
12 Economic Growth II (Endogenous and Schumpeterian Growth): .................................................... 42
13 Real Business Cycles. ....................................................................................................................... 44
14 New Keynesian Economics - Microfoundations. ............................................................................. 47


1. A review of the Aggregate Demand / Aggregate Supply Model:
Aim: To review the derivation of the AS-AD model
Learning objectives: To derive the Aggregate Demand schedule and the Aggregate Supply schedule.
Carlin & Soskice Chapter 2.

The AD/AS Model simply describes the short and medium-run equilibrium state of the
Macroeconomy under which the Price Level and Output balance. The AD curve represents a locus of
equilibrium between the IS and LM curves. The IS schedule is derived from Goods Market
equilibrium and the LM schedule from Money Market equilibrium. We then turn our attention to the
AS curve which is a graphic representation of Labour Market equilibrium.

IS Curve (Goods Market Equilibrium):


The IS curve is downward sloping as Investment shares an inverse linear relationship with the real
interest rate (which is plotted on the y axis) and hence the higher the interest rate the lower investment
(and vice-a-versa). Since Output is directly dictated by Investment (and Output is on the X axis)
higher real interest rate = lower Investment = lower levels of Output. Hence:


















1) Change in size of multiplier = change in gradient of IS Curve.
2) Change in interest sensitivity of investment = change in gradient of IS Curve.
3) Change in Govt. Spending = shift in IS Curve.
4) Change in Autonomous Consumption = shift in IS
Curve.

LM Curve (Money Market Equilibrium):


Speculative (Asset) Motive Transactions Motive

In equilibrium M
D
= M
S
(naturally), hence:


Since Money Supply is set exogenously by the BoE:
The Multiplier



















1) Increases in Velocity of Money = Flattening of the LM Curve.
2) Higher interest sensitivity of Asset Demand = Flatter LM Curve.
3) Increase in Money Supply = Shift outwards of LM Curve.
4) Price Level Increase = Shift inwards of LM Curve (since Real Money Supply falls).

Putting the IS/LM model together requires us to assume that the nominal and real interest rates are the
same (as we derive IS with the real interest rate (r) and LM with the nominal interest rate (i)). This is
why the IS/LM model only works in the Short-run (no inflation).

Key Assumption: Money Market adjusts rapidly whilst Goods Market adjusts slowly.















ISLM = AD:
Naturally this diagram is fairly self-
explanatory. Since the LM curve is referenced
with regard to the Real Money Supply, a
change in the Price Level will cause it to shift.
As it does so, the interest rate changes and
Output alters in the Goods Market to account
for this.

Therefore, for each and every Price level there
is a new equilibrium in the IS-LM diagram
with its own Output level.

It stands to reason from this definition of the




































Aggregate Supply:

The Perfectly Competitive (Neoclassical) Labour Market is a combination of a downward sloping
Labour Demand (Marginal Product of Labour) curve, which slopes downwards due to decreasing
returns to Labour inputs, and an upward sloping Labour Supply curve. Workers act atomistically and
have no wage bargaining power. Firms have no wage setting power either. The Competitive Labour
Market therefore looks like this:




(P.T.O for diagram)
























In the Imperfectly Competitive Labour Market however, things are different.

1) Wage Setting by Trade Unions: Finds a balance between Wages so high that they make the
firms price uncompetitive (hence reducing demand for their goods and thus employment) and
so low that Workers quality of life is reduced. The mark-up they attain is known as Union
Wage Premium.
2) Efficiency Wage Setting by Firms: Wage premium could also come about as result of firms
setting Wage above market clearing to attract most productive workers and with lowest search
costs to find them (they will come to you).

Efficiency Wages

Assume that there is a positive relationship between the wage paid by a firm and the effort put in by
its workers. This can be motivated in various ways:
1. Nutritional explanation: workers who are well fed can work harder (relevant for development
economics)
2. The wage acts as a signal for the firm to attract good quality workers, that is the firm is unable
to observe precisely the quality of the workers it hires and uses the wage as a signal.
3. The firm is unable to monitor precisely the effectiveness of its workers. Assume that the
penalty for being caught shirking is dismissal, then a higher wage raises the cost of shirking,
persuading workers to work hard.

Or as Henry Ford put it:
If you pay people peanuts, you get lazy monkeys.
Summarise all these arguments into an effort function such as:
) , (
R j
W W E E =
Where W
j
is the wage paid by the individual firm and W
R
the reservation wage which can be thought
of as a combination of unemployment benefits and the wage that workers could obtain working for
other firms (i.e. Transfer Earnings). Logically:
0
E
>
c
c
j
W
;
0
E
<
c
c
R
W

i.e. The greater the wage offered to the employee, the greater his Economic Rent (assuming Trasnfer
Earnings stay fixed), thus the opportunity cost of getting fired if he is caught shirking and hence the
greater effort the employee expends. Conversely the greater the workers Transfer Earnings, the less
his Economic Rent (assuming wages offered by the firm stay fixed) and the lower the opportunity cost
of the sack for shirking, thus the lower his efforts will be.
Now consider a representative firm that maximises profit, taking price as given.
N W PY
j
= H
Where we assume a production function of the type ) (EN f Y = because it is not just the labour input
(number of hours) that determines output but also the effort with which those hours are worked. Now
the firm needs to choose two things: the number of labour hours that it wants to demand (N) and the
wage it wants to offer (W
j
). So differentiating we have:
E
W
f P W E f P
N
j
N j N
= = =
c
H c
0 1

1 0 =
c
c
=
c
c
=
c
H c
j
N
j
N
j
W
E
f P N
W
E
N f P
W

Where f
N
is the marginal product of labour (notice the application of the chain rule to differentiate the
argument of the production function which is EFFECTIVE LABOUR that is the number of labour
hours multiplied by the effort). Now substituting the first condition into the second

1 1 =
c
c
=
c
c

j
j
j
j
W
E
W
E
W
E
E
W

which means that the condition for optimum is to choose that wage for which the elasticity of the
effort function with respect to the wage paid by the firm is equal to 1. Now this condition is purely
determined by the shape of the effort function and is totally unrelated to market conditions. Therefore
the level of the wage need not be the market clearing wage and it is likely to be above that level. The
result is a Wage Setting curve which lies above the Perfectly Competitve Demand for Labour curve,
hence involuntary unemployment and a rigidity (or stickiness) of the wage as it is only changes in the
effort function which are going to motivate the firm to change the wage it offers.
If you consider the diagram representing the effort function, the lower (towards the origin) portion
represents the region where increasing the wage increases the effort by more than the actual increase
in the wage. This means that the elasticity of effort w.r.t. the wage is higher than one. Graphically the
slope of the effort function at each point is increasing. Now, whilst the firm is in this region it pays for
the firm to raise the wage it offers, because it obtains a disproportionately greater increase in effort as
a result. Conversely in the upper region of the effort function (further away from the origin) further
increases in the wage do not lead to proportional increases in effort. Indeed the effort function tapers
asymptotically to a constant and after this point increasing the wage further will not lead to any higher
effort at all. So offering a wage in this region is not optimal, and the firm will lower its offer. In this
region the elasticity of the effort function is lower than one.
The only condition for optimum is precisely where the elasticity of the effort function with respect to
the wage offered is one, because any lower than that a marginal improvement in effort could be
obtained at the price of a less than proportional increase in the wage, whilst any higher than that level,
insufficient increases in efforts are obtained at the price of higher and higher wage rises. Graphically,
take a 45 line, where this line is tangential to the effort function we are going to have a condition of
unitary elasticity because the slope of the line tangential at that point and the ray from the origin that
connect to that point are the same. Knowing that point we can trace the level of the wage on the
horizontal axis.
There is no reason to believe that the effort function will be the same for all industries and indeed it is
likely to vary leading to different (involuntary) unemployment rates across different sectors of the
economy:
Hence the Wage Setting curve lies above the Labour Supply curve by a given margin:






















Thus there is Involuntary Unemployment at the market clearing wage (W
1
).

Another cause of Involuntary Unemployment is Price Setting by firms with greater control over price:
Generally a firm with the power to choose a price which maximises profits will pay a Real Wage
below the Competitive level and this translates into a Price Setting curve which lies below the Labour
Demand curve:





















In general, a flat Price Setting Labour Demand curve is used (for reasons I dont really understand, so
Im not going to bother to try and describe them).

By overlaying the Imperfectly Competitive Labour Market curves (WS and PS) on to the Perfectly
Competitive Curves (Labour Supply and Labour Demand) we can see the extent of Involuntary
Unemployment etc:























AD / AS not a particularly good model for analysing shocks and policy responses but is useful is
helping to determine the Price level and provides a further lens for comparing Macroeconomic models.

The Long-Run AS curve is vertical above a point determined by the Perfectly (or Imperfectly)
Competitive Labour Market Equilibrium level of Output. If Wages and Prices adjust immediately to
AD shocks then Output does not change in response to AD shocks, only Price level does. Hence we
move up and down a vertical AS curve.

The Short-Run AS curve is upward sloping however, because in the Short-Run Wages and individual
Prices are assumed to be fixed. Thus as AD increases (due to G, I or C
0
for example), Prices rise and
employers increase Output to sell at the new higher price. This is a movement along the SRAS curve.
When Wages are subsequently bid-up (in an attempt to return Real Wage to its former level), firms
immediately pass on this cost and prices rise again. Thus Real Wage has not increased and in the
Long-Run employment once more falls to its Long-Run level. In short, Employment level is fixed at
LRAS level because Real Wage will never rise whilst Wages and Prices are instantly flexible, and
since Real Wage is fixed, so is level of Employment. To encourage extra workers, youd have to pay
more.










2 Inflation and Unemployment
Aim: To introduce the Phillips relationship between Inflation and Unemployment in its different
incarnations.
Learning objectives: To distinguish between the short run and the long run Phillips curve.
To examine the effectiveness of stabilisation policies under different specifications of PC.
Carlin & Soskice Chapter 3.

Inflation is good because:
1) Oiling the Wheels of the Labour Market: Keynesians argue Nominal Wages are sticky
downwards. Hence if Price level whilst Nominal Wage constant, Real Wage and labour
market can adjust to new equilibria quicker.
2) Debt Relief: If Nominal interest rate on debt fixed, higher inflation = lower Real interest rate.
Often counter though by higher initial Nominal rates or variable Nominal rates.
3) Room to Manoeuvre: Moderate level of inflation tends to help keep Nominal interest rate
sufficiently above 0 to avoid a liquidity trap.
4) Tobin Effect: Moderate Inflation can stimulate Investment. Buying machines means your
cash isnt eroded by inflation and so its real value doesnt fall.

New-Keynesian Macroeconomists state 3 main causes of inflation (Robert Gordons Triangle Model):
1) Cost-Push Inflation: Increases in costs of raw materials (such as oil) and labour costs (due to
decreased productivity for example). Also known as Supply Shock Inflation.
2) Demand-Pull Inflation: Increases in AD due to higher G and C for example. This type of
inflation is more favourable to quicker economic growth as it stimulates investment to meet
higher Demand.
3) Built-in Inflation: Resulting from Adaptive expectations and linked to the Price/Wage
Spiral.

Phillips Curves:
Inertia-Augments Phillips Curve (based on Adaptive Expectations):

=
t-1
+ (y - y
e
)
Current Inflation Lagged Inflation Output Gap
This can be translated into a Philips curve diagram with Inflation on the y axis and Output on the x
axis:



















It is clear to see that each SRPC is defined by 2 things:

1. Lagged Inflation Rate (
t-1
) This fixes the height of the SRPC.
2. Slope of the WS curve. The steeper the WS curve, the higher the Wage increase / decrease for a
given fluctuation in Output level and hence the greater the change to Inflation for a given Output Gap.
This fixes the slope of the SRPC.

The Long-Run Philips Curve (shown in red) highlights the fact that Inflation is stable (i.e. constant) at
(and only at) the equilibrium Output level.

Lucas Critique: Phillips curve relationship may exist but cannot be exploited as attempts to do so
cause it to break down.

Disinflation is costly: Only way to reduce inflation in the above diagram is to increase Unemployment
above its natural level. Costless disinflation could be achieved in we could make actors forget
past inflation and have them incorporate their inflationary expectations, together with the Output gap
into their wage claims (and hence into actual inflation). This means that the Phillips curve is then
based on Rational expectations and the Expectations Augments Phillips Curve is given by:

=
t-1
+ (y - y
e
) +
Current Inflation = Expected Inflation + Multiple of Output Gap + Shocks

For the Inflation Target (
T
) set by the Central Bank to be credible, it must be consistent with:

=
T
+

i.e. The Inflation Rate does not systematically deviate from its target level (only randomly - in
response to shocks).
Rational expectations mean that the only difference between what economic actors expect Inflation to
be and what it turns out to be is given by random events (). I.e. rational economic actors do not make
systematic errors. When applied to our model, rational expectations means:

E
E() E(
T
+ ) E(
T
) + E(). Since the error term is expected to be 0:
E
=
T
.

Subbing this identity back into our first equation gives:

=
T
+ (y y
e
) +
If we re-arrange this, we get:

y y
e
= 1/ (
T
)
= 1/ (
T
)

Hence: y = y
e
+ 1/ (
E
) Lucas Surprise Supply Equation

This simply states that Output only deviates from its equilibrium level in response to deviations of
inflation away from expected inflation (caused by random shocks).

Lucas Supply highlights that under assumptions of Rational Expectations, Credible Monetary Policy
and Zero Inflation Inertia, there is no need for systematic Monetary Policy since economy returns
directly to equilibrium once shocks have disappeared. This is not in fact the case though, as Inflation
Inertia means that once shifted away from equilibrium the economy cannot return costlessly of its
own accord. Central Banks (as a consequence) regularly engage in systematic policies to stabilise
Output back to the equilibrium (the so called MR rule).

In reality both the Adaptive Expectations and the Rational Expectations models of the Phillips
curves are over-simplistic. Downplaying the information limitations faced by both policy makers and
economic actors and oversimplifying the expectations formation mechanism may lead to some
common problems, such as the suggestion of Phillips curves being able to forecast inflation more
accurately than is in fact the case or the indication of an exploitable long-run trade-off.

This all leads to the IS-PC-MR equation set by which Central Banks attempt to stabilise the economy
around its equilibrium level of Output:

If we simplify the IS equation which was:


To simply: y = A ar (i.e. Holding the Multiplier, Autonomous Consumption & Government
expenditure constant).
We can see that the only thing affecting Output is the interest rate (through its effect on Investment).
Thus there must be some stabilising rate of interest (r
s
) which corresponds with equilibrium Output:

y
e
= A ar
s


can subtract this identity from the IS equation to get:

y y
e
= a(r r
s
) (IS Equation)

i.e. Output Gap = some multiple of the gap between the stabilising interest rate and the actual rate.
Thus Central Bank will choose a rate of interest which will cause Output to change to a level
consistent with their inflation target.

The inertia augmented Philips curve needs no modification:

=
t-1
+ (y y
e
) (PC Equation)

N.B. Using Inertia Augmented because if we assumed Rational Expectations instead (Expectations
Augmented Phillips Curve) then there would be no need for systematic policy and thus no IS-PC-MR
rule anyway.

The final rule (MR Rule) is derived from the Central Banks Output Inflation trade-off.

y y
e
= b(
T
) (MR Equation)

States that given a certain Phillips Curve the Central Bank will choose a certain level of Output and
Inflation. Higher b = More Inflation Averse (indifference curves lie closer to LRPC):


































Sacrifice Ratio: Cumulative level of Unemployment required to achieve a given reduction in
Inflation.
Gradualist: Lower b indifference curves lie closer to LRPC (takes longer to reduce inflation).
Cold-Turkey: Higher b indifference curves further from LRPC (quicker to reduce inflation but
more unemployment required.

If SRPC is linear then Sacrifice Ratio same for Gradualist and Cold-Turkey. If not then it may differ.

LM Rule vs. MR Rule:

MR Rule (Keynesian):
i) Ultimate determinant of price level and inflation is policy,
ii) Instrument of policy is the short-term nominal interest rate, i.e. the Base Rate (possibly set in line
with the Taylor Rule),
iii) Active stabilisation policy,

Taylor Rule:

Set out in 1993 by John B. Taylor of Stanford University. It essentially states the magnitude of interest
rate change that a Central Bank should deliver in their attempts to deliver their inflation target:

r
0
r
S
= 0.5(
0

T
) + 0.5(y
0
y
e
)

Which essentially states that the Central Bank should choose an interest rate for which:

The difference between the interest rate (r
0
) and the stabilising interest rate (r
S
) is equal to half of the
gap between current (0) and Target inflation (
T
) plus half the gap between current (y
0
) and potential
Output (y
e
).

This was an empirical description of how the Federal Open Market Committee (FOMC) in America
(equivalent of the MPC) behaved. Not designed to be a hard and fast rule but more of a very close
guideline for Monetary Policy-makers.
Taylor Rule may have helped Rational Expectations in giving analysts a possible way in which to
guess Central Banks (if indeed they follow it).

Lags between interest rate cuts / rises and their real effects on the economy are assumed. According to
the Bank of England:
Maximum effect of a Base Rate change on Output (spending / saving decisions) is estimated to take
up to 1 year.
Maximum effect on Price level (inflation) is expected to take up to 2 years.

- Problem with MR Rule is the Deflation Trap (see Why not deflation in section 5). This requires
either Expansionary Fiscal policy or a recovery of Autonomous Investment or Consumption which
would all shift IS right.

LM Rule (Monetarist e.g. Friedman):
i) Ultimate determinant of price level and inflation is rate of growth of the Money Supply,
ii) Instrument of policy is the Money Supply,
iii) Passive stabilisation policy,

In order to operate monetary policy in a passive (LM Rule based) fashion (which is generally
considered sub-optimal), you can either fix the Money Supply or the Interest Rate. The way to choos
depends on whether shocks are predominantly in the Goods or Money markets. This is because:

- A fixed Interest Rate (MR Rule) works better for Money Market shocks.
- A fixed Money Supply (LM Rule) works better Goods Market shocks.

Poole (1970) suggests the above finding and also that the MR Rule is better than the LM Rule for an
economy characterised by shocks and lags in adjustment.

Milton Friedman conceded in The Financial Times, 7
th
June 2003 that the use of money supply
growth as a target has not been a success and that Im not sure I would, as of today, push it as hard
as I once did.


3 ...Policy makers are impotent... (Sargent and Wallace 1976)

Aim: To examine the role of the mechanism of expectations formation in the general equilibrium
model. To state and assess the Policy Ineffectiveness Proposition
Learning objectives: To understand the implications of the rational expectations revolution.
To derive the Sargent & Wallace PIP under one-term and multiple term contracts.
Branson Chapter 11 Snowdon and Vane Chapter 1.

Rational Expectations Revolution:

Rational Expectations by far most common Expectation Formation assumption used in
contemporary Macro.
Peoples Expectations Forecasts from model being used to describe them.
Early roots with John Muth (1960s) in Competitive Market Models.
Lucas made REH famous in 1970s and made it mathematically operational.
Made much of previous Macro obsolete.
Many modern schools of Macro based on REH including New Classical, RBC School, New
Keynesian, New Political Macro and Neoclassical Synthesis.
Lucas Critique: Nave to try to predict effect of a policy experiment based purely on historical
data.
Lucas (1976) Parameters of models should not be structural (i.e. Policy Invariant), they
should change when policy changes.
Lucas Critique implies we must model the deep parameters when forming Macro models
things like Preferences, Technology and Resource Constraints that govern individual
behaviour. Then we can add up all the Micro responses to a policy experiment and predict the
Macro outcome.
Micro foundations were always thought to be important, Lucas convinced Macroeconomists
that they were essential and Macroeconomists started to build Micro foundations into their
models, e.g. Pioneers Kyland and Prescott.
Most well known application of the critique is that systematic attempts by policy-makers to
exploit the Phillips Curve relation between inflation and unemployment will cause it to break
down.

Sargent & Wallace Policy Ineffectiveness Proposition (1976) New Classical theory:

- Adaptive Expectations not realistic agents do not make systematic forecasting errors.
- Rational Expectations means agents foresee Govt. (and Central Bank) actions and counteract
them immediately leaving the Govt. (and Central Bank) powerless.
- Only stochastic (random) shocks can affect Output level.
- Therefore adopt a constant money supply growth rule (such as Friedmans k percent rule)
which will avoid expectational errors (which are likely to drive us away from full
employment).

Derivation:

y = + a(
E
) + 1 Lucas Surprise Supply Equation.
= by + M + 2 Demand Function.

So, to apply Rational Expectations (to anything we are not going to get the above equations in the
exam, they will probably be substantially different) and derive the PIP, what we need to do is follow
some simple steps:

Step 1) Find Equilibrium Output in this case that means subbing 2 into 1 to get:

Step 2) Re-arrange and tidy up:

y = + a(by + M +
E
) + so: (P.T.O)

y + aby = + a(M
E
) + a + and:

(1 + ab)y = + a(M
E
) + a + then:

y = 1 / (1 + ab)[ + a(M
E
) + a + ] 3

Step 3) To find expected inflation, apply Rational Expectations to 2 and reduce:


E
= by
E
+ M
E
+
E


i) b is a constant and is therefore left unchanged by the expectations operator.
ii)
is a random shock and therefore its expected value is 0. This leaves:

E
= by
E
+ M
E
4


Step 4) To find expected Output, take Rational Expectations of 1 and reduce:

y
E
=
E
+ a(
E

EE
) +
E


i) Once again, a is a constant and is left unchanged by the expectations operator.
ii) is equilibirum output and is a constant determined by the state of the Labour Market,
hence as a constant it too is left unchanged by the expectations operator, so
E
= .



iii)
EE
would mean taking expectations of expectations and since the information set has
not changed, the expected value must stay the same for consistency, so
EE
=
E
.

iv) Since
EE
=
E
, then
E

EE
=
E

E
= 0, and bracket reduces to 0.

v) " is a random shock and thus its expected value is 0. This leaves:


y
E
= . 5 i.e. Output is expected to be at equilibrium level.

Step 5) Sub expected inflation (4) into 3 and re-arrange to get:

y = 1 / (1 + ab)[ + a(M (by
E
+ M
E
)) + a + ] then:

y = 1 / (1 + ab)[ + a(M + by
E
M
E
) + a + ].

Step 6) Remember to sub expected Output (5) in as well, then re-arrange to get:

y = 1 / (1 + ab)[ + a(M + b

M
E
) + a + ] then :

y = / (1 + ab) + a / (1 + ab) (M M
E
) + ab / (1 + ab) + 1 / (1 + ab)(a + ) thus :

y = (1 + ab) / (1 + ab) + a / (1 + ab)(M M
E
) + 1 / (1 + ab)(a + ) hence:


y = + a / (1 + ab)(M M
E
) + 1 / (1 + ab)(a + )


Which is the 1976 Sargent & Wallace Policy Ineffectiveness Proposition stating that Output only
deviates away from equilibrium as the result of either Policy Surprises: (M M
E
)
or Random Shocks: 1 / (1 + ab)(a + ).

Critiques:

Friedman: Questioned the assumption of the Rational Expectations hypothesis (do agents have the
cognitive power to second guess the Governments intentions?)

Grossman / Stiglitz: Even if they have the cognitive power, they cannot profit from finding out what
the Governments intentions are. Naturally there is a cost involved in being the first to investigate the
Governments intended actions, but by reacting to the knowledge that you have paid for the
information becomes freely available to all other agents who can then costlessly exploit this
knowledge. Therefore there is a disadvantage in being the first to find out and so no rational economic
agent would step up to the plate, meaning no-one finds out what the Government is up to and their
policies remain effective.

Fischer / Phelps / Taylor: Assumed multi-period contracts and hence PIP does not hold since
(even if we assume that someone has paid to find out what the Govt. is up to) agents cannot react if
their expectations of what the Govt. will do happen to change between periods. Also, Govt.
intervention is desirable here because if agents cannot react to shocks, but Govt. can, then Govt. has
the power to stabilise (i.e. return to equilibrium) the level of Output.

Barro-Gordon: Showed that the Govts ability to manipulate Output away for equilibrium (via
the Money Supply or Govt. Spending) would lead to a tendency for agents to assume that they would,
leaving them no choice but to do so. This leads to inefficiencies both for Govt and for agents and
therefore Govt would not wish to manipulate Output away from equilibrium even though they could
do so. Govts role was therefore limited to Output stabilisation only.

Lucas: Shows how the historical Philips Curve relation (trade-off between Inflation and
Unemployment) breaks-down if the Govt tries to exploit it. This is due to adaptive expectations and
accelerating Inflation above equilibrium Output. Again, this would render Govt attempts to keep
Output above equilibrium undesirable and they would thus not attempt it.

It was possible to include REH into Macro models without reaching stark conclusions found by
Sargent & Wallace. As a result PIP had less of a lasting effect than it might have. In preface to 1987
Dynamic Macroeconomic Theory Sargent himself admitted Macro policy could have non-trivial
effects.


4 The Labour Market.
Aims: To examine and understand the basic stylised facts about the labour market in advanced market
economies.
Learning objectives: To explain what it is meant by hysteresis.
Carlin & Soskice Chapter 4

- Equilibrium Rate of Unemployment is shifted by Supply Side Factors.
- Policy implications are two-fold:
i) AD shocks have a short-run effect on Unemployment, but not in the medium-run,
ii) AD is for stabilising the economy around the ERU, not for influencing its level.

Wage Push Factors:

When a Wage Push factor changes, it alters the distance between the Competitive Labour Supply
curve and the WS curve:
i) Unemployment Benefits = Margin narrows,
ii) Unions legal protection = Margin narrows,
iii) Weaker Unions (e.g. proportion of the workforce represented) = Margin narrows,

Price Push Factors:

Again, when a Price Push factor changes, so does the Mark Up per employee obtained by the Non-
Competitive firm over the Competitive one (i.e. the margin between MPL and PS alters):
i) Tax Wedge = Margin narrows,
ii) Mark-Up = Margin narrows,
iii) Productivity = Margin narrows,




Hysteresis:

Also known as Path Dependence, hysteresis is the phenomenon where if Unemployment stays
above its equilibrium for too long, this can damage the Supply Side and ultimately lead to an increase
in the level of ERU.
The theory postulates 2 main arguments in support of this:

i) Insider/Outsider Effect.
ii) Long-Term/Short-Term Unemployment Effect.

Insider/Outsider:
- Those still in employment after the increase in unemployment (due to Demand side shock) are
in a better bargaining position than those out of employment.
- This is because here are high turnover costs to replacing insiders with outsiders and so no
wage underbidding occurs.
- Insiders care only about keeping their job and increasing their wage, not creating new
employment for outsiders.
- Thus those who are out of employment remain out of employment (as they are unable to
underbid those still in employment) and the ERU rises.

Long-term Unemployed:
- Long-Term Unemployed = progressive loss of skills and an erosion of the psychology of
working life.
- Makes them poor substitutes for active labour.
- The greater the overall pool of Unemployed Labour that is accounted for by Long-Term
Unemployed, the less impact the Unemployment level has on wage setting.
- Traditional dampening effect that high Unemployment has on wage inflation is thus reduced.
- To limit scarring effects of long-term Unemployment, Welfare to Work initiatives use a
combination of stick (benefits taken away if active search not undertaken) and carrot (grants
for travelling to interviews and free training for interviews).


5. Monetary Policy: Ulysses and the Sirens.
Aim: To examine the case for and against discretionary stabilisation policies and for the independence
of the Central Bank.
Learning objectives: To evaluate the role of rational expectations in the design and formulation of
economic policy. To understand the main rationale in support for an independent central bank.
R.J. Barro and D.B. Gordon (1983) Rules, Discretion and Reputation in a Model of Monetary Policy
Journal of Monetary Economics Vol.12 pp.101-121.
Carlin & Soskice Chapter 5

BarroGordon Inflationary Bias:

There are 2 main reasons the Government would wish to deceive the public and make them think that
future inflation will be lower than they actually intend it to be:

1) Inflate away Public Debt.
2) Increase (Keynesian) Output: In a model with sticky prices (Keynesian), the ability for the
Govt. to unexpectedly increase the Nominal Money Supply would mean they could
temporarily (before prices adjust) increase the Real Money Supply, shift LM outwards,
increase Output and hence reduce Unemployment.

But the problem is (under Barro-Gordon) the public isnt soft and knows the Govt. is out to deceive
them.

- Govt. has a loss function (which will be given in the exam). When optimal inflation is
achieved, the loss function is minimised. An example is:
( )
2 2
2
1
2
1
y k y V
t t
+ = t

- We will also be given a Supply function. Lets take the Lucas Surprise Supply Function for the
sake of argument: y = + a(
E
).

What we need to show is that if the public believes the Govt. about its inflation target and signs
contracts based on this, that there will then be a temptation for the government to renege on its word
in order to minimise social loss (Dynamic Inconsistency Problem). We further need to demonstrate
that (fully aware of this) the public disbelieves the word of Govt. and sets its inflationary
expectations by second guessing what the Govt. will really do. They do this by minimising the Govt.s
loss function themselves and determining optimum inflation. They then build this level of inflation
(rather than the level the Govt. says it will aim for) into their contracts and so the Govt. is left unable
to deliver anything but that level:
Step 1) Public believes Govt. that they will aim for (say) 0% inflation.
Lucas Surprise Supply Curve then becomes: y = + a().
Govt. Loss Function thus becomes: V =
2
+ ( + a() k)
2
.

Step 2) Differentiate Loss Function and set FOCs:

V / = + a( + a() k) = 0.
= a( + a() k).
= a((1 k) + a())

So inflation will not be 0 at all if the Govt. minimises loss in the knowledge that is has managed to
deceive the public, it will in fact be much higher.

Step 3) Knowing this, the public will minimise the loss function themselves, initially leaving
inflationary expectations undetermined:

V / = + a( + a(
E
) k) = 0
= a( + a(
E
) k).
= a((1 k) + a(
E
)).

So they expect a level of inflation of: a((1 k) + a(
E
)). We can re-write this, therefore, as:


E
= a((1 k) + a(
E
)). Thus:

E
= a + ak a
2
+ a
2

E
. Hence:

E
a
2

E
= a + ak a
2
. And:
(1 a
2
)
E
= a + ak a
2
. Therefore:

E
= ( a + ak a
2
) / (1 a
2
).

Since the Govts Loss function (and hence its own optimal level of inflation) depends on the level of
inflation expected by the Public, the Govt. has no choice but to choose this level of inflation.

The problem is that this results in a greater social loss than if the public had simply let themselves be
duped in the first place. The only way that results in no Social Loss is if the Govt. is able to set a
credible inflation target consistent with equilibrium Output.
There are 3 main ways to do this. They are known as:

i) Replacing Discretion by a Rule (i.e. Commitment),
ii) Delegation,
iii) Reputation,

i) Commitment: If the timing of the game is altered so that Central Banks cannot choose inflation
after contracts have been signed by the public, then inflation bias disappears. One way to do this is to
create personal incentives for the Central Bank to stick to a set target for Inflation (e.g. a contract
which costs the governor his job if inflation goes outside its pre-set bounds).

ii) Delegation: If we delegate the task of Monetary Policy to an independent Central Bank which has
both:
a. A lower Output target (closer to equilibrium Output than the Govts Output target),
b. Greater Inflation Aversion (hence a flatter MR),

Then the inflationary bias will be reduced. When introduced this policy can produce costless
disinflation if (and only if) agents believe that policy makers have changed their preferences. But if
Govt. can give independence to the Central Bank, surely it can take it away again straight after
contracts have been signed and once again set a surprise inflation level? For this reason, Central
Banks are often constitutionally independent of Govt. and often use Commitment devices (such as the
one above) simultaneously.

iii) Reputation: Prisoners Dilemma exists for Governments as they face re-election.
Doesnt exist for independent Central Banks as they do not face re-election and
therefore there is no end-game for them.

Recent and Contemporary Global Examples:

Bundesbank: German Central Bank. First one to be given full independence from Govt. Thus fully
independent Central Banks are often said to be following the Bundesbank Model. The Bundesbank
was greatly respected for its control of inflation through the second half of the 20th century.

The Reserve Bank of New-Zealand: Responsible for independent management of Monetary Policy,
but with an inflation target set by New Zealands Finance Minister, hence not fully independent as in
the case of the Bundesbank.

The Bank of England: Same as New-Zealand.

Fixed Exchange Rate: Under fixed exchange rates (and with Open Financial Markets) the Central
Bank loses control of Monetary Policy and must use it solely to keep domestic currency in line with
the reference currency. In addition, the domestic inflation rate becomes determined by the inflation
rate in the reference nation. E.g.
- Bretton-Woods System of 1944 where reference currency was Gold (hence called the Gold
Standard). Collapsed in 1971.
- Bank of England in the 80s until the crashing out of the ERM debacle of 1992.
- The Currency Board used by Hong Kong which fixes the value of $1 at 7.80HKMA (Honk
Kong Dollars).

The Independent Monetary Policy Debate:

Questions about Inflation:

1) Why do we want low and stable inflation in the first place?
- Extremely high inflation leads to excess Menu and Shoe-Leather costs.
- Reduces economic performance Investment, consumption and hence Output all fall.
- High inflation is more volatile volatility is a problem because it increases uncertainty and
thereby undermines the information content of prices (leading to resource allocation
inefficiencies).

2) Why dont we want deflation?
- None of the 4 main benefits of inflation (see section 2).
- Deflation Trap: If Nominal interest rate = 0, but there is deflation then the Real interest rate is
+ve. If it is so high that it discourages Consumption then this could lead to even greater
deflation and push the Real interest rate even higher (and so on in a vicious circle deflation
can feed on itself). Unlike a process of rising inflation this does not require the co-operation of
the Central Bank to continue, in fact they are powerless as they cant drop the interest rate any
further to stimulate demand and stop the rot.

Given this information it is clear that the Central Bank should set a credible Nominal Anchor for the
economy which keeps inflation low and stable. So what is the best way of achieving this end?

Two Monetary Policies

See Section 3.


6. Is there a Political Business Cycle?.
Aim: To examine the possible existence of cycles generated by the timing of elections under
alternative assumptions over the political system and the mechanisms of expectation formation.
Learning objectives: To evaluate the role of the government objective function in determining
economic policy and the level of output and inflation, and the consistency of these levels with the
objective function of wage and price setters / voters.
To review the policy implications of an independent central bank for both UK and EU monetary
policy.
Carlin & Soskice Chapter 16.4 pp. 667-687
Alesina, Roubini and Cohen (1997) Chapters 2, 3;
Snowdon and Vane (1997) Chapter 8.

Different Political Models:

Rather than simply maximising some sort of benign Social Welfare function (as in the Barro-Gordon
inflationary bias example), we assess here the deeper motivations and actions of politicians to
establish whether they are accountable for the Business Cycle:
Nordhaus Opportunistic Model (1975):

1. Supply Curve characterised by an Expectations Augmented Phillips Curve:
( )
t t t t
E y y t t 0
1
+ =
2. Expectations are Adaptive:
( )
1 2 1 1 2 1
+ =
t t t t t t t
E E E t t t t
3. Politicians are identical. All wish to be in rather than out of office.
4. Two candidates per election, an Incumbent and a Challenger.
5. Incumbents lose, Challengers do not win.
6. Voters like Output Growth and dislike Unemployment and Inflation.
7. They vote entirely retrospectively. If the incumbent has delivered the above during their previous
period in office, then they are re-elected.
8. Past is heavily discounted (via the term in the above function) so that the performance of the
economy just before the election is crucial.
9. Policymaker controls inflation and unemployment through control of the Money Supply (not Fiscal
Policy or interest rate).
10. Timing of elections is exogenously fixed (better for the incumbent).

Under this model the prime interest of Govt. is re-election. Since Unemployment is generally
considered more damaging (and thus more unpopular) than inflation, a Govt. will (in order to be re-
elected) induce higher Output just before an election and then engage in costly disinflation after re-
election. Since the past is heavily discounted this will have been forgotten by the time of the
subsequent election and the same thing will happen. This produces swings in Unemployment which
explain the Business Cycle.
In his model, Nordhaus considers this behaviour to be common to all parties, irrespective of political
persuasion.

Alesina Rational Partisan Model (1987):

1. Supply Curve characterised by an Expectations Augmented Phillips Curve (again):
( )
t t t t
E y y t t 0
1
+ =
2. Expectations are Rational:
) (
1 1
O =
t t t t
E E t t
3. Politicians are different. Left wing are more concerned about Unemployment and less about
inflation than Right wing. Respective Utility functions are given by:
Left Wing: ( ) | |

=
+ =
0
2
*
t
t L L t
t
L
y b U t t |
Right Wing: ( ) | |

=
+ =
0
2
*
t
t R R t
t
R
y b U t t |

Where Left Wing Inflation Target (*
L
) Right Wing Inflation Target (*
R
) 0 and
Left Wing Output Weighting (b
L
) Right Wing Output Weighting (b
R
) 0

4. Two candidates per election, an Incumbent and a Challenger.
5. Voters have different preferences between Unemployment and Inflation and vote for the party most
suited to their preference. The ith Voter Utility function is given by:

( ) | |

=
+ =
0
2
*
t
t i i t
t
i
y b U t t |
6. Voters preferences for Inflation Target and the weighting given to Unemployment are distribute
across entire spectrum and subject to stochastic shocks.
7. Policymaker controls inflation and unemployment through control of the Money Supply (not Fiscal
Policy or interest rate) again.
8. Timing of elections is exogenously fixed (better for the incumbent).

In this model, political parties attempt to maximise the welfare of the section of society which their
votes come from. Lowerscale socioeconomic groups are more dependent on salaried jobs for welfare
and this is why they hate Unemployment so much, whereas Upperscale socioeconomic groups have
higher levels of wealth and are therefore more susceptible to the eroding effects of inflation, which is
why they hate inflation so much but are less fussed about cash flow from employment.
As a result, the Unemployment and Inflation rate are extremely dependent upon the party which is
elected:
i) Left Wing wins: Output higher in 1
st
period than 2
nd
.
ii) Right Wing wins: Output below full employment in 1
st
period and at y
e
in 2
nd
.

The reason for this is that people know that under a Left Wing Govt inflation will be higher than
under a Right Wing one, but inflation expectations are set before the outcome of the election is known.
Hence inflationary expectations are set somewhere in between depending on how likely people think
each side is to win. As a result the new Govt. can set a level of inflation not consistent with
expectations upon taking office and in the first period can hold Output (Employment) above or below
its Natural level.
In the 2
nd
period, however, the election result is (obviously) known and so people build it in to their
expectations, hence returning Output at equilibrium.

Hibbs (1977) had developed a Partisan Model which acted as the fore-runner to the Alesina (1987)
model above, the only difference was that the election of a Left or Right Wing Govt. was associated
(in his model) with permanently lower (or higher) level of Unemployment for the whole duration of
their office (rather than just for the 1
st
period as with Alesina).
The problem with this is that to accept it would be to deny the existence of an equilibrium level of
Unemployment (i.e. a Natural Rate of Unemployment) all together. This is why Alesina modified it.

Schneider (1978): Proposed that since all Govts have the option of either Opportunistic or Ideological
behaviour, they will engage in both, switching from Ideological to Opportunistic when their
popularity dips.

There was a decade or so of lull after the emergence of the Policy Ineffectiveness Proposition (why
would you both to study policy if it was ineffective anyway), followed by a new breed of PBC theory
which permitted Govts to effect changes in real economic variables even under REH due to either
imperfect information or policy surprises (e.g. Alesina)

Rogoff & Sibert Rational Retrospective Theory (1988): Rational Expectations version of the
Opportunistic Model:
- Voters choose party based on both their partisan preferences and the current state of the
economy.
- However, they rationally estimate how much the current state of the economy is down to the
incumbent Govts competence and how much is just good luck.
- There is no post-election recession.

Persson Tabellini Model:
This model concentrates on competent versus incompetent politicians. Whilst there are varying
assumptions about how competent politicians are selected (perhaps there mix of rewards and costs in
politics means that it only pays for competent politicians to enter the political arena? Yeah, Right! Or
perhaps political parties know who is competent and who is not and only select competent people?
Again, doubtful) Persson-Tabellini adopt the idea that competent politicians can signal their abilities
in ways which incompetent politicians cannot. Specifically, under this assumption, we find that:
1. How challengers behave matter much less than how incumbents do, giving rise to the idea that
Incumbents lose elections, Challengers do not win them.
2. Voters vote retrospectively because they are using signals given out by the incumbent in the
last period to judge whether they will be competent in the next period.
3. Voters care only about recent economic performance because only the most recently elected
politician can be re-elected, hence they are judging the incumbent only on his work and not the
work of his predecessors.
4. Surely Rational Voters can spot a pre-election induced boom and know that unemployment
will follow? Well, the boom can actually be a signal of competence to voters by Competent
politicians:
i. In a Separating Equilibrium model only Competent politicians are able to reduce the ERU
and they exploit this by setting Output high so high that it does not pay the Incompetent to
mimic them because they would have to accept a level of inflation which is too high for their
preferences.
ii. Therefore the costs of signalling are always higher for the Incompetent than the Competent and the
benefits of winning are always lower.
iii. As a result, the Incompetent accept loss in the elections.
iv. Therefore with a Separating Equilibrium the presence of a pre-election boom shows a well
functioning political system in which only the Competent are elected.

A Separating Equilibrium always exists, but if the gap between respective rewards and
respective costs is not so great, a Pooling Equilibrium may also exist where it pays the
Incompetent to mimic the Competent.
If this is the case then, knowing in advance of the Pooling Equilibrium, the Competent will
set optimal values for Output so as to minimise signalling costs (which would only be wasted
anyway) and accept that he will be copied.
Voter choice is once again random.


7. Fiscal Policy
Aim: To introduce fiscal policy issues.
Learning objectives: To examine essential choices in conducting fiscal policy
Carlin & Soskice Chapter 6

Macroeconomic role of Fiscal Policy is:

i) Provide Automatic Stabilisers:
- These insulate the economy to some extent from shocks to AD.
- Stabilisation provided is, however, mainly a by-product of structure of Tax and Social Security
system.
- These systems are typically designed to meet Income Distribution and Micro goalds rather
than Macro objectives.

ii) Stabilise Output around ERU.
- Using Discretionary changes in Tax and Govt. Spending.

iii) Plan financing of Govt. Spending to maintain a sustainable burden of public debt in the economy.

Automatic Stabilisers:

Tax Rate depends on Output. So do Govt. Transfers. As a result, this reduces the size of the
multiplier.
Smaller multiplier = Steeper IS curve.
Steeper IS curve = exogenous changes in I and C (AD shocks) have less of an impact.

- Budget Deficit falls decreases Output rises and increases when Output falls:
- Impact of Automatic Stabilisers is 0 when Output is at equilibrium (y
e
).
- When y < y
e
then Tax revenues decrease and Transfers increase, effectively increasing the
budget deficit. Opposite is true when y > y
e
.


To assess overall potency of automatic stabilisers, need to determine how households will
react to short-term changes in Disposable Income.
Under the Pure Permanent Income Hypothesis, households do not alter Consumption patterns
in response to short-term fluctuations in Disposable Income, only to changes in Permanent
Income.
However, poorer households likely to be more liquidity constrained than richer ones, hence
they probably will alter their Consumption patterns in response to short-term changes in
Disposable Income.

Discretionary Fiscal Policy:

The way in which a Govt. finances expenditure matters.

First: We will assume that households and firms consider Govt. Bonds they hold comprise part of
their wealth. Under this assumption, three possible financing methods exist:
i) Taxation,
ii) Bond issuance,
iii) Money creation,

Second: We will assume that households and firms are smart. They realise that Govt. Bonds issued
today will need to be repaid. To do this, the Govt. will (at some point) need to increase taxation. As a
result Bonds are considered the same as Taxation (this is known as the Ricardian Equivalence) and
this reduces us to just the two financing methods.

Fiscal Policy Transmission Mechanism:

G = y = (M
D
/P) = r = I

Hence an increase in Govt. spending crowds out some of the interest sensitive part of Investment
expenditure from the private sector.
This will obviously not occur if the interest rate is held constant (by allowing the Money Supply to
increase by the same as the increase in Money Demand shown above). This would require Monetary
and Fiscal Policy makers to work in unison.

Tax Financing

For a given increase in Govt. spending, the extra Tax revenue from increased Consumption is
insufficient to re-imburse the Govt. fully for their initial expenditure (because of that good-old
leakage named Savings).
Govt. budget deficit results.
What if Govt. raised t
y
so that increased Tax revenues were equal to increased spending and no
budget deficit resulted at the new equilibrium?
This is known as a Fully Tax Financed expenditure programme.
Govt. injects new spending and full force is felt by AD in the initial round.
When the Govt. taxes the same amount back, however, the same blow to AD is not felt in
reverse because only a certain proportion of the money taxed away would have been spent and
the rest would have been saved (and as we know, Saving does not increase AD, only
Consumption does). As a result C decreases by less than G increased by at the start and so it is
not a case of the Govt. giving with one hand and taking with the other, they actually can
stimulate higher Output in the economy without having to engage in either debt or money
financing.
Over time the increased Income from higher Output will lead to higher Money Demand and
hence higher interest rates (unless the Money Supply is increased accordingly), thus crowding
out some private investment and so IS curve may move back to its pre-stimulus level.




Bond Financing

If Bonds are considered wealth, then:
Govt. spending = IS
= IS further due to increased Consumption resulting from Real Wealth
effects of introduction of new Bonds.
= M
D
(if Consumption goes up due to wealth effects and Govt.
spending, naturally Money Demand goes up to finance the transactions).
Hence LM shifts to the left.

Ricardian Equivalence Debate:

It seems that many of the assumptions of the Ricardian Equivalence theory (which posits in essence
that households do not consider Govt. Bonds part of their wealth because they know they will be
taxed to repay themselves in future) are violated in practice and so the above Bond Financing results
are more accurate for the real world.

Money Financing:

Govt. sells Bonds to Central Bank (which prints Money to buy them).
Ruled out in most economies by the constitution of the Central Bank.
Monetary Policy cannot be used to provide both a nominal anchor for the economy and used at
will to finance Govt. expenditure.
Say, for example, that the economy was at y
e
and
T
. An increase in the Money Supply to
finance Govt. spending would lead to an outward shift of the LM curve and hence Output
above equilibrium (and thus inflation above
T
Central Bank would once again lose its
credibility, leading to the Barro-Gordon problem again).


8. The Wide World Part I .
Aims: To introduce the Mundell-Fleming model under different assumptions on the exchange rate
regime.
Learning objectives: To examine the effectiveness of monetary and fiscal policy in an open economy.
Carlin & Soskice Chapter 9 (excluding section 6)

Goods Market equilibrium in an open economy (ISXM Curve) :




Where = Marginal Propensity to Import and = Fixed Exports.

Real () Vs Nominal (e) Exchange Rates:

Price Competitiveness (aka Real Exchange Rate) = P*e / P
e = Nominal Exchange Rate, P* = Foreign Price Level, P = Domestic Price Level

e = Units of home currency required to buy one unit of foreign currency. (e.g. /$ or /)




Price Setting (Open Economy):

Prices can be set based on either home costs or based on the prices of equivalent goods in foreign
market (and hence on foreign costs).

(i) Home Pricing: P* = P - Increase in home costs = increase in home and foreign prices.
(ii) World Pricing: P* P - Increase in home costs = home prices up, foreign prices same
(profit margins squeezed and international competitiveness reduced).

International Competitiveness is often measured with Relative Unit Labour Costs (RULC):

RULC = Foreign Unit Labour Costs x Nominal Exchange Rate
Home Unit Labour Costs

RULC = ULC* x e
ULC

Law of One Price (LOP)

Real Exchange Rate () is always 1 (i.e. 1) since price discrepancies for identical goods would
lead to arbitrage across economies. In practice transport costs, barriers to international trade (both
legal and informational) and most notably non-tradeable goods mean that LOP is certainly not true
and fluctuations in follow fluctuations in e almost perfectly.

Purchasing Power Parity (PPP)

Based on LOP, PPP is the idea that all identical goods should costs the same when expressed in a
common currency, such that:
e = P
P*

e.g. If a Chocolate Bar costs 1 in Liverpool and the exact same Chocolate Bar costs 1.2 in Paris,
then the Nominal Exchange Rate (e) should be 0.833 (i.e. 83p is required to buy a ). In this instance
the Chocolate Bar costs 1 in both cities.
- Can be used to state whether you think a currency is over / undervalued against another.
- Does not take account of transports costs / local costs of living.
- Hence the exchange rate PPP would suggest and the actual Nominal Rate are often v. different

Balance of Trade is affected by:

Real Exchange Rate (competitiveness of Home Goods),
Global Output,
Domestic Output,
Marginal Propensity to Import,
broken down into 2 effects:

Volume Effect: = P
X

and P
M
= = Q
X
and Q
M
= Balance of Trade Improves.
Terms of Trade Effect: If Q
X
does not increase enough and Q
M
does not decrease enough, will
actually be spending more on M in terms of domestic goods than before, hence = Balance of Trade
Worse.

Marshall-Lerner Condition: If PeD
X
+ PeD
M
> 1, then (weakening of Home Currency) =
improvement in Balance of Trade (more Exports, fewer Imports). In short-run often not the case
(usually Short-Run elasticity is about half that of Long-Run), hence for the first 6 months or so of
Home Currency deterioration () we see a J-Curve effect and BoT actually worsens initially.

Short-term inelasticity due to goods being invoiced in Home currency, so e hence sees them pay
less immediately, whereas we pay more until contracts can be revised (and we charge them more in
our currency to return them to the amount they were paying in their own currency before ).

ISXM Curve:

1) Steeper than IS curve due to inclusion of leakage of Imports from circular flow, thus lower i
leading to higher C and I leads to reduced increase in Output (y).
2) Shifts in response to changes in e and hence . = XM and hence y (but same domestic
interest rate) so ISXM shifts outwards (assuming Marshall-Lerner holds).
3) Shifts in response to changes in y* (easy to see why).

Open Money Markets:

Assumptions:

i) Perfect International Capital Mobility,
ii) Home Country Small (cannot affect i*),
iii) Govt Bonds all have same level of Risk,
iv) Perfect Asset Substitutability: People only hold Domestic Money, but may buy either
Domestic OR Foreign Bonds.

- Any differential between i and i* will be immediately eliminated by currency speculators.
- Example: There are UK and US Govt. Bonds both offering 4% (i = i* = 4%).
- e = 0.75 (i.e. 1 buys $1.33). This is the assumed Long-Term Correct rate.
- If UK suddenly start offering 6.5%, then investors will immediately buy Sterling to get
attractive rate on UK Bonds, driving down e.
- They do this until the point at which the depreciation they expect in the over the course of a
year (back to e = 0.75) is equal to 2.5% (the same as the extra gain from holding s over $s)
and so equilibrium is restored. This point is e = 0.73125 so that 1 = 1.37 (if the pound
depreciates by 2.5% over a year then itll buy $1.37*0.975 = $1.33 again).

Hence when any interest rate differential opens up, immediately the Exchange Rate jumps up just
sufficient to eliminate the Interest Rate gains. These jumps in price (in Financial Markets unlike in
Goods Markets) are very commonly observed (see Dornbusch Overshooting Exchange Rate Model).

Uncovered Interest Parity (UIP) Condition:

Long-Run e is obtained when i = i*:



























Naturally the key features of the UIP condition are:

i. Every UIP curve must cross the point where i* and e = E(e) intersect.
ii. For a given Expected (or Long-Term) Exchange Rate a decrease in i* will shift the UIP inwards
and an increase will shift it outwards.
ii. For a given i* a higher Expected (or Long-Term) Exchange Rate will shift the curve outwards and a
lower Expected (or Long-Term) Exchange Rate will shift the curve inwards.

In a pegged exchange rate, if traders revise their expectations of the Expected (or Long-Term)
Exchange Rate then the Govt. will have to intervene by changing the domestic interest rate away from
i*. E.g.

- Traders downwardly revise their Expected Sterling / Deutschmark Exchange Rate from 50p
per DM to 60p per DM. As a result the UIP curve shifts outwards.
- But UK has an accord with Germany to keep e = 0.5 and hence must intervene.
- UK must increase domestic interest rate above i* so that the extra benefit of holding UK
Bonds (and hence the Sterling to buy the Bonds) is equal to the depreciation over the course of
1 year between 50p/DM and the Expected Long-Run Exchange Rate of 60p/DM.

This is why on 16
th
September 1992 (Black Wednesday) the John Major government was forced to
raise interest rates to 15% in an attempt to keep the from depreciating below its agreed lower limit
with DM.

Alternatively, the Central Bank could enter the FOREX market and buy up Sterling (by selling its
Foreign Currency Reserves) to shore-up the price of Sterling. This is again what went down on Black
Wednesday when the BoE spent 27bn of foreign reserves trying to prop up s. By the end they
apparently had nothing but Sterling in the vault!

Mundell-Fleming:

Assumptions of the Mundell-Fleming Model:

1) Prices and Wages are fixed. = 0.
2) Home economy is too small to affect i* or y*.
3) Perfect Capital Mobility and Perfect Asset Substitutability. i.e. UIP holds.

Mundell-Fleming consists of 4 elements:

i. ISXM curve,
ii. LM curve,
iii. UIP curve,
iv. i = i* line,

i. Mundell-Fleming and Monetary Policy:

Fixed Exchange Rate: Monetary Policy becomes Ineffective as the Central Bank is committed to
maintaining an Exchange Rate peg.
The only way to effect the equivalent of a Monetary Policy change here is to perform a
discrete adjustment of the Exchange Rate Peg.
If the MPC wanted to reduce Output (for example), then they would need to change the peg
and lower e (domestic currency appreciates). This reduces X and increases M, causing the
ISXM curve to shift in.
Interest rate drops below i* and Hot Money flows leave the UK.
This would normally devalue domestic currency away from its new peg (due to excess supply
of ) so the MPC must step in and buy up the Sterling.
Monetary base therefore shrinks and LM curve shifts inwards, forming a new equilibrium at
the world interest rate (i*) with lower Output.

However!

Regular fluctuations in the Exchange Rate peg cause speculators to lose confidence in it and to
begin speculating on future adjustments to it.
As a result, the MPC will have to adjust the interest rate to maintain whatever peg it is that
they have going at the time and so Fixed Exchange Rates cannot survive in an atmosphere of
Exchange Rate speculation (see Black Wednesday and the ERM).
There are hence limits on the extent to which the MPC can fuck about with the Exchange Rate
Peg, using it like it were independent Monetary Policy.

Flexible Exchange Rate: Monetary Policy becomes Super-effective as both the ISXM and LM
schedules move.

Graphically:

Fixed Exchange Rate:
BoE performs Expansionary Open Market Operation by purchasing Bonds.
Bonds price = interest rate .
interest rate = Capital Inflows = Demand = Value = e
BoE must reduce e again by increasing i back to i* (by reducing Sterling Money Supply).
BoE performs Contractionary Open Market Operation by selling Bonds until initial Money
Supply increase is completely eroded. Hence LM moves out and directly back in again:













Flexible Exchange Rate:
BoE performs Expansionary Open Market Operation by purchasing Bonds.
Bonds price = interest rate.
interest rate = Investment & Consumption = AD = ISXM Curve shifts Outwards.
Also, interest rate = Capital Inflows = Value = e = (assuming Marshall-Lerner) AD = ISXM
Shifts Outwards again.
This depressed currency persists until interest rate returns to i*, at which point currency returns to
its Long-Run (Expected) level and new equilibrium is reached at i = i* with extra-high Output:




ii. Mundell-Fleming and Fiscal Policy:

Fixed Exchange Rates: Whereas Monetary Policy was completely ineffective under fixed exchange
rates (because the Central Bank is obligated to maintain a given peg), Fiscal Policy is extremely
effective in raising (or reducing) Output.

Government engages in Expansionary Fiscal Policy.
ISXM Shifts outwards increasing Output and increasing interest rate (i).
i moves above i* and attracts Hot Money Flows, thus Value = e
But e fixed by BoE and hence they must engage in Expansionary Open Market operations to
increase M
S
and reduce i. This shifts LM outwards, increasing Output even further:
























Flexible Exchange Rates: Less effective than it would be in a closed economy and certainly less
effective than above:

Government engages in Expansionary Fiscal Policy.
ISXM shifts outwards. Output and i.
i = Hot Money Flows = e but BoE not obliged to step in.
e = UK less competitive = XM = Output = ISXM curve moves back in (possibly even to
its old, pre-Govt stimulus position):

























All of the above point to the impossible triangle or open-economy trilemma under which it is
possible to maintain only two of the three things below in a small open economy:

i. Open Capital Market,
ii. Fixed Exchange Rate,
iii. Independent Monetary Policy,

Given the increasingly globalised nature of Capital Markets, the assumption that (a) will definitely be
chosen and that only one of (b) or (c) will be chosen is becoming ever more ingrained.


9 The Wide World Part II
Aim: To introduce the Dornbusch overshooting model of exchange rates behaviour.
Learning objectives: To (again) examine the effectiveness of monetary and fiscal policy in an open
economy.

Dornbusch Exchange Rate Overshooting Model:

Overshooting occurs when agents have Rational Expectations but the Goods Market adjusts
sluggishly to Monetary Policy changes. This is a much more realistic model of the real world (rather
than Adaptive Expectations or a rapidly adjusting goods market) and helps to explain why there is so
much exchange rate volatility in the FOREX markets.























The above diagram outlines a graphical model of overshooting. We assume (as stipulated above) that
Rational Expectations causes currency traders to respond to Policy announcements immediately and
that Goods markets only respond slowly (there is a wealth of evidence to support these assumptions,
Carlin et al. (2001) suggest that full effect on export market share of a change in r can take 5 to 6
years to feed through!). So:

MPC decreases Money Supply in an attempt to control inflation (for example).
LM shifts inwards from LM to LM.
Traders react immediately, setting the new UIP curve at UIPz (with their Long-Run
expectations of the exchange rate set to ez).
They set it here because they know that when Output adjusts fully to yz (i.e. the ISXM curve
shifts inwards to ISXM(ez)) this is where the equilibrium Exchange Rate will lie.
In the Short-Term, however, the Goods Market is slow to react and the interest rate
consequently stays high.
Because of this, international speculators keep buying Sterling Bonds (to get the extra interest)
and driving an appreciation in the exchange rate until the expected depreciation in the
Exchange Rate over the longer term (to ez) is equal to the extra benefit they get from holding
UK bonds, this is an Exchange Rate of eb which is naturally above ez.
The opposite process works for an Expansionary Monetary Policy.

Implications:

The Exchange Rate volatility in the Dornbusch model is considered bad as it can lead to a
misallocation of resources. E.g:
Resources can be taken away from the tradeables sector and re-allocated to the non-tradeables
sector (which is impervious to fluctuations in Exchange Rate as Output here is not traded
internationally).
Production units in the export sector may be closed prematurely and / or investment may be
carried out based on Exchange Rate signals which do not reflect fundamental economic
conditions.

Details:

Size of Overshoot depends on the expected lag before Goods Market adjusts to new
equilibrium. Quicker adjustment = Smaller Overshoot.


10 Consumption and Investment
Aim: To introduce inter-temporal models of consumption.
Learning objectives: To compare and contrast the permanent income and life cycle hypotheses
Carlin & Soskice Chapter 7 (excluding pp. 234-243)

Consumption:
Keynesian Consumption Function (Derived from Keynesian Cross diagram):
C = + C
y
(y T)
i.e. Consumption = Autonomous Consumption () + MPC*Disposable Income.
However, this model predicts Consumption which is far too volatile to fit with the data. Here current
Consumption depends not on long-term income, but solely on what you are earning right now.
Modigliani-Brumberg (1954) Life-Cycle Hypothesis (LCH):
- Rests on the assumption that agents are forward-looking, able to predict with certainty their future
income, able to borrow and lend on the same terms and prefer a smooth consumption pattern over
a volatile one.
- In youth agents will borrow (as they typically have a low income due to low productivity), in
middle-age their Income rises due to increased productivity and they first repay their debts from
youth, followed by saving for their future when they know that their productivity (and hence their
salary) will fall. In this way they are able to sustain a relatively constant level of Consumption
throughout their lives.
- In this model, Consumption is not volatile as short-term fluctuations in Income do not affect short-
term spending at all and even Long-term Income fluctuations are also inbuilt slowly into current
Consumption:













Friedman (1957) Permanent Income Hypothesis (PIH):
This is an extremely closely related model in which agents take their expected average income during
their lives and spend commensurately, using borrowing and saving services to smooth intertemporal
Consumption.
In the same way that current changes in Income do not affect Consumption if they are perceived to be
transitory, so too Consumption can change if agents revise their expectations of future Income (due to
some piece of news for example) even if current Income has not changed.
We can model our assumption that households prefer smooth consumption using good-old
Indifference Curves, Budget Constraints and Utility Maximisation (assuming that Households enter
and exit the world with no money and that they are able to borrow and lend on the same terms):

As we can see from the diagram to
the left, the Budget Constraint
remains constant, but a Utility of
only 100 (for example) is
delivered when there is an
extremely high level of
Consumption in 1 period and an
extremely low level of
Consumption in the next (or
previous) period as with A and B
(respectively).
On the other hand, a similar level
of Consumption in both periods
(as with C) delivers a Utility of 200 (for example).



- If there is an increase (or decrease) in Income in either period then (as long as period 2
increases are known about before period 1) this will lead to a parallel shift outwards in the
budget constraint.
- A 45 (Symmetrical) budget constraint implies neither patience nor impatience in allocating
resources.
- If the interest rate were Zero then there would equally be no tendency towards period 1 or
period 2 Consumption either. This is because foregone Consumption in the 1
st
period is not
rewarded with extra (or punished with less) Consumption in the 2
nd
period over and above (or
below) the initial foregone Consumption.

Empirical Evidence:
Credit Rationing:
Since the worst thing that can happen to an individual is that they go bankrupt, their Utility is bounded
on the down-side it does not make a difference to a bankrupt whether they cannot repay large debts
or huge debts. Because of this, they would tend to borrow too much (adverse selection) and over-
consume today, thus increasing their chances of default and raising the risk for banks. As a result,
banks limit the amount that an individual can borrow against future income, regardless of what the
individual thinks his income will be in future.
Thus in conclusion PIH has empirical shortcoming whilst the Keynesian model has conceptual
(theoretical) shortcomings.


11. Economic Growth I (Solow-Swan aka Exogenous aka Neoclassical Growth
Theory):
Aim: To evaluate the contributions to the growth of output from labour and capital inputs and total
factor productivity.
Learning objectives: To examine the causes of economic growth with reference to the neo-classical
(exogenous) and Solow growth models, and in particular the role played by the rate of saving,
population growth and technical progress.
Carlin & Soskice Chapter 13
Charles I Jones Introduction to Economic Growth chapter 2-3

Background to Economic Growth:

It is clear that going all the way back to Adam Smiths An enquiry into the Nature and Causes of the
Wealth of Nations, there have been questions about disparities in wealth across lands. Specifically,
Why are We so Rich and They so Poor? We now lay out 7 main stylised facts about economic growth
and in this (and the next section) go about building models which endeavour to explain these
observations:

1. There is enormous variation in per capita income across economies. The poorest countries have
incomes that are less than 5% of those in the richest countries.
2. Rates of economic growth vary substantially across countries.
3. Growth rates are not generally constant over time. For the world as a whole growth rates were close
to 0 over most of history but have increases sharply in the 20
th
century. For individual nations, growth
rates also change over time.
4. A countrys relative position in the world distribution of per Capita incomes is not immutable. That
is to say that countries can move from being poor to being rich and vice-versa.
5. In the U.S.A over the last century, there are several curious observations to be made:
i. The Real RoR on Capital shows no trend upward or downward.
ii. The shares of income devoted to Capital (rK / Y) and Labour (rL / Y) show no trend (they are
constant over time).
iii. The average growth rate of Output per person has been positive and relatively constant over time
(i.e. the USA exhibits steady, sustained per capita Income growth).
6. Growth in Output and growth in the volume of international trade are closely related.
7. Both skilled and unskilled workers tend to migrate away from poor countries or regions towards
rich countries or regions.

The Harrod-Domar Model:

The pre-cursor to the Solow model of growth was the Harrod-Domar model.
Commonly used in Development Economics, the model was initially developed to help
explain the Business Cycle, but is now more widely used to analyse growth in LDCs.
It has a (fairly simple) mathematical derivation which I cant be arsed explaining, but it
essentially suggests that:
i. Growth depends on the quantity of Labour and Capital.
ii. More Investment leads to Capital accumulation which generates economic growth.
iii. Because it does not feature diminishing returns to Capital, more Investment always
generates growth.
The Solow Model:

Solow was awarded the Nobel Prize in economics in 1987 for this model of growth. Solows model is
built around 2 basic equations:

1) The first is a standard Cobb-Douglas Production function exhibiting CRS (implying Perfect
Competition):
Y = f(K, L) = K

L
(1
-
)


N.B. Since we are assuming Perfect Competition then maximisation (by differentiating and setting
FOCs) of the profit function (which is of course: = P*K

L
(1
-
)
r*K w*L) would show that each
factor of production is paid the value of its respective marginal product.

Since we are often as bothered about Output per worker (y) as about total Output (GDP) we clarify the
convention from here that lowercase letters stand for per worker, so that:
Output per worker (y) = Y/L and
Capital per worker (k) = K/L.
From this we see that: y = k

< 1 (usually 0.33)

Hence y as k, but with diminishing returns It doesnt matter how many extra machines you give
him, at some point a man is going to have reached the limit of how much he can produce. Whislt there
are Constant Returns to Scale for the entire production function, there are thus Diminishing Returns to
individual factor inputs.

2) The second important equation is a Capital accumulation function:

K/t = sY dK

i.e. Change in Capital Stock over time = Gross Investment (Savings) minus Depreciation.
N.B. Term (ii) in the equation (Gross Investment) is considered equal to Savings since the economy
is closed and Investment must therefore be equal to Savings.
Term (iii) represents depreciation. d is usually some decimal which dictates what percentage of
the Capital Stock becomes defunct in each period (often d = 0.05 is used, implying a 5% wear rate).
Notice that this term is not a function of Output i.e. that %age of the Capital Stock will wear out
regardless of how much we produce.

If we also consider that an exogenous increase in the labour force (n) without a change to the
participation ratio will reduce the Capital per worker (assuming no commensurate increase in Capital)
then we can derive a term for the Capital accumulation per worker of a given period (V. Important!):

k/t = sy (n + d)k

This takes us on to plotting the basic Solow diagram:
(See Overleaf)

We can thus see that where the curves cross, there is a 0 growth rate of Capital per worker (and hence
Output per worker) over time. This is known as steady state.







Mathematically you can obtain the growth rate of a variable over time by taking natural
logarithms and then differentiate with respect to time.

If we were to do this, we could find out what point the growth rate of Capital per worker and Output
per worker are 0 and thus calculate an expression for the steady state:

At the steady state, Capital per worker would be:
( )
o
(

+
=
1
1
*
d n
s
k

and output per worker would be:
( )
o
o

+
=
1
*
d n
s
y


We notice three things from this straight away:
1. Output per worker is related proportionally to Capital per worker (as discussed earlier).
2. Countries with higher savings rates (s) will (ceteris paribus) tend to be richer (through greater
Capital per worker and hence Output per worker) than those with lower savings rates (since s is the
numerator and thus as it gets bigger the value of the overall expression gets bigger).
3. Countries with higher population growth rates (n) will tend to be poorer (through lower Capital per
worker and hence Output per worker) than those with lower population growth rates (since n is part
of the denominator, the larger it gets the smaller the value of the overall expression becomes).

This basic form of the Solow model (without Technology) makes several statements:
An economy may only grow in the Short-Run whilst obtaining a steady state level of Capital
per worker. At some point it will obtain steady state and thus growth of Capital per worker
(and hence Output per worker since the two are proportionally related) will become 0 where
it will remain for the Long-Run.
This contrasts with other growth models where it is assumed that as long as you are investing
in machinery, then growth will continue (i.e. no diminishing returns to Capital input). This
view point is known as Capital Fundamentalism.
Poorer economies should converge with richer ones. Those which start off with relatively
lower Capital (and hence Output) should experience a relatively quicker increase in Capital per
worker (k) since the further you are from steady state the quicker you move towards it. Those
who are already very close will be moving very slowly towards it and so will be caught up.
Those already there will be stationary and will also be caught up. This is known as the
Hypothesis of Unconditional Convergence. It assumes, however, that all countries have the
same steady state level of Capital per worker. In reality this does not happen due to the
peculiarities of the individual nation (factors such as Savings rate (s), Population growth rate
(n), Technology growth rate (g) etc).
This gives rise to a weaker form of convergence hypothesis called (surprisingly) the
Hypothesis of Conditional Convergence under which economies only converge if they have
the same steady state level of Capital per worker (denoted k* in the above diagram). If not
then it is still possible that a given economy may grow more quickly than another if (and only
if) it happens to be further from its own equilibrium (k*) than another economy is from its own.

Technology (manna from heaven):

In order to generate sustained growth in Output per worker, we must (as Solow did) implement
technological progress into the model. The production function becomes:
Y =f(K,AL) = K

(AL)
1-


Entered this way, technology is said to be Labour-augmenting or Harrod-neutral. This
means that the way in which technology takes effect is to augment the productivity of the
existing Labour force on the existing Capital Stock.
Solow gave technology as exogenous. We also make the assumption that A is growing at a
constant, given rate (g).
In per capita terms the technology augmented production function is thus given by:

y = f(k, A) = k

(A)
1-


To obtain a relationship between the growth rates of Output per worker (y), Capital per worker (k) and
Technology we once again take logarithms and differentiate w.r.t time. This gives:







Another name for Technology is Total Factor Productivity.
Since the growth in Capital per worker is directly observable, we can perform the neat little
trick of taking this away from growth in Output per worker. Solow said that once you
accounted for growth in Capital per worker the remaining growth in Output per worker was
due to increases in Total Factor Productivity (or Technology).
For this reason growth in TFP (often denoted (1-)g) is known as the Residual, or often
the Solow Residual sometimes even the measure of our ignorance.

Stated another way the above equation tells us the contribution to the growth in Labour productivity
contributed by Capital Deepening and the growth in Labour productivity contributed by Total Factor
Productivity. This is known as Growth Accounting, introduced by Solow in 1957.
We now introduce the and terms. We define as Capital per effective (or technology augmented)
worker and as Output per effective worker.

Just like before, Output per effective worker is proportional to Capital per effective:

o
k y
~
~
=

Also like before:

Which essentially states that the growth of Capital per effective worker over time is a function of the
Savings (or Investment) rate (s), Population growth rate (n), Total Factor Productivity (or
Technology) growth rate (g) and Depreciation (d).

The diagram is just the same as before, except the equilibrium or steady state depicts a point at which
there is 0 growth of Capital per effective worker.
The important difference is that there is still growth of Capital per worker, but technology increases
stave off the effects of Diminishing Returns to Capital inputs. As a result, Output, Capital, Population
and Consumption are all growing in proportion and the economy follows a balanced growth path.

As before, we can determine expressions for when the economy is in steady state by setting the
growth rate of Capital per effective worker equal to 0 such that:


At the steady state, Capital per effective worker would be:


And Output per effective worker would be:


So we can simply see that it is the same as before, except that the value are reduced because of the
presence of g in the denominator of the expression. If the growth rate of technology (g) were to be 0
then it is easy to see that the results would be exactly the same as the Solow model without
Technological progress.



















Essentially what we
are saying,
therefore, is that in this Technology augmented Solow model, Long-Run growth in Capital per
worker is possible, even once youve reached the steady state.
What becomes constant (and therefore has a 0 growth rate) when you reach the steady state is not
Capital per worker (as with the previous model) but Capital per effective worker (also known as
the Capital-Technology ratio).
The growth of Capital per worker on the other hand is determined at steady state by Technological
growth (g).

As with the previous diagram, economies below equilibrium will find that there is more Investment
than necessary to keep the Capital-Technology ratio constant. As a result Capital is increasing more
rapidly than Technology and so the ratio increases towards equilibrium.

Again, the Comparative Statics of a random increase in Investment or Population growth are the same
(red curve shifts up and blue curve shifts up respectively).

In this Neoclassical model, there is (of course) no role for Govt. intervention. If they were to increase
the rate of interest and stimulate higher Saving (and hence higher Investment) then they could only
increase Growth in the Short-Term. Once Capital per worker has reached its steady state, then there
will be no further growth in Output per worker. That is to say, that in the Long-Run they could only
have a level effect (where they increase the overall level of GDP but not its growth rate).


12 Economic Growth II (Endogenous and Schumpeterian Growth):
Aim: To evaluate the role of ideas and imperfect competition in the context of economic growth
models.
Learning objectives: To examine the causes of economic growth with reference to the Romer model
of endogenous growth.
Carlin & Soskice Chapter 14
Charles I Jones Introduction to Economic Growth chapter 4-5

Endogenous Growth theory proposes a no. of mechanisms for overcoming diminishing returns to
Capital and thereby opening up the possibility that changes in Policy or preferences can affect the
growth rate in the Long-Run steady state.
It was developed in the 1980s as a response to criticisms of the Solow-Swan model.
Endogenous growth theory demonstrates that policy measures can have an impact on the long-run
growth rate of an economy. For example, subsidies on research and development or education
increase the growth rate in some endogenous growth models by increasing the incentive to
innovate.
Production function:
Y = AKL
Therefore y = Ak (known as the AK Model for obvious
reasons)
N.B. There are no diminishing returns to Capital input (the coefficient is 1) and thus CRC.
In this model, the Capital Accumulation function is given by:




- Higher Savings Rate (s) raises the growth rate of the Capital stock and the growth rate of
Output permanently.
- Exponent on Capital in AK model always has to equal 1.
- Growth in Output per worker = sA d.
- Higher Savings (s), a greater level of Technology (A) and lower Depreciation (d) all positively
affect Output growth.
- Does not exhibit convergence.
- No Transition Dynamics as Output growth immediately jumps to its new level following a
change to any of the aforementioned variables.


Further Endogenous Growth Theory:

Economy populated by numerous firms, each of which is characterised by a Cobb-Douglas
Production Function:
Y
i
= K
i

(AL
i
)
1-
[1]

Knowledge (Technology) is considered a Public Good (i.e. available to the public at 0 cost).

A = A
0
k

[2]
Subbing [1] into [2] gives: Y = K

(A
0
k

)
1-

Hence: Y = A
0
1-
k
(1-)1-
L
1-


Diminishing returns to Capital at an individual Firm level.
Constant Returns to Capital at the aggregate level.
Increasing Returns to Scale for the economy as a whole: ((1-)++1) > 1
Knowledge spillovers from Capital accumulation () will determine whether returns to aggregate
accumulation are Constant (=1), Increasing ( > 1) or Decreasing ( < 1).

Again, taking Logs and differentiating w.r.t. time:

y / t / y = / 1- x n

N.B. n , whilst n = population growth, = knowledge spillovers from Capital
accumulation.

So, growth of Output per worker is due entirely to Technological progress, but this is now
Endogenous. Model also implies that faster pop. growth = faster growth of living standards.
There is also a difference between the optimal amount of Investment from the perspective of firms
and from the perspective of the economy as a whole.


13 Real Business Cycles.
Aim: To investigate the potential sources of business cycles as suggested by the Real Business Cycle
literature.
Learning objectives: To explain and assess the contributions to our understanding of the
Macroeconomy provided by a simplified real business cycle model.
To evaluate the evidence in favour of the alternative models.
Charles Plosser Journal of Economic Perspectives 1989 n. 3, pp. 79-90
Gregory N. Mankiw Real Business Cycles: a New Keynesian Perspective Journal of Economic
Perspectives 1989 n. 3, pp. 79-90

Stylised facts about Business Cycles:

1. Labour input varies considerably and procyclically. Most of this variation is in employment rates,
though some is in increased / decreased hours for staff who are already employed.
2. Capital stock varies little at Business Cycle frequencies (1-3 years).
3. Productivity growth (measured by the Solow residual) is procyclical, but does not fluctuate
anywhere near as much as Labour input. I.e. most of the Output loss in recessions can be traced to
Unemployment, not productivity loss.
4. Wages vary even less than productivity and have little correlation with Output levels.

Questions:

1. Why do Labour inputs vary? Specifically:

If there is cyclical Unemployment, what causes Labour demand to fall?
If Labour demand falls, why is employment reduced? Why not wages instead?

2. DRS in Labour implies countercyclical productivity, but productivity varies procyclically, why?

3. Why are recessions so persistent?

4. Why is Investment spending more variable than Consumption spending?

RBC answers these questions thus:

1. Varying Labour inputs simply represent Intertemporal Labour substitution by rational, utility
maximising individuals. Sometimes Labour is more productive and at other times it is less so. It
makes sense to work in the times when it is more productive and enjoy leisure in the times when it is
less so.

2. Productivity varies procyclically because it is productivity fluctuations which actually cause the
boom / bust cycles. When there is a positive exogenous shock to technology, workers are more
productive and there is a boom. Conversely, negative shocks drive productivity down and hence result
in a recession.

3. The internal propagation mechanism which convert shocks without lasting consequences into
long lasting ones are given in RBC theory as several:
i) Firstly, Capital accumulation: If productivity in a recession is low, Output is low so Investment is
low. Thus, even if technology returns to normal in the next period, the legacy of reduced Investment
during the unproductive period causes lower Output next period as well (Weak).

ii) Secondly, time lags in Investing (time to build) see increased Investment from higher Output today
come to fruition some time down the line, and thus higher Output obtains for multiple periods
(basically the inverse of the above argument).

4. Investment spending is more variable than Consumption spending if we assume ( la Permanent
Income Hypothesis and Life-Cycle Hypothesis) that rational agents engage in Consumption
smoothing. If so, Investment is the means by which they will account for short-term fluctuations in
income. They will invest in good times to eat in bad times, but always spend about the same amount.

So, what is Real Business Cycle theory?

Real Business Cycle theory is the latest incarnation of the Classical view of economic
fluctuations.
In this model, labour market is always in equilibrium. Recessions and periods of economic
growth are efficient responses of Output to changes in exogenous variables (usually
productivity).
Neoclassical RBC proponents thus argue that the level of GDP at any given time represents a
utility maximisation by rational agents and that Govt. should not intervene with Fiscal or
Monetary policy to offset the effects of a recession or cool a rapidly expanding economy. This
is because they would at best be ineffective and at worst cause adverse effects by impeding the
invisible hand.
RBC embraces the Classical dichotomy and accepts the complete irrelevance of Monetary
policy. Only Real variables such as Technology and Productivity (rather than Nominal
variables such as Money Supply and Price level) have a role in explaining Output and
employment.

Lets take an example to aid understanding:

Lets assume an exogenous increase in technology (say, teleportation). This would improve the
Marginal Product of Labour who can now get to work quicker and shift the MPL (Labour Demand)
curve to the right:

(P.T.O)
















We move from
equilibrium
point A to equilibrium
point B this is a boom.
As the Real Wage increases, the opportunity to earn higher wages attracts more workers and hence
Employment increases also. This is a movement along the Es curve, rather than a shift because it is a
change to one of the endogenous variables (Real Wage on the y axis) which has caused the
increased Supply of Labour rather than a change in an Exogenous variable, such as population growth
(which would lead to an outward shift in the Es curve).

A recession, on the other hand, would be brought about by a sudden Supply Side Shock (such as
productivity of labour reducing due to a poor tea harvest meaning workers cant get those all
important brews!) thus shifting the MPL curve inwards to MPL. Hence under RBC theory, workers
choose to shift their supply of labour as a response to shifts in Labour Demand. They work more in
good times (when higher wages obtain) and less in bad times (with lower wages) i.e. they make hay
whilst the sun shines. This is called the Intertemporal Substitution of Labour.

How is the model built?

Kyland and Prescott (1982) use the process known as Calibration to estimate their model. That is:

Use Microeconomic theory to find values for all the parameters,
Solve the model numerically and simulate the economy,
Compare the moments (Standard Deviations, Correlations etc) of the simulated economy with
those of the real economy,
If they match, success! If not, those moments which dont match suggest areas of
improvement for the model.

Arguments For and Against RBC:

For:

Micro foundations greater degree of Internal consistency.
Stadler (1994) [RBC] models seem capable of mimicking the most important empirical
regularities displayed by business cycles. but thats pretty much where it ends. It may well
be discarded in future as an explanation of observed fluctuations (Mankiw, 1989) rather than
a model capable of predicting future outcomes.

Against:

If productivity shocks drive Output fluctuations, the two should be positively correlated. In
reality the correlation is negative or zero at best.
There is no evidence of the large, economy wide technology disturbances which are supposed
to drive these models. Specifically:
Most technology disturbances are industry specific, not economy wide.
If they were economy wide, then they would be much discussed and thus built into Rational
economic actors forecasts, hence averting their negative effects (e.g. .
Accumulation of knowledge (and hence technological opportunities) accrue over time, not in
sudden and massive shock form.
As a result, RBC models cannot account for recessions, where (under their theory) every
worker in the economy would need to suffer a negative productivity shock.
RBC theorists fail to provide an explanation for the Short-Run Phillips Curve. Under King &
Plosser, Prices should actually be countercyclical, rather than rising in a boom and falling in
recession!
RBC models have not been rigorously tested. In fact, there seems to be no objective way to
test how well these models explain Business Cycles.
Offer only weak explanations of the persistence of recessions (and booms for that matter).
The ability for agents to engage in Intertemporal Substitution of Labour is completely false. In
reality the elasticity of Labour w.r.t wage is very limited (E
S
curve is very steep). Basically,
work is a necessity.

Despite its shortcomings, RBC theory has influenced the mainstream in two ways:

1. It highlights the importance of modelling how ERU is determined. Although New Keynesian
models are pre-occupied with fluctuations of Output away from ERU which result from AD shocks,
they also analyse Supply Side shocks and incorporate the determinants of the ERU.
2. It gave us Dynamic Stochastic General Equilibrium (DSGE) models. The main advantage of these
is that, since they are grounded in Microeconomic theory (in the best traditions of Lucas) and are
dynamic (i.e. agents preferences and choices are not policy invariant) they should not be vulnerable to
the Lucas critique (Woodford, 2003; Tovar, 2008). The parameters of these models can also be altered
so as to give results commensurate with the region or nation under observation at any given time.

So what are the alternative models?

Mainly the New Keynesian Business Cycle models:

Most economists (including both New Keynesians and Monetarists) remain sceptical about the Real
Business Cycle. It is not particularly probable that technological change (and other supply side factors)
drive the boom bust cycles. Far more likely is the opposite way round - boom bust cycles drive
changes in Labour Productivity through the process of labour hoarding.
For example, when entering a recession, Firms may cut production to avoid oversupply, but not
lay-off a proportionate number of workers (as this is costly) they keep them on (perhaps
shortening their hours) and hope the recession will be short-lived.
Thus Output may fall to half its previous level, whilst the number of units of labour employed
might only fall by one third (for instance). Hence overall Labour productivity will fall below its
long-run trend level.
In booms, Firms Output more than usual, but may simply employ existing workers on overtime
contracts or increase their targets (because hiring addition units of labour is also costly) and
overall Labour Productivity will rise disproportionately, taking it above its long-run trend level.

14 New Keynesian Economics - Microfoundations.
Aim: To introduce the monopolistic competition and price rigidity in Macroeconomic models.
Learning objectives: To understand the contributions made by New Keynesian economists.
Carlin & Soskice Chapter 15 (parts thereof)
Snowdon and Vane Chapter 7 by Prof. Huw Dixon

Background:

- Original Keynesian economics came about as a response to the inability of Neoclassical
economics to explain the inter-war Great Depression where unemployment was clearly
involuntary.
- Keynes went to great lengths in his General Theory to base his Micro foundations on models
of Perfect Competition (to prove to the Neoclassical school that, even under this somewhat
tenuous assumption, involuntary unemployment could still persist).
- Ironic therefore that New Keynesian Macroeconomics is based solely on Micro models of
Imperfectly Competitive markets and all the major innovations of the New Keynesian school
are made possible or worthwhile only because of imperfect competition (Prof. Huw Dixon in
Snowdon and Vane, Chapter 7).
- Keynes argued that AD could determine equilibrium Output and employment and thus explain
persistent involuntary unemployment.
- This claim is taken less seriously today, where it is generally agreed that Supply Side factors
and the peculiarities of the Labour Market are dominant in determining ERU although
hysteresis is one avenue through which AD can affect ERU slightly.
- Keynes Microfounded models of Perfectly Competitive markets with flexible prices and
wages are not seen as adequate to explain why AD would keep Output away from equilibrium.
- In fact, with Perfect markets, wage and price flexibility, perfect information and R.E. (all of
which essentially characterise a Neoclassical model) it is said that Output should never deviate
from ERU. Labour market should clear through a Walrasian process of flexible prices and
wages.
- Why didnt Keynes writing feature Imperfect Competition? Robin Marris (1991) has written
extensively on Keynes and Imperfect Competition. It is clear from his writing that Keynes paid
little if any attention to the theory of Imperfect Competition.
It is particularly surprising since, at the time Keynes was developing his General Theory at
Cambridge, so Joan Robinson and Richard Kahn were developing their Imperfect Competition
theory in the same place.
Although Robinson did discuss the General Theory with Keynes, the link between it and
Imperfect Competition was never made.

New Keynesian Macroeconomics:

New Keynesian Macroeconomics is a school of Macro which seeks to provide Micro
foundation for Macro theory. However, in the sense that Macro theory should be consistent
with Micro theory, so too Micro theory cannot simply ignore the behaviour of the
Macroeconomy and so this is clearly a 2 way street (Dixon).

Assumes Rational Expectations (just like New Classical).

But also assumes Wage and Price stickiness due to Imperfect Competition (unlike New
Classical) which can result in market failures.

Therefore activist Fiscal and Monetary policy to stabilise economy around ERU is preferable
to passive (e.g. LM rule). Although New Keynesian is generally less optimistic about the
potential benefits from Govt. intervention than Keynesian was.

Contributors:

N. Gregory Mankiw and David Romer in 1991 compiled New Keynesian Economics, Vol. 1
and 2. These papers focused mainly on Microfoundations.
Michael Woodfords textbook Interest and Prices: Foundations of a theory of a Monetary
policy, seeks to explain the new DSGE models with Keynesian features.
Taylor: Gave us Overlapping wage contracts which are one of the building blocks of New
Keynesian Macro.
Gali: Provided time-series evidence that increases in productivity are responsible for decreases
in Labour demand this is at odds with RBC Theory but (according to Gali) consistent with
New Keynesian theory.

How is it like Keynesian economics?

Central argument is for price and wage stickiness. They cite:
Small Menu Costs (although Golosov and Lucas recently argued that the menu costs needed
to deliver the Microeconomic data of price adjustment would be implausibly high).
Disincentive to reduce Prices as the firm doing the cutting would not receive all of the
benefit of the rise in Real income of their customers (they would spend the extra that they save
from the price cut elsewhere).

How is it different to Keynesian economics?

Main difference is that they are based on Rational Expectations. Obviously the Rational
Expectations revolution was no where in sight when Keynes published his General Theory and
so old Keynesian models were based on other specifications of expectation formation
(probably Adaptive Expectations).

Also based on Imperfectly rather than Perfectly Competitive Markets at the Micro level.

Govt. spending multipliers are much smaller (i.e. the effect of Fiscal stimulus is expected to be
much smaller GDP and employment effects are around 1/6 of those predicted by original
Keynesian models).

Calvo Model of NKPC

The New Keynesian Phillips Curve generally looks like this:

t
= E
t
(
t+1
) + (y y*)
Where and are parameters.

Unlike the Staggered or Over-lapping contracts proposed by Fischer (1977) and Taylor (1980) who
assumed that all firms set prices once every N periods, Calvos price setting model (1983) assumed
that any given firm faced only a certain probability () of changing prices or not changing prices (1
) in a given period.

Note that, the lower the probability of changing prices (i.e. the greater the level of price stickiness) the
lower in the equation (the flatter the slope of the SRPC).

Criticisms:

Ball (1991): NKPC implies that a Central Bank making a credible commitment to a reduced
inflation rate could produce a boom together with rapid disinflation! Naturally this flies in the
face of practical experience.
Estrella and Fuhrer (2002): NKPC implies correlations between inflation. Future inflation and
Real Marginal Costs which are simply not reflected in the data.
Bils and Klenow (2004): NKPC typically estimates a duration of between 20 and 30 months
for price changes, whereas real world statistics show it to be more like 6 months.
Rudd and Whelan (2006): Suggest that (contrary to the NKPC) lagged inflation plays a greater
role in current inflation than do expectations of future inflation. Also, current inflation is
largely unresponsive to movements in Real Marginal Costs (associated with the Output gap).

Other specifications of the NKPC which seek to answer these problems:

Smets-Wouters (2005) (one of the leading models in Michael Woodfords opinion):
Similar to the Christiano model, except that remaining firms do not change their prices one-
for-one with inflation, but by some proportion of inflation (generally considered to be less than
one).
This prevents infinitely persistent inflation.
Smets-Wouters estimated that around 10-15% of firms changed their price optimally each
quarter (reminiscent of Calvo).

Christiano, Euchenbaum and Evans (2005):
Similar to Calvo model in which a certain proportion of Firms change their prices and
choose an optimal level based on expectations of future inflation (together with the knowledge
that they may be unable to change them again for several periods).
Different in that the remaining firms dont just leave their prices unchanged, but update them
in line with lagged inflation.
Produced a hybrid Phillips curve which depended both on past and expected future inflation
(i.e. it had a lead-lag structure.

Mankiw and Reis (2002) :
Delivered a model in which not all firm adjust price optimally each period (like Calvo) but
(unlike Calvo) not because they are unable to, but because the information they need to make
their inflation predictions is costly to obtain.
As a result only a certain (randomly determined) proportion of firms is able to obtain the
information needed to optimally set prices.
All firms thus make inflation predictions based on very different sets of information.
Shocks therefore pass through to aggregate prices slowly because it takes some firms time to
realise that a shock has actually occurred.
In this model information rigidity rather than price rigidity explains price inertia.

Dennis (2006):
Very similar to Calvo in which a proportion of firms are actually able to change price and the
rest are not.
Of those who are able, only a certain percentage are able to set price optimally, the rest set
their new price in line with lagged inflation.
When menu costs are high, a higher proportion of firms will choose not to change prices
(obviously)
Similarly, when costs of information gathering and processing (to set prices optimally) are
high, a larger number of firms will revert back to an index pricing strategy based on lagged
inflation.
Dennis estimates (from US data from 1982 to 2002) that around 60% of firms change their
price each year, suggesting that menu costs are quite small.

Dupor et al. (2006):
Provides a split model with 2 types of firms. Those behaving like the Calvo model suggests
(price rigidity) and those behaving like the Mankiw and Reis model suggests (information
rigidity).
Dupor et al. use U.S. data spanning 1960:Q1 to 2005:Q2 and estimate that only about 15%
of firms change their price each quarter and that about 60% of the firms that do change their
price do so using information that is outdated (lagged inflation).

Conclusions:

The NKPC has a number of problems that raise questions about its use for practical
policymaking. Importantly, although it is useful for pedagogic purposes, the curve struggles to
explain why inflation is persistent and why inflation responds gradually to shocks.
Further, some believe that the curve provides a misleading description of the relationship
between inflation and real marginal costs.
Economists have developed a range of alternatives to the NKPC, such as indexation models,
with better explanatory power and better descriptions of how inflation responds to shocks.
However, these alternatives also generally fall short when exposed to micro-data on price
changes, and are still often viewed as being ad hoc.
Models that combine both sticky prices and sticky information hold promise but remain in
their infancy.