Third Edition
manfred gärtner
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ma
croeconomics
manfred g
ärtner
Third
Edition
Macroeconomics is aimed at courses in intermediate macroeconomics,
applied macroeconomics, and on the European economy.
manfred gärtner is Professor of Economics at the University of
St. Gallen, Switzerland.
Visit
www.pearsoned.co.uk/gartner
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What’s new
Macroeconomics of the global economic and financial crisis
• – Recent events are a running
theme in the business cycle chapters, featuring several case studies and boxes. Concepts that drifted to the edge of intermediate macroeconomics curriculums in recent years, such as
liquidity traps, market psychology, risk premiums and deflation, receive renewed attention.
Monetary policy rules
• – While the text retains its full treatment of money markets, using the
LM curve, Chapter 3, Money and Interest Rates, has been thoroughly re-written to discuss the implications of monetary policy rules, such as the Taylor Rule, that many central banks have adopted. The chapter shows how the two approaches relate, offering instructors the option to emphasise one or the other in later chapters.
Extended bridge towards graduate macroeconomics
• – The text’s concluding chapters offer a
bridge towards graduate macroeconomics, with Chapter 16 offering a serious introduction to the New Keynesian and Sticky Information Phillips Curves, and Chapter 17 introducing the real
business cycle approach.
Glossary and notes on Nobel laureates
• – A comprehensive Glossary of all relevant technical
terms has been added to the book, as has a new appendix titled Economics Nobel prize winners
and earlier giants, introducing students to the names and work of the greatest minds that have contributed to the concepts and models that form the backbone of this textbook.
Macro
economics
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instant grading.
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Macro
economics
THIRD EDITION
Manfred Gärtner
University of St Gallen, SwitzerlandPearson Education Limited
Edinburgh Gate Harlow Essex CM20 2JE England
and Associated Companies throughout the world
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First published as A Primer in European Macroeconomics 1997 Revised edition published as Macroeconomics 2003
Second edition Macroeconomics published 2006
Third edition Macroeconomics published 2009
© Prentice Hall Europe 1997 © Manfred Gärtner 2003, 2006, 2009
The right of Manfred Gärtner to be identified as author of this work has been asserted by him in accordance with the Copyright, Designs and Patents Act 1988.
All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording or otherwise, without either the prior written permission of the publisher or a licence permitting restricted copying in the United Kingdom issued by the Copyright Licensing Agency Ltd, Saffron House, 6–10 Kirby Street, London EC1N 8TS. All trademarks used herein are the property of their respective owners. The use of any trademark in this text does not vest in the author or publisher any trademark ownership rights in such trademarks, nor does the use of such trademarks imply any affiliation with or endorsement of this book by such owners.
ISBN: 978-0-273-71790-4
British Library Cataloguing-in-Publication Data
A catalogue record for this book is available from the British Library
Library of Congress Cataloging-in-Publication Data
Gärtner, Manfred.
Macroeconomics / Manfred Gärtner. —3rd ed. p. cm. ISBN 978-0-273-71790-4 1. Macroeconomics. I. Title. HB172.5.G365 2009 339—dc22 2009007017 10 9 8 7 6 5 4 3 2 1 12 11 10 09 Typeset in Sabon 10/12 by 73
Printed by Ashford Colour Press Ltd, Gosport
FOR DAVID, CHRIS, KAI, DENNIS AND LOU
Guided tour of the book xiv
List of case studies and boxes xvi
Preface xix
Publisher’s acknowledgements xxiii
1 Macroeconomic essentials
12 Booms and recessions (I): the Keynesian cross
343 Money, interest rates and the global economy
644 Exchange rates and the balance of payments
995 Booms and recessions (II): the national economy
1246 Enter aggregate supply
1507 Booms and recessions (III): aggregate supply
and demand
1818 Booms and recessions (IV): dynamic aggregate
supply and demand
2099 Economic growth (I): basics
24010 Economic growth (II): advanced issues
27211 Endogenous economic policy
30612 The European Monetary System and Euroland at work
33013 Inflation and central bank independence
36114 Budget deficits and public debt
39215 Unemployment and growth
42116 Sticky prices and sticky information: new perspectives
on booms and recessions (I)
45317 Real business cycles: new perspectives
on booms and recessions (II)
476Appendix A: A primer in econometrics
504Appendix B: Glossary
521Appendix C: Economics Nobel prize winners
and earlier giants
535Index 537
Guided tour of the book xiv
Listof case studies and boxes xvi
Preface xix
Publisher’s acknowledgements xxiii
1 Macroeconomic essentials
1
1.1 The issues of macroeconomics 1
1.2 Essentials of macroeconomic accounting 7
1.3 Beyond accounting 21
Chapter summary 26
Exercises 27
Recommended reading 29
Appendix: Logarithms, growth rates and logarithmic scales 30
2 Booms and recessions (I): the Keynesian cross
34
2.1 The circular flow model revisited: terminology and overview 39
2.2 Income determination: a first look 44
2.3 Income determination: a second look 49
2.4 An intertemporal view of consumption and investment 52
Chapter summary 59
Exercises 60
Recommended reading 62
Applied problems 62
3 Money, interest rates and the global economy
64
3.1 The money market, the interest rate and the LM curve 65
3.2 Aggregate expenditure, the interest rate and the
exchange rate: the IS curve 77
3.3 The IS-LM or the global-economy model 83
Chapter summary 93
Exercises 94
Recommended reading 96
Applied problems 96
4 Exchange rates and the balance of payments
99
4.1 Globalization 100
4.2 The exchange rate and the balance of payments 102
4.3 Back to IS-LM: enter the FE curve 106
4.4 Equilibrium in all three markets 114
Chapter summary 119
Exercises 119
Recommended reading 121
Applied problems 121
5 Booms and recessions (II): the national economy
124
5.1 Fiscal policy in the Mundell–Fleming model 125
5.2 Monetary policy in the Mundell–Fleming model 128
5.3 The algebra of monetary and fiscal policy in the
Mundell–Fleming model 133
5.4 Comparative statics versus adjustment dynamics 134
5.5 Adjustment dynamics with expected depreciation 136
5.6 When prices move 139
5.7 Today’s exchange rate and the future 142
Chapter summary 144
Exercises 145
Recommended reading 146
Applied problems 147
6 Enter aggregate supply
150
6.1 Potential income and the labour market 151
6.2 Why is there unemployment in equilibrium? 159
6.3 Why may actual output deviate from potential output? 173
Chapter summary 176
Exercises 177
Recommended reading 178
Applied problems 179
7 Booms and recessions (III): aggregate supply
and demand
181
7.1 The short-run aggregate supply curve 182
7.2 The aggregate demand curve 183
7.3 The AD-AS model: basics 191
7.4 Policy and shocks in the AD-AS model 195
Chapter summary 204
Exercises 205
Recommended reading 206
Appendix: The algebra of the AD curve 206
8 Booms and recessions (IV): dynamic aggregate
supply and demand
209
8.1 The aggregate supply curve in an inflation–income diagram 210
8.2 Equilibrium income and inflation: the DAD curve 211
8.3 The DAD-SAS model 212
8.4 Inflation expectations 215
8.5 The DAD-SAS model at work 218
Chapter summary 232
Exercises 233
Recommended reading 234
Contents xi
Appendix: The genesis of the DAD-SAS model 235
Applied problems 237
9 Economic growth (I): basics
240
9.1 Stylized facts of income and growth 240
9.2 The production function and growth accounting 242
9.3 Growth theory: the Solow model 249
9.4 Why incomes may differ 251
9.5 What about consumption? 254
9.6 Population growth and technological progress 259
9.7 Empirical merits and deficiencies of the Solow model 264
Chapter summary 267
Exercises 268
Recommended reading 269
Applied problems 270
10 Economic growth (II): advanced issues
272
10.1 The government in the Solow model 273
10.2 Economic growth and capital markets 276
10.3 Extending the Solow model and moving beyond 284
10.4 Poverty traps in the Solow model 286
10.5 Human capital 290
10.6 Endogenous growth 294
Chapter summary 299
Exercises 300
Recommended reading 301
Appendix: A synthesis of the DAD-SAS and the Solow model 302
Applied problems 302
11 Endogenous economic policy
306
11.1 What do politicians want? 306
11.2 Political business cycles 310
11.3 Rational expectations 314
11.4 Policy games 316
11.5 Ways out of the time inconsistency trap 321
Chapter summary 326
Exercises 327
Recommended reading 328
Applied problems 328
12 The European Monetary System and Euroland at work
330
12.1 Preliminaries 331
12.2 The 1992 EMS crisis 334
12.3 Exchange rate target zones 340
12.4 Speculative attacks 345
12.5 Monetary and fiscal policy in the euro area 348
Chapter summary 354
Exercises 355
Appendix: The two-country Mundell–Fleming model 356
Applied problems 359
13 Inflation and central bank independence
361
13.1 Inflation, central bank independence and the EMS 362
13.2 Supply shocks and central bank independence 370
13.3 Disinflations and the sacrifice ratio 377
13.4 Lessons for European Monetary Union 385
Chapter summary 387
Exercises 388
Recommended reading 389
Applied problems 390
14 Budget deficits and public debt
392
14.1 The government budget 393
14.2 The dynamics of budget deficits and the public debt 394
14.3 Maastricht, the budget and the central bank 408
14.4 What is wrong with having deficits and debt? 411
14.5 Does monetary union need budget rules? 412
Chapter summary 416
Exercises 417
Recommended reading 418
Applied problems 419
15 Unemployment and growth
421
15.1 Linking unemployment and growth 421
15.2 European unemployment 424
15.3 Persistence in the DAD-SAS model 439
15.4 Lessons, remedies and prospects 443
Chapter summary 448
Exercises 449
Recommended reading 450
Applied problems 450
16 Sticky prices and sticky information: new perspectives
on booms and recessions (I)
453
16.1 Reality checks: business cycle patterns and the
DAD-SAS model 454
16.2 New Keynesian responses 458
16.3 The Phillips curves and monetary policy rules
of current research 463
16.4 Supply shocks in the DAD-SAS model 471
Chapter summary 473
Exercises 474
Recommended reading 475
17 Real business cycles: new perspectives on
booms and recessions (II)
476
Contents xiii
17.2 A real business cycle model 478
17.3 A graphical real business cycle 492
Chapter summary 501
Exercises 502
Recommended reading 503
Appendix A: A primer in econometrics 504
A.1 First task: estimating unknown parameters 505
A.2 Second task: testing hypotheses 507
A.3 A closer look at OLS estimation 509
Appendix summary 519
Exercises 520
Recommended reading 520
Appendix B: Glossary 521
Appendix C: Economics Nobel prize winners and earlier giants 535
Index 537
Supporting resources
Visit www.pearsoned.co.uk/gartnerto find valuable online resources.
Companion Website for students
● Macroeconomic tutorials with interactive models, guided exercises
and animations, plus an interactive road map connecting key concepts and models.
● A data bank with macroeconomic time series for many countries,
along with a graphing module.
● Extensive links to valuable resources on the web, organized by chapter.
● Self-assessment questions to check your understanding, with instant
grading.
● Index cards to aid navigation of resources, plus chapter summaries,
macroeconomic dictionaries in several languages, and more.
For instructors
● Downloadable Instructor’s Manual including the solutions to chapter
exercises and questions.
● Downloadable PowerPoint slides of all figures and tables from the
book.
For more information please contact your local Pearson Education sales
G U I D E D T O U R O F T H E B O O K
12Macroeconomic essentials
CASE STUDY 1.1 Measuring income: gross domestic income vs gross domestic product
Income is a key variable in any economy, both as proposed in our theoretical models, and as mea-sured in reality. In our models we simply call it ag-gregate income, or output, and stick the label Y onto it. In reality, it can be measured in a number of ways. The two most important and most fre-quently used definitions are gross domestic
prod-uct (GDP) and gross national prodprod-uct (GNP). Gross
domestic product sums up what is being produced within the geographical borders of a country. Gross national product is the term for all income received by the inhabitants of a country, no matter whether it results from production at home or abroad. This is why it is often called gross national income (GNI) these days.
Which of these two measures of income is the proper one in a specific context depends on whether we are modeling economic activity in a geographic region or the material well-being of a group of people. In most models introduced in this book, the geographic region, say the UK, France, Europe or China, takes centre stage. Then the appropriate measure of income is GDP. In a few instances, though, such as when we talk about the effects and the motives behind globalization, we need to look at how people rather than regions are affected, and thus cast an eye on GNP.
In the real world, the distinction between GDP and GNP is not seriously relevant for most coun-tries, as Figure 1.8 shows. In Europe, there is less than a handful of countries for which the differ-ence between GDP and GNP is much larger than what may be attributed to measurement error. At one end, Ireland stands out, in addition to Luxem-bourg, with a GNP that falls short of GDP by a whopping 15%. The reason is well known. By low-ering taxes aggressively in competition with other European countries for foreign capital since the 1980s, Ireland succeeded in attracting foreign firms and capital investment from abroad at a breath-taking pace. As a consequence, a substantial part of the Irish capital stock – machines, buildings, com-puters, laboratories and more – belongs to foreign-ers, or has been bought with foreign capital. The earnings generated with this capital go to resi-dents of foreign countries, and are thus included in Ireland’s GDP, but not in its GNP.
The opposite applies to Switzerland. Here GNP exceeds GDP by 8%. This is because a substantial
part of Switzerland’s savings has been invested abroad, in countries such as Ireland. The capital in-come generated by these investments – interest earnings, dividends, rents or profits – adds to Switzerland’s GNP, but is not included in its GDP.
Figure 1.9 compares the absolute levels of GDP and GNP for the selected group of countries. The message is that for most countries the difference is barely visible, and we may not make a serious mis-take by using one of the measures instead of the other: say, if the other is not available. Even for Switzerland and Ireland, the difference between the two income aggregates appears less dramatic in Figure 1.9 than it did in Figure 1.8.
GNP–GDP (%)
–20
IRL PA NLEID GER DK GR USA FNSBJP UK CH
–15 –10 –5 0 5 10 Gap GNP–GDP, in % of GDP, 2004 Figure 1.8 0 10 20 30 40 50
Per capita income in 1,000 US dollars
GDP GNP
IRL PA NLEID GER DK GR USA FNSBJP UK CH
GDP and GNP, 2004
Figure 1.9
78Money, interest rates and the global economy
Working with graphs (part II)
I do not recommend learning the slopes of equilib-rium curves like LM by heart. Neither do I advise memorizing which factor shifts the graph which way. As long as the economic reasoning behind some market equilibrium is understood, slopes and shifts of curves can, in most cases, be worked out by simple thought experiments. Algebra or calcu-lus is not necessary.
For example, take the LM curve to demonstrate the nature of the thought process. Suppose you forgot how the graph slopes in the i/ Y diagram and how it shifts when the money supply increases. Here is a way out.
The slope of a curve
1 Pick an arbitrary point A in the i/ Y plane. As-sume that A is an equilibrium, i.e. a point on LM. (You may safely do that as, without any further information, you are free to position the LM curve anywhere in the diagram.) See Figure 3.9. 2 Move horizontally from A to B. With i being the same at A and B, but Y being larger at B, the de-mand for money at B is obviously higher than at A. Thus, as we are holding the money supply constant, B features an excess demand for money. In other words, B is not on LM! 3 Starting from B, work out in which direction i
has to move in order to restore equilibrium. As demand is too high in B, i must change so as to
reduce money demand via higher opportunity costs, i.e. it must rise. At some point such as C it will have risen just enough to re-establish equi-librium.
4 Now that we have two points A and C on the LM curve, we have identified the curve’s slope. In fact, we may draw the curve right through A and C.
How does the curve shift? 1 As before, pick an arbitrary point A in the i/Y
plane. Assume that it is an equilibrium point, i.e. it lies on LM. See Figure 3.10. 2 Assume that the money supply has been
in-creased. Since the old money supply equalled demand at A, A must now feature an excess sup-ply of money.
3 Holding i constant, work out whether Y has to rise or to fall in order to raise money demand and thus re-establish equilibrium. Here the an-swer is, obviously, that Y has to rise. So the new equilibrium point is found east of A – say, at B.
4 As we could have started from any other point on the old LM curve and obtained the same qualitative result, we may now conclude that the entire LM curve has shifted to the right into the position of the new LM curve.
BOX 3.2 Interest rate i Income Y A B C LM curve Supply < demand Supply = demand Supply = demand
Raising the interest rate re-establishes equilibrium Raising income creates excess demand Figure 3.9 Interest rate i Income Y A B Old LM curve New LM curve Supply = demand Supply > demand Supply = demand
Raising the money supply creates excess supply at former equilibrium point A A is initially an equilibrium
Raising income raises money demand; establishes new equilibrium at point B 1 2 Figure 3.10
108 Exchange rates and the balance of payments
The current account tracks net exports of goods and services. These we already know from the above analysis of the goods market.
(4.2) Figure 4.4, panel (a), shows the current account as a function of income and the interest rate. While the interest rate has no impact on the current account (i is missing from equation (4.2)), CA deteriorates with a factor as income rises.
For given world income and real exchange rate, only one income level exists which balances the current account. An algebraic expression for this is ob-tained by letting in equation (4.2) and solving for Y. This yields
Current account equilibrium (4.3) All points that balance the current account lie on a vertical line in the plane, as shown in Figure 4.4, panel (b). As indicated in the graph, this
line shifts as its positioning parameters change. For example, if the real exchange rate goes up, meaning that the home currency depreciates, ex-ports rise and imex-ports fall. At the initial level of income, i.e. on the old line, where there was by definition, we now face the dise-quilibrium situation Imports, which are too small at this new real exchange rate and the initial level of income, can only rise up to the now higher exports if domestic income increases. So what we need is a movement to the right to find a new current account equilibrium: after a real deprecia-tion a new equilibrium with can only be found to the right of the initial line. Therefore, a real depreciation moves the line to the right. By analogous arguments we find that an increase in world income moves to the right as well. The text in the white boxes summarizes these results.
CA = 0 CA = 0 CA = 0 CA = EX - IM = 0 EX 7 IM.EX = IM CA = 0 CA = 0 i–Y Y =x1 m1 YWorld+x2 +m2 m1 R CA = 0 m1 CA K NX = EX - IM = x1YWorld+x2R - m1Y + m2R Income Y Current account plane Current account CA 0 (a) (b) Interest rate i Interest rate i Income Y CA = 0 Current account deficit Current account surplus
Line shifts left as Here the current account
is balanced (CA = 0)
R↑
Yworld↑
Line shifts right as
R↑ Yworld↑
Figure 4.4The current account worsens as rising income raises imports. The interest rate does not affect CA. The cur-rent account equilibrium line, therefore, projects as a vertical line onto the i–Y plane. An exchange rate depreciation or a rise in world income moves the CA plane up, shifting the CA⫽ 0 line to the right.
Note. Economists rarely work with 3D graphs. They are used here and below to show where the 2D graphs on the right of Figure 4.4 come from. If you have no problem understanding the 2D graph you can ignore the 3D version.
Maths note. One euro invested at home grows to (1 + i ) euro after one period. If invested abroad it grows to (1 + iWorld)(1 + (Ee
+1⫺ E)>E).
Setting this equal to (1 + i ) and subtracting 1 from both sides gives interest parity as
Equation (4.4) simplifies this by ignoring the involved exchange rate gain on the interest payment, which is small under normal circumstances. +iWorldEe+1-E E i = iWorld + Ee +1-E E What to expect
Bullet points at the start of each chapter show what the reader can expect to learn, and highlight the core coverage.
Key terms
Key terms and concepts in each chapter are highlighted in colour, with definitions in the margin.
Case studies
Every chapter contains one or more case studies that apply core concepts to recent experiences in Europe and in other parts of the world.
Boxes
Boxes in each chapter present useful guidance to the reader and illus-trate the concepts.
Margin notes
Helpful tips and guidance appear in the margins, giving maths reminders, examples, rules, empirical notes and reality checks.
Enter aggregate supply
After working through this chapter, you will understand: 1In more detail the meaning of potential incomeor output. 2How wages and employment are determined in the labour market. 3How regulations, trade unions, and other labour market
characteris-tics, or demographic features, may give rise to involuntary unemploy-mentwhich persists in the long run.
4Why aggregate outputproduced by firms may temporarily exceed or fall short of the level of potential output produced in equilibrium (or the long run).
What to expect
By now we have a good understanding of aggregate demand: that is, of what happens on the economy’s demand side. This contrasts with our understand-ing of aggregate supply, the treatment of which so far has been, well, rather simplistic. The only time we have explicitly touched upon the issue of firms’ level of output was when we discussed money in the circular flow model in Chapter 1. There we considered two extreme cases of the aggregate supply (AS) curve, the line that indicates how much output firms produce at differ-ent price levels. For easy reference, Figure 6.1 replicates these two versions. The horizontal aggregate supply curve shown in panel (a) is the one we em-ployed in Chapters 2–5 in the context of the Keynesian cross, the IS-LM model and the Mundell–Fleming model. It is usually referred to as the extreme Keynesian aggregate supply curve. It assumes there is slack and the presence of one or more production factors in abundance. Then how much firms produce depends only on demand. At the given price level, firms supply any level of output that is demanded. But then the price level never changes! How does this correspond with the real world where continuous price changes in the form of inflation are the rule rather than an exception? Quite obviously, a horizontal aggregate supply curve cannot be the whole story.
Panel (b) in Figure 6.1 shows a vertical aggregate supply curve. Firms sup-ply potential output Y* no matter what the price level is. This curve is gener-ally referred to as the classical aggregate supply curve, for reasons that will become evident in a moment. The drawback here is that, unless we assume that the AS curve shifts backwards and forwards all the time, only prices change, but never income. This is clearly at odds with real-world observations of business cycles, evidence of which was presented in Chapter 2. Again, a vertical aggregate supply curve cannot be the whole story either.
C H A P T E R 6
The extreme Keynesian aggregate supply curveis horizontal, stating that, at the current price, firms are ready to produce any output that is demanded. A refined Keynesian aggregate supply curve will be introduced later. The aggregate supply curve
shows the total quantity of goods and services supplied by all firms in the economy at different price levels.
The classical aggregate supply curveis vertical, stating that firms produce only one output Y*, no matter how high prices are.
Chapter summary59
CHAPTER SUMMARY
■A country’s income at a given point in time is determined by the steady-state level of income, the deviation of potential income from steady-steady-state income, and the deviation of income from potential income. The latter is called the business cycle.
■In the circular flow model there exists one equilibrium level of income at which actual spending is exactly as planned. What sets this level of income apart from all other feasible income levels is that firms will try to set pro-duction to this very level to avoid having to invest or disinvest involuntarily. ■An increase in autonomous expenditure, such as government purchases, generates an income increase that may vastly exceed the original stimulus. This multiplier effect occurs because the exogenous spending increase raises income and thus induces consumers to spend more and raise income even higher.
■When the multiplier is large, small changes in government expenditure or other autonomous injections or leakages may cause sizeable booms or recessions.
■Factors that reduce the size of the multiplier are high marginal income tax rates and a high marginal propensity to import.
■Consumption does not depend on current income only, but, more impor-tantly, on expected future income.
■Multiplier effects apply fully only if consumers consider observed income changes to be permanent.
■The multiplier becomes much smaller if observed income changes are con-sidered transitory.
■Investment rises when expected future income rises and/or when the interest rate falls.
actual expenditure 40 aggregate (planned) expenditure 40 average income tax rate 49 boom 35 business cycle 35 capital costs 56 consumption function 49 disposable income 49 equilibrium income 47 government purchases 43 import function 49 Keynesian cross 45 marginal income tax rate 49 marginal propensity to consume 44 multiplier 48 net taxes 43 permanent income 58 potential income 35 rate of return 56 recession 35 steady-state income 35 transitory income 58
Key terms and concepts
60Booms and recessions (I)
France 6,000 2,000 4,000 1900 1910 1920 1940 Real GDP 1960 1930 1950 1970 1980 1990 Figure 2.19 E X E R C I S E S
2.1Consider French real output between 1900 and 1991 as given in Figure 2.19. Add your guess of the paths of steady-state income and potential income to the graph.
Two US economists, Arthur F. Burns and Wesley C. Mitchell, claimed half a century ago that the typical business cycle lasts between six and thirty-two quarters.
(c) Does this agree with your findings? 2.3Consider an economy with the following data
(note that I is planned investment, which may not coincide with actual investment): (a) Is this economy’s circular flow in equilibrium
in the sense that firms do not have to change inventories involuntarily? (b) Translate the above data into a diagram with
demand on the vertical axis and income on the horizontal axis. Add the assumption . (c) Draw the aggregate-expenditure and
the actual-expenditure lines. Identify demand-determined income in equilibrium in your graph and analytically. (d) What happens to equilibrium income if
government expenditure increases by 500 units? Show your result in a graph and verify that it is supported by the multiplier formula of equation (2.9).
(e) Using a graph, show what happens if net exports fall from 250 to 100.
C = 0.75Y NX = 250Y = 1,000 C = 750I = 500T = 0G = 250
2.2Figure 2.20 displays the evolution of real GDP between 1978 and 2002 for the United States and France.
(a) Try to identify business cycles, marking peaks and troughs on the graphs. (b) Identify the US position in 1991 in a diagram
with prices on the vertical axis and income on the horizontal axis. Mark potential income, steady-state income and actual income.
4,000 7,000
Real GDP (billions of US$)
6,000 5,000 8,000 9,000 10,000 1980 1984 1988 1992 1996 2000 Real GDP (billions of FF) 1980 1984 1988 1992 1996 2000 United States 4,000 7,000 6,000 5,000 8,000 9,000 10,000 France Figure 2.20
328 Endogenous economic policy
Models of political business cycles are surveyed in Manfred Gärtner (1994) ‘Democracy, elections, and macroeconomic policy: Two decades of progress’,
European Journal of Political Economy 10: 85–109.
The empirical evidence is reviewed in Bruno S. Frey and Friedrich Schneider (1988) ‘Politico-economic models of macroeconomic policy: A review of the em-pirical evidence’, in Thomas D. Willett (ed.) Political
Business Cycles: The Political Economy of Money, Inflation, and Unemployment, Durham and London:
Duke University Press, pp. 239–75. Applications to US presidential elections are dis-cussed in Ray C. Fair (1996) ‘Econometrics and presidential elections’, Journal of Economic
Perspec-tives 10(3): 89–102. Recommended reading
RECENT RESEARCH
The economy and US presidential elections
Ray C. Fair (1996, ‘Econometrics and presidential elections’, Journal of Economic Perspectives 10(3): 89–102) offers a non-technical update of earlier
efforts to explain the Democratic Party’s share by economic variables and what he calls incumbency variables. His new equation reads as follows:
A P P L I E D P R O B L E M S
The economic variables highlighted in the equation all have a significant influence on the incumbent’s re-election prospects: if income growth speeds up by 1 percentage point, his vote share rises by 0.65 percentage points. If inflation moves up by 1 percentage point, his vote share falls by 0.83 percentage points. There is an added bonus to high income growth. For each quarter in which it exceeds 2.9%, which represents good news, the vote share rises by 0.99 percentage points. The equation explains 96% of the variation in the Democratic Party’s vote share. It predicts the winner in 17 out of the 20 presidential elections since 1916 correctly. The
use of the I dummy variable serves to turn effects on the Democratic vote share around when a Republican holds the presidency. The d dummy variable serves to sever the link between inflation and good news, and the vote during the world wars.
WORKED PROBLEM
Who wanted the euro? (part I)
Journalists and politicians closely monitored public attitudes towards the single European currency. Table 11.3 gives the result of one such opinion poll
Endogenous variables: V Democratic Party’s share of the two-party vote Exogenous variables:
Variable Coefficient t-value Explanation
cnst. 0.468 (90.62) constant
I -0.034 (1.26) Democrats are in White House (I = 1); Republicans are in White House (I = -1)
I * d 0.047 (2.09) d = 1 if world war went on during last 15 quarters; else d = 0 g3 * I 0.0065 (8.03) income growth during last 3 quarters (g3) p15 * I * (1 - d)-0.0083 (3.40) inflation during last 15 quarters (p15) n * I * (1 - d) 0.0099 (4.46) number of last 15 quarters with good news (meaning g 7 2.9).
DPER 0.052 (4.58) Democratic President is running (DPER = 1); Republican President is running (DPER = -1)
DUR -0.024 (2.23) number of consecutive terms in office by incumbent party (negative for Republicans)
R2=0.96; 20 presidential elections 1916–92
Applied problems63
consumption almost perfectly. The marginal propen-sity to consume is found to be 0.71. The t-statistic of 486.5 renders this coefficient highly significant.
It can be argued that parts of consumption spend-ing cannot be adjusted to changspend-ing income immedi-ately: your summer vacation that has been booked since the previous autumn; high car maintenance costs that can only be reduced by selling the car at a loss; your second daughter who insists on taking ballet lessons just like her older sister, and so on. To allow for such adjustment lags we may suppose that only desired consumption C* is related to income, that is . If desired consumption drifts away from actual consumption, the response of actual consumption only closes a fraction a of this gap. Formally we may write . Substituting the above explanation of desired con-sumption for in the partial adjustment equation yields . Estimating this equation yields
The autoregressive coefficient (the one in front of ) carries a t-statistic of 6.31,
render-ing it highly significant. The coefficient of disposable income is also significant, but smaller than in our first estimate above. Note, however, that it represents the product . Since is estimated at 0.78, we may compute , which barely differs from the previous estimate. So while the long-run
c1=0.57>0.78 = 0.73 a ac1 0.22 = 1 -a C-1 R 2 =0.999Annual data 1961–91 (3.07) (6.31) (25.10) C = -1,830.6 + 0.22C - 1+0.57(Y - T ) C =ac0+(1 -a)C-1+ac1(Y - T ) C* C - C-1=a(C* - C-1) C* = c0+c1(Y - T) Table 2.4
Year C Year C Year C
1960 14,561 22,520 1971 43,660 65,960 1982 335,448 475,205 1961 15,919 25,151 1972 47,951 72,136 1983 387,170 553,129 1962 17,967 28,215 1973 58,484 86,914 1984 443,268 634,682 1963 21,017 32,109 1974 73,637 108,296 1985 498,048 706,280 1964 22,784 34,988 1975 85,972 120,875 1986 551,868 782,365 1965 24,366 37,708 1976 106,383 153,198 1987 606,889 858,348 1966 26,873 40,973 1977 129,209 187,982 1988 670,883 953,439 1967 29,767 45,192 1978 150,848 222,825 1989 740,267 1,037,647 1968 31,762 49,082 1979 185,051 275,473 1990 806,593 1,137,230 1969 34,838 54,302 1980 236,603 344,912 1991 881,171 1,231,558 1970 39,992 60,652 1981 284,030 406,106 Y - T Y - T Y - T
marginal propensity to consume is the same as estimated above, the short-run effect is smaller. If disposable income increases by 100,000L, consump-tion immediately goes up by 57,000L. This is not the end, however. One period later, consumption goes up by another , one period later by another , and so on. So while the partial adjustment version of the consumption function estimates the same overall response of consumption as the simple version, it sug-gests that the response is spread over a longer span of time.
YOUR TURN
Consumption function in first differences
One thing to note in the above study of Italian con-sumption functions is that both concon-sumption and dis-posable income show a clear upward trend during the thirty-one years considered here. This can be a problem. Regressing two heavily trended variables on each other may give a statistically significant re-sult, although the two have nothing to do with each other (a classic example is the negative correlation between the number of telephones and the number of storks during the first half of the 20th century). In an attempt to alleviate this problem we may compute first differences on both sides of the con-sumption function to obtain . Please check whether this formulation is supported by the data.
¢C = c1¢(Y - T ) 0.22 * 0.22 * 57,000 = 2,758.8L 0.22 * 57,000 = 12,540L
To explore this chapter’s key messages further you are encouraged to use the interactive online module found at
www.pearsoned.co.uk/gartner Chapter summary
Each chapter ends with a bullet-point summary which highlights the material covered in the chapter and can be used as a quick reminder of the main issues.
Key terms and concepts
A list at the end of each chapter of all the key terms and concepts, for quick reference.
Exercises
Exercises at the end of each chapter are geared towards the chapter’s central ideas and consolidate the acquired knowledge.
Applied problems
These optional problems show students how intermediate statistical skills may be applied to the study of macroeconomics, and en-courage them to try for themselves.
Recommended reading
Each chapter is supported by an annotated recom-mended reading section, directing the reader to ad-ditional printed and elec-tronic sources in order to gain an alternative per-spective, or to pursue a topic in more depth.
Companion website references
A web reference is given at the end of each chapter, guiding the student to useful and relevant interactive resources on the companion website to support their learning.
Case studies
1.1 Measuring income: gross domestic income vs gross
domestic product 12
1.2 Central banks and the beginning subprime mortgage
crisis of 2007–08 16
2.1 Income vs leisure time in France and the USA 43
2.2 How to pay for the war: Great Britain in 1940 51
3.1 Policy options during the financial crisis of 2008 90
4.1 Italy’s current account before and after the 1992 EMS crisis 109
5.1 The 1998 Asia crisis 131
6.1 Ford’s focus: an experiment in efficiency wages 170
7.1 International evidence on the quantity equation and the
AD curve 198
7.2 AD-AS in crises 203
8.1 Deflation: inflation’s ugly sister 223
8.2 Quantity equation, Fisher equation and purchasing power
parity: international evidence 230
9.1 Growth accounting in Thailand 248
9.2 Income in Eastern Europe during transition 253
9.3 Income and leisure choices in the OECD countries 262
10.1 National incomes during the Second World War, east and
west of the Atlantic 277
11.1 Elections and the economy 309
11.2 Who wanted the euro? The role of past inflations 325
12.1 German unification as a tug of war 336
13.1 New Zealand’s Reserve Bank Act: a case from down under 364
14.1 The rise and fall of Ireland’s public debt 404
14.2 Who wanted the euro? The role of government debt 410
14.3 Lessons from the Belgium–Luxembourg monetary union 415
15.1 US vs European job growth: cutting the ‘miracle’ to size 444
16.1 The Canadian business cycle 457
17.1 Technology change in Malaysia: the return of the Solow residual 496
Boxes
1.1 GDP as a measure of total output or income 6
1.2 Working with graphs (part I) 24
2.1 Actual income, potential income and steady-state income:
Great Britain in 1933 38
2.2 Big stock market crashes 55
3.1 Money and monetary policy 70
3.2 Working with graphs (part II) 78
3.3 Exchange rates 81
List of case studies and boxes xvii
3.4 Money supply vs interest control in a changing world 87
4.1 Traditional vs new balance of payments terminology 105
4.2 Forecasting the US dollar in 2004: an exercise in
predicting exchange rates 112
4.3 Interest rates, default risk and the risk premium 114
4.4 The IS-LM-FE model in a different dress 117
4.5 Endogenous and exogenous variables 117
5.1 The Mundell–Fleming model under capital controls 128
8.1 How to solve rational expectations models 225
9.1 The mathematics of the Cobb–Douglas production function 247
10.1 An illustration of the income and distribution effects
of globalization 282
10.2 Labour efficiency vs human capital: an example 294
11.1 Political business cycle mathematics 313
11.2 From the political business cycle to the inflation bias 320
12.1 Convergence criteria in the Maastricht Treaty 340
12.2 The Stability and Growth Pact 352
14.1 Seignorage vs inflation tax revenue 407
16.1 The mathematics of the New Keynesian Phillips curve 465
17.1 A pocket guide to the history of macroeconomic thought 498
What makes this book unique?
This text reverses the usual priorities in intermediate macroeconomics instruc-tion. Here, the ultimate goal is not to simply to teach general macroeconomic theories, models and concepts, with real-world applications thrown in for motivation and excitement; rather, students work through this book towards an understanding of the macroeconomic issues and challenges facing the global economy and individual countries. Macroeconomic concepts are taught only as they serve this end.
What is new in the third edition?
Whenever possible, graphs, tables and information in general were updated. Countless explanations have been improved, case studies brought up to date or replaced, and new exercises added. Beyond that, major innovations in this new edition are:
■ The macroeconomics of the global economic crisis The third edition was
being prepared while this millennium’s first global economic crisis, indis-putably the harshest in generations, unfolded and gained momentum. In the Spring of 2009, the jury is still out on how far incomes will plummet and how long the downturn may last. But as experts in many trades are trying to come to grips with what has happened, and what is yet to come, it is becoming increasingly clear that current events will have a lasting impact on how we teach macroeconomics. Curriculums will not have to be scrapped. Textbooks will not have to be rewritten. But the startling speed at which demand and employment are receding, and the sheer magnitude of change, has gravely tarnished belief in the self-healing power of the markets. This calls for a revitalized interest in what can go wrong in financial and goods markets, and when and how the government should step in to augment pri-vate demand when it is lacking. Acknowledging this, the text’s business cycle chapters use the events of 2008–2009 very much as a running theme that features in several Case Studies and Boxes. Key concepts that are given new emphasis – concepts that had drifted to the edge of, or even off the radar of, intermediate macroeconomics curriculums in recent decades – are liquidity
traps, market psychology and risk premiums in various guises. A related
con-cept that must be taken seriously, and makes an appearance, is deflation, with all the negative repercussions it may generate for the real economy.
■ Monetary policy rules While the text retains its full treatment of money
markets, where supply and demand interact in an explicit fashion and match on the LM curve, it now acknowledges that recent years have seen many central banks adopt monetary policy rules. Chapter 3 has been thor-oughly rewritten to lay out in detail how the two approaches are related,
thus offering instructors the option to emphasize one or the other in later chapters.
■ An extended bridge towards graduate macroeconomics Oftentimes, students
struggle with the gap between what they learned in intermediate macroeco-nomics and the models that graduate macroecomacroeco-nomics rely upon. The text’s concluding chapters try to bridge this gap, with Chapter 16 offering a seri-ous introduction to the New Keynesian and Sticky Information Phillips
Curves, and Chapter 17 introducing the real business cycle approach. Here
also, empirical facts taken from current research are evaluated to explain these concepts. Nevertheless, these chapters do stray from the book’s guid-ing philosophy, in that they focus on theory more than on issues. And since they include the book’s most demanding sections, they may certainly be skipped in courses where a majority of students do not plan to proceed to graduate school.
■ Glossary and notes on Nobel laureates In order to spare students the effort
of searching for explanations in the main text, a comprehensive Glossary of all relevant technical terms has been appended to the book. Another new Appendix, ‘Economics Nobel prize winners and earlier giants’, introduces students to the names and work of the greatest minds that have contributed to the concepts and models that form the backbone of this textbook.
Content
The text’s main body comprises 17 chapters. Chapters 1–9 are fairly conven-tional in content, amounting to a streamlined, no-frills introduction to the macroeconomic concepts that are useful for discussion of contemporary macroeconomic issues in the world economies. Essential macroeconomic con-cepts are introduced in the context of the circular-flow-of-income model. Stu-dents are then led via the Keynesian cross, the IS-LM, the Mundell–Fleming model and the aggregate demand-aggregate supply model to a fully dynamic aggregate demand-aggregate supply framework for analysing short- and medium-term macroeconomic issues. Chapters on the supply-side topics of unemployment and growth round out this predictable set of tools.
Chapters 10 and 11 extend the toolbox into areas that most intermediate macroeconomics textbooks barely mention in passing. The first refines and extends the Solow growth model (introduced in Chapter 9) for a discussion of human capital and poverty traps, and concludes with a first glimpse at endogenous growth. Under the heading ‘Endogenous economic policy’, Chap-ter 11 then shows that politicians may steer the economy along courses not considered desirable from society’s point of view, and discusses how institu-tions should be structured to reduce this risk.
Chapters 12–15 explore issues at the heart of European and global mone-tary and economic integration. All major topics are addressed in these chap-ters: inflation, monetary unions, budget deficits and the public debt, and unemployment.
Chapters 16 and 17, thoroughly expanded for the third edition, offer a sneak preview of what students might expect in macroeconomics courses at the Masters level. They also make a serious effort to motivate students and explain why current macroeconomic research has moved beyond the work-horse models of intermediate macroeconomics to study the potential of
Preface xxi
macroeconomics models with explicit microfoundations – of the real-business-cycle mould, or with sticky prices and information. To this end, stu-dents learn about the co-movement of macroeconomic variables, and why sticky prices or sticky information may perform better than sticky wages in explaining empirically observed patterns. They also grasp the intuition behind real-business-cycle dynamics, without the elaborate formal apparatus that usually comes with it.
Learning features
The book has a user-friendly design, featuring margin notes and definitions that emphasize important concepts. Exercises geared towards each chapter’s central ideas consolidate the acquired knowledge. An extensive and innova-tive use of graphs facilitates access and enhances learning success. Every chap-ter contains one or more Case Studies that apply core concepts to recent experiences in Europe and in other parts of the world. And all chapters feature links to our elaborate online material that includes interactive graphical ver-sions of the book’s key models, guided exercises, online tests, macroeconomic data, and much more.
What courses does the book accommodate?
The organization of the book gives instructors various options:
■ Primarily, the text is designed for courses in undergraduate or intermediate
macroeconomics that on the one hand insist on providing a sound
theoreti-cal foundation, but on the other also want to make a point of emphasizing
applications in the form of Case Studies or even, if so desired, elementary
statistical work.
■ The book’s first half can also be used for a self-contained short course in
macroeconomic theory whenever time does not permit working through a
voluminous 600–900-page macroeconomics text which has become the standard.
■ Also, the book readily accommodates courses in Economic policy and
Applied macroeconomics. Such courses may be organized around an
appro-priate selection from the several dozen Case Studies and empirical applica-tions. Conveniently, as deemed necessary, students can be referred to the required theoretical tools in the same textbook.
■ Finally, the book accommodates European studies courses that can be or-ganized around the applied topics discussed in Chapters 12–15. Here also, should it be necessary to freshen up or expand previously acquired theoret-ical knowledge, such material is readily available in the same textbook.
Prerequisites
Ideally, students should approach this book with a Principles of economics course under their belt. The formal mathematical requirements are mild: anything close to the most basic mathematics training in high school should do. In fact, most of the formal manipulations are optional and either shown in margin notes or in separate sections that supplement graphical arguments.
I am quite confident, though, that the book can also be adopted and used successfully if a principles course is missing and algebraic manipulations are avoided altogether. Dozens of Case Studies, some brief, some rather elaborate, provide ample ammunition for keeping up motivation, and the big payoff waits in the later chapters of the book.
Finally, and though it may sound frivolous: I believe that the book is even suited for self-study. The acquired knowledge will definitely be more fragile and lack depth compared with what can be achieved under the guidance of an experienced instructor. But it should provide an up-to-date first foundation for informed discussion of today’s national and global macroeconomic issues.
Acknowledgements
This brings me to the people I want to thank for their contributions to what-ever merits this text may have. In the very first place, these are my students, who amaze me time and again. Most of all, teaching teaches the teacher. Stu-dents’ questions and curiosity constantly force me to refine explanations, and in the process very often make me understand things better myself.
It has been a joy to work with the professionals at Pearson Education, to whom I owe a big ‘thank you’. They helped and guided me, with unmatched skill and great patience, in preparing this thoroughly extended third edition, and brought the book into its final shape: Georgina Clark-Mazo (senior editor), Linda Dhondy (proofreader), Pauline Gillett (editorial administrator), Robin Lupton (editorial assistant), Ellen Morgan (acquisitions editor) and Chris Bessant (copy editor).
More than any other book of mine, this one would not even be close to what it is without the talents and the enthusiasm of the people working with me at the University of St. Gallen’s Institute of Economics. This new edition owes more than I can express to Susanne Burri. She updated numerous graphs and tables, often with data for more than a dozen countries, scrutinized Exercises and Case Studies, prepared most of the new Glossary, and, playing the devil’s advocate, challenging me on virtually everything I say between the front and the back cover. In the course of joint teaching ventures based on this textbook, Florian Jung of-fered criticism and many constructive suggestions that improved this edition. He also accepted the responsibility for proofreading along with Pascal Bischof, Hanna Köpper, Björn Griesbach, Andreas Kleiner and Thomas Seiler. Frode Bre-vik performed the simulations reported in Chapter 17. And the interactive online material that augments the textbook continued to grow and shine thanks to the programming magic of Christian Busch and the maths skills of Frode Brevik. I am deeply indebted to all of them; and to Gudrun Forster, for unparalleled ad-ministrative support and her eye for the big and the little things that contribute to a work atmosphere which helps us all deliver our very best.
I have also benefitted from the reviews commissioned by Pearson Educa-tion. Both those that offered applause and encouragement, and those that were more reserved, helped shape the book into a better teaching tool.
The mere writing of a textbook may mostly happen at the desk. But the enthusiasm, the creativity and the discipline that are essential for such a project come from beyond office doors. In this respect I owe much more to my wife Louise and to our sons Dennis, Kai, Chris and David than they can possibly know.
P U B L I S H E R ’ S A C K N O W L E D G E M E N T S
We are grateful to the following for permission to reproduce copyright material: Figure 9.2 from Penn World Tables, Figure 6.2; Figure 9.6 and Figure 12.1 from
Economics, 1st edn, Prentice Hall Europe (K Case, R. Fair, M. Gärtner and
K. Heather 1999) Pearson Education Ltd; Figure 15.9 from Trade Unions in
Western Europe since 1945, 1st edn, Macmillan: New York (Ebbinghaus and
Vissner 2000) Macmillan; Figure 15.12 from http://www.wtrg.com/oil_graphs/ oilprice1869.gif.
In some instances we have been unable to trace the owners of copyright mate-rial, and we would appreciate any information that would enable us to do so.
Macroeconomic essentials
After working through this warm-up chapter, you will know:
1 What macroeconomicsis all about, and how it relates to microeconomics.
2 All you need to know about national income accounting, including government budgets and the balance of payments.
3 What the circular flow modelis, how to use it and what its limitations are.
4 How moneyfits into the macroeconomy.
5 Why economists need to use models, and why these simplified pictures of the real world are useful.
6 How to work with graphs.
What to expect
1.1
The issues of macroeconomics
Economics is about how people use time and tools to produce what other people want to buy – and about the sometimes intricate choices that must be made and the things that can go wrong.
The two major subdisciplines of economics are microeconomics and macro-economics. Microeconomics looks in great detail at how individuals make choices – as consumers, as employees, as entrepreneurs, as investors, or even as politicians. Macroeconomicslooks at the big picture, at the way things are and how they develop after we add everything up, in the whole economy or in large segments or sectors of the economy. Of course, microeconomics and macroeconomics cannot lead separate lives. What happens in the macroecon-omy must be the result of all the individual decisions analysed and explained in microeconomics. This is why the search for the microfoundations of
macro-economics ranks high on today’s research agenda. However, to model all the
choices of millions of different people and show how they interact to generate specific macroeconomic outcomes is simply not feasible. It probably never will be. Inevitably, at some point we have to resort to simplifications or abstractions: either by assuming, say, that all individuals are alike, which is what so-called
representative agents models of the macroeconomy do; or by postulating
rela-tionships between macroeconomic variables which are ad hoc in the sense that they only proxy the outcomes of individual choices, but nevertheless seem to work well in many real-world situations.
C H A P T E R
1
Microeconomicsstudies individual entities such as consumers or firms.
Macroeconomicsstudies the whole economy from a bird’s-eye perspective.
Key $905 or less
Income brackets: $906–$3,595 $3,596–$11,115 $11,116 or more
19 out of the last 24 winners of US presidential elections were predicted by the state of the economy
Income in many sub-Saharan countries is only 2% of what it is in the world’s rich countries
The economies of China and India grow some 10% each year. At such rates, income doubles in about seven years
New Zealand’s central bank governor is to be fired if inflation exceeds 2% 1 out of 10 Europeans is out of work 20% of Brazilians receive 70% of Brazil’s income
Figure 1.1 The map shows the huge differences that exist in the per capita incomes of the world’s nations in 2006. Other important macroeconomic variables and issues are reported in boxes: economic growth, unemployment, inflation, the distribution of income and the close link between the economy and politics.
Source: World Bank Key Statistics Online.
The foremost single measure of how an economy performs is the aggregate level ofincome. Presenting the world at a glance, Figure 1.1 gives an overview of this variable by classifying countries according to income per capita, which is total income divided by population. Huge differences in per capita incomes exist. At the high end are the industrialized countries with annual incomes per head of $20,000 to $50,000. Lowest are a number of countries in sub-Saharan Africa with average annual per capita incomes of barely $100. To make matters worse, the world’s poorest countries do not seem to be growing very much – if at all. In stark contrast, the Asian ‘tigers’ – Hong Kong, Singapore, South Korea and Taiwan – have been growing at or near double-digit percentage rates throughout the 1980s and much of the 1990s. Other Asian nations, China and India most notably, by far the world’s most populous nations, seem poised to copy this miracle. At such growth rates, incomes double in less than ten years. Incomes given in Figure 1.1 are nominal incomes, i.e. incomes expressed in currency (here US dollars) at current prices. If you want to compare incomes between countries, nominal incomes may not be the best data to look at. Neither should we rely on nominal income as an indicator of how a country’s income evolved over time.
Measuring income growth over time in a single country is the simpler prob-lem. Note that nominal income is prices P times real income Y, that is . Now consider that US nominal income per capita grew by 22% from
in 2002 to in 2006. This does not
necessarily mean that US citizens could buy 22% more goods and services in
P2006 * Y2006 = $44,155
Y2002 = $36,126
P2002 *
P * Y Incomeis revenue derived
from work and assets, such as wages, interest, dividends and profits.
Rule of 72. As a rule of
thumb, divide 72 by the annual income growth rate (in per cent) to learn in how many years income doubles. Example: 72/9 8.
1.1 The issues of macroeconomics 3
Table 1.1 Nominal and real income in 2006. The second column shows nominal income.
Because prices differ substantially between countries (third column), real income, the amount of goods that income can buy, turns out quite differently, as shown in the fourth column.
2006 than they could in 2002. Possibly, the increase in nominal income might have been entirely due to a 22% rise in prices, with no real improvements in the purchasing power of US incomes at all. Of course, this has not really been the case. In fact, US prices rose by 12% from an index value of, say, 1 in 2002 to 1.12 in 2006. To obtain 2006 real income (expressed in 2002 prices), we need to divide 2006 nominal income by the 2006 price level and multiply by 2002
prices: .
So while nominal income rose by 22%, real income grew by only 9%.
Similar issues, with one added complication, arise when comparing incomes between countries. Noting that per capita income in 2006 was $39,424 in the United States but $48,080 in Switzerland would only permit a meaningful comparison of purchasing power if one dollar bought the same in Switzerland as in the United States. Although $10.23 buys four Big Macs at $3.41 each in the United States, you need $15.60 to buy the same (at $5.20 each) in Switzerland. This price difference may have two causes: at 6.30 Swiss francs Big Macs may simply be expensive in local currency; or the dollar may be undervalued, mean-ing it takes too many dollars to buy a Swiss franc. Our current knowledge does not put us in a position to sort this out. All we know is that a dollar buys fewer Big Macs in Switzerland than in the United States, and that we need to take this into account when comparing Swiss income to US income.
Table 1.1 summarizes our Big Mac example. Column 2 shows that in 2006 nominal income per capita in Switzerland was almost $10,000 higher than in the United States. In Poland it was less than a fifth of Switzerland’s. Taking into account the level of prices relative to the United States, the picture changes substantially. In Switzerland, $48,080 buys what only $36,522 buys in the United States. So Switzerland’s real income per capita is slightly lower than America’s. Prices in Poland are a little more than half as high as in the United States, and some 40% of what they are in Switzerland. Therefore, in terms of real income, Poland performs much better than it seems to perform in terms of nominal income.
A statistical average, which is what income per capita is, is one thing. The actual distribution of income may be quite another story. In Brazil, to give one example, the richest 20% of the population earn more than 60% of the nation’s aggregate income. The poorest 20% earn as little as 3%. In Europe, high aver-age incomes conceal that almost one in ten of those who want to work do not find a job. Good unemployment insurance and social security have so far pre-vented high unemployment from showing up in a deteriorating distribution of income. But welfare states are struggling and are quickly scaling down the role of the government.
Y2006 = (P2006 * Y2006)>P2006 * P2002 = 44,155>1.12 * 1 = $39,424
Empirical note.World-wide the richest countries, with 15% of the population, make some 80% of world income. The poorest countries, with 57% of the population, make 5% of world income. Nominal income (per capita, in $) PY Real income
(in US purchasing power)
Y
Price level
(relative to US price level)
P
Poland 8,182 0.58 14,221
Switzerland 48,080 1.32 36,522
Netherlands NL Population 16.4 million Per capita GNP €34,118 Unemployment 3.2% Inflation 1.6% European Union EU Population 495.09 million Per capita GNP €24,854 Unemployment 7.1% Inflation 2.3% Portugal P Population 10.6 million Per capita GNP €15,354 Unemployment 8.0% Inflation 2.4% Key
Members of the European Union
United Kingdom UK Population 60.8 million Per capita GNP €33,204 Unemployment 5.3% Inflation 2.3% Norway N Population 4.7 million Per capita GNP €60,427 Unemployment 2.6% Inflation 0.7% Spain E Population 44.5 million Per capita GNP €23,592 Unemployment 8.3% Inflation 2.8% Austria A Population 8.3 million Per capita GNP €32,631 Unemployment 4.4% Inflation 2.2% Greece GR Population 11.2 million Per capita GNP €20,442 Unemployment 8.3% Inflation 3.0% Switzerland CH Population 7.5 million Per capita GNP €41,329 Unemployment 2.6% Inflation 0.8% Italy I Population 59.1 million Per capita GNP €25,982 Unemployment 6.1% Inflation 2.0% Sweden S Population 9.1 million Per capita GNP €36,478 Unemployment 6.1% Inflation 1.7% Finland FIN Population 5.3 million Per capita GNP €33,912 Unemployment 6.9% Inflation 1.6% Germany D Population 82.3 million Per capita GNP €29,451 Unemployment 8.4% Inflation 2.3% Denmark DK Population 5.4 million Per capita GNP €42,160 Unemployment 3.8% Inflation 1.7% France F Population 63.4 million Per capita GNP €29,846 Unemployment 8.3% Inflation 1.6% Ireland IRL Population 4.3 million Per capita GNP €43,170 Unemployment 4.6% Inflation 2.9% Luxembourg LUX Population 0.48 million Per capita GNP €75,286 Unemployment 4.1% Inflation 2.7% Belgium B Population 10.6 million Per capita GNP €31,208 Unemployment 7.5% Inflation 1.8%
Non-members of the European Union
In the United States the results of eighteen out of the twenty-two presiden-tial elections preceding 2008 could have been predicted simply by looking at how the economy was doing, as measured by key indicators such as income growth and inflation. This implies a close link between macroeconomic per-formance and all the other (and, you may argue, more important) things in life, not only because all these other things typically cost money, but because a precondition for being in power – and thus being able to realize one’s dream, ideology or vision, in whatever field – is a satisfactory economic performance. New Zealand’s government made the headlines in the 1990s by putting a clause in the employment contract of its central bank governor that threatens him with the sack if he allows inflation to exceed 2% annually. This reflects a serious concern for inflation, the rate at which prices grow. Many other nations share this concern, which points to inflation as a third important variable in the macroeconomic context.
The world abounds with economic challenges and puzzles. These differ from one part of the world to another, and they must be viewed in the context
Figure 1.2 The map provides 2006 data on the countries of Western Europe that formed the European Union at the turn of the millennium, or that had completed negotiations before choosing not to join. GNP is a measure of a coun-try’s total income. Country names are followed by shorthand abbreviations that are used in the text.