Introduction to
MACROECONOMICS
1. Edition
Fundamentals and Applications
to Switzerland
Stefan Legge
Introduction to
MACROECONOMICS
Fundamentals and Applications
to Switzerland
Stefan Legge
1. Edition
February 2024
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© 2024
“The best thing a human being can do
is help another human being know more.”
Charlie Munger, Berkshire Hathaway Annual Meeting, 2010
1
Contents
0 Intro
0.1
0.2
0.3
0.4
0.5
9
Approach of the Book . . . . . . . . . . . . . . . . . . . . . . . . . .
Target Audience . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Prerequisites . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Central Learning Objective . . . . . . . . . . . . . . . . . . . . . . .
Structure of the Book . . . . . . . . . . . . . . . . . . . . . . . . . . .
I The ShortTerm
1 Fundamental Macroeconomic Concepts
1.1
1.2
1.3
1.4
1.5
1.6
1.7
1.8
From Microeconomics to Macroeconomics . . . . . . . . . . . . . .
Relevant Markets . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Analysis Using Models . . . . . . . . . . . . . . . . . . . . . . . . . .
Empirical Macroeconomics . . . . . . . . . . . . . . . . . . . . . . .
Gross Domestic Product . . . . . . . . . . . . . . . . . . . . . . . . .
1.5.1 Economic Cycle . . . . . . . . . . . . . . . . . . . . . . . . . .
1.5.2 GDP Equation . . . . . . . . . . . . . . . . . . . . . . . . . . .
1.5.3 Economic Growth . . . . . . . . . . . . . . . . . . . . . . . .
National Accounts of the Economy . . . . . . . . . . . . . . . . . . .
Price Indices . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
2 The Goods Market
2.1
2.2
2.3
2.4
2.5
2.6
2.7
12
13
14
14
16
19
20
20
22
23
26
27
36
39
43
46
49
51
53
Intro and Learning Objectives . . . . . . . . . . . . . . . . . . . . . .
The Short-, Medium-, and Long-Term . . . . . . . . . . . . . . . . .
The Components of GDP . . . . . . . . . . . . . . . . . . . . . . . .
2.3.1 Private Consumption . . . . . . . . . . . . . . . . . . . . . .
2.3.2 Private Investment . . . . . . . . . . . . . . . . . . . . . . . .
2.3.3 Government Consumption . . . . . . . . . . . . . . . . . . .
Equilibrium . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Comparative Statics and Multiplier . . . . . . . . . . . . . . . . . . .
The IS Curve . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
2
53
54
57
58
65
66
67
69
74
78
Contents
3 The Financial Market
3.1
3.2
3.3
3.4
3.5
3.6
3.7
79
Motivation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 79
Modeling Framework . . . . . . . . . . . . . . . . . . . . . . . . . . . 80
Money . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 81
3.3.1 Money in Modern Economies . . . . . . . . . . . . . . . . . . 83
Interest Rates . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 85
Financial Market Model . . . . . . . . . . . . . . . . . . . . . . . . . 88
3.5.1 Demand for Money . . . . . . . . . . . . . . . . . . . . . . . 89
3.5.2 Money Supply . . . . . . . . . . . . . . . . . . . . . . . . . . 92
3.5.3 Equilibrium in the Money Market . . . . . . . . . . . . . . . 94
3.5.4 Monetary Policy . . . . . . . . . . . . . . . . . . . . . . . . . 96
3.5.5 The LM Curve . . . . . . . . . . . . . . . . . . . . . . . . . . 98
Money Creation by Private Commercial Banks . . . . . . . . . . . . 101
Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 104
4 The IS-LM Model
4.1
4.2
4.3
4.4
4.5
105
Modeling Framework . . . . . . . . . . . . . . . . . . . . . . . . . . .
Shocks and Economic Policy . . . . . . . . . . . . . . . . . . . . . .
4.2.1 Economic Shocks . . . . . . . . . . . . . . . . . . . . . . . . .
4.2.2 Fiscal Policy in the IS-LM Model . . . . . . . . . . . . . . . .
4.2.3 Monetary Policy in the IS-LM Model . . . . . . . . . . . . .
Extensions and Limitations of the Model . . . . . . . . . . . . . . .
Business Cycles . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
II The MediumTerm
5 The Labor Market
5.1
5.2
5.3
5.4
105
110
110
114
121
128
130
133
134
135
Motivation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
The Labor Market . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
5.2.1 Actors . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
5.2.2 Dynamics . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Unemployment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
5.3.1 Stylized Facts . . . . . . . . . . . . . . . . . . . . . . . . . . .
5.3.2 Types of Unemployment . . . . . . . . . . . . . . . . . . . .
5.3.3 Causes and Consequences of Unemployment . . . . . . . .
Labor Market in the Model . . . . . . . . . . . . . . . . . . . . . . .
5.4.1 Labor Supply . . . . . . . . . . . . . . . . . . . . . . . . . . .
5.4.2 Labor Demand . . . . . . . . . . . . . . . . . . . . . . . . . .
5.4.3 Equilibrium on the Labor Market . . . . . . . . . . . . . . .
3
137
139
139
141
145
145
146
149
151
151
153
156
Contents
5.5
5.4.4 Natural Unemployment Rate and Production . . . . . . . .
5.4.5 Comparative Statics . . . . . . . . . . . . . . . . . . . . . . .
5.4.6 Political Influence Options in the Model . . . . . . . . . . .
Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
157
158
162
164
6 Ination
166
6.1
6.2
6.3
6.4
166
169
173
181
181
191
195
202
6.5
Inflation Rates in Practice . . . . . . . . . . . . . . . . . . . . . . . .
Measurement of Inflation . . . . . . . . . . . . . . . . . . . . . . . .
Costs and Benefits of Inflation . . . . . . . . . . . . . . . . . . . . . .
Causes of Inflation . . . . . . . . . . . . . . . . . . . . . . . . . . . .
6.4.1 Quantity Theory . . . . . . . . . . . . . . . . . . . . . . . . .
6.4.2 The Phillips Curve . . . . . . . . . . . . . . . . . . . . . . . .
6.4.3 Economic Model to Explain the Phillips Curve . . . . . . . .
Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
7 The Economy in the Medium-term
7.1
7.2
7.3
7.4
7.5
7.6
203
IS-LM with Real Interest Rates and Risk Premia . . . . . . . . . . .
7.1.1 Risk Premia . . . . . . . . . . . . . . . . . . . . . . . . . . . .
7.1.2 IS-LM Model with Real Interest Rate and Risk Premia . . .
The IS-LM-PC Model . . . . . . . . . . . . . . . . . . . . . . . . . . .
7.2.1 Elements of the IS-LM-PC Model . . . . . . . . . . . . . . .
7.2.2 Equilibrium in the IS-LM-PC Model . . . . . . . . . . . . . .
Economic Policy in the Medium-term . . . . . . . . . . . . . . . . .
7.3.1 Monetary Policy in the IS-LM-PC Model . . . . . . . . . . .
7.3.2 Fiscal Policy in the IS-LM-PC Model . . . . . . . . . . . . . .
Discussion of Economic Policy . . . . . . . . . . . . . . . . . . . . .
Alternatives to the IS-LM-PC Model . . . . . . . . . . . . . . . . . .
Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
204
207
209
212
213
215
216
216
230
232
236
237
III The Open Economy
238
8 The Open Economy
239
8.1
8.2
8.3
Dimensions of Openness . . . . . . . . . . . . . . . . . . . . . . . . .
International Trade . . . . . . . . . . . . . . . . . . . . . . . . . . . .
8.2.1 Brief History of International Trade . . . . . . . . . . . . . .
8.2.2 Trade Theory . . . . . . . . . . . . . . . . . . . . . . . . . . .
8.2.3 Gains and Losses from International Trade . . . . . . . . . .
8.2.4 Trade Policy . . . . . . . . . . . . . . . . . . . . . . . . . . . .
8.2.5 GDP with Exports and Imports . . . . . . . . . . . . . . . . .
The Balance of Payments . . . . . . . . . . . . . . . . . . . . . . . . .
4
239
241
244
247
254
256
257
258
Contents
8.4
8.5
Prices in an Open Economy . . . . . . . . . . . . . . . . . . . . . . .
8.4.1 Exchange Rates . . . . . . . . . . . . . . . . . . . . . . . . . .
8.4.2 Law of One Price and Purchasing Power Parity . . . . . . .
8.4.3 Interest Rate Parity . . . . . . . . . . . . . . . . . . . . . . . .
Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
9 International Macroeconomics
9.1
9.2
9.3
9.4
9.5
262
262
269
275
278
279
IS-LM Model with International Trade . . . . . . . . . . . . . . . . .
9.1.1 IS Curve in the Open Economy . . . . . . . . . . . . . . . . .
The Mundell-Fleming Model . . . . . . . . . . . . . . . . . . . . . .
IS-LM in the Open Economy: IS-LM-IP Model . . . . . . . . . . . .
Economic Policy in the Open Economy . . . . . . . . . . . . . . . .
9.4.1 Fiscal Policy in the Open Economy . . . . . . . . . . . . . .
9.4.2 Monetary Policy in the Open Economy . . . . . . . . . . . .
9.4.3 Peculiarities in Poorer Countries . . . . . . . . . . . . . . . .
9.4.4 International Economic Cycles . . . . . . . . . . . . . . . . .
9.4.5 The Dutch Disease . . . . . . . . . . . . . . . . . . . . . . . .
Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
279
280
286
289
290
291
294
303
305
306
307
IV The LongTerm
308
10 Long-term Economic Growth
309
10.1 GDP Growth in the Long-term . . . . . . . . . . . . . . . . . . . . .
10.2 Determinants of Growth . . . . . . . . . . . . . . . . . . . . . . . . .
10.2.1 Cobb-Douglas Production Function . . . . . . . . . . . . . .
10.3 The Solow Model . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
10.3.1 Modeling . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
10.3.2 Changes in the Capital Stock . . . . . . . . . . . . . . . . . .
10.3.3 Comparative Statics . . . . . . . . . . . . . . . . . . . . . . .
10.3.4 Model Statements vs. Reality . . . . . . . . . . . . . . . . . .
10.3.5 Convergence . . . . . . . . . . . . . . . . . . . . . . . . . . .
10.3.6 Golden Rule . . . . . . . . . . . . . . . . . . . . . . . . . . . .
10.4 Extensions of the Simple Solow Model . . . . . . . . . . . . . . . . .
10.5 Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
11 Innovation and Institutions
311
318
328
333
334
335
338
343
344
347
349
354
356
11.1 Endogenous Growth Theories . . . . . . . . . . . . . . . . . . . . . .
11.2 The Business Environment . . . . . . . . . . . . . . . . . . . . . . . .
11.2.1 Porter’s Diamond . . . . . . . . . . . . . . . . . . . . . . . . .
11.2.2 Institutions . . . . . . . . . . . . . . . . . . . . . . . . . . . .
5
357
362
363
366
Contents
11.2.3 Geography . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
11.3 Long-term Growth Policy . . . . . . . . . . . . . . . . . . . . . . . .
11.3.1 Developing Countries . . . . . . . . . . . . . . . . . . . . . .
11.4 Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
12 Summary, Applications, Outlook
369
373
378
382
384
12.1 Central Findings . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
12.1.1 Analysis with Economic Theories . . . . . . . . . . . . . . .
12.1.2 The High Prosperity of Switzerland . . . . . . . . . . . . . .
12.2 Current Macroeconomic Debates . . . . . . . . . . . . . . . . . . . .
12.3 Outlook . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
6
384
386
388
390
394
List of Variables
Textbooks necessarily use a large number of letters for variables. To avoid any
confusion in this book, here is an overview of all the variables used. They are
sorted alphabetically, with Greek letters at the end.
7
Contents
A
b
c0
c1
C
CC
CF
D
E
F (i, iW )
g
G
i
I
IM
K
L (i )
L
Md
Ms
n
N
Nn
NX
P
Pe
PB
Q
s
S
T
TFP
u
un
U
V
W
X
Y
Yn
YV
z
Z
Productivity of the labor force
Share of cash holdings in money in circulation
Autonomous private consumption independent of disposable income
Marginal propensity to consume
Private consumption by households
Currency in circulation
Cash flow
Deposits of non-banks
Nominal exchange rate (in price quotation)
Balance of the financial account
Productivity growth
Government consumption and investment expenditure
Nominal interest rate
Private investment by households and companies
Imports
Physical capital
Demand for liquidity
Labor force
Money demand
Money supply
Population growth
Employed persons
Natural employment level
Net exports
Price level
Expected price level
Price of government bonds
Value of imports in units of foreign goods
Savings rate
Savings of private households
Taxes and transfer payments
Total factor productivity
Unemployment rate
Natural rate of unemployment
Unemployed people
Velocity of money
Nominal wage
Exports
Gross domestic product (GDP)
Natural production level
Disposable income of households
Factors that influence wage demands (such as minimum wage)
Total demand for goods
α
∆
ε
µ
π
θ
Income share of the factor labour (alpha)
Difference (delta)
Real exchange rate (epsilon)
Mark-up (my, pronounced mi or mü)
Inflation rate (pi)
Reserve holdings of private commercial banks (theta)
8
0 Intro
Most people approach complex, difficult-to-understand topics with a mixture of
curiosity and rejection. For example, the experiments in the particle accelerator at
the CERN research center are exciting for many visitors. But as with most complex topics, such as nuclear physics, we ignore the details and don’t even try to
comment on them in a meaningful way. However, as citizens in a democracy, we
cannot escape the complexity of economic issues. The media constantly inform
us about current developments and politicians outdo each other with economic
policy proposals. In order not to lose track of this complex topic, this book aims
to explain the basics of macroeconomics.
Economists often work as translators, as a supportive force between citizens and
politicians. Citizens know much better than economists what the real economic
problems are. Lawyers and politicians know better how best to implement political measures in the form of new laws. The task of economists, however, is to
translate citizens’ statements into suitable models. These are often mathematical in nature. Here too, economists are generally far inferior to mathematicians.
But for economists, mathematics is also merely a tool for precisely visualizing
problems and possible measures. It is the clean and well-founded analysis that
characterizes the economist — combined with the ability to present the findings
to the public in an understandable way. My book is intended to convey this
process to readers and show them how macroeconomists analyze problems.1
Economics analyses the allocation of scarce resources, which have multiple uses.
This means that in each country there is only a limited amount of land, labor, machinery, natural resources and so on. These resources are used for the production
of goods and services. Since demand is practically unlimited — we would all like
to have some additional products and services — a problem arises: with limited
1 Some people will notice that only the masculine form is used in this book. This is for reasons
of readability. Of course, this is not intended to exclude half the readership. To paraphrase
Warren Buffett, we should not exclude half of our talents simply out of self-interest: “We’ve
seen what can be accomplished when we use 50% of our human capacity. If you visualize what
100% can do, you’ll join me as an unbridled optimist about America’s future.” — Forbes, 6
March 2013
9
0 Intro
resources, only a limited number of goods and services can be produced. Moreover, not every resource is equally suitable for the production of different goods.
The task of economists is now to show how a society can use (i.e. allocate) resources in such a way that we can fulfill as many demands as possible. Again,
the function of economists is to carry out analyses. It is not the task of economists
to describe what the goals and demand desires should be (that would be a normative analysis), but how the goals expressed by citizens can be achieved as well
as possible (a positive analysis).2 While microeconomics analyses this allocation
at the individual level (individuals, firms), macroeconomics discusses this at the
economy-wide level.
With these fundamental considerations in mind, this textbook aims to achieve
three specific learning objectives:
• Gain a basic understanding of macroeconomics.
• Know the benefits, applications, and limitations of economic models.
• Analyze current economic policy problems.
The core objective is to enable readers to analyze current macroeconomic problems in a structured way. This involves using suitable modeling frameworks and
critically questioning them. To illustrate this with an example, let us look at
Figure 0.1. This shows the gross domestic product per capita in some selected
countries and also the global average. How should this information be understood?
2 Nevertheless,
Nobel Prize winner Robert Merton Solow once commented on the task of
economists: “Maybe the main function of economics in general is not, as we usually think,
the systematic building of theories and models, or their empirical estimation. Maybe we are
intellectual sanitation workers. The world is full of nonsense, full of things people and institutions know that ’ain’t so. Maybe the higher function of economics is to hold out against
nonsense.”
10
0 Intro
Figure 0.1: Gross domestic product (GDP) per capita in selected countries
First, the reader is faced with questions about the terminology: What exactly is
gross domestic product (GDP) per capita? How is it measured? And what are
purchasing power parities (PPPs)? We will look at these and other questions
in more detail in the course of the book. In somewhat simplified terms, Figure 0.1 shows the average per capita income in some countries. Here we take
into account that goods and services have different prices in these countries. For
example, the income of people in Switzerland is higher than in Germany, but the
prices are also higher. This aspect was taken into account and yet the GDP per
capita in Switzerland is significantly higher than in its northern neighbour. It is
also higher than in the USA, Japan or China.
This observation raises further questions. Why is Switzerland at the top of the
chart? What does this mean in concrete terms for people in Switzerland? Why is
per capita income lower in other countries? What is going ’wrong’ in Germany,
France or Uganda? If a high GDP per capita is desirable, why is this better
achieved in some countries than in others?
In a way, Figure 0.1 illustrates the essence of economics. If we could answer the
above questions comprehensively, economists would have achieved their most
important goal. Adam Smith (Scottish moral philosopher, 1723–1790) is considered the founding father of economics with his work ’The Wealth of Nations’,
published in 1776. A conclusive explanation of the figures in Figure 0.1 would
11
0 Intro
mean that we can actually explain the wealth of nations.
However, it quickly becomes apparent that the explanations are extremely complex. The economic success of the USA or Switzerland is the result of an endless number of processes and decisions. In this book, we want to understand
some of these processes. To do this, we will focus on the central macroeconomic
variables: production (which corresponds to GDP, as we will soon see) and its
growth, the unemployment rate and the inflation rate. It is no coincidence that
these three variables are usually the focus of economic reporting in the media. In
the following chapters, we want to gain an understanding of the definitions, the
determinants and the interaction of the variables. Equipped with this, economic
information can be better interpreted and discussed. And finally, we will look
again at Figure 0.1 and will then be able to explain the figures, not perfectly, but
much better.
0.1 Approach of the Book
Writing a book is of course a big effort. Since there are already a large number
of textbooks on macroeconomics, the question arises as to whether another one
is needed at all and, if so, how it differs from others. The latter can be answered
quickly: My aim is to explain the central macroeconomic aspects and models in
an understandable, concise, intuitive and practical way. My own teaching experience has increasingly given me the impression that existing textbooks only fulfill
these four characteristics to a limited extent. In many cases, these books are over
500 pages long and yet are difficult for students to understand at the crucial and
difficult points. In particular, there is often a lack of explicit explanation of what
practiced economists take for granted: for example, why we use mathematical
models to analyze, why exactly we distinguish between the short, medium and
long term, or how exactly expansionary monetary policy affects an economy. It
is also important to establish the link between the theoretical methods presented
and practical reality. This textbook focuses in particular on Switzerland and
relevant partner countries. Ultimately, my book is an attempt to fulfill this selfimposed requirement. If I have succeeded in doing so, the question of whether
another textbook on macroeconomics is needed can hopefully be answered in the
affirmative. The primary aim of writing a textbook is to convey the key findings
of a subject area to the next generation. Accelerating the transfer of knowledge is
important for progress in society: the aim must be for one generation to pass on
its knowledge to the next in such a way that they can reach the same level more
quickly and subsequently reach a higher level.
In any case, writing a textbook illustrates the meaning of the much-quoted ex12
0 Intro
pression ‘standing on the shoulders of giants’: This book would never have been
possible without a seemingly endless list of insights and ideas from other publications. Every reader is encouraged to familiarize himself with the many works
cited here. Many aspects cannot be covered in detail in a general textbook. Therefore, please refer to the relevant publications for further analysis and discussion.
0.2 Target Audience
A textbook on macroeconomics is, of course, primarily aimed at those studying
the subject at a university or college. These are primarily students in a bachelor’s
program in economics or business administration. However, students with other
thematic specializations also attend such courses. An understanding of macroeconomics will also be of great benefit to those who are not primarily concerned
with macroeconomics in their careers.
Figure 0.2: Gross domestic product (GDP) growth in Switzerland
In business management practice, for example, managers have to deal with cyclical fluctuations in the economy. These have a major impact on the development
of sales figures and company profits. For Switzerland, we see in Figure 0.2 the
annual economic growth in recent decades. Managers are also faced with the
question of which countries a company should produce in and in which markets
13
0 Intro
demand will increase in the future. Successful management requires the ability
to answer such questions in a well-founded manner. An understanding of basic
macroeconomic concepts is of great relevance here. In addition, any attentive
managers will realize that the success of a company depends largely on external
factors. This refers to all those aspects that are not under the control of a company. Examples include interest rate decisions by the central bank or the spread
of the coronavirus in 2020. Individual events or political decisions can quickly
and substantially change the market environment for companies. Interpreting
economic developments and economic policy decisions correctly is therefore the
task of every successful manager.
A second example is the legal profession. Articles 26 and 27 of the Federal
Constitution of the Swiss Confederation enshrine the guarantee of property and
economic freedom as fundamental rights. Linked to this, Article 36 describes the
restrictions of fundamental rights. From an economic perspective, two aspects
are of particular interest here: restrictions must be in the public interest and
proportionate. What this means in concrete terms and how the situation is to
be assessed in individual cases often requires the application of basic economic
methods. The importance of macroeconomics is even more obvious in Article 99
paragraph 2: “The Swiss National Bank, as an independent central bank, shall
conduct a monetary policy that serves the interests of the country as a whole.”
These examples illustrate why the topics and concepts discussed in this textbook
are valuable to a broad audience.
0.3 Prerequisites
The book assumes little prior knowledge. However, the reader should be familiar with some basic mathematical methods for a complete study of the textbook.
Even if higher mathematics is not necessary, it will be necessary to use mathematical functions, for example. In addition, it will be helpful for readers to
have some basic knowledge of microeconomics. The exact difference between
macroeconomics and microeconomics will be explained in the next chapter.
0.4 Central Learning Objective
The study of this textbook will have been successful if readers can subsequently
understand and assess the macroeconomic development of an economy. We have
already seen gross domestic product (GDP) as the central variable for this, which
we will analyze in more detail in Chapter 1. For now, it is sufficient to know that
14
0 Intro
this refers to the total value of the production of goods and services: everything
that is produced in a country in one year. If we look at the development of
Switzerland’s GDP since 1990, we get Figure 0.3.
Figure 0.3: Gross domestic product (GDP) in Switzerland 1990–2022
While the black line illustrates the GDP, the straight line shows the trend from
1990 to 2022 (in dashed form and blue color). Several aspects stand out here.
First, a straight line describes the development of GDP well over longer periods
of time. However, there are significant deviations from the trend line over shorter
periods. The first half of the 1990s, for example, was a period of rather poor
economic performance in Switzerland. Accordingly, GDP developed worse than
the long-term trend: the black line is flatter in this period than the blue line.
Using actual figures, Figure 0.3 shows very clearly how the GDP of an economy
deviates from the trend in the short term, but returns to this trend in the medium
and long term. We can illustrate this schematically as shown in Figure 0.4 . We
refer to periods in which economic output increases faster than the long-term
average as an upswing. This is followed by the boom: a period in which GDP
is significantly above trend. In the subsequent downturn, however, GDP falls
below the trend again. The country falls into a recession when economic output
shrinks for two consecutive quarters. The sequence then repeats itself again.
The representation in Figure 0.4 is more even and more extreme in terms of the
15
0 Intro
BIP
downturn than we observe in the Swiss data (Figure 0.3). This serves to illustrate
the economic cycle, i.e. the ups and downs of the economy.
boom
dow
up
sw
in
g
GDP
ntu
up
s
w
in
g
rn
recessio
n
trendli
e
n
n
recessio
time
Figure 0.4: Development of GDP shown schematically
In essence, the aim of the textbook is to explain three aspects:
• the short-term fluctuations in GDP,
• the medium-term tendency back to the trend line, and
• the determinants of the long-term trend.
Since changes in GDP correlate very strongly with many other variables — such
as unemployment or inflation — analyzing these three aspects contributes a great
deal to macroeconomic understanding.
0.5 Structure of the Book
The basic structure of the book is such that we first analyze a closed economy
(i.e. without international trade) in the short term. This means that we want
to understand the development of key macroeconomic variables over a period
of a few quarters or years. Much of the reporting in the media focuses on this
aspect. For example, we read that the US economy weakened in the first half
of 2020. Or we read about how the Japanese government increased the VAT in
October 2019 and as a result, GDP growth was slowing down. To understand
and analyze these processes, we will examine the goods market (chapter 2) and
the financial market (chapter 3). We will then develop the so-called IS-LM model
to analyze the economy as a whole in the short term (Chapter 4). As we will
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0 Intro
see, the IS-LM model already helps us to understand many processes and basic
economic policy ideas. However, it also shows that we make a number of highly
simplifying assumptions in this modeling framework. These will be discussed
later.
Now that we have a comprehensive understanding of the development of an
economy in the short term, we turn our attention to the medium term. We
are not only interested in the short-term ups and downs of the economy, but
also in the medium-term level of key macroeconomic variables. Many readers
quickly realize intuitively that the state can, for example, stimulate the economy
positively through tax cuts or additional government spending. However, the
question arises as to whether this is more than a short-term stimulus. With the
medium-term perspective, we particularly want to understand the structural production potential of an economy. To do this, we need to analyze the economy’s
resource constraints, unlike in the short-term analysis. This is done in this book
by analyzing the labor market in Chapter 5. In addition, we must address a second simplification of the short-term perspective: Prices change in the medium
term. Economists often assume that prices are fixed in the short term, as this
simplifies the analysis enormously. For short periods of time, this assumption
is often valid: many goods prices change only slowly and wages are often contractually fixed for a certain period of time. In the medium term, however, i.e.
when analyzing several years, this no longer applies. Therefore, in Chapter 6 we
look at inflation, i.e. price changes from year to year. To conclude our analysis of
the medium term, we develop the IS-LM-PC model in Chapter 7, which includes
the so-called Phillips curve (Phillips curve, PC for short) in addition to the IS-LM
model. This allows us to analyze macroeconomic developments not only in the
short term, but also in the medium term. With a view to Figure 0.3, we then also
understand why an economy always moves back to the trend line in the medium
term.
A very important simplification of our analysis in the first two parts of the book
is that we focus on a closed economy. This excludes trade in goods, services and
finance across borders. We take up these issues in the third part of the book. In
chapter 8 we discuss two central aspects of an open economy: international trade
and exchange rates. Then, in chapter 9, we discuss two important phenomena in
the globalized world: purchasing power parity and interest rate parity. Finally,
we briefly examine how the IS-LM model from Chapter 4 can be extended to
include imports and exports.
In the fourth and final part of the book, we look at the long term. In particular, we
will analyze why an economy can achieve greater production and thus increased
material prosperity for its inhabitants over decades. To this end, we analyze the
determinants of long-term GDP growth in general in chapter 10. In addition, we
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0 Intro
consider the Solow model, which focuses on one determinant (capital accumulation). As we will see, sustained economic growth requires technological progress.
We discuss how this comes about and what role institutions play in this in chapter 11. The core objective is to understand what determines the slope of the trend
line with a view to Figure 0.3.
Finally, chapter 12 summarizes the key findings and shows how these can be
applied to current and future issues.
18
Part I
The ShortTerm
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1 Fundamental Macroeconomic Concepts
1.1 From Microeconomics to Macroeconomics
Economics is the science of dealing with scarce resources. There is only a limited
amount of raw materials, labor or machines. As these can be used in a variety of
ways to produce goods and services, the question of the best possible allocation
arises: What should be used where? In the words of the American economist
Thomas Sowell (Basic Economics, 2015, p.7): “Life does not ask us what we want.
It presents us with options. Economics is one of the ways of trying to make the
most of those options.” A fundamental distinction is made between three levels
of analysis:
• Individual economic level:
The behavior of individual economic agents. The focus here is primarily on
households and companies, which are assumed to maximize their utility (a
common term among economists for well-being) or their profit.
• Interaction level (markets):
The relationships and cooperation between economic agents. This refers to
economic transactions, such as an employment relationship in a company
or the purchase and sale of goods.
• Overall economic level:
To analyze the economy as a whole, we need to look at the overall result
of individual economic actions. We also look at the environment in which
individual economic decisions are made.
In practice, but also in theory, these three levels are interlinked. Modern macroeconomics, for example, is based on microeconomics. This means that it describes
decisions made by households and companies and derives the results for markets and the economy as a whole from the totality of decisions. In practice, this is
20
1 Fundamental Macroeconomic Concepts
exactly the same: many individual decisions by households and companies determine what happens on individual markets and how the economy as a whole
develops. As a result, we can state that from a macroeconomic perspective, the
individual markets — for example, the property market and the labor market —
are interlinked. This link can be clearly seen in the example of the property boom
and crash in Europe during the 2008 financial crisis.
Figure 1.1: Illustration of the linking of markets
Figure 1.1 shows how the housing market in Ireland, Latvia and Spain has developed since 2005 in the left-hand image.1 Until the financial crisis, property prices
rose sharply, as we can see from the so-called House Price Index. This made the
construction of new properties attractive, which is why the construction industry
prospered. As construction sites require a relatively large labor force, unemployment fell in the three countries as shown in the middle image. The workers
employed in this way paid taxes and did not receive unemployment benefits.
This was one of the reasons why state finances improved, as shown in the third
picture. All of this turned around after the 2008 crash: property prices fell, less
was built, the construction industry collapsed, many workers lost their jobs and
were dependent on state support instead of paying income taxes themselves, and
as a result, government debt rose rapidly.
While microeconomists focus intensively on analyzing individual markets — for
example the property market in Spain — it is the task of macroeconomics to understand the relationships and interactions between markets. This broader perspective also means that instead of looking at the market for individual products,
the goods market, for example, is analyzed as a whole.
A second central aspect of macroeconomics is the so-called second-round effects.
Loosely quoted from Henry Hazlitt’s book “Economics in One Lesson”: The art
1 A chart from the article “Going to extra time”, published on 16 June 2012 in the magazine The
Economist, was used as a template for Figure 1.1.
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1 Fundamental Macroeconomic Concepts
of economics consists in looking not only at the direct and short-term effects of a
measure or policy, but also at the long-term consequences. Furthermore, it is important to determine these consequences not only for one group, but for society
as a whole. A good example of this is the consequences of immigration. Critics
of immigration often argue that the additional labor force would put pressure
on local wages. However, the task of economics is to show under which conditions there are actually negative effects on wages. It quickly becomes apparent
that the effect is by no means so clear. Immigrants can, for example, create more
jobs through successful entrepreneurship than they ’take away from the locals’.
This is illustrated by the story of Henri Nestlé, who was born in Germany and
emigrated to Vevey in Switzerland in 1839, where he founded today’s global
corporation Nestlé in 1866.
In macroeconomic analysis, a distinction must therefore be made between partial
equilibrium in one market and general equilibrium in all markets. In this analysis, the large number of possible causal chains can quickly become confusing
and too complex to make clear statements. Economists therefore use simplifying assumptions to understand the situation. Probably the most important such
assumption is the ceteris paribus assumption: this means “all other things being
equal”. Mentally, we only change one influencing variable and keep all others
constant in order to be able to determine their exact influence. Of course, this assumption is only justified to the extent that variable and constant model variables
are independent. Applied to the above example of immigration: If we examine
the effects of migration on domestic wages, we can show a negative effect in a
simple labor market model: since immigration causes a constant demand for labor to encounter a greater supply of labor, the price of labor, i.e. the wage, will
fall. However, in this argument we assume that no new innovations are brought
into the country by the immigrants and that nothing else changes (this is exactly
what ceteris paribus means).
1.2 Relevant Markets
Which markets and players are of key relevance from a macroeconomic perspective? In Figure 1.1 we have already seen the real estate and labor markets. It
is easy to argue that the stock market, the foreign exchange market and many
other markets are important. But which markets are essential for a macroeconomic analysis?
In this book, we initially focus on the goods market and the financial market. No
macroeconomic analysis would be particularly insightful if we could not say anything about the production of goods. Since these goods are traded on a market, it
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1 Fundamental Macroeconomic Concepts
is essential to understand how the supply and demand for goods are determined
in an economy. The demand for goods is divided into private consumption, private investment, government demand and (net) demand from abroad. As we will
see in Chapter 2, investment demand in particular is very volatile (fluctuating)
and depends on the interest rate at which companies and private individuals can
borrow money for investments. For this reason, a macroeconomic analysis requires a look at the financial market. We will do this in more detail in Chapter 3.
With regard to the supply of goods, we need to understand the production process and therefore analyze the markets for the factors of production. This refers
to the resources that are used to produce goods. These are primarily labor and
physical capital, for example in the form of machinery.
From an economic point of view, the equilibrium on the various markets is of
interest. We need to understand both the demand and the supply side and then
determine the price at which the quantity offered and the quantity demanded
match. Based on this, we can analyze how changes in demand or supply change
the equilibrium quantity. For example, additional government spending — such
as on a new highway — can lead to an increased demand for goods in the economy. How does this affect equilibrium production in the goods market? We
also want to understand the interdependence between the markets. How does
the changed equilibrium on the goods market affect the labor market? We use
suitable mathematical models to analyze these often complex relationships. This
allows us to analyze both general macroeconomic developments and possible
political interventions.
1.3 Analysis Using Models
To ensure that the discussion of macroeconomic developments does not get lost
in endless complexity, the use of mathematical models is of great benefit. This
serves to make the problem more precise, the assumptions transparent and the
analysis consistent. To illustrate the importance of these aspects, it is sufficient to
look at numerous political discussions in the media. There, opposing points of
view are presented purely verbally, usually without any knowledge being gained
from the discussion. Why does this happen and how can it be prevented?
First, you need to understand what exactly the argument of a person involved
in the discussion is. This requires the person to be transparent about the basic
assumptions and causal relationships they are working from.2 A mathematical
2 Thomas Sowell describes very clearly in “A Conflict of Visions” how implicit assumptions, for
example about human behavior, are rarely addressed in political discussions. As a result, the
discussion remains inconclusive because the people involved are largely talking past each other.
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1 Fundamental Macroeconomic Concepts
model makes many of the assumptions made very transparent. In addition, the
assumed causal relationships are derived from the formula used. This has several advantages. First, this approach enables other participants in the discussion
to understand how a person’s line of argument is structured. In addition, the
criticism can now be formulated much more precisely. The entire discussion is
raised to a higher level and is therefore more productive.
This aspect was also described by the German portfolio manager Andreas Beck
in his book Erfolgreich wissenschaftlich investieren: “In logic, you are confronted
early on with the fact that there is no causality without a model. Every connection of events in the sense of “because” is a construction of the observer, which
only makes sense because the observer bases reality on a certain model. Statements such as “Germany benefits from the euro” or “the euro harms Germany”
formulate causal relationships that apply in certain models of reality but not in
others. The tiring thing about talk shows is that they argue on the surface, as
if one statement were true and the other false. It would be more interesting to
reveal and scrutinize the respective implicitly assumed model.”
The use of (relatively simple) maths is neither an end in itself nor should it be an
obstacle to understanding. Dani Rodrik writes in his book Economics Rules: “Too
many economists fall in love with the maths and forget its instrumental nature.”
His point is that some economists are too enamored with their mathematical
models, their precision and clarity. Reality, on the other hand, is unmanageable
and confusing. Conversely, it can be said that many students quickly lose touch
with economics due to their aversion to abstract mathematics. This textbook aims
to avoid both.
The mathematical models we use here are necessarily very abstract. This is due
to the fact that we make a number of highly simplifying assumptions. However,
this is necessary so that we can work out and understand essential aspects. Joan
Robinson once illustrated this beautifully: “A model that takes into account all
the colorfulness of reality would be no more useful than a map on a scale of 1:1”.
The American mathematician Norbert Wiener (1894–1964) described it similarly:
“The best model for a cat is a cat; preferably the same cat.” Paul Krugman
(1995, The Fall and Rise of Development Economics) described the benefits of
analysis using models somewhat more specifically: “You make a set of clearly
untrue simplifications to get the system down to something you can handle; those
simplifications are dictated partly by guesses about what is important, partly by
the modeling techniques available. And the end result, if the model is a good one,
is an improved insight into why the vastly more complex real system behaves the
way it does”. This quote vividly describes the process of creating a model, but
also emphasizes its possible weaknesses (“if the model is a good one”). Some
summarize this aspect succinctly with the statement “All models are wrong, but
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1 Fundamental Macroeconomic Concepts
some are useful.”3 With this in mind, the reader should always have three goals
with the models: understand, apply, scrutinize. It is important not to mix up the
order: only a clear understanding of the model allows it to be applied and this
reveals limitations and problems, which in turn lead to questioning or extending
the model.4
A well-designed mathematical model in economics consists of the assumptions
made and the assumed causal relationships between the variables depicted in
the model. In addition, a distinction must be made between variables that are
explained in the model (so-called endogenous variables) and the exogenous variables considered as given. Finally, it often requires some parameters that determine, for example, how strongly the increase in one variable affects another
variable. The model formulated in this way is suitable for a dynamic analysis: using so-called comparative statics, we can analyze how economic shocks
or government intervention affect the variables we are interested in. Specifically,
we change individual exogenous variables and analyze how the macroeconomic
equilibrium of the economy shifts as a result.
An illustrative example of this is the introduction of a (relevant) minimum wage.
In purely verbal terms, it is easy to argue that this measure increases or decreases
employment in the country concerned. Two simple lines of argument could be
as follows:
• The introduction of the minimum wage means that employees earn a higher
wage and therefore have more money at their disposal. As they use at least
part of the additional income for consumer spending, this creates additional
demand. This motivates companies to expand their production and hire
additional labor. As a result, unemployment falls.
• The introduction of the minimum wage increases labor costs for companies.
Companies will try to avoid labor costs wherever possible so that their
profits do not fall. As labor has become more expensive at home due to
the minimum wage, more and more machines or robots and workers are
being deployed abroad in order to save on the more expensive domestic
workforce. As a result, the demand for labor is falling and unemployment
is rising.
3 The American business economist John Sterman from MIT expressed it as follows: “It’s not a
choice of this model or that model, they’re all wrong. See what you can do to combine those
multiple perspectives and enhance the quality of your mental model.”
4 Robert Skidelsky writes in his 2020 book “What’s Wrong With Economics” as follows: “The
great strength of economics lies in its power of generalization; its weakness is to generalize
from oversimple premises.”
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1 Fundamental Macroeconomic Concepts
Both chains of argumentation presented here can be correct. In order to understand whether an argument is conclusive and also to recognize which effects
are greater — the described positive or negative effects on unemployment —
economists use the modeling approach described above. Depending on the design of the economic model, a minimum wage leads to a lower, higher or constant
unemployment rate. This does not mean that economists develop arbitrary models just to support a desired economic policy statement. Rather, we learn from
this which assumptions lead to certain effects of the minimum wage on the labor
market. Having several rival models is therefore an advantage, as the American
investor Charlie Munger (The Complete Investor, p.43) said in 1994: “You’ve got
to have multiple models - because if you just have one or two that you’re using,
the nature of human psychology is such that you’ll torture reality so that it fits
your models.” It is also useful to analyze data and actual events. For example,
the introduction of a general minimum wage in Germany on 1 January 2015 can
be examined. It is then important to compare the causal relationships assumed
in the theoretical model (such as how companies react to higher labor costs) with
observations from practice. A large number of model parameters, such as how
easily labor can be replaced by machines, can also be estimated through empirical
studies.
1.4 Empirical Macroeconomics
Theoretically, an endless number of causal relationships can be postulated, so it
is unclear which relationships are ultimately decisive. This is where analyzing
empirical observations is of great benefit. For example, some time after the introduction of a minimum wage, it is possible to evaluate whether the positive or
negative effects on the labor market can actually be determined. How the empirical analysis is actually carried out is part of the field of econometrics and will
not be explained in detail here. However, from an econometric point of view,
we should ideally be able to conduct experiments under controlled conditions.
Like a natural scientist who heats water under the same conditions (such as air
pressure), we should then be able to observe and derive laws. The empirical
approach thus follows the ceteris paribus idea known from theory.
The problem with empirical macroeconomics, however, is that we are generally
unable to conduct experiments and we cannot control all other factors. The introduction of the above-mentioned minimum wage in Germany may coincide with
a general tax cut or an improving global economy. If we observe reduced unemployment in the data after the introduction of the minimum wage, it is unclear
whether this is really due to the minimum wage. The only way out for empiri26
1 Fundamental Macroeconomic Concepts
cal macroeconomists are special events, so-called shocks, which are large enough
for their influence to be detected in a clean and detailed analysis. Time series
data and the comparison of affected and unaffected regions or individuals are
of particular value here: How has the unemployment rate of low earners (who
are affected by the minimum wage) developed relative to other employees? Ultimately, econometric methods are about estimating how unemployment would
have developed without the introduction of the minimum wage. In technical
terms, we estimate the counterfactual, the counterfactual development, i.e. what
did not happen but would have happened.
1.5 Gross Domestic Product
Probably the most important single indicator of an economy is that of Gross domestic product (or GDP for short). Often expressed as GDP per capita, it serves
as a measure of economic success. This focus on one variable can certainly be
justified. Although people are not directly interested in GDP, empirical evidence
shows a high correlation between GDP per capita and a large number of prosperity indicators. We will go into this in more detail below. Since GDP is so
important for macroeconomic analyzes, it is worth taking a closer look at its history and, above all, its measurement. Even though some databases, such as the
Maddison Project, provide GDP figures for the last few centuries, the concept is
relatively new. It was only in the first half of the 20th century that the discussion about a systematic collection of economic data to measure prosperity was
pushed forward. Interestingly, it was the Second World War that emphasized
the need for continuous statistical recording of current data on the state of the
economy. The current definition of GDP was first introduced in 1940 by John
Maynard Keynes.
GDP allows us to compare economic activity in a country over time or across
countries. The concept was developed in the 1930s and 1940s. Even before that,
it was important for governments to have a picture of the economic state of the
country. Wars were often of great importance in this respect: as early as 1665,
the British scientist William Petty attempted to compile key figures on income,
expenditure, population and land area in England and Wales. The aim was to
estimate what resources would be available for military conflicts. As Diane Coyle
wrote in her 2014 book GDP: A Brief But Affectionate History, GDP by today’s
definition is also in some respects the result of the economic crisis of the 1930s
and the Second World War.
Interest in a figure such as GDP increased at that time for two reasons. First, since
the industrial revolution, economies were growing much faster than in previous
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1 Fundamental Macroeconomic Concepts
centuries. In the words of Angus Maddison (British economist, 1926–2010): “Economic growth was much slower before the 19th century and therefore seemed
irrelevant or uninteresting.” Second, the 1930s were characterized by economic
turbulence. The severe economic slump from 1929 onwards led to new ideas
for measuring economic activity, particularly in the Anglo-Saxon countries. Both
Colin Clark (British-Australian economist, 1905-1989) and Simon Kuznets (American economist, 1901–1985) were instrumental in developing the basis for today’s
GDP. Building on this, the work of John Maynard Keynes (British economist,
1883–1946), including his book How to Pay for the War from 1940, is considered
the starting point of GDP measurement. Ultimately, however, it was the British
economists Richard Stone (1913–1991) and James Meade (1907–1995) who developed the first modern collection of economic aggregates including GDP. Their
work built on the ideas of Keynes and other economists and was later honored
with the Nobel Prize in Economics.
So even though many economists were involved in the development of GDP,
the measure was never uncontroversial. As Diane Coyle explains in her book,
even in the early years of GDP there was no consensus on how exactly economic
performance should be measured. The American economist Simon Kuznets, for
example, criticized the fact that the production of all goods - whether useful or
harmful - was equally included in GDP: “The welfare of a nation can scarcely
be inferred from a measurement of national income. The big problem is that the
measure is crude – production of weapons, hospital beds or chocolate cake all
get counted in the same way, regardless of whether or not they are beneficial
to society and the environment.” He also criticized the fact that government
spending by definition always increases GDP, regardless of whether the spending
actually increases people’s prosperity. This aspect must not be forgotten if we
want to understand macroeconomic policy since the 1940s. This was largely
linked to the ideas of John Maynard Keynes and envisaged a very active role
for the state in economic activity. In the words of Diane Coyle: “The story of
GDP since 1940 is also the story of macroeconomics. The availability of national
accounts statistics made demand management seem not only feasible but also
scientific.” As soon as economic performance could be measured, there was a
great desire to be able to control it. Ultimately, the 1940s were the beginning of a
great experiment: to measure, understand and control the economy as a whole.5
We go into this in more detail in this textbook.
Over the decades, the guidelines for calculating GDP have been internationally
5 Many economists, politicians and commentators followed the principle of “You can’t manage
what you can’t measure”. However, even though this statement is often attributed to W. Edwards
Deming, the following quote from him is more appropriate: “Nothing becomes more important
just because you can measure it. It becomes more measurable, that’s all.”
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1 Fundamental Macroeconomic Concepts
harmonized and further developed. Higher computing capacities, finer data collection and the increasing complexity of national economies have meant that
today only a few people know and understand the details of GDP measurement.
The first edition of the United Nations’ System of National Accounts for the coherent (standardized) measurement of economic variables was less than fifty pages
long. The current version from 2008 already comprises 722 pages.
Complexity and definitional issues are just two of the frequent criticisms leveled
at GDP. The story of the widower who marries his cleaning lady and then stops
paying her wages, thereby reducing GDP, is well known among economists. The
woman may do the same work after the marriage, but as she is no longer paid
a wage, GDP falls. The fact that working from home is generally not counted as
part of GDP may also have historical and normative reasons. De facto, however,
it is the result of a value-free and practical definition: what wage should be used
as a basis for home-based work in order to include it in GDP? If a woman works
instead of being a housewife, GDP increases by definition. However, whether
this increases prosperity is a priori (fundamentally) unclear. If a father reduces
his workload and takes more care of his family, GDP decreases. Again, it is
unclear whether he or his family is worse off as a result. It is also irrelevant for
GDP whether someone earns their income as a producer of cakes or landmines.
Quite a few economists would describe the latter as less prosperity-enhancing.
However, GDP as a statistical measure is value-free here and simply counts all
income. In short, GDP is not a perfect measure of prosperity. It correlates with
many prosperity indicators, as shown in Figure 1.2, but the causal chains are
complex and only partially understood.
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1 Fundamental Macroeconomic Concepts
Figure 1.2: Correlation of GDP per capita with prosperity indicators
Overall, the figures in Figure 1.2 show that people in countries with a high GDP
per capita are materially better off. Of course, this only applies if a high GDP
per capita — this is an average value — is not extremely unequally distributed.
Outliers such as Equatorial Guinea (GNQ) thus confirm the rule: the extreme
concentration of wealth there means that poverty is still very widespread despite
a high average GDP per capita. With regard to Figure 1.2, it should also be
noted that a comparison is made here across countries at a fixed point in time.
The paradox first established by Richard Easterlin (American economist, born in
1926) that within a country rising GDP per capita does not lead to higher satisfaction should therefore be briefly addressed. Such observations and the associated
criticism of GDP must be carefully analyzed. Firstly, GDP can theoretically grow
infinitely, whereas satisfaction measured on a scale of 1–10 has a natural limit.
Secondly, unlike GDP, for example, a Happiness Index based on surveys is not an
objective but a subjective measure. Thirdly, it has been shown that the population’s happiness falls in a recession (i.e. in a situation of two consecutive quarters
of falling GDP). There is also a statistical correlation between GDP per capita
and satisfaction within a country (Matthew A. Killingsworth, Proceedings of the
National Academy of Sciences, 2021). Ultimately, however, the satisfaction of the
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1 Fundamental Macroeconomic Concepts
population depends on many developments. Therefore, indicators such as the
Happiness Index are only of limited use for economic policy. For good reason, no
developed country bases its economic policy decisions on them.6 To summarize,
it can be said that indicators such as the Happiness Index are of limited value as
a target figure for economic policy. However, the indicators from Figure 1.2 help
us to draw a better picture of the reality of life in different countries.
The criticism of GDP also includes the statement that it is an estimated figure
that can be easily manipulated politically. It is therefore possible for GDP to
change significantly within a short period of time. For example, Nigeria’s GDP
almost doubled in 2014 when Nollywood films and mobile phones were added
to GDP. Similarly, in 1987, Italy’s GDP increased by around 20% when estimates
for the informal sector (the ’shadow economy’) were added to GDP. This statistical adjustment meant that Italy overtook the UK as the fourth largest economy
virtually overnight and even the New York Times reported on euphoric Italians
celebrating what became known as il sorpasso. Not only in Italy, but also in other
European countries, GDP rose in 2014 when estimates for prostitution and illegal
drug trafficking were added. The incentive for such adjustments in the statistics
is partly to improve the recording of economic activities in a country. Sometimes,
however, there are simply political reasons for an upward adjustment of GDP: in
an election campaign, a rising GDP is usually quite favorable to the government.
In general, GDP plays an important political role. In the Euro zone, for example,
the Maastricht criteria for government debt stipulate a maximum of 60% of GDP.
Many media report a decline in GDP of 0.1% differently than an increase of 0.1%
— even if subsequent corrections can change the figures again. GDP is ultimately
an estimate and is updated several times, even retrospectively. Corrections in the
order of a few tenths of a percentage point are common (Miles, Scott, Breedon
(2014). “Macroeconomics”, p.52).7 Even if this is common knowledge, it does
little to change public reactions and expectations of politicians: if GDP falls for
two quarters in a row, a country is officially in recession and calls for supportive economic policy are voiced. Fixed GDP growth targets, such as those publicly announced by the Chinese government over the years, are also problematic.
Whether and to what extent this has led to ’embellished’ statistics is disputed.8
In short, GDP is not a perfect measure of a country’s economic performance.
6 The Kingdom of Bhutan, one of the poorest and most authoritarian countries in the world, has
had Gross National Happiness as a national goal in its constitution since July 2008.
7 The former head of India’s central bank once joked that the future is uncertain everywhere, but
in India even the past is uncertain (quoted from Ruchir Sharma, 2016, p.6).
8 Some researchers compare the development of GDP with other indicators of economic activity,
such as electricity consumption. However, in 2015, there were reports that the Chinese government ordered lights to be left on in uninhabited apartment complexes so that electricity data
matched GDP trends (Ruchir Sharma, 2016, Ten Rules of Successful Nations, p.6).
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1 Fundamental Macroeconomic Concepts
However, Diane Coyle states: “There’s no obvious single candidate to replace
GDP at the moment”. It makes sense to use GDP as a measure of what it actually
measures. If the aim is to quantify the average standard of living in a country,
other figures should be taken into account in addition to GDP per capita. It
should also not be forgotten that only services invoiced via the market are included in GDP. As already mentioned, this is necessarily the case and does not
represent a normative judgment with regard to unpaid domestic work.9 In the
words of Richard Stone: “This treatment whereby products are valued at market
price, government services are valued at cost and unpaid household activities are
simply ignored, is not a matter of principle but of practical convenience. It can
be defended, therefore, only on practical grounds.” (quoted from The Accounts
of Society, Nobel Memorial Lecture, 8 December 1984). However, it explains why
some underdeveloped countries can at times record very high GDP growth rates:
as long as the country is very backward, many inhabitants work in their own
agriculture, whose harvest is consumed and therefore not recognized in GDP.
However, as soon as more and more people are employed in factories and their
products are sold on the market, their labor counts towards GDP. In China, for
example, less than 10% of agricultural production was traded on markets in 1978.
Twelve years later, however, it was already 80% of the harvest that was sold on
open markets (Sowell, Basic Economics, 2015, p.25).
9 The criticism that a focus on GDP growth does not take into account the associated environ-
mental damage also starts here: ‘Environment’ as a stock variable is not included in the flow
variable GDP — there is also no market price for fresh air or clean rivers.
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1 Fundamental Macroeconomic Concepts
The basic aim of GDP is to describe the value added in an economy. Information
from individual companies is aggregated at industry level and then totaled at
national level:
Company −→ Industry −→ National economy
Before the development of GDP, sales and production figures in important industries were considered. GDP, on the other hand, reflects the economy as a whole.
Specifically, the nominal GDP measures the value of all final goods and services,
expressed in current prices, produced in a country during a specific period of
time. There are three aspects to consider here:
• There is a geographical and temporal focus,
• it is a flow variable (̸= stock variable)10
• value added is recorded and double counting is avoided, as we will see in
more detail shortly.
10 Flow variables are related to time periods, whereas stock variables are related to points in time.
For example, income is a flow variable as it relates to a period of time: in one year, a person
has earned 80,000 francs. The income saved is one of the flow variables that cause changes in
the stock variable "wealth" over time.
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1 Fundamental Macroeconomic Concepts
Theory box 1.1: Nominal vs. real quantities
Even though many people think of money when they hear the terms economics and
macroeconomics, economists are only interested in monetary quantities, i.e. quantities
expressed in monetary units, to a limited extent. In many cases, money is simply a means
to an end (as we will see in more detail in Chapter 3) and what we are really interested in
are the real quantities expressed in physical units.
Nominal quantities are expressed in monetary units. These include, for example, nominal
wages or nominal interest rates. This means, for example, the 5,000 francs that a person
earns per month or the 0.8% interest that is credited to their savings account balance per
year.
Real quantities, on the other hand, are measured in physical goods. They are therefore
the real measure of prosperity, as they reflect purchasing power. They are also crucial
for economic analyzes, including at an individual level. One example is the real wage:
this indicates how many goods and services a person can buy with their nominal wage
at current prices. If the nominal wage rises by 10% to CHF 5,500 and all prices in the
economy also rise by 10%, then the real wage remains unchanged: the employee can still
afford the same basket of goods (−→ physical goods).
Applied to GDP, we can state the following: Nominal GDP measures the annual value
added in a country at current prices. Real GDP measures the same value added, but at
constant prices of a fixed base year — it uses constant prices for calculation, so it corrects
for inflation. If we see an increase in nominal GDP, this can therefore have two causes:
production is higher and/or prices have risen.
Before we get into the details of calculating GDP, let’s take a look at the practical
side. As Figure 1.3 illustrates, the economies of China and the USA are by far the
largest in the world. The fact that China’s GDP is higher than that of the USA may
surprise some readers. This is due to the fact that GDP is reported in purchasing
power parities. Put simply, this takes account of the fact that many products and
services are cheaper in China than in the USA. We look at this aspect in more
detail in Chapter 8. In addition to the two major powers China and the USA, we
also see the next 13 largest economies in Figure 1.3. While Canada still makes it
into the top 15 with around two trillion US dollars, Switzerland is in 36th place
with around 745 billion.
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1 Fundamental Macroeconomic Concepts
Figure 1.3: The top 15 countries by GDP and GDP per capita
In addition, Figure 1.3 illustrates the fifteen countries with the highest GDP
per capita. This shows that it is mainly small countries such as Luxembourg
and oil states that appear on top. In addition, there is Ireland, which achieves
its very high GDP primarily through international corporations headquartered
there. With the exception of the USA, no country in this list has a population
of more than twenty million. It is also not surprising that it is primarily small
countries that achieve a high GDP per capita. Even just one important industry
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1 Fundamental Macroeconomic Concepts
can lead to very high GDP values in small geographical regions. For example,
according to the Federal Statistical Office, the canton of Basel-Stadt had a per
capita GDP of CHF 204’000 in 2021 — due in particular to the pharmaceutical
companies Roche and Novartis based there. The same can be seen in the USA,
where Silicon Valley has a GDP per capita of more than USD 120,000, well above
the national average.
1.5.1 Economic Cycle
How is GDP actually measured? Firstly, we need to understand that GDP is the
result of the interaction of millions of individual economic actors in an economy.
Every day, people make dozens of decisions and carry out transactions with
others. These include the purchase of food as well as the decision to hire an
additional worker in a company. In order to be able to analyze this multitude
of processes and decisions, we use a model that is as simple as possible. In it,
we summarize groups of actors and interactions. In very simplified terms, we
can distinguish between companies and households. Economists use the latter
term to describe all natural persons in an economy. They own all the factors
of production (labor, capital, land) and make these available to companies in
exchange for a so-called factor income (wages, interest, rent) for the production
of goods and services.
To visualize this vividly, the representation of a simple economic cycle is very
useful as a framework for thinking. We can see it in Figure 1.4. This simple economic cycle includes households as suppliers of factors of production and buyers
of goods. Factors of production include labor and physical means of production
(e.g. machines) owned by households. It should be noted that all companies
must ultimately belong to some households. The production factors, such as
labor, are traded on the factor markets.
The model shown in Figure 1.4 can be extended as required. For example, we
can add the state as an actor that interacts with households via taxes and transfer
payments, interacts with companies via taxes and orders, and is also active on the
factor markets itself. We could also integrate foreign countries into the economic
cycle. None of this would change the basic logic.
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1 Fundamental Macroeconomic Concepts
outputs = GDP
sales revenue = GDP
goods markets
goods, services
goods, services
companies
households
labor, capital, land
labor, capital, land
factor markets
factor compensation
income
= GDP
= BIP
money flows
good/factor flows
Figure 1.4: Simple economic cycle
The circular flow axiom is important for understanding the illustration 1.4: The
sum of the flows flowing in must be equal to the sum of the flows flowing out
for each pole. In concrete terms, we can describe the cycle as follows
• Households offer factors of production (here summarized as labor, capital and land) on the factor markets. These include in particular the labor
market and the capital market.
• The factors of production are in turn demanded by companies because they
are used to produce goods and services.
• These goods and services are offered on the goods markets, where they are
purchased by households.
• To finance expenditure on goods and services, households use the factor
income they have received for providing the factors of production.
• Companies can pay this factor compensation (wages, interest, rent) because
they have generated the corresponding income from the sale of goods and
services.
The gross domestic product in this highly simplified economy is now shown in
four places in Figure 1.4: Since the factor compensation paid by companies differs
only semantically (i.e. in terms of the name) from the income of households,
economists speak of three approaches to measuring GDP:
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1 Fundamental Macroeconomic Concepts
• production approach: GDP as the sum of the value added of all economic sectors (= value of production minus the value of intermediate consumption).
• income approach: GDP as the sum of payments for the factors of production
(labor, capital, land): Wages, interest, rents.
• expenditure approach: GDP as the sum of expenditure on domestically produced final goods for private and government consumption purposes, investment and (net) exports.
The investments and (net) exports mentioned in the last point show that our
representation in Figure 1.4 must be expanded for practical purposes. In particular, we need foreign countries that both sell goods and services to the domestic
market and purchase them from the domestic market. In addition, companies
can also purchase goods and services from other companies themselves. And
we could also add a public sector (“state”) as already mentioned. All this would
make the graph much more complicated, but would not change the basic calculation of GDP.
An alternative view of the economy in Figure 1.4 makes it clear why all three
approaches must lead to the same GDP. The total supply of goods in an economy
is created by the factors of production (labor, capital, land) and the technologies
used. This must be matched by an equivalent demand for goods (consumption,
investment, government consumption, net exports). Otherwise there would be a
surplus supply or a surplus demand. Consequently, all income, all expenditure
and the value of production must be identical in terms of value.
Let us consider a simple example for the calculation of GDP. Assume there are
only two companies: A sawmill with sales revenue of 150, wages of 120 and a
profit of 30. There is also a joinery with sales revenue of 250, inputs (timber
from the sawmill) of 150, wages of 80 and a profit of 20. What is the GDP in
this case? Firstly, we must realize that wood is an intermediate good (i.e. an
intermediate product). It is therefore not included in GDP. In contrast, a table
made in a joinery is a final product and is included in GDP. Following the three
approaches outlined above, GDP can now be calculated:
• Total value added = GDP = 150 + (250 - 150) = 250
• Total income = wages + profits = GDP = 120 + 80 + 30 + 20 = 250
• Total expenditure on end products = GDP = 250
In the case of income, profits count as capital income. As we can see, in this
example we get the same GDP according to all three types of measurement. In
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1 Fundamental Macroeconomic Concepts
practice, however, this is much more complex due to the enormous number of
interactions between millions of individuals, hundreds of thousands of companies and transactions across national borders. Nevertheless, to get an idea of
the relative orders of magnitude, we will look at the corresponding figures for
Switzerland in Chapter 1.6.
If we look again at Figure 1.4, we can already recognize the basic logic of many
macroeconomic ideas: One person’s spending is another person’s income (“everyone’s spending is someone else’s income”). If, for example, households reduce their consumer spending, companies will lack demand. They will therefore
produce less and lay off some people. The fact that the state can increase overall economic demand in such a case is a key idea that we will explore in the
following chapters.
1.5.2 GDP Equation
The third approach of GDP measurement is of particular importance for the following chapters: the expenditure approach. On the goods market, the total quantity of goods and services supplied must correspond to the quantity demanded.
The supply consists of domestic production (for which we use the letter Y) and
imports (I M). Total demand (Z), in turn, is made up of consumer demand from
private households (C), private sector investment (I), government consumption
and investment expenditure (G) and foreign demand in the form of exports (X).
Since supply and demand must be equal, the following applies
Y + IM = Z = C + I + G + X
←→
Y = C + I + G + (X − I M)
(1.1)
The equation Y = C + I + G + ( X − I M) will keep us busy for quite some time. It
is therefore worth taking a closer look at the individual components. Private consumer demand (C) comprises all goods and services purchased by private individuals for consumption purposes. For the sake of simplicity, the term "demand
for goods" will be used from now on. It always includes goods and services. This
includes both the television purchased by individuals and the money spent on a
monthly Netflix subscription. In highly developed countries, the service sector is
now significantly larger than the industrial and agricultural sectors, as illustrated
by Figure 1.5. More than two thirds of value creation takes place in the service
sector.
39
1 Fundamental Macroeconomic Concepts
Figure 1.5: Share of economic sectors in GDP in selected countries
40
1 Fundamental Macroeconomic Concepts
Private investment (I) includes, for example, expenditure on the construction of
a private family home or a new machine in a company. Government consumption and investment expenditure (G) includes, for example, the purchase of new
books for the public library or the construction of a new university building. It
is important to note that transfer payments are not included, as there is no value
added here. However, salaries for employees in the public sector are included
in G. A brief example illustrates why this is the case. Let’s take an unemployed
person who takes up a position as a lecturer at a university. Since he creates value
from now on, GDP must increase. In the production approach, the value added
is simplistically estimated on the basis of wages (it is difficult to estimate the
actual value added, especially as the public university does not charge students
for their courses). The income approach takes into account the income earned.
Both thus increase by the same amount compared to the situation in which the
lecturer was still unemployed. In the expenditure approach G is increased by the
same amount, as the state is buying a service. What would happen if the lecturer
worked as a freelance lecturer for the university instead of being permanently
employed? Nothing would change in the GDP. And what if the lecturer were to
offer his courses privately in future? In this case, he would charge the participants for his services. With the production approach, the sum of the invoices is
now decisive, with the income approach his income continues to be decisive and
with the expenditure approach his contribution to G drops to zero (the state is
no longer involved), but the expenditure of the course participants increases C.
The distinction between C, I and G is of economic interest. For example, the same
laptop can be counted as private consumption (if someone buys it for private
purposes), private investment (if a company buys it for an employee) or public
consumption (if a public university buys it). Since investment enables higher
production in the long term, it is important to distinguish between C and I. In
addition, for a number of questions it is interesting to know how much of the
total demand for goods comes from the government.
Finally, the demand for goods also includes net exports (X − I M), i.e. the difference between exports and imports. In addition to international trade in goods,
this also includes tourism, for example: a Japanese tourist who spends money
on hotel accommodation during his holiday in Lucerne increases Swiss exports
of services. But why do imports reduce a country’s GDP? Let’s assume that the
Swiss economy is closed and there is no foreign trade. In this case, X and I M are
equal to zero. What happens as soon as Swiss consumers buy potatoes abroad
instead of from local farmers after trade liberalization, for example? If German
consumers do not buy Swiss potatoes to the same extent, potato production in
Switzerland must fall. Whether imports are therefore a bad thing will be considered in more detail in Chapter 8.
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1 Fundamental Macroeconomic Concepts
To get an understanding of the order of magnitude in practice, the Table 1.1
shows data for the individual components of GDP for the year 2021 in Switzerland, Germany and the USA.11 The figures show, among other things, the enormous importance of international trade for Switzerland. It is also noticeable that
private consumption is significantly more important in terms of value than private investment or government consumption.
Switzerland
Germany
USA
China
bn CHF
share
bn EUR
share
bn USD
share
bn USD
share
Private consumption (C)
365
49.9%
1,774
49.3%
15,903
68.2%
6,684
37.7%
Investments (I)
191
26.1%
839
23.3%
4,920
21.1%
7,624
43.0%
Government consumption (G)
89
12.1%
797
22.1%
3,354
14.4%
2,961
16.7%
Exports (X)
522
71.3%
1,694
47.0%
2,540
10.9%
3,546
20.0%
Imports (I M)
435
59.4%
1,502
41.7%
3,401
14.6%
3,085
17.4%
BIP (Y)
732
3,602
23,316
17,730
Figures for the year 2021 (at current prices). Source: OECD Nat. Acc. 2022(2), World Bank
Table 1.1: GDP components in selected countries
In highly developed economies, the share of investment is typically lower than in
emerging economies. One reason for this is that a large part of the infrastructure
has already been built. In the case of China, large investments were necessary
to create roads, railways, harbors and so on, which are essential for a modern
economy. The relationship between consumption, investment and long-term development is discussed in more detail in Chapter 10.
11 In practice, in addition to the five components (C, I, G, X and I M), there is also the change in
inventory investment. Some goods that are produced in one year are only sold or consumed
in the following year. The difference between the production and sale of goods is referred to
as inventory investment. However, as these are quite small in quantitative terms, we will leave
them out here.
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1 Fundamental Macroeconomic Concepts
Practice box 1.1: GDP measurement from space
For many underdeveloped economies, only limited data on their gross domestic product
(GDP) is available. In addition, GDP data is often only available at the national level,
although information on a regional basis is also valuable for research. To address this
shortcoming, researchers have developed a clever idea. Vernon Henderson, Adam Storeygard, and David N. Weil published the study “Measuring Economic Growth from Outer
Space” in the American Economic Review in 2012. In it, they document that satellite images of
the Earth at night show varying degrees of illumination. Regions with a high population
density and pronounced economic development are brighter than uninhabited and less
developed regions. The researchers were also able to show that there is a close statistical
relationship between night-time illumination and the GDP of a country or region.
GDP is reported quarterly in most highly developed countries. It is important
to seasonally adjust the data. For example, it is of little relevance that spending
is higher from October to December than from July to September — Christmas
sales distort the figures. Therefore, such seasonal patterns are removed from
the statistics or the quarterly GDP data is compared with the quarter from the
previous year. If (seasonally adjusted) real GDP falls in two consecutive quarters,
economists speak of a recession.
1.5.3 Economic Growth
The annual change in a country’s gross domestic product (GDP) is expressed by
the growth rate. This is defined as:
Percentage GDP growth in the year t = 100 ∗
Yt+1 − Yt
Yt
(1.2)
where Yt+1 and Yt express the GDP in the years t + 1 and t. For example, if
Switzerland’s GDP increases from CHF 700 billion in 2018 to CHF 720 billion in
2019, the growth rate is (720 − 700)/700 = 0.02857 or around 2.86 per cent.
The so-called base effect must be taken into account here. The growth rate alone
may not be very meaningful, as it sometimes does not only reflect developments
in the past year. For example, there was a sharp slump in GDP in 2020 as a result
of the coronavirus crisis, which was then recovered the following year. However,
the high GDP growth figures in 2021 are due to the fact that the base (here: GDP
in 2020) was relatively small. In general, therefore, if the base has been reduced,
growth rates ceteris paribus are relatively high.
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1 Fundamental Macroeconomic Concepts
When looking at several years, it is important to note the difference between the
arithmetic and geometric mean. If the Swiss economy grows by five per cent
in 2017, three per cent in 2018 and two per cent in 2019, for example, growth
will total around 10.31 per cent (1.05 ∗ 1.03 ∗ 1.02 = 1.10313). What constant
growth rate over the three years would√result in the same growth? For this we
have to calculate the geometric mean ( 3 1.10313 = 1.03326) and recognize that
annual growth of 3.326% also results in 10.31 percent growth after three years.
This must be distinguished from the arithmetic mean, which in the example is
(5 + 3 + 2)/3 = 3.33.
To get an idea of real proportions here too, Figure 1.6 shows the annual GDP
growth rates for the global economy, China, the USA, Germany, Japan and Switzerland. We see that the growth rate of real GDP generally varies between 0 and
5 per cent. However, in less wealthy countries, such as China, economic growth
was sometimes significantly higher.
Figure 1.6: GDP growth rates in selected countries
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1 Fundamental Macroeconomic Concepts
Figure 1.6 shows a very high growth rate for Japan in the 1980s of around five
per cent, which then fell significantly. How far-reaching was the reduction in the
annual growth rate from five per cent to one per cent? In 2020, the Japanese
economy would have been three times larger if the country had maintained
the high growth figures from the 1980s (calculation: 100 · 1.0530 = 432 and
100 · 1.0130 = 135). At that time, the “Land of the Rising Sun” was seen as a
future superpower. But the 1990s went down in history as a “lost decade” for the
country.
How can this enormous difference be explained? If an economy grows by 5% per
year, GDP doubles approximately every 14.4 years. At 3% growth, a doubling
takes 24 years, at 2% it takes 36 years and at 1% it even takes 72 years. These
figures illustrate the large differences caused by ’small’ changes in the growth
rate over time. This can be seen in Figure 1.7. The actual growth rate of Swiss
per capita income from 1970 to 2022 was around one per cent. As the graph
clearly shows, even 0.5 percentage points more or less growth over such a long
period makes a big difference.
Figure 1.7: GDP per capita in Switzerland with hypothetical trajectories
Few people have a good intuition for exponential growth processes.12 The famous wheat grain legend surrounding Sissa ibn Dahir, the inventor of the game
of chess, illustrates this: In the third or fourth century AD, the Indian ruler
12 Experiments by economists from Berlin (Ensthaler et al., Management Science, 2018) have shown
how difficult people find multiplicative growth processes.
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1 Fundamental Macroeconomic Concepts
Shihram wanted to reward the inventor of the game of chess.13 The inventor
asked for grains of wheat, one on the first square of the chessboard, twice as
many on the second square, i.e. two, twice as many on the third, i.e. four, and so
on. According to legend, the king was both amused and angry at the supposed
modesty. However, it didn’t take long for the king’s arithmetic masters to realise
that so much wheat could not be raised in the entire kingdom. Expressed in
words, 264 − 1 is 18 trillion, 446 quadrillion, 744 trillion, 73 billion, 709 million,
551 thousand, and 615. This figure illustrates the enormous effect of compound
interest, which has also been described as the eighth wonder of the world.
The so-called 72 rule is recommended in order to make a better assessment of
exponential growth processes such as the development of GDP. It reads: Years
to double ≈ 72 / growth rate. With two per cent annual growth, it therefore
takes 72/2 = 36 years to double. Countries with an average GDP growth rate
of seven per cent therefore double their economic output every decade. The
Chinese economy achieved an annual GDP growth rate of around 9.35% in the
years from 1978 to 2019. This has increased GDP by a factor of 39 over this period
(1.093541 =39).
1.6 National Accounts of the Economy
The National Accounts is a collection of several subaccounts that record the performance of an economy. The national accounts document the creation, distribution and utilization of gross domestic product (GDP) and gross national income
(GNI). The basis for this is the already familiar circular flow axiom and the illustration 1.4. We look at the economy again using three approaches: Production
approach (what is produced?), income approach (who receives which part of the
GDP?) and utilization approach (what are the goods and services produced used
for?).
To illustrate the orders of magnitude, we rely on figures from the Federal Statistical Office.14 Table 1.2 first shows the production approach, i.e. how Switzerland’s
GDP was created in 2019. In total, goods and services worth CHF 1,498 billion
were produced. Intermediate consumption totaling CHF 791 billion must be deducted from this. After offsetting taxes and subsidies on goods, this results in
gross domestic product (GDP) of around CHF 727 billion. We obtain the same
value when using the income approach. In Switzerland, for example, around
CHF 420 billion was paid in employee compensation in 2019. If we add net
13 The story of Sissa ibn Dahir is based on the corresponding Wikipedia article.
14 The figures shown here can be found in the documents of the Federal Statistical Office (FSO)
with the numbers je-d-04.02.01.02, je-d-04.02.01.031, je-d-04.02.01.07 and je-d-04.02.02.0.
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1 Fundamental Macroeconomic Concepts
operating surpluses, depreciation, amortization and taxes and deduct subsidies,
this again gives us GDP. As the expenditure statement shows, this GDP also corresponds to the sum of private consumption, private investment, government
consumption and net exports.
Production approach
Income approach
Expenditure approach
Gross production value
1,498,229
Compensation of employees
419,798
Private consumption
424,105
- Intermediate consumption
-791,485
+ Net operating surplus
131,027
+ Gross capital formation
178,259
+ Depreciation
159,654
+ Government consumption
35,133
+ (Exports - Imports)
89,424
= GDP
726,921
+ Taxes on products
35,936
- Product subsidies
-15,759
= GDP
726,921
+ Production and import taxes
38,848
- Subsidies
-22,406
= GDP
726,921
Table 1.2: Swiss GDP (in m CHF) 2019 according to three calculation approaches
In order to produce GDP, a large number of physical goods (especially machines)
were used — economists speak of (physical) capital employed. As these only
have a limited shelf life, companies depreciate them over time. If we subtract
the total economic depreciation from GDP, we obtain the net domestic product
(NDP).
Table 1.2 ultimately shows how much value was created in Switzerland in 2019.
In economic terms, the question now arises as to who received this value and
to what extent. Firstly, a distinction must be made between residents and nonresidents. For example, if we want to determine the purchasing power of the
domestic population, we need to take into account that some of the income generated by production flows abroad. In the national accounts, factor incomes
(compensation of employees and property income) from abroad are therefore
added to GDP and those to foreign countries are subtracted to obtain gross national income (GNI):
Gross domestic product (GDP, CHF 727 billion in 2019)
+ Factor income from abroad (155 bn)
− Factor income to foreign countries (150 bn)
= Gross national income (GNI, 732 bn)
A distinction is made here between the domestic principle (GDP) and the national
principle (GNI). GDP does not take into account factor income (such as wages or
dividends) earned abroad by residents. Conversely, income earned by foreigners
in Switzerland is included. The opposite is true for GNI: only income earned by
47
1 Fundamental Macroeconomic Concepts
residents is taken into account. Consequently, income earned abroad is added
to GDP and income earned by foreigners at home is subtracted. A Swiss citizen
who works temporarily in France thus increases French GDP and Swiss GNI, but
not French GNI or Swiss GDP.
In most countries, the difference between GDP and GNI is small. For Switzerland, the data in Figure 1.8 show a slightly positive factor income balance. In
contrast, Ireland shows a significantly lower GNI than GDP due to the many
international corporations based there.15
Figure 1.8: Ratio of GDP to GNI
We can also distinguish between gross and net national income: By subtracting
depreciation and amortization from gross national income (GNI), we obtain net
national income (NNI). This amounted to around CHF 572 billion in Switzerland
in 2019. If indirect taxes (such as VAT) are deducted from this figure and subsidies are added, the result is national income (NI), which totaled around CHF
528 billion. This is earned by the people of a country in the form of employee
compensation as well as corporate and property income. The distribution of
national income between the production factors of labor and capital is referred
to as primary distribution. However, it must be taken into account that taxes
and transfers cause a redistribution of income and that many people also earn
15 In the case of Ireland, the large difference between GDP and GNI meant that the Irish economy
grew in terms of GDP in 2020. However, this only reflected the change in living standards to a
limited extent (Financial Times, “Multinationals flatter Ireland’s economic data”, 18.11.2020).
48
1 Fundamental Macroeconomic Concepts
property income through shares.
1.7 Price Indices
As we now know, the nominal GDP is the sum of all quantities of final goods
multiplied by their current prices. It follows, however, that nominal GDP can
increase for two reasons: (i) more goods and services are produced or (ii) prices
rise. In our example with the sawmill and the joinery, there was only one end
product: a table worth CHF 250. Therefore, the calculation of nominal GDP was
very simple, it was 250 francs. The real GDP is also easy to determine: it is a
table.
But how should we make this distinction between nominal and real GDP in
practice, where both the goods produced each year and their quality and prices
change? Let’s imagine that in 2019, an economy sold a total of four tables at
a price of CHF 250 each and sixteen chairs at a price of CHF 30 each. The
following year, four tables were sold for 300 francs each and ten chairs for 30
francs each. The price of the tables therefore increased and the number of chairs
sold decreased. We can quickly calculate the nominal GDP for both years:
• Nominal GDP in 2019: 4 ∗ 250 + 16 ∗ 30 = 1′ 480 francs
• Nominal GDP in 2020: 4 ∗ 300 + 10 ∗ 30 = 1′ 500 francs
Formally, the nominal GDP results as
N
GDPnominal
= ∑ Pti Xti
t
(1.3)
i =1
We multiply each product quantity X of the good i by the respective price from
the year t and add everything up. In our example, nominal GDP increased by
20/1480 = 1.351%. However, the quantity sold was smaller (the same number
of tables, but six fewer chairs). Real GDP must therefore have fallen. As both
quantities and prices have changed in our example, we have to take out the pure
price changes in order to obtain the change in real GDP. The key idea here is that
we calculate the monetary value of production in different years on the basis of
the same prices. To do this, we need to determine a base year. If we take the year
2019 and its prices, we obtain the real GDP based on the prices in 2019:
• Real GDP in 2019: 4 ∗ 250 + 16 ∗ 30 = 1, 480 francs
49
1 Fundamental Macroeconomic Concepts
• Real GDP in 2020: 4 ∗ 250 + 10 ∗ 30 = 1′ 300 francs
We therefore use the price from 2019 for the production of the tables in 2020 and
thus consider the price increase of the tables. Real GDP has fallen by 180/1480 =
12.16 percent. This shows that actual production has fallen.
Couldn’t we also take the prices from 2020 as a basis? In principle, there is
nothing to be said against it. We then get the real GDP for 2019 and 2020 based
on 2020 prices: 4 ∗ 300 + 16 ∗ 30 =1,680 and 4 ∗ 300 + 10 ∗ 30 =1,500. However,
if we now calculate the growth rate of real GDP, we get a decline of 180/1680 =
10.71 per cent. The choice of base year is therefore not insignificant for the results.
In practice, there are different approaches here. In Switzerland and Germany, the
prices of the previous year are used, while in the USA, for example, an average
value is calculated for simplicity’s sake.
If we look at more than just two years, the question arises as to which year we
should take as the base year for prices. In the past, many countries have defined
a base year for the entire time series (such as 2005) and updated it every five
years, for example.16 However, this had the disadvantage that all real growth
figures changed every five years. The resulting distortions were not insignificant.
If goods become cheaper over the years, demand and production generally increase. The first LCD televisions, for example, were very expensive and only a
few were sold. However, as the cheaper goods are weighted lower each time the
base year is updated, the real growth rate is lower.
To avoid this problem, most statistical authorities now use a different method:
the chain index. Here, the growth rate of real GDP is calculated from year t
to the following year t + 1 by weighting the quantities produced in t + 1 with
the prices of the goods from the previous year. The quotient Pt Xt+1 /Pt Xt then
corresponds to the growth rate of real GDP. Unlike a fixed base year (which
may only be updated every few years), the price base changes every year in the
chain index method: for the growth rate of real GDP from year t + 1 to t + 2,
Pt+1 Xt+2 /Pt+1 Xt+1 applies accordingly.
By calculating the real GDP and its change from year to year, we also implicitly
address the change in the price level. If we calculate the real GDP of the year
t + 1 with the prices of the previous year, the so-called GDP deflator is the ratio
of nominal to real GDP. Formally, the following applies:
GDP deflator for the year t+1:
Pt+1 Xt+1 /Pt Xt+1
(1.4)
16 Ghana’s GDP rose by 60% from 5 to 6 November 2010 after the country’s statisticians updated
the price index for the first time since 1993 (Diane Coyle, GDP: A Brief But Affectionate History,
2014, p.32).
50
1 Fundamental Macroeconomic Concepts
If we use the figures from our example above, we get 1,500/1,300 = 1.1538 —
the pure price effect was therefore around 15.4 per cent. The GDP deflator is a
so-called Paasche Index named after the German statistician Hermann Paasche
(1851–1925). As an alternative Price index there is also the Laspeyres index,
which is named after Étienne Laspeyres (German statistician, 1834–1913). This
is defined as Pt+1 Xt /Pt Xt . This means that the quantities from the base year are
multiplied by the prices from the two years. In our example above, this would
result in 1,680/1,480 = 1.1351, i.e. 13.51 per cent.
The GDP deflator is suitable for measuring the inflation rate in an economy. In
contrast to the consumer price index, which we will look at in more detail in
Chapter 6, the GDP deflator not only shows price changes for goods in a selected
basket of goods, but also the changes in all prices in the economy.
1.8 Summary
In this first chapter, we have familiarized ourselves with a number of basic
macroeconomic concepts. Particular attention was paid to the most important
economic variable: gross domestic product. We now understand how it is calculated and can, for example, better interpret the development of the Swiss economy as shown in Figure 1.9. We use gross domestic product (GDP) to summarize
the economic activities within a country and year. We distinguish between nominal and real GDP, whereby these two are identical for the year of the reference
prices as shown in Figure 1.9.
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1 Fundamental Macroeconomic Concepts
Figure 1.9: Switzerland’s nominal and real GDP until 2021
We have seen that a high GDP per capita is desirable. The question therefore
arises as to how a country can achieve a higher GDP per capita in the short,
medium and long term. In this textbook, we start with the short run and develop
a model in the next three chapters to better understand the short-run changes in
GDP.
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2 The Goods Market
2.1 Intro and Learning Objectives
Every day, the media report on current macroeconomic developments and economic policy measures: The Euro area economy shrank by 0.7% in the last quarter of 2020. The newly elected Biden administration plans to revitalize the economy with an economic stimulus package. Most of this reporting deals with what
economists refer to as short-term developments. We therefore begin our analysis
of the economy with the short term. In this chapter, we lay the foundations and
briefly discuss the idea and structure of a macroeconomic model. In essence,
we focus on the gross domestic product (GDP) known from Chapter 1. When
discussing the goods market, we will focus on the components of GDP and their
determinants. As the short-term fluctuations in GDP are primarily determined
by the demand side, equation (1.1), i.e. Y = C + I + G + ( X − I M), will keep us
busy for a while.
In order to understand the short-term fluctuations in GDP, we need to analyze
which factors determine the individual components of GDP. For the time being,
we will leave net exports out of the equation and consider a closed economy. In
chapter 2 we discuss the goods market, while chapter 3 takes a closer look at
the financial market. The aim of both chapters is to develop the IS-LM model,
which is discussed in Chapter 4. This model helps us to analyze the economy in
the short term. We can use it to analyze both economic shocks (e.g. a sudden
drop in consumer demand) and economic policy measures (e.g. a tax cut). We
want to keep the building blocks of the model as simple as possible. The markets
for goods and financial products are essential, leaving out the labor market, the
stock market, foreign countries, and many other aspects of the economy in reality.
We start by describing when supply and demand on the goods market are in
equilibrium using a concise mathematical formula (−→ provides us with the IS
curve). Chapter 3 then analyzes supply and demand in the financial market. The
equilibrium there (−→ the LM curve) is then the second building block for the
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2 The Goods Market
IS-LM model.
Before we begin to develop the IS-LM model, a brief categorization is in order. It
is by no means the case that all macroeconomists use this model and consider it
’appropriate’. Since it is a model that attempts to analyze reality by making simplifying assumptions, it is inevitably viewed critically. At its core, it is based on
the ideas of John Maynard Keynes and the associated Keynesian doctrine. There
are a number of different schools of economic thought among economists. In the
USA, the contrast between ’saltwater and freshwater economists’ is famous. This
means that economists at the universities on the Pacific and Atlantic (salt water)
tended to follow the Keynesian view (with more state intervention). In contrast,
there were several influential economists in Chicago, for example, such as Milton
Friedman (American economist, 1912–2006), who developed fundamentally different economic policy ideas.1 The fact that we follow the IS-LM model here is
not to be understood as a normative decision. Rather, three aspects appear to be
important: The fundamental ideas behind the IS-LM model are still the implicit
framework of thought that underlies many economic statements today.2 In addition, the IS-LM model can be described and analyzed without overly complex
mathematics. In addition, the book shows what the critical assumptions of the
model are and why model statements must be assessed accordingly.
2.2 The Short-, Medium-, and Long-Term
The short, medium and long term have already been mentioned several times.
This categorization is often used by economists, but should be explained and
justified. In very simplified terms, some economists describe the short term as a
period of less than five years, the medium term as a period of 5 to 10 years and
the long term as a period of more than 10 years. However, this categorization is
neither particularly helpful nor really correct. It is better to categorize the short,
medium and long term according to how quickly economic processes take place.
This means, for example, how quickly prices change or adjustment processes
are carried out in general. Companies can hardly change their headcount or
capitalization in the short term, for example, as contracts are concluded over
several months or years. In essence, the temporal subdivision is about the fact
that many economic variables behave differently in the short term than in the
1 A detailed description of the various schools of economic thought can be found in Alessandro
Roncaglia’s book entitled ‘A Brief History of Economic Thought’, published in 2017.
2 The American economist Ben Bernanke, head of the Federal Reserve from 2006 to 2014, put it
this way: “Keynesian economics, in a modernized form, remains the central paradigm at the
Fed and other central banks.” (21st Century Monetary Policy, 2022)
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2 The Goods Market
medium or long term. It therefore makes sense to use a different perspective and
economic analysis approach in each case.
The example of a new CO2 tax illustrates the distinction between the short,
medium and long term very well. It shows that many adjustment processes
take time. Let’s assume that the Swiss government introduces such a tax and
petrol and diesel prices rise significantly across the country as a result. How will
this affect the number of kilometers driven by car in Switzerland? Initially, many
people will simply drive less because of the higher costs in order to save money.
However, this is a short-term effect that will materialize because many aspects
will not change in the short term: people have a relatively stable income, an unchanged place of residence and commute, and so on. However, in the medium
term, i.e. over a period of a few years, these aspects change. For example, many
people buy a new car every few years. Due to higher petrol prices, people will
now opt for more economical models. However, as soon as a sufficient number
of people own a more economical car, the kilometers driven in Switzerland may
rise again to the original level. If this is the case, we will have a different effect of
the CO2 tax on the number of kilometers driven in the short and medium term.
This is due to the fact that adjustment processes take time. A car is only changed
every few years. The development and distribution of completely new car models takes even longer. It is possible that the CO2 tax will lead to an increase in the
number of electric cars in Switzerland in the long term. This is not possible in
the short and medium term because such cars cannot be developed and offered
on the market in significant numbers within a few years.
A second example of the importance of differentiating between the short, medium
and long term is the payment of CHF 1’000 by the Swiss National Bank (SNB)
to all residents of the country. Many residents would certainly be delighted with
such a gift and would use the extra money to buy a new mobile phone or other
goods and services. In the short term , the prices of these goods and services do
not change, so people’s real purchasing power is higher: they have more money
and everything still costs the same. However, more goods and services are not
suddenly available just because the SNB has transferred money to everyone. Consequently, the increased demand for goods is not matched by a greater supply,
so that the scarcity of goods soon leads to higher prices. In a market economy,
scarcity — i.e. the ratio of supply to demand — determines the price. However,
as soon as prices rise, people realize that although they have more money, prices
are correspondingly higher. Economists then say that the situation in real terms,
in the medium-term has not changed. Truly more prosperity — more available
goods — only arises if more can be produced and more is manufactured. This
depends on how many workers and machines are available and which technologies can be used. We will look at these aspects when analyzing the long term
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2 The Goods Market
later in the book.
In a similar way to the example of the CO2 tax, we need to analyze economic
policy measures taken by the state. If a government increases public spending,
for example, it will come as no surprise if this increases GDP in the short term.
After all, government spending is a direct part of the GDP equation. However,
whether this policy also has a positive effect on value added in the long term is
a completely different question and requires a different analytical framework.
Short-term
Medium-term
Long-term
Goods prices
fixed
flexible
irrelevant
Wages
fixed
flexible
flexible
Resource constraint
ignored
central point
changes over time
Table 2.1: Subdivision of the time periods
Table 2.1 summarizes some key differences between the three time periods. In
general, economists consider both goods prices and wages to be fixed in the short
term. This follows from the consideration and actual observation that prices are
not constantly changing. Restaurants do not constantly print new menus and
wages are not renegotiated on a daily basis. In addition, the assumption of stable
goods prices and wages simplifies the analysis in the model. In the short term,
we also ignore the resource constraints of an economy.
The assumption of constant goods prices has far-reaching consequences, as we
will see in more detail later in the book. To illustrate this briefly now, let us
consider a goods market in which demand increases, for example, as a result of
additional government spending. Many readers will be familiar with the simple
supply-demand model with a rising supply curve and falling demand curve. In
this model, a rightward shift in the demand curve leads to an increase in quantity
and price. However, if we exclude price changes by assumption, equilibrium can
only be achieved by adjusting the quantity: the higher demand must be satisfied
by a higher supply. Such an increase in supply is possible in the model, as we
ignore the resource constraints. This modeling framework makes measures to
increase the economic demand for goods appear much more attractive than if
they (primarily) lead to a price increase. Similarly, an increased money supply
in the model with fixed goods prices does not lead to inflation, but to a greater
demand for goods and thus to higher production. The assumption of constant
goods prices therefore has a major impact on the effects that the model predicts
for government intervention.
These two central assumptions when analyzing the short run — the assumption
of stable prices and the ignoring of resource constraints — are also dealt with
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2 The Goods Market
here in the textbook: Resource constraints on the supply side, specifically on the
labor market, are not introduced until chapter 5. We talk about price changes
(−→ inflation) in chapter 6. In contrast, we look at the short run in chapters 2
to 4. The last part of the book then examines the long term, where goods prices
play no role. Instead, in chapters 10 and 11, we turn to the change in available resources: how much labor, how much capital and which production technologies
are available for production and why does this change over time? In this context,
real variables such as the real wage are important, but not monetary variables. In
the long term, money is merely a veil: we could divide all monetary variables (i.e.
all prices expressed in francs) by ten today — the nominal GDP per capita would
then be only one tenth everywhere — without anything changing real. If ten
times as much money had been printed everywhere to date or all nominations
had been ten times higher, only the figures would change. Money is therefore a
veil over real values. Of course, this does not mean that money is irrelevant to
the economy, as we will see later.
In this textbook, we divide the analysis into the short, medium and long term.
Intuitively speaking, we therefore consider three time periods and ask ourselves
three questions with regard to Figure 0.3 on page 15:
• What moves GDP in the short term?
• Why are we returning to the trend line in the medium term?
• What determines the long-term trend line?
2.3 The Components of GDP
With annual fluctuations in economic activity, the interrelationship between production, income and demand is central to macroeconomic understanding:3
• Changes in demand lead to adjustments in production.
• Changes in production trigger changes in income.
• Changes in income cause changes in demand.
3 In some respects, this poses a chicken-and-egg problem:
does demand determine supply or,
conversely, does supply determine demand? Where economists start the cycle is crucial for their
economic policy recommendations. Different schools of economic thought pursue different
perspectives here.
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2 The Goods Market
When analyzing the goods market, we therefore focus on the demand for goods,
production and income. As seen in chapter 1.1, all three correspond to GDP. We
use an economic model to ensure that we do not lose track of the interrelationships mentioned above due to the complexity that quickly arises. The starting
point for this is the equation (1.1), which describes GDP in a closed economy as
the sum of private consumption, private investment and government consumption and investment expenditure. We discuss these three components of GDP in
detail below. First, we look at these for Switzerland and the period from 1996
as an example. Figure 2.1 shows several important observations: While both private consumption (C) and government consumption (G) have shown very stable
growth, private investment (I) and foreign trade (X, I M) show great volatility.
These observations are important if we want to understand the business cycles
later in the chapter.
Figure 2.1: Growth contributions to Switzerland’s GDP
2.3.1 Private Consumption
In order to understand the short-term development of GDP, we must first explain
which factors determine private consumption. Table 1.1 already showed us that
this is the most important component of GDP in terms of size. We must therefore now explore how people determine their private consumption expenditure.
Economists have developed a variety of explanatory and modeling approaches
for this. The most important of these are Keynesian consumption theory and
the permanent income hypothesis. In the following, we will describe both, but
then focus on the Keynesian approach. This is because the IS-LM model from
chapter 4 follows this approach.
Keynesian consumption theory
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2 The Goods Market
In 1936, John Maynard Keynes published one of the most influential books on
economics: "The General Theory of Employment, Interest and Money". In it,
he described his explanation for macroeconomic developments with a view to
the economic depression of the time, which differed greatly from the prevailing
neoclassical approach at the time. Summarized to the core, Keynes questioned
whether markets could quickly and automatically (without government intervention) return to an equilibrium with high employment in view of the ongoing
economic misery. With regard to the question of how people determine their
private consumption expenditure, he postulated a simple correlation based on
aggregated data. As Figure 2.2 shows using Swiss data, there is a positive correlation between consumer spending and income over time. The higher people’s
disposable income, the higher their consumer spending.
Figure 2.2: Keynesian consumption function with Swiss data
Based on this observation, Keynes assumed that private consumption expenditure depends on available income. The latter is denoted by YV and is defined as
income Y minus taxes and plus transfer payments:
YV = Y − T
It should be noted here that T is generally used to summarize all taxes (income
tax, VAT, etc.) as well as transfer payments (unemployment benefit, child bene59
2 The Goods Market
fit, etc.). Basically, T is therefore the net amount that households either pay to
the state or receive from it. The disposable income is either used for consumer
spending or saved: YV = C + S, where we use S to denote private savings. Since
private consumption expenditure C depends positively on disposable income, we
can define
C = C (YV )
(+)
This simply shows that C is an increasing function in YV : the higher YV , the
greater is also C. Mathematically you write ∂C (YV )/∂YV > 0, the first derivative
is positive. We are therefore describing an economic relationship using a mathematical function. If we assume for the sake of simplicity that this is a linear
function, it can be represented as follows
C = c0 + c1 ∗ YV = c0 + c1 ∗ (Y − T )
(2.1)
There are two parameters in the Consumption function shown here. Autonomous
consumption c0 describes consumption that is independent of disposable income.
This does not mean the consumption necessary for survival, but ultimately the
positive vertical intercept shown in Figure 2.2. The propensity to consume c1 , on
the other hand, describes how much private consumption increases when disposable income rises by one franc. In Figure 2.2, this corresponds to the slope of the
straight line. Conversely, we can define s as the savings rate, where s = 1 − c1 :
from one franc of additional income, c1 francs are spent on consumption and
s francs are saved. For example, c1 = 0.8 and s = 0.2, so that for every additional franc of income, 80 centimes are spent on consumption and 20 centimes
are saved.
In practice, the savings rate varies greatly across countries. According to OECD
data, it recently stood at around 10% in the United States and just under 40% in
China. As Figure 2.3 shows, Switzerland tends to have a relatively high savings
rate of more than 15%. However, there is a variation in the savings rate over time:
during the coronavirus crisis in 2020, for example, the savings rate rose sharply
in many countries.
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2 The Goods Market
Figure 2.3: Savings rates in selected countries
For our model of the goods market, we assume that 0 < c1 < 1 applies and can
illustrate the function as in Figure 2.4. John Maynard Keynes wrote about this in
his 1936 book “The General Theory of Employment, Interest, and Money” (page
96): “Men are disposed, as a rule and on the average, to increase their consumption as their income increases, but not by as much as the increase in their income
[...] dC/dY is positive and less than unity”. The assumption that private consumption expenditure is determined according to such a simple formula is, of
course, a gross oversimplification of reality. But as already mentioned, every economic model requires simplifying assumptions. After a thorough understanding
of the model, it is important to take a critical look at the assumptions so that we
do not misinterpret the findings and economic policy conclusions drawn from a
model. Many of the results in the model are explained by the implicit and explicit model assumptions; if these are incorrect with regard to reality, the model
statement must also be critically evaluated.
61
consumption C
2 The Goods Market
consumption function
C = c0 + c1 YV
slope = c1
c0
disposable income YV
Figure 2.4: Keynesian consumption function in theory
The most important criticism of the Keynesian consumption function is that it is
only postulated on the basis of aggregated data. There is no derivation based on
individual decisions. Economists refer to this as a lack of microfoundations. This
is an important benchmark in modern economics. For example, a more complex
model could be described in which households adjust their consumption in such
a way that they achieve the greatest possible benefit. In addition to their current
disposable income, they also take into account other aspects such as their future
income. This micro-foundation does not take place in the Keynesian consumption function. Other important factors that determine consumer spending are
also not taken into account. Consumption is based only on present disposable
income, without taking into account wealth, income shifts over the life cycle, future income and taxes. In addition, savings and borrowing opportunities and the
interest rate are not taken into account as influencing factors.4 The criticism is
certainly justified, but overall it merely shows what we already know: reality is
more complex than we can depict in a (simple) macroeconomic model.
4 Keynes writes in his book ‘The General Theory of Employment, Interest and Money’ on page
94: “There are not many people who will alter their way of living because the rate of interest
has fallen from 5 to 4 per cent, if their aggregate income is the same as before.” It can also be
noted that the income and substitution effects almost cancel each other out in the event of a
change in interest rates with regard to aggregate consumer spending.
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2 The Goods Market
The permanent income hypothesis
The second important explanatory approach for consumer spending was essentially developed by Milton Friedman. Here, households have a longer-term planning horizon and choose their current consumption in such a way that an intertemporal utility function is maximized. This means that households consider
income and the benefit from consumption over a longer period of time. Important elements in this model are lifetime income (all current and future income),
the utility function (describes how consumption and leisure makes individuals
happy), and an intertemporal budget constraint (specifies that households cannot
spend more than they earn in the long term). Given their income, utility function
and budget constraint, households maximize utility within the constraints.
To illustrate the difference to the Keynesian consumption function, a simple example is given. Let us assume that a household has a disposable income of CHF
100’000 and spends CHF 90’000 of this on consumption. Using equation (2.1),
this can be explained by the fact that the household spends a fixed proportion
c1 = 0.9 of its disposable income. If this household wins ten million francs in the
lottery in 2021 (after tax), it will spend the same fixed proportion (90%) in 2021
according to the Keynesian model. According to the permanent income hypothesis, this is not realistic. Instead, the household will consume the one-off gain,
which does not correspond to a permanent income, spread over several years.
An important observation here is that the permanent income hypothesis predicts
consumption smoothing. This means that people want to avoid large fluctuations
in consumption over the years.
These considerations are of great importance in terms of economic policy. When
the US economy fell into recession in 2020, there was extensive debate about
an economic stimulus program. Part of the Coronavirus Aid, Relief, and Economic
Security (CARES) Act passed at the time was a one-off payment of around 1’200
US dollars to every American. What the recipients do with the money — spend
it on goods or save it in their bank account — is decisive for the stimulating effect
of the economic policy measure.
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Theory box 2.1: Income and substitution effect
Many students only have a very limited budget that they can use for consumer spending.
It is not uncommon for a substantial part of this to be used for food. This also includes
alcoholic beverages such as beer and wine. Let’s assume a student has 20 CHF, a beer
costs 5 CHF and a wine costs 10 CHF. Furthermore, the student considers the two drinks
to be partially substitutable (i.e. mutually interchangeable): although he has a preference
for beer, he likes to drink both. At the given prices, he consumes two beers and one
glass of wine. Let us now imagine that the price of wine falls to 5 CHF. How should
an economically minded student react to this? Should he buy more wine instead of beer
because wine has become cheaper in relative terms? Or should he buy the same amount
of wine and use the money saved to buy more beer?
We can answer this question by using two concepts from microeconomics. The substitution
effect refers to a change in demand for a good as a result of a change in relative prices
(i.e. the price ratio). This is to be distinguished from the income effect, which describes the
change in demand as a result of a change in real income. In our example, wine has become
cheaper (in absolute and relative terms). Therefore, the substitution effect is positive with
regard to wine: more wine should be bought and less beer. In other words, beer should be
substituted for wine. However, the income effect occurs in parallel: due to the fall in wine
prices, the student can afford more overall, his real income has risen: he could now afford
two beers and two glasses of wine, for example. This speaks in favour of higher wine
and beer consumption. The same would happen if the student suddenly had a higher
disposable income without a price change. If the student in our example comes to the
conclusion that he should consume less beer and more wine in response to the lower wine
price, the substitution effect prevails.
For economists, the income and substitution effects are often of great importance. For
example, the question arises as to how the labor supply reacts to a wage increase. For
example, someone currently works for an hourly wage of 40 francs and their wage rises
to 50 CHF. Should he now work more or less? On the one hand, it is now worth working
more. Economically speaking, every hour of free time now costs more (−→ opportunity
costs). The person should therefore increase their labor supply. On the other hand, the
person can also reduce their working hours and continue to earn the same income.
As already mentioned, we are focusing on the Keynesian approach in this textbook. This is not a statement as to whether it describes reality better than the
permanent income hypothesis. Rather, Keynes’ approach is part of the IS-LM
model, which we will use in chapter 4 to describe the economy in the short term.
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2 The Goods Market
2.3.2 Private Investment
In addition to private consumption expenditure, private investment is the second component of the GDP equation. Specifically, this is gross investment. Private investment is important for two reasons. Firstly, it is part of GDP (Y =
C + I + G + NX) and thus explains the level and, above all, the short-term fluctuations in GDP growth (see Figure 2.1 on page 58). As we have already seen,
investment is much more volatile than consumer spending and is therefore important for explaining business cycles. In addition, investment increases the stock
of productive capital, i.e. the number and quality of existing machines. Investment is therefore central to long-term economic growth, as we will see in more
detail in Chapter 10. The more machines and other (physical) capital an economy has, the more it can produce structurally. As some of the machines break
down or become unprofitable every year (in technical terms, the machines are
depreciated), a certain level of investment is needed just to keep the capital stock
unchanged. In somewhat simplified terms, this can be described as follows
Ktomorrow = Ktoday + I − amortization
What determines the level of private investment? We focus on one important
determinant, the interest rate. The influence of the interest rate can best be understood if we assume that companies have many potential investment projects
with different rates of return (returns-on-investment or RoI for short). If this return
exceeds the interest rate at which companies can borrow money, it makes sense
to invest. Consequently, with a lower interest rate, there are a greater number of
profitable projects and private investment increases. In slightly different terms,
the net present value (NPV for short) can also be calculated for each project:
NPV = CF0 + CF1 /(1 + i ) + CF2 /(1 + i )2 + CF3 /(1 + i )3 + ...
(2.2)
where we use CFt to denote the payments (cash flows) at time t.5 The initial
payment CF0 is negative because the company invests money. For example, it
buys a new machine for CHF 1’000. This is potentially attractive, as the company
benefits from higher income (CF1 , CF2 , etc.) in subsequent years. The future
payments must be discounted to the present day, which is why we divide by
(1 + i ). Let us assume that the investment in a new machine brings the company
two future revenues of 500 and 540 francs. Should it then make the investment?
This depends on the interest rate and we can determine the break-even interest
5 For an infinitely long series of constant annual payments in the future, the result is: NPV = CF/i.
65
2 The Goods Market
rate at which costs and (discounted) income are exactly equal: 1000 = 500 +
540/(1 + i ). We can resolve this to i = 8%. So if the interest rate is lower than
8 per cent, the investment is worthwhile. If, on the other hand, the interest rate
is higher, the investment should not be made. We summarize the relationship
between private investment and the interest rate mathematically as follows
I = I( i )
(−)
Further factors could be added to the model with regard to the determinants of
private investment: For example, risk appetite and expectations about the future
play an important role. John Maynard Keynes (1936, p.161) and other economists
emphasize animal spirits as an important factor: if we imagine entrepreneurial
decision-makers as temperamental and impulsive, expectations regarding future
economic developments are important.6 A wave of euphoria can therefore become a self-fulfilling prophecy. How optimistic managers are about the current
situation and economic development is often estimated using the business climate index (Purchasing Managers’ Index, PMI). Thousands of managers in numerous countries are surveyed every month on the order situation and their
assessment of future developments.
2.3.3 Government Consumption
If we consider a closed economy without foreign trade, the level of GDP is determined not only by private consumption and investment but also by government
consumption: Y = C + I + G. The variable labeled G includes all government
spending on goods and services. For example, if a public university buys new
computers, G increases and with it the aggregate demand for goods. Similarly,
wages for employees in the public sector are included in G.7
In our model, the state can in principle influence GDP in two ways: by increasing/decreasing government consumption (G) and by changing taxes and transfer
payments (T). Under the latter, we can imagine a reduction in income tax, for
example. This increases disposable income and thus private consumer spending.
According to the model, a reduction in VAT, such as in Germany in the second
6 The 2009 book ‘Animal Spirits:
How Human Psychology Drives the Economy, and Why It
Matters for Global Capitalism’ by George A. Akerlof and Robert J. Shiller discusses in detail
how animal spirits influence the economy.
7 GDP does not include unpaid activities such as home gardening because no market prices are
paid. In the public sector, however, wages are paid that are not generated in a market but are
still included in GDP. Ronald Indergand and Felicitas Kemeny describe further details on this
in Die Volkswirtschaft, 10/2021.
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2 The Goods Market
half of 2020, or the aforementioned $1’200 that every adult in the USA received
as a result of the coronavirus crisis, would have a similar effect.8 In both cases,
economic studies are investigating whether the desired positive effect on GDP
has materialized: has the tax cut increased consumption as expected and thus
boosted economic growth? In addition or alternatively, countries have attempted
to increase GDP in 2020 through new government consumption expenditure.
This includes, for example, the construction or purchase of at least two quantum
computers in Germany as part of the ’economic stimulus and future package’
(June 2020), provided that these (or components for them) are purchased by public institutions.
Decisions on the scope of government spending, G, and the level of taxes and
transfer payments, T, are referred to as fiscal policy. We use G and T as exogenous variables, which means that we do not explain their level in our model.
The fields of political economy and public finance (or public economics) deal in
more detail with the determinants and effects of public finances. In practice, it
is particularly important to note that government spending — as well as private
investment — depends on interest rates on loans.
2.4 Equilibrium
If we summarize the three components of GDP now discussed, we have the total
(aggregated) demand for goods. All goods that are demanded in a year in a
closed economy are either used for private consumption, private investment or
government consumption. An equilibrium on the goods market only occurs if the
total production of goods, Y, corresponds to the aggregate demand for goods, Z:
Y = Z = c 0 + c 1 ∗ (Y − T ) + I ( i ) + G
(2.3)
This equation describes a equilibrium condition. It should be noted that we are
still considering a closed economy without foreign trade: Exports and imports
are equal to zero (X = I M = 0). In equilibrium, production Y (left-hand side
of the equation) equals demand (right-hand side of the equation).9 Demand in
turn depends on income Y and income in turn is equal to production. This again
shows the interrelationship between production, income and demand that we
described at the beginning of the chapter. This leads to an idea that is as banal as
8 For comparison, families in Germany received a one-off subsidy of 300 euros for each child
entitled to child benefit in 2020.
9 Both production and income are denoted by Y. In practice, Y and Z can deviate from each other,
which is referred to as inventory changes in the national accounts.
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2 The Goods Market
it is important: what is demanded is produced. The higher the total demand for
goods, the greater production (and therefore employment) will be. To stimulate
the economy and increase GDP, it is therefore sufficient for the state to boost
demand through fiscal policy. However, as we will see from chapter 5 onwards,
this only applies as long as production capacities are underutilized, i.e. we can
produce more if demand for goods is higher.
As Figure 2.5 shows, in equilibrium the supply of goods shown in red (= production = income = Y) must correspond to the demand for goods shown in blue (=
Z). Since the propensity to consume c1 is less than 1, there is a clear equilibrium.
This results in an intersection of the two straight lines in the graph, which is why
the figure is referred to as a Keynesian cross. Formally, we can determine the
equilibrium income Y0 by solving the equilibrium condition (2.3) for Y:
Y = c 0 + c 1 (Y − T ) + I ( i ) + G
Y (1 − c1 ) = c0 − c1 T + I ( i ) + G
1
Y0 =
c0 + I ( i ) + G − c1 T
1 − c1
(2.4)
This rather inconspicuous equation has far-reaching effects. Firstly, it states that
there is only one income level (namely Y0 ) for which the goods market is in equilibrium. This contradicts the neoclassical theory that prevailed before Keynes and
the Say’s theorem named after Jean-Baptiste Say (French economist, 1767–1832):
“Every supply creates its own demand”. According to neoclassical theory, any
income level is compatible with a goods market equilibrium and a certain level
is determined by the labor market. According to neoclassical theory, the supply
of goods is determined first and demand adjusts accordingly. With Keynes, it is
the other way round: demand determines supply.
Equation 2.4 has a further central implication: every increase in autonomous expenditure (c0 , I (i ), G), i.e. independent of disposable income, or reduction in
taxes leads to an increase in GDP — and in multiplied form, since 1/(1 − c1 ) is
greater than one. We will go into this in more detail in a moment.
68
demand Z, production Y
2 The Goods Market
gr
ad
ie
nt
=
1
45° line: Y = C + I + G
e=
slop
•
c1
Z = ( c0 + I ( i ) + G − c1 T ) + c1 Y
equilibrium Y=Z
Autonome
Outputs
Y0
income Y
Figure 2.5: Keynesian cross
It is important to note in Figure 2.5 that the Z-line was drawn for a specific
interest rate level. This is a fundamental point for understanding model graphs
in this book: if a variable is not shown on the axes (as i here), then the graph
applies to a specific value of this variable.
2.5 Comparative Statics and Multiplier
In Figure 2.5 we see the equilibrium on the goods market: as the intersection of
the demand for and supply of goods. Assumedly, the latter always adjusts to
the demand for goods. We described this with the equation Z = (c0 + I (i ) + G −
c1 T ) + c1 Y. This means that the demand for goods, and therefore production and
GDP, increases if
• autonomous consumption (c0 ) increases
• government spending (G) is increased
• taxes are reduced or transfer payments are increased (T decreases)
• the interest rate (i) is lower
In order to show the dynamics of how the goods market reacts to a change in the
exogenous variables, we analyze an increase in government consumption G by
∆G (we use the Greek symbol ∆ for a difference, for example one million francs).
In a first step, this causes an increase in the aggregate demand for goods. Since in
the model, the economy always produces what is demanded, production Y also
69
2 The Goods Market
demand Z, production Y
increases and with it income (also Y). The latter leads to an increase in disposable
income YV = Y − T if taxes remain constant (T unchanged). As people have
a higher disposable income, their consumer spending C increases. This again
increases aggregate demand, production and income. The process described here
is repeated several times and is graphically illustrated in Figure 2.6.10
45° line
Z′
A1
Y1
B
Y0
•
•
D
Z
E
C
A0
Y0
Y1
income Y
Figure 2.6: Keynesian multiplier
Starting from the original equilibrium (point A0 ), G initially increases because the
state has increased spending. As a result, the demand for goods increases: the
Z- line increases by the same amount as G. However, the total demand for goods
is then greater than the total supply of goods (see point B). In order to meet the
excess demand, supply (or production Y) increases. Graphically, we move from
point B to C. However, we are not yet in equilibrium, as income and therefore
consumption C rise due to the increase in production: remember: C = c0 + c1 ∗
(Y − T ). Private consumption C therefore increases and with it the demand for
goods. This can be illustrated graphically as a movement from point C to D. Now,
once again, demand is greater than supply. This chain can be continued until the
changes are negligible and we have reached the new equilibrium at point A1 .
As a result, GDP has risen by significantly more than ∆G. We can see this in
Figure 2.6, as the difference between point A0 and point B corresponds exactly
to ∆G and point B to C also corresponds to ∆G. However, the increase in GDP is
10 When looking at Figure 2.6, it should be noted that the reactions described take place immedi-
ately in the model. In equation (2.3), we have assumed that production always equals demand.
In reality, however, the adjustment process will be much slower: Firms and households do not
increase their production and spending immediately when demand and income rise.
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2 The Goods Market
greater than the distance from point B to C. But by how much exactly has GDP
risen? In equilibrium, the following applies: Y = Z = c0 + c1 ∗ (Y − T ) + I (i ) + G.
If we solve the equation for Y, we get as shown above:
1
Y=
c0 + I ( i ) + G − c1 T
1 − c1
This results in 1/(1 − c1 ) as Keynesian multiplier. For example, if G increases
by one unit, Y increases by 1/(1 − c1 ) > 1 or in other words: ∆Y = 1/(1 − c1 ) ∗
∆G > ∆G. Every franc of additional government spending increases GDP by
more than one franc.
How can this multiplier effect be explained? An increase in demand (e.g. due
to an increase in government spending) leads to an increase in production and
a corresponding increase in income. This increase in income induces a further
increase in demand. This in turn leads to a further increase in production and
so on. The end result is that the increase in demand — and therefore production
— is far greater than the original shift in demand, by exactly the factor corresponding to the multiplier. Graphically, we quickly recognize in Figure 2.6 that
the increase in GDP from Y0 to Y1 is particularly large when the slope of the consumption function, i.e. c1 , is very large. This is no surprise, because the greater
the marginal propensity to consume, the more of the additional income is spent
on greater consumption C when we move from point C to D. How quickly the
economy moves from Y to Y1 depends on how quickly firms react to the new
situation by adjusting production.
A numerical example illustrates the process. Let us assume that the state buys
office supplies for 100 CHF. The stationer thus receives an additional order and
earns an additional CHF 100 in income. Leaving aside taxes and other levies,
his income increases by 100 CHF, of which he spends, for example, 80% (formally this corresponds to c1 = 0.8). The retailer saves the remaining CHF 20.
If we assume that the 80 CHF additional consumer spending takes place in a
supermarket, the supermarket owner has an additional 80 CHF income. If he
has the same propensity to consume c1 = 0.8, he will spend 80 ∗ 0.8 = 64 CHF
and save 16 CHF. After just two rounds, this results in a cumulative increase
in demand for goods of 100 + 80 + 64 = 244 CHF. As the supermarket owner’s
additional consumer spending also generates additional income somewhere, the
process continues. The result is a geometric series in which the additional demand is constantly decreasing. Expressed mathematically, we get
∆Z = 100 + 100 ∗ c1 + 100 ∗ c21 + 100 ∗ c31 + ... + 100 ∗ c1∞ = 100/(1 − c1 )
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2 The Goods Market
After all rounds, a consumption propensity of 80% (c1 = 0.8) results in an increase in GDP of CHF 500 (= 100/0.2) according to the formula. Conversely,
this means that the multiplier is exactly 1/(1 − c1 ) = 5: every additional franc
of government spending has increased GDP by five francs. As already seen,
the marginal propensity to consume c1 therefore determines how strongly an increase in government spending stimulates the economy. We have already seen in
Figure 2.6 that for a given increase in the Z- line, the increase in GDP depends
on how large c1 is.
The fact that the marginal propensity to consume c1 determines the value of the
multiplier can also be interpreted differently. There are two possible leaks in the
process described above: Saving and — as we will see in more detail later in the
book — consumer spending on imported products. In our example above, it was
important for a strong increase in demand that the stationer and the supermarket
owner spend as much of their additional income as possible on domestically produced goods. The higher their savings rate — we assumed 20% — the lower the
stimulating effect of government spending. In this context, economists also speak
of the savings paradox (paradox of thrift). As John Maynard Keynes explained, individual citizens can save more, but if everyone saves more, this reduces the
demand for goods and therefore production and income. However, since savings
depend on these same incomes, less is saved overall if everyone saves more. In
his own words: “Whenever you save five shillings, you put a man out of work for
a day”. This view is correct in the modeling framework here. However, Keynes
saw saving primarily as non-consumption. But savings are also the basis for investment and the latter determines how much capital is available for production
in the long term. When assessing the economic consequences of a high savings
rate, a distinction must therefore be made between the short and long term.11
The fact that one additional franc of government spending increases GDP by
more than one franc puts government spending in a particularly favorable light.
It significantly increases GDP and thus also employment in an economy. It is
not surprising that many economic policy projects were and are motivated in
this way. But how big is the multiplier in reality? Research on this topic is very
extensive due to its great economic policy significance. It is not surprising that
the estimates vary greatly. Ultimately, the multiplier effect depends on many
aspects: Are taxes lowered or government spending increased? Which taxes or
expenditure will be changed? Are there tax cuts for lower earners (with a high
propensity to consume) or high earners (low propensity to consume)? How will
the additional expenditure be financed, through debt or tax increases? Of course,
11 John Maynard Keynes is often quoted as saying ’In the long run we are all dead’.
This quote
comes from the 1923 book Tract on Monetary Reform (page 80) and refers to a discussion of
quantity theory, which we cover in Chapter 6.
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2 The Goods Market
high multipliers are attractive to political decision-makers because they provide
a good justification for government spending. For example, the European Union
calculated a multiplier of around ten at the beginning of 2020 as part of its Green
Deal.12 In an analysis published in 2019 in the Journal of Economic Perspectives,
Valerie A. Ramey analyzed a large number of recent studies and came to the
conclusion that the multiplier is often only between 0.6 and 1.0. However, there
is a large variation depending on how the expansionary fiscal policy is organized.
There are also a large number of different estimation methods for the multiplier
effect, which provide different values. And it also plays a role when expansionary
fiscal policy is implemented: As Sebastian Gechert and Ansgar Rannenberg (Journal of Economic Surveys, 2018) show, the multiplier is significantly larger in times
of recessions. This is not surprising, as the increase in production in Figure 2.6
assumes that production capacities are not being utilized. In other words, the
increase in GDP due to an increase in government spending is easier to achieve
if many workers are unemployed in the baseline situation.
A final important observation on the effect of higher government spending concerns what happens to the goods market equilibrium when G and T are increased
by the same value. Let us imagine that the government raises taxes by one million francs in the same year and uses the money to make additional expenditures
immediately. In our model, we can use the equation 2.4 to show the effects:
• The increase in G causes a change in GDP:
∆Y = [1/(1 − c1 )] ∗ ∆G
• The increase in T causes a change in GDP:
∆Y = [−c1 /(1 − c1 )] ∗ ∆T
Since ∆G = ∆T, we obtain the total effect on GDP: ∆Y = [(1 − c1 )/(1 − c1 )] ∗
∆G = ∆G. The multiplier of an increase in government spending is therefore exactly one. In other words, GDP increases by exactly one franc for every additional
franc of government spending that is refinanced through taxes. The disposable
income YV = Y − T remains constant. This result is known as the Haavelmo theorem after the Norwegian economist and Nobel Prize winner Trygve Haavelmo
(1911–1999).13 How can the stimulating effect of a government spending increase
financed entirely by tax revenues be explained? Every additional franc in taxes
reduces disposable income by one franc, but consumer demand C only by c1 < 1
francs. At the same time, government consumption increases by one franc, as
12 Source: “EU’s eye-catching green measures are not quite what they seem”, Financial Times, Jan
29, 2020.
13 Original study: Trygve Haavelmo (1945). Multiplier Effects of a Balanced Budget, Econometrica,
13, 311-318.
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2 The Goods Market
there is no government saving. As we saw above, saving is detrimental to GDP
in the short term. A transfer from private households (which save part of the
money) to the state therefore has a positive effect on demand and thus on GDP.
2.6 The IS Curve
Our aim in chapters 2–4 is to develop a model for the economy in the short term.
For this we will use the IS-LM model, where IS and LM describe the equilibrium
on the goods and financial markets respectively. As we have already discussed
the former, we can now summarize it as the IS curve at the end of the chapter.
First of all, the equilibrium concept should be briefly explained. This term is of
central importance to economists, but is not always used consistently. According to the textbook “Macroeconomics and New Macroeconomics” by Bernhard
Felderer and Stefan Homburg, a distinction can be made between the methodological, theoretical and normative concept of equilibrium. We follow the same
approach here and use the methodological concept of equilibrium: “An economic
system is in equilibrium if the endogenous variables (with the exogenous variables remaining constant) do not change over time.” (page 18). We refer to the
coincidence of supply and demand plans as market clearing.
In order to derive the IS curve as a description of the equilibrium on the goods
market, we consider the effects of a rise in interest rates on income. Since investments depend negatively on the interest rate (I = I (i ), where ∂I (i )/∂I < 0),
an increase in the interest rate causes investments and thus the overall economic
demand for goods and thus income to fall. As shown graphically in Figure 2.7,
the demand for goods Z shifts downwards. As the interest rate i rises, income Y
falls in the goods market equilibrium. The IS curve therefore has a downward
slope: At the higher interest rate i1 , the Z- line and the equilibrium income Y1 are
lower. In Figure 2.7 we show the relationship between interest rate and income
graphically on the right-hand side.
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2 The Goods Market
Z
i
45° line: Y = Z
Z ( i0 )
•
•
Z ( i1 > i0 )
i1
A
•
B
•
i0
A
B
IS
45°
Y1
Y0
Y
Y1
Y0
Y
Figure 2.7: derivation of the IS curve
An economy that is in goods market equilibrium has an interest-income combination that lies on the IS curve. Above the IS curve, however, there is a surplus
supply on the goods market (the interest rate is too high, consequently savings
are too high, investments I are too low and thus the demand for goods is too low
for the given income Y), while below the IS curve there is a surplus demand on
the goods market.
When analyzing the IS curve, we must distinguish between two cases. On the
one hand, there can be a movement along the IS curve. This is the case when
the interest rate changes. We then have, as shown in Figure 2.7, an endogenous
adjustment of the production quantity. On the goods market, the adjustment
takes place via quantities, as prices are fixed in the short term. On the other
hand, there are shifts in the IS curve. These occur when factors change that
trigger a fall (or rise) in the demand for goods at a given interest rate. One
example is increased government spending. As already seen, this shifts the Zline upwards and thus the IS curve to the right.
Where does the term ’IS curve’ for the equilibrium on the goods market come
from? The two letters describe the iinvestments and savings. In our model,
we have labeled the non-consumed part of disposable income as private savings
S = YV − C = Y − T − C. If we solve this equation for Y we get
Y = S + T + C.
We can equate this with the equilibrium condition (2.3) for the goods market
(Y = C + I + G) and solve:
S+T+C = Y = C+I+G
75
−→
I = S + (T − G)
(2.5)
2 The Goods Market
The goods market is only in equilibrium if investment and savings (the sum of
private and government savings) are equal. Government saving is the difference
between taxes and government spending: ( T − G ). In the open economy with
imports and exports, i.e. Y = C + I + G + ( X − I M), the condition would read
accordingly:
I = S + (T − G) + ( I M − X )
(2.6)
All domestic investments can be financed in three ways: through domestic household savings (S), through government savings (T − G) or through foreign savings.
If a country imports more goods and services than it exports, it has to borrow
abroad — and thus in a sense imports foreign savings. To describe this more intuitively, let’s imagine a person who spends more on investment and consumption
than they earn. This person must in some sense have a trade deficit (this is what
we call the situation in which imports are greater than exports). Equation (2.6)
also shows that a larger government budget deficit (T − G < 0) must be accompanied by a combination of higher private savings S, lower investment I and a
larger trade deficit (I M − X).
The equations (2.4) and (2.5) both describe the equilibrium on the goods market.
There is a simple way to show that the two equations are linked. We start with
the observation that savings are equal to what remains of disposable income
after deducting consumption expenditure: S = Y − T − C. If we replace C in this
equation with the consumption function, we obtain S = Y − T − c0 − c1 (Y − T ).
We insert this expression for the “S” into equation (2.5) and obtain: I = −c0 +
(1 − c1 )(Y − T ) + ( T − G ). If we solve this for Y, we get the equation (2.4).
Before concluding the chapter, let us turn to another important question. Since
I = S in the goods market equilibrium (without government savings and without foreign countries), is S or I the driver? Do savings determine investment
or, conversely, do investments determine savings? There is a key difference here
between Keynes’ theory of effective demand and the supply-oriented theory of
(neo-)classicism. The equilibrium condition “savings = investment” can be interpreted causally in two ways: According to Keynes, the demand for investment
determines production, income and thus the formation of savings. The demand
for goods induces the supply of goods so that investment makes savings possible. In contrast, neoclassical theory postulates that every supply creates the
corresponding demand (known as Say’s law). Production is determined on the
labor market and what is not consumed from the production generated — ultimately the savings supply — is automatically invested. The creation of savings
thus determines the volume of investment. In a nutshell, in the neoclassical case
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2 The Goods Market
S(i ) = I (i ) and in the Keynesian case S(Y ) = I.
These considerations must also be taken into account when evaluating the effects
of a government budget deficit (T < G) with regard to equation (2.5). Based
purely on the equation, one could conclude that private investment increases
when a government reduces its budget deficit: If the expression T − G increases
and S remains unchanged, then I must increase. The crucial point, however, is
that if T − G increases (either by an increase in T or a decrease in G), income Y
falls and thus S does not remain unchanged. It is even the case that S will fall
more than T − G rises, so that investment will fall as a result of a reduction in
the government deficit. In a sense, we are once again dealing with the already
familiar savings paradox — this time on the basis of government savings.
Practice box 2.1: Parable of the Capitol Hill Babysitting Cooperative
We look at a group of families in Washington DC. All couples need regular childcare for
their children. To avoid having to spend money on childcare, they have developed a system. They take turns taking time off and then look after not only their own children, but
also those of the other families. In order to ensure that everyone looks after the children
regularly, they draw up authorization slips. Each license entitles the holder to have their
child looked after for half an hour. For example, if a couple wants to go out for dinner
in the evening without their children, they pay another couple with the vouchers. The
babysitting couple receives a certain number of vouchers from the parents of the child in
their care, depending on the amount of time the child is looked after.
The system worked smoothly for a while. But then all parents want to collect more vouchers at the same time. In a figurative sense, all parents wanted to increase their savings.
This leads to a crisis, because without anyone issuing vouchers (i.e. requesting childcare),
no one can collect vouchers.
The parable shows that a recession - i.e. a slump in economic activity - can occur due
to a lack of demand. It was first described in 1977 by Joan Sweeney and Richard James
Sweeney in the Journal of Money, Credit and Banking.
In the Keynesian model framework pursued here, private savings do not depend
on c0 or c1 . The equilibrium income is determined as
1
Y=
c0 + I + G − c1 T
1 − c1
This implies for the savings:
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2 The Goods Market
S = YV − C
= (1 − c1 )(Y − T ) − c0
= c0 + I ( i ) + G − c1 T − (1 − c1 ) T − c0
= I (i ) + G − T
Private savings S are therefore not determined by the propensity to consume, but
by investment demand and government consumption. A comparison of the neoclassical and Keynesian approaches may sound rather theoretical at first. However, many of the economic policy discussions are ultimately the result of the different theories. If an economy is in a deep recession — such as Greece from 2009
onwards — there are often two different recommendations. From a Keynesian
perspective, the economy should be stimulated through additional government
spending, i.e. through additional demand. In contrast, economists of the neoclassical school will look for the cause of the economic misery on the supply side:
For example, high minimum wages or taxes prevent greater production. Reducing such inefficient state intervention will increase production and thus income
and therefore demand — in that order. The two perspectives are accordingly also
referred to as demand-orientated and supply-orientated economic policy.
2.7 Summary
We have analyzed the goods market of an economy. The IS curve summarizes
the equilibrium on the goods market in the interest-income diagram. The IS
curve is described by the following equation: Y = C (Y − T ) + I (i ) + G. Here we
assume a closed economy (i.e. X = I M = 0). In addition, we have seen in this
chapter that the IS curve falls in the interest rate: as the interest rate rises, the
demand for investment and therefore total production falls. But where does the
interest rate come from? As we will see in the next chapter, the interest rate is
determined in the financial market. We therefore need to analyze this market in
more detail. In doing so, we will derive the LM curve as an equilibrium condition
on the financial market. Together with the IS curve, we can then derive the IS-LM
model for analyzing the economy in the short term in chapter 4.
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3 The Financial Market
3.1 Motivation
Our aim is still to develop a model of the economy for the short term. When
looking at the goods market in the previous chapter, we considered a central
equation for the gross domestic product of an economy. This describes the equilibrium on the goods market in that the total supply of goods (Y) is equal to the
total demand for goods (Z). The latter is divided into autonomous consumption c0 , private consumption dependent on disposable income (YV = Y − T),
private investment I (i ) and government consumption G.
Y = Z = C + I + G = c 0 + c 1 (Y − T ) + I ( i ) + G
We have seen that the IS curve describes the equilibrium on the goods market.
In the diagram with the interest rate (i) and GDP (Y) on the axes, the GDP is
larger at a lower interest rate. Now that we know the relationship between the
interest rate, private investment and GDP, a key question arises: Where does
the interest rate that determines private investment in our model come from?
The answer is relatively simple: it is determined in the financial market. But
how exactly is the interest rate determined in an economy? This quickly raises
further questions about the financial market: What interest rates actually exist in
a modern economy? What is the role of money in the economy? What influence
does a central bank have on interest rates and therefore on the economy?
These questions are answered in this chapter. First, we define the analytical
framework and examine what exactly money is and what functions it fulfills.
We then create a simple model of the financial market, determine the demand
for money and the supply of money, and then use the LM curve to describe the
equilibrium on the financial market. Finally, we turn to the role of commercial
banks.
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3.2 Modeling Framework
The financial market plays a central role in the economy. It is complementary to
the goods market. While goods and services are traded on the latter, financial
market is a generic term for a market on which trading in financial instruments
takes place. In addition to the credit market, which includes the money and capital markets, this also includes the foreign exchange market.1 Foreign currencies
are traded on this market. According to Arthur Spiethoff, the money market and
the capital market can be distinguished according to maturity, although the dividing line is not entirely sharp.2 Specifically, the various financial markets can
be categorized as follows
• money market: this is where the short-term supply of money and the demand for money meet. The terms or maturities range from a few hours to
around two years. Specifically, the following are traded: overnight and term
deposits, Central bank money balances, repo and lending transactions, bills
of exchange, short-term securities (money market paper), or central bank
facilities (standby credit agreements).
• capital market: securitized receivables, liabilities and securities with a term
of more than two years are traded here. The trading objects include, for example, shares, profit participation certificates, investment loans, mortgage
loans or also municipal loans.
• foreign exchange market (also foreign currency market): this is where the
equilibrium exchange rate, i.e. the price of one currency expressed in another currency, is determined by the supply and demand for foreign exchange.
In the financial market for our model of the economy in the short term, we do
not deal with the complexity of the many financial instruments that we find in
reality. To gain a large number of key insights, it is sufficient to look at just two
forms of investment: Money and fixed-interest securities. This reduction allows
us to understand how interest rates are set and the role of the central bank.
Individuals in our model can choose what proportion of their assets they want
to hold as money and as fixed-interest securities. The advantage of money is that
it can be used for transactions. Money is said to be liquid. The disadvantage,
however, is that holding cash earns no interest: 100 francs today will still be 100
1 The subdivision follows Erwin von Beckerath, “Kapitalmarkt und Geldmarkt”, 1916, p.52
2 Arthur Spiethoff, Die äußere Ordnung des Geld- und Kapitalmarktes, in: Gustav von Schmoller
(ed.), Jahrbuch für Gesetzgebung, Verwaltung und Volkswirtschaft im Deutschen Reich, Heft
2, 1909, p.17 ff.
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3 The Financial Market
francs in a year’s time. In contrast, fixed-interest securities earn a positive interest
rate i, which we will look at in more detail. The term "fixed-interest" is correct in
that someone who buys a security at a price of x1 francs will certainly receive the
amount x2 at the end of the term. For example, someone buys a security today
at a price of 95 francs and will certainly receive 100 francs for the security after
one year. We will discuss the relationship between the price and interest rate of
a security in detail later in the chapter. The big disadvantage of securities — and
thus the reason why individuals want to hold cash — is that securities cannot be
used for transactions. They are not liquid. So if you want to treat yourself to a
large glass of beer in the bar in the evening, for example, you cannot pay with
securities, but have to ’liquidate’ them in advance, i.e. sell them for cash.
In the following two sub-chapters, we will first take a closer look at money and
interest before developing a model of the financial market.
3.3 Money
In a modern and highly developed economy, money fulfills several important
functions. It serves as a means of payment, a store of value and a measure of
value. In order to fulfill these properties, a number of requirements must be
met. These include portability, uniformity, durability, divisibility and scarcity in
supply. The importance of these characteristics becomes clear when we consider
an economy in which money does not possess them. This can either be an underdeveloped economy or a country in which money has lost its value due to
hyperinflation (we will discuss this in more detail in Chapter 6).3
If people and companies do not have access to money as a means of payment, economic processes become extremely difficult. For example, how can someone buy
a used car if there is no money? The prospective buyer must then offer the seller
other items that are considered to be of equal value by both contracting parties.
As Martin Kolmar describes in his textbook “Grundlagen der Mikroökonomik”
(2017, p.54), this creates the problem of so-called double coincidence: the buyer
must (coincidentally) possess precisely those goods for the purchase of the car
that the seller wants at the same moment (i.e. coincidentally). It is difficult to
express the price of the car without money. Is the used car worth as much as
a motorbike in good condition, a watch, or both together? Money fulfills an
important role here as a unit of calculation and a measure of value.
3 Before the introduction of the euro, several southern European countries suffered from weak
currencies that only fulfilled the function of storing value to a limited extent. As a result, people
there invested their savings in property more so than in Germany or Switzerland, for example,
instead of holding money. To this day, the ownership rate in Italy or Spain is significantly
higher than in Germany or Switzerland.
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In addition, money allows people not only to express values in a standardized
way, but also to store them. Money fulfills the function of storing value. The
seller can sell his car for money and use it to buy something at a later date.
However, this assumes that the money does not lose value or purchasing power
in the meantime. This happens when the inflation rate is positive (see chapter 6).
In this case, people cannot simply hold money in order to transfer value into the
future. This is problematic insofar as most people regularly want exactly that:
they have more today than they want to consume and therefore want to bring
savings into the future. However, if the domestic currency is unstable in value,
they cannot simply hold money, but instead flee into other currencies or real
assets.
So for something to fulfill the functions of money, it must be stable in value over
time. Historically, there have been many forms of money. In the distant past,
people used so-called primitive money. This included, for example, rare stones,
animal teeth or shells, but also goods that have a use value in addition to their
exchange value, such as tobacco, salt, tea, or cocoa beans. The central feature
of traditional means of payment is that they can, in principle, be produced and
circulated by anyone. Consequently, there is no need for a central issuing or
control center.
This changed with coinage, which was first used a few centuries before Christ.
These were mostly circular and relatively thin, embossed or cast discs, which
were almost always made of a metal alloy. Gold and silver coins are still particularly well known today, as they were found during archaeological excavations.
While anyone could in principle find the corresponding precious metals in nature
and mint coins themselves, this was often prohibited. However, it was not only
the minting of coins that was prohibited, in some cases even the possession of
certain precious metals was illegal. For example, private ownership of gold coins
or bars was prohibited in the United States between 1933 and 1975 by Executive
Order 6102, with few exceptions.
Historically, there were both state and private currencies. Nowadays, many people are discussing privately created crypto currencies or digital currencies organized by private companies, such as Diem, formerly known as Libra, from the
company Facebook. What is less well known is that the East India Company
(1600–1874), for example, issued money as a private company a long time ago.
However, the value of private currencies without the support of the state is problematic insofar as money also derives its value from the fact that people can pay
taxes with this money. The state’s monopoly on the use of force thus gives value
to a particular currency.4
4 See “The Fiscal Theory of the Price Level” by John Cochrane, published in 2023.
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While gold and silver coins facilitated the trade of goods in many economies,
new forms of money developed over time. Very early on, people realized that
coins themselves did not always have to change hands when two people traded.
If both parties had a balance of coins on deposit at a bank, the buyer could issue
the seller with a so-called bill of exchange. Similar to a check, the buyer could
use it to request a transfer of the credit balance at the bank and thus receive the
purchase price. Bills of exchange were therefore the forerunners of banknotes,
which most people associate with money today. In modern economies, so-called
fiat money (from the Latin fiat for ’let there be’) is used instead of gold and silver
coins. In contrast to commodity money (gold, tobacco, salt), modern banknotes
and coins have no inherent value. They are practically worthless in themselves
and only gain their value through their general acceptance as valuable money
that fulfills the central functions.
The forms of money have therefore changed over time. It can be said that money
has become increasingly abstract (Kolmar, 2017, p.54). Instead of exchanging
seven apples for four potatoes, we now see the same apples being exchanged for
some colorful printed paper. This only works because the seller relies on being
able to buy other goods and services with banknotes. Cryptocurrencies such
as Bitcoin are even more abstract these days.5 Whether this is actually money
from an economic point of view depends on whether the functions of money are
fulfilled: Money is what fulfills the functions of money. In view of the fact that
Bitcoin can only be used for purchases in a few places in 2023 (it is not legal
tender) and fluctuates greatly in value, it can only be considered money to a
limited extent, at least in 2023.
3.3.1 Money in Modern Economies
In highly developed economies today, central banks determine the money supply. This refers to the amount of money held by private households, companies
(excluding credit institutions), the state and foreign countries (excluding foreign
banks). Central banks measure the money supply using so-called Monetary aggregates, whereby the exact definitions vary slightly from central bank to central
bank. The definitions of the Swiss National Bank (SNB) provide for four aggregates. How liquid individual financial instruments are serves as a demarcation.
Firstly, there is the monetary base, which is made up of banknotes in circulation
and the sight deposits of domestic banks at the SNB. The sight deposits of domestic banks at the SNB are not a subset of the monetary aggregates M1, M2 and
5 The British-American comedian John Oliver (*1977) described Bitcoin a few years ago as “ev-
erything you don’t understand about money combined with everything you don’t understand
about computers”.
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M3, which are defined as follows
• M1: Currency in circulation plus sight deposits (bank balances with a term
or period of notice of less than one month) in Swiss francs held by residents
plus deposits in transaction accounts.
• M2: M1 plus savings deposits (bank deposits not intended for payment
transactions) in Swiss francs, but excluding pillar 2 or 3a savings.6
• M3: M2 plus time deposits (short to medium-term deposits with banks) in
Swiss francs.
Each larger aggregate thus includes the previous aggregate and supplements
it with further aspects.7 Figure 3.1 shows the three monetary aggregates for
Switzerland. This graph is based on a similar illustration from the book “Volkswirtschaftslehre” by Aymo Brunetti (2013, p.280).
Figure 3.1: Money supply aggregates in Switzerland
6 The Swiss pension system is made up of three pillars: state, occupational and private pension
provision. The first pillar, the so-called old-age, survivors’ and disability insurance (AHV for
short), serves to secure your livelihood. The second pillar, occupational pension provision (BVG
for short), is intended to maintain the standard of living to which you are accustomed in old
age. The first two pillars are mandatory, while the 3rd pillar enables voluntary private pension
provision with tax relief.
7 It should be noted that the sight deposits of domestic banks at the SNB are included in the
monetary base, but are not a subset of the monetary aggregates M1, M2 and M3. The exact definitions can be found at the Swiss National Bank (SNB): https://www.snb.ch/de/mmr/
reference/gemenge_definition/source/gemenge_definition.de.pdf.
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Of course, the money supply has not remained constant, but has risen quite
sharply in some cases in recent years. To get an overview of how the monetary
aggregates in Switzerland have changed, Figure 3.2 shows the corresponding
figures since 2000.
Figure 3.2: Money supply growth in Switzerland since 2000
It can be seen that the monetary base in particular has increased sharply: by a
factor of 21 in the period shown from the beginning of 2000 to the end of 2021.8
The other aggregates have also increased significantly (M1 by a factor of 3.7, M2
by a factor of 2.7, M3 by a factor of 2.4) — especially after the global financial
crisis in 2008, there were enormous increases here.
3.4 Interest Rates
As we will have fixed-interest securities as well as cash in our model of the
financial market, it is worth taking a brief look at interest rates. In an economy,
this refers to the remuneration that a debtor pays a creditor in return for capital
that is temporarily provided. It is therefore a price, and one of the most important
in the economy. However, in a highly developed economy there are a variety of
8 The sharp decline in the monetary base on the right-hand side must be put into perspective
insofar as "liabilities from repo transactions in Swiss francs" and "own debt securities" have
risen from zero in July 2022 to CHF 150 billion in November 2022. The SNB has therefore
started to issue debt not included in the monetary base. This also happened in 2009.
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interest rates: savings interest, lending interest, mortgage interest, base rate, and
so on. What distinguishes these interest rates and what connects them?
Figure 3.3: Yields on Swiss government bonds since 2000
The yield on government bonds is an important reference for all interest rates in
an economy. This refers to the interest rate at which a state can borrow in its own
currency. Government bonds are securities that give the creditor (i.e. the holder
of the government bond) a claim to payment from the state. In Switzerland, they
are known as federal bonds, while in Germany and Austria the term "Bundesanleihe" is commonly used. In the USA, a distinction is made between treasury bills
(term of less than one year), treasury notes (term of up to ten years) and treasury
bonds (term of ten to thirty years). As a state does not usually become insolvent
— it can usually print money via its central bank if necessary — government
bond yields are regarded as a risk-free interest rate in an economy.9 Figure 3.3
shows how much this interest rate has fallen in Switzerland over the years. This
decline in interest rates can also be observed in a similar form in other countries,
as illustrated in Figure 3.4.
9 The term ’risk-free’ is not entirely accurate: even if there is virtually no default risk, the repay-
ment amount of a government bond may have lost value due to high inflation. We look at this
inflation risk in more detail in Chapter 7.
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3 The Financial Market
Figure 3.4: Yields on government bonds since 1970
Figure 3.3 also shows that yields are generally higher with longer maturities. This
is also known as Yield curve, where the term is shown on the horizontal axis and
the interest rate on the vertical axis. The yield curve then usually has a positive
slope. The phenomenon arises from the consideration that investors are exposed
to greater uncertainty with longer maturities: if someone buys a bond for one
year for CHF 1’000 today, it is relatively certain how much the person will be
able to buy in twelve months’ time with the amount received. With terms of ten
or more years, on the other hand, there is a greater risk that (unexpectedly) high
inflation will have substantially reduced the purchasing power by the redemption
date.
In addition to the yield on government bonds, the so-called leading interest rate
is the most important interest rate. This is the price at which commercial banks
can obtain money from the central bank. The lower the key interest rate, the
more favorable it is for banks to obtain liquidity. If they pass this favorable rate
on to their customers, the central bank directly influences the financing costs of
companies. We take a closer look at the role of commercial banks with regard to
monetary policy later in the chapter.
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Practice box 3.1: Steadily falling and negative interest rates
A look at Figure 3.4 illustrates a decades-long trend: since the 1990s and until recently, we
observed falling yields on government bonds in the major highly developed economies. In
the USA, the interest rate for 10-year bonds was still over 15 per cent in September 1981.
In 2020, the same interest rate was below one per cent. There are a number of explanations
for this decline, which we will discuss in the textbook. Lower nominal interest rates are
partly the result of lower inflation rates and inflation expectations, while lower real interest
rates can be understood as the result of reduced demand and increased supply.a
Until the financial crisis in 2008, the rule was practically always that interest rates in a
modern economy must be positive. Even though the nominal interest rate level in Switzerland was relatively low by international standards in the early 2000s, Figure 3.3 shows a
positive yield even for one-year bonds. With the outbreak of the financial crisis, central
banks around the world attempted to stimulate the economy by lowering interest rates. In
many places, they encountered the problem that interest rates were already very low. The
concept of the zero lower bound was widely discussed among economists: Can the nominal
interest rate in an economy fall below zero or is there a lower bound at zero? Since banks
and private individuals can theoretically always hold money that earns zero interest, there
is a limit to how low interest rates can be. In response to negative interest rates, banks have
been holding large amounts of cash. But even holding cash is not free. Large cash holdings
must be protected and insured with safes. Due to these costs of holding cash, marginally
negative interest rates, as in Switzerland since 2015, are quite possible. The abolition of the
500 euro note is interesting in this context: no new notes have been issued since May 2019.
As the next smallest note is only worth 200 euros, the number of notes required to hold
cash increases by a factor of two and a half.
a Greg Mankiw summarized some explanations in the article “The Puzzle of Low Interest
Rates” in the New York Times on 4 December 2020.
3.5 Financial Market Model
Now that we have dealt with the topics of money and interest rates in more
detail, we will describe a model for the financial market. In this model, as already
mentioned, we make the simplifying assumption that there are only two forms
of investment: Money and fixed-interest securities. There is therefore a money
market and a securities market. First, we look at the money market, the demand
for money, the supply of money, and the equilibrium.
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3.5.1 Demand for Money
People in our model economy choose whether to hold their assets as money or
securities. We already know that holding money has the disadvantage that interest is foregone by means of securities. So why does it still make sense to hold
part of your assets as cash? There are three motives for holding cash: transactions, prudence, and speculation.10 Firstly, people need cash to buy goods and
services. Since these purchases are not always predictable, it is also sensible to
have a certain amount of cash on hand as a precaution. The washing machine
or laptop can break down unexpectedly and then you do not want to have to
liquidate your securities to buy a replacement. It also makes sense to hold cash
if you are speculating on rising interest rates: if you could buy securities with
3% interest today and expect securities with 4% interest to be available in a few
months, it may be worth holding cash until then.
The higher the interest rate on securities, the more expensive it is to hold cash,
because you are missing out on the corresponding interest income. We therefore
describe and define the demand for money as follows:
Md = PY ∗ L( i )
(+)
(−)
(3.1)
The demand for money (Md ) is assumed to increase proportionally with nominal
income (PY) and depends negatively on the interest rate i. The formulation in
equation (3.1) picks up on the motives for holding money. The higher a person’s
income, the greater the transactions. In the case of the precautionary motive, it is
also true that people with high incomes generally set aside larger amounts. On
the other hand, it is important to weigh up the costs and benefits with regard
to the interest rate: Caution has a price. And with the speculative motive, lower
interest rates today make it more likely that interest rates will rise again in the
future.
Strictly speaking, the nominal demand for money results from the nominal income multiplied by the real demand for money L(i ). The latter is also called
liquidity preference. We also refer to L(i ) as a function of the interest rate. Equation (3.1) simply states that the real demand for money falls when the interest
rate rises. Figure 3.5 illustrates exactly how the demand for money depends on
the interest rate: As the interest rate rises, the liquidity preference and thus also
the demand for money falls.
10 We follow the discussion by Felder and Homburg (2005), page 120–125.
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interest rate i
3 The Financial Market
i2
C
•
A
•
i0
B
•
i1
M2
M0
M1
Md (PY)
Money supply M
Figure 3.5: Demand for money
interest rate i
In Figure 3.5, it should be noted that the demand for money depends on both
the interest rate i and nominal income. Since only the interest rate is shown in
the diagram, the demand for money was drawn for a given nominal income was
drawn. For a given interest rate, an increase in nominal income shifts the demand
for money to the right or upwards. This is shown in Figure 3.6.
i0
A
•
B
•
M1d (PY1 > PY0 )
M0d (PY0 )
Money supply M
M0 M1
Figure 3.6: Demand for money with increased nominal income
The fact that the demand for money only depends on nominal income and the
interest rate is a simplification of reality. Numerous extensions are possible. For
example, Md can depend on the costs of liquidating securities. The more difficult,
time-consuming or expensive it is to exchange securities for cash, the more cash
will be held. However, even without extensions, the model describes several key
aspects. In addition, the core statement of the model can be easily compared
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with reality.11 To do this, we have to reformulate the equation (3.1) so that the
real demand for money L(i ) is on the right-hand side alone. To do this, we divide
equation (3.1) by PY:
Md = PY ∗ L(i )
←→
Md
= L (i )
PY
The function L(i ) is also referred to as cash holding coefficient. According to
the formula, this corresponds to the ratio of cash holdings to nominal income.
We already know that L(i ) depends negatively on the interest rate. This means
that Md /PY should also depend negatively on the interest rate and rise when
the interest rate falls. The lower the interest rate, the more money people should
hold in relation to their nominal income. They then miss out on less interest. In
Figure 3.7 we show the empirical relationship between the interest rate and the
cash holding coefficient in Switzerland since 1990.
Figure 3.7: Interest rate and cash holding coefficient in Switzerland
It turns out that the data support our simple model. Since 1990, the interest
rate in Switzerland has fallen continuously and the cash-to-cash ratio has risen
over the same period. We have used the 10-year bonds as the interest rate here.
As other relevant interest rates in a modern economy develop in line with the
trend in bonds, we obtain a very similar picture with other interest rates. What
11 We follow an approach from Blanchard & Illing (2017), p.117.
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is important is the trend and this points downwards for practically all relevant
interest rates in the period shown.
3.5.2 Money Supply
Now that we have understood the demand for money, let us turn to the supply
side. Money is supplied by central banks in the form of cash and reserves for
commercial banks and by commercial banks in the form of sight deposits. This
means that money is created in a modern economy by both central banks and
private banks. We will understand this process step by step. First, however, we
will focus on how a central bank can influence the money supply. It has several
monetary policy instruments at its disposal:
• Open market operations: The central bank buys or sells assets such as foreign
currencies, government bonds or corporate bonds on the open market. If
the central bank buys long-term, riskier assets on a large scale, this is known
as quantitative easing (QE).
• Incentives for banks to lend: Among other things, a central bank sets the
minimum reserve, which determines how much money commercial banks
must deposit with the central bank. In addition, a central bank can create
incentives for commercial banks to grant loans to the private sector in other
ways. In acute crisis situations, this also includes direct cash injections
(known as cash infusions).
• Helicopter money: This term, coined by Milton Friedman, describes a process
in which a central bank pays out newly created money directly to the state
or citizens.12 Figuratively speaking, the central bank distributes freshly
printed banknotes from a helicopter.
While helicopter money is still just a thought experiment, central banks in modern economies use the first two instruments to control the money supply and
thus the interest rate. Of particular interest for our model of the financial market
are open market operations. As a rule, central banks influence the interest rate
by buying and selling government bonds. With an expansive open market policy,
a central bank buys government bonds and thus expands its balance sheet: the
additional securities are recognized on the assets side, while the newly created
money supply is recorded on the liabilities side. The opposite of expansionary
monetary policy is known as contractionary (or restrictive) monetary policy.
In addition to the instruments described above, a central bank can also influence
the economy by managing expectations regarding future policy: also known as
12 Milton Friedman (1969). “Optimum Quantity of Money”, Aldine Publishing Company, p.4ff.
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forward guidance, this is an attempt by a central bank to manage expectations
about interest rates in the future. This also includes indicating the conditions
under which the central bank will raise or lower interest rates in the future. In
the USA, the instrument of forward guidance has been increasingly used since Ben
Bernanke, the head of the US Federal Reserve from 2006 to 2014. His successors
(Janet Yellen 2014-2018 and Jerome Powell since 2018) also regularly announce
the necessary changes — such as a lower unemployment rate — for a change in
course alongside their current monetary policy strategy.13
But how exactly does a central bank determine the interest rate in an economy
through its monetary policy? To find out, we need to look at the relationship
between the price of a (fixed-income) security and its interest rate. For example, if
the state wants to borrow money for a period of ten years, it offers a government
bond whose holder will receive, say, 1’000 francs in ten years. At what price
can the state sell this government bond today? As it is highly unlikely that the
state will go bankrupt in the next ten years, this is a very safe investment.14
If someone buys the bond today for 900 CHF, they achieve an annual yield of
(1000/900)1/10 = 1.06%. Within ten years, 900 CHF in this example becomes
1’000 francs. It is easy to see that the lower the purchase price, the higher the
return. There is therefore an inverse relationship between security price and
interest rate: the higher the price, the lower the interest rate. Formally, we can
write that the price of a 1’000 franc bond with a ten-year term is determined as
follows
PB = 1000/(1 + i )10
Here we use the term PB for the price of a government bond. Large numbers of
government bonds with different maturities are traded on the financial market
every day. If a central bank now creates new money and uses it to purchase
government bonds, the price of the bonds rises due to the additional demand.
Implicitly, this lowers the (risk-free) interest rate in the economy. As we already
know from chapter 2, this should stimulate private investment and thus the economy. Based on these considerations, central banks lowered interest rates very
13 In the Euro area, Jean-Claude Trichet, the former President of the European Central Bank (ECB),
liked to proclaim “We never commit ourselves in advance”. However, since around 2013, under
Trichet’s successors Mario Draghi and Christine Lagarde, the ECB has adopted the practice
of monetary policy promises with regard to future interest rate developments, i.e. forward
guidance, which is common in Anglo-Saxon countries (Neue Zürcher Zeitung, 14 October 2020).
14 If the state has its own currency, it can simply print the money it needs in ten years’ time if
necessary. The risk for the buyer of the government bond is then not default, but the loss of
purchasing power resulting from additional money printing by the central bank.
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3 The Financial Market
significantly during the financial crisis of 2008, both in Europe and in other parts
of the world. This can also be seen in Figure 3.4.
3.5.3 Equilibrium in the Money Market
Now that we have considered both the demand for money and the supply of
money, we can bring the two together to determine the interest rate. A equilibrium in the money market occurs when the supply of money equals the demand
for money. If we denote the supply with Ms for money supply, the equilibrium
must be Ms = Md . Combined with equation (3.1) for the demand for money, this
results in the equilibrium on the money market:
Ms = Md
←→
Ms = PY ∗ L(i )
The properties of this equilibrium depend heavily on whether the central bank
uses the money supply Ms or the interest rate i as a control instrument. In the
first case we speak of money supply control, in the second of interest rate control.
From the late 1970s to the early 1990s, Western central banks focused primarily
on money supply management. In order to control the high inflation rate at
the time, the main aim was to control the money supply. Since the early 1990s,
there has been a stronger focus on interest rate management. When interest rates
were then lowered to zero (or close to it) in the wake of the 2008 financial crisis,
other instruments such as the forward guidance mentioned above also gained in
importance.
How do money supply and interest rate management differ in our model? If the
central bank controls the money supply, it makes a certain amount of money M
available, so that M = Ms . In this case, the interest rate in equilibrium results
from the fact that the interest rate-dependent demand for money corresponds to
the supply of money. We represent this graphically in Figure 3.8.
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3 The Financial Market
interest rate i
Ms
equilibrium interest rate i: Md =Ms
i
A
•
M
Md = PY ∗ L(i )
money supply
Figure 3.8: Money supply control
In the case of interest rate control, the central bank sets the interest rate at i0 .
In order to achieve this fixed or target interest rate i0 , the central bank provides
the necessary money supply. Even if the exact money demand curve Md is not
known, the central bank can bring the interest rate to the desired level by increasing or reducing Ms . Figure 3.9 illustrates this case graphically.
interest rate i
Ms
equilibrium interest rate i0 : Md (i0 ) = Ms
i0
A
•
M
Md = PY ∗ L(i )
money supply
Figure 3.9: Interest rate control
Now we have determined the equilibrium in the money market for both cases —
money supply and interest rate control. However, our actual aim is to determine
the equilibrium in the financial market. This includes not only the money market
but also the securities market. Thanks to Léon Walras (French economist, 1834–
1910), we do not have to determine the securities market and its equilibrium
separately. The Walras’s law named after him states that in an economy consisting
of n markets, it is sufficient for n − 1 markets to be in equilibrium. The remaining
market must also be in equilibrium.
Specifically applied to our situation, this means that the financial market (consist95
3 The Financial Market
ing of the money and securities markets) is in equilibrium if the money market
is in equilibrium. Since there are only two forms of investment that people can
choose between (money and securities), it is sufficient to determine the equilibrium demand for money. To understand this intuitively, we can imagine a person
who has 50’000 francs in assets and can only choose between cash and securities.
If we know that the person wants to hold CHF 20’000 in cash, it is immediately
clear what amount they want to hold in securities. For our model of the financial
market, this follows: If the money market is in equilibrium, the securities market
must also be in equilibrium.
3.5.4 Monetary Policy
In our model, a central bank can use open market operations to influence the
equilibrium interest rate in the money market. To understand this process in
more detail, we first look at money supply management and the left-hand graph
in Figure 3.10. An increase in the money supply from M1 to M2 shifts the money
supply curve to the right: from M1s to M2s . As long as the interest rate remains
at the initial level i1 , there is an imbalance: the money supply is greater than the
demand. A new equilibrium is only reached when supply and demand match
again: The equilibrium interest rate falls from i1 to i2 . In this case, the interest rate
is determined endogenously and results from the new “money supply = money
demand” equilibrium.
This relationship between the expansion of the money supply and equilibrium
interest rates is not always described in detail in practice. For example, if a newspaper states that the European Central Bank (ECB) has lowered interest rates, we
can translate this statement as follows: The ECB’s Open Market Committee has
decided to buy bonds as part of open market operations in order to increase the
money supply, shift the LM curve and lower the equilibrium interest rate.
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3 The Financial Market
i
i1
M1s
•
M2s
i
A1
i1
•
i2
A2
•
A1
•
i2
A2
Md (PY)
M1
M2
Md (PY)
M
M1
M2
M
Figure 3.10: Expansive monetary policy: money supply vs. interest rate control
If, on the other hand, the central bank controls interest rates, it chooses a target
interest rate. This situation is illustrated in the right-hand graph of Figure 3.10.
Starting from the interest rate i1 , the central bank aims for a lower interest rate
i2 . To achieve this, the central bank increases the money supply to M2 . The increased money supply causes the interest rate to fall from i1 to i2 and the new
equilibrium is at point A2 . In this case, the money supply is determined endogenously. This second case of interest rate control describes very well the current
implementation of monetary policy in reality. In an expansionary open market
operation, the central bank buys securities (e.g. government bonds) in exchange
for central bank money. This increases the price of the securities, which lowers
the implicit interest rate of the securities and increases the money supply. This
relationship always applies to securities with short maturities. The interest rate
for long-term securities is determined less by the central bank’s current key interest rate. Instead, the key interest rates expected over the entire term are decisive.
When short-term interest rates in Europe and other regions were already at zero,
forward guidance regarding future interest rates got increasingly important. In
Switzerland, the SNB implements its monetary policy by managing liquidity on
the money market in Swiss francs and thus influencing the interest rate level.
In doing so, it sets the SNB policy rate and endeavors to ensure that the secured
short-term money market interest rates in Swiss francs are close to the SNB policy
rate.
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3 The Financial Market
Theory box 3.1: Central bank balance sheet
Like every private commercial bank, the central bank has a balance sheet with assets and
liabilities. The central bank balance sheet is simplified as follows
assets
liabilities
reserve assets
securities
gold
other assets
banknotes in circulation
sight deposits of commercial banks
liabilities from repo transactions
equity
other liabilities
If the central bank pursues an expansive monetary policy, for example through open market operations, it expands its balance sheet. It uses newly created central bank money to
buy securities on the open market. Conversely, a contractionary monetary policy reduces
the balance sheet.
3.5.5 The LM Curve
As mentioned at the beginning of chapter 2, our aim is to understand the economy in the short run. To do this, we develop a model with a goods market and a
financial market. We have already described the equilibrium on the goods market with the IS curve. Now we would like to describe the equilibrium on the
financial market in a similar way. The IS curve was described with the following
equation:
Y = c 0 + c 1 ∗ (Y − T ) + I ( i ) + G
(3.2)
Graphically represented in a diagram with Y on the horizontal axis and i on the
vertical axis, the result is a falling curve: the lower the interest rate, the greater
the private investment and thus the aggregate demand, and the greater the GDP.
Based on the considerations from chapter 3, we can now add i as an equilibrium
result from the financial market. To do this, we introduce the LM curve, which
describes the equilibrium in the financial market. Here “LM” stands for liquidity
demand and money supply. To derive the LM curve in the (Y, i ) diagram, we first
consider the case of money supply management. The central bank determines the
money supply Ms and the money market is in equilibrium if the money supply
corresponds to the demand for money:
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3 The Financial Market
M s = P ∗ Y ∗ L (i )
(3.3)
If we divide both sides by the price level P, we get
Ms /P = Y ∗ L(i )
(3.4)
The real money supply (Ms /P) is equal to the real money demand. The latter
depends on the real income (Y) and liquidity preference. Since we are looking at
the short term, the price level P is constant. For a given Ms , Ms /P is determined.
Equation (3.4) therefore implies a positive relationship between Y and i: As long
as the central bank leaves Ms unchanged, the left-hand side of the equation remains constant. Therefore, the right-hand side of the equation (3.4) must also
remain constant. If the interest rate increases, nothing changes on the left-hand
side (Ms /P). Therefore, the right-hand side (Y ∗ L(i )) must also remain constant.
Since i has risen and L(i ) depends negatively on the interest rate, Y must rise so
that the right-hand side remains unchanged.
A second way to show the positive relationship between i and Y is to consider
the following: If the central bank keeps the money supply constant as income
rises, the interest rate increases. We can see this graphically in Figure 3.11. A
′
higher income shifts the money demand curve from Md to Md . Since the money
supply has remained constant, the interest rate rises from i A to i B (we move from
point A to point B). It can be said that the ’price of money’, i.e. the interest rate,
has risen because a higher demand meets a constant supply. With money supply
control, the relationship between income and interest rate is therefore a rising
LM curve in Y. This is illustrated on the right-hand side in Figure 3.11.
i
Ms
i
LM
iB
iA
•
•
B
A
B
iB
′
Md (for Y ′ > Y)
iA
A
•
•
Md (for Y)
M/P
M
Y Y′
Y
Figure 3.11: Derivation of the LM curve for money supply management
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3 The Financial Market
With money supply management, we therefore obtain a rising LM curve, which
describes the equilibrium in the financial market. What happens if the central
bank controls interest rates? In this situation, the central bank sets the interest
rate i and adjusts the supply of money endogenously to the demand for money
prevailing at this interest rate. If income (Y) rises, the demand for money increases. In order to achieve equilibrium on the financial market at the same
interest rate as before, the central bank must increase the money supply. We then
obtain the same interest rate at two different income levels. This is illustrated
graphically in Figure 3.12. The LM curve can be described by a horizontal line.
interest rate i
i
i0
M1s
•
A
M2s
•
i
B
i0
A
•
B
•
Y1
Y2
LM
M2d (for Y2 )
M1d (for Y1 )
M1 /P M2 /P
M
Y
Figure 3.12: Derivation of the LM curve with interest rate control
In both cases, money supply and interest rate management, the LM curve describes the equilibrium in the financial market. However, it is possible that the
financial market is temporarily out of equilibrium. We therefore need to clarify
what a point (an i-Y combination) above or below the LM curve means. Above
the LM curve there is excess supply on the money market (M > PY ∗ L(i )), while
below the LM curve there is excess demand on the money market. Since there
are only two forms of investment (money and securities), it follows directly that
there is excess demand on the securities market above the LM curve and excess
supply below the LM curve.
Intuitively, this can be explained as follows. Above the LM curve, the interest
rate is too high for equilibrium on the financial market. Since the interest rate
is so high, people want to get rid of cash and buy securities. This raises the
price of them, which lowers the implicit interest rate — until we are back in
equilibrium. At points below the LM curve i is too low for a given Y. Since
the interest rate is very low, people favour cash. This increases the demand for
liquidity and ensures that many people want to sell securities. This creates an
additional supply of securities. As a result, the price of securities falls and the
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3 The Financial Market
implicit interest rate i rises. This process only ends when the financial market is
back in equilibrium.
3.6 Money Creation by Private Commercial Banks
To conclude the chapter, we turn to private money creation. At the beginning
of the chapter, we established that the supply of money in an economy is determined by both the central bank and private commercial banks. In order to keep
the discussion of the financial market simple, we have so far only considered the
supply of money by the central bank. In practice, however, in addition to central
banks, private commercial banks also determine the available money supply.
But how exactly can private banks create money? Let us consider a student who
deposits 100 CHF into his savings account at a private commercial bank. The
bank will not simply put this money in a vault, because how would it pay the
student an interest rate? In practice, the bank will lend most of the 100 CHF to
other people or companies. The bank’s profit then results from the difference
(spread) between the (lower) savings interest rate and the (higher) loan interest
rate. We will now take a closer look at how money is ’created’ in this process.
In an economy with commercial banks, the central bank can only directly control
the central bank money supply; the money supply Ms is controlled indirectly.15
We therefore distinguish between the monetary base (also called M0, central bank
money or high-powered money in some textbooks) and the money supply Ms . As
already mentioned, the central bank money supply is made up of the currency in
circulation CC (currency in circulation) and the commercial banks’ sight deposits
at the central bank R (reserves).
To understand the role of commercial banks in money creation, let us look again
at the example above, in which the commercial banks do not lend out sight deposits D (deposits) such as the 100 CHF at 100%. Instead, they hold reserves
for several reasons: First, deposits and withdrawals by investors are not always
equal in size. The commercial bank must therefore always hold a certain amount
of cash in order to be liquid at all times. The same applies to debts to other
banks. A commercial bank must also hold sufficient reserves for this at all times.
In addition to these motives for voluntarily holding reserves, there are also statutory minimum reserve requirements. These are intended to ensure that private
banks hold sufficient liquidity to prevent a bank run.16 The minimum reserve re15 A detailed description of the process can be found in Thomas J. Jordan’s lecture of 16 January
2018 on the topic of "How money is created by the central bank and the banking system", which
was published by the SNB.
16 As a rule, doubts about a bank’s ability to survive lead to a bank run, as savers fear for their
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3 The Financial Market
quirements demand that reserves be held in the amount of a certain percentage
of sight deposits. In April 2024, the minimum reserve ratio was 4.0% in Switzerland, 1.0% in the Euro area, 7.0% in China and zero percent in the USA (since
March 2020).
Commercial banks lend out the majority of sight deposits. They only keep a
portion, which we refer to as θ, as a reserve. This can be done voluntarily and /
or on the basis of the statutory minimum reserve. Private banks deposit this
reserve with the central bank. Formally, the reserve is: R = θD. Since the central
bank money supply M0 consists of currency in circulation (CC) and the banks’
reserve deposits (R), the following applies:
M0 = CC + R ←→ M0 = CC + θD
(3.5)
Let us assume that the money market is in equilibrium, so that Ms = Md . We
will refer to the money supply in this equilibrium as M. If we assume that cash
or demand deposits account for a fixed share (b or 1 − b ) of the total amount of
money in circulation Ms , the following applies:
CC = bM as well as D = (1 − b) M
(3.6)
If we now replace CC with bM and θD with θ (1 − b) M in equation (3.5), we get
M0 = bM + θ (1 − b) M
(3.7)
Solving for M gives the so-called money creation multiplier:
M=
1
M0
b + θ (1 − b )
(3.8)
This multiplier, i.e. the fraction before the M0, increases when θ falls and/or
when b falls.17 To better understand this multiplier and the model, we can look at
Figure 3.13. In it, the total money supply M is divided into currency in circulation
CC and deposits D. The latter are held proportionately as reserves at the central
bank.
deposits. However, as a bank only holds a fraction of the deposits as reserves (cash), a bank
run can easily lead to the bank becoming insolvent.
17 In some simplified illustrations it is assumed that there is no cash holding (b = 0). In this case,
the money creation multiplier is reduced to 1/θ.
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3 The Financial Market
(1 − θ ) D
θD (= R)
CC
M0
CC
D
M
Figure 3.13: Model with private commercial banks
What does private money creation mean for the central bank, which wants to control the money supply or the interest rate? It can influence the money supply M
indirectly in two ways via θ: firstly via the minimum reserve and secondly via incentives to hold reserves voluntarily.18 The central bank can therefore control the
money supply M via three channels. Firstly, it can change the key interest rate.
This is the price at which commercial banks can obtain money from the central
bank. In Switzerland, this was 1.5% in May 2023, after years of being in negative
territory at -0.75%. If the central bank raises the key interest rate, it makes it
more expensive for commercial banks to obtain liquidity. This indirectly reduces
the money supply: if the commercial banks pass on the higher costs to their bank
customers, the demand for loans falls. This restricts private money creation. The
second option for controlling the money supply is the deposit rate. This refers
to the interest rate on deposits by commercial banks at the central bank. This
currently stands at 1.25 to 1.75% in Switzerland. For years it was -0.75%, making
it unattractive for commercial banks to voluntarily park large amounts of money
as reserves at the central bank. Here too, the central bank controls the money
supply M indirectly. The third way for the central bank to control the money
supply is directly: it can change the minimum reserve ratio. This is currently
2.5% in Switzerland and is therefore higher than in the Euro area or the USA.
If we expand our simple financial market model to include private commercial
banks — and thus come closer to reality — then the central bank has an indirect
influence on the volume of lending by commercial banks and thus on the amount
of their sight deposits and the money supply M. Expansive monetary policy then
no longer takes place simply by increasing the money supply. Instead, the central
bank chooses the three paths mentioned above. For example, the central bank can
make it more attractive not to park money at the central bank by lowering the
deposit rate. In our modeling framework, the commercial banks would then
18 The indirect control of money creation by private commercial banks is also known as discount
policy.
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3 The Financial Market
reduce θ to a minimum. However, the central bank must weigh up whether this
would jeopardize the stability of the banking system.
The more realistic financial market model also explains why the Swiss National
Bank (SNB), for example, sometimes has to use other “tricks” to achieve a certain
interest rate level. To illustrate this, let us look at the situation at the end of 2022
when the SNB wanted to raise interest rates. Specifically, the Saron (Swiss Average Rate Overnight) was to rise. This is the interest rate at which commercial
banks can borrow money from other banks in the short term. Although the SNB
can raise the so-called SNB policy rate by decree, this does not mean that the
Saron will rise to the same level. Rather, the SNB key interest rate is the target
for the Saron. Due to the very expansive monetary policy since the 2007 financial
crisis, many commercial banks have more liquidity than they actually need. As
a result, there is little trading between the banks and the Saron would not rise
to the level targeted by the SNB. The central bank must therefore intervene directly in the market. It takes out loans itself (so-called repo transactions and SNB
bills) and introduces staggered interest rates for credit balances at the SNB. If the
commercial banks receive the interest rate that the SNB is aiming for as the key
interest rate via sight deposits at the SNB, repo transactions or SNB Bills, they
will not offer loans to companies or households at a lower interest rate.19
3.7 Summary
In this chapter, we have analyzed the financial market of an economy. In doing so,
we have explored the question of what economic role money fulfills. In addition,
it is now clear how the interest rate is determined in an economy and what
influence the central bank can exert on it — and thus on the economy as a whole.
As we have seen, the LM curve describes the equilibrium on the financial market
in the interest-income diagram. Together with the goods market discussed in
chapter 2 and the IS curve as the equilibrium on this market, we now have all the
elements for our model of the economy in the short term. In the next chapter, we
will bring the IS and LM curves together to obtain the IS-LM model. This will
allow us not only to explain short-term fluctuations in GDP, but also to better
understand economic policy interventions.
19 The detailed explanation can be found in the Neue Zürcher Zeitung (3 January 2023).
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4 The IS-LM Model
In the last two chapters, we developed the two elements for our model of the
economy in the short term: the goods market including the IS curve and the
financial market including the LM curve. Now we can put the two together and
obtain the IS-LM model. This allows us to better understand numerous economic
policy ideas and debates. As explained in the introductory chapter of the book,
we first want to understand the model, then apply it and finally scrutinize it
critically.
One aim of the fourth chapter is also to show which economic framework underlies many statements in the media. There are often controversial debates about
the effects of a tax increase or an interest rate cut by the central bank. It is easy
to get lost in the complexity of the economy. A well-founded modeling framework helps to prevent this. The IS-LM model provides an approach for this, but
it should be noted that other models also exist. Our aim is to understand the
application of a specific model and then to take a closer look at its weaknesses,
in particular the simplifying assumptions.
4.1 Modeling Framework
Before we summarize the IS-LM model, we briefly reflect on its two elements.
The goods market is in equilibrium when production Y is equal to the demand
for goods Z: Y = C (Y − T ) + I (i ) + G. Here we assume a closed economy
without international trade (formally: X = I M = 0). As already explained in
Chapter 2, investment I (i ) falls with the interest rate. Therefore, as the interest
rate rises in the goods market equilibrium, income falls. The IS curve therefore
has a downward slope as shown in Figure 4.1 on the right-hand side.
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4 The IS-LM Model
Z
i
45° line
Z ( i0 )
•A
•
Z ′ ( i1 > i0 )
i1
B
•
i0
B
A
IS
45°
Y1
•
Y0
Y
Y1
Y0
Y
Figure 4.1: The IS curve
Since the equilibrium on the goods market depends on the interest rate i, we
analyzed the financial market in chapter 3. There, the equilibrium interest rate is
determined by money supply and money demand. As we have seen, the financial
market is in equilibrium when the real supply of money corresponds to the real
demand for money: M/P = Y ∗ L(i ). We distinguish here between money supply
control and interest rate control. In Figure 4.2 we see the case of money supply
control at the top and the case of interest rate control at the bottom.
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4 The IS-LM Model
Ms
i
i
LM (M/P)
•
iB
•
iA
B
B
iB
d′
M (for Y ′ > Y)
A
A
iA
•
•
Md (for Y)
M
M/P
i
i0
M1s
•
A
Y
M2s
•
Y′
Y
i
B
i0
A
•
B
•
Y1
Y2
LM(i0 )
M2d (for Y2 )
M1d (for Y1 )
M/P
M2 /P
M
Y
Figure 4.2: The LM curve for money supply and interest rate control
With the two elements, IS curve and LM curve, we can now put together the
IS-LM model. This was originally developed by John Hicks (British economist,
1904–1989) in 1937 as a mathematical representation of John Maynard Keynes’
ideas. It was later expanded by Alvin Hansen (American economist, 1887–1975).1
Until the 1970s, the IS-LM model was the central framework for macroeconomic
discussion. The combination of a stagnating economy and high inflation — collectively referred to as stagflation — in the 1970s then led to a critical examination
of the underlying assumptions of the IS-LM model.
In a Stagflation there is no lack of aggregate demand, the limiting factor is rather
the supply of goods. While demand can be rapidly increased in the short term,
including through fiscal and monetary policy measures, this is not the case for the
supply of goods and services.2 If there is an overall lack of demand in an econ1 The key publications are: John Richard Hicks (1937). “Mr Keynes and the ’Classics’: A Suggested
Interpretation”, Econometrica, 5(2), 147-159 and Alvin Harvey Hansen (1953). “A Guide to
Keynes”, New York: McGraw Hill.
2 The release of strategic oil reserves is one of the few exceptions.
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4 The IS-LM Model
omy, economists speak of a Keynesian recession. In this situation, expansionary
fiscal and monetary policy (Keynesian policy) can be very effective and increase
GDP. However, if the supply side is the limiting factor, demand-side policy instruments (such as interest rate and tax cuts, additional government spending)
are not only ineffective, but harmful. Since supply is not expanded as a result,
but demand is additionally stimulated, expansive economic policy interventions
lead to higher inflation.
However, the central statements of the IS-LM model are still part of economic
analysis and debate today. While in the original IS-LM model the central bank
controls the money supply, i.e. we assume money supply control, nowadays the
case of interest rate control is considered more frequently. This can be explained
by the fact that most central banks now control interest rates in practice. The
IS-LM model is essentially described by two equations.
Y = c 0 + c 1 (Y − T ) + I ( i ) + G
(4.1)
i = i0
(4.2)
The IS-LM model is shown graphically in Figure 4.3. In addition to the IS curve
falling in the interest rate, we see the horizontal LM curve (with interest rate
control) and the LM curve rising in the interest rate (money supply control). As
we already know, the IS and LM curves represent the equilibria on the goods
and financial markets. Only at point A, the intersection of the two curves, is
there a simultaneous equilibrium on the goods and financial markets. In short,
we also say that the economy (consisting of these two markets) is in equilibrium
at point A.
i
i
LM (money market)
i0
•
A
LM (money market)
A
•
IS (goods market)
Y0
Y
IS (goods market)
Y0
Y
Figure 4.3: The IS-LM model with interest rate control (left) and money supply
control (right)
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4 The IS-LM Model
With the IS-LM model, both in equation form and in graphical form, we can
now analyze the economy in the short term. We distinguish between two events.
First, we look at how the economy reacts to sudden changes. These are often
referred to as exogenous shocks, whereby a distinction is made between demand
and supply shocks.3 Second, we turn to economic policy measures. In addition
to fiscal policy (changes in taxes and government spending), this also includes
monetary policy (central bank measures).
Theory box 4.1: Keynes’ model
The ISLM model is essentially based on ideas presented by John Maynard Keynes in 1936
in the book The General Theory of Employment, Interest, and Money. He summarized the
essence of his theory in just a few considerations (pages 28ff.):
• The national income – the real and nominal production — depends on the number
of employed persons N.
• The total consumption expenditure D1 depends on the propensity to consume.
• Employment N depends on two variables: consumption expenditure D1 and investment expenditure D2 .
• The total demand for goods is calculated as D = D1 + D2 and must correspond to
the total supply of goods. The latter depends on employment and we refer to it as
ϕN. If we assume that the propensity to consume corresponds to χ and therefore
D1 = χN, the following must apply: ϕN − χN = D2 .
• Employment in an economy therefore depends on three variables: (i) the goods
supply function, i.e. ϕ, (ii) the propensity to consume χ and (iii) the investment
expenditure D2 .
• The resulting employment level N determines the real wage in the economy via the
marginal product of labor.
According to Keynes, classical economists understand the economy with the equation D =
ϕN. If N increases, the demand for goods increases, but only to a limited extent, as χ < 1
applies — the propensity to consume is not 100%. An increase in N also increases D2 so
that the system remains in equilibrium at full employment. This is where Keynes comes in
and doubts that D2 will inevitably rise. However, if this is not the case, the economy can
remain permanently in a state of low employment. This was essentially his explanation for
the situation in the 1930s: a lack of aggregate demand.
3 It is important that such shocks occur unexpectedly. Otherwise, there would already be effects in
anticipation. The same applies to the policy measures considered here: these are also analyzed
as unexpected changes.
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4 The IS-LM Model
4.2 Shocks and Economic Policy
The equilibrium of the economy shown in Figure 4.3 changes when the IS curve,
the LM curve or both curves are shifted. Using the equations (4.1), we can recognize what leads to a shift in the curves. The IS curve shifts when one of the
following variables changes: autonomous consumption (c0 ), taxes and transfer
payments (T) and government consumption (G). An increase or decrease in the
marginal propensity to consume (c1 ) causes the IS curve to become steeper or
flatter. It is important to note here that a change in the interest rate i leads to a
movement along the IS curve. This is because the IS curve shows those combinations of i and Y for which the goods market is in equilibrium. However, each
IS curve is drawn for a specific level of the exogenous variables (c0 , c1 , G and T).
In contrast, we shift the LM curve when the central bank changes the money
supply Ms . In the case of money supply control, this results in an endogenous
change in the interest rate, whereas in the case of interest rate management, the
change in the interest rate is specifically targeted by the change in the money
supply.
In addition to the question of what leads to a shift in the IS and LM curves, it
is also important in which direction the curves are shifted. Generally speaking,
changes that trigger a fall in the demand for goods at a given interest rate shift
the IS curve to the left (or downwards). This includes, for example, an increase in
taxes. Conversely, an increase in the demand for goods leads to a shift in the IS
curve to the right (or upwards). This includes, for example, a reduction in taxes.
If the central bank raises the interest rate (by tightening the money supply), the
LM curve shifts upwards; if it lowers it, the LM curve shifts downwards. We use
so-called comparative statics to investigate how exactly the economy reacts to a
shift in the IS and LM curves and then moves to the new equilibrium.
4.2.1 Economic Shocks
As a first case, we analyze how the economy in the IS-LM model reacts to a
change in autonomous consumption c0 and the marginal propensity to consume c1 . So far, we have taken these two variables as given (i.e. exogenous).
They influence private consumer demand and thus aggregate demand in the
goods market. Without the state or the central bank having done anything, c0
and c1 can change. For example, consumer sentiment can suddenly deteriorate. In modern economies, government institutions usually conduct monthly
or quarterly surveys to assess how the population views economic development,
the situation on the labor market or their own financial situation. In Switzerland, the State Secretariat for Economic Affairs (Seco) surveys over 1,000 people
at the beginning of each quarter. When the coronavirus crisis began in spring
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4 The IS-LM Model
2020, consumer sentiment in Switzerland fell to a significant low, as illustrated in
Figure 4.4. What are the consequences of this for the economy?
Figure 4.4: Consumer sentiment in Switzerland since 1972
In the IS-LM model c0 and c1 influence the goods market and thus the position
of the IS curve. Let us consider the case where autonomous consumption is
reduced to c0′ (we leave c1 unchanged).4 To stay with the example above, people
are concerned about the economic consequences of the coronavirus crisis and
reduce their consumption. This reduces the demand for goods Z, which we
show in Figure 4.5 at the top left as a downward shift of the Z- line. It should
be noted that the Z- line was drawn for a certain interest rate i0 and thus for a
certain level of investment I (i0 ). This means that the equilibrium GDP (Y) falls
for a given interest rate level. At the top right of Figure 4.5 we can therefore see
that the IS curve has been shifted downwards (or to the left). The goods market
is now in equilibrium for combinations of i and Y that lie below the original
IS curve. For all graphs in Figure 4.5, we label new curves or values with an
apostrophe or a higher number (e.g. Y1 instead of Y0 ).
The result is an equilibrium on the goods market with a lower income Y. What
effect does this have on the financial market? There, the demand for money Md
depends positively on income. If Y falls, the demand for money also falls. If we
assume that the central bank controls the money supply, then a lower demand
for money meets an unchanged supply of money. In this case, the interest rate on
4 A decrease in the marginal propensity to consume c
111
1 would reduce the slope of the Z- line.
4 The IS-LM Model
the money market would fall. We can also see this reduction in the interest rate
at the bottom right in Figure 4.5: if we shift the IS curve downwards and have
an LM curve with a positive slope (as with money supply control), the interest
rate falls. If, on the other hand, we assume that the central bank is controlling
the interest rate, it will reduce the money supply Ms so that the interest rate i0
remains unchanged. The LM curve therefore remains unchanged in this case.
If we compare the case with interest rate control and money supply control in
the lower part of the Figure 4.5, it is noticeable that the decline in GDP is smaller
in the second case. This is hardly surprising, as in this case the central bank has
not reduced the money supply and has therefore allowed the interest rate to fall.
As a lower interest rate has a positive effect on private investment, the fall in
GDP is not as large as in the case of interest rate control (where the central bank
ultimately exacerbates the economic slump caused by the fall in consumption
through a contractionary monetary policy). So we can already see that the central
bank plays an important role in how economic shocks affect the economy. We
will shortly look at the specific options a central bank has and how these affect
the IS-LM model.
As a result, the collapse in consumer sentiment — and the subsequent reduction
in autonomous consumption c0 — leads to a decline in GDP. We move from the
original equilibrium at point A to the new equilibrium at point B.
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4 The IS-LM Model
Goods market
Z
A
•
Z (c0 )
Z’ (c0′ < c0 )
•
B
Y0
Financial market with
money supply control
Y1
B
Y1
•
A
Y0
IS
IS′
Y
i
LM (M/P)
i0
•
i1
•
A
Md (for Y0 )
B
A
i0
B
i1
•
•
d′
M (for Y1 )
M
M/P
i
interest rate control
Y
Ms
i
•
i0
45°
Financial market with
i
45° line
M1s
•
i0
B
M0s
i
A
•
Y
Y1 Y0
i0
B
•
A
•
Y1
Y0
LM(i0 )
Md (for Y0 )
′
M1 /PM0 /P
Md (for Y1 )
M
i
Y
i
IS-LM model
LM
i0
•
B
Y1
•
A
Y0
A
B•
•
LM
IS
IS′
Y
Y1 Y0
IS
IS′
Y
Figure 4.5: Reduction of autonomous consumption in the IS-LM model
113
4 The IS-LM Model
Using Figure 4.5, we can also analyze other economic shocks (in addition to a
reduction in autonomous consumption c0 ). For example, it is conceivable that in
spring 2020 the Swiss population, concerned about the economic consequences of
the coronavirus crisis, also reduced that part of their consumption that depends
on disposable income. In this case, the marginal propensity to consume c1 would
have fallen. This would also have a negative impact on demand in the goods
market. Specifically, the slope of the Z- line would flatten out. Once again, at a
given interest rate (i0 ), GDP in the goods market equilibrium would be lower. As
in Figure 4.5, this would result in a decline in GDP, the extent of which depends
on central bank policy.
As we have considered a reduction of c0 and c1 , the final question is what the
reverse case would look like. When the first vaccines against the new coronavirus
were introduced in November 2020, consumer sentiment improved. In the IS-LM
model, an increase of c0 and c1 mutatis mutandis (with the necessary changes)
has an effect analogous to Figure 4.5. The IS curve shifts to the right and in
equilibrium with interest rate control, GDP is higher with an unchanged interest
rate. With money supply control, both GDP and the equilibrium interest rate
rise.
The higher GDP due to an increase in c0 and c1 raises an important question: Can
we actually increase our wealth by simply consuming more? This result from the
model gives reason to reflect on the basic assumptions of the model. We have
once again come across the savings paradox already familiar to us from Chapter 2. In the model, we assume that what is demanded is always produced. This
means that demand determines production and therefore income. An increase
in c0 and c1 increases demand and must therefore lead to a higher GDP. To conclude this chapter and in the next two chapters, we will examine in more detail
the question of how much we can increase GDP through additional demand.
4.2.2 Fiscal Policy in the IS-LM Model
In spring 2020, consumer sentiment in Switzerland fell to an all-time low due
to the coronavirus crisis. As we have now seen, according to the IS-LM model,
this reduces private consumer spending and thus also leads to a decline in Swiss
GDP. Such a decline is usually accompanied by lower incomes and higher unemployment — we will discuss this aspect in more detail in Chapter 5. In view of
this result, two important questions must be asked:
• How can the state or the central bank prevent or at least mitigate the decline
in GDP?
• Should the state and central bank try to prevent the decline in GDP?
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4 The IS-LM Model
The first of the two questions is much easier to answer. As we will see shortly,
fiscal and monetary policy can stimulate the economy in the short term and thus
boost GDP. The second question is more difficult to answer. It can be argued that
a recession can cause long-term damage. For example, an economy can fall into a
liquidity trap, a situation that we will analyze later in the chapter. There is also a
risk that the unemployment rate will permanently rise to a higher level.5 We will
look at this phenomenon, known as hysteresis, in Chapter 5. Both expansionary
fiscal and monetary policy can be used to reduce the adverse consequences of a
recession. However, in addition to the short-term effect on GDP, these government measures also have other effects that need to be considered. For example, a
tax cut can increase government debt or an expansion of the money supply can
lead to inflation. We will analyze these and other aspects in more detail, but will
first turn to the question of how fiscal policy affects the economy in the IS-LM
model. In principle, the state has several ways of influencing the economy. The
instruments of Fiscal policy include:
• Tax reduction/increase: e.g., income tax or value added tax
• Higher / lower transfer payments: e.g., unemployment benefits
• Higher / lower government consumption: e.g., investments in infrastructure
We distinguish here between expansionary fiscal policy, which increases the demand for goods, and contractive fiscal policy, which reduces the demand for
goods. Tax cuts and increases in transfer payments and government consumption are therefore measures of expansionary fiscal policy. In order to understand
how these affect the economy in the short term, we consider the case of a tax cut
in detail. A change in taxes T influences the IS curve, but not the LM curve. We
recognize this in equation (4.1): lower taxes increase disposable income (Y − T)
and thus consumer spending C. For every Franc that households do not have
to pay in taxes, a proportion c1 is spent on additional consumption (the rest is
saved). This increases ceteris paribus the total demand for goods Z. As production
in the model is orientated towards demand (“what is demanded is produced”),
production (Y) increases and with it income (which is also denoted by Y). This
increase in income in turn leads to a further increase in private consumer demand C, as this depends on disposable income. We thus obtain the multiplier
5 Many of the causes of longer-term damage from a recession that economists put forward during
the 2020 coronavirus crisis are described in the article “Psychological scars of downturns could
depress growth for decades” in the magazine The Economist of 29 August 2020.
115
4 The IS-LM Model
effect that we are already familiar with, which is illustrated in Figure 4.6 at the
top left by the sharp rise in GDP (which is greater than the rise in the Z- line).
The result is a higher Z- line in the goods market, as illustrated in Figure 4.6
top left. The increase in private consumption C raises the Z- line to the level Z ′ .
As we know, the Z- line is drawn for a certain interest rate i (and thus I (i )). By
lowering taxes, we now obtain a higher GDP (Y) for each interest rate level, so
that the IS curve shifts to the right (or upwards).
In the goods market, this results in a higher GDP in equilibrium. This also means
that income Y is higher in equilibrium. As a result, the demand for money in
′
the financial market increases from Md to Md . This is shown in the middle
four graphs of Figure 4.6 for the case of money supply control and interest rate
control. If the central bank keeps the money supply fixed at Ms , a higher demand
for money meets a constant supply and the equilibrium interest rate rises from i0
to i1 . If, on the other hand, the central bank expands the money supply from M0s
to M1s , the interest rate remains unchanged.
As we can see in the bottom two graphs of Figure 4.6, the increase in GDP as
a result of the tax cut is greater when the central bank controls interest rates.
Why is this the case? If the government cuts taxes (T) and leaves its consumption
expenditure (G) unchanged, it reduces government savings (T − G) or increases
the government deficit (if it was already spending more money before the tax cut
than it was taking in through taxes). This has an impact on the financial market:
If, for example, the state has to take out additional loans to finance the tax cut,
it enters into competition with other, private borrowers. In this case, economists
speak of crowding out, i.e. crowding out private investment. The rise in interest
rates as a result of the tax cut leads to a decline in private investment I (i ), which
is negatively dependent on interest rates. In the graph at the bottom right of Figure 4.6, we can see that the IS curve moves more to the right than the difference
between Y1 and Y0 . The central bank can prevent crowding out by expanding the
money supply accordingly (as with interest rate control) and thus keeping the
interest rate at the original level.
116
4 The IS-LM Model
Goods market
Z
B
•
Z′
Z
•
A
Financial market with
money supply control
Y0
Y1
•
B
Y0
Y1
IS
Y
i
LM (M/P)
•
i1
•
i0
B
M (for Y0 )
A
i
M1s
•
i0
A
B
i1
d′
A
i0
Md (for Y1 )
M
M/P
interest rate control
A
IS′
Y
Ms
i
•
i0
45°
Financial market with
i
45° line
Y
i
B
′
Md (for Y0 )
M1 /PM0 /P
•
Y0 Y1
M0s
•
•
i0
Md (for Y1 )
M
i
A
•
B
•
Y0
Y1
LM(i0 )
Y
i
IS-LM model
LM
i0
•
A
Y0
•
B
Y1
B
A•
•
LM
IS′
IS
Y
Y0 Y1
Figure 4.6: Tax reduction in the IS-LM model
117
IS
IS′
Y
4 The IS-LM Model
The causal chain that we have described verbally and graphically is referred to by
economists as the transmission mechanism. The aim is to show how a measure
(in this case the tax cut) affects GDP. We can summarize the sequence of changes
as follows:
• For interest rate control:
T ↓ −→ YV ↑ −→ C ↑ −→ Demand for goods ↑ −→ Production ↑ −→ Y ↑
−→ multiplier effect: [if Y ↑, then C ↑, thus Y further ↑]
−→ Y ↑−→ Demand for money (PY ∗ L(i )) ↑ −→ Money supply (MS ) ↑
−→ i unchanged
• For money supply control:
T ↓ −→ YV ↑ −→ C ↑ −→ Demand for goods ↑ −→ Production ↑ −→ Y ↑
−→ multiplier effect: [if Y ↑, then C ↑, thus Y further ↑]
−→ Y ↑→ Demand for money (PY ∗ L(i )) ↑
−→ Money supply (MS ) remains constant −→ i ↑ −→ I ↓
We end the causal chain in the case of money supply control with the decline in
private investment. Of course, the decline in private investment I would trigger
further effects. In macroeconomics, such second- and third-round effects are of
great importance. However, these diminish with each round (see Figure 2.6 on
page 70).
Having considered the case of a tax cut in detail, we can now also analyze the
reverse case of a tax increase. Since lower taxes increase the demand for goods
and thus GDP, it is quickly apparent that a tax increase in the IS-LM model leads
to a lower GDP. However, the effect on GDP also depends on the central bank’s
policy. It can leave the money supply unchanged or adjust it so that the interest
rate remains unchanged. The central bank also has the option of changing the
money supply and interest rate in such a way that GDP does not fall at all. In the
figures 4.7, 4.8 and 4.9 we see the three possible cases graphically illustrated.6
6 These figures are based on Figure 11-4 from the book ‘Macroeconomics’ by N. Gregory Mankiw
from 2010.
118
4 The IS-LM Model
i
A tax increase shifts
the IS curve to the left...
...to keep the inter-
B
•
i0
A
•
LM
est rate constant, the
IS
central bank reduces
IS′
the money supply
Y1
Y
Y0
Figure 4.7: Contractive fiscal policy, IS-LM model, interest rate control
A tax increase shifts
i
LM
the IS curve to the left...
...but since the cen-
i0
tral bank keeps the
B
•
i1
money supply con-
A
•
IS
IS′
stant, the (rising) LM
curve is unchanged
Y
Y1 Y0
Figure 4.8: Contractive fiscal policy, IS-LM model, money supply control
i
A tax increase shifts
the IS curve to the left...
...to keep income con-
i0
•
i1
•
A
LM
B
IS
LM′
stant, the central bank
lowers the interest rate
Y0 = Y1
IS′
Y
Figure 4.9: Contractive fiscal policy, IS-LM model, income control
119
4 The IS-LM Model
In addition to changing taxes and transfer payments (T), the state can also influence the economy via government consumption (G). For example, new government construction projects increase the demand for goods and thus GDP. In this
case too, the IS-LM model shows us the transmission mechanism. If we assume
that the central bank controls interest rates, we obtain the following causal chain:
• G ↑ −→ Demand for goods Z ↑ −→ Production ↑ −→ Income Y ↑ −→
multiplier effect: [if Y ↑, then C ↑, therefore Y increases further] −→
Y ↑−→ Demand for money (PY ∗ L(i )) ↑ −→ Money supply (MS ) ↑ −→
i unchanged
As shown in Figure 4.10 on the left, the interest rate i remains unchanged when
the central bank controls the interest rate. With money supply control (rising
LM curve as shown in the right-hand graph in Figure 4.10), however, i rises as
a result of higher government spending. As a result, expansionary fiscal policy
increases GDP in both cases, but the effect is greater if the central bank prevents
the crowding out effect by controlling interest rates.
i
i
LM
i0
•
A
•
B
LM
A
•
IS′ (G ′ > G)
B
•
IS (G)
Y
Y′
IS′ (G ′ > G)
IS (G)
Y
Y Y′
Y
Figure 4.10: Expansionary fiscal policy in the IS-LM model
The distinction between interest rate and money supply control as shown in
Figure 4.10 shows that the government certainly wants to influence monetary
policy. If the government increases consumption G, part of the stimulating effect
on GDP is lost due to crowding out. From an economic perspective, it can be
argued that there should certainly be coordination between the state and the
central bank. However, there are also good reasons in favor of the (political)
independence of central banks, as we will see in Chapter 6.
Even without the support of expansionary monetary policy, the state can increase
GDP through fiscal policy. Since we have seen that GDP per capita correlates with
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4 The IS-LM Model
many indicators of well-being (see Figure 1.2 on page 30), the question arises as
to why the state should not permanently increase GDP through expansionary
fiscal policy. There are a number of economic objections here. Firstly, money
supply control leads to the already discussed crowding out, i.e. the crowding out
of private investment. In addition, the effectiveness of fiscal policy depends on
the size of the multiplier effect. As we have already seen in Chapter 2, this effect
is reduced by a high savings rate or by the increase in imported products. The
third criticism leveled at expansionary fiscal policy is the time-lagged effect. If
the state wants to stimulate the economy through additional government spending, as in the case of the coronavirus crisis in 2020, there are possible delays (time
lags) in realization, implementation and impact. It takes time for the government to realize that the economy is in recession, for it to decide on additional
spending through political channels, and for the additional investments (such as
construction projects) to actually begin. The delays can be so long that the effect
of expansionary fiscal policy only materializes after the economy is already out
of recession. As a result, fiscal policy interventions would reinforce rather than
weaken economic cycles. The situation is reminiscent of a sentence by Abraham
Lincoln, who once asked the audience how many legs a dog has if you call the
tail a leg. When some gave the answer “five”, Lincoln corrected: “The correct
answer is four. Just because you call the tail a leg doesn’t mean the dog has a
fifth leg.” Even a stimulus program, despite its name, does not have to stimulate
the economy, or not in time.
In addition to the criticisms of expansionary fiscal policy already mentioned,
some economists also doubt the efficiency of government spending. To quote
Milton Friedman, there are four ways of spending money: spending your own
money on yourself, spending other people’s money on yourself, spending your
own money on someone else and spending someone else’s money on someone
else. If you spend your own money, you pay particular attention to the costs.
If you receive the goods and services bought with your own money, you pay
particular attention to quality. As people usually spend other people’s money on
others when it comes to government spending, economists sometimes question
the value for money. Finally, there is also the argument of so-called Ricardian
equivalence: This is the term used by economists to describe the idea that citizens
do not spend the additional income on consumption when taxes are cut, as they
anticipate a future tax increase (to finance the tax cut).
4.2.3 Monetary Policy in the IS-LM Model
When the global economy collapsed as a result of the coronavirus crisis in 2020,
Monetary policy was also available as an instrument to mitigate the slump along-
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4 The IS-LM Model
side fiscal policy. As with fiscal policy, we can distinguish between expansionary
and contractionary monetary policy. The former leads to an increase in the demand for goods, while the latter reduces it. However, while fiscal policy can
increase GDP directly by increasing government consumption G, monetary policy can only increase GDP indirectly. By expanding the money supply, the central bank can lower the interest rate and thus stimulate private investment I (i ).
Monetary policy is therefore a crude tool whose main idea is to shift economic
demand from the future to the present (by lowering interest rates) or to shift the
same demand from the present to the future (by raising interest rates).
Let us consider the case of expansionary monetary policy. To stimulate the economy in a recession, the central bank can increase the money supply. As a result, a
greater supply of money meets an unchanged demand for money, causing the interest rate to fall in the equilibrium of the money market. Specifically, the central
bank creates new money and uses it to buy securities, which then rise in price
and the implicit interest rate falls (see Chapter 3). A reduction in the interest rate
shifts the LM curve downwards. If we look at the IS-LM model in Figure 4.11,
we can see that the economy reaches a new equilibrium (point B) in response to
the expansionary monetary policy. In this equilibrium, the interest rate has fallen
from i0 to i1 and GDP has risen from Y0 to Y1 .
i
i0
i
•
A
LM
•
i1
Y0
B
Y1
i0
i1
LM′
IS
LM LM′
A
• B
•
IS
Y
Y0 Y1
Y
Figure 4.11: Expansionary monetary policy in the IS-LM model, interest rate and
money supply control
In Figure 4.11, it should be noted that we have shifted the LM curve but left the
IS curve unchanged. Has there been no change in the goods market as a result
of the expansionary monetary policy? The increase in GDP from Y0 to Y1 already
shows that this is not correct. The intervention of the central bank has lowered
the interest rate and therefore private investment I has risen. The multiplier effect
also increases consumer demand. The result is an increased demand for goods,
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4 The IS-LM Model
which leads to increased production. However, the IS curve is not shifted. We
move along the curve from point A to point B. As with fiscal policy, we can again
describe the transmission mechanism as a causal chain:
• MS ↑ −→ i ↓ −→ I (i, Y ) ↑ −→ Z ↑ −→ Y (production and income) ↑
−→ [...multiplier effect...] −→ Y ↑
−→ Demand for money (PY ∗ L(i )) ↑ −→ Money supply (MS ) ↑
In the last step, we assume that the central bank adjusts the supply of money
to the increased demand for money so that the interest rate does not (slightly)
increase again. We can illustrate the reverse case of contractive monetary policy
in the same way: An increase in the interest rate (a reduction in the money
supply) shifts the LM curve upwards, the interest rate rises and GDP is lower in
the new equilibrium.
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4 The IS-LM Model
Theory box 4.2: Dynamics in the IS-LM model
We have already analyzed several times how an economy reacts to shocks as well as fiscal
and monetary policy using the IS-LM model. In doing so, we have used the comparative
statics approach. In other words, we have shifted the curves and analyzed how the equilibrium of the economy changes. One aspect that we have neglected so far is how exactly
the economy moves from the old to the new equilibrium. Let’s look at the case of an interest rate cut by the central bank, which controls the money supply. This expansionary
monetary policy causes the LM curve to shift downwards.
i
i0
i1
LM LM′
A
• C
•
•
B
Y0 Y1
IS
Y
Figure 4.12: Dynamics in the IS-LM model, expansionary monetary policy
The economy is initially in equilibrium at point A. As soon as the central bank increases
the money supply, the interest rate falls and the LM curve shifts to LM′ . Assuming that
adjustment processes on the financial market are faster than on the goods market, the
economy remains in financial market equilibrium (i.e. at LM′ ) and falls to point B. There,
however, we are below the IS curve. There is therefore excess demand on the goods market
(see Chapter 2.6). This is eliminated by an expansion of production. However, since an
increase in production is accompanied by a rise in income Y, the demand for money also
increases. If the central bank does not change the money supply again, the interest rate
rises. As a result, the economy moves from point B to point C.
Monetary policy by the central bank can therefore also increase the GDP of an
economy. The question therefore arises again as to why this instrument is not
constantly used. In practice, there is an ongoing debate between those in favor of
expansionary monetary policy and those against it. The former are often referred
to as doves (doves in English), the latter as hawks (hawks).7 What arguments do
7 The use of these two animals presumably goes back to military debates in which doves were
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4 The IS-LM Model
the hawks use?
It must be noted that an expansionary monetary policy only increases GDP if the
transmission mechanism described above works. In particular, two causal relationships must hold: First, the relevant interest rates in the economy must fall
as a result of the expansionary monetary policy and second, private investment
must react positively to a falling interest rate. Both are by no means certain: on
the one hand, interest rates may not be able to fall any further. We will look at
this phenomenon, known as the liquidity trap, shortly. In addition, expansionary
monetary policy by the central bank can be seen as a beacon of a coming recession. In this case, investors will demand higher risk premiums and generally
invest more cautiously. We discuss the influence of risk premiums in more detail
in Chapter 7.
As with fiscal policy, it must also be noted that there may be a time lag in monetary policy. Even a reduction in interest rates does not immediately lead to higher
investment, as companies need time to plan for this. To a certain extent, this is
a general problem of economic policy: future economic development is unclear,
information is often only available for the past and any measure has a delayed
effect. Some have compared this to a car driver who has poor forward visibility
and whose steering wheel, accelerator pedal and brakes have a delayed effect on
the car.8
There are other possible effects, especially with regard to monetary policy. The
most important criticism, that an increase in the money supply will lead to inflation in the medium term, is addressed in Chapter 6. In analyzing the economy
in the short term, we have assumed that prices are fixed. In addition, an expansionary monetary policy can lead to a depreciation of the domestic currency. We
discuss this aspect in Chapters 8 and 9 when we consider an open economy. In
contrast, we do not discuss the effects of an expansionary monetary policy on the
credibility of the central bank and the risk appetite of investors (search for yield)
in detail in this textbook. However, it should be noted that a central bank that
immediately tries to support the economy with expansionary monetary policy
every time there is a recession runs the risk of creating a so-called moral hazard
problem. By this, economists mean that people take greater risks if they consider
described as a sign of peace and hawks as being in favor of warlike measures. Why some
monetary politicians are doves and others hawks is difficult to explain. According to a study by
Malmendier, Nagel and Yan (Journal of Monetary Economics, 2021), personal inflation experiences
play an important role.
8 In a similar comparison, John Kay asks in the 2016 book “Other People’s Money”: “Is it desirable
for government and its agencies — which have sensibly extricated themselves from the business
of controlling most prices — to manipulate interest rates? [...] Is it possible to imagine a
government trying to manage the economy by controlling the supply and price of electricity?”
(page 245).
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4 The IS-LM Model
themselves insured against possible losses. In relation to the financial market,
this is referred to as Greenspan put, named after the former US Federal Reserve
Chairman Alan Greenspan. If every economic slump is ’corrected’ by expansionary monetary policy, the risk appetite of many investors increases, as they
then assume that the central bank will intervene in the event of any economic
downturn.
Ineective Monetary Policy in the IS-LM Model
John Maynard Keynes already doubted in the 1930s that an expansionary monetary policy would stimulate the economy in any case. In his 1936 work “The
General Theory of Employment, Interest and Money”, he argued that cash has a
liquidity premium: since money is liquid, unlike securities, the interest rate on
securities must be sufficiently high so that people do not just hold cash. Conversely, if the interest rate is very low, people will only hold cash so that the
interest rate cannot fall any further.9 In this context, economists speak of an effective interest rate floor (also known as the zero lower bound). The transaction
costs of investing money exceed the interest rate. Keynes described this phenomenon as liquidity trap. In this case, interest rates are so low that everyone
believes in interest rate hikes (and thus in price losses). As a result, there is
hardly any demand for securities. If the central bank creates new money in this
environment, it flows into the speculative coffers. Economists also speak of the
additional money being hoarded. The LM curve is then horizontal for a certain
range and it is not possible for the interest rate to fall below i0 . This is shown in
the left-hand graph of Figure 4.13. In this case, the central bank can only shift the
rising part of the LM curve to the right, but this does not change the equilibrium
point A. Keynes himself wrote about this in 1936:
“There is the possibility...that, after the rate of interest has fallen to
a certain level, liquidity-preference may become virtually absolute in
the sense that almost everyone prefers cash to holding a debt which
yields so low a rate of interest. In this event the monetary authority
would have lost effective control over the rate of interest. But whilst
this limiting case might become practically important in the future,
I know of no example of it hitherto.”
9 John Maynard Keynes once emphasized the limited possibilities of monetary policy in this situa-
tion with the words: “You can lead a horse to water, but it has to drink itself. The central banks
could flood the markets with money to make loans cheap. But whether companies demand
and invest in loans at all is something that no central banker can determine through interest
rates, only the companies themselves.
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4 The IS-LM Model
So while he could not give an example of an economy in the liquidity trap, some
economists such as Hans-Werner Sinn (“Die wundersame Geldvermehrung”,
p.231 ff.) argue that the Euro area, for example, has been in the same trap for
several years.10 We discuss this in more detail in Chapter 6.
In addition to the liquidity trap, there is a second situation in which expansionary
monetary policy cannot stimulate the economy: the investment trap. If investors
are very pessimistic, investments do not react to the interest rate. Even if companies can obtain loans more cheaply, they will not invest if they consider future
earnings to be low due to pessimistic assessments of economic development. In
this case, the IS curve is vertical, as shown in the right-hand graph of Figure 4.13.
The position of the LM curve then only changes the interest rate i, but no longer
the GDP (Y). The investment trap assumes a very recessionary situation, i.e. that
the economy is in a deep crisis. This shows once again that the theory was developed by John Maynard Keynes in the 1930s, i.e. in times of economic depression.
Both interest-inelastic (interest-independent) investments and the assumption of
underutilized production factors (labor, capital) can be justified for this period.
i
i0
i
LM
A
•
i0
IS
•
LM
A
IS
Y0
Y
Y0
Y
Figure 4.13: Liquidity and investment trap in the IS-LM model
10 The interest rates on government bonds in the Euro area have been reduced to zero. Since ban-
knotes are a special form of government security, it makes little difference whether government
bonds or cash are held.
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4 The IS-LM Model
Practice box 4.1: Fiscal or monetary policy
As we have seen, both the state and the central bank can influence the economy. If a country experiences a recession, the question arises as to whether it is better to stimulate the
economy through expansionary fiscal policy or expansionary monetary policy. John Maynard Keynes favored fiscal policy, as monetary policy is ineffective in a deep depression
(see liquidity and investment trap). Other economists, on the other hand, favor monetary policy as a means of combating a recession. One of the arguments put forward is that
monetary policy is controlled by an ’independent’ central bank with a longer time horizon.
While politicians often want to stimulate the economy in the short term due to elections in
order to increase their chances of re-election, the often more technocratic central banks see
the economic trade-offs associated with economic policy. The independence of the central
bank from the respective government plays an important role here.
4.3 Extensions and Limitations of the Model
With the IS-LM model, we now have a basis for understanding a wide range
of macroeconomic developments and economic policy decisions. For example,
when Japan raised VAT from 8% to 10% on 1 October 2019, many media outlets reported that this would have a negative impact on the country’s economic
growth (in the short term). This assessment is based on fundamental assumptions about how an economy works. The IS-LM model provides us with a framework in which many economists analyze the economy. How well the model
describes the economy is not easy to assess. There are several empirical studies
that support the core propositions of the model.11 Empirically, however, a test of
the IS-LM model is complicated by the fact that large shocks and policy changes
(isolated from other changes) rarely occur in reality. While we can change individual variables in the model and then analyze the effects ceteris paribus, this is
hardly ever the case in reality. This is also due to the fact that the relationship between economic variables can change over time. The Nobel Prize winner Robert
E. Lucas concluded from this in his well-known Lucas critique from 1976 that the
consequences of an economic policy measure cannot be estimated on the basis of
relationships that have been observed in the past.
However, many readers will also have noticed that we have not yet discussed
many important macroeconomic aspects. In particular, unemployment and infla11 See Lawrence Christiano, Martin Eichenbaum and Charles Evans (1996). “The Effects of Mon-
etary Policy Shocks: Evidence from Flow Funds”, Review of Economics and Statistics, 78, 16-34
and Olivier Blanchard and Gerhard Illing, “Macroeconomics”, 2017, Chapter 5.5.
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4 The IS-LM Model
tion have not yet been analyzed. The reason for this is that we have deliberately
developed a very simple, reduced model. We have made many very simplifying
assumptions in it so that it does not become too complex. However, it is certainly
possible to extend the IS-LM model. For example, in Chapters 5 and 6 we will
take up the aspects of the labor market and inflation. We can then extend the
IS-LM model to the IS-LM-PC model in Chapter 7. In addition, the IS-LM model
can also be used for the open economy, in which exports and imports influence
GDP.
However, there are also many extensions that we do not consider in this textbook.
For example, private consumption C could be influenced not only by disposable
income, but also by expectations regarding future economic development (the socalled consumer sentiment or consumer confidence). One could also assume that
consumer spending depends on household wealth. However, the IS-LM model
ignores stock variables such as wealth. It would therefore require some major
changes, which we do not consider in detail here. In addition to private consumption, private investment I could also depend on other factors in addition to
the interest rate. Expectations about the future are also likely to play an important role here. In practice, the Purchasing Managers’ Index (PMI) is often used
as a barometer for estimating economic development.12
Another aspect of macroeconomic ideas that we do not address in detail in this
book is how the price mechanism works in an economy. A major simplification of
the Keynesian view is that it completely abstracts from the behavior of individual
people. Other economists, in contrast, emphasize the importance of the countless interactions. Friedrich August von Hayek described the role of knowledge in
an economy in his essay “The Use of Knowledge in Society” (American Economic
Review, 1945): “Economics has come nearer than any other social science to an
answer to that central question of all social sciences, how the combination of fragments of knowledge existing in different minds can bring about results which, if
they were to be brought about deliberately, would require knowledge on the part
of the directing mind which no single person can possess.”13 Hayek based this
on the ideas of Adam Smith, who spoke of an “invisible hand”.14 Prices that arise
in a market show scarcities and opportunity costs. In view of complex supply
chains, these signals issued by prices (e.g. high prices signal scarcity) are much
more efficient than centralized economic policy planning. The market economy
12 The extent to which PMIs are suitable for making economic forecasts about the near future is
disputed in the literature. A recent evaluation for Switzerland by Claude Maurer and Tiziana
Hunziker (Die Volkswirtschaft, 2019) documents a trend towards decreasing accuracy.
13 Quoted from “Economics and Knowledge”, published in 1937 in the journal Economica.
14 Any politicians or economists who claimed to be able to control an economy were accused by
Hayek of “pretense of knowledge”.
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4 The IS-LM Model
is therefore superior to a planned economy.15
When we consider how best to extend the IS-LM model, in some respects the limitations of the model point the way forward. For example, the model says that
expansionary fiscal and monetary policies lead to higher GDP. What then stops
us from increasing GDP at will by maximizing tax cuts, government spending increases and monetary expansion? While we can theoretically shift the IS and LM
curves infinitely to the right in the model in this way, there are indeed limits in
practice. These also show us which simplifying assumptions we need to address:
Firstly, production in the IS-LM model is determined purely by demand: what
is demanded is produced. This ignores the supply side, i.e. which resources
are available for production in the first place. Only as long as additional labor
is available and machines are underutilized is it possible to expand production
through additional demand. Secondly, we cannot assume that all prices will remain constant in the medium term. We must therefore also bear in mind that a
substantial expansion of the money supply can lead to inflation. We will look at
these aspects in more detail in the next two chapters.
4.4 Business Cycles
To conclude our discussion of the economy in the short term, we turn once again
to economic fluctuations in general, which we see in Figure 4.14 for Switzerland.
Why are there sometimes these strong fluctuations from year to year and why
are there business cycles — recurring phases of upturns and downturns — in the
economy?
15 An intuitive explanation of the importance of the price system can be found in the 1958 work “I,
Pencil” by Lawrence W. Reed. The theoretical basis for the criticism of a planned economy was
provided by the Austrian-American economist Ludwig von Mises (1881–1973) in his book Die
Gemeinwirtschaft published in 1922.
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4 The IS-LM Model
Figure 4.14: Growth rate of real GDP in Switzerland
Since GDP is defined as the sum of private consumption C, private investment I,
government consumption G and net exports (X − I M), the fluctuations must also
be attributable to these four components. Figure 2.1 on page 58 already showed
that the majority of the variation is explained by investment and foreign trade.
In contrast, private and government consumption are very stable over time.
A better understanding of business cycle fluctuations is not only interesting for
economists, but also for many companies. There are sectors whose turnover
and profits are particularly dependent on whether an economy is in a boom or a
recession. For example, many households significantly reduce their consumption
during a recession. However, they continue to buy food and other necessities. On
the other hand, they save on durable goods such as furniture and cars or even
travel.16 As these goods also frequently appear in advertising, the advertising
industry also tends to be pro-cyclical. This means that it benefits from booms
and is hit particularly hard during recessions. Tobacco products are a countercyclical example of the opposite: People smoke more when the economy is in
recession.
But what explains economic fluctuations? There are many possible explanations
in the literature. This is not surprising, as ultimately the behavior of the four
demand components in the GDP equation (Y = C + I + G + NX) play a role.
One of the most important explanations is the so-called impulse and propagation
16 On the one hand, it is relatively easy to do without many durable goods, such as a recreational
vehicle, and on the other hand, these are also available as used products.
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4 The IS-LM Model
theory, which has been formulated in various ways. 17 The core idea here is that
an economy as a system is regularly exposed to exogenous shocks. This can be
a new technical invention, a natural disaster or an event abroad. As these shocks
occur irregularly and an economy always reacts to them, the result is a seemingly
random fluctuation as seen in Figure 4.14 for Switzerland.
Some shocks can nevertheless be explained. For example, it is argued that political influence can be a cause of shocks. It is assumed that a government is
interested in being re-elected and that the chances of this are better if the economy is booming in the election year. Fiscal and monetary policy measures can
— as we have seen in the IS-LM model — generate a short-term increase in GDP.
This influence by the state therefore does not stabilize the economy, but rather
leads to greater fluctuations in GDP.
There are also other explanations for business cycles. For example, Hyman Minsky (American economist, 1919-1996) formulated the Minsky hypothesis named
after him. This describes a recurring cycle in the financial market in three phases,
which leads to instability. In phase 1, after a (financial) crisis, banks and lenders
are very cautious. They only grant loans very restrictively, i.e. only if a debtor
has both the capital sum (the so-called principal) and can pay the interest. In
phase 2, some time later, confidence grows again. All loans have recently been
successfully serviced again, so the lenders’ risk appetite increases. Debtors who
can only pay the interest also receive a loan. The latter are secured by assets (e.g.
property), which increase in value. In phase 3, the last crisis was a long time
ago. Many current financial players have only limited memories of it. Financial
institutions are now once again granting riskier loans where debtors can neither
pay the principal nor the interest. The basis is rather the belief that the assets will
rise in price so much that debtors can pay the interest and the principal.18 If this
is no longer the case at some point — such as in 2007 with the so-called sub-prime
property loans in the USA — a crisis occurs and the cycle starts all over again.
17 In addition to early works by Frisch (Economic Essays in Honor of Gustav Cassel, 1933) and Slutsky
(Problems of Economic Conditions, 1937), important contributions also include the work on the
so-called real business-cycle theory by Finn E. Kydland and Edward C. Prescott (Econometrica,
1982), among others.
18 The US economists and investors Benjamin Graham and David Dodd, founders of so-called
Value Investing, explained in their 1934 book “Security Analysis” how the boom and crash of
the American stock market in 1929 came about. They noted that many investors disregarded the
fundamental values of companies and only looked at share price developments: “the rewards
offered by the future had become irresistibly alluring”. It goes on to say: “An investment
operation is one which, upon thorough analysis, promises safety of principal and an adequate
return. Operations not meeting these requirements are speculative.”
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4 The IS-LM Model
4.5 Summary
We now have an economic model for analyzing the economy in the short term:
the IS-LM model. This enables us to better understand a large number of macroeconomic developments and economic policy decisions that are reported in the
media on a daily basis. However, we have also made initial considerations that
show the limitations of the IS-LM model. In the model, for example, GDP could
be increased arbitrarily by increasing government spending G. This raises the
question of where the model needs to be extended. As we will see in the following part of the book, resource constraints are important in the medium term.
In addition, prices are not stable and inflation can occur — for example, due to
expansionary monetary policy. In Chapters 5 and 6 we therefore examine the
labor market and the issue of inflation.
133
Part II
The MediumTerm
134
5 The Labor Market
Now that we have a model for analyzing the economy in the short term, we turn
to the medium term in Chapters 5 to 7. As we know from Table 2.1 on page 56,
this means that from now on we no longer consider goods prices and wages as
fixed and also pay attention to resource constraints. We must therefore extend
our IS-LM model to take these aspects into account.
The IS-LM model has many advantages: it explains essential relationships in an
economy in an intuitive way without too many equations. However, we have
already seen that it also has some weaknesses. David Romer (Journal of Economic
Perspectives, 2000) describes a number of shortcomings of the IS-LM model and
discusses possible adaptations and extensions. We follow his ideas and also those
described by Olivier Blanchard (“Macroeconomics”, 2017).
Essentially, the criticism of the IS-LM model focuses on the assumptions described above. Although these simplify the analysis, they are only partially justified. If an economy is in a state of (high) unemployment, an expansionary fiscal
policy can reduce it. The assumption of constant goods prices and the ignoring
of resource constraints are less problematic in this case. However, as soon as
unemployment is eliminated, further increases in government spending — and
thus additional demand for goods — lead to an excessive burden on the factors of
production. The many demands on the goods and services produced in the economy (by consumers, investors and the state) can only be met if they are matched
by a corresponding supply. This can only be achieved to a limited extent in the
short term. Employees may accept overtime in the short term, but in the medium
term this will be reduced or paid out. Excess demand therefore leads to rising
wages and prices, i.e. inflation. The IS-LM model therefore reaches its limits.
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5 The Labor Market
Theory box 5.1: Criticism of Keynesianism
As already mentioned, the IS-LM model is essentially based on the ideas of John Maynard
Keynes, which he published in 1936. Keynes himself emphasized the word “General”
in the book title The General Theory of Employment, Interest, and Money. He saw classical
economics, which was the predominant theory until the 1930s, as a special case. Ironically,
Friedrich August von Hayek later pointed out that Keynes himself regarded it as a special
case: he wrote his work at extraordinary times — the Great Depression of the 1930s.
Keynes was primarily concerned with the persistently very high level of unemployment.
In his view, this was due to a lack of aggregate demand and rigid wages. The latter
describes the assessment that a reduction in nominal wages would not be accepted by
employees. Keynes concluded from these observations that the state should generate the
missing macroeconomic demand if necessary (fiscal policy) and that real wages should not
be reduced by lowering nominal wages, but by increasing the price level. In Keynesian
policy, monetary policy, namely inflation, therefore plays a key role alongside fiscal policy. It is hardly surprising that escalating government deficits and inflation rates led to
a renaissance of “classical economics” from the 1970s onwards — with economists such
as Milton Friedman (Nobel Prize winner in 1976) or Friedrich August von Hayek (Nobel
Prize winner in 1974).
Demand determines GDP in the short term. Production factors such as labor
and capital can be underutilized or overutilized. In the medium term, the economy returns to an equilibrium in which production equals potential output. We
will now focus on the scarcity of labor as a factor of production. We are therefore switching from a demand perspective to a supply perspective. Figuratively
speaking, we examine the level of the trend line at a certain point in time with a
view to the Figures 0.3 and 0.4 (pages 15 and 16). It is also important to understand why GDP always moves back to the trend line in the medium term. The
slope of the trend line is then discussed in Chapters 10 and 11.
These considerations give rise to a number of tasks: First, we need to analyze the
resource constraints of an economy, such as the labor force available for production. For this purpose, we examine the labor market in Chapter 5. Secondly, we
need to understand the aspect of inflation in more detail. This will be done in
Chapter 6. Finally, we need to analyze how additional production factors can be
made available in the long term. This is the subject of Chapters 10 and 11.
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5 The Labor Market
5.1 Motivation
In order to significantly simplify the analysis of the short term, we have largely
refrained from describing the production process in the economy (the so-called
supply side) in more detail. In the IS-LM model, we assumed that what is demanded is simply produced. This is a simplification and is only economically
permissible if there is sufficient free production capacity — for example, because
people are unemployed or machines are not fully utilized. In the short term, it
is also possible for employees to work more overtime. However, this will not be
permanent, as overtime will either be reduced or financially compensated in the
medium term.
But how much labor is available to an economy for production? We can answer
this question by analyzing the labor market. There, employees determine how
much labor they offer (for a given wage) and how much labor companies demand
(also for a given wage). What is decisive for us in this chapter is not so much
why the labor market sometimes performs better and sometimes worse, why unemployment is higher or lower in some years. We already know from studying
the short term that production in an economy is subject to cyclical fluctuations.
And it is obvious that this also directly affects the labor market: in a recession,
unemployment is high, whereas in boom years it is low. Empirically, there is a
clear correlation between the GDP growth rate and the change in the unemployment rate (in percentage points). This so-called Okun’s Law, named after Arthur
Melvin Okun (American economist, 1928–1980), is shown in Figure 5.1.1
1 The term ’law’ is somewhat misleading here. It is an empirically observable correlation.
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5 The Labor Market
Figure 5.1: Okun’s Law in the data for Switzerland, 1992–2022
What interests us in this chapter, however, is not the change in the unemployment
rate from year to year. Rather, we want to understand why unemployment is
persistently at a higher level in some countries than in others. Figure 5.2 shows
the unemployment rates (as defined by the International Labor Organisation ILO)
in six selected countries. It is noticeable that the unemployment rate is subject to
cyclical fluctuations in all countries. However, even in good years, countries such
as France and Italy did not achieve unemployment rates as low as Switzerland,
for example. It can also be seen that Germany has consistently reported lower
unemployment figures since 2005.
Unemployment is generally recognized as one of the biggest economic problems.
We therefore need to ask ourselves several questions. Why do unemployment
rates vary so much across countries and over time? Why does the unemployment
rate never fall to zero? How has Germany managed to achieve a permanently low
level of unemployment? We seek to answer all these questions in this chapter.
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5 The Labor Market
Figure 5.2: Unemployment rates in selected countries, 1980–2023
If unemployment in a country is permanently very high, this means that it has
a reduced production potential in the medium term: the unemployed people
are not available for the production of goods and the provision of services. The
country’s GDP will therefore remain below its potential. To understand this in
more detail, in this chapter we will first examine what exactly unemployment
is, what types there are, how it is measured and why it occurs. We will then
develop a model of the labor market that allows us to understand a country’s
medium-term unemployment rate. A key output from this model will be the
Phillips curve, which we will relate to the IS-LM model in Chapter 7.
5.2 The Labor Market
5.2.1 Actors
Only part of a country’s population participates in the labor market. As shown
in Figure 5.3 based on data for Switzerland, many people are either too young
or already retired. Of the people of working age, there are also some who do
not participate in the labor market. This can be for various reasons, such as
focusing on looking after their own children or being unable to work due to
illness. Among the remaining people, a distinction must be made between those
who are employed and those who are unemployed. A person is considered to
be gainfully employed if they are engaged in an occupational activity for at least
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5 The Labor Market
one hour per week (definition according to ILO recommendations).
population (8’739)
working-age population (5,770)
labor force (5’317)
employed
unemployed
(5’116)
(201)
non-employed persons (453)
population outside
of working age (2’969)
< 16 years (1’404)
> 65 years (1’565)
Figure 5.3: Swiss population breakdown, in thousands, year 2022
Based on the subdivision into Figure 5.3, various rates of employment and unemployment can be calculated. Firstly, there is the employment rate, which expresses the number of people in employment in relation to a reference population:
employment rate =
Employed
· 100
Reference population
(5.1)
If the total population is used as the reference population, the result is the gross
labor force participation rate. Alternatively, there is the standardized employment rate (reference population = population aged 15 and over) and the net labor
force participation rate (reference population = population aged between 15 and
64). The Participation rate is calculated in the same way, whereby we now have
the labor force in the numerator:
participation rate =
Labor force
· 100
Reference population
(5.2)
The unemployment rate finally results as 100% minus the employment rate. It
is important to distinguish national definitions from the international standard
set by the International Labor Organisation (ILO). While the ILO reports the
unemployment rate in Switzerland at 201/5317 = 3.8% in 2022, the Swiss State
Secretariat for Economic Affairs (Seco) reports a lower unemployment rate of just
97/5317 = 1.9%. The difference is explained by the fact that Seco further divides
the unemployed into recipients and non-recipients of social benefits.
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5 The Labor Market
5.2.2 Dynamics
The numbers for the Swiss labor market shown in Figure 5.3 change over time.
In times of economic boom, the employment rate tends to be high and unemployment low. The number of job vacancies also varies over the economic cycle:
Companies tend to advertise more jobs when economic growth is high and unemployment is low.
From an economic point of view, the dynamics on the labor market are of great
importance. It provides information on how well the labor market is functioning.
Like any other market, the labor market also fulfills an allocation function: every
vacancy should be filled efficiently by a suitable unemployed person. Economists
use the so-called Beveridge Curve to analyze whether this is working well. This
curve, named after the British economist William Beveridge (1879–1963), empirically represents the relationship between the unemployment rate and job vacancies. Figure 5.4 shows this for Switzerland. The job vacancy rate determines the
proportion of total jobs that are vacant (i.e. not filled). Mathematically, this is calculated by dividing the number of vacancies by the sum of the number of filled
vacancies and the number of vacancies.
Figure 5.4: Beveridge curve in Switzerland, 2003–2023
The Beveridge curve always has a negative slope: in times of high unemployment, there are generally few jobs advertised. However, the curve can shift
downwards to the left or - as recently observed in Switzerland - upwards to
the right. If the curve moves towards the origin (i.e. downwards to the left),
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5 The Labor Market
economists speak of an improvement in the matching process on the labor market. The idea behind this is that all job seekers should be linked to a vacancy (to
match). The matching process improves if, for example, job centers place unemployed people in suitable jobs more quickly or if the job seekers’ qualifications
match the advertised vacancies better.
To put it simple, (involuntary) unemployment occurs because not every unemployed person finds a job straight away. Despite this fact, the labor market is
highly dynamic. Many people change their status on the labor market over the
course of a year. In Figure 5.5 we see the stocks as at 31.12.2021 and the flows
from 1.1.2021 to 31.12.2021, with all figures expressed in thousands. The data
comes from the Federal Statistical Office (je-d-03.02.00.06.02). We can see in the
figure that 85,000 people in Switzerland entered unemployment over the course
of a year, but 127,000 came out of it. This means that unemployment fell in
2021. We also observe that 232,000 people moved to the inactive population in
the course of 2021. This may have been the case due to retirement, for example.
employed
5’145
6
85
22
228
2
12
7
23
unemployed
48
inactive
55
3’800
Figure 5.5: Dynamics on the Swiss labor market in 2021
To analyze the dynamics shown in Figure 5.5, labor market economists use socalled search-and-matching models. In these models, the population relevant to
the labor market (L for labor force) is divided into two groups: Employed (N) and
unemployed (U). The following therefore applies: L = N + U. Furthermore, we
assume that every employed person has a probability p of losing their job in the
course of a year. In addition, every unemployed person has a probability s of
finding a new job in the course of a year. This means that p ∗ N people move
into unemployment in the course of a year and s ∗ U come out of it. This can be
represented graphically as follows
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5 The Labor Market
Move to unemployment = p ∗ N
employed (N)
unemployed (U)
Exit from unemployment = s ∗ U
As in other economic models, we are interested in the equilibrium here. To
find this, we determine the condition under which the number of unemployed is
constant:
entry into unemployment = outflow from unemployment
p∗N = s∗U
We can reformulate this expression by using the definition of the potential labor
force (labor force) L = N + U and replacing N with L − U:
p ∗ (L − U) = s ∗ U
p ∗ ( L/L − U/L) = s ∗ U/L
If we define the unemployment rate as u = U/L, we can determine the equilibrium unemployment rate u∗ in the model:
p ∗ (1 − u ) = s ∗ u
u∗ = p/( p + s)
To better understand this expression, let us look at a numerical example. Assume
that 1.5% of employees lose their jobs in the course of a year (p = 0.015) and
20% of all unemployed find a new job (s = 0.2). In this case, the equilibrium
unemployment rate is seven percent: u∗ = 0.015/(0.2 + 0.015) = 0.07.
What is the benefit of this labor market model? We recognize that unemployment
falls in equilibrium if p falls and/or s rises.2 This explains the logic behind
numerous labor market policy measures. Since the so-called Hartz reforms in
2 Mathematically, the following applies: ∂u∗ /∂p = s/ ( p + s )2 > 0 and ∂u∗ /∂s = − p/ ( p + s )2 < 0.
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5 The Labor Market
the years 2003 to 2005, Germany has been regarded as an example of a country
that was able to permanently reduce its unemployment rate (see Figure 5.2 on
page 139). At the heart of the reforms was the reduction of transfer payments for
the unemployed, which lowered their reservation wage: the minimum wage they
required from an employer in order to accept a job. This measure was aimed
at getting the unemployed to accept a job more quickly. In our model, s would
then increase. In addition, job centers have been set up in Germany, where case
managers place the long-term unemployed more intensively in vacancies. This
would also be equivalent to an increase in s and would reduce the unemployment
rate in equilibrium. To get an idea of how high the two parameters p and s are
in practice, we can refer to average values from Michael Elsby, Bart Hobijn and
Ayşegül Şahin (Review of Economics and Statistics, 2013):
Australia
Germany
France
Japan
Switzerland
USA
United Kingdom
Unemployment rate (u)
Outflow rate (s)
Inflow rate (p)
7.1
8.3
8.1
3.3
4.4
6.1
7.7
22.8
6.0
7.7
18.9
33.0
56.5
13.9
1.7
0.5
0.7
0.6
1.5
3.6
1.0
In the table, the high dynamics in the American labor market are particularly
striking.3 The differences between the countries can be explained by the countryspecific labor market regulations (employment protection laws such as notice
periods or severance payments). For example, the higher the protection against
dismissal in a country, the lower the probability that an employee will lose their
job (p). However, an unemployed person may also be less likely to find a job
(s), as employers are reluctant to hire someone if it is difficult to fire them again.
Search-and-matching models start at this point and try to explain the parameters
of the model (p and s).
We can also gain two further insights from the simple labor market model. Unemployment never falls to zero because there is always a positive probability
that employees will lose their jobs (p > 0). In addition, all unemployed people
never find a suitable job within a year (s < 1). Even if it were possible to find
a new job for every unemployed person within a year (s = 1), there would still
be temporary unemployment. We must therefore turn to the different types of
3 It should be noted in the table that we see the monthly outflow and inflow rates.
The average
duration of unemployment is calculated as 1/s months. The reported unemployment rate u
may differ from the equilibrium unemployment rate u∗ = p/( p + s).
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5 The Labor Market
unemployment in the next step.
5.3 Unemployment
There is no unique answer to the question of why people are unemployed. There
are unemployed people who have only recently lost their job as a result of a company bankruptcy. Others have been looking for a job for many years without
success. In order to better understand the labor market and the problem of unemployment, we therefore need to look at the different types of unemployment.
To do this, it is helpful to first look at some statistics.
5.3.1 Stylized Facts
Figure 5.6 shows the monthly unemployment rate in Switzerland according to
the State Secretariat for Economic Affairs (Seco). Several aspects stand out. The
unemployment rate fluctuates both in the short term from month to month and
in the medium and long term. Why does the Swiss unemployment rate change
every month? Why does it follow repeating patterns in which the rate falls to
a low point roughly every ten years (1981, 1990, 2001, 2008, 2019)? And what
explains the fact that the unemployment rate has apparently remained at a much
higher level than before since the 1990s?
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5 The Labor Market
Figure 5.6: Unemployment rate in Switzerland, 1975-2023
In addition to the time trend, we see the average unemployment rate for each
calendar month in the lower graph of Figure 5.6. We recognize a seasonal pattern
here: unemployment is above average in winter. This is because some sectors,
such as construction, where many people are employed, require less labor during
the cold season.
5.3.2 Types of Unemployment
To better understand the variation in the unemployment rate in Switzerland
shown in Figure 5.6, we need to familiarize ourselves with the different types of
unemployment. In particular, we need to distinguish between so-called base un146
5 The Labor Market
employment and short-term fluctuations in the unemployment rate. Economists
categorize unemployment into four groups: frictional, seasonal, cyclical and
structural.
The term frictional unemployment already indicates its cause: there is friction in
the labor market. Economists use this term to describe resistance and delays in
markets. If an employee loses their job, it may well be that a new suitable position
is immediately available for them. However, job seekers and companies often
have to find each other first. The so-called search costs mean that a match (coming
together) does not occur directly. However, if private or state job placement
services succeed in quickly matching unemployed people with vacancies, this
reduces frictional unemployment.
In the case of seasonal unemployment, the term itself explains the cause of the
problem. A large number of economic sectors have seasonally fluctuating sales.
In the construction sector, some construction sites come to a standstill in winter
and fewer workers are needed. Similarly, the demand for labor in tourism and
agriculture fluctuates throughout the year. In these sectors, it also happens that
employees are made redundant and then re-employed by the same employer for
a few months.4
The cyclical unemployment rate describes the observation that the unemployment rate develops systematically with the economic cycle. In times of economic
boom, companies see a high demand for their goods and services. Consequently,
there is also a high demand for labor and the unemployment rate is relatively
low. Conversely, many companies lay off staff during a recession. Those job
seekers who are unemployed due to the economic situation are categorized as
cyclical unemployment.
Perhaps the most significant form of unemployment is what is known as structural unemployment. This arises in two ways: Firstly, when an economy undergoes structural change — some sectors grow and others shrink — but workers
cannot move from the old to the new sectors. For example, they lack the necessary qualifications or would have to move to another region. For example, in
1900, with a population of just over 3 million people, Switzerland had a total of
over 90,000 employees in the textile industry. As this economic sector gradually
shrank and migrated abroad, there were many workers who had to find work in
a new sector. This structural change in an economy, in which individual sectors
grow and others shrink, leads to structural unemployment. The second cause
is political or economic structures that lead to permanent unemployment. For
example, high unemployment benefits can increase the ’attractiveness’ of unem4 Reto Föllmi, Tanja Zehnder and Josef Zweimüller (Die Volkswirtschaft, 2014) document that in
Switzerland, around 14% of all unemployment episodes that began between June 2009 and
June 2011 end with a return to employment with the previous employer.
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5 The Labor Market
ployment and thus lead to a high unemployment rate in the long term. Often
both causes play together: as an economy is constantly subject to change, it is
important that labor can move into growing sectors as quickly and efficiently as
possible.
In addition to the four forms of unemployment mentioned above, the employment
rate is also of great importance to economists. We can see this in Figure 5.7,
where it is noticeable that Switzerland has a comparatively high employment
rate. As we have already seen in Figure 5.3, there are many people who fall into
the group of inactive people. This can severely limit the informative value of
the labor force participation rate or unemployment rate. If, for example, there is
high unemployment in a region, jobseekers may at some point give up looking
for a job and drop out of the labor force altogether. This aspect is described
as underemployment. This also includes employed persons with involuntarily
short working hours who are available for a higher workload. If we combine
underemployment and unemployment, we obtain the labor shortage. We can
quantify this for Switzerland. Here, 11.6% of the labor force was affected by labor
shortages in 2019. This is made up of the underemployment rate (7.3%) and
the unemployment rate according to the ILO (4.4%). According to the Federal
Statistical Office, the additional volume of work desired by these people totaled
284,000 full-time equivalent jobs. At 16.1%, the labor shortage rate for women
was twice as high as that for men (7.7%).
Figure 5.7: Employment rates in selected countries, 1991–2022
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5 The Labor Market
5.3.3 Causes and Consequences of Unemployment
Now that we know the different types of unemployment, we need to briefly
summarize their respective causes and consequences. The various forms of unemployment must be assessed differently from an economic perspective. Even
if none of the forms can ultimately be completely avoided, the damage caused
is not the same. From an economic (and social) perspective, long-term unemployment and youth unemployment are particularly problematic. Around forty
percent of all unemployed people in Switzerland are considered long-term unemployed. These are people who have been registered as job seekers with a regional
employment center (RAV) for a year or longer. Due to prolonged unemployment,
important qualifications are lost and many of those affected also suffer from private consequences (loss of friends, depression, alcohol consumption). Such consequences of long-term unemployment also make the reintegration process more
difficult, causing people to fall into a vicious circle. In macroeconomic terms, this
can also lead to so-called hysteresis. This generally describes the fact that a system does not return to its original state once a shock has subsided. For example,
if there is a deep recession, many people remain permanently unemployed after
losing their job during the recession. Looking beyond the labor market, such
consequences of a deep recession are also referred to as economic scarring.
Unemployment ultimately means that not all people in an economy who are able
and willing to work contribute to value creation. It is therefore very important to
understand the causes of unemployment. These then also provide direct indications as to which economic policy measures a government can use to reduce the
unemployment rate. In addition, we can then better understand why countries
differ so much in terms of their unemployment rate (see Figure 5.2 on page 139).
Basically, unemployment arises due to deviations from the ’perfect’ labor market.
In such a labor market, employees would offer their work for a wage and firms
would demand this work. However, this simple supply-demand model ignores a
variety of aspects that cause unemployment. Therefore, in a perfect labor market,
the wage always adjusts so that no involuntary unemployment arises in equilibrium. We must therefore explain why the wage is permanently too high and why
there is not always a match between employer and employee.
Firstly, there are the search or information costs mentioned earlier. If someone
loses their job, it takes a while to find a suitable new position. This process takes
particularly long if the job seeker first needs new qualifications or has to move
to another region. If the employer and unemployed person find each other in
principle, an employment contract does not necessarily materialize. For example, high taxes and social security contributions can drive a wedge between the
employer’s costs and the employee’s net salary. Since a company cannot pay
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5 The Labor Market
more than the employee creates in value and the employee has a reservation
wage (a minimum requirement to take on work), this wedge can destroy an employment relationship (or shift it to undeclared work). The same can happen if a
government-mandated minimum wage is higher than the worker’s productivity.
Another cause of unemployment is described by the insider-outsider theory of
Assar Lindbeck and Dennis Snower (American Economic Review, 1986). This theory assumes that trade unions primarily represent the interests of insiders in
wage negotiations, i.e. those workers who have a job. Low wage growth or even
a wage reduction would increase the incentive for companies to hire more people
and thus benefit the outsiders (i.e. the unemployed). However, the trade union in
the model primarily represents the interests of the employees and enforces high
wage growth.
However, the cause of unemployment is not only on the part of the state or the
employees. Excessive market power on the part of companies can also lead to
unemployment, as we will see in detail in the following model. It is also possible
that information asymmetries lead to unemployment. This means that employers
and employees have different information. As a rule, an employer cannot permanently monitor the performance and work commitment of an employee. In order
to achieve a high level of labor input without constant monitoring and control,
the employer can pay a so-called efficiency wage. This is a wage that is above the
standard market level. Henry Ford already introduced the five-dollar day in 1914
— a very high salary at the time — to increase labor efficiency.5 The core idea
here is that employees will work harder if they earn significantly more from their
employer than they could elsewhere.
A good understanding of the causes of unemployment is the basis for economic
policy measures to reduce it. In addition, this also shows that markets function
particularly well when there is sufficient flexibility. The greater the mobility and
flexibility of employees and employers, the lower the unemployment rate ceteris
paribus. If companies offer flexible working hours, home office and the like,
they enable more people to contribute their labor. Flexibility is also important
for employees in this respect. For example, it is advantageous in terms of the
labor market if many people rent a flat or house instead of owning their own
property. As flats and houses are immobile (immovable), their owners tend to be
less mobile.
5 Both the works of Janet L. Yellen (American Economic Review, 1984) and Daniel M. G. Raff and
Lawrence H. Summers (Journal of Labor Economics, 1987) provide further details on this aspect.
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5 The Labor Market
5.4 Labor Market in the Model
On the basis of a solid understanding of the labor market, we can now turn to
our actual goal in Part II of the textbook: the further development of the IS-LM
model for the analysis of the economy in the medium term. The starting point of
our considerations at the beginning of Chapter 5 was that an economy can only
be stimulated to a limited extent by additional demand. The scarcity of production factors (e.g. labor) restricts the maximum possible level of production. We
therefore want to develop a model of the labor market that explains how much
labor is available to us. In other words, we want to understand how high the
unemployment rate in an economy is structurally.
In order not to make the labor market model too complex, we focus on four
approaches to explaining unemployment: the market power of companies, the
insider-outsider theory, minimum wages and unemployment benefits. Since the
search-and-matching model described above is not very suitable as a framework
for this, we follow a slightly different approach. This is also not the simple
supply-demand model, as this abstracts from the aspects discussed above (the
imperfection of the labor market). Instead, we first define labor supply and labor
demand before determining the equilibrium in the labor market.
It is easy to explain why we are again using a modeling framework for this.
For example, let us consider the question of whether a minimum wage leads to
more or less unemployment. This is a very complex question. Purely verbal (and
rhetorically skillful) answers can provide contradictory answers. Some argue that
higher labor costs motivate firms to lay off some workers and replace them with
machines. Others postulate that a higher minimum wage means that employees
earn more and put in more effort as well as having greater purchasing power,
which in turn increases the demand for goods. Since purely verbal answers do
not provide a clear answer, it is important that we clearly state under which assumptions which statements are correct. It is not difficult for a trained economist
to argue that a minimum wage destroys jobs — or that it creates jobs. However,
both happen under completely different assumptions about how the minimum
wage is organized, how employees and companies react to it, and so on. The
model framework is intended to bring order and argumentative discipline to this
complexity, in which it is easy to get lost.
5.4.1 Labor Supply
For our model of the labor market, we first look at the labor supply. From an
economic perspective, employees offer labor and companies demand it. The labor supply is therefore determined by potential employees. Firstly, they decide
whether they want to participate in the labor market at all (this is the extensive
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5 The Labor Market
labor supply) and secondly, how many hours of work they want to offer (intensive labor supply). What factors explain extensive and intensive labor supply?
First and foremost, the achievable wage plays a central role. While there may
also be other motives for providing labor — if the work has an intrinsic value,
the remuneration does not play such a significant role — the employer usually
“rewards” the performance with money: in Switzerland, thank you is written
in CHF. A possible labor income must also be assessed against the opportunity
costs of labor. This refers to the costs incurred by not using the time for other
purposes (opportunities). Every hour spent working is no longer available for
leisure activities, education or childcare, for example. People are therefore faced
with a trade-off between working time (income) and leisure time with regard to
their labor supply.
We simplify this balancing process and state: If the wage offered to the worker is
above his opportunity cost, the labor is offered. Otherwise, someone is voluntarily unemployed. But how does involuntary unemployment, which we observe in
reality, occur in the model? Wages are not as flexible in reality. We start with the
observation that individual wage negotiations between employees and employers
often only take place for higher-skilled jobs. For many jobs, collective bargaining
between trade unions and employers’ organizations takes place instead.6 Wages
are usually set for a period of 1–2 years.
Two factors are of central importance in wage negotiations. Firstly, the expected
price level in the future. If employees (or their union representatives) expect a
high inflation rate in the coming years, they will demand a correspondingly high
nominal wage. Employees will not be satisfied if they receive around 3% higher
wages but the prices of goods rise by more than 3%. In this case, their real wages
would fall. The second important factor in wage negotiations is the bargaining
power of the two sides. As with any other negotiation, the outcome depends on
the extent to which the negotiating parties can enforce their demands. In the case
of wage negotiations, the employee’s reservation wage plays an important role.
The better the alternatives available to employees, the harder they can negotiate
and the higher the enforceable wage will be. It is therefore an advantage in an
employee’s wage negotiations if they can earn more with another employer or if
unemployment benefits are very generous.
We summarize the discussion with an equation:
W = Pe F (u, z)
(5.3)
(−,+)
6 Collective bargaining can take place at company, industry or national level. In general, this form
of wage setting is much more important in European countries than in Anglo-Saxon countries.
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5 The Labor Market
This mathematical equation states that the nominal wage W depends on three
influencing variables. Firstly, W rises at the expected price level Pe , as employees
demand a higher wage if they expect high inflation rates. Secondly, the higher
the unemployment rate u, the lower the nominal wage W. This follows from the
consideration that the bargaining power of trade unions is lower when unemployment is higher. Put simply, employees have difficulty finding an alternative
job and are therefore satisfied with a lower wage. Thirdly, equation (5.3) states
that the nominal wage depends on other factors, which we summarize as z. These
include, for example, unemployment insurance or a minimum wage. We summarize these aspects in such a way that a higher z leads to a higher wage. The
more generous the unemployment benefits, for example, the harder employees
will negotiate and the higher their wages will be.
5.4.2 Labor Demand
The demand on the labor market is determined by companies that need workers
for production. Let us assume that companies have the following production
function:
Y = A∗N
(5.4)
How much output Y a company can produce is determined by the productivity (A) and the number of employees (N). For the sake of simplicity, we have
assumed a constant marginal product here: each additional worker increases
output by the same amount. As we will see shortly, this also means that the
labor demand curve is horizontal.
We also assume that there is no perfect competition on the goods market. Firms
are therefore not price takers. This means that they choose a selling price themselves and do not accept a market price determined by other suppliers. This
self-selected price does not correspond to the marginal costs of production (as
is the case in perfect competition), but is higher. The companies can therefore
impose a price for their production that allows them to make a profit. Specifically, we assume that firms charge a mark-up on the marginal costs. For example,
each additional unit of output incurs 100 francs in costs and is sold at a price of
more than 100 francs. The price is therefore above the so-called marginal costs.
Formally we write:
P = (1 + µ)W/A
153
where µ > 0
(5.5)
5 The Labor Market
With the production function described above, the marginal costs are W/A and
the companies choose a mark-up of (1 + µ). The stronger the competition on the
goods market, the lower the mark-up will be. In perfect competition, µ = 0 and
the price would correspond to the marginal costs. The derivation of the mark-up
is described in more detail in the box below. As a result, the market power of
the companies means that companies deliberately produce less than in perfect
competition (in order to keep prices and profits high) and therefore also have a
lower demand for labor.
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5 The Labor Market
Theory box 5.2: Price setting in the case of monopoly
Microeconomics deals extensively with the question of how firms set prices. In perfect
competition (i.e. many small suppliers), no firm has any influence on the market as a
whole and must take the market price as given. A small oil producer, for example, can
only sell at the current world market price. The situation is different for companies that
have a certain amount of market power. They can charge a price above marginal costs.
We have also assumed this in our model. The marginal costs result from the ratio of
wages (W) to productivity (A), i.e. how much each additional unit of output ultimately
costs. Graphically, this results in the following picture
P
marginal revenue = marginal cost (W/A)
P = (1 + µ ) W
A
•
W
A
•
•
goods demand
Y
Y∗
YM
Without market power
We assume that the companies maximize their profit (G = P(Y ) ∗ Y − W/A ∗ Y). In perfect
competition, P would not depend on Y (own production), so that price = marginal cost.
Here, however, we obtain the optimum:
∂G (Y )
=0
∂Y
←→
∂P(Y )
P (Y ) +
∗Y =
∂Y
|
{z
}
=marginal revenue
⇐⇒
W
A
|{z}
⇐⇒
P (Y ) + P (Y ) ∗
Y
∂P(Y )
∗
∂Y
P (Y )
=
W
A
=
W
A
marginal cost
P (Y )
1 + ηYP
W
=
A
⇐⇒
1
P (Y ) 1 + Y
ϵP
!
∂P(Y )
Y
∂Y ∗ P(Y ) ) and the price elas
∂Y ( P)
1
ticity of demand (ϵYP = η1P = ∂P ∗ Y (PP) ) is used. For W
>
0,
P
(
Y
)
1
+
> 0 ⇐⇒
Y
A
ϵP
Y
Y
ϵP < −1, This means that the monopolist always bids in the elastic range of the demand
In the last row, we have the inverse price elasticity (ηYP =
function. We use µ to denote the price premium, which measures
the percentage difference
1
between marginal costs ( W
A ) and the market price (P): P (Y ) 1 + ϵY
(1 + µ ) W
A
P
with µ = − 1+1ϵY
P
155
= W
A
⇐⇒
P=
5 The Labor Market
5.4.3 Equilibrium on the Labor Market
If we bring together both labor supply and labor demand, we can determine the
equilibrium on the labor market. However, in order to equate both sides, we need
to make a few assumptions and adjustments. Firstly, we assume that the actual
price level P corresponds to the expected price level Pe , so that W = P ∗ F (u, z)
applies to the labor side. For employees, however, it is ultimately not the nominal
wage but the real wage W/P that is decisive. We therefore divide both sides by
P and obtain the wage-setting equation:
W/P = F (u, z)
(5.6)
The real wage demanded by employees depends on the function F (u, z), i.e. on
the unemployment rate u and the factors summarized by the variable z. The
price level P is determined by the price setting of companies:
P = (1 + µ)W/A
(5.7)
We can rewrite this equation and obtain the price-setting equation:
W/P = A/(1 + µ)
(5.8)
We have now written down both the labor supply and the labor demand with
W/P on the left-hand side. To determine the equilibrium, we now equate the
equations (5.6) and (5.8). Equilibrium on the labor market therefore applies:
F (u, z) = A/(1 + µ)
(5.9)
Since F (u, z) falls within u and A/(1 + µ) is independent of u, this results in an
equilibrium. From now on, we denote the wage setting equation by WS (for wage
setting) and the price setting equation by PS (for price setting). Graphically, we
can represent the labor market as in Figure 5.8. Note that the WS curve is drawn
for a given z.
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5 The Labor Market
W
P
A
(1+ µ )
•
A
PS (price-setting equation)
WS (wage-setting equation)
u
un
Figure 5.8: Equilibrium in the labor market model
5.4.4 Natural Unemployment Rate and Production
We can see in Figure 5.8 that in the equilibrium of the model created in this way
there is unemployment of un . We used the subscript n here, as this is the socalled natural rate of unemployment. The term is slightly misleading. Basically,
it is structural unemployment, which results from the assumed structure of the
model economy. On the labor demand side, we have assumed that companies
have market power and therefore produce ’too little’. At the same time, on the labor supply side, we assume that wage demands by trade unions fall in u, but only
to a limited extent. Wage negotiators are more cautious with their wage demands
when unemployment is high. However, they weigh up the insider-outsider problem and as a result the WS curve does not have an extremely negative slope.
Figure 5.8 quickly shows that both sides of the labor market contribute to equilibrium unemployment: the lower the market power of companies and the price
premium they charge µ, the lower the unemployment rate. And the more the
employees’ wage demands fall in u, the lower the un . In addition, a higher z
shifts the WS curve upwards, as for a given u the function F (u, z) and thus W/P
increases (see wage-setting equation).
The equilibrium unemployment rate un is therefore not ’natural’ in the sense
that it cannot be prevented or reduced. The causes of the unemployment rate
in equilibrium are clearly identifiable and neither the level of unemployment
benefits, the market power of firms, nor the insider-outsider thinking of wage
negotiators are invariant. For this reason, it is more appropriate to refer to the
natural rate of unemployment as the structural unemployment rate. This is also
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5 The Labor Market
because the model only represents the structural types of unemployment. As we
are analyzing the economy in the medium term, we have little interest in seasonal
or cyclical unemployment. Rather, we are interested in how many workers are
available to the economy for production in the medium term. The natural level
of employment follows from the natural rate of unemployment:
Nn = LF ∗ (1 − un )
(5.10)
where LF describes the potential labor force. Associated with the natural employment level is a natural production level
Yn = A ∗ Nn = A ∗ LF ∗ (1 − un )
(5.11)
GDP
which we can also call the production potential of the economy in the medium
term. We already know this Yn . It is the Yn,t at a given time t on the trend line
in Figure 5.9. The economy can move downwards or upwards from this level
in the short term, but returns to Yn in the medium term. A country that has a
structurally high unemployment rate — for example due to high unemployment
benefits — has a structurally lower natural production level.
Yt
Yn,t
g
in
sw
dow
up
boom
nsw
n
recessio
up
sw
in
g
ing
e
n
trendli
n
recessio
time t
Figure 5.9: Development of GDP shown schematically
5.4.5 Comparative Statics
Now that we have a model of the labor market, we can use it to examine several
developments and policy measures. Below we analyze three such developments.
First, we look at the impact of an increase in unemployment benefits on the level
of the natural rate of unemployment. In the model, this increase is equivalent to
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5 The Labor Market
an increase in z, which in turn increases F (u, z). For any given unemployment
rate u, F (u, z) increases when z is raised. As a result, employees’ real wage
demands increase and the WS curve shifts upwards or to the right. As shown
in Figure 5.10, the equilibrium unemployment rate increases from un to u′n as a
result of the change in unemployment benefits. Intuitively, this increase can be
explained by the fact that employees now have a better outside option.
W
P
A
(1+ µ )
A
•
A’
•
PS
WS′
WS
un
u′n
u
Figure 5.10: Increase in unemployment benefits
As a second example of comparative statics in the labor market model, we consider the effects of a higher entrepreneurial mark-up µ on the natural rate of
unemployment. If there is a reduction in competition in the goods market — for
example because two firms merge — the market power of the firms increases.
Optimally, they will then demand a higher price and sell less. The reduction in
production therefore also reduces the demand for labor. In Figure 5.11 we see
how the PS curve shifts downwards when the price premium increases from µ
to µ′ . As a result, not only does the equilibrium unemployment rate rise, but
the higher mark-up also increases the price level P and therefore lowers the real
wage. These consequences illustrate why economists are generally in favor of
strong competition on the goods market.
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5 The Labor Market
W
P
A
(1+ µ )
•
A
A
(1+ µ ′ )
PS(µ)
•
A’
PS(µ′ > µ)
WS
un
u′n
u
Figure 5.11: increase in price mark-up
Our model of the labor market predicts that countries with weaker competition
on the goods market (and consequently a higher mark-up) will have a higher
unemployment rate and thus a lower level of employment in the medium term.
We can verify this statement using data from the OECD for 2018. There is an
index value for the regulation of the goods market for each member state. The
higher this is, the weaker the competition tends to be. As Figure 5.12 illustrates,
the employment rate is actually lower in countries with a highly regulated goods
market. Switzerland has the second-highest employment rate despite relatively
high regulation.
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5 The Labor Market
Figure 5.12: Goods market regulation and employment rates
In the third example of the application of the labor market model, we consider
the case where the state sets a minimum wage Wmin . For this to have an effect,
it must be at a sufficiently high level. How does such a minimum wage affect
the unemployment rate? A comprehensive literature has not provided a clear
answer to this question.7 We can analyze the effects within the framework of our
model. First, a higher minimum wage leads to an increase in z and thus F (u, z).
This shifts the WS curve upwards. Intuitively speaking, the higher minimum
wage increases the bargaining power of employees. The PS curve, on the other
hand, remains unchanged: the demand for labor is given by the equation P =
(1 + µ)W/A.
The companies increase the price P in proportion to the increase in the nominal
wage. As a result, the real wage W/P remains unchanged, but the equilibrium
unemployment rate has risen. A verbal explanation for this result is that the trade
union demands higher wages due to the higher minimum wage. Economists
speak of a ’concertina effect’: if the lowest wages are raised, the higher-paid
workers also want a pay rise. The trade union represents their interests and
accepts higher unemployment. The companies, in turn, pass on the higher wages
in the medium term in the form of higher prices, but sell and produce less. In the
medium term, the minimum wage therefore leads to higher prices and a higher
7 The much-cited study by David Card and Alan Krueger (American Economic Review, 1992) did not
document any negative effect on employment. However, there are a large number of follow-up
studies that discuss this result (see, for example, David Neumark and William Wascher, 2007).
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unemployment rate.
Practice box 5.1: Empirical evidence for the labor market model
As with any economic model, we should also ask the question of whether the model statements stand up to empirical analysis with regard to our labor market model. In other
words, can the developments predicted by the model be observed in reality? In the context
of comparative statics, we have analyzed a number of policy measures. For example, we
saw that an increase in unemployment benefits leads to an increase in the medium-term
unemployment rate. Conversely, a reduction in unemployment benefits would reduce
unemployment in our model. We can compare this result with observations in reality. Germany adopted a series of labor market reforms in the early 2000s. Part of the so-called
Hartz reforms was a change in unemployment benefits. From 2005, unemployment benefit (ALG) was reduced to a low level (ALG II, also known colloquially as Hartz IV) after
12 months of unemployment. As can be seen in Figure 5.2, the unemployment rate in
Germany fell permanently to a lower level in the following years. As it was not only unemployment benefits that changed in Germany after 2005, empirical studies must attempt
to empirically isolate the effect of the Hartz reforms. A study by Brendan M. Price (2019),
for example, found that the reform led to a reduction in the structural unemployment rate
in Germany of 0.9 percentage points.
5.4.6 Political Inuence Options in the Model
The natural or structural unemployment rate of an economy is of great importance because it determines the natural or structural production level. In the
medium term, the GDP of an economy will always return to structural GDP, as
we have seen in Figure 5.9. The question therefore arises as to how the state
can reduce unemployment in the medium term and thus increase potential output Yn . This is a very complex question. However, we can use the model as a
guide and identify several possibilities.
Firstly, in order to reduce the natural rate of unemployment, the state can try to
increase the productivity of workers. In the model, this would be equivalent to an
increase in A. Better training, higher capitalization (better machines), innovations
or better management can be approaches to this. We will take a closer look
at productivity in chapters 10 and 11, as it is the central source of long-term
economic growth.
A second way to reduce the natural rate of unemployment is to intensify competition policy on the goods market. In the model, this policy, known as antitrust,
leads to a reduction in the parameter µ.
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Thirdly, the state can also cut benefits as part of a reform of unemployment
insurance and thus reduce z in the model. This also leads to a lower natural rate
of unemployment. Applied to reality, we can state that the large variation in wage
replacement rates (amount of unemployment benefit in % of the previous wage)
across countries offers an explanation for the different structural unemployment
rates in these countries.
Theory box 5.3: Influence of competition on production and prices
Martin Kolmar and Magnus Hoffmann’s “Workbook for Principles of Microeconomics”
illustrates very clearly how the number of competing firms affects total output and prices.
If we follow the task 12.2.1.2 described therein, we have a number n of identical companies
that are in Cournot competition. The inverse demand for goods is given by P(y) = 100 − y
and the constant marginal cost is MC (y) = 10.
Each firm i maximizes its profit (= sales minus costs), taking the total production of all
other firms (Y−i ) as given:
πi (yi , Y−i ) = P(yi , Y−i ) ∗ yi − C (yi ) = (100 − yi − Y−i ) ∗ yi − 10yi
(5.12)
If we form the first derivative, we get
∂πi (yi , Y−i )
= 0 ⇐⇒ 100 − 2yi − Y−i − 10 = 0 ⇐⇒ 90 − 2yi − Y−i = 0
∂yi
(5.13)
which says nothing other than that the marginal revenue (100 − 2yi − Y−i ) corresponds to
the marginal costs (10). Since all n firms are identical and optimize in the same way, we
can replace Y−i with (n − 1) ∗ y∗ , where y∗ describes the optimal production of a single
firm. This gives us
90 − 2y∗ − (n − 1) ∗ y∗ = 0 ←→ y∗ = 90/(n + 1)
(5.14)
The total production in the market (in Cournot-Nash (CN) equilibrium) is therefore yCN =
n ∗ y∗ = 90n/(n + 1) and the price is pCN = 100 − 90n/(n + 1). It follows that y∗ decreases
in n, yCN increases in n and pCN decreases in n. The more companies compete, the less each
individual company will produce (and make a profit), but the higher the total production
and the lower the price. Stronger competition in the goods market therefore reduces the
price premium and increases the demand for labor, as more is produced.
Our labor market model provides a good basis for analyzing various labor market policy measures. However, we must also be aware of the limitations of the
model. For example, a reduction in unemployment benefits clearly leads to lower
structural unemployment in the model. However, there are also good arguments
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in favor of such support: it serves to bridge the short-term loss of income during
unemployment and it can increase job-match quality. As the unemployed do not
have to take up the first job offer that comes along, they will tend to opt for more
suitable jobs. However, the support benefit also increases the reservation wage
and can lead to lower search efforts.
Our model of the labor market also ignores other ways of reducing structural unemployment. For example, lowering income tax and social security contributions
can reduce the aforementioned wedge between net wages and costs for employers. Improved job placement — whether by private or state organizations — can
also lead to lower unemployment. In addition, there is the instrument of active
labor market policy: the state can directly create jobs in the public sector or —
and this would be illustrated in our model by an increase in A — increase the
productivity of job seekers through training measures.
5.5 Summary
If we look at an economy in the medium term, we have to deal with resource
constraints. A central aspect of this is the question of how much labor is available for production in the medium term. We have therefore analyzed the labor
market in this chapter and determined the structural unemployment rate. This
also results in the structural production level of the economy.
Our labor market model enables us to examine many economic policy measures
and understand the logic behind them. However, this model is not without simplifying assumptions. For example, we have assumed that every job on offer is
the same. More comprehensive models of the labor market differentiate workers
according to their qualifications, so that the aspect of wage inequality can also
be analyzed. However, we can also use our model to explain why higher-skilled
workers are less likely to be unemployed. To do this, we must remember that
unemployment exists in our model because wages are not agreed individually.
If we assume that highly educated people are less likely to work in jobs where
collective wage bargaining plays a role, this would explain lower unemployment
among this group.
A key simplification in this chapter was that the actual price level always corresponds to the expected price level. In determining the equilibrium on the labor
market, we have equated P and Pe (see equations 5.3 and 5.6). In the short term,
however, the price level may deviate from the price level expected at the time
of wage setting. The unemployment rate then deviates from the natural unemployment rate and production differs from the natural production potential.
However, since expectations are unlikely to be systematically wrong in the long
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term, output will correspond to potential output in the medium term. However, if production is temporarily above medium-term potential, wages (and thus
goods prices) rise. We analyze this aspect in more detail in the next chapter,
which looks at inflation and the Phillips curve.
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Alongside gross domestic product and the unemployment rate, inflation is the
third important indicator of an economy. There are many interactions between
these indicators. We have already seen in Okun’s law that there is an empirical
correlation between the growth rate of GDP and the change in the unemployment
rate. We also saw in the previous chapter that the structural unemployment
rate of an economy has an impact on its medium-term production potential.
In addition, the IS-LM model shows us that expansionary fiscal and monetary
policy lead to an increase in GDP in the short term, but that there are limits to
this effect: If only a limited number of production factors (such as labor) are
available and these are fully utilized, higher demand leads to rising prices.
Once we consider the resource constraint, we also need to look more closely at
goods prices and inflation. As described in Chapter 5, an economy has only
limited factors of production and therefore a limited supply of goods. If demand
is increased through expansionary fiscal and monetary policy in an environment
where the factors of production are fully utilized, an expansion of production —
i.e. an increase in the supply of goods — is no longer possible. Abundant money
then competes for a scarce supply of goods and, as a result, the prices of goods
rise. This leads to inflation. This is described with the expression “too much
money is chasing too few goods and services”.
In order to better understand the aspect of inflation, we will first summarize some
facts in this chapter. We will then look in detail at how inflation is measured and
what its economic costs and benefits are. This is followed by two explanations
for the occurrence of inflation: the quantity theory and the Phillips curve.
6.1 Ination Rates in Practice
We use the inflation rate to describe the percentage change in prices over time.
The situation of falling prices is described with the term deflation. If we look at
the inflation rate for a number of important economies over the past decades, we
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obtain the figures shown in Figure 6.1. The two decades of the 1970s and 1980s
were characterized by a significantly higher inflation rate. In the United States,
for example, this was 13.5 per cent in 1980. Since the mid-1980s, however, we
have seen significantly lower inflation rates again. For some time, we then saw
years of falling rates of inflation — even deflation, primarily in Japan, but also in
Switzerland.
These observations give rise to a number of questions. Why did such high inflation rates occur at the beginning of the 1970s? How was it possible to bring
this inflation back below 5%? Why are there differences between countries, with
Switzerland generally having one of the lowest inflation rates in international
comparison? 1
Figure 6.1: Inflation rates in selected countries since 1970
A look at Figure 6.1 led some to ask whether (until 2021) inflation is still a problem at all. After all, we had observed that annual inflation rates in the economies
shown did not exceed 5% for decades. A short answer to this question is that
the inflation rates shown in Figure 6.1 are based on a basket of various goods
and services. We therefore see the average change in the prices of many goods
and services. Despite the low average value, there are certainly examples of high
price increases. The inflation rate is significantly higher in the healthcare sector
in particular, but also for tuition fees (primarily in the English-speaking world).
1 According to the Credit Suisse Global Investment Returns Yearbook 2020, the average annual infla-
tion rate in Switzerland since 1900 has been just 2.1%, making it the lowest in the world.
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For Switzerland, we can see in Figure 6.2 how the various prices have developed
since 1982. Firstly, the monthly data shows that prices have hardly increased
overall since 2007 (line ’Total’). Secondly, there is a large difference in price
trends between goods and services (+27.5% versus +103.6%). This observation
is also known as Baumol’s cost disease after the American economist William
J. Baumol (1922–2017). The core idea is that productivity gains in the service
sector are lower than in industry. While machines and robots, for example, have
enormously reduced the manufacturing costs of many goods, such automation
and productivity increases are not possible in services (care, hotels, teaching).
Productivity increases in industrial goods lead to a general increase in wages,
from which employees in the service sector also benefit. This is because otherwise
the supply of services would fall due to a shortage of labor. In addition, there is
an increasing willingness to pay for services due to higher wages.
Figure 6.2: Selected price indices for Switzerland since 1982
Services make up a steadily growing part of the economy (see Figure 1.5 on
page 40). Price trends in this area are therefore of great importance. In addition, various developments give reason to believe that we could again see higher
inflation rates in the future. On the one hand, the money supply has recently increased significantly in important economic areas and, on the other, demographic
trends could also increase the inflation rate. Charles Goodhart and Manoj Pradhan, among others, argue the latter in their book “The Great Demographic Reversal” published in 2020. As the working-age population in major economies
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such as China is no longer rising but shrinking, new inflationary pressure could
arise: “Put simply, improvements in the dependency ratio are deflationary, since
workers produce more than they consume (otherwise it would not be profitable
to employ them in the first place), while dependents consume but do not produce. The sharp worsening in the dependency ratios around the world means
that dependents who consume but do not produce will outweigh the deflationary
workers. The inevitable result will be inflation.”
6.2 Measurement of Ination
The term inflation comes from the Latin word inflatio meaning ’to inflate’ or ’to
swell’. Since inflation rates are usually greater than zero, we use inflation to
describe the increase in prices from one point in time to the next. For example,
the inflation rate for the year 2020 is calculated by comparing the price level in
2020 (P2020 ) with that of the previous year:
π2020 ≡ [ P2020 − P2019 ]/P2019
(6.1)
The question is, of course, how exactly we determine the price level P. This can
be done by compiling a basket of goods and services. This should be as representative as possible of what people spend their money on. There are several
aspects to consider here: The shopping basket changes over time. In the past,
people spent a much larger proportion of their income on food than they do
today. The German statistician Ernst Engel (1821-1896) recognized that the proportion of income spent on food decreases over time (as people get richer). The
Engel’s Law, which describes this observation, is named after him. The composition of the shopping basket also differs between poorer and richer people. If
a Swiss person with a low income (perhaps CHF 60’000 gross per year) lives in
a flat for CHF 1’500 per month, he spends 30% of his gross income on housing.
In contrast, a very high-earning person with a gross salary of CHF 300’000 will
not spend 30% on housing, even with a much more expensive rental flat. Even
with the same income, people’s consumer spending differs because they have
different preferences.2 For Switzerland, the Federal Statistical Office calculates
2 In addition, certain prices are perceived much more strongly than others. Many people see the
price of petrol every day and interpret an increase as a sign of high inflation. The fact that other
expenses remain stable (such as rent) or even fall (food) is given less weight, as their prices have
a lower salience (conspicuousness). As a result, not everyone may ’experience the same rate of
inflation’. After the introduction of the euro, many restaurants took the opportunity to increase
prices moderately, as they had to print new menus anyway. Due to the visibly rising prices,
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the inflation rate based on a basket of goods. This is referred to as the Consumer
Price Index (CPI). At around 25%, expenditure on housing and energy accounts
for the largest share of the basket of goods compiled. Figure 6.3 shows the other
components and their weight in the calculation.
Figure 6.3: Weights in Switzerland’s LIK shopping basket, 2022
There is a significant difference between the Swiss CPI and its Euro area counterpart, the Harmonized Index of Consumer Prices (HICP). While rental costs,
for example, only account for around 7% of the basket of goods in the HICP, the
Swiss Federal Statistical Office gives significantly more weight to housing. This
is also due to the fact that, since a revision in 2016, the costs of owner-occupied
housing have also been taken into account in addition to rental costs. The concept of rental equivalence is applied here. It is assumed that the flat costs the
owner the amount of rent that he or she forgoes through owner-occupation. This
pragmatic approach is also used in the United States, for example.
But even within the Euro area, the weights in the basket are by no means the
same in every member state. If we look at the "food and non-alcoholic beverages"
category, for example, the weighting in 2022 varied from 12.7% in Germany to
16.6% in France and 25.9% in Latvia. These differences can be explained by the
fact that the basket of goods is designed to be representative of consumption
in each country. In a rich country like Germany, consumers spend a smaller
the term ’euro’ was coined in Germany at the time (despite generally low inflation) for the
currency that came into circulation in 2002.
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proportion of their income on food and drink than in poorer Latvia. The different
weights make sense from this perspective, but make international comparisons
of inflation rates more difficult.
In addition to the Consumer Price Index, there is a second measure of inflation.
The so-called GDP deflator is calculated as the quotient of nominal and real gross
domestic product:
GDP deflator =
nominal GDP
real GDP
(6.2)
The logic behind the GDP deflator is that nominal and real GDP are identical for
the base year (from which the prices are used). Let us assume 2015 as the base
year and take Switzerland’s nominal GDP from that year (CHF 676 billion). In
the following year, nominal GDP totaled around CHF 685 billion. The increase of
CHF 9 billion may be due to higher prices and/or increased production. As real
GDP excludes price changes, we can use the ratio of real to nominal GDP — i.e.
the GDP deflator — as a measure of inflation. For example, if nominal GDP rises
from 100 to 110 and real growth is 5%, the GDP deflator is: 110/(100 ∗ 1.05) =
4.76 per cent.
The consumer price index and the GDP deflator are not identical for a given year
and country, as the consumer price index only takes into account consumption
by private households. The GDP deflator, on the other hand, also includes industrial and government consumption. It is ultimately based on all domestically
produced goods and services and therefore weights them differently.3 Imported
products and services are only taken into account in the consumer price index.
As Switzerland does not produce any cars itself, a change in the price of BMWs
or Toyotas affects the consumer price index, but not the GDP deflator.
The measurement of inflation is complicated by a number of aspects. Firstly, the
proportions shown in Figure 6.3 are disputed, as people spend their money differently. Poorer people, for example, spend a larger proportion of their income
on food (this is described by the aforementioned Engel’s law). The weighting
therefore varies across individuals. Different inflation rates can therefore be calculated using different weightings in the basket of goods. Sometimes we also
speak of “perceived inflation”, in which the price changes of those goods that are
frequently purchased and where the price is particularly visible (such as petrol
prices) are given a larger weight. The weights also vary over time. During the
3 The GDP deflator is a Paasche price index, as the prices of the different periods are each weighted
with the quantities of the current period. In contrast, the consumer price index is a Laspeyres
price index: the prices are weighted with the quantities of the base period. To minimize distortions due to the substitution effect, the basket of goods is updated every few years.
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coronavirus crisis in 2020, for example, people spent an unusually high amount
on food deliveries and relatively little on transport.4 In some cases, the weights
in the basket of goods are also changed from year to year. This is justified by the
fact that people can often substitute goods (i.e., exchange them for each other).
For example, if beer becomes more expensive and wine becomes cheaper, some
people will switch from beer to wine. When calculating the inflation rate, wine
is therefore given a higher weight and beer a lower weight in order to avoid the
so-called substitution bias (the distortion caused by changes in consumer behavior). In addition, some goods such as heating oil and petrol are subject to very
strong price fluctuations. For this reason, the so-called core inflation is often
shown in addition to the inflation rate. This ignores the price changes of goods
from the food and energy sector. As the prices of such goods are mostly determined on the world market, an increase is not an indication of inflation that has
its cause within the economy under consideration. For example, many Western
countries in the 1970s and 1980s ’imported’ inflation to a certain extent due to
the oil price shocks. Based on these considerations, different core inflation rates
are often determined — with different goods left out. There is therefore not just
’one’ inflation rate for an economy, but several. The results differ depending on
the measurement method. Among other things, this is problematic for a central
bank that wants to control inflation, i.e. is aiming for a fixed target inflation rate
(around 2%).
A second problem for the calculation of inflation arises from quality improvements and entirely new products. Nowadays, most people have a television and
a smartphone. How their prices change over time is therefore significant for the
inflation rate. However, decades ago, these products did not exist at all or only in
significantly poorer quality. If a statistical authority constantly adjusts the basket
of goods when measuring inflation, a comparison over time is only meaningful
to a limited extent. In the case of services, quality is also difficult to measure. For
example, if a hotel does not want to increase prices, the cleaning of the rooms may
be less thorough. Customers then pay the same price for a poorer service, but no
inflation is recorded in the statistics. Some economists have recently shown that
the distortions in the measured inflation rate due to quality changes and new
products can be very significant (Philippe Aghion et al., American Economic Review, 2019). As the inflation rate was systematically overestimated, the reported
real GDP growth in the USA was too low by around 0.5 percentage points per
year.
The third criticism leveled at the inflation rate is that assets are not taken into
4 Alberto Cavallo calculated on the basis of these considerations that the inflation rate in many
countries in 2020 was significantly higher than the official values.
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account. As we will see later in the chapter, consumer prices in Switzerland have
hardly risen in recent years. However, assets such as property and shares have
become much more expensive. As these are not included in the calculation of the
inflation rate, the reported inflation is low, even though many people can hardly
afford a flat or even a house.
Due to the difficulty of accurately measuring a country’s inflation rate, it is better
to speak of estimating rather than measuring inflation. The calculation itself is
precise, but several conceptual challenges limit the interpretation. As with gross
domestic product or the unemployment rate, the methodological approach to the
calculation must be taken into account.
6.3 Costs and Benets of Ination
There is a simple reason why economists consider the inflation rate to be the
third important economic variable alongside GDP and unemployment: inflation
is associated with substantial costs and benefits. We look at these below, starting
with the negative effects. The higher the rate of inflation, the faster the purchasing power of a currency decreases. As a result, it increasingly fails to fulfill one of
the central functions of money: the preservation of value. If the inflation rate is
particularly high, the other two functions — means of payment and measurement
of value — are also barely fulfilled.
Inflation is therefore generally regarded as harmful to the economy. More precisely, price stability — i.e. neither inflation nor deflation — is desirable from an
economic point of view. This is also because the price level of an economy is inherently unstable. To understand this, we can look at the deviations downwards
(deflation) and upwards (inflation). If prices fall for a while, many consumers
expect the trend to continue and hold back on purchases. Economists speak of
them hoarding money and thus depriving the economy of part of its demand.
This increases deflation. Conversely, if the price level rises, many consumers and
companies try to bring forward their purchases as far as possible, as they expect
that they may otherwise have to pay even higher prices. However, the resulting
increase in demand increases the inflation rate.
Inflation is therefore harmful. But how exactly does the damage occur? Let us
first look at moderate inflation rates. Even these are already a problem. Many
people are regularly faced with the challenge of wanting to bring value into the
future. Specifically, they have more today than they want to consume. If there is a
stable currency, they can hold on to it and thus overcome the challenge. However,
this rarely works in practice, as one example shows. The former German mark
and the euro are considered to be relatively stable in value. In Germany, the
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average annual inflation rate between 1995 and 2020 was just 1.38 %. However, as
Figure 6.4 shows, this has increased the price level by around 40%. So if someone
had 100 DM in 1995, this would have lost almost 30% of its value in the period
under consideration. If the money had been held in a savings account with a
three-month notice period for the entire period, the interest would not have been
sufficient to maintain purchasing power. The real interest rate was therefore
negative. In order to preserve value and achieve a real return on savings, people
therefore often have to rely on other financial investments (property, shares).
However, such investments fluctuate greatly in value and are risky, so they are
not a problem-free substitute for a stable currency.
Figure 6.4: Savings and price level in Germany 1995-2022
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The harmful consequences of inflation are therefore particularly evident when
inflation rates are very high.5 A high level of inflation is associated with greater
variation in the inflation rate (see Figure 6.1). This variation creates considerable
uncertainty regarding the future inflation rate. Let us look at the years 1981 to
1984 in Switzerland. The inflation rates were 6.5, 5.7, 2.9 and again 2.9 per cent.
Anyone who had to set a wage increase at the beginning of 1983 was faced with
a problem: If inflation remains at the recent very high level of 5.7 or 6.5%, then
the nominal wage should rise at least to such an extent that the real wage does
not fall. However, if the nominal wage is increased by 6.5% and the inflation
rate falls to 2.9% (as actually happened), the real wage increases by over 3 per
cent. Uncertainty about the future inflation rate therefore makes it difficult to
determine nominal values such as wages or interest rates. The amounts paid
out in pensions or unemployment benefits and also the income tax rates (from
which income which tax rate is applied) are expressed in nominal values. Without adjustment to the changed prices, inflation leads to undesirable distortions
here too. However, as the inflation rate is only known ex post (retrospectively),
distortions can hardly be avoided if there is a high degree of uncertainty about
future inflation.
If a country’s inflation rate rises to an extremely high level, this is referred to
as hyper inflation. There is no exact definition for this, but many economists
use a monthly inflation rate of 50% as a benchmark. Such high price increases
are particularly possible since people have been using fiat money, i.e. money
that is not backed by gold or other scarce goods. Such money can be produced
quickly in large quantities, which causes the value of money to fall accordingly:
the existing supply of goods is matched by a rapidly increasing money supply.
Famous examples of hyperinflation include the German Reich in the years 19191923, Zimbabwe from 2006-2009 and Venezuela since 2016. In all three examples,
the money lost so much value that it ultimately had to be replaced by a new currency. In 2013, economists Steve Hanke and Nicholas Krus presented an overview
of historical hyperinflations. In such phases, the price level doubled within a few
days. Money loses its essential functions: it no longer serves as a store of value
and is only suitable for measuring value or as a medium of exchange to a limited
extent. We can see how important it is for money to fulfill these functions in the
economic consequences of hyperinflation. Without a functioning currency, economic transactions become more difficult and major economic upheavals occur.
One of the disadvantages of inflation is that prices no longer fulfill their central
function in an economy: To indicate scarcity. To use Adam Smith’s image of the
5 Numerous studies have analyzed the effects of inflation rates on economic development.
For
example, the work of Robert J. Barro (Annals of Economics and Finance, 2013) shows the harmful
effects of high inflation.
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"invisible hand", prices ultimately determine the allocation of scarce resources.6
Without distorting interventions, prices (ideally) reflect the preferences of consumers and the costs for producers.7 Competition is the key to the operation of a
price-coordinated economy (Sowell, Basic Economics, p.31). In an economy with
a very high inflation rate, prices only fulfill this allocation function to a very limited extent. Instead, there is malinvestment and also strong redistribution. The
latter go in favor of debtors, as their liabilities are ’inflated away’. We can illustrate this with an example. Let us assume that someone has borrowed a million
francs to buy a house. If the value of the property doubles within a few years
due to unexpectedly high inflation, he can sell the house, repay the loan and (depending on the interest paid) has made a considerable real profit. However, this
is offset by an equally large loss on the part of the creditor. It is therefore worth
holding tangible assets instead of money in times of high inflation. However, this
’flight into real assets’ (or stable foreign currencies such as the US dollar or the
Swiss franc) is economically inefficient. Individuals make rational decisions, but
in economic terms a lower inflation rate would be much more favorable. And
since not all prices rise equally in times of high inflation (some are contractually
fixed over a fixed period or regulated by the state), inflation also influences the
real distribution of income in this way. All those assets that only represent claims
secured by nominal value (such as pension entitlements, savings, life insurance
policies, cash holdings) are devalued in real terms by inflation.
Even more or less constant and moderate inflation rates cause costs. These are
referred to in the literature as ’menu costs’ and ’shoe leather costs’. This refers to
the fact that restaurants and other businesses have to regularly print new menus
due to inflation. In addition, people try to hold as little cash as possible due to
inflation, as this does not earn interest and therefore does not compensate for
inflation. Figuratively speaking, people therefore often have to go to the bank
to sell securities when they need money. As a result, their leather shoes wear
out faster. In practice, however, it is less about the shoes and more about the
6 Thomas Sowell describes in his book "Basic Economics" (page 11) how the last President of the
Soviet Union, Mikhail Gorbachev, allegedly asked the then British Prime Minister Margaret
Thatcher how she ensured that the British had enough food. The answer was that she did not,
but that prices did. These ensured that the British were better fed than people in the Soviet
Union — even though the UK did not produce enough food for its own consumption. But the
prices made the necessary imports from other countries attractive.
7 In order to assess the effect of prices, the distribution of resources and competition must also
be considered. Only under certain conditions do free prices ensure the desired allocation.
Even in perfect competition, where supply and demand determine the price, we must bear in
mind that consumers’ willingness to pay (i.e. the demand curve) also takes into account their
ability to pay. A very rich person may pay a higher price for a product than a poorer person.
However, this does not necessarily lead to the conclusion that the richer person needs or wants
this product more.
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generally high costs associated with keeping cash low.
Even two per cent annual inflation is not insignificant. As the familiar rule of
72 for exponential growth already showed us in chapter 1.5.3 on page 43, money
loses half its purchasing power in around 35 years with two per cent annual
inflation. This is illustrated very clearly by the Bank of England’s long-term
data on price trends. The CPI (consumer price index) shows that £10 in 1800 had
the same purchasing power as £844 in 2019. This enormous increase over 219
years is based on an annual inflation rate of around 2.05 per cent (calculation:
10 ∗ 1.0205219 ).
The figure of two per cent inflation is also interesting because this corresponds to
the target value of the European Central Bank and the US Fed. But if even moderate inflation rates are so damaging to an economy, why don’t central banks aim
for 0% inflation? Firstly, the measurement and controllability problem speaks
against it. As we saw earlier, inflation cannot be calculated exactly (there are different inflation rates), nor can a central bank control the inflation rate precisely.
By increasing or tightening the money supply, it can influence inflation, but only
with limited precision. An annual inflation rate of around two per cent is therefore often targeted. This is low enough to keep the costs manageable and at the
same time prevent inflation from falling below zero — in other words, to prevent
the economy from experiencing deflation. In the United States, the average annual inflation rate since the Fed was founded has been around 2.9 per cent. As
can be seen in Figure 6.5, even this moderate inflation has significantly reduced
the purchasing power of the US dollar. In particular, the phases of high inflation
are recognizable, such as the 1970s, when purchasing power halved. We also recognize a clear correlation between the money supply (US dollars in circulation)
and the purchasing power of money. While there are around 600 times as many
US dollars in circulation today as in 1917, purchasing power has fallen by around
96% over the same period.
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Figure 6.5: Purchasing power of the US dollar since 1917
Inflation is such an economic problem that the US economist Arthur Okun added
the inflation rate to the unemployment rate in the misery index. As both unemployment and a high inflation rate cause economic and social costs, the misery
index is intended to be an indicator of prosperity. However, there are numerous
other important variables that influence prosperity. In addition, it is unclear how
the individual components of an indicator should be weighted.
And as much as economists emphasize the problems of inflation, the detrimental
consequences of deflation are also clearly described. In particular, the so-called
deflationary spiral can be harmful to the economy. This refers to the vicious
circle of falling prices and an economic downward trend. Many events can act
as triggers. For example, the coronavirus crisis in 2020 could have led to a sharp
drop in spending by private households. As a result, companies would have tried
to win over customers by cutting prices. If this is not successful, investments are
postponed and staff are made redundant. This unsettles private households,
who are already holding off on purchases due to falling prices (in anticipation of
further price cuts). If this uncertainty leads to a continued reluctance to spend,
the downward trend intensifies in a spiral. As the price level falls and many
nominal wages and nominal interest rates are contractually fixed, real wages and
interest rates also rise. Both of these factors increase costs for companies that are
already in a difficult situation. Deflation therefore has a self-reinforcing effect
and can also cause problems in the banking sector if debtors are no longer able
to pay the higher real interest rates.
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Whether deflation is really so harmful cannot be answered conclusively. The
experience in Japan since the 1990s is widely regarded as a negative example.
However, David Hacket Fischer already showed in his 1996 book The Great Wave:
Price Revolutions and the Rhythm of History that there have historically been periods
of falling prices and high GDP growth in both the USA and Europe. Since the end
of the Second World War, however, there have hardly been any highly developed
countries that have gone through deflationary phases. In this respect, the data
basis for an empirical analysis in modern times is relatively small. An analysis
by Claudio Borio and other economists at the Bank for International Settlements
(BIS) in 2015 found no significant difference in GDP growth between inflationary
and deflationary periods. Another fundamental problem is that deflation can be
caused by a rapidly growing supply of goods (good), falling import prices (good)
or low demand for goods (bad).8
Even apart from the goal of avoiding deflation, moderate inflation has favorable
economic effects. For example, nominal wage cuts can hardly be implemented
in practice.9 However, if a company finds itself in a difficult situation, it may
make sense to cut wages temporarily. An inflation rate of a few per cent can
enable such companies to reduce real wages by keeping nominal wages constant.
Resistance from employees is significantly lower in this way, as many are less
aware of the wage cut.
8 While the empirical evidence for harmful effects of deflation is rather limited, high inflation
— especially bubbles in the property and stock markets — is often the trigger for a severe
recession. Examples include Japan in 1990, the Asian crisis of 1997 and the financial crisis of
2008. The work of Jorda, Schularick and Taylor (Journal of Monetary Economics, 2015) documents
the dangers posed by such bubbles.
9 John T. Addison, Pedro Portugal and Hugo Vilares (British Journal of Industrial Relations, 2017)
show the empirical distribution of wage changes in Portugal. What is particularly striking here
is the very high proportion of zero rounds in 2013 and the very rare nominal wage cuts.
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Practice box 6.1: Inflation rate as an entrepreneurial challenge
For companies, low inflation is a problem if costs have risen and cannot be passed on to
customers. Since cost reductions in the form of ’secret’ real wage cuts are hardly possible
at low inflation rates, another means is often used. Many manufacturers of consumer
products have reduced product sizes in recent years. Instead of 100 gram chocolate bars,
90 gram bars are sold, or the 500ml bottle of cola is now only offered in Switzerland with
a capacity of 450ml. The quality of ingredients can also be reduced by using cheaper
products. Such measures not only make it more difficult to measure inflation rates, they
can also distort perceived inflation.
A high inflation rate is also problematic for companies, as it is often synonymous with rising prices for intermediate goods and services. In order to keep profitability high, companies must produce more efficiently and be able to pass on increased costs to their customers
by raising prices. In times of high inflation rates, companies that have pricing power are
therefore at an advantage.
Another benefit of inflation is the so-called seigniorage. This refers to government
revenue from the issuance of money. Every banknote that a central bank can
produce for a few centimes is ultimately ’sold’ for the face value of the banknote.
This results in a money creation profit for the central bank. As the state needs
revenue for important tasks such as the judiciary, national defense or education,
the question arises as to which is the most efficient source of revenue. Taxes often
have a distorting property: income taxes, for example, can make working less
attractive and thus increase unemployment.10 From this perspective, the money
creation profit can be a source of revenue for the state that is less distorting than
taxes.
However, the ’inflation tax’ is by no means transparent. If the central bank increases the money supply, the purchasing power of money falls. However, the
owners of financial assets do not initially notice the loss of purchasing power. In
nominal terms, they still have just as much wealth as before. Only when they
buy something do they realize the higher prices and thus the lower purchasing
power. However, the seller is then often criticized for the high prices rather than
linking the loss of purchasing power to the increase in the money supply. The
seller himself will justify himself with higher purchase prices, the manufacturer
of goods with increased costs. This shows how opaque ’inflation tax’ is. Con10 A large number of studies have estimated these distortions (deadweight loss).
Martin Feldstein (Review of Economics and Statistics, 1999) and Frank Bodmer (Die Volkswirtschaft, 2002)
for Switzerland document the sometimes considerable costs of taxation caused by distortions
and disincentives.
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sider the case in which a central bank creates additional money and uses it to
buy the bonds of a government that is borrowing to finance additional spending.
The benefits of this government spending are often clearly recognizable — higher
social benefits, new infrastructure — but the costs are disguised.
Since most countries today are highly indebted, moderate inflation provides the
opportunity to reduce the real debt burden without spending cuts or tax increases. Adam Smith already described this process in his 1776 book “The Wealth
of Nations”. In the fifth book, Chapter III (Of Public Debts), Smith uses the term
“pretended payment” to express the fact that states borrow money and repay it
formally years later, but with less purchasing power. A thousand francs that the
Swiss state borrows today will no longer have the same real value in five or ten
years’ time when the state pays it back.
However, there are also limits to this endeavor. If a state as a debtor uses a
large amount of money creation to reduce its real debt burden or to finance its
expenditure, economists speak of an inflation tax. Citizens pay this tax as their
money is devalued by inflation. As a result, people will try to hold as little money
as possible. Not only is this inefficient, the inflation tax also increasingly loses
its tax base. The state can therefore only finance itself to a very limited extent
through money creation without causing major problems itself.
This is because high inflation is not only harmful, but also represents a form of
tax. As described above, inflation causes a redistribution in favor of debtors.
6.4 Causes of Ination
Now that we have dealt in detail with the measurement and economic effects of
inflation, let us turn to its causes. Put simply, there are two basic explanations
for the emergence of inflation: the quantity theory and the Phillips curve. In the
following, we will look at both aspects separately and then recognize that there
is no rivalry between the two approaches. Rather, both explanations complement
each other.
6.4.1 Quantity Theory
Inflation is an ancient phenomenon, as old as money itself. If the latter exists,
there is an incentive to create as much money as possible. This applies regardless
of what is actually used as money: Shells, gold, paper money or Bitcoin. If these
objects are assigned a value that exceeds their production costs, it is natural that
people want to create as much of them as possible. This explains the behavior of
gold miners in earlier times as well as the so-called mining of crypto currencies
today. However, if the money supply grows faster than the available goods,
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services and real assets (e.g. land or machinery) — i.e. everything that can be
bought with money — their prices rise and we observe inflation.
The origins of the quantity theory probably go back to Nicolaus Copernicus (German mathematician and astronomer, 1473–1543). He was involved with coinage
from 1517. This was triggered by developments in the then state of the Teutonic
Order (1230 to 1561). There was a standardized currency there, but the state had
been in decline since the 15th century. In order to maintain state expenditure,
new coins were minted that contained less silver and cheaper metals instead.
Copernicus criticized this policy, among other things with his 1522 “Denkschrift
über die Münze” (Memorandum on Coinage). Part of his argument was the
quantity theory, according to which inflation is caused by an increase in the
money supply.
This theory, in one form or another, was the predominant explanation for inflation until Keynes’ research in the 1930s.11 In essence, this says that inflation
occurs when the money supply increases too quickly. If, for example, the money
supply increases by 7% annually, but the quantity of goods, services and other
assets only increases by 3%, then rising prices are the result. The money supply
and thus demand increases relatively to the values on offer. And since prices in
a market economy express scarcity, the relative scarcity of goods (relative to the
available money supply) leads to rising prices. Milton Friedman (The CounterRevolution in Monetary Theory, 1970) put it in a nutshell as follows: “Inflation
is always and everywhere a monetary phenomenon in the sense that it is and
can be produced only by a more rapid increase in the quantity of money than
in output”. However, the relationship between money supply and inflation is a
little more complex, as we will see in a moment.
11 Keynes himself never disputed the quantity theory. On the contrary, he emphasized its obvious
correctness in his book ‘A Tract on Monetary Reform’, published in 1924, but saw it as unsuitable for the short run: “The long run is a misleading guide to current affairs. In the long run we
are all dead. Economists set themselves too easy, too useless a task if in tempestuous seasons
they can only tell us that when the storm is past the ocean is flat again.”
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Figure 6.6: Money supply growth and inflation, 2000–2015
Figure 6.6 shows the empirical relationship between money supply growth and
inflation for a large number of countries and the period 2000 to 2015. The correlation is 0.81, which shows a strong statistical relationship between the two
variables shown.
Another way to check the relationship between the money supply and the price
index is to use long time series data. British statisticians have provided such
data. As Figure 6.7 illustrates, there is a striking pattern: if the money supply
increased particularly strongly in the UK, the price level also rose rapidly.12
12 A similar graph can be found in Thomas Mayer’s book “Das Inflationsgespenst” published in
2022.
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Figure 6.7: Money supply growth and inflation in the UK
These empirical observations lead to the hypothesis that there is a proportional
relationship between the growth of the money supply and the change in the price
level. Inflation is therefore caused by the growth in the money supply. To demonstrate this relationship mathematically, we start with the quantity equation:
M∗V = P∗O
(6.3)
This equation is an identity, i.e. it is correct by definition. We denote the money
supply with M, the velocity of money with V (for velocity), the price level with P
and the number of transactions (operations) with O.13 The latter is equivalent to
the supply of real values in the economy: all goods and services produced in a
year as well as all real assets that can be bought with money.
The quantity equation is often presented as real GDP Y instead of transactions O
(so that P ∗ Y then describes the nominal GDP). This is a simplification, but quite
problematic, as Ronald Marcks (“Dying of Money”, page 120, published in 1974
under the pseudonym Jens O. Parsson) explains.14 If someone has money and
13 Economists usually use the letter T for transactions.
Since we already use this for taxes and
transfer payments, the use of O is intended to avoid confusion.
14 The transaction version described here in the book is more difficult to apply empirically in practice
because the number of transactions and the associated average price level are almost impossible
to determine. The income version with GDP is more practicable, but ultimately incomplete, as
explained in the text.
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puts it into circulation (i.e., spends it), he basically has two options. Firstly,
he can spend it on newly produced goods and services (i.e. the current GDP).
Alternatively, however, the money can also be spent on existing assets. How
much money is used in practice for each of the two possible uses is not constant
over time. As we will see later with regard to monetary policy since the global
financial crisis, an increase in the money supply can primarily be used to buy
existing assets (shares, property). If the velocity of circulation remains constant,
there will be no inflation in goods and services, but there will be sharp rises in
share and property prices.
Also new for us in equation (6.3) is the velocity of money. This describes how
often the existing money supply is converted within a year. In simple terms, the
velocity of circulation indicates how often each banknote in circulation is used
on average per year. If we write GDP (Y) in equation (6.3) instead of O, the
velocity of circulation (V) must be interpreted as the frequency with which the
existing money supply is used per year for the purchase of new goods and services
(i.e. real GDP). To illustrate this, let us imagine an economy in which there are
only twenty notes of 10 francs each. The money supply is therefore 20x10 =
200 CHF. The economy is inhabited by only 10 people, each of whom produces
five kilograms of vegetables. If the entire harvest is sold on an annual market at
a price of 4 CHF per kilogram, the nominal GDP is exactly 200 CHF (10 people
x 5kg x 4 CHF). If no transactions with existing assets take place (no resident
sells his farm), the 200 CHF money supply was converted exactly once for the
settlement of all purchases. The velocity of circulation is therefore exactly one.
We can rewrite the quantity equation as P = ( M ∗ V )/O. Written in this way, it
shows that prices in an economy are determined by the ratio of demand relevant
to purchasing power (M ∗ V) to purchasable goods, services and other real assets.15 In simple terms, demand and supply ultimately determine the price. The
price level moves in the same direction as the money supply and the velocity of
circulation, but in the opposite direction to the transactions. For example, if the
money supply in a country is 100 billion francs and each franc is used 5 times
per year, then 5*100 = 500 billion francs purchasing power is available for the
transactions carried out. The supply of real values is then decisive for the price
level.
Two assumptions are necessary to get from the quantity equation to a statement
about inflation. Firstly, the supply of real values (O) must be independent of the
money supply. Secondly, we assume that the velocity of money is constant. If we
write equation (6.3) as a differential, we get
15 Money is only considered relevant to purchasing power insofar as it is used for purchases.
Therefore, M ∗ V and not only M must be taken into account.
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dM ∗ V + dV ∗ M = dP ∗ O + dO ∗ P
(6.4)
where we use d to express the differences: dM describes how much the money
supply has changed in absolute units. In our small numerical example, the following numbers could apply: dM = 100, dV = 0, dP = 2 and dO = 0. A
doubling of the money supply with a constant velocity of circulation and an unchanged supply of real values leads to a doubling of the price level. If we divide
equation (6.4) by equation (6.3), the result is
dM dV
dP dO
+
=
+
M
V
P
O
(6.5)
We can express this as a growth equation by using %∆ to express the percentage
change of a variable (e.g. dM/M = %∆M):
%∆M + %∆V = %∆P + %∆Y
(6.6)
Now the two assumptions mentioned above are applied. Firstly, we assume that
the supply of real assets and their change over time (%∆O) is not determined
by the money supply. Secondly, we assume that the velocity of circulation is
constant (%∆V = 0). If these two assumptions are correct, the following applies
to a change in M
%∆M = %∆P
(6.7)
There is a direct relationship between the money supply M and the price level P.
In other words, this expression shows that inflation is due to an increase in the
money supply. Let us assume, for example, that the money supply in an economy increases by 5%, the velocity of circulation is constant and the supply of
real assets increases by 2%. In this case, equation (6.6) directly implies that the
inflation rate is 3%.
However, it should not be forgotten that the direct correlation between the money
supply and the price level only exists if the velocity of circulation and the supply
of real assets remain constant. If the money supply increases by around 10%,
there will be no inflation if the velocity of circulation falls by 10% or if there are
10% more real assets. Conversely, there is an increase in the price level if the
velocity of circulation increases while the money supply and the supply of real
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assets remain constant. As long as the money supply, velocity of circulation and
supply of real assets remain constant, the price level will also remain stable. Any
additional expenditure on one transaction is then offset by reduced expenditure
on another transaction. The focus on the money supply as a driver of inflation is
only justified if the two assumptions mentioned above apply: constant velocity
of circulation and supply of real assets. We will therefore discuss both in detail.
How exactly is the velocity of circulation determined and is it actually more or
less constant in reality? To answer these questions, we must first recognize that
money has two central functions: it can be used to purchase goods and assets
or to store value. In the first case, money is in circulation, in the second case it
does not move. It only fulfills the second function as long as money can actually
be used to purchase goods and assets in the future. If nobody hoarded money
to store value (this term is common among economists), the average holding period would be short and the velocity of circulation would be correspondingly
high. Conversely, if money is increasingly hoarded, the velocity of circulation
decreases. In practice, various considerations determine how much cash is optimal to hold. We have already dealt with this in Chapter 3. These considerations
therefore also determine the velocity of circulation. If, for example, the central
bank increases the money supply substantially, the velocity of circulation initially
falls.16 A considerable proportion of the newly created money supply is initially
hoarded. This changes as soon as people expect the value of money to fall due
to the increased money supply. The velocity of circulation then increases, as the
previously hoarded money is used for purchases. Conversely, deflation can reduce the velocity of circulation, as many people wait to make purchases when
prices fall. In this case, the central bank would have to increase the money supply
in order to keep the price level constant. As a result, equation (6.3) shows that
inflationary pressure arises from the interplay between the money supply and
the velocity of circulation.
The assumption that an increase in the money supply has no influence on the
supply of real assets should also be discussed in greater depth. In the medium
(and long) term, an increase in the money supply can logically have hardly any
effect on real values. An increase in the amount of color-printed paper (banknotes) does not increase prosperity. Accordingly, we are not twice as rich after
doubling the money supply. In the medium and long term, a doubling of the
money supply merely leads to a doubling of prices (at a constant velocity of
circulation). In the short term, however, the effects can be different. Firstly, as
described in chapter 4, it is possible that in the short term an increase in the
16 Ronald Marcks published the book “Dying of Money” in 1974 under the pseudonym Jens O.
Parsson. In it, he describes in detail, using examples, how the velocity of circulation is determined (see page 115ff).
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money supply leads to lower interest rates, higher investment and thus to rising
GDP. However, this is only possible if an expansion of production is possible due
to underutilized production capacities. Otherwise, even in the short term, an
increase in the price level will primarily follow if the money supply is increased.
Secondly, we can drop the assumption of a constant velocity of money. If the
money supply increases, people could simply spend the higher money supply
less often. If V falls to the same extent as M rises, an increase in M leaves both
P and O unchanged. This phenomenon was described by Keynes as a liquidity
trap. In this case, an increase in the money supply leads neither to higher prices
nor to higher GDP because all the additional money is hoarded. According to
Keynes, such a situation existed in the 1930s and it took an expansive fiscal policy
to end the depression. For some years now, economists — such as Hans-Werner
Sinn (“Die wundersame Geldvermehrung”, p.231 ff.) — have also seen the Euro
area economies in a liquidity trap.
The quantity theory was the reason why numerous economists expected a sharp
rise in the inflation rate in the wake of the expansionary monetary policy following the financial crisis of 2007/2008. For Switzerland, we have seen in Figure 3.2
(page 85) how strongly the money supply was increased. However, the inflation
rate has by no means risen, as shown in Figure 6.1 (page 167). Apparently, there
has been no proportional relationship between money supply growth and the inflation rate, at least in the past ten years. How can this be explained? In principle,
additional money, i.e. an increase in M, can have an effect on all three other variables of the quantity equation (V, P, and O). If financial resources are hoarded,
the velocity of circulation decreases and inflationary pressure does not necessarily arise. This is clearly the case in Switzerland, as the central bank money supply
has increased much more than the money supply M1 or M2. Much of the newly
created money has therefore not flowed into the real economy at all, but is held
at the central bank as surplus reserves. In the context of the quantity equation,
we must therefore first realize that the assumption of a constant velocity of circulation was not correct. If we solve equation (6.3) for V, we get V = ( P ∗ O)/M. If
we take the real GDP for O (and therefore the nominal GDP for PO) of Switzerland and the money supply M2 of Switzerland for M, the result is the Figure 6.8.
The velocity of money has indeed fallen significantly since the financial crisis.17
17 A similar development is also shown by data for the United States.
As the magazine The
Economist wrote on 21 November 2020, the velocity of circulation in the USA has been below
one for the first time since 2020.
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Figure 6.8: Velocity of money in Switzerland, 1995-2022
Nevertheless, the money supply M1 and M2 have also increased significantly.
Where is this money and has it led to rising prices? In fact, this money was only
used to a very small extent to buy goods and services. Consumer prices therefore remained relatively stable. Much more money was used to buy securities
(especially shares) and existing property. Inflation therefore took place primarily
on the financial and property markets, without being measured as inflation in
the national consumer price index. It manifests itself in the form of rising share
prices or rising property prices. Figure 6.9 illustrates how the Swiss stock market
(Swiss Market Index, SMI) and the price of condominiums have developed since
2008.18 To quote Ronald Marcks (“Dying of Money”, 1974, page 131), there are
several pools in which the newly created money supply can end up. Firstly, the
money can be hoarded, which leads to a fall in the velocity of circulation. Secondly, the newly created money can be invested in existing assets such as shares
or property. The third ’catch basin’ is goods and services, i.e. those components
of the consumer price index basket. Only when the last option comes into play
does an expansion of the money supply lead to an increase in consumer prices.
However, there are hardly any barriers between the three basins: there is little to
stop people from no longer hoarding large amounts of money or selling shares
in the short term and buying goods and services instead.
In contrast to nominal wages, which have hardly increased at all, the price of
18 It should be noted that the SMI is a price index (unlike the DAX, for example) and dividends
are therefore not included in the index.
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assets in Switzerland has risen considerably, as can be seen in Figure 6.9. Monetary policy therefore also had clear distributional effects. The fact that the sharp
rise in share prices has not led to inflation in consumer goods is also due to the
unequal participation of the population in the stock market (shares are primarily
owned by wealthy individuals) and the low propensity to consume of most share
owners.19 If someone owned one million Swiss francs in shares in 2008 and these
are worth about two million today, they will often not realize the capital gain and
use it for consumer spending.20 The money thus remains in the “catch basin” of
existing assets and therefore does not increase the “water level” (the price level)
in the pool of goods and services. There is no increase in the consumer price
index (which does not include assets).
Figure 6.9: Price trends in Switzerland since 2008
This raises the question of whether the calculation of inflation based on the consumer price index should also take into account the price development of assets
such as property. There are discussions about this in various countries. Ultimately, however, the consumer price index simply cannot be equated with "infla19 According to data from the World Wealth and Income Database, the richest 1% of the Swiss popu-
lation owned over 42% of Swiss assets. If pension assets are taken into account, this is reduced
to around 25%.
20 The British private bank Coutts reported in 2019 that the inflation rate for luxury goods was
17.6%, more than twice as high as the official consumer price index (8.0%). This indicates that
wealthy individuals are certainly utilizing their increased purchasing power in niche markets
for (new) goods and services.
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tion". The index measures how the ordinary expenditure of a country’s citizens
develops over time as a result of price changes. To analyze inflation, i.e. the
general increase in the price level in an economy, all prices must be taken into
account.
This also applies because additional money created by the central bank can in
principle be used freely by citizens and institutions. They can hoard the money
or use it to buy services, goods or assets. If a lot of additional money is created
by the central bank, the price changes for individual goods or assets such as
shares can be considerable. This ensures that individuals benefit considerably.
After the financial crisis, for example, a lot of newly created money was invested
in the stock and property markets. As a result, share prices and property prices
rose. This led to inflation in asset prices. However, as the money flows ex ante
were unpredictable, inflation rewarded speculative behavior. We can recognize
another negative effect of inflation here: thrift and work become less attractive
relative to speculation. The aforementioned redistribution of real income through
inflation is therefore not a zero-sum game, as nations as a whole are made worse
off by inflation, precisely because less effort is expended on productive activities.
This is particularly damaging because inflation (i.e. price increases) is usually
recognized as an increase in the value of assets, i.e. as profits. Inflation, which
leads to redistribution for speculative behavior, thus gains influential advocates.
However, in order to bring property prices back down to a lower level, other possible measures must be analyzed in addition to changing monetary policy. These
include adjustments to tax laws as well as legislative and regulatory changes that
increase the supply of property.
6.4.2 The Phillips Curve
Inflation refers to an increase in the prices of goods and services. In a market,
prices rise if demand increases while supply remains the same or if supply decreases while demand remains the same. An example of the second case are the
oil price shocks of 1973 and 1979/1980. A reduction in production by the Arab
oil-exporting countries led to an increase in the price of oil from around three
US dollars per barrel (159 liters) in the summer of 1973 to over 30 US dollars
in 1981. As oil is a necessary energy source for the production of many goods
and services, prices generally rose and the inflation rate increased significantly.
However, the very high inflation rates in the 1970s shown in Figure 6.1 (page 167)
had a second cause: a limited supply met an increasing demand for goods. The
high (monetary) demand in turn had its origins in an expansive monetary policy. As already explained, this led to rising inflation. To prevent real wages from
falling in the face of rising goods prices, employees and their representatives de-
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manded high increases in nominal wages. The very low unemployment rate at
the beginning of the 1970s (around 1% in Germany, less than 1% in Switzerland)
strengthened the negotiating position of the labor side. The result was a sharp
rise in nominal wages.
If we are primarily interested in the inflation rate for the prices of goods and
services in the consumer price index, the development of nominal wages plays a
central role. It is primarily employees whose nominal purchasing power determines the price level of the basket of goods described above. High increases in
nominal wages also lead to corresponding cost increases for companies. If these
companies pass on the increased costs to customers in the form of higher prices,
inflation occurs. Such a development presupposes that employees can actually
enforce high wage demands. As this is primarily possible when unemployment
is low, we should expect inflation rates to rise when unemployment is low.
We can also link these considerations with those from the quantity theory. When
production factors are underutilized — i.e. when unemployment is high — an
expansion of the money supply leads to additional purchasing power and demand. The supply of goods and services can then increase as seen in the IS-LM
model and we do not get inflation (in equation 6.3 rise M and O). However,
if the factors of production are fully utilized — if the economy is in a phase
of low unemployment — the supply of goods and services can hardly increase.
Consequently, in the quantity equation, the money supply M increases, but the
supply of real values hardly increases at all. This results in an increase in the
price level P, i.e. inflation.
The empirical relationship between the inflation rate and the unemployment rate
is known as the Phillips curve, in honor of the English statistician and economist
William Phillips (1914-1975). However, his study “The Relation between Unemployment and the Rate of Change of Money Wages in the United Kingdom”, published in the journal Economica in 1958, was not the first documentation of the correlation. As early as 1926, Irving Fisher (American economist, 1867–1947) noted
that there was a connection between inflation and the unemployment rate.21 He
noted that in times of economic prosperity with low unemployment, the inflation
rate was high and during an economic recession with high unemployment, inflation fell. However, according to James A. Trevithick (“Inflation: A Guide to the
Crisis in Economics”, 1977, p.55), this observation received little attention until
21 See “A Statistical Relation between Unemployment and Price Changes”, International labor Re-
view, 13(6), 785-92. This study was republished in 1973 as “I Discovered the Phillips Curve:
A Statistical Relation between Unemployment and Price Changes”, Journal of Political Economy,
81(2, Part 1), 496-502. While Fisher used the inflation rate on the vertical axis, Phillips used the
rate of change in nominal wages.
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6 Inflation
Phillips published his study in 1958.22
The interpretation of the Phillips curve has been discussed many times. In general, it describes — as shown in Figure 6.10 for Switzerland — a negative empirical correlation between wage changes (or price level changes, i.e. inflation) and
the unemployment rate. As with any other correlation, it is not possible to directly conclude a causal relationship. The observation of an empirical correlation
does not mean, for example, that high inflation rates lead to lower unemployment.
But why does the data paint the picture we see in Figure 6.10? The explanation
begins with the consideration of how companies react to additional demand.
Let’s imagine a restaurant that has an increasing number of customers. To meet
the increased demand, the owner of the restaurant can set up additional tables
and the employees can work additional hours. If this is not enough to serve all
the guests, the owner can also hire additional labor. All of this increases the
capacity of the restaurant. However, there are limits to this expansion: there is a
limit to the number of tables that can be set up and it is difficult to find suitable
staff in times of low unemployment. The restaurant owner can therefore react
to additional demand by increasing prices instead of increasing capacity. The
more difficult it is to hire additional labor to meet demand, the more likely the
restaurant will respond to additional demand by raising prices. We therefore
have an initial explanation as to why prices rise more when unemployment is
low. In addition, the bargaining position of employees improves in times of
low unemployment. If it is easy to find a suitable job elsewhere, employees are
more likely to insist on large wage increases. Economists say that their outside
option (alternative) has improved. Companies also compete more strongly for
scarce labor when few people are unemployed. As a result, wages tend to rise
more when unemployment is low. The higher wages are an additional cost for
companies and they will try to pass the cost increases on to customers in the
form of higher prices. In times of low unemployment, the economy is booming
and price increases tend to be easier to implement than in a recession. This
explanation also gives us a higher inflation rate in times of low unemployment.
If we look at Figure 6.10 in detail, we notice that the curve is very flat if we only
consider the 2010s. We can also observe this in other countries. Many economists
have therefore debated whether the correlation between the unemployment rate
and the inflation rate has weakened — and if so, why. For example, it is argued
that the price of many products is nowadays determined (or at least very strongly
determined) on the world market. Therefore, national labor market conditions
22 William Phillips himself developed many other economic and non-economic ideas. On 22 Au-
gust 2020, the magazine The Economist described the curve named after him as his ‘least solid
piece of work’.
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6 Inflation
have less influence on the inflation rate in a globalized world. However, a study
by Peter Hooper, Frederic S. Mishkin and Amir Sufi (Research in Economics, 2020)
shows that the Phillips curve can still be found. The correlation between inflation
and the unemployment rate is particularly evident when using subnational data.
In addition, a clear Phillips curve emerges when we look at the 2020s data in
Figure 6.10.
Figure 6.10: Phillips curves in Swiss data since 1970
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6 Inflation
Practice box 6.2: The emergence of inflation
Using the quantity equation M ∗ V = P ∗ O and the Phillips curve, we can also understand
how inflation occurs in practice. It is important to note that the four variables (M, V, P
and O) are not independent of each other. The trigger (trigger event) of higher inflation can
be many things. For example, an oil price shock (ultimately an exogenous increase in P),
which causes energy prices to rise, thereby pushing up producer prices and then consumer
prices. As a result, it is crucial how the population reacts to this. Consumers and companies can limit their purchases or, in view of the rising prices, bring forward purchases in
order to "still be able to buy cheaply". The latter increases the velocity of circulation (V)
and therefore has an inflation-increasing effect. This shows that inflation expectations play
an important psychological role, as they influence the velocity of circulation and wage demands in particular. Another trigger is, for example, an interruption in supply chains,
which limits the supply of goods in the short term. As there are fewer goods, the number of transactions (O) decreases, which can also have an inflation-increasing effect ceteris
paribus. From an economic perspective, it is important to identify the trigger and then
analyze the subsequent developments.
The effects of an oil price shock can be dampened if, for example the domestic currency
appreciates (such as the Swiss franc), an economy is energy-efficient (i.e. requires little
energy per franc of GDP) or the population spends relatively little of its budget on energy.
As Rudolf Minsch pointed out in March 2022, Switzerland was in a favorable position with
regard to the latter two points. In 2020, for example, it required around 1 megajoule per
1 billion Swiss francs of GDP. In Germany, this figure was significantly higher due to the
industrialized economic structure. At the same time, the share of fossil fuels in the national
consumer price index was only 3.03%, compared to 7.11% in Germany.
6.4.3 Economic Model to Explain the Phillips Curve
How can we understand the Phillips curve in the context of an economic model?
In the previous chapters, this formal approach to explaining various economic
aspects has provided us with many insights. To illustrate the Phillips curve mathematically, let us start with two equations from the previous chapter:
• Wage-setting equation: W/Pe = F (u, z)
• Price-setting equation: W/P = A/(1 + µ)
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In Chapter 5.4.3 we assumed that the actual price level P corresponds to the
expected price level Pe . We therefore wrote W/P = F (u, z) for the wage-setting
equation. Now we allow that P ̸= Pe can be and therefore write Pe in the wagesetting equation: the expected price level determines what wage the employees
demand. In the price-setting equation, we make the simplifying assumption that
A = 1. This shortens the expression to P = (1 + µ) ∗ W. If we solve the wagesetting equation for W, we obtain the modified wage and price-setting equations:
W = Pe ∗ F (u, z)
as well as
P = (1 + µ ) ∗ W
(6.8)
We now replace W in the second equation with the expression of the modified
wage-setting equation and obtain
P = (1 + µ) ∗ Pe ∗ F (u, z)
(6.9)
The function F (u, z) describes how the wage demands of employees depend on
the unemployment rate u and other aspects z (such as unemployment benefits).
So far, we have only said that F (u, z) decreases in u and increases in z (see equation 5.3). Now we give this function a clear structure and assume the following
equation:
F (u, z) = 1 − αu + z
(6.10)
where α describes how strongly wage negotiators react to the unemployment
rate u. The larger the parameter α, the steeper the wage-setting curve in Figure 5.8
(page 157). We insert the function F (u, z) described in this way into equation (6.9)
and obtain
P = Pe ∗ (1 + µ) ∗ (1 − αu + z)
(6.11)
Reformulating this in such a way that a Phillips curve results requires a series
of mathematical steps, which we will look at in detail below. First, we add time
indices and then divide by Pt−1 :
Pt /Pt−1 = Pte /Pt−1 ∗ (1 + µ) ∗ (1 − αu + z)
(6.12)
We expand the left-hand side in the numerator with − Pt−1 and + Pt−1 . Since
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6 Inflation
Pt−1 /Pt−1 = 1 and ( Pt − Pt−1 )/Pt−1 corresponds to the inflation rate πt in year t,
the result is
Pt − Pt−1 + Pt−1
Pt − Pt−1
= 1+
= 1 + πt
Pt−1
Pt−1
We can now do the same with the right-hand side of equation (6.12) for Pte , so
that we obtain
(1 + πt ) = (1 + πte )(1 + µ)(1 − αut + z)
We now divide both sides by (1 + πte )(1 + µ) and the result is
(1 + π t )
= 1 − αut + z
(1 + πte )(1 + µ)
As long as πt , πte and ut are relatively small, the approximation applies
1 + πt − πte − µ = 1 − αut + z
This can be rewritten as the equation
πt = πte + (µ + z) − αut
(6.13)
How do we now interpret equation (6.13)? This mathematical expression describes a Phillips curve: For given values of the expected inflation rate π e , the
price premium µ and other factors z, a decrease in the unemployment rate u
leads to an increase in inflation. In other words, ceteris paribus, a decrease in u
leads to an increase in the inflation rate (πt ).
We have thus derived the relationship of the Phillips curve within the framework
of the economic model. The advantage of this formal approach is that we can
now analyze what leads to a shift in the Phillips curve. From an economic point
of view, the lowest possible curve is advantageous: for any given level of inflation, we then have a lower unemployment rate (and conversely, for any given
unemployment rate, a lower inflation rate). According to the equation (6.13), the
Phillips curve shifts upwards if: higher inflation is expected (π e ↑), the price premium increases (µ ↑) or factors that lead to higher wage demands increase (z ↑).
Looking purely at this modelling framework, the last two points mean that in197
6 Inflation
tense competition in the goods market (low markup µ) and lower unemployment
benefits (low z) are desirable. We will look at the role of inflation expectations πte
in more detail below.
Ination Expectations
How is the expected inflation rate πte determined, what inflation do people expect
for the next year? There is no clear answer to this question; it depends on the
circumstances. The simplest situation is that of anchored inflation expectations. If
the inflation rate is stable at a level π ∗ for years without an upward or downward
trend, then rational individuals also expect inflation of π ∗ for the next year. In
this case, πte = π ∗ . According to the equation (6.13), low unemployment then
leads to high inflation (provided µ and z remain unchanged). There appears to
be a conflict of objectives between inflation and unemployment: both should be
as low as possible, but this is not possible. The statement by former German
Chancellor Helmut Schmidt in the Süddeutsche Zeitung of 28 July 1972 became
famous in this regard: “It seems to me that the German people can tolerate - to
put it bluntly - 5% price increases rather than 5% unemployment.”
Since a government can influence the inflation rate directly through fiscal policy
and indirectly through the central bank via monetary policy, an important question arises: Can a government really control the unemployment rate by choosing
an appropriate inflation level? Milton Friedman decisively contradicted this hypothesis in his speech at the American Economic Association in 1967.23 In essence,
Friedman criticized the fact that the Phillips curve is nothing more than a temporary phenomenon in the short term. In the medium and long term, governments
cannot choose between inflation and unemployment, as the trade-off only applies
in the short term. If a government (or central bank) unexpectedly increases inflation through expansionary monetary policy, it temporarily lowers real wages
(nominal wages minus inflation). This makes it more attractive to hire labor and
thus actually lowers the unemployment rate. However, people adjust their inflation expectations when actual inflation exceeds their expectations. However,
once this happens, π e rises, leading to an upward shift in the Phillips curve (as we
showed earlier). As a result, an expansionary monetary policy with an increase
in the inflation rate leads to lower unemployment in the short term. In the medium
term, however, unemployment returns to its original level when real wages rise
again to their original level. However, the economy then has the same unemployment rate again, but with a higher inflation rate. Based on this argument, Milton
23 The entire speech was printed in 1968 in the American Economic Review.
Its paramount importance is emphasized both in the book “Inflation” by James Trevithick (1977, page 59) and by N.
Gregory Mankiw and Ricardo Reis (Journal of Economic Perspectives, 2018).
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Friedman predicted in his 1967 speech that a situation of high unemployment
and high inflation would soon arise. The situation in the 1970s, subsequently
referred to as stagflation (a word mix of stagnation and inflation), confirmed this
prediction.
We must therefore abandon the assumption that π e is constant. It is more realistic
to assume that people form their inflation expectations on the basis of past inflation rates.24 For example, if inflation has been stable at two per cent for years,
most people will also expect two per cent inflation next year. We can describe
this level of inflation as π ∗ . However, if the inflation rate then rises to four per
cent, people will gradually adjust their expectations upwards. Mathematically,
we can describe this as follows
πte = (1 − θ )π ∗ + θπt−1
(6.14)
where the parameter θ (which lies between zero and one, 0 ≤ θ ≤ 1) indicates
how strongly the expectations for inflation in year t depend on inflation in the
previous year. In the 1970s, repeated increases in inflation caused the parameter θ to rise to one, so that πte = πt−1 . If we insert this expression into the
equation (6.13), we obtain
πt − πt−1 = (µ + z) − αut
(6.15)
The unemployment rate therefore influences the change in the inflation rate. We
also refer to the equation (6.15) as a modified or extended Phillips curve.
The Natural Rate of Unemployment (NAIRU)
Let us look again at the equation (6.13) πt = πte + (µ + z) − αut . Milton Friedman and Edmund Phelps (American economist, *1933) pointed out in the late
1960s that employees do not permanently underestimate inflation. While they
may over- or underestimate the coming inflation rate in the short term, the expected and actual inflation rates are at the same level in the medium term. If we
therefore write πt = πte and replace πte with πt in equation (6.13), we obtain
u = un = (µ + z)/α
(6.16)
24 In practice, for example, the so-called Breakeven Inflation Rate is used in the USA to estimate
inflation expectations. It is calculated from the difference between government bonds that are
inflation-indexed and those that are not.
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where we have resolved to u and denote the natural rate of unemployment described in this way as un . We already know this unemployment rate from Chapter 5. However, we can now define it differently as we have determined the function F (u, z). We recognize in equation (6.16) that the greater the profit mark-up µ
and the greater the factors summarized by z (such as unemployment benefits),
the higher the natural rate of unemployment. The extent to which employees
reduce their wage demands when the unemployment rate rises also plays a role:
the higher α, the lower the natural rate of unemployment. We can rewrite equation (6.16) as αun = (µ + z) and insert it into the modified Phillips curve of
equation (6.15):
πt − πte = −α(ut − un )
(6.17)
The Phillips curve now results from the relationship between the change in the
inflation rate and the deviation of the unemployment rate from the natural rate of
unemployment. For this reason un is also referred to as the non-accelerating inflation rate of unemployment (or NAIRU for short). According to the model, how high
this NAIRU is in practice depends on the structural conditions of an economy:
the intensity of competition on the goods market (µ), the labor market policy (z)
and the behavior of the trade unions (α). In the medium term, the unemployment
rate tends towards the natural rate of unemployment (or NAIRU). This can also
be seen in Figure 6.11. For example, unemployment in the United States rose
significantly from 2008 due to the financial crisis. However, the NAIRU did not
change and the unemployment rate returned to a level of around five per cent in
the following years. It is also clear to see how Germany has structurally reduced
its unemployment rate.
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Figure 6.11: Trend to the natural rate of unemployment (ALQ)
So, how does ination arise?
The analysis in this chapter helps us to understand how high inflation rates can
occur in practice. Starting from years of low inflation, this requires a trigger. This
is referred to as initial inflation. This is caused, for example, by a severe supply
shortage such as the lockdowns during the coronavirus crisis. Alternatively, a
strong stimulation of demand by the state can briefly push the inflation rate to a
high level. But how can such a higher inflation rate be sustained? This requires
reinforcing effects such as the wage-price spiral described above as well as a
change in inflation expectations. The latter also leads to many people prioritizing
purchases in anticipation of higher prices, thus exacerbating a shortage of goods.
Psychology therefore also plays an important role: the current inflation rate also
influences inflation expectations for the future. However, if employees demand
higher nominal wages in anticipation of a high inflation rate, this leads to even
higher inflation through higher labor costs. In addition, a strongly expansionary
monetary policy in an open economy also leads to a devaluation of the domestic
currency against foreign currencies. This makes imports more expensive and
a country “imports additional inflation” if, for example, crude oil or primary
products become more expensive.
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6.5 Summary
We have seen two approaches to explaining inflation in this chapter: the quantity
equation and the Phillips curve. Both approaches contribute to macroeconomic
understanding, but are also the subject of critical debate among economists due
to the current situation. It is important to note that there is no rivalry between the
two explanatory approaches. The quantity equation applies as an identity and
the Phillips curve ultimately describes how additional demand meets limited
supply. The origin of the additional demand can be an increase in the money
supply or an increase in the velocity of money in circulation. The scarcity of
supply results from the limited production possibilities available (or an actual
decline, such as during the oil crisis).
We have also seen that there is only a trade-off between inflation and unemployment in the short term. In the medium term, inflation expectations adjust to the
actual inflation rate. The state thus loses the possibility of ’swapping’ unemployment for inflation. We will analyze what this means for economic policy in the
medium term in the next chapter.
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7 The Economy in the Medium-term
In the fourth chapter, the IS-LM model already provided us with a framework for
analyzing many economic developments and government interventions. However, the limitations of the model also became apparent: in the medium term, we
have to deal with the supply (i.e., production) side. In addition, we cannot maintain the assumption of constant goods prices. Having dealt with the resource
constraints of the economy, specifically the labor market, and the issue of inflation in Chapters 5 and 6, we can now extend the IS-LM model. The aim is to take
into account the two aspects of resource constraints and inflation in the model.
Specifically, in this chapter we will develop the so-called IS-LM-PC model, where
PC stands for the already familiar Phillips curve. Based on the considerations of
the last two chapters, we will add another curve to the IS-LM model. This will
also help us to better understand the limits of state intervention in the model
framework. In theory, the IS-LM model allows for ever higher GDP purely by
increasing the demand for goods (through expansionary fiscal and monetary
policy). The 1970s in particular showed that this is not feasible in practice. It
is important to consider the historical context here: After the most important
indicators such as GDP had been developed in the 1930s and 1940s, the idea of
being able to control the economy as a whole became established. The IS-LM
model, which was also developed in the 1940s, provides a framework for this.
To this day, the model illustrates the basic ideas of what is known as Keynesian
policy.
In her 2014 book “GDP: A Brief but Affectionate History” (see page 65f.), Diane Coyle describes the reasons for the failure of Keynesian policy. As so often
in life, the roots of failure lay in the nature of success. The instruments of demand management proved too tempting and were used to stimulate the economy whenever there was a downturn. Both lower interest rates and additional
government spending (or tax cuts) were used to limit downturns and keep employment levels high. Politicians had the model of the economy as a controllable
machine in mind. The strong post-war growth seemed to confirm their confidence. They overlooked the fact that GDP increases as a result of expansionary
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fiscal and monetary policy by definition. The definition of GDP was constructed
around Keynes’ model of how the economy works. However, the ideas of John
Maynard Keynes in 1936 were characterized by the economic depression: scarcity
of resources and inflation were not pressing problems. This shows that a model
and the associated model assumptions must always be assessed in the respective
context.
The fundamental problem with expansionary fiscal and monetary policy is that
shortages persist: If the state or the central bank act expansively, there is competition between state and private actors for scarce productive resources and a crowding out of private actors. However, the crowding out already known from chapter 4
does not only affect financial resources: the state generally withdraws resources
from the private economy. When analyzing the economy in the medium term,
we take the scarcity of resources into account. In this chapter, we will therefore address economic policy issues using a different framework (the IS-LM-PC
model). What are the effects of fiscal and monetary policy in the medium term?
How do the short and medium-term effects of economic policy interventions differ? The answer — as we will see — depends on how far an economy is from its
medium-term production potential.
7.1 IS-LM with Real Interest Rates and Risk Premia
The first objective of this section is to further develop the IS-LM model. We start
with the interest rate in the model. In Chapter 4, there was only one interest
rate in the IS-LM model that can be influenced by the central bank. This was the
nominal interest rate, which does not take into account any changes in the price
level. Now that we are familiar with the aspect of inflation, we need to replace
the nominal interest rate in the model with the real interest rate. The difference
between these two interest rates is clearly described by the Fisher equation. This
expression, named after the American economist Irving Fisher (1867-1947), states
that the nominal interest rate corresponds to the sum of the real interest rate and
the expected inflation rate:
it ≈ rt + πte+1
(7.1)
We denote the nominal interest rate in year t by it , the real interest rate by rt
and the expected inflation rate by πte+1 . Specifically, πte+1 = ( Pte+1 − Pt )/Pt . Two
aspects of the equation (7.1) are striking. Firstly, it is not the actual but the expected
inflation rate that is taken into account. The idea behind this is that the nominal
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interest rate is set under uncertainty about future price changes. Let us take
the example of a person who is considering whether to invest 100 francs in a
savings account for a period of one year. In this case, the bank will compensate
the saver. As the money is not available to the person for twelve months, he
wants compensation. We call this the real interest rate. As long as all goods
prices remain unchanged in a year, the nominal interest rate corresponds to the
real interest rate (πte+1 = 0). However, if the saver assumes that the prices of
goods will rise by two per cent in the next twelve months, for example, he would
also like to be compensated by the bank for the loss of purchasing power during
the lending period. The decisive factor for the amount of compensation is the
expected inflation rate for the next twelve months. It should be noted that the
compensation for the expected inflation does not represent interest, but ensures
the repayment of the borrowed amount of money (the so-called headmaster).
The second important observation regarding the equation (7.1) is that this equation only applies approximately. The exact Fisher equation results from a consideration of arbitrage (i.e. the utilization of exchange rate, interest rate or price
differences). If someone invests a franc at a nominal interest rate of, for example,
5%, he will get back 1.05 francs (or 1 + it with it = 0.05) after one year. Alternatively, someone could buy a real asset (such as gold) with the franc and sell it
after one year. Let us now assume that the price level rises from Pt to Pte+1 within
one year. In this case, the person could sell the real value after one year at the
price (Pte+1 /Pt ). If prices rise by around 3%, the person succeeds in ’converting’
one franc into 1.03 francs over a period of twelve months. Instead of buying gold
— i.e. something that does not change over time — the person can also use the
franc to buy something that increases in value in real terms. If there is such a real
increase in value, the one franc becomes 1 + rt francs within a year, where rt indicates the real return. The nominal interest rate must be so high that alternative
investment options are neither better nor worse.1 The following must therefore
apply:
(1 + it ) = (1 + rt ) ∗ Pte+1 /Pt
(7.2)
How do we get from this exact Fisher equation to the simpler formulation in
equation (7.1)? Firstly, we note that: πte+1 = ( Pte+1 /Pt ) − 1. If we insert this into
equation (7.2), the result is:
1 The Mundell-Tobin effect describes why an increase in the (expected) inflation rate does not in-
crease nominal interest rates one-to-one. In response to higher inflation, people will hold less
cash and buy securities instead, which lowers the interest rate on them. The real interest rate
therefore falls. The Canadian economist Robert Mundell and the American economist James
Tobin were thus able to show that inflation expectations had real effects.
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7 The Economy in the Medium-term
1 + it = (1 + rt ) ∗ (1 + πte+1 )
(7.3)
Here we can multiply out the right-hand side of the equation and then subtract
one on both sides. Since rt ∗ πte+1 is very small for normal interest rates and
inflation rates, we can neglect this expression. What remains is the simple Fisher
equation from equation (7.1).
If we apply the Fisher equation to practice, we can look at data for Switzerland
from the past three decades. Real interest rates (ex post) can be calculated from
nominal interest rates and the realized inflation rates based on the consumer
price index (CPI). Figure 7.1 shows that the nominal interest rate (on ten-year
bonds) has fallen continuously from over six per cent to below zero per cent. In
contrast, the real interest rate was already at a very low level at the beginning of
the 1990s and has fallen less sharply overall.
Figure 7.1: Nominal and real interest rates in Switzerland, 1990–2022
What is striking in Figure 7.1 is the strong correlation between the nominal interest rate and the inflation rate (the correlation is 0.72). This shows that although
buyers of government bonds are hardly exposed to any default risk — as a rule,
a state can print the money required for repayment itself if necessary — there
is certainly an inflation risk. If someone buys Swiss government bonds with a
nominal value (repayment amount) of CHF 1’000 in ten years’ time, it is unclear
what their purchasing power will be in ten years’ time. Therefore, as a rule, the
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higher the inflation rate, the higher the nominal interest rate that a state has to
pay on its debt.
7.1.1 Risk Premia
However, there are also countries and debtors in general where there is a risk
of default. In addition to the real interest rate and compensation for expected
inflation, these debtors must also pay a premium (reward) for the risk. For example, countries in the Euro area no longer have their own currency, which they
can use at will to pay off government debt. Bonds from Greece, Italy, Portugal
and Spain were therefore considered at risk of default during the euro crisis from
2010 onwards. We can see in Figure 7.2 that the yield on 10-year Greek government bonds rose from around 5% at the beginning of 2010 to almost 30% two
years later. Due to the high national debt and poor economic development in
some southern European countries, their creditworthiness was called into question. On 26 July 2012, the then head of the European Central Bank (ECB), Mario
Draghi, made it clear that the ECB would step in if in doubt: “Within our mandate, the ECB is ready to do whatever it takes to preserve the euro. And believe
me, it will be enough”. The calming effect on the financial markets is clearly
recognizable in Figure 7.2.
Figure 7.2: Yield on government bonds during the euro crisis
Similar to Greek government bonds, many other securities are also exposed to a
default risk. The extent of this risk can be estimated on the basis of information
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7 The Economy in the Medium-term
about the debtor. As this risk assessment process is often very time-consuming,
ratings from rating agencies are frequently used. These are private companies
that commercially assess the creditworthiness of companies, financial products
or even countries. The most important rating agencies include Fitch Ratings,
Moody’s, and Standard & Poor’s. All three award ratings, with AAA (Triple A)
representing the best possible credit rating with a very low risk of default, even in
the long term. Riskier securities subsequently receive the ratings AA, A, BBB, BB,
B, CCC, CC, C and D (for default), whereby everything below BBB is considered
a speculative investment (non-investment grade, high-yield or junk). In practice, the
lower the rating, the higher the risk premium demanded by investors. This can
be seen very clearly in the data, as illustrated in Figure 7.3.
Figure 7.3: Interest rates by asset class in the United States (USA)
If the default risk of a security is estimated to be higher, investors demand corresponding compensation. Let us denote the nominal interest rate on safe bonds
with i, the risk premium (also risk premium) with x and the probability of default
with p. An investor will then make the following calculation
(1 + i ) = (1 − p ) ∗ (1 + i + x ) + p ∗ 0
(7.4)
On the left-hand side, we see the risk-free return: each franc invested is certain to
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generate 1 + i. The risky investment must yield in the expected value just as much.2
Therefore, on the right-hand side of the equation we find both the return in the
event that the payment materializes (1 + i + x) and the return if the payment does
not materialize (zero). We can reformulate equation (7.4) and obtain:
x = (1 + i ) ∗ p/(1 − p)
(7.5)
The higher the probability of default (p), the higher the risk premium (x) that
investors demand. In practice, other factors such as the risk appetite of investors
also play a role in the level of the risk premium. However, we leave these aspects
out here.
Figure 7.3 also illustrates how central banks attempt to influence the interest rate
level in the economy by buying and selling government bonds: Since government
bonds such as the 10-year US Treasury bonds shown have almost no default risk,
all other bonds are directly related to them.3
7.1.2 IS-LM Model with Real Interest Rate and Risk Premia
We can now add two aspects to the IS-LM model: real interest rates and risk
premiums. If we define the real interest rate as r = i − π e and denote the risk
premium by x, we obtain new conditions for the equilibrium on the goods market:
Y = C (Y − T ) + I ( r + x ) + G
(7.6)
The IS curve still describes this equilibrium, but private investment now depends
on the real interest rate and the risk premium. The higher r and the greater x,
the lower the investments (I). The investing companies must compensate their
lenders for inflation and risk.
The inclusion of inflation in the model also has an impact on the financial market and the equilibrium there, which we describe with the LM curve. Since
investments now depend on the real interest rate (r), we now also describe the
LM curve on the basis of the real interest rate. If we subsequently assume that
the central bank controls interest rates, this results in a horizontal LM curve, as
shown in Figure 7.4.
2 We assume risk-neutral investors at this point, who are purely interested in the expected value
and are neither risk-loving nor risk-averse.
3 Treasury bonds are not entirely risk-free either, as Zivney and Marcus point out in a study for
the journal The Financial Review from 1989.
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7 The Economy in the Medium-term
r
r0
•
A
LM (money market)
IS (goods market)
Y
Y0
Figure 7.4: IS-LM model with real interest rate control
In order to influence the economy, the central bank now controls the real interest
rate. On the one hand, it can influence the nominal interest rate (e.g., through
open market operations). On the other hand, it is possible for central banks to
change expectations about future inflation (forward guidance). The real interest
rate falls if the central bank lowers the nominal interest rate i with given inflation
expectations π e or if the central bank succeeds in raising inflation expectations
(with a given nominal interest rate).
r = i − πe
(7.7)
The IS-LM model extended in this way already allows us to analyze further economic developments. We can illustrate this with a practical example. In 2019,
some economists feared that the US economy could fall back into recession after
more than ten years. A frequently cited indication of this was the yield curve,
which was inverted in the US for the first time since 2007: short-term interest
rates were higher than long-term interest rates. Normally, interest rates on longterm government bonds (around ten years) are higher than on short-term bonds.
This reflects the fact that the risk of unexpectedly high inflation is greater with
a longer time horizon. If, on the other hand, short-term interest rates are higher
than long-term rates, this is referred to as an inverted yield curve. Historically,
such an inversion has often been followed by a recession, as illustrated in Figure 7.5 (recessions are shaded in grey).
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7 The Economy in the Medium-term
Figure 7.5: Interest rate curve in the United States (USA)
Many investors and the US Federal Reserve (Fed) saw an increased risk of recession in 2019 due to the inverted yield curve. As many companies get into
financial difficulties during a recession and some debtors are no longer able to
repay borrowed amounts, investors become more cautious. In the model, we can
understand this as an increase in the risk premium x. This increase leads to a
leftward shift of the IS curve, as investments and thus GDP (Y) are lower for a
given real interest rate (r). To support the economy in this situation, the government could pursue an expansive fiscal policy. Alternatively, the US Federal
Reserve can cut interest rates, which it did in July 2019 with the first rate cut
since 2008. In our model, the LM curve shifts downwards, which is why Y rises.
In principle, the central bank can bring the economy back to the original GDP (Y).
Despite greater uncertainty among investors, the economy then does not fall into
recession. This approach by the central bank is also known as Greenspan put, as
discussed in Chapter 4. However, the central bank can also reach its limits here.
In the event of a sharp rise in x and a low initial level of interest rates (i), it is
possible that the central bank will not be able to lower the interest rate sufficiently.
This is the case if there is an effective interest rate floor (known as the zero lower
bound) and this makes it impossible for the central bank to bring r + x back to
the old level. As shown in Figure 7.6, the real interest rate may even have to fall
into negative territory in order to keep GDP at the original level (Y0 ). However, if
inflation expectations (π e ) are very low, r can only be negative if i is also negative
(r = i − π e ). In principle, the central bank can also try to manipulate inflation
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7 The Economy in the Medium-term
r0
•
A′
•
A
real interest rate r
real interest rate r
expectations. This strategy, known as forward guidance, is successful if higher
inflation expectations (π e ) lower the real interest rate (r = i − π e ).
LM
IS
0
Y1
Y0
r0
IS′
A
LM
IS
0
r1
Y
•
Y0
A
′
•
Y
LM′
IS′
Figure 7.6: Negative rates in the IS-LM model with real interest rate control
7.2 The IS-LM-PC Model
Even with the extensions described above, the IS-LM model describes the economy in the short term. However, our aim is to extend the model so that it also
takes into account the findings from Chapters 5 and 6, i.e. the scarcity of resources and inflation. With these aspects added, we can then analyze the economy in the medium term. In particular, it is then possible to answer a central
question of this textbook: Why does an economy always return to its production
potential in the medium term? We already know that expansionary fiscal and
monetary policy can raise GDP above the natural, structural level in the short
term. In the already familiar figure 7.7, this means that GDP is above the trend
line in the short term as a result of government intervention. In such a boom
phase, the following applies: Yt > Yn,t and ut < un . GDP is above the structural
level and unemployment is below it. Our aim now is to understand why this is
only a short-term development and why the economy will return to the trend
line in the medium term. To do this, we develop the IS-LM-PC model below.
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BIP
7 The Economy in the Medium-term
up
sw
boom
in
g
GDP
dow
ntu
up
s
w
in
g
rn
recessio
e
n
trendli
n
n
recessio
time t
Figure 7.7: Schematic representation of the development of GDP
7.2.1 Elements of the IS-LM-PC Model
As the name suggests, the IS-LM-PC model consists of three elements. We are
already familiar with two of them:
• IS curve: Y = C (Y − T ) + I (r + x ) + G
• LM curve: r = r0 = i0 − π e
We now develop the third element, the PC curve, where PC stands for Phillips
curve. We already know this Phillips curve from Chapter 6:
πt − πte = −α ∗ (ut − un )
(7.8)
If the unemployment rate ut is below the natural rate un , the inflation rate πt
rises above the expected level πte . However, in order to relate the change in the
inflation rate (left-hand side) to production, we need to change this equation
slightly. If we assume that there are LF people in the labor force, of whom N are
employed and U are unemployed, then N = L ∗ (1 − u), because u ≡ U/LF. If
we assume the simple production function Y = N (assumption A = 1), then we
obtain
Y = N = L ∗ (1 − u )
(7.9)
With Nn as the natural employment level, we obtain the production potential (or
natural production level) of the economy:
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7 The Economy in the Medium-term
Yn = Nn = L ∗ (1 − un )
(7.10)
The difference between the equations (7.9) and (7.10) results in
Y − Yn = N − Nn = L ∗ ((1 − u) − (1 − un )) = − L ∗ (u − un )
(7.11)
In this equation, we have used the expression Y − Yn to describe the so-called
output gap (output gap). This shows the deviation of actual production from
potential production. We reformulate equation (7.11) and obtain:
−1/L ∗ (Y − Yn ) = (ut − un )
(7.12)
We use this expression to replace (ut − un ) in equation (7.8) and obtain the PC
curve:
πt − πte = (α/L)(Y − Yn )
(7.13)
How is this PC curve to be understood? If production in an economy is above its
structural level (i.e. above its potential), the output gap is positive: Y − Yn > 0.
Equation (7.13) states that inflation is then higher than expected. In other words,
as soon as the economy’s GDP is above the structural level, inflationary pressure
arises. We can visualize the PC curve graphically as shown in Figure 7.8.
PC
change in inflation
πt − πte
•
0
Yn Y
Production Y
Figure 7.8: The PC curve
But where exactly does inflationary pressure come from? If unemployment is
very low, employees have a stronger negotiating position with companies. They
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7 The Economy in the Medium-term
therefore demand higher wages and are able to enforce them. Companies are
faced with high capacity utilization and demand and therefore pass on the increased wage costs to customers in the form of higher prices. As production can
hardly be increased in this situation of high capacity utilization, we end up with
a situation in which prices rise, i.e. inflation occurs.
7.2.2 Equilibrium in the IS-LM-PC Model
real interest r
We can now put the three elements together and create the IS-LM-PC model.
We do this by adding the PC curve from Figure 7.8 below the IS-LM model. As
the production (Y) is on the horizontal axis in both cases, we can combine all
three curves in one figure. The IS-LM-PC model is shown in Figure 7.9. The
equilibrium of the economy in the medium term is at point A0 : Both the goods
market and the financial market are in equilibrium and production corresponds
to the structural level (Yn ).
rn
A0
LM
•
A1
•
IS
Production Y
change in inflation
PC
A1
πt − πte
0
A0
•
•
Y1
Production Y
Yn
Figure 7.9: The IS-LM-PC model
In the medium term, the inflation rate corresponds to the expected inflation. As
can be seen in Figure 7.9, πt − πte = 0 in equilibrium. There is therefore no
inflationary pressure. The real interest rate rn in the medium-term equilibrium
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(point A0 ) is referred to as the natural or neutral real interest rate. The term
Wicksell’s real interest rate is also commonly used, as the Swedish economist
Knut Wicksell (1851–1926) showed that this interest rate is compatible with a
stable price level.
7.3 Economic Policy in the Medium-term
As in the IS-LM model for the short term, we can now use the IS-LM-PC model
to analyze how the economy reacts to shocks and economic policy measures. In
contrast to the IS-LM model, we also take into account resource constraints and
inflation. Once again, we use comparative statics as our approach. We change individual, exogenous variables (such as the money supply M or government consumption G) and analyze how the endogenous variables (such as GDP) change
as a result.
7.3.1 Monetary Policy in the IS-LM-PC Model
As a first application example for the IS-LM-PC model, we look at the effects of
expansionary monetary policy. Let us assume that an economy is in mediumterm equilibrium in the initial situation. This means Y0 = Yn , u0 = un , π0 = π0e
and r0 = rn . How high the structural GDP and the natural rate of unemployment
are depends on structural conditions, which we can ignore here.
Based on this situation, the central bank lowers the nominal interest rate i by
expanding the money supply Ms (it uses this newly created money to buy government bonds in open market operations, which lowers their implicit interest
rate). We are already familiar with the short-term effects of such an expansionary monetary policy from the IS-LM model. In the IS-LM-PC model, too, there
is initially no change in inflation expectations (π e initially remains constant).
Therefore, the real interest rate falls from r0 to r1 . As a reminder, i = r + π e
and since π e is constant, a fall in the nominal interest rate must be accompanied
by a lower real interest rate. The LM curve therefore shifts downwards and private investments I (r + x ) rise because r has fallen and the risk premium has not
changed. Due to the higher investments, the overall demand for goods increases.
Production and income are determined by demand (‘what is demanded is produced’) and must therefore also rise. However, in order to increase production,
additional labor is needed, which is why the unemployment rate u falls. The
multiplier effect already familiar to us from chapters 2 and 4 reinforces these results of expansionary monetary policy: higher incomes have a positive effect on
private consumption, which in turn stimulates the economy. The overall result
is a new equilibrium with higher GDP and lower unemployment. We depict this
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real interest r
graphically in Figure 7.10 as a movement from the original equilibrium point A0
to the new equilibrium at point A1 .
r0 = r n
A0
LM0
•
A1
r1
LM1
•
IS
Production Y
change in inflation
PC
π − πe
0
A1
A0
•
•
Y1
Production Y
Y0 = Yn
Figure 7.10: Expansive monetary policy in the IS-LM-PC model
It is worth explaining once again why exactly the economy is flourishing as a
result of the expansionary monetary policy in the short term. The expansion of
the money supply has reduced the real value of all monetary assets (such as
banknotes and savings). Basically, the central bank has redistributed real wealth
on a grand scale: from those whose assets have been devalued to debtors whose
liabilities have also been devalued. In addition, all those who receive some of
the newly created money supply benefit. This process can be visualized as the
central bank withdrawing a small proportion of all banknotes and savings from
the population and redistributing them. This initially has a similar stimulating
effect on the economy as if the holders of banknotes and savings were to put
their money into circulation themselves. Even relatively small increases in the
money supply (and, as we will see shortly, the inflation rate) can therefore have
an enormous stimulating effect.4
4 In Switzerland, the total amount of cash in circulation in 2020 was around CHF 90 billion and
sight and savings deposits totaled CHF 570 billion and CHF 340 billion respectively. Imagine
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7 The Economy in the Medium-term
The redistributive effect of inflation is basically the same if the state had levied a
tax on existing money and other assets. In concrete terms, the value of money is
measured by its scarcity relative to assets. In relation to the assets expressed in
monetary units, 3% is a considerable amount. This also explains the substantial
effect of inflationary policies.
The IS-LM-PC model therefore predicts the same result for expansionary monetary policy as the IS-LM model: the economy is flourishing, GDP has risen and
unemployment has fallen to a lower level. Where is the gain in knowledge over
what we already know from Chapter 4? We recognize in Figure 7.10 that the
economy is no longer in medium-term equilibrium. Production is above Yn , unemployment is below un and the real interest rate is also lower than the natural
real interest rate rn . As a result, Figure 7.10 shows that inflationary pressure
arises: π − π e > 0. The actual inflation rate is higher than the expected inflation
rate.
To a certain extent, the unexpectedly high inflation rate is also the cause of the
(short-term) booming economy. The central bank has created additional money,
which initially does not change the real supply of goods and assets. Simply
’printing money’ does not create any real value. However, those actors who
receive this newly created money can use it to increase the demand for goods.
For companies, this creates an incentive to expand production.
However, as we assumed that we were in medium-term equilibrium in the initial
situation (point A0 ), the factors of production were already fully utilized. The
unemployment rate was at its structural level, which is why, in simple terms,
an increase in production is only possible through excessive utilization of the
factors of production. For example, the labor force has to work overtime so that
production can be increased in the short term. However, as we already know
from the discussion in Chapter 5, this is only possible for a certain period of
time. In the medium term, employees will demand payment for overtime worked
and companies will react to the sustained high demand by raising prices. This
creates a wage-price spiral, which we will discuss in more detail below. It should
be noted that this can happen even though many people in the economy are
unemployed. The decisive factor is structural unemployment: if this is high, for
example due to high unemployment benefits or the market power of companies,
inflationary pressure arises even if the unemployment rate is relatively high.
From Chapter 6 we also know another explanation as to why inflation occurs
in this situation. The quantity equation states that an expansion of the money
supply leads to rising prices if the money supply (Ms ) has increased more than
if even just a few per cent of this were to be spent in the coming months. This would be
tantamount to a very strong increase in the demand for goods and would therefore have a very
stimulating effect on the economy.
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the supply of goods and services (Y) and there has been neither a decrease in the
velocity of circulation nor is the money being spent on other real assets. Since
the economy under consideration here was already highly utilized (Y = Yn in
the initial situation), the quantity equation also tends to predict a higher inflation
rate.
As we can see in Figure 7.10, GDP is above Yn as long as π e remains unchanged.
This is an attractive situation for companies, as their sales rise thanks to price
increases, but costs do not increase to the same extent if, for example, wage
increases are still based on lower expected inflation rates. However, if inflation
rises, inflation expectations (π e ) will also rise in the medium term and with them
the wage demands of employees. The inflation gains for companies are therefore
only of limited duration. But how exactly are inflation expectations formed in
the population? We can describe the process mathematically as follows
πte = (1 − θ ) ∗ π ∗ + θ ∗ πt−1
(7.14)
where the parameter θ is between zero and one (0 ≤ θ ≤ 1) and we use π ∗ to
describe the anchored inflation expectation. The latter is the inflation rate that
people have been ’used to’ for a long time. For example, inflation can be 1.5%
for years and then suddenly increase to 3.0%. According to the equation (7.14),
what inflation rate do people then expect for the coming year? They will attach
a certain weight to both the 1.5% and the 3.0%, as described by the parameter θ.
The higher this parameter is, the more weight is given to the current inflation
rate (i.e. the 3.0% in our example).
In the case of the expansionary monetary policy discussed here, there was a
short-term increase in GDP and a higher inflation rate in the medium term. What
happens now as soon as inflation expectations (π e ) in the economy increase? To
understand this, we distinguish between three possible scenarios. The decisive
factor is how the central bank reacts to the increased inflation rate and higher
inflation expectations. It had originally moved the economy from its mediumterm equilibrium (point A0 ) to a new equilibrium (point A1 ) with higher GDP
by expanding the money supply. However, since there is inflationary pressure at
this point, it must now distinguish between three options:
• The central bank controls nominal interest rates.
• The central bank steers real interest rates.
• The central bank controls inflation.
We will analyze these three cases in detail below.
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7 The Economy in the Medium-term
Scenario 1: The central bank controls nominal interest rates
real interest r
As soon as inflation expectations (π e ) have risen, the real interest rate falls further,
as i = r + π e and the central bank leaves the nominal interest rate (i) unchanged.
In Figure 7.11 we therefore see that the real interest rate has fallen to an even
lower level. This has a positive effect on private investment, which depends on
the real interest rate. As the increased investment demand leads to an increased
demand for goods (Z), production, GDP and thus income continue to rise: to
the level Y2 in Figure 7.11. Graphically, we move from point A1 to point A2
Economists say that the economy is “overheating” even more. It is even more
above its natural production potential and inflationary pressure (π − π e ) continues to increase.
r0 = r n
A0
LM0
•
A1
r1
r2
•
LM1
A2
•
LM2
IS
Production Y
change in inflation
PC
A2
π − πe
π − πe
0
A1
A0
•
•
•
Y1 Y2
Production Y
Y0 = Yn
Figure 7.11: Expansionary monetary policy in the IS-LM-PC model
How should we visualize this situation? Inflation rates are constantly rising in
the economy. However, as every increase in the inflation rate also leads to higher
inflation expectations, the real interest rate falls further and inflationary pressure
increases. This creates an economically very damaging wage-price spiral. This is
a self-reinforcing process in which an increase in the price level causes an increase
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in wages, which in turn leads to an increase in prices. Inflation expectations are
central to this process. Let us assume that the inflation rate was originally stable
at 1.5%. If it then rises to 3.0%, this leads to lower real wages: less can be
bought with a given amount of money due to higher prices. As the nominal
wage is typically only set annually, employees suffer a loss of purchasing power.
In response, they can demand that nominal wages be raised very sharply in the
following year. This can be justified in two ways: as compensation for the loss of
purchasing power suffered in the past and as a kind of insurance against a similar
situation in the future. However, if nominal wages are actually increased very
sharply, this leads to an increase in costs, which companies pass on to consumers
in the form of higher prices for goods. This increases the price level and the
process starts all over again.
In this way, the inflation rate increases with each round. The Phillips curve
continues to shift upwards. We described it in Chapter 6 with the equation:
πt = πte + (µ + z) − αut . As inflation expectations continue to rise, the economy
needs an ever higher inflation rate (π) in order to keep the unemployment rate
at a certain level. However, this ever-increasing inflation rate is economically
harmful. As explained at the beginning of chapter 6, inflation causes costs and
at very high inflation rates, money fulfills its functions less and less.
There are many real-life examples that illustrate this process. For example, according to data from the International Monetary Fund, the inflation rate in Argentina was relatively stable at around 9.5% between 2005 and 2013. However,
it then rose within a few years to 25.7% (in 2017), 34.3% (in 2018) and 53.6% in
2019. Turkey also experienced a comparable, albeit significantly faster, development. At the beginning of 2018, the inflation rate rose from around 10% to over
25% within just a few months. In an open economy with flexible exchange rates,
such developments are also associated with a sharp depreciation of the domestic
currency. Whereas in 2013 it took around five Argentinian pesos to buy one US
dollar, in 2019 it was already over fifty pesos. In the case of Turkey, the exchange
rate of the Turkish lira rose from 3.8 (lira per US dollar) to 6.4 in the period from
January to August 2018. We take a closer look at how such a development can
trigger a currency crisis in chapter 9.
Scenario 2: The central bank controls real interest rates
The IS-LM-PC model predicts that inflation will continue to rise if the central
bank steers nominal interest rates. Sooner or later, this will lead to money losing
its value completely. The central bank must therefore choose a different course
at some point. Hence, we now examine the case of real interest rate control. As
soon as inflation expectations (π e ) rise, the central bank must raise the nominal
interest rate (i) so that the real interest rate (r = i − π e ) remains unchanged.
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7 The Economy in the Medium-term
In Figure 7.10, the economy then remains at point A1 and the real interest rate
at level r1 (it does not fall to r2 as in the case of nominal interest rate control).
In principle, the central bank can also try to increase the real interest rate by
reducing inflation expectations. However, we are focusing here on the nominal
interest rate as an instrument. The central bank must therefore reduce the money
supply in order to raise the nominal interest rate (i). If i is raised in this way to
such an extent that the real interest rate is back at r1 < rn despite higher inflation
expectations (π e ), inflationary pressure remains (we remain at point A1 ).
The question arises as to whether this solves the problematic situation. To understand this, let us briefly recapitulate the developments. The economy was
originally in medium-term equilibrium (without inflationary pressure). Then the
money supply was increased, GDP rose above Yn , unemployment fell below un ,
inflationary pressure arose, the inflation rate increased, inflation expectations
rose and the central bank raised the nominal interest rate. As a result, the economy is at point A1 and inflationary pressure (π − π e ) persists. The inflation rate
will therefore continue to rise and, as a result, so will inflation expectations. With
each round, π e rises and the central bank must bring the nominal interest rate i
to a higher level so that the real interest rate remains at r1 and does not fall. The
economy is therefore by no means in a stable situation. Rather, we are observing
a spiral of rising inflation rates and ever higher nominal interest rates.
Examples of this situation can also be found in practice. In the case of Turkey
mentioned earlier, the inflation rate rose from around 10% to over 25% within
just a few months in 2018. The Turkish central bank countered this development
by raising the nominal interest rate from 7.25% in 2016 to 24% in September 2018.
Figure 7.12 shows the development of the interest rate and inflation rate (based
on the consumer price index) over time. Due to the measures taken by the central
bank, the inflation rate in Turkey fell to below 10% in the short term. But as the
IS-LM-PC model predicts, this does not end the inflation problem. In addition,
the Turkish central bank lowered the interest rate again due to political pressure
from President Recep Tayyip Erdoğan. As a result, the inflation rate rose again
to over 30% at the end of 2021.
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7 The Economy in the Medium-term
Figure 7.12: Rising rate of inflation in Turkey
Scenario 3: The central bank puts an end to rising inflation
Even real interest rate control does not end the negative spiral: The nominal
interest rate (i) and inflation expectations (π e ) continue to rise. Sooner or later,
the central bank will have to choose a different strategy. If we look at Figure 7.10
again, we can see what the central bank has to do to get the economy out of the
vicious spiral. It must raise the real interest rate to the original level rn . However,
since the real interest rate depends on both the nominal interest rate and inflation
expectations (i = r + π r ⇐⇒ r = i − π e ), and inflation expectations have risen,
the central bank must raise i above the original level i0 so that the real interest
rate rises to rn again. If it succeeds in doing so, investment will fall again and
GDP will return to Yn .
The longer the economy has been above Yn — i.e. the longer the boom caused by
the expansionary monetary policy has lasted — the more inflation expectations
have risen among the population. Accordingly, enormous efforts are needed to
bring the economy back out of the vicious spiral. Firstly, the central bank must
raise the nominal interest rate very sharply and secondly, it must credibly signal that it will pursue a less expansionary monetary policy in future. The latter
will help to reduce inflation expectations. Even if the central bank succeeds in
this, one finding remains: GDP will fall if the central bank wants to get inflation
under control. In the words of James Trevithick (“Inflation”, 1977, p.74f.): “An
inflationary binge will inevitably be followed by a deflationary hangover”. An
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7 The Economy in the Medium-term
inflationary exuberance will inevitably be followed by a deflationary hangover.
And as with a hangover caused by excessive alcohol consumption, it is best to
simply endure it: “The best thing to do with a hangover [...] is to endure it”.
Ronald Marcks (“Dying of Money”, 1974, p.48) also describes the necessity of
a painful recession: “Though it was always possible to dismount, it was never
possible to dismount painlessly. Every day that passed, appeasing the inflationary dragon with more inflation, increased the assured severity of the inevitable
medicine.”
However, it is not enough for the economy to return to medium-term equilibrium
at point A0 through a contractionary monetary policy. Although there is then no
longer any inflationary pressure (π = π e ), both the inflation rate (π) and inflation
expectations (π e ) are now higher than in the initial situation — i.e. before the
central bank increased the money supply for the first time. Mathematically, we
can summarize this as follows
rnbefore = i0 − π e = iafter − π e,nachher
(7.15)
The real interest rate is now back at the level rn , but only because the higher nominal interest rate compensates for the higher inflation expectations. The temporary
boom phase, in which GDP was above Yn , therefore has permanent consequences.
The level of inflation is persistently at a higher level — with all the associated
costs (see chapter 6). If the central bank wants to bring the inflation rate (π), inflation expectations (π e ) and the nominal interest rate back to the original level, it
must reduce the money supply further. If the real interest rate then rises above r0 ,
GDP falls below Yn and the inflation rate falls: π − π e < 0. As the inflation rate
is now below expectations, inflation expectations will also slowly fall. The longer
the inflation rate and thus inflation expectations have risen, the more the nominal
interest rate must be raised.
This very detailed discussion shows that a phase of boom caused by expansionary monetary policy comes at a substantial price. Inflation can only be brought
back to its original level through a sometimes very severe recession (in Figure 7.10
GDP falls from Y1 to below Yn ). This insight from the model can also be illustrated with data from practice. The best-known example comes from the United
States, where former Federal Reserve Chairman Paul Volcker (1927–2019) succeeded in reducing the inflation rate from 14.8% in March 1980 to below 3% in
1983 at the beginning of his term of office in the 1980s. To achieve this, the Federal Reserve raised interest rates from around 11% to over 20% in 1981. However,
as in the IS-LM-PC model, this success was not possible without a severe recession: US GDP fell by 0.3% in 1980, grew by 2.5% in 1981 and fell again by 1.8%
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7 The Economy in the Medium-term
in 1982. In order to understand why the term “Volcker shock” is used in this
context, the figures must be seen in the context of an average GDP growth rate of
3.2 to 5.5% in the years 1976 to 1979. The turnaround in monetary policy in the
USA not only plunged the USA into recession, but was also one of the causes of
the Latin American debt crisis.5
Switzerland experienced a similar development around ten years earlier. After
the collapse of the Bretton Woods system — in simple terms, an international
system of fixed exchange rates from the mid-1940s to 1973 — the Swiss National
Bank (SNB) gained greater freedom to pursue its own monetary policy.6 It used
the autonomy it had gained to drastically reduce the growth rate of the money
supply. As the SNB no longer had to ensure a fixed exchange rate, it was able
to reduce the growth of the money supply and allow the Swiss franc to appreciate. While the inflation rate subsequently fell significantly and the Swiss franc
appreciated considerably, the Swiss economy fell into a deep recession, as shown
in Figure 7.13. Real GDP fell by 7.3% in 1975 — as a result of monetary policy,
but also the oil shocks.
5 The interest rate hikes in the USA increased the attractiveness of investments in US securities
and therefore led to a strong appreciation of the US dollar (see interest rate parity in Chapter 8).
However, many Latin American countries had borrowed in dollars and from then on had to
pay these debts with higher amounts in local currency. In addition, banks came under pressure
as their balance sheets, which were denominated in local currency, had to value loans higher
after the dollar appreciation. This reduced their equity and drove many banks into bankruptcy.
6 Ernst Baltensperger and Peter Kugler describe the developments in detail in their 2017 book
“Swiss Monetary History since the Early 19th Century”, page 106–112.
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7 The Economy in the Medium-term
Figure 7.13: Monetary policy and the end of inflation in Switzerland
The experience of the 1970s and 1980s teaches us something obvious: expansionary monetary policy does not generate real wealth. At best, central banks can
create good framework conditions. And they do this primarily by providing a
well-functioning currency (i.e. money with a stable value). An excessive increase
in the money supply may appear beneficial in the short term, but the gains are
short-lived. Partly because of these insights, central banks have essentially replaced money supply and interest rate management with inflation management.
The central consideration here is that the inflation rate is determined indirectly by
interest rate policy. Figure 7.14 illustrates how monetary policy exerts its effect
via a series of links.7 Economists speak of a transmission mechanism when they
explain how monetary policy decisions ultimately affect the economy.
7 The figure is based on a similar illustration in the book “Macroeconomics” by David Miles,
Andrew Scott and Francis Breedon.
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7 The Economy in the Medium-term
Interest Rates
Domestic Demand
Share Prices
Total Demand
Monetary Policy
Expectations
Domestic
Inflationary
Pressure
Inflation
Net Foreign
Demand
Import Prices
Exchange Rates
Figure 7.14: Transmission mechanism of monetary policy
Monetary Policy with the Taylor Rule
What conclusions can be drawn from the above about the consequences of an
expansionary monetary policy? The central bank increased the money supply on
the basis of a situation in which the economy was in medium-term equilibrium.
As a result, the inflation rate rose and a return to the original inflation rate was
only possible through a recession. In practice, central banks pursue several objectives, including monetary stability and stable economic growth. In Switzerland,
the Federal Constitution mandates the National Bank, as an independent central
bank, to conduct monetary policy in the interests of the country as a whole (Art.
99 BV). This mandate is specified in the National Bank Act (Art. 5 para. 1) and
entrusts the National Bank with the task of ensuring price stability while taking account of economic developments. According to its own presentation, the
SNB equates price stability with an increase in the national consumer price index
(CPI) of less than 2% per year.
This mandate can be understood to mean that the central bank should support
the economy in times of recession. During such a phase, GDP is below Yn (see
graph 7.7 on page 213) and the inflation rate is also low. In this situation, the
central bank should lower the nominal interest rate through an expansionary
monetary policy and thus promote economic development. Conversely, monetary policy should be designed in such a way that it has a dampening effect in
boom phases: if GDP is above Yn and inflation is above the target, the central
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bank should raise interest rates.
A very well-known approach to monetary policy that follows these ideas is the
Taylor rule, which is named after the American economist John Brian Taylor
(*1946).8 In a study presented in 1993 (“Discretion versus policy rules in practice”), he established the following mathematical rule for the central bank:
it = rt + πt + a(πt − π ∗ ) + b(Yt − Yn,t )
(7.16)
The central bank chooses the nominal interest rate it in year t depending on
the real equilibrium interest rate rt , the current inflation rate πt (relative to the
target rate π ∗ ) and the current GDP (relative to GDP on the long-term trend
Yn,t ). The parameters a and b determine how much value the central bank places
on monetary stability and economic growth. In the 1993 study, Taylor simply
assumed the values a = b = 0.5. Note that it should be raised by more than one
percentage point if πt rises by one percentage point.
Surprisingly, this simple rule describes very well how high the actual interest rate
in the USA is. Figure 7.15 shows this very impressively, with the federal funds rate
(key interest rate) corresponding to the short-term nominal interest rate. While
the details of the equation (7.16) have been refined over the years, it remains the
case that the US Federal Reserve has orientated itself towards this model and the
ideas behind it since the 1980s. The situation was problematic both during the
global financial crisis of 2007/2008 and the coronavirus crisis of 2020: according
to the Taylor rule, the interest rate should have been set below zero. However,
the US Federal Reserve left it at marginally positive interest rates.
8 The European “equivalent” to this is the so-called Orphanides rule.
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7 The Economy in the Medium-term
Figure 7.15: Taylor Rule and actual monetary policy in the USA
In the medium term, the central bank must bring inflation to a targeted, moderate
level in accordance with its mandate. The Taylor rule is one approach to this.
However, the independence of the central bank from the respective government
is important for this. If the economy is in a boom phase, it is politically and in
the short term not very attractive to raise interest rates and thus ’cool down’ the
economy. In the words of the former head of the US Federal Reserve, William
McChesney Martin: “The Fed’s job is to take away the punch bowl just when the
party gets going”.
Of course, even with formally independent central banks, governments usually
have some influence. The aim of independence is primarily to avoid short-term
influence for electoral reasons. In 1951, the German Bundesbank was the first central bank to be granted full independence. Particularly in the 1980s and 1990s,
the idea of central bank independence gained popularity due to high inflation
rates. Empirical analyzes such as those by Alberto Alesina and Lawrence Summers (Journal of Money, Credit and Banking, 1993) indicated that countries with
a more independent central bank had lower inflation rates. But how independent central banks really are today can be critically questioned. In particular, the
strong consideration given to the reaction of the financial markets can lead to the
thesis that monetary policy is determined by people who have money. Although
the primary task of central banks is to ensure price stability, history casts doubt
on this. “The historical reason for the existence of central banks”, wrote Gerald
P. O’Driscoll Jr. in 2012, is “the financing of budget deficits”. One example is
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the Bank of England, which was founded in 1694. In the 17th century, Charles II
(1630–1685) had not repaid the loans of his bankers. A few years after Charles’
reign, from 1660 to 1985, King William III (1650–1702, King 1689–1702) devised a
system to raise £120’000. To this end, the Bank of England was founded, capital
of the said amount was raised and the bank was authorized to issue notes of the
same amount, which were then lent to the king (Gerald P. O’Driscoll Jr., Why
do we need central banks?, 2012, p.94). This is reminiscent of so-called “fiscal
dominance” today. This describes a situation in which fiscal policy determines
monetary policy. In order to avoid state bankruptcy, the central bank is forced
to support state budget deficits with low interest rates and an expansion of the
money supply.9
7.3.2 Fiscal Policy in the IS-LM-PC Model
Now that we have looked in detail at the short and medium-term effects of monetary policy in the IS-LM-PC model, we need to analyze fiscal policy. The state
can influence the economy in the form of government spending (G) as well as
taxes and transfer payments (T). As a concrete example, we choose a permanent,
credit-financed increase in government consumption from G0 to the level G1 .
How does this economic policy measure affect the economy in the short and
medium term? 10
Let us assume that the economy is originally in medium-term equilibrium. That
is, GDP is at Yn , the unemployment rate is at un and the real interest rate is at rn .
In Figure 7.16, the economy is at point A0 . The increase in government spending G increases the total demand for goods (Z) at any given real interest rate.
Therefore, the IS curve shifts to the right and both income and production (both
labeled Y) increase. Whether the real interest rate also increases depends on
whether the central bank reacts to the increased demand for money (which increases with income Y) with an increased or unchanged supply of money. In
the following, we assume real interest rate control, so that the central bank initially keeps the interest rate at rn by increasing the supply of money. Overall, the
economy thus moves from point A0 to point A1 due to the expansionary fiscal
policy.
9 Further historical examples of the role of central banks in financing states can be found in the
book “Das Inflationsgespenst” by Thomas Mayer, published in 2022.
10 The distinction between tax-financed and credit-financed financing of additional government
spending is important: we consider the credit-financed case, as a loss of demand on the part of
consumers would have to be taken into account if taxes were increased.
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real interest r
7 The Economy in the Medium-term
r1
r0 = r n
A0
A1
•
LM0
•
IS′
IS
Production Y
change in inflation
PC
A1
π − πe
0
A0
•
•
Y1
Production Y
Y0 = Yn
Figure 7.16: Expansive fiscal policy in the IS-LM-PC model
In the new equilibrium, GDP is at a higher level than before (Y1 > Y0 ). Since
the production factors of the economy were already fully utilized in the original
equilibrium — we were in medium-term equilibrium — inflationary pressure
arises. In Figure 7.16 we see that at point A1 applies: π − π e > 0. The additional
government spending has created additional demand, which leads to an overutilization of the factors of production. While the expansionary fiscal policy thus
has a positive effect on the economy in the short term, the same problem arises
in the medium term as with the expansionary monetary policy discussed above:
inflation occurs.
As long as the economy is at point A1 and GDP is above Yn , the inflation rate
rises. As inflation expectations (π e ) are also constantly increasing, the economy
finds itself in an inflation spiral. There are several ways out of this predicament.
Firstly, the government can reduce government spending G again. In this case,
the IS curve shifts back to its original level and GDP also returns to its natural
level. However, the inflation rate will be higher than before if inflation expectations have already increased: π − π e is again equal to zero at point A0 . If
this is the case, the government would have to temporarily reduce government
spending G below the original level in order to bring the inflation rate back to
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the original level. It therefore takes another recession for the inflation rate to be
reduced to the original level. This is no different if we look at an alternative way
to get out of the inflation spiral. The central bank can raise interest rates so that
the real interest rate rises to the level r1 . As can be seen in Figure 7.16, GDP in
the economy then returns to its natural level. It should be noted that the following applies: i = r + π e . If inflation expectations have risen, the central bank
must raise the nominal interest rate i accordingly. If the central bank succeeds
in raising the real interest rate to r1 , GDP is Yn again. Because the additional
government spending does not increase potential output (Yn ), private investment
is completely crowding out. Formally, this means: ∆G = −∆I. This changes the
composition of GDP (Y = C + I + G): the state takes on a larger role in the
economy at the expense of the private sector.
7.4 Discussion of Economic Policy
The effects of expansionary fiscal and monetary policy must be assessed differently in the medium term than in the short term. They create additional demand,
which has a positive effect on GDP. However, we must bear in mind the resource
constraints. If expansionary policies cause GDP to rise above the natural level,
the inflation rate increases. As we have seen, it is only possible to subsequently
reduce the inflation rate again by accepting a recession.
This creates a new perspective on economic policy. With the extensions to the
IS-LM model, we can now better analyze the effects of expansionary policy. The
problem of a higher inflation rate adds to the list of disadvantages already familiar to us from Chapter 4. We must also consider the incentives of economic policy
makers. If the economy is doing badly, it is politically very attractive to adopt
stimulative measures. In a boom phase, however, restrictive measures are very
unpopular. This results in an asymmetry that can lead to a long-term increase in
government debt.
However, the economic impact of additional government demand also depends
on where the government spends additional money. A key assumption in our
analysis in this chapter was that an increase in G has no impact on Yn . However,
it can be argued that investments in education or infrastructure, for example, increase potential output. From Chapter 5 we already know the variable A, which
describes the productivity of the labor force. If the government succeeds in increasing this through additional government spending, the structural unemployment rate falls and the natural production level increases (Yn = A ∗ L ∗ (1 − un ),
see equation (5.11) on page 158). In this case, economists speak of a supplyoriented economic policy, the aim of which is not primarily to increase the de232
7 The Economy in the Medium-term
mand for goods, but to increase the production potential (i.e. the medium-term
supply of goods).
Another important aspect in the economic assessment of expansionary fiscal and
monetary policy is the starting position. In both of the examples discussed above,
we have assumed that the economy was originally in medium-term equilibrium.
In this case, an increase in the money supply or additional government spending
leads to higher inflation. However, it is worth recalling the historical background
of the theoretical framework. The central assumptions on which the IS-LM model
is based go back to John Maynard Keynes. He published the book “General
Theory of Employment, Interest and Money” in 1936. As in his other works,
Keynes deals with the prevailing problems (in each case). When inflation was
the pressing problem about a decade earlier, he devoted himself to this topic.
But as a result of the Great Depression in the 1930s, underemployment and weak
economic growth were the predominant problem. He therefore shows that in
this situation expansionary monetary and, above all, fiscal policy can increase
economic growth and thus reduce unemployment. The fact that the measures he
advocates can lead to inflation should not be criticized per se. As Ronald Marcks
(“Dying of Money”, 1974, p.162) writes: “Monetary inflation is a legitimate tool
of economic management. It has some good effects and some bad ones. Instead
of being taken as a matter of emotion, monetary inflation should be evaluated
dispassionately like any medicine for its good effects and bad effects in particular
circumstances. This medicine is proper when its good effects will do more good
than its bad ones harm. [...] Like a dose of cocaine, one calls for inflation when
the situation demands, but not usually for a mild tummyache.”
While the positive effects of expansionary fiscal and monetary policy materialize
quickly, the many negative consequences only follow after some delay. The latter
include inflation and other consequences. In the short term, it is advantageous to
save many companies in a recession. However, economic policy means that not
only ’healthy’ companies are saved, but also those which, from a macroeconomic
perspective, would be better off going bankrupt. In this case, economists speak of
the ’cleansing effect’ of recessions and creative destruction. Without this, many
resources and workers continue to be deployed in companies where they are
relatively unproductive — while at the same time they are lacking in up-andcoming industries. As a result, wage and economic growth will be lower in the
medium term.11
11 The marginal productivity of capital will also be lower. Therefore, the argument that the ’natural’
interest rate is very low today should be viewed critically: this may also be partly the result of
economic policy.
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Practice box 7.1: Which instrument should be chosen?
We have already seen in Chapter 4 that, in principle, both expansionary fiscal and monetary policy can stimulate an economy. In practice, the question often arises as to which
instrument should be favored. In the wake of the 2008 financial crisis, many argued that
monetary policy was the instrument of choice. This was because many countries were
already heavily indebted and an overly expansive fiscal policy could lead to doubts about
the financial stability of the countries. The essay “Growth in a time of debt” by Carmen
Reinhart and Kenneth S. Rogoff, published in 2010, attracted particular attention. In it,
the thesis was put forward that economic growth would be greatly reduced if government
debt rose to over 90% of GDP. With reference to this work, a so-called austerity policy was
often pursued in which government debt was to be limited. However, further analyses,
including those by Thomas Herndon, showed that there is no clear empirical link between
government debt and economic growth. In addition, the results of Reinhart and Rogoff
were based on incorrect Excel tables.
Based on these studies, the negative consequences of austerity policies and years of highly
expansionary monetary policy, many economists then saw the need for fiscal policy during
the coronavirus crisis in 2020. Some also argued in favor of a combination of the two
instruments: expansionary fiscal policy financed by an expansion of the money supply.
However, we already know from Chapter 6 why this can lead to high inflation. Ultimately,
expansionary fiscal policy does not remain favorable even when interest rates are low,
as the resources used for this are no longer available for other purposes. The American
economist John Cochrane summarized this with the words, “Spend as if you have to pay
it back. Because you do.”
So should the state or the central bank now stimulate the economy with expansive fiscal and monetary policy? Economists see a number of trade-offs in the
answer and therefore answer with ‘it depends’. In a sense, the state stabilizes
an economy anyway, in that government spending and revenue automatically
respond to the business cycle. Economists therefore speak of “automatic stabilizers”. For example, if the unemployment rate rises, the state collects less income
tax and at the same time increases transfer payments (without changing policy).
In a recession, in which resource utilization is low, expansionary economic policy
can also stimulate the economy without generating inflationary pressure. The situation is different in situations with high resource utilization. In the model, the
decisive factor is therefore whether GDP is below or above Yn . In practice, however, it is not clear where exactly the natural production level (Yn ) of an economy
lies. Economists therefore estimate the so-called output gap:
output gap = Yt − Yn
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(7.17)
7 The Economy in the Medium-term
It should be noted that the reference value — potential output Yn — can be very
low due to structural deficits in the economy. Based on OECD data, this output
gap is shown for a number of selected economies in Figure 7.17. It can be seen
that Switzerland, Germany and the USA were close to their production potential
before the coronavirus crisis. In the case of Spain, on the other hand, we also see
an output gap of zero, although the unemployment rate in 2020 was around 14%.
This indicates that the structural factors on the labor market there are leading to
high structural unemployment.
Figure 7.17: Output gaps in selected countries
Another relevant insight from the discussion of the IS-LM-PC model concerns the
importance of inflation expectations. We have seen their important influence and
recognized that they make it more difficult to control inflation if they are not (or
no longer) firmly anchored. This shows once again that psychology also plays a
substantial role in the economy. This observation also emphasizes the importance
of an independent and credible central bank. If, for example, after years of high
money supply growth and inflation rates, a central bank announces that it will
make its monetary policy more restrictive in future, inflation expectations will
only fall (or fall faster) if this announcement is credible. The reputation of a
central bank is therefore of great value.
As a final point, it is important to distinguish between demand and supply
shocks when applying the IS-LM-PC model. As we have seen, inflationary pressure arises when the level of output Y rises above the natural level (Yn ). This can
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be caused either by too much demand (as in the case of expansionary monetary
or fiscal policy when resources are fully utilized) or by a fall in supply. In practice, the latter can be caused, for example, by an interruption in supply chains or
a shortage of energy.
7.5 Alternatives to the IS-LM-PC Model
In this textbook we have used the IS-LM model for analyzing the economy in
the short run and the IS-LM-PC model for the medium run. However, these
two models are not the only explanatory approaches. In particular, the AD-AS
model (for aggregate demand-aggregate supply) is frequently used for the medium
term. This is a model that is very similar in terms of its basic economic ideas,
which is why we will not go into more detail here. However, it differs both
in terms of the graphical representation and the formal derivation. Based on
our previous considerations, however, we can understand the logic of the ADAS model. Essentially, there are also two curves here. The AD curve describes
aggregate demand and shows all combinations of price level (P) and GDP (Y) in
which both the goods and financial markets are in equilibrium. The AS curve
shows the supply of firms at each price level. A distinction is made between
the flat left and the steep right part: the former describes the short-term supply
curve (short-run aggregate supply or SRAS for short), while the latter represents
the long-term supply (long-run aggregate supply curve, LRAS for short). We see
the AD-AS model illustrated in Figure 7.18.
P
P0
AS
A
•
AD
Yn
Y0
Y
Figure 7.18: The AD-AS model
The essence of the model can be described as follows. As long as the GDP of the
economy is below Yn , the means of production are underutilized. This means
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that some people are unemployed and existing machines would allow higher
capacity utilization. In this situation, an increase in demand — graphically a
rightward shift of the AD curve — leads to an increase in production (= GDP)
without causing inflation.12 However, as soon as the natural GDP is reached or
exceeded, additional demand leads to rising prices.
7.6 Summary
In this chapter, we have developed the IS-LM-PC model to analyze the economy
in the medium term. As we have seen, an economy returns to its production
potential in the medium term. In this period, the output gap is closed and the
inflation rate is stable. The assessment of economic policy measures — such as
expansionary fiscal or monetary policy — depends on both the initial situation of
the economy and the time horizon used. If GDP in an economy is already close
to its structural potential, purely demand-led policy measures will lead to higher
GDP, but also to rising prices. As we have seen, an inflation rate increased in this
way can only be reduced again with negative side effects. This observation emphasizes the importance of structural aspects of an economy and its production
potential.
We have already provided initial answers to the question of how economies can
increase this potential with regard to chapters 5–7 (or more specifically equation (5.11)). The natural production level Yn depends, among other things, on the
intensity of competition (specifically the price premium µ). The more companies
compete with each other on the goods market, the lower the natural rate of unemployment and the higher the medium-term production level. This realization
from the model was described by the former Minister of Economics and Chancellor of the Federal Republic of Germany in 1957 in his book “Wohlstand für alle”
with the words: “prosperity for all and prosperity through competition belong inseparably together; the first postulate characterizes the goal, the second the path that
leads to this goal.” In addition to competition, we have also seen the importance
of productivity (A) and the labor force potential (LF). We will examine these two
factors in more detail in Chapters 10 and 11. Before that, however, we turn to
another topic. So far we have only looked at the closed economy. In the following
two chapters, we will look at economic activities across national borders.
12 Both expansionary fiscal and monetary policy increase the overall demand for goods and there-
fore shift the AD curve to the right. The AS curve, on the other hand, is shifted if, for example,
the available labor force or the physical capital changes.
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Part III
The Open Economy
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8 The Open Economy
So far, we only looked at a closed economy. The reason for this is that it allowed us to understand a number of important macroeconomic aspects without
having to deal with the complexity of foreign trade. However, trade with other
countries plays an important role for almost all countries. Especially for smaller
nations like Switzerland, economic transactions with other countries are of great
importance. Consumers can choose between domestic and foreign products and
services on a daily basis. In addition, companies decide where to set up their
production facilities, while employees decide in which country they offer their
labor.
In order to analyze the central macroeconomic issues in an open economy, in
Chapter 8 we look at international trade, the balance of payments, exchange
rates, purchasing power and interest rate parity. We then extend the IS-LM model
to include exports and imports in Chapter 9. This then serves as an analytical
framework for a discussion of economic policy in the open economy.
8.1 Dimensions of Openness
An open economy is characterized by cross-border transactions on the goods,
financial and factor markets. Firstly, this means that goods and services are
traded internationally: There are exports and imports. Secondly, financial flows
between countries are possible. For example, people can invest their money
abroad or companies can receive loans from foreign investors. And thirdly, it is
possible for people to emigrate to other countries and offer their labor there. In
addition to migration, technologies and ideas as well as physical capital in the
form of machines are also internationally mobile.
The increasing openness of countries to such transactions across borders is referred to as globalization. Economists at the Swiss Economic Institute (KOF)
at the Swiss Federal Institute of Technology (ETH) in Zurich calculate the international integration of all countries based on numerous variables. These in239
8 The Open Economy
clude global trade in goods as well as international tourism and cross-border
exchange in research and education.1 According to this data, Switzerland is the
most globalized nation in the world, followed by the Netherlands and Belgium.
As Figure 8.1 shows, Germany (ranked 6th out of 196) and the USA (ranked
25th) are also among the countries with strong international ties. We can also see
that globalization accelerated particularly after the fall of the Soviet Union in the
early 1990s. However, the process has slowed noticeably since the financial crisis
of 2008.
Figure 8.1: Globalization index since 1970
The individual aspects of an open economy are partly interdependent. Without
the ability to exchange currencies against each other, for example, cross-border
trade in goods and services is hardly possible. The migration of labor also plays
an important role for companies that want to sell their products internationally.
In this textbook, we focus primarily on the short and medium term when discussing the open economy. Therefore, we will focus in particular on open goods
markets — trade in goods and services (including tourism) — and open financial
markets. In the latter case, the focus is on international financial investments
and foreign exchange trading (buying and selling foreign currencies). Aspects
that influence macroeconomic development in the long term will be dealt with
1 The details of the variables used, the methodology and the data sources can be found in the
study “The KOF globalization Index - Revisited” published in 2019 in the Review of International
Organizations by Savina Gygli, Florian Haelg, Niklas Potrafke and Jan-Egbert Sturm.
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in chapters 10 and 11. These include, in particular, open factor markets, i.e. topics such as labor migration, foreign direct investment (FDI) and the exchange of
technologies.
8.2 International Trade
Perhaps the most important aspect of an open economy is the international trade
in goods and services. Container ships such as the HMM Megamax class launched
in 2020 with almost 24,000 containers (volume of 38 cubic meters each) shape the
image of globalization. However, a look at the data shows that global trade has
stagnated since the financial crisis in 2008. According to the World Bank, all
global exports of goods and services amount to around 30% of global GDP. If all
exports and imports are added together and divided by GDP, the result is the
foreign trade ratio (also known as the degree of openness). This amounted to
around 60% worldwide in 2019, around 120% in Switzerland, 88% in Germany
and around 26% in the USA. The absolute trading volume has also stagnated
since 2018, as the CPB from the Netherlands shows.
Figure 8.2 illustrates that globalization was already taking place over a hundred years ago. In the wake of the Industrial Revolution and the invention of
steamships, the volume of international trade increased significantly. In 1913, the
world was as globalized as it was in 1974. The two world wars and protectionism in the 1930s are clearly recognizable in Figure 8.2. From the mid-1970s until
the financial crisis, the volume of global trade rose sharply. This globalization
was driven in particular by improvements in information and communication
technology, the development of standardized containers and the political liberalization of trade in goods and services as well as cross-border investments. This
development only came to an end with the financial crisis of 2008. Since then,
trade has no longer grown faster than global GDP.
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8 The Open Economy
Figure 8.2: Historical development of international trade
However, the volume of trade continues to rise, albeit not as strongly as between
2000 and 2008, as shown in Figure 8.3 based on the World Trade Monitor. Price
changes (e.g. for oil) and exchange rate changes are factored out so that we can
see the actual trade volume. The two slumps during the financial and COVID-19
crises are striking in Figure 8.3. International trade usually falls more sharply
than GDP during recessions. This is because durable goods such as cars and
energy (e.g. oil) account for a large proportion of trade and are pro-cyclical.
Demand for these goods therefore falls disproportionately sharply during recessions.
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8 The Open Economy
Figure 8.3: Development of trade since the year 2000
As a relatively small economy, foreign trade is of great importance for Switzerland. Compared to Germany or the USA, the high proportion of exports and
imports in relation to GDP is striking. As we have already seen in Table 1.1 on
page 42, the sum of Swiss exports and imports (CHF 522 + 435 billion in 2021)
is even greater than GDP (CHF 732 billion). This is possible because some imports are processed and exported again. While Figure 8.2 shows a global average
of around 45% (= 2x22.5%), foreign trade in Switzerland amounted to 119% of
GDP in 2021. In contrast, the figures for Germany (88%) and the USA (26%) are
significantly lower.
If we look at Swiss foreign trade in detail, we can distinguish between trade in
goods and services and between exports and imports. Overall, it can be seen
that Swiss foreign trade has increased significantly over the last twenty years. In
addition, the numbers from Figure 8.4 show that trade in goods (even excluding
precious metals) is around twice as large as trade in services. It is also noticeable
that Switzerland has had an export surplus for years. The country therefore
exports more than it imports. We will discuss whether this is advantageous later
in the chapter.
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Figure 8.4: Development of Swiss foreign trade
The figures on globalization and international trade considered so far raise a
number of questions. Why was there a wave of globalization in the 1990s and
early 2000s? What were the causes of the slowdown since 2008? How can the
developments be categorized historically? And what impact does global trade
have on the population? We will analyze these and other questions in more
detail below.
8.2.1 Brief History of International Trade
The first references to ’international’ trade date back thousands of years. A study
by Jan David Bakker, Stephan Maurer, Jörn-Steffen Pischke and Ferdinand Rauch
published in the Review of Economics and Statistics in 2021 shows that the effects
of trans-regional trade in the Mediterranean region can already be traced back
to the Iron Age (around 750 BC). These observations lead to the conclusion that
there has always been an incentive for international (or interregional) trade. Since
this exchange of goods is voluntary, it is clear from an economic perspective what
the driver is: the profit from trade. Specifically, we can state that international
trade is always motivated by arbitrage opportunities: if it is possible to buy (or
produce) something cheaply in one place and sell it at a higher price elsewhere,
there is an opportunity for arbitrage. However, utilizing this is associated with
expenses. Transport, customs duties and similar political barriers cause costs. If
it is nevertheless profitable to buy (or produce) a good in one place and sell it in
another country, international trade takes place.
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For a long time, trade over large geographical distances was too expensive due
to limited technical possibilities. However, there were important trade routes
early on, but they were mainly used for trading luxury goods. To be more precise, these were ordinary, simple goods in their countries of origin. However, as
the transport was so complex and expensive, only wealthy people could afford
these goods in the destination country. Examples include spices from Asia, such
as pepper. However, the trade routes known today did not only bring valuable
goods to Europe. In the book “A Splendid Exchange”, published in 2008, William
Bernstein explains how the bacterium Yersinia pestis came to Europe via Mongolian trade routes from the Far East. Between 1346 and 1353, the Black Death (the
plague) claimed an estimated 25 million lives, around a third of the population
at the time.
This example shows that the various dimensions of openness — as already mentioned — cannot be clearly separated from each other. The trade in goods is also
linked to currency trading, a certain degree of migration and reciprocal financial
flows. These diverse links have both advantages and disadvantages. Both have
intensified significantly in recent centuries as the barriers to international trade
have been gradually reduced. On the one hand, there was a move away from mercantilism, i.e. the political idea that international trade was primarily valuable
due to the revenue earned from exports (which was used for military purposes).
In particular, the ideas of Adam Smith and David Ricardo (British economist,
1772–1823) demonstrated the true benefits of trade and underpinned political
liberalization well into the 21st century. In addition, new technical achievements
such as the steamship or the Suez Canal, which opened in 1869, reduced the costs
of international trade in goods.2
Since the 1980s, the new information and communication technology (also known
as the ICT revolution) has enabled companies to increasingly operate globally and
bring production processes from rich to poorer countries. In this way, they lowered production costs and, in a sense, created the arbitrage opportunities that
motivate international trade. In addition to the new technical possibilities, however, a series of political liberalization waves were also necessary so that companies could globalize their production through outsourcing and offshoring. As part
of the General Agreement on Tariffs and Trade (GATT), tariff barriers and other
political hurdles were repeatedly lowered from 1948 onwards. Both the so-called
Tokyo Round and the Uruguay Round (1973–1979 and 1986–1994, respectively)
2 In particular, transport by sea is very cheap today, even for intercontinental deliveries, due to
gigantic container ships and the relatively low energy costs of a few cents per kilogram due
to physical factors. In contrast, the much faster transport by plane costs two to three dollars
(Financial Times, Suez Canal/supply chains: stuck ship sinks trade flows, 24 March 2021).
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led to a significant reduction in global tariffs, as illustrated in Figure 8.5.3
Figure 8.5: Worldwide average tariff 1870–2000
When looking at the last two hundred years in Figure 8.3, however, in addition to the general increase in world trade, the sometimes severe slumps are
also noticeable. These are mostly due to political developments. The two world
wars in the first half of the 20th century, together with the economic depression
and increasing protectionism, led to global trade in terms of GDP being roughly
halved. In the 1970s and 1980s, the oil crises weighed on global trade and in
2009 and 2020, the major slump was linked to the global financial and COVID-19
crises. There are a number of reasons for the stagnation in globalization that
has persisted for over ten years. Firstly, there are the one-off effects, such as
China’s accession to the World Trade Organization (WTO) in 2001, and liberalizations within the WTO have not been successful since the Uruguay Round. The
so-called Doha Round from November 2001 is considered a failure. Instead of
broad liberalization, we are now seeing hundreds of bilateral and multilateral
free trade agreements. However, these only reduce political trade barriers for
the nations involved. Economists such as Dani Rodrik (Journal of Economic Perspectives, 2018) also criticize the complexity of free trade agreements. As they
now cover a wide range of topics - from the protection of intellectual property to
environmental protection - the actual idea of trade liberalization is increasingly
3 The graph is based on Silvia Nenci (The World Economy, 2011) and uses data from Brian R.
Mitchell (1992) as well as John H. Coatsworth & Jeffrey G. Williamson (2002).
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receding into the background. This development is combined with a new form
of protectionism: particularly since the global financial crisis, numerous governments are trying to support their domestic economies with non-tariff trade barriers. In addition to subsidies, these include awarding public contracts exclusively
to domestic companies. Such political measures contradict the promise made by
the heads of state and government at the first G20 meeting in November 2008:
“We will not repeat the historic mistakes of protectionism of previous eras”. The
comprehensive data from the Global Trade Alert shows, among other things, that
politicians have not honored this promise. In addition, the trade dispute between
China and the USA has significantly impaired the most important bilateral trade
relationship (trade volume of around 550 billion dollars, around 3% of global
trade).
8.2.2 Trade Theory
Economists have been trying to better understand the causes and effects of international trade for a long time. From today’s perspective, the most relevant contributions to trade theory are based on the framework outlined above: International
trade is motivated by arbitrage (price differences) and constrained by political as
well as technical barriers. The utilization of arbitrage opportunities consists of
buying or producing goods in one country and selling them in another. The
selling price must be higher than the cost, which includes the purchase price or
production costs as well as the trading costs. Trade economists summarize all
costs incurred in international trade under trade costs. These include transport
costs (including insurance), customs duties and other levies, information costs,
contract costs and currency costs. As James E. Anderson and Eric van Wincoop
(Journal of Economic Literature, 2004) and current data from the World Bank show,
the average bilateral trade costs are around 170% of the value of goods.
As the costs of international trade are still considerable, high price differences
are required for it to be worthwhile at all. Trade theories offer different explanations for the emergence of such price differences. David Ricardo provided
the most important approach in 1817 with his book On the Principles of Political
Economy and Taxation: the Ricardian theory of trade. Countries differ in terms
of their productivity in the production of various goods. Due to favorable climatic conditions, bananas, for example, can be produced very cheaply in Costa
Rica. Although it is also possible to produce bananas in Switzerland, this will
only be possible at considerably greater expense. In addition, the resources used
for this in Switzerland (labor, machinery, land, energy) have alternative uses. As
Switzerland is very productive in the production of other goods, it would be
worthwhile foregoing domestic banana production and trading with Costa Rica
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instead. David Ricado went one step further and showed that specialization and
international trade also increase prosperity if a country has lower productivity
in every good than a partner country — economists then speak of an absolute
disadvantage in all goods. However, it is not the absolute but the comparative
advantages that are decisive. Even if Switzerland could produce every product
more cheaply than Costa Rica, the opportunity costs must be taken into account:
Each production of a good consumes resources that are no longer available for
the production of other goods.4
Table 8.1 illustrates the logic of David Ricardo’s trade model. Switzerland has
a comparative advantage in the production of cheese: it forgoes 1.2 kilograms
of cheese when it produces bananas, while Costa Rica only has to forgo 0.89
kilograms. If both countries specialize according to their comparative advantage,
total production is higher than without trade: 2,200 kg of cheese instead of 2,000
kg and 2,125 kg of bananas instead of 2,000 kg.
without trade
Schweiz
Costa Rica
Workers
Quantity
Productivity
Workers
Quantity
Productivity
100
1000kg cheese
10kg cheese per worker
90
1000kg cheese
11.11kg cheese per worker
120
1000kg bananas
8.33kg bananas per worker
80
1000kg bananas
12.5kg bananas per worker
220
2000kg
9.09kg per worker
170
2000kg
11.76kg per worker
with trade
Schweiz
Costa Rica
Workers
Quantity
Productivity
Workers
Quantity
Productivity
100
1000kg cheese
10kg cheese per worker
90
1125kg bananas
12.5kg bananas per worker
120
1200kg cheese
12kg cheese per worker
80
1000kg bananas
12.5kg bananas per worker
220
2200kg cheese
10kg per worker
170
2125kg
12.5kg per worker
Table 8.1: Trade model of David Ricardo
4 On an individual level, the logic of comparative advantage is quickly apparent.
Since each
person has only 24 hours in a day, they must leave certain activities to others. Even if a very
talented manager can organize trips and write letters faster than his assistants, every minute
spent on these tasks is wasted for more valuable tasks where the assistants have an even greater
productivity disadvantage.
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Ricardo’s model is therefore essentially based on opportunity costs. However, it
should be noted that there are also transaction costs. Economists use this term to
describe the costs of finding a suitable trading partner, negotiating the terms of
exchange and enforcing contracts. In the example above, the two countries have
to give up their own production (of bananas and cheese respectively) completely
in order to maximize trade profits. However, this creates mutual dependency.
This may be less of a problem with bananas and cheese, but ultimately the same
logic applies to all goods. The question then arises as to whether Switzerland
should completely outsource the production of essential goods (such as food in
general or important medicines). Interestingly, we find such extreme specialization in a few activities among individuals in rich countries. As a rule, they
only pursue one profession and use their earnings to buy practically all other
goods and services from other people. The fact that most people in Switzerland
are therefore dependent on many others — they do not produce food, electricity or medical products — can be interpreted as the result of progress. In his
1939 work "On the Process of Civilization", the German-British sociologist Norbert Elias (1897-1990) defined the degree of civilization as the extent to which we
are dependent on one another. The quintessence of his considerations is that the
more our lives are interwoven with the lives of others, the greater the degree of
civilization.
The logic of bilateral trade — for example between Switzerland and Costa Rica
— can be applied to all possible trading partners. The standard model of international trade often used today comes from Jonathan Eaton and Samuel Kortum (Econometrica, 2002). In this model, each country i is assumed to be able
to produce every product at a cost ci and to offer it to every country j at a
price pij = ci τij . All trade costs are described by τij (whereby the following applies: τii = 1 and τij > 1 for i ̸= j). Each country therefore offers every other
country and itself all products at the respective costs. As each country buys every
product from the cheapest supplier, trade flows arise. For example, Switzerland
imports bananas from Costa Rica if this is the cheapest source of supply. The
model explains very well why the majority of foreign trade often takes place
with neighboring countries (trade costs with these countries are very low). We
also understand the concentration of bilateral trade flows on a small number of
goods. For example, Switzerland imported goods totalling CHF 142 million from
Costa Rica in 2022. Around 96 million of this was accounted for by coffee, tea
and spices and 20 million by fruit and nuts. We can also use this model to understand a third important observation of international trade: when new barriers are
introduced, trade diversion occurs. When the US introduced new bilateral tariffs
in the trade dispute with China, American imports from Vietnam subsequently
increased. As a result of the tariffs, the most favorable supplier switched — albeit
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not to those in the USA, as the Trump administration had hoped.
In addition to Ricardian trade theory, there are also other explanations for international price differences. In particular, the approach of Eli Heckscher (Swedish
economic historian, 1879–1952) and Bertil Ohlin (Swedish economist, 1899–1979)
should be mentioned: the Heckscher-Ohlin theory. In this model, countries differ in terms of their endowment with production factors (labor, machinery, land).
As prices in a market economy are determined by scarcity, these factors of production are relatively cheap in countries that have a high level of these factors.
For example, if a country has very large agricultural areas, agricultural land will
be relatively cheap. As a result, the agricultural products grown on it will also
be relatively cheap.
Both the Ricardian and Heckscher-Ohlin models have one aspect in common:
they can only explain trade between different countries. The more two countries
differ in terms of productivity and production factors, the more worthwhile trade
is. Consequently, we should see the largest trade flows between Switzerland and
those countries that are very different from Switzerland. However, as Table 8.2
shows, for example, there is more trade with the Netherlands — a very similar
country — than with the entire African continent.
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Imports
Exports
Trade
Balance
Total
235.2
278.6
513.8
43.5
Europe
167.4
152.5
319.9
-14.9
Asia
46.6
58.3
104.9
11.7
North America
15.8
54.5
70.4
38.7
Latin America
2.5
7.0
9.5
4.4
Africa
2.5
3.6
6.1
1.1
Oceania
0.3
2.7
3.1
2.4
Germany
64.5
43.9
108.4
-20.6
Italy
21.4
21.3
42.7
-0.1
France
20.4
16.3
36.7
-4.1
Austria
10.9
7.4
18.4
-3.5
United Kingdom
4.4
8.7
13.1
4.2
Netherlands
5.6
6.8
12.4
1.2
USA
15.2
50.7
65.9
35.5
China
20.4
15.9
36.3
-4.5
Japan
4.2
9.3
13.4
5.1
Hong Kong
1.0
4.2
5.2
3.1
European partners
Non-European partners
Table 8.2: Swiss trade in goods (excluding gold) in 2022 by partner country
We therefore need an additional approach to explaining international trade. This
realization led Paul Krugman (American economist, *1953) to develop the Krugman trade models named after him. The central idea is that international trade
makes sense even if countries are very similar, but there are fixed costs in production or a preference for varieties. Economic cooperation and specialization
of individual countries in certain products means that the fixed costs of production are not incurred in every country. For example, it would be very inefficient
for Switzerland to develop its own car industry: the associated high fixed costs
are already incurred in other countries. Krugman’s models also show that many
products come in different flavors, such as French and Swiss wine. As consumers
generally appreciate a wide range of variations, international trade is also worth-
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while for this reason.5
Theory box 8.1: How companies benefit from globalization
Economic theories usually focus on trade between nations. However, in practice, the crossborder exchange of goods takes place between companies. More recent trade theories, such
as those based on the model by Marc J. Melitz (Econometrica, 2003), take this aspect into account. If we assume that companies differ in terms of their productivity and that there are
both fixed costs of production and access to foreign markets, a three-way division emerges:
companies with low productivity are completely squeezed out of the market, those with
medium productivity only serve the domestic market and companies with the highest productivity also sell their products internationally. In this model, trade liberalization leads
to prosperity gains: Since the highly productive firms can expand, they will attract means
of production from the less productive firms. As a result, labor and machinery are used
more productively. This is referred to as the reallocation effect.
Business research also considers the role of companies in globalization. For example, the
so-called AAA thinking framework by Pankaj Ghemawat (“The New Global Road Map”,
2018) defines three entrepreneurial strategies to benefit from internationally open markets:
Aggregation, Adaptation and Arbitrage. The first describes the approach of concentrating
production in one place, exploiting economies of scale and exporting to other countries.
Adaptation, on the other hand, involves adapting to local conditions, which can be profitable in the form of higher achievable prices. For a long time, there was a debate (proximity
versus scale) as to which of the two approaches should be favored. Over the past two to
three decades, however, a third option has emerged: in addition to the globalization of
markets, there is the globalization of production. Ghemawat uses the term arbitrage to
describe the idea that companies strategically choose production locations that are most
favorable for the respective production steps. This can be the case due to low wages,
subsidies on offer or attractive tax rates.
To conclude our discussion of trade theory, we will look at one last important
model for understanding international trade flows. The Dutch economist Jan Tinbergen (1903–1994) developed the gravity model of international trade in 1962.
This is strongly orientated towards the law of gravity in classical physics, according to which the gravitational attraction between two objects is proportional to
5 Many readers will notice that the central arguments in favor of international trade are based
on cost considerations. This is also evident in trade theory, where demand-side aspects play
a much less important role. Although there are some trade flows that are primarily determined by international differences in demand, these are often based on anecdotal evidence. A
well-known example among trade economists is chicken feet: a fairly worthless by-product in
Western countries, but a delicacy in some Asian countries.
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their masses and indirectly proportional to the square of their distance. Applied
to bilateral trade flows, this results in the following gravitational model
Xij =
Yi Yj
dij
(8.1)
where Xij describes the exports from country i to country j, Yi and Yj represent
the GDP and dij indicates the geographical distance. Consequently, each country
trades a lot with countries that have a large economy and are not very far away
geographically. For example, Germany is by far Switzerland’s most important
trading partner. And as Table 8.2 documents, the other central trading partners
also fit the core statement of the gravity model. Figure 8.6 also shows how well
the model explains real trade flows. In it, we can see both the expected and actual
trade volume for each of Switzerland’s partner countries in 2019. The red straight
line shows a 45-degree line. Around 74% of the variation in Switzerland’s actual
trade flows can be explained by the simple gravity model. It should be noted that
in addition to the geographical distance for dij we can also use other aspects such
as a common national border, common language, free trade agreements and so
on.
Figure 8.6: Gravity model using the example of Switzerland
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8.2.3 Gains and Losses from International Trade
Based on the trade theories discussed, we can now better understand why there
are both winners and losers in international trade. A distinction must be made
between the country level and the individual perspective. At the macroeconomic
level, international trade enables efficiency and prosperity gains through specialization and the exploitation of economies of scale (fixed costs are not incurred
everywhere). The overall lower production costs enable an increase in total production and therefore increase overall prosperity. In addition, international trade
can increase competition between companies and support the spread of new
technologies.
It is important to note that trade gains are generated by imports. A country does
not increase its prosperity by selling goods abroad (exports), but by increasing
the supply of goods at home through trade. Put simply, every country has the
choice of producing goods itself or acquiring them through trade. Switzerland
can produce bananas in two ways: grow them itself or use the resources to produce something else that can then be exchanged for bananas in international
trade. The fact that imports are the source of prosperity gains also explains why
a country does not lose money if it has a trade deficit with a partner country.
As can be seen in Table 8.2, Switzerland imports more from Italy than it exports
to Italy. Hence, there is a trade deficit with Italy. How should this be assessed
in economic terms? Firstly, it is not the bilateral deficits or surpluses that are
relevant, but a country’s overall trade balance (which in Switzerland’s case was
+43 billion). Similar to individuals, countries also have deficits and surpluses in
their bilateral relations without this indicating problems. As Anne O. Krueger
writes in her 2020 book “International Trade: What Everyone Needs to Know”:
There is no reason why pairs of countries should have balanced trade. After all,
a doctor also has a trade deficit with the supermarket or petrol station, but a
surplus with his patients. If a country has an overall trade deficit, it goes into
debt abroad to finance its current consumption. If this happens permanently,
the country is ultimately living beyond its means. As we already know from
equation (2.6) from page 76, there is a connection between savings and the trade
deficit. In an open economy, GDP is given by C + I + G + ( X − M). If the latter
term (X − M ) is positive, that is if there are positive net exports (NX > 0), a
country provides a credit to foreign countries. Vice versa, if NX < 0, the country
must borrow from abroad to finance the excess imports. This implies we can
re-write the simple S = I equation for the open economy:
S = I + (G − T ) + (X − M)
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Whether a current account deficit poses a problem depends on the circumstances.
The analogy with a company helps here. If it is operating very successfully, it may
make sense to expand capacity - even if this entails higher debt. The company
then has a ’current account deficit’ and a ’capital account surplus’. The situation
in which a company is unprofitable and borrows money to finance the losses is
to be assessed quite differently. Therefore, to assess whether a trade deficit is
problematic, we need more information than just the current account balance.
While the gains from international trade at the macroeconomic level are rarely
questioned by economists, there are clear losers at the individual level.6 As already mentioned, prices in a market economy are determined by scarcities, i.e.
the relationship between supply and demand. This also applies to factor prices
such as wages. If the supply of labor in an economy is relatively scarce compared
to the available machinery, wages are high. However, if the country opens up to a
country where labor is plentiful and wages are low, domestic wages come under
pressure. We can understand this process using Switzerland as an example. As
long as Switzerland is a closed economy, labor is scarce and products that require
a lot of labor (such as textiles) are relatively expensive. If Switzerland then opens
up to trade with Bangladesh, a country with a large labor force and therefore low
textile prices, Swiss consumers will no longer buy textiles from local producers.
As a result, demand for labor in Switzerland will fall and wages will decrease.
The two American economists Wolfgang Stolper (1912–2002) and Paul Samuelson (1915–2009) describe this with the Stolper-Samuelson Theorem named after
them: under certain economic assumptions (constant returns to scale, perfect
competition, equality of the number of factors with the number of products), an
increase in the relative price of a good leads to an increase in the real income of
the factor that is used most heavily in the production of the good. It is important
to emphasize the real income here: although workers in Switzerland gain access
to cheaper textiles as a result of trade liberalization, their nominal income falls
more sharply than the price of textiles.
It can now be argued that Swiss textile workers can switch to other sectors in the
medium term or be compensated by transfer payments. Since a country is better
off overall as a result of trade liberalization, such compensation is theoretically
possible. In practice, however, it is not so easy to switch to another sector, nor
are the losers of trade liberalization fully compensated. The structural change
necessary for the gains from trade thus creates losers at the individual level.
However, this does not mean that globalization has been the central driver behind
the rising income inequality of recent decades. Comprehensive analyzes tend to
6 There are also considerations that participation in international trade can be harmful to a country
as a whole. One example is the study by Oded Galor and Andrew Mountford (Review of
Economic Studies, 2008).
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attribute the greatest significance to technological change, as Elhanan Helpman
points out in his book “Globalization and Inequality”, published in 2018.
8.2.4 Trade Policy
What are the implications of international trade for economic policy? How can
governments influence foreign trade? Politicians have a wide range of options at
their disposal to control the dimensions of openness. On the goods market, there
are several protectionist instruments such as tariffs, import quotas and non-tariff
measures such as product regulations or subsidies in favor of domestic production. Governments can also use free trade agreements to determine which sectors
are liberalized and under which circumstances preferential tariffs are granted.
There is also the option of devaluing one’s own currency through expansionary
monetary policy in order to make exports cheaper and imports more expensive.
Such a strategy is also known as competitive devaluation.
In addition to the goods market, the openness of the financial markets can also
be controlled by the state. For example, governments can influence whether
foreign investors can invest domestically and whether money can flow abroad.
Such investment and capital controls are used in crisis situations in particular.
When there is great economic uncertainty or political unrest, investors quickly
try to withdraw their money. This process can further exacerbate an economic
crisis, which is why capital controls can be an effective instrument. However,
this also raises the question of enforceability: investors have various ways of
circumventing such controls, be it through overpriced imports, cash in briefcases
or crypto currencies such as Bitcoin.
Governments face the same problem of enforceability with the third dimension
of openness: migration. In principle, states can determine who is allowed to
offer their labor within the country and under what circumstances. From an
economic perspective, migration flows can be explained by the so-called push
and pull factors. The former create an incentive to leave a particular country
of origin. This can be a poor economic development or a military conflict. If
someone decides to leave their home country, the question arises as to where they
will move to. This decision is determined by the Pull factors, i.e. characteristics
that attract migrants. This can be a higher level of prosperity, but also cultural
proximity or migration networks based on previous migration. Targeted control
of migration therefore focuses - as far as possible - on both push and pull factors.
Two important findings apply to practical economic policy: Firstly, the various
dimensions of openness must be considered and managed as a whole. Secondly,
these opennesses can have a considerable influence on a country’s economic success. Examples such as the European Union show both the necessary connections
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between international co-operation and the associated advantages and disadvantages. We will go into this in more detail at the end of chapter nine.
8.2.5 GDP with Exports and Imports
How exactly does international openness influence the economic performance
of an economy? For the short and medium term, we can use the demand-side
definition of gross domestic product as a guide:
GDP = Y = C + I + G + ( X − I M) = C + I + G + NX
(8.3)
So far we have ignored foreign trade. Now we will take a closer look at it.
Exports (X) are goods and services sold abroad. This also includes domestic
tourism: if a Japanese tourist stays overnight in a hotel in Lucerne, Switzerland exports a service to Japan. In other words, tourism creates additional demand, which we therefore add to GDP. The reverse is true for imports (I M).
This includes goods and services purchased from abroad. The difference between exports and imports is also known as net exports. If exports exceed imports (NX > 0), this is referred to as a trade surplus.
The fact that exports are added to GDP but imports are subtracted from it can
quickly lead to misinterpretations. Does the equation (8.3) imply that exports are
better than imports? This would contradict the argument that imports are the
source of trade gains (see previous sections). In fact, the purchase of domestic
products — whether by domestic or foreign consumers — increases domestic
demand and thus GDP. However, to satisfy this demand, resources must be used
domestically, which have alternative uses. Perhaps the most important function
of economics is also evident here: to point out what is not visible. If a Swiss
consumer buys their food exclusively from Swiss producers, we can see the production of this food and count it towards Swiss GDP. What we cannot see, however, are all the products and services that could have been produced with the
resources used. As Henry Hazlitt wrote in his 1946 book “Economics in One Lesson”: “The art of economics consists in looking not merely at the immediate but
at the longer effects of any act or policy; it consists in tracing the consequences
of that policy not merely for one group but for all groups.”
The often (perhaps wrongly7 sentence attributed to Abraham Lincoln is therefore
not true: “When we buy manufactured goods from abroad, we get the goods and
the foreigner gets the money; when we buy manufactured goods from domestic
producers, we get the goods and we keep the money.” Imports do not represent a
7 Whether this sentence can really be attributed to the former American president was critically
scrutinized by Frank William Taussig in 1914 in the Quarterly Journal of Economics.
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loss and a trade deficit (NX < 0) does not necessarily make a country poorer. It is
important to understand why consumers opt for foreign goods, what happens to
the resources freed up as a result and, more generally, why a country has a trade
deficit. The opposite should also be viewed critically. The fact that Switzerland
has had a considerable trade surplus for many years, as shown in Figure 8.4,
may be an expression of higher product quality compared to other countries.
Both domestic and foreign consumers then buy Swiss products because of their
convincing quality. However, the surplus in foreign trade can also be the result
of an undervalued Swiss franc or have other causes.
These considerations already show that we also need to look at the determinants
of exports and imports. Just as we considered what determines the level of private consumption and investment in chapters 2 and 3, we must also do the same
for the components of foreign trade. Before we can tackle this, however, we first
need to look at other aspects of the open economy: the balance of payments and
exchange rates.
8.3 The Balance of Payments
Every country records its economic transactions across external borders in the
balance of payments. This generally records the value of all economic activities
between residents and non-residents for the period of one year. The balance of
payments is divided into two sub-balances, the current and capital account, as
well as capital transfers and the statistical difference:
BP = CUA - CAA + capital transfers + statistical difference
(8.4)
The total is shown in Figure 8.7. The two sub-balances are in turn divided into
further sub-balances. In the current account, we see the external contribution to
GDP (trade in goods and services), the income and capital account (labor and
capital income) and transfers (such as money transfers to families living abroad
or development aid). The current account balance therefore shows all of the
economy’s income and expenditure. If a country has a current account surplus,
such as Switzerland in 2020, the income from the sale of goods and services as
well as primary and secondary income from abroad exceeds the corresponding
outflows abroad.
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Balance of Payments
Statistical Discrepancy
Balance of Capital Transfers
(Change in Currency Reserves)
Foreign Exchange Balance
Capital Account
Financial Account
(FDI, Securities Transactions)
Secondary Income Balance
Primary Income Balance
Services Balance
Goods Balance
Current Account
Figure 8.7: Components of a balance of payments
Each transaction is considered in a balance of payments analogue to business
income and expenses. The balance of payments can therefore also be regarded
as a net financial assets statement that relates to the entire economy. As with
every balance sheet, the principle of double-entry bookkeeping also applies here:
every entry triggers an offsetting entry. For example, if a Swiss company exports
a watch to Germany for CHF 3,000, this export of goods is posted on the debit
side (which shows foreign currency receipts) in the current account. If the German customer pays in euros and transfers a corresponding amount to the Swiss
company’s house bank, the latter has a short-term claim against the German customer’s house bank. In this transaction, Switzerland exports capital and builds
up foreign assets. Double-entry bookkeeping ensures that the balance of payments is always balanced overall. There can only be deficits in partial balances.
This can also be seen in the figures for Switzerland in Table 8.3.8
8 The figures in this table are from the Federal Statistical Office (FSO number je-d-04.09.01).
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2000
2005
2010
2015
2020
52’121
65’414
91’699
75’514
26’755
2’634
14’894
45’304
58’907
63’794
— Revenue
160’783
192’917
297’706
298’218
333’769
— Expenditure
158’149
178’024
252’402
239’312
269’974
Services, balance
21’781
18’375
20’030
13’240
960
— Revenue
79’488
85’801
104’315
117’403
107’804
— Expenditure
57’707
67’426
84’285
104’162
106’844
Primary income, balance
32’179
42’574
34’764
15’234
-23’642
— Revenue
103’755
129’420
130’070
144’578
133’756
— Expenditure
71’575
86’846
95’306
129’344
157’398
Secondary income, balance
-4’473
-10’428
-8’399
-11’868
-14’357
— Revenues
13’187
21’055
27’252
36’868
43’677
— Expenditure
17’661
31’484
35’652
48’735
58’035
Transfers of assets, balance
Current account, balance
Goods, balance
-5’958
-2’845
-4’614
-29’401
-161
Revenues
826
584
359
3’269
844
Expenses
6’784
3’430
4’972
32’670
1’005
Capital account, balance
78’559
100’615
110’307
42’211
4’074
Direct investment, balance
41’914
63’983
58’723
12’962
60’029
— Net acquisition of assets
81,199
67,678
76,979
119,458
-68,669
— Net increase in liabilities
39’284
3’695
18’256
106’496
-128’697
Portfolio investments, balance
28’216
55’849
-36’839
51’372
30’028
— Net additions to assets
46,030
63,020
-8,268
38,198
23,609
— Net addition to liabilities
17’814
7’172
28’571
-13’174
-6’419
Other investments, balance
15’734
-1’237
-49’635
-113’165
-193’861
— Net additions to assets
177’130
94’287
-40’223
-31’753
-54’232
— Net increase in liabilities
161’396
95’524
9’413
81’413
139’629
Currency reserves, balance
-7’305
-21’079
137’802
94’434
116’732
3,098
257
-3,391
-8,854
38’046
23’223
-3’902
-22’520
Derivatives, balance
Statistical difference
32’396
Table 8.3: Switzerland’s balance of payments in the years 2000 to 2020
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As Table 8.3 shows, Switzerland recorded a current account surplus in all the
years shown. Compared to other countries, this is also very high in terms of
GDP. Figure 8.8 shows a comparison with Germany and the United States.
Figure 8.8: Current account balance measured by gross domestic product
Closely linked to the balance of payments is the foreign assets (net international
investment position) of an economy. If a country’s investments abroad exceed its
investments in the opposite direction — i.e. it exports net capital — its net international investment position increases. The current account must show a surplus
in this case. Put simply, the country lives below its means, it consumes less than
it produces. The surplus production is sold abroad. However, foreign assets are
not only influenced by investments. Changes in exchange rates, precious metal
prices and share prices also have an impact.
At the end of 2020, Switzerland had net international investment position of
around CHF 662 billion, which corresponded to around 94% of GDP. This puts
Switzerland in one of the top places in the ranking of countries with the highest foreign assets — both in absolute terms and as a percentage of GDP. Other
nations with relatively large foreign assets include Singapore, Norway, Taiwan,
Saudi Arabia, Japan and the Netherlands.
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8.4 Prices in an Open Economy
The theories already discussed to explain international trade and its effects generally consider the real trade in goods and services. This means that they abstract
from monetary aspects, i.e. money. In practice, however, nominal variables play
an important role and we need to take a closer look at prices in international
trade. To this end, we will examine three relevant aspects below: (i) exchange
rates, (ii) prices of goods across borders and purchasing power parity, and (iii)
interest rate parity. Exchange rates and their changes determine, among other
things, whether consumers buy domestic or foreign goods and whether investors
buy domestic or foreign securities. We must therefore analyze which economic
laws determine these decisions and therefore also the exchange rates.
8.4.1 Exchange Rates
If consumers in an open economy can choose between domestic and foreign
goods, the exchange rate plays an important role in the purchasing decision.
The exchange rate is also an important decision-making factor when choosing
a holiday destination, i.e. when purchasing services. Specifically, the nominal
exchange rate indicates the price of one currency in units of another currency. A
distinction must be made between two forms of representation:
• quantity quotation: how many units of foreign currency you have to pay for
one unit of domestic currency. For example, the exchange rate is 0.91 euros
per CHF.
• price quotation: how many units of domestic currency you have to pay for
one unit of foreign currency. For example, the exchange rate is 1.10 CHF
per euro.
The exchange rate in the quantity quotation thus corresponds to the reciprocal of
the exchange rate in the price quotation. Internationally, the quantity quotation
is the most widespread, but in German-speaking countries the price quotation is
commonly used. To avoid any confusion in the following, we will use the price
quotation. The nominal exchange rate (E) thus indicates how many francs you
have to pay for one euro (or dollar). If E falls, we refer to this as an appreciation
of the domestic currency. You then need fewer francs to buy one euro (or dollar).
Conversely, an increase in E signals that the Swiss franc is depreciating, i.e. losing
value.
If we look at the development of the exchange rate between the Swiss franc and
other major currencies since 1960, we get Figure 8.9. Firstly, we can see that
exchange rates were very stable before 1973 and were only subject to greater
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fluctuations afterwards. This was due to the so-called Bretton Woods system, an
international monetary order with more or less fixed exchange rates, which we
will discuss in more detail shortly. Since this system collapsed in 1973, the Swiss
franc has appreciated against all the currencies shown. For example, whereas it
once took over twelve francs to buy one pound sterling, today it is less than CHF
1.50.
Figure 8.9: Development of exchange rates against the Swiss franc
The US dollar is the most important international currency. As many commodities such as crude oil or metals such as copper are traded on a global market and
their prices are expressed in US dollars, the exchange rate against the dollar is
very important. Other widely used currencies are the euro, the Japanese yen, the
British pound and the Swiss franc. Figure 8.10 illustrates the share of global foreign exchange market transactions for the most important currencies. It should
be noted that two currencies are exchanged in each transaction, so the total in the
figure must add up to 200%.
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Figure 8.10: The most important international currencies
How have the Swiss franc, the euro, the Japanese yen, the British pound and
the Chinese renminbi (often referred to as the yuan, which in Chinese indicates
the amount of renminbi) developed against the dollar? We can see the answer
in Figure 8.11. There are two aspects to consider. Firstly, the standard international quantity quotation is used — an increase therefore means a depreciation.
Secondly, 10 renminbi (RMB) and 100 yen are shown for scaling reasons.
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Figure 8.11: Development of exchange rates against the US dollar
As already mentioned, there are various exchange rate regimes. There are basically two different regimes. In a flexible exchange rate regime, the exchange
rate is freely determined by supply and demand on the foreign exchange market
(also known as the FX market). Foreign exchange refers to foreign currencies. In
terms of turnover, the foreign exchange market is the largest financial market in
the world: An average of around USD 6.6 trillion was traded daily on the international foreign exchange market in 2019. To put this into perspective, it should
be mentioned that on an average day, around 250 billion US dollars are traded
on the world’s largest stock exchange in New York (NYSE).
The alternative to freely fluctuating exchange rates is a fixed exchange rate regime.
This involves a state-fixed exchange rate, which is usually guaranteed by central
bank intervention. As an example of this, we can look at the exchange rate of
the Saudi Arabian riyal to the US dollar. This has been fixed at 3.75 Saudi riyals
per US dollar since June 1986. Such a link to another currency is referred to as
a peg. In concrete terms, this means that the central bank of the Kingdom of
Saudi Arabia constantly intervenes in the foreign exchange market to keep the
exchange rate at this level. In fact, there are always very small deviations. In
March 2021, however, the exchange rate against the US dollar only fluctuated
between 3.7495 and 3.7517 — as soon as the rate was below or above 3.75, the
central bank bought or sold riyal. However, these interventions in the market
presuppose that the central bank always has sufficient foreign currency that it
can sell if necessary.
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In practice, in addition to such fixed exchange rates, there are also those with a
permissible range of fluctuations. For example, the Chinese government pegged
the renminbi to the US dollar until July 2005 and has since used a managed
floating exchange rate, where daily fluctuations against a mix of other currencies
cannot exceed two per cent. A comparable range of permissible fluctuations
also existed in the run-up to the introduction of the euro, i.e. in the European
Monetary System (EMS) from 1979 to the end of 1998. The approach is also
known as snake in a tunnel, whereby the tunnel is represented by the upper and
lower limits and the snake by the exchange rate moving up and down within it.
This approach is still used today for euro accession candidates.
Switzerland has also had experience with a managed exchange rate in the past.
Until 23 January 1973, the Swiss franc was pegged to the US dollar. Since then,
there has been a flexible exchange rate, but the Swiss National Bank (SNB) has
intervened very strongly at times. Between 6 September 2011 and 15 January
2015, the SNB set a minimum exchange rate of CHF 1.20 per euro. This was a
reaction to the euro crisis, which increased demand for Swiss francs and thus led
to a strong appreciation of the Swiss currency. As other measures to weaken the
franc did not have the desired effect, the SNB finally announced in September
2011 that it would buy foreign currency on an unlimited basis in order to achieve
the exchange rate target of at least CHF 1.20 per euro.
The advantages and disadvantages of fixed or managed exchange rates can be described on the basis of the Swiss minimum exchange rate against the euro. The
SNB’s constant interventions reduced fluctuations in the exchange rate, which
overall limited uncertainty about future changes. Such uncertainties are generally problematic for companies that conduct business across national borders.
For example, if a company produces machines in Switzerland at a production
cost of CHF 1,000, it has to set a price in euros or dollars for foreign customers.
If payment is then processed in the future, it is unclear how much (expressed
in francs) the purchase price will ultimately be. For less developed countries,
a fixed exchange rate is also advantageous because it can increase confidence
among international investors. In addition, a central bank can credibly signal
that it will not allow a high inflation rate. This is because a fixed exchange rate
restricts the autonomy of the central bank to a certain extent. This brings us to
the disadvantages of a fixed exchange rate. A fixed exchange rate requires constant intervention by the central bank and therefore restricts its monetary policy
flexibility. In order to guarantee a fixed exchange rate, it must have sufficient
foreign exchange reserves — in order to buy domestic currency if necessary and
thus prevent devaluation. Alternatively, a central bank can prevent the depreciation of the domestic currency by raising the domestic interest rate through
contractionary monetary policy.
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So far we have focused exclusively on the nominal exchange rate. However, in
addition to the nominal exchange rate, the respective price level also plays a role
in consumers’ purchasing decisions between domestic and foreign goods. If we
take this aspect into account, we obtain the real exchange rate in price quotation:
ε=
E ∗ P∗
P
(8.5)
where we use P and P∗ to describe the domestic and foreign price levels respectively. The numerator shows the price of foreign goods expressed in domestic
currency, while the denominator shows the price of domestic goods (also in domestic currency). We are therefore comparing two prices in the same currency.
Since we are looking at the price quotation here, the following applies: If ε rises,
the domestic currency depreciates in real terms. Consequently, foreign goods
become more expensive in relation to domestic goods. The calculation can be
easily illustrated with two countries and just one good. Let us assume that a liter
of milk costs 1.80 CHF in Switzerland and 1.09 euros in Germany. Assuming a
nominal exchange rate of E = 1.10 CHF / Euro, the real exchange rate is:
ε = 1.10 CHF/ Euro ∗
1.09 Euro
= 0.6661
1.80 CHF
(8.6)
The real exchange rate does not have a unit (the currencies are canceled out),
but it indicates how expensive the product is domestically relative to abroad. In
our example, milk in Germany costs around 66.6% as much as in Switzerland.
In other words, milk in Switzerland is around 1.5 times more expensive than in
Germany — i.e. around 50% more (CHF 1.80 instead of the equivalent of CHF
1.199 per liter). In general, the real exchange rate gives us the price of domestic
goods in units of foreign goods. One liter of milk in Switzerland buys 1.5 liters
in Germany. This would indicate that the Swiss franc is overvalued.9
The real exchange rate of a currency for a specific product and a specific other
currency is, of course, only of limited relevance. Of more economic interest is the
real exchange rate overall to other currencies and on the basis of a large number
of products and services. This is provided by the so-called real effective exchange
rate (also known as REER or the real multilateral exchange rate). The calculation
is performed as described in equation (8.5), but we consider all trading partners
9 The British magazine The Economist’s Big Mac Index is a well-known tool for comparing product
prices across countries. However, this burger is not very suitable for such a comparison, as
McDonald’s Big Mac customers primarily pay for the service and not the product.
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of a country (or their currencies) and use, for example, the respective consumer
price index (see chapter 6) for the price level for each partner country:
n −1 REER = ∏
i
Ei ∗
Pi∗
P
gi
n −1
with
gi > 0
as well as
∑ gi = 1
(8.7)
i =1
where gi is the weight of the currency of the partner country i and we consider all
n countries in the world (we therefore write n − 1 in the formula because our own
country does not receive any weight). The weighting of the partner countries is
usually based on the bilateral trade volume. For example, if 40% of Swiss foreign
trade takes place with countries that use the euro as their currency, the euro is
given a weighting of 40% for Switzerland in equation (8.7).
Instead of the consumer price index, we can also use alternative measures such
as the producer price index (PPI) or the GDP deflator. It may also be interesting
to use the prices of domestic exports and imports — i.e. what Switzerland sells
abroad and what it buys from abroad. This ratio of export goods price level and
import goods price level is also referred to as the terms of trade or real exchange
ratio.
The level of the real effective exchange rate is not very meaningful on its own;
what is important are its changes. If the REER rises, Swiss goods become cheaper
compared to foreign goods. The real effective exchange rate is therefore a measure of a country’s competitiveness. As Switzerland maintains important trade
relations with many countries, the question arises as to how its competitiveness
has developed on the basis of the REER. Figure 8.12 shows the answer for the
most important trading partner: the eurozone. The strong nominal appreciation
of the franc against the euro from 2008 was partially offset by lower inflation in
Switzerland.
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Figure 8.12: Nominal and real exchange rate against the euro
8.4.2 Law of One Price and Purchasing Power Parity
We need to take a closer look at one aspect of the real exchange rate: the different price levels in different countries. Why do prices for identical goods differ
across national borders — and how big can the differences be? Many people are
aware that goods and services are generally more expensive in richer countries.
For many Swiss people, going to a restaurant abroad is often a pleasure, as the
prices are considerably lower than in their own country. However, the joy is less
pronounced among those Swiss who believe they can also get a new iPhone at a
lower price abroad. Figure 8.13 shows how expensive the iPhone 14 was in European countries in January 2023 according to the manufacturer’s official website.
Although we recognize a certain variation from 804 to 920 francs, the price is
highest in the poorest countries of all. In general, there is hardly any correlation
between the income of a country and the price of the iPhone — especially if you
consider the euro countries. How can this be explained?
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Figure 8.13: Price of the Apple iPhone 14 in European countries
Why is the iPhone not cheaper in a relatively poor country like the Czech Republic than in rich Luxembourg? The question becomes clear when we consider
what would happen if Apple actually sold its iPhone at a significantly higher
price in rich countries than in poorer countries. The iPhone is an internationally
tradable good: it is relatively light in relation to its value (so transport costs are
relatively low), customs duties are almost zero everywhere and it can be used
in the same way in every country. Little would stop Swiss companies such as
Digitec or Microspot from buying the iPhone in large quantities at a low price
abroad and then offering it more cheaply in Switzerland than Apple itself. This
type of transaction is known as arbitrage, a trading activity in which the price
differences between identical products on different markets are exploited.
For example, if Apple offers the iPhone significantly cheaper in the Czech Republic than in Switzerland, some Swiss retailers will buy the product cheaply in the
Czech Republic and undercut Apple’s Swiss prices. This increases the demand
for iPhones in the Czech Republic, increases the supply of iPhones in Switzerland
and creates additional demand for Czech crowns (retailers exchange francs for
crowns to buy iPhones). All three processes have the effect of harmonizing prices
in the Czech Republic and Switzerland.10 These considerations can be applied to
all tradable goods and we obtain the law of one price: Identical consumer goods
10 In practice, small price differences are still possible.
Even though Figure 8.13 shows prices
excluding VAT, it should be noted that Apple does not change country-specific prices on a
daily basis, but exchange rates do vary.
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tend to have the same price, regardless of where they are sold. As formulated by
the English economist William Stanley Jevons (1835–1882) as early as 1871: “In
the same open market, at any moment, there cannot be two prices for the same
kind of article.” In practice, however, there are obstacles that prevent prices from
being equalized: Transport costs, trade barriers or country-specific regulations. It
is these obstacles that enable companies to implement a pricing-to-market strategy,
i.e. to demand higher prices in rich countries.
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Practice box 8.1: The Big Mac Index
The British weekly newspaper The Economist has been calculating the so-called Big Mac
Index since 1986. This not entirely scientific index is based on the idea that the McDonald’s
hamburger is produced and sold in the same way in many countries. However, while the
Big Mac tastes the same everywhere, the price varies considerably. In the USA, it was
sold for around $5.15 in July 2022, while in Switzerland you had to pay 6.50 CHF, which
equated to around $6.71 at the nominal exchange rate of 0.97 CHF per US dollar. This is
interpreted in the Big Mac Index as an overvaluation of the Swiss franc of around 30% (=
(6.71-5.15)/5.15). For all countries in which the burger is sold, the Economist calculates an
overvaluation or undervaluation.
From an economic point of view, however, it must be noted that the Big Mac is hardly
suitable for a test of uniform prices. McDonald’s customers primarily pay for a service —
the preparation of the burger on site — which cannot be traded internationally. Therefore,
local wages, property prices, competition, income levels or the preference for fast food play
an important role in the price. Unlike the iPhone, prices are not expected to converge, as
arbitrage transactions are hardly possible.
The law of one price can be applied to all tradable goods and services. In this
context, the adjective ’tradable’ is to be judged relatively: how high are the trading costs in relation to the price difference? The iPhone can easily be ordered
from abroad, there are no customs duties and the shipping costs are low. The
situation is different with a haircut: customers have to travel abroad themselves,
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which significantly increases the costs. Services such as hairdressing are therefore generally much less tradable — and the price differences are correspondingly greater. While an iPhone is relatively cheap in Switzerland, a haircut costs
more than twice as much as in the Czech Republic.
This observation is also known as the Balassa effect after the Hungarian-American
economist Béla Balassa (1928–1991). It describes the cause of relatively low prices
in poorer countries. Roughly speaking, all goods can be divided into tradable
and non-tradable goods and services. In the case of the former, poorer countries
are less productive, but prices are very similar internationally due to the law of
one price. For non-tradable goods and services (such as hairdressers), there are
no differences in productivity. As the tradable goods sector is economically more
important, it determines wage levels to a large extent. In poorer, less developed
countries, wages are therefore lower than in rich nations. And since the mobility of labor is relatively low internationally, but relatively high within a country
(between sectors), low wages are also paid in the non-tradable goods sectors. A
hairdresser or taxi driver in Zurich is no more productive than his counterpart
in Prague, but he earns a significantly higher wage due to the Balassa effect. He
benefits from the fact that the Swiss have higher productivity in tradable sectors
and that Swiss customers do not (or cannot) source the services they offer from
abroad.
These differences in price levels between countries are problematic if we want
to compare material living standards, for example. It is often said that although
people earn more in Switzerland, the cost of living is correspondingly higher. As
a result, the standard of living is not (that much) higher. Is that true? Economists
use so-called purchasing power parities (PPPs) for such comparisons. These PPPs
are calculated on the basis of the price of a standardized basket of goods and services in each economy. They are a measure of what can be bought with the local
currency of one economy in another economy. PPP-based conversions of expenditure eliminate the effect of differences in price levels between economies. If
purchasing power parity applies, a basket of goods can be purchased in different
currency areas for the same amount of money. An amount of money has the
same purchasing power across all countries.11
The World Bank (in the so-called International Comparison Program, ICP) and other
organizations provide PPP conversion factors for all countries. In Figure 8.14
we can see how this affects the GDP per capita of Switzerland, Germany and
the USA. As the latter serves as a reference, the PPP conversion factor for the
USA is equal to one. We also see that the difference in living standards between
11 With perfect purchasing power parity, the exchange rates are as follows: Nominal PPP exchange
rate (CHF/$) = CH price level / US price level and Real PPP exchange rate = 1 (= nominal PPP
exchange rate (CHF/$) x US price level / CH price level).
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Switzerland and Germany remains even after taking into account the higher price
level in Switzerland. However, GDP per capita is only 26% higher under PPP
instead of 76%.
Figure 8.14: GDP per capita, with/without purchasing power parity
Purchasing power parity is also important if we want to compare the size of two
economies. For example, every now and then you see a graph in which the GDP
of the USA is larger than that of China and sometimes it is the other way round.
The difference is explained by the fact that PPP was taken into account in the second case. GDP measures the economic performance of an economy. Accordingly,
all goods and services produced in a year are counted. International comparison
is difficult for two reasons. Firstly, countries have different currencies. Although
the current exchange rates allow us to make a comparison, exchange rates can
fluctuate significantly in the short term due to various developments. Secondly,
there is the problem that the service sector accounts for over half of GDP in most
economies. As already mentioned, services are generally much less tradable than
goods, so their price is heavily dependent on local income levels. A simple haircut costs around five francs in Bulgaria and 30 francs in Switzerland. As there
are no significant differences in quality, a haircut should therefore increase GDP
in both countries to the same extent. However, due to the higher price, GDP
increases more in Switzerland. Economists use purchasing power parities to address this aspect.
In 2019, Chinese GDP totaled around 98.65 trillion renminbi, which corresponds
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to around 14.1 trillion US dollars at the official exchange rate (around 7 renminbi
= 1 USD). The World Bank now calculates a conversion factor of 4.184, which
is why China’s GDP in purchasing power parity terms was USD 23.6 trillion
and therefore larger than that of the US (21.43 trillion, no adjustment necessary
as the country is used as the basis for PPP). Thus, ignoring PPP leads to an
underestimation of the GDP of less developed countries.12
8.4.3 Interest Rate Parity
To conclude the chapter, we turn to the financial markets. In the law of one price,
we have seen that prices converge internationally when trade costs are low. In
the financial market, trade costs are often very low because international capital
movements have been largely liberalized. What does this mean for prices (i.e.
interest rates) on the financial market?
In an open economy, individuals can also choose where to invest their money —
that is, whether to buy domestic or foreign securities. For example, investors can
choose between 10-year government bonds issued by the Swiss Confederation
(so-called Bundesanleihen) and those issued by the US government (treasury notes).
On 31 March 2021, the interest rate for Swiss bonds was -0.27 percent and for
treasury notes 1.72 percent. As both are very safe forms of investment — the
default risk for both government bonds is extremely low — the question arises
as to why anyone would want to buy Swiss government bonds at all. Apart from
certain investment rules, there seems to be little reason not to buy the higheryielding US government bonds when making this choice.
Why an investment in Bundesanleihen might nevertheless be favored in this case
can be seen if we take a closer look at both investments. Let us assume that CHF
1,000 is invested today. With which investment will we have more money in ten
years’ time? In the case of Swiss government bonds, the CHF 1,000 will become
1, 000 ∗ (0.9973)10 = 973 over ten years due to the negative interest rate. If an
investment in US government bonds is chosen instead, the 1,000 francs must first
be converted into US dollars. The exchange rate on 31 March 2021 was around
1.062, so we invest 1,062 US dollars for ten years at an interest rate of 1.72%. This
results in 1,259 US dollars, which we will receive in ten years. To compare this
with the CHF 973, we need to know the exchange rate in ten years’ time. This
is not known today, but we can use the forward rate. This stood at around CHF
12 This observation is also referred to as the Penn effect, based on the Penn World Tables (a database
of country-specific economic variables). It is based on the Balassa-Samuelson effect, which
supplements the discussed Balassa effect with the Samuelson effect. This states that when
poorer countries rise economically, the productivity of tradable goods in particular increases.
If the wage level then rises, this makes non-tradable goods more expensive, so that a relatively
undervalued currency (Balassa effect) is accompanied by higher inflation.
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0.77 per US dollar on 31 March 2021. Investors therefore expect the Swiss franc
to appreciate significantly by 31 March 2031.13 As a result, if we invested in US
government bonds, we would have 0.77 ∗ 1, 259 =970 francs after ten years. Based
on current information, both investment options will therefore yield almost the
same return or interest rate over a period of ten years. The higher annual interest
rate on US government bonds is offset by the expected annual depreciation of
the US dollar against the Swiss franc.
We can generalize this result. If the domestic (risk-free) interest rate it , the foreign
interest rate it∗ , the current exchange rate Et and the expected exchange rate in
one year Ete+1 , then the following must apply for a risk-neutral investor:
(1 + it ) = (1 + it∗ ) ∗ Et /Ete+1 for small values: it ≈ it∗ −
Ete+1 − Et
Et
(8.8)
Expressed verbally, this equation means that the domestic interest rate is equal to
the foreign interest rate plus appreciation or depreciation. This is referred to as
uncovered interest rate parity. For covered interest rate parity, the forward rate
is used instead of Ete+1 — as in the example above. As with the law of one price,
the intuition for interest rate parity follows from the arbitrage opportunity. If the
investment in the USA were to yield a higher expected interest rate, investors
would already sell their Swiss securities today and invest in American government bonds. This would increase the supply of Swiss francs and the demand
for US dollars. As a result, the Swiss franc would depreciate today and thus appreciate more strongly in the future, making investing in the USA less attractive
again.
The introduction of the euro provides an illustrative example of interest rate parity. In December 1995, the European Council decided to introduce a single currency, the euro. At the time, there were a large number of currencies in Europe,
with some, such as the German mark, tending to appreciate and others, such as
the Italian lira or the Spanish peseta, depreciating. Exchange rate movements
also had an impact on the interest rates at which European governments could
borrow money. As Figure 8.15 shows, Italy and Spain had to pay over 10% interest on ten-year government bonds, while the German and Swiss governments
were able to borrow much more favorably. However, with the announcement of
the euro in 1995, the devaluation risk gradually disappeared. Until the introduction of the euro — digitally in 1999, physically as cash in 2002 — the interest
13 For foreign currencies, the forward rate is usually given in points. In the example chosen here,
the forward rate was around -1,700. This can be read as meaning that the exchange rate will
fall by -1,700/10,000 = -0.17 over the ten-year period, i.e. from CHF 0.94 per US dollar to CHF
0.77 per dollar.
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rate differences (called spreads) between the Euro countries were also completely
reduced. These only reappeared in the course of the financial crisis in 2008, when
the exit of individual countries from the Euro zone was discussed. As predicted
by interest rate parity, interest rates on Italian, Spanish and, above all, Greek
government bonds rose when a reintroduction of national currencies (and thus a
devaluation risk) was discussed.
Figure 8.15: Yields on ten-year government bonds
In practice, however, it has been shown that interest rate parity, which incidentally goes back to John Maynard Keynes, does not always apply. Rather, it has
been shown that it can be profitable to borrow money in a country with low interest rates and invest it in a country with higher interest rates. This is also known
as Currency Carry Trade (interest rate differential speculation). According to the
interest rate parity theory, such forms of investment should not be profitable, but
in practice this sometimes deviates somewhat from the simple theory.
Nevertheless, interest rate parity is one explanation for today’s exchange rates.
What other factors determine the exchange rate between two currencies in the
short and medium term? As most currencies are freely traded, the price is determined by supply and demand. As we have already seen, central banks can
influence this — both supply and demand. Either they buy and sell foreign
currency themselves or they change the domestic interest rate, which influences
the exchange rate according to the logic of interest rate parity. In addition to
the more short-term determinants, differences in inflation rates and expectations
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as well as different levels of government debt (and the associated incentives for
higher inflation rates in the future) also play an important role in the medium
term. Economic development in general also plays a role: global investors tend
to want to invest in fast-growing economies, which increases demand for their
currencies. We will take a closer look at the influence of politics on the exchange
rate in the next chapter.
8.5 Summary
Economies are linked to other countries in a variety of ways, via trade in goods
and services, via financial flows and migration. In this chapter, we have looked
at the main explanatory approaches to understanding international trade and
financial linkages. Trade theory helps us to analyze gains and losses through
trade. Trade across borders usually involves different currencies, so nominal and
real exchange rates are important. In the next chapter, we extend the IS-LM
model to include the open economy aspects. We also discuss the implications for
economic policy.
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Having dealt intensively with the aspects of an open economy in the previous
chapter, we can now combine the insights gained with results from earlier chapters. Specifically, there are two tasks. Firstly, we would like to extend the IS-LM
model we are familiar with so that the relevant relationships in an open economy
are also taken into account. To this end, we will develop the so-called MundellFleming model and the IS-LM-IP (IP for interest parity) model in this chapter.
Secondly, we aim to gain a better understanding of the effects of fiscal and monetary policy, taking into account the aspects of an open economy. In this context,
we will also consider special topics such as currency crises in poorer countries or
international business cycles.
An important restriction that we make in this chapter is the disregard of crossborder factor incomes. This simplifies the analysis, as the gross domestic product
corresponds to the gross national income (GDP = GNI) and the balance of trade
equals the balance of the current account. The latter is also referred to as net
exports.
9.1 IS-LM Model with International Trade
In Chapter 4, we used the IS-LM model to analyze the economy in the short
term. The economy was assumed to be closed, i.e. no economic transactions took
place across national borders. However, as we know from Chapter 8, foreign
trade and, more generally, economic relations with other countries are of central
importance for countries such as Switzerland. So how can we add the central
aspects of an open economy to the IS-LM model? If we consider the equation for
gross domestic product, it immediately becomes clear where we need to start:
GDP = Y = C + I + G + X − I M = C + I + G + NX
(9.1)
When analyzing an open economy, we can no longer set net exports to zero (as in
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chapters 2 to 7), but must take a closer look at the exports and imports of goods
and services. In particular, we need to determine which factors influence exports
and imports. In addition, we need to look at international capital flows, which
are influenced in particular by the interest rate parity described in the previous
chapter.
9.1.1 IS Curve in the Open Economy
The IS curve describes the equilibrium on the goods market. The question therefore arises as to how international trade in goods and services flows into our
analysis of the goods market. Looking at equation (9.1), we realize that in an
open economy we have to consider two new components of GDP: there is foreign
consumption of domestic goods (exports) and domestic consumption of foreign
goods (imports). The demand for goods in a country is therefore influenced by
exports and imports. In the open economy, part of the domestic demand is for
foreign goods and part of the demand for domestic goods comes from abroad.
Since the demand side determines GDP in the IS-LM model (“what is produced
is what is demanded”), we must now take these two components into account.
Specifically, the demand for domestically produced goods now consists of five
components:
Z ≡ C + I + G + X − IM
(9.2)
We need to make a few comments here. The first three components (C + I + G)
describe domestic demand as before. With X we denote the demand from abroad,
i.e. exports. And finally I M indicates the imports. However, we must be careful
with these: products from abroad have prices in foreign currency. In order to
put these in relation to domestic products, we have to express them in units of
domestic goods. To do this, we use the real exchange rate (ε = E ∗ P∗ /P), which
we defined in the previous chapter as the price of domestic goods expressed in
units of foreign goods. If we use Q to denote the value of imports in units of
foreign goods, then εQ = ( EP∗ /P) ∗ Q is the value of imports in units of domestic
goods. Therefore, if we denote imports as I M in equation (9.2), the following
applies: I M = εQ.
To illustrate this problem, let us take a student who wants to buy a new computer.
Suppose this PC costs 1’200 CHF in Switzerland and 982 Euro in Germany and
the exchange rate (in price quotation) is 1.10 CHF per Euro. If we disregard
transport costs or taxes, the computer is cheaper abroad (982 euros correspond
to around 1’080 CHF). If the student decides to buy abroad in this case, the
domestic market does not lose 1’200 CHF in demand, but 1’080 CHF. The real
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exchange rate (ε) corresponds to 1.10 CHF/Euro ∗ (982 Euro/1′ 200 CHF) =0.90.
In other words, the purchase of ten foreign PCs — in terms of demand — is
equivalent to the purchase of nine domestic computers (10 ∗ 1′ 080 = 9 ∗ 1′ 200).
As in Chapter 2, we must now ask ourselves what determines the level of the
two components (exports and imports). Let us take a look at the Swiss economy.
Foreign demand for Swiss goods, i.e. Swiss export demand, depends primarily
on foreign income. We denote this as Y ∗ . The higher the foreign income, the
greater the demand there for all goods — Swiss and foreign — so that exports
increase with Y ∗ . However, foreign consumers take into account the different
price levels and the exchange rate when making their purchasing decisions. The
real exchange rate therefore plays a key role. The higher ε = E ∗ P∗ /P, the more
favorable Swiss products are for foreign consumers in relation to domestic products. This becomes clear when we realize that ε can rise for three reasons. Firstly,
the nominal exchange rate (E) can rise, which corresponds to a depreciation of
the Swiss franc. Secondly, the foreign price level (P∗ ) can rise. And thirdly, it is
possible that the Swiss price level (P) will fall. All three developments make it
more attractive for foreigners to buy Swiss goods. We summarize these considerations in an equation:
X = X( Y∗ , ε )
(+) (+)
(9.3)
Both an increase in foreign income and the real exchange rate increase the exports
of our economy. Since the imports of one country ultimately correspond to the
exports of another country, we have also determined the determinants of imports:
I M = I M( Y , ε )
(+) (−)
(9.4)
Domestic imports depend positively on domestic income and negatively on the
real exchange rate. An increase in the real exchange rate (ε) makes foreign products more expensive and therefore leads to lower imports. However, it should
be noted that there are two opposing effects here. Let us return to the example mentioned above, in which a Swiss student could buy a new computer for
1’200 CHF domestically or for 982 euros from abroad. If the foreign price increases, the incentive to buy the computer abroad decreases. However, as long
as the PC continues to be purchased from abroad, expenditure on the computer
will increase.1 From now on, we assume that spending on imports falls when
1 For example, if the foreign PC now costs 1’000 instead of 982 euros or the nominal exchange rate
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the real exchange rate rises — i.e. the first effect dominates. If we summarize the
equations (9.3) and (9.4), we obtain the following for net exports (= X − I M):
NX = NX (Y , Y ∗ , ε )
− + +
(9.5)
A special feature of the short term should be mentioned here. While net exports
increase according to the equation (9.5) as a result of a devaluation (ε increases),
in practice this is only the case with a certain time lag. Economists refer to this as
the J-curve. This describes the observation that, in practice, net exports initially
fall after a devaluation and then rise. How can this be explained? If a currency
depreciates, the quantities of exports and imports do not change in the very short
term, but the prices in domestic currency do. Using our previously introduced
notation: it changes ε, but both X and Q remain unchanged. In the case of
Switzerland, a devaluation of the franc causes the euro prices of Swiss exports
to fall and the franc prices of imports to rise. Let us assume that Switzerland
exports goods worth CHF 200 billion to the Euro area and imports goods worth
EUR 150 billion from there. In the first few days after a devaluation of the franc,
the quantities will not have changed — it takes more time for supply chains to be
adjusted — but all imports are now recognized at the new exchange rate in the
Swiss current account. Since the franc has depreciated in our example, imports
in franc terms will initially increase. Over time, however, the Swiss will order
less from abroad and foreigners will buy more goods from Switzerland, so that
net exports will then increase.
Both exports and imports therefore depend on the real exchange rate. One could
argue that this exchange rate itself has yet to be determined. However, in this
textbook we treat the real exchange rate (ε) largely as an exogenous variable.
That is, we do not explain the level of the real exchange rate within the framework of our model. Instead, we can compare the demand for goods in an open
economy (see equation 9.2) with that from the closed economy. Figure 9.1 shows
the domestic demand for goods as in a closed economy at the top left. We have
to subtract the import demand from this (top right) and add the export demand
(bottom left). The result is demand as C + I + G + NX. Net exports (NX) determine whether demand is higher or lower than in the closed economy. It is easy
to see that NX is negatively dependent on domestic income (Y): the higher the
domestic income, the higher the imports. However, exports do not depend on
depreciates to 1.15 CHF per euro, more will have to be spent on imports and the (remaining)
demand for domestic goods will be reduced. However, in addition to this price effect, there will
also be a quantity effect: some consumers will favor domestic goods as a result of the increase
in the price of foreign goods.
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domestic income, so that net exports fall as income rises. We use YHB to denote
the income level at which the trade balance is balanced.
Z
Z
C+I+G
C+I+G
rts
po
Im
C + I + G − IM
Y
Y
Z
Z
C+I+G
C + I + G + NX
s
ort
exp
C
•
•B
C + I + G − IM
•A
trade surplus
trade deficit
Y
YHB
Y
YHB
Y
NX = X − I M
Figure 9.1: Goods demand in the closed and open economy
In Figure 9.1, there are a number of aspects to consider. Firstly, we obtain a
flatter straight line at the top right after deducting imports. This reflects the
fact that with rising income, part of the additional demand is for foreign goods.
We also see at the bottom left that the line with exports (C + I + G + NX) runs
parallel to the line without exports (C + I + G − I M). Since exports are not
dependent on domestic income (Y), the demand for goods simply shifts upwards.
We also recognize several relevant variables. The line A–C denotes exports, A–
B shows the imports and B–C the net exports. And there is another interesting
observation: The demand for goods in the open economy (C + I + G + NX) is less
income-elastic (i.e. flatter in the graph) than in the closed economy (C + I + G).
This takes account of the fact that the demand for goods in an open economy is
less dependent on domestic income (Y) than in a closed economy.
As in Chapter 2, the equilibrium on the goods market results from the condition
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Y = Z: domestic production corresponds to the demand for domestic goods. We
can see this equilibrium graphically in Figure 9.2.
Z
r
45° line: Y = Z
C + I + G + NX
•
•
A
C + I + G + NX with i1 > i0
i1
•
B
•
i0
A
B
IS
45°
Y1
Y0
Y
Y1
Y0
Y
Figure 9.2: Goods market equilibrium, IS curve of the open economy
Once again, the IS curve describes the equilibrium on the goods market, whereby
we refrain from the extensions from chapters 5–7 (real interest rate, risk premium):
Y = C (Y − T ) + I (i ) + G + NX (Y, Y ∗ , ε)
(9.6)
The GDP of the economy thus depends on a whole range of influencing factors:
Y = Y ( T , i , G, Y ∗ , ε )
− − +
+ +
(9.7)
One aspect must be discussed here: How do net exports react to an increase in
the real exchange rate — i.e. a real depreciation of the Swiss franc? In equation (9.7) we see a positive correlation. However, this is the result of three effects
— two quantity effects and one price effect — which occur in the case of a real
depreciation (an increase of ε):
• exports increase as Swiss products become relatively cheaper for foreigners.
• Imports decline as foreign products become relatively expensive for Swiss
people.
• The value of imported goods and services expressed in Swiss francs increases.
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9 International Macroeconomics
In order to obtain a positive relationship between NX and ε, i.e. net exports
increase with a real depreciation, the first two effects must be superimposed
on the third. This is also known as the Marshall-Lerner condition, in honor of
the English economist Alfred Marshall (1842–1924) and the Moldavian-BritishAmerican economist Abba P. Lerner (1903–1982). In practice, however, this condition does not always have to be met. For example, almost all Colombian exports
— whether oil, coffee or gold — are traded in US dollars. When the Colombian
peso depreciated sharply in the summer of 2014, there was therefore no increase
in exports.2
Depending on whether we assume that the central bank controls interest rates or
the money supply, the IS-LM model with the two curves results:
• IS curve: Y = C (Y − T ) + I (i ) + G + NX (Y, Y ∗ , ε)
• LM curve: i = i0
MS /P = Y ∗ L(i )
or
i
i
LM (money market)
i0
•
A
LM (money market)
A
•
IS (goods market)
Y0
Y
IS (goods market)
Y0
Y
Figure 9.3: IS-LM model for interest rate and money supply management
It appears in Figure 9.3 that we can also analyze some aspects of the open economy within the framework of the already known IS-LM model. For example,
expansionary fiscal policy continues to lead to an increase in GDP. However, as
we will see, the multiplier effect is now smaller. This is because people spend
part of their increased income on imports. In addition, as in Figure 9.3, the IS-LM
model disregards the effects on the exchange rate. In our modeling framework,
2 This example is discussed in detail in the article “Global trade’s dependence on dollars lessens its
benefits”, published on 29 August 2020 in the British magazine The Economist. The underlying
research comes from Emine Boz, Camila Casas, Georgios Georgiadis, Gita Gopinath, Helena Le
Mezo, Arnaud Mehl and Tra Nguyen, among others: “Patterns in Invoicing Currency in Global
Trade”, IMF Working Papers, 2020.
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an expansionary fiscal policy leads to an increase in Y and thus to a decrease in
net exports (see equations 9.3 and 9.4). To be able to analyze this, we need to extend the IS-LM model a little. First, we consider the case of fixed exchange rates
(Mundell-Fleming model) and then turn to the situation with flexible exchange
rates (IS-LM-IP model or sometimes IS-LM-UIP for uncovered interest parity).
9.2 The Mundell-Fleming Model
The Canadian economist Robert Mundell (1932–2021) and the British economist
John Marcus Fleming developed the Mundell-Fleming model named after them
in the 1960s. In addition to the IS and LM curves, there is also the FE curve (for
fixed exchange rate, in some representations also known as the ZZ or BoP curve,
for balance of payments). The IS curve remains as described in equation (9.6). The
LM curve can also be adopted unchanged, at least as long as the domestic residents are assumed to hold only the domestic currency as cash. It is important to
note that the interest rate is no longer an endogenous variable, but is determined
by the interest rate parity as described in Chapter 8. The LM curve therefore describes the equilibrium on the financial market with an interest rate determined
by the foreign country:
L(Y, i ) = M/P
(9.8)
With fixed exchange rates and free international capital movements, the central
bank must base its monetary policy on the world market interest rate. Interest
rate parity applies:
i = iW +
Ete+1 − Et
Et
(9.9)
where we use iW to describe the world market interest rate. This serves as a
reference value for the small open economy: the domestic interest rate (i) can
only be below the world market interest rate if the domestic currency is expected
to appreciate. In equation (9.9), this means that the nominal exchange rate (Ete+1 )
expected for the future (i.e. period t + 1) in price terms is below the current
exchange rate (Et ). For example, the interest rate may be 1.0% in Switzerland and
1.9% in the Euro area if the expected exchange rate, starting from today’s level
Et = 1.10 is around Ete+1 = 1.09. Without expected appreciation or depreciation,
the domestic interest rate must be equal to the world market interest rate. We
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can therefore add it to Figure 9.4 as a horizontal FE line (for fixed exchange rate).
With fixed exchange rates, the interest rate, the nominal money supply (M) and
also the price level (P) are thus exogenously given in equation (9.8) (we generally
consider the price level in the IS-LM model to be fixed). This leaves GDP (Y) as
the only endogenous variable. An increase in the money supply must therefore
lead to an increase in GDP.3
i
i
LM
i0 = iW
•
A
LM resp. FE
iW
A
•
IS
Y0
FE
IS
Y
Y0
Y
Figure 9.4: Mundell-Fleming model for interest rate and money supply control
We can also interpret the FE curve in such a way that it represents all balance
of payments balances of zero, i.e. all interest-income combinations in which the
external contribution to GDP (NX) and net capital exports add up to zero. As
we know from Chapter 8, a country with a current account surplus (NX > 0)
must export net capital, i.e. have a capital account deficit. Conversely, a country
can only consume more than it produces (current account deficit) if it simultaneously receives capital from abroad (capital account surplus). Mathematically,
this results in F (i, iW ) as the balance of the capital account:
NX (Y, Y ∗ , ε) + F (i, iW ) = X (Y ∗ , ε) − I M(Y, ε) + F (i, iW ) = 0
(9.10)
Assuming free international capital mobility, the FE curve describes the equilibrium on the foreign exchange market. Rising net exports (NX > 0) mean a
rising supply of foreign exchange: if Switzerland exports more goods, foreign
customers must exchange their money (from a Swiss perspective, this is foreign
exchange) for Swiss francs in order to buy Swiss goods. A capital account deficit
(F (i, iW ) < 0) in turn leads to an increase in demand for foreign currency. If a
3 The Keynesian approach is again evident here: Since we disregard the supply side and resource
constraints there, any demand-side expansionary policy leads to an increase in GDP.
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9 International Macroeconomics
Swiss citizen buys a flat in France, he must pay for it in euros and thus sell Swiss
francs.
From equation (9.10) it follows that the FE curve is horizontal with complete
capital mobility. To see this, we form the total differential:
NXε dε + NXY dY + NXY∗ dY ∗ + Fi di + FiW diW = 0
(9.11)
Since the exchange rate is constant (dε = 0) and we take the foreign GDP (Y ∗ )
and the world market interest rate (iW ) as given (i.e. dY ∗ = diW = 0), follows
from this:
NXY
di
=−
dY
Fi
(9.12)
We know that net exports fall with domestic income (NXY < 0) and that capital
imports rise with the domestic interest rate (Fi > 0). This basically results in a
rising FE curve for Figure 9.4. However, we have assumed perfect international
capital mobility, so that: Fi = ∞. This results in a flat FE curve. This curve shifts
when the variables considered as given (such as the real exchange rate) change.
The economy in Figure 9.4 is in equilibrium at point A. However, a distinction
must be made here between domestic, foreign and macroeconomic equilibrium.
The domestic equilibrium is the intersection between the IS and LM curves, while
all external equilibria are represented by the FE curve. An economy is only in
macroeconomic equilibrium if the domestic equilibrium lies on the FE curve. The
FE curve must therefore run through the intersection of the IS and LM curves. If
the economy is above the FE curve, the domestic interest rate is higher than the
world market interest rate. This attracts capital from abroad, which increases the
demand for domestic currency and thus leads to a nominal appreciation. Since
we consider the price level as fixed in the IS-LM modeling framework, this also
implies a real appreciation. This will reduce net exports, GDP and incomes will
fall until the economy is back in macroeconomic equilibrium.4
We can see in Figure 9.4 that in the case of interest rate control, the LM and FE
curves coincide. With flexible exchange rates and complete capital mobility, a
central bank can no longer choose the interest rate. Instead, it must maintain the
interest rate in such a way that neither upward nor downward pressure arises. In
this context, economists speak of the macroeconomic trilemma. Also known as
4 In the case of money supply management, a fall in income automatically leads to a fall in the
interest rate. In the case of interest rate control, the central bank must lower the interest rate to
the world market level in order to achieve external equilibrium.
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the impossible trinity, Mundell (Canadian Journal of Economics and Political Science,
1963) and Fleming (IMF Staff Papers, 1962) showed that there is a conflict between
three objectives of the central bank: autonomous monetary policy, free movement
of capital, and fixed exchange rates. Of these three objectives, a maximum of two
are achievable. In our case, we assume that there should be no appreciation or
depreciation (hence i0 = iW ). The central bank thus chooses stable exchange rates
and the free movement of capital. As a result, it must forego an autonomous
monetary policy. The situation is no different if the central bank controls the
money supply (right-hand graph in Figure 9.4). In this case too, the central bank
must aim for the interest rate iW so that there is neither upward nor downward
pressure.
9.3 IS-LM in the Open Economy: IS-LM-IP Model
The Mundell-Fleming model assumes that the current exchange rate corresponds
to the expected exchange rate for the future, so that: i0 = iW . However, if we look
at equation (9.9) again, we can also allow for deviations from Et and Ete+1 . In
this case, the domestic interest rate can deviate from the world market interest
rate. An increase in the domestic interest rate (i) relative to the world market
interest rate leads to an appreciation at given expected exchange rate (Ete+1 ). This
appreciation today causes the currency in the future to either appreciate less or
even depreciate. This raises the question of how the expected future exchange
rate is determined. We will discuss this later. First, we take it as given and denote
e
it by E :
e
i = iW +
E − Et
Et
(9.13)
Since the world market interest rate (iW ) is also given exogenously, we obtain
(with price quotation) a negative relationship between the domestic interest rate (i)
and the current exchange rate (Et ): if the interest rate rises, the domestic currency
appreciates (i.e. Et falls). This is also shown in the right-hand graph in Figure 9.5
in the form of a rising IP curve (interest rate parity curve).
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i
i0
i
•
A
i0
LM
IS
Y0
IP
Y
E0
E
Figure 9.5: The IS-LM-UIP model for interest rate management
In Figure 9.5 we see the case of interest rate control, but we could just as well
use money supply control (with a rising LM curve). As before, the intersection of
the IS and LM curves describes the simultaneous equilibrium on the goods and
financial markets. The graph on the right shows the corresponding equilibrium
exchange rate (E0 ). This results from the domestic interest rate level (i0 ) and the
interest rate parity. There are two aspects to consider. Firstly, the IP curve is
drawn for a given world market interest rate (iW ) and for a given expected future
exchange rate (Ete+1 ). If these two exogenous variables change, the IP curve shifts.
Specifically, it shifts upwards if iW or Ete+1 increases. Secondly, the IS curve now
has a downward slope for two reasons: if the interest rate (i) rises, investment
falls and the domestic currency appreciates, which in turn reduces net exports.
9.4 Economic Policy in the Open Economy
The IS-LM model has allowed us to analyze the closed economy in the short run
— in particular how the state can exert influence via fiscal and monetary policy.
How does the analysis change in the open economy? First and foremost, the
effectiveness of economic policy interventions designed to increase the demand
for goods changes. Additional income (Y) can now also be spent on imports.
This can reduce the effectiveness of economic stimulus programs or make them
more expensive. In small open economies in particular, a lot is "lost abroad".
Economists therefore also speak of import leakage.
In addition, fiscal and monetary policy in the open economy influence the real
exchange rate (ε), which in turn has an impact on exports and imports. There
are thus further possibilities for the state and the central bank to stimulate the
economy in a recession. As we know, exports increase GDP (see GDP equation).
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The question therefore arises as to whether it makes sense to devalue one’s own
currency. It should also be noted that international trade is often influenced by
measures that are not primarily motivated by trade policy. For example, new consumer, environmental or climate protection laws sometimes have a very strong
impact on a country’s exports and imports. In addition, a government can influence the attractiveness of a country as a production location — for example
through low corporate taxes — in order to attract foreign investment. We will
analyze all these aspects below.
9.4.1 Fiscal Policy in the Open Economy
In a first step, we turn to fiscal policy and analyze how it works in an open economy. As already discussed in chapters 2 to 4, in the IS-LM model the Keynesian
multiplier is crucial for the impact of higher government spending (G) or lower
taxes (T). In chapter 2 we had the equation 2.3 (see page 67):
Y = c 0 + c 1 (Y − T ) + I ( i ) + G
(9.14)
In the closed economy, exports and imports were equal to zero and we found the
multiplier to be 1/(1 − c1 ). In other words, as a result of an expansionary fiscal
policy, (1 − c1 ) of stimulus was ’lost’ in each round, as part of the additional
income is saved by people. In the open economy, imports are added as a second
’leakage’ (leakage). If we use m to denote the marginal propensity to import, i.e.
what percentage of disposable income is spent on imported goods and services,
then we get5
Y = c 0 + c 1 (Y − T ) − m (Y ) + ( i ) + G + X
If we solve this again for Y, the result is
1
Y=
c0 + I ( i ) + G − c1 T + X
1 − c1 + m
(9.15)
(9.16)
We obtain the new multiplier: 1/(1 − c1 + m). As the denominator is increased
by the marginal import slope (m), the multiplier is now smaller. As an example
from practice, we can cite the so-called environmental premium (also known as
5 Strictly speaking, we would have to write I M = m (Y − T ), i.e. that spending on imports depends
on disposable income (after taxes). However, we would then also have to write in equation (9.4):
I M = I M(Y − T, ε). For the central point here, the changed multiplier effect, it does not matter.
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the scrappage premium or “cash for clunkers” program) in Germany from 2009.
The German government subsidized the purchase of new cars with a total of
five billion euros. Under certain conditions, people received 2’500 euros if they
scrapped an old car and bought a new or year-old car. However, as the cars often
came from abroad, a considerable portion of the five billion euros ultimately
flowed to the respective countries of origin and did not stimulate the German
economy. The OECD followed the same logic in its Economic Outlook in March
2021, forecasting that the USD 1.9 trillion US economic stimulus package would
boost GDP in the USA by 3-4 per cent, but would also increase GDP growth in
countries such as China and the Euro area by around half a percentage point.
Additional government consumption expenditure (G) or tax cuts increase the
economic demand for goods (as in the closed economy) and thus GDP. However,
imports also increase with income (Y), which according to the equation (9.4)
are positively dependent on income. As exports, on the other hand, depend on
foreign income (see equation 9.3) and therefore remain unchanged, net exports
fall in our model (NX = X − I M). The smaller multiplier and the trade deficit
have the same cause: Part of the demand created by the expansionary fiscal
policy is accounted for by foreign goods.
What conclusions can be drawn from this? It can be seen that the effectiveness
of expansionary fiscal policy in an open economy is limited by the possibility of
imports. We now understand why many economists are in favor of international
coordination of economic policy. In this way, the costs of economic policy are
spread and the free-rider problem is taken into account.
However, we have so far ignored a second effect of expansionary fiscal policy:
the consequences for the exchange rate. To take this into account in the analysis,
we can use the IS-LM-IP model. Let us assume that the government increases
government consumption (G) as part of an expansionary fiscal policy. As in the
simple IS-LM model, this will shift the IS curve to the right. We can see this in
Figure 9.6. The economy moves from point A to point B. As the central bank
controls interest rates and keeps the interest rate at the level i0 , there is also no
change in the exchange rate (E) in the right-hand graph.
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i
i1
i0
i
•
A
•
C
•
B
LM′
i1
LM
i0
IS′
IS
Y0 Y2
Y1
IP
Y
E1
E0
E
Figure 9.6: Expansive fiscal policy in the IS-LM-IP model
The result of expansionary fiscal policy is that government spending (G), private
consumption (C) and GDP (Y) have increased. Since neither the exchange rate
nor (according to the assumption) foreign GDP have changed, net exports must
have fallen: exports have remained unchanged, but imports have risen. The
higher government budget deficit leads to a deterioration in the trade balance.
However, as we already know from chapters 5 to 7, the effects of expansionary
fiscal policy also depend on the initial situation, specifically whether GDP was
originally below or above potential output (Yn ). If we assume that GDP in the
initial situation already corresponded to the natural production level, i.e. Y0 =
Yn , the central bank must expect an increase in the inflation rate as a result of
the expansionary fiscal policy. To prevent the economy from overheating, it can
raise interest rates. We see this in Figure 9.6 as an upward shift of the LM curve.
However, since we are looking at an open economy, the rise in interest rates
has an impact on the exchange rate. In the right-hand graph of Figure 9.6, we
can see that the domestic currency has appreciated (a reduction of E describes
an appreciation in the price quotation). The higher domestic interest rate has
attracted foreign capital.
As a result, the expansionary fiscal policy in combination with a contractionary
monetary policy leads to an increase in government spending, GDP and private
consumption (depends positively on income). Private investment falls due to
the higher interest rate and net exports fall due to increased imports (positively
dependent on domestic income) and real appreciation (which causes imports to
rise and exports to fall). In this case, the additional government spending not
only crowds out private investment (the crowding out known from Chapter 4),
but also exports (referred to as international crowding out). The result of both is
that GDP does not increase as much as with interest rate control.
Let us compare the situation illustrated in Figure 9.6 with two alternatives. Firstly,
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we can assume that the central bank controls the money supply. In this case, the
LM curve is rising. In this case, expansive fiscal policy — i.e. a rightward shift
of the IS curve — leads to an increase in the interest rate and an appreciation of
the domestic currency. Once again, private investment and exports are crowded
out. As a second alternative, we can analyze expansionary fiscal policy within
the framework of the Mundell-Fleming model from Figure 9.4. As long as we
assume perfect international capital mobility, the exchange rate is to remain unchanged and the central bank controls interest rates, the central bank must keep
the interest rate at the level iW . An expansionary fiscal policy therefore results
in a strong increase in GDP, as there is neither an increase in interest rates nor
an appreciation. The situation is completely different with money supply management (right-hand graph in Figure 9.4): expansionary fiscal policy shifts the IS
curve to the right so that the new intersection point is at an interest rate above iW .
This leads to capital imports, which causes the domestic currency to appreciate.
As long as the central bank does not react to this, the upward pressure remains.
Exports fall as a result, which leads the IS curve back to the initial situation.
An important insight from this discussion is that the effect of expansionary fiscal policy depends on both monetary policy and the exchange rate regime (fixed
or flexible). Tax cuts and additional government spending tend to cause an increase in interest rates and thus additional capital imports, which in turn leads
to an appreciation of the domestic currency. If the central bank does not prevent this appreciation through appropriate monetary policy measures, exports
are squeezed out.
9.4.2 Monetary Policy in the Open Economy
If we look at the effects of monetary policy in an open economy, we can take another look at Figure 9.6. This shows the consequences of contractionary monetary
policy, which shifts the LM curve upwards, increases interest rates, lowers GDP
and leads to an appreciation of the domestic currency. The latter causes a decline
in (net) exports and thus a further decline in GDP. This double effect on GDP
also occurs with an expansionary monetary policy. This not only lowers interest
rates, but also stimulates the economy by devaluing the domestic currency. Devaluation makes a country more competitive internationally (in the short term),
which is referred to as competitive devaluation. In an open economy, expansionary
monetary policy is therefore particularly attractive in the short term.
However, this only applies in a regime of flexible exchange rates. With fixed
exchange rates and free international capital mobility, however, the central bank
loses its monetary policy autonomy. As we have already seen in the macroeconomic trilemma, the central bank must then adjust the interest rate to the relevant
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world market level. For example, if the Swiss National Bank wants a fixed exchange rate against the euro and does not introduce any restrictions on capital
movements, it must also lower interest rates every time the European Central
Bank (ECB) cuts rates. This was hardly possible as the key interest rate was already below 0.5% from 2009 (it was then lowered to -0.75% in January 2015). The
SNB therefore had to intervene in the foreign exchange market itself and buy
assets denominated in euros (such as German government bonds) with newly
created francs. The idea was to buy unlimited amounts of euros and other foreign currencies on the open market, as a strengthening Swiss franc would be just
as damaging to the economy as an interest rate hike.
It is worth taking a closer look at this process. If the SNB pursues an expansionary monetary policy in order to prevent the Swiss franc from appreciating, this
initially appears very attractive. In exchange for cheaply ’produced’ Swiss francs,
the SNB can buy shares in French companies, for example. However, it must be
noted that this monetary policy ultimately shifts purchasing power from the citizens of Switzerland to the central bank: the appreciation would have given the
Swiss population greater purchasing power. Instead, the SNB acquires assets.6
In addition, the SNB’s policy has led to a very large increase in its balance sheet.
This is shown in Figure 9.7.7 On the asset side, there are mainly government and
corporate bonds as well as shares and gold. The SNB’s interventions since the
2008 financial crisis have led to a massive increase in securities denominated in
foreign currencies.8 This also increased the liabilities side, as the SNB credited
the sellers of the securities with corresponding credit balances on their sight deposit accounts at the SNB. These accounts are denominated in Swiss francs and
can theoretically be increased by the SNB without restriction. The interest rate on
sight deposits has been -0.75% since 22 January 2015 — so it was by no means
attractive to leave money at the central bank. But why didn’t private commercial
banks withdraw it? This issue is more complex than an introductory textbook
can explain. In a nutshell, however, it can be said that there are exemption limits
below which commercial banks did not have to pay penalty interest. In addition, they could convert the balances into cash, but this would also involve costs
6 It can be argued that the SNB’s interventions weaken the Swiss franc, thereby promoting the
export industry and thus increasing the purchasing power of some citizens. The net effect
on the purchasing power of the Swiss population is therefore a priori unclear and varies from
person to person.
7 The graphic is based on a similar illustration in the article “Was steckt eigentlich in der Nationalbank drin?”, published in the journal Republik on 7 May 2018.
8 At the end of 2020, 40% of the SNB’s foreign exchange reserves were denominated in euros, 36%
in US dollars, 8% in yen, 6% in pounds sterling and 10% in other currencies. In terms of asset
classes, government bonds accounted for 70% and equities for 20%. In terms of default risk,
62% had an AAA rating, 19% an AA rating and 15% an A rating.
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(vaults, insurance). Although the high credit balances allowed the commercial
banks to grant many loans to the private sector - in line with an expansive monetary policy - there was a lack of sufficiently attractive business opportunities in
the lending and investment business. As a result, the money remained at the SNB
and did not become inflationary. In the context of quantity theory (equation 6.3
on page 184), this corresponds to a very strong increase in the money supply (M)
combined with a very strong decrease in the velocity of circulation (V).
Figure 9.7: Balance sheet of the Swiss National Bank
In 2021, the SNB’s balance sheet totalled over CHF 1,000 billion. This was only
possible due to a sharp increase in the money supply, as we have already seen in
Figure 6.9 (page 190). This does not necessarily lead to higher inflation, as private commercial banks hoard most of the money created by the National Bank.
Nevertheless, the expansion of the central bank balance sheet is problematic. On
the one hand, the National Bank’s profits and losses from its currency reserves
are higher and more volatile. Secondly, there is the problem of political influence.
The large assets arouse political interest, which in Switzerland is often expressed
in the form of a sovereign wealth fund. There are also considerations to steer
the SNB’s investments according to political objectives. However, due to the size
of its balance sheet, the central bank would then intervene heavily in the economy without having a clear mandate to do so. It would be faced with difficult
trade-offs: should it invest broadly in order to minimize fluctuations in value or
specifically in ’green’ companies, for example? In addition to its actual objec296
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tives (price stability and stable economic growth in Switzerland), new objectives
would be established, which would inevitably lead to conflicting goals.
Exchange Rate Policy
In an open economy, a central bank not only determines monetary policy, but also
directly or indirectly exchange rate policy. An expansionary monetary policy
leads to a nominal devaluation in the short term, as there are more francs in
relation to other currencies. In equation (9.17) terms, E rises (we use the price
quotation). As prices do not change in the short term, the nominal devaluation
also leads to a real devaluation. This improves the competitiveness of domestic
companies.
ε = E∗
P∗
P
(9.17)
However, if the expansionary monetary policy leads to inflation in the medium
term, as described in Chapter 6, then domestic prices rise relative to those abroad
(P∗ /P falls). Using equation (9.17), we can see that this equates to a real appreciation (ε falls). The effects of expansionary monetary policy on the real exchange
rate thus differ in the short and medium term. And we recognize once again that
the change in a nominal variable such as the money supply does not affect a real
variable such as the real exchange rate in the medium term.
Nevertheless, the question arises as to whether countries should aim for a fixed
or a flexible exchange rate. Firstly, a number of disadvantages of fixed exchange
rates need to be considered. Essentially, by setting a fixed exchange rate, a country gives up the ability to set its own domestic interest rate. This is illustrated
by an example from the early 1990s. After the reunification of Germany, there
was an economic boom in Germany (annual GDP growth of around 5% in 1990
and 1991). The Bundesbank pursued a contractionary monetary policy at the
time in order to prevent the German economy from overheating. The UK, on
the other hand, was in recession at the same time (GDP growth of 0.7% and
-1.1% in 1990 and 1991). However, as the country had been a member of the
European Monetary System (EMS) since 8 October 1990, the Bank of England had
to keep the exchange rate to the German mark stable within narrow fluctuation
margins (plus/minus 6%). Since mid-1990, the exchange rate had been DM 2.95
per pound, which was a relatively high value for the British currency. In order
to maintain this, the British central bank had to raise interest rates in line with
the German Bundesbank. However, this had a detrimental effect on the British
economy and caused problems in the property market, as many house buyers
were no longer able to service the rising interest rates on loans. In the end, 16
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September 1992 went down in history as Black Wednesday. As many investors
such as George Soros were betting on a devaluation of the British pound — they
borrowed British pounds and used them to buy DM-denominated assets — the
Bank of England initially raised interest rates from 10 to 15%, but announced at
7 pm that it would leave the EMS. Interest rates were cut again to 10% and the
British pound lost around 15% of its value against the German mark within a
few weeks.
While George Soros became known as the “man who broke the Bank of England”
and made billions in profits, the Bank of England lost several billion as a result of
the ultimately unsuccessful attempts to support the British pound. The event
was seen by many as a national humiliation and shows how problematic a fixed
exchange rate can be. If there is speculation about an imminent devaluation of a
currency, a central bank may need large foreign exchange reserves to maintain the
exchange rate. From the speculators’ point of view, this results in a very attractive
calculation. Let us assume that there is a 10% probability that the British pound
will depreciate by 15% within the next month. If we insert the interest rate for
Germany (i D ) and that for the UK (iUK ) into the interest rate parity equation, the
result is
1 + i D = 0.9 ∗ (1 + iUK ) + 0.1 ∗ ((1 + iUK ) ∗ 0.85)
(9.18)
⇐⇒ 1 + i D = 0.985 ∗ (1 + iUK )
The monthly interest rate in the UK must therefore be (1/0.985 = ) 1.52 percentage
points higher than the interest rate in Germany. Since ten-year German government bonds yielded around 9% per year at the time, i.e. around (1.09)1/12 = 0.7%
per month, the annual interest rate in the UK should have been around 30.1%
(1.022212 ). This shows how attractive speculation can be, even with a relatively
low probability of devaluation (we have assumed 10%). If it is foreseeable that
a central bank will not have sufficient foreign exchange reserves to defend an
exchange rate, the probability of devaluation increases and the potential return
rises very sharply.
The example of the UK illustrates some of the disadvantages of fixed exchange
rates. Flexible exchange rates also enable rapid economic adjustment in the event
of major negative shocks. The economic slump in Thailand, Indonesia, Malaysia
and Korea during the 1997 Asian crisis was comparable to the decline in GDP
in Greece, Ireland, Spain and Italy during the euro crisis from 2009 onwards.
However, the Asian countries were able to devalue their currencies and thus
quickly become competitive again. In contrast, the euro countries lacked this
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flexibility. The UK economy also managed to keep the unemployment rate low
and the economic slump to a minimum in the wake of the surprising Brexit
decision in 2016 thanks to a devaluation of the British pound.
In some respects, a currency union represents the extreme case of a fixed exchange rate. In such a union, asymmetric shocks are problematic, i.e. shocks that
hit certain countries particularly hard and others less. There are then three adjustment mechanisms: flexible wages and prices, a mobile labor force and balancing
fiscal flows. This is precisely the core problem of the Euro area: it is susceptible
to asymmetric shocks and the equalization mechanisms are only available to a
limited extent. For example, labor mobility in the Euro area is significantly lower
than in the United States. As described by Aymo Brunetti (“Economics”, 2013,
pages 323-331), the decision to introduce the euro at the Madrid summit in 1995
came as a shock. Interest rates fell dramatically in the GIPS countries (Greece,
Ireland, Portugal, and Spain) because there was suddenly no longer any risk of
devaluation. The institutions of the Euro area, in particular the European Central Bank, were modeled on the German Bundesbank, which had achieved price
stability in Germany for decades. The decision to introduce the euro and the
resulting interest rate cuts in southern Europe had a very stimulating effect on
the economies of the GIPS countries. However, the economic boom had two side
effects: a steady loss of competitiveness and strong incentives for government
debt. However, currency devaluation was no longer available to the GIPS countries as an instrument to combat rising unemployment and growing government
debt.
In view of these disadvantages of a fixed exchange rate regime, the question
arises as to why some countries nevertheless either peg their currency to another
or even enter into a common currency union with other countries. A central
argument is that a fixed exchange rate reduces volatility and therefore uncertainty. Few investors want to invest money in countries whose currency fluctuates greatly in value. Cross-border activities are also more difficult for companies — or more expensive with insurance against exchange rate risks — if there
are flexible exchange rates. While this is a particularly important argument for
smaller, poorer economies, it also applies, for example, to the countries of today’s
Euro area. However, the extent to which the creation of a common European currency has promoted trade between the participating countries is disputed among
economists.9
Another advantage of a fixed exchange rate is that a central bank can use it to
9 For recent examples, see the study by Larch, Wanner, Yotov and Zyklin (Oxford Bulletin of Eco-
nomics and Statistics, 2018) and Larch, Wanner and Yotov (Economics Letters, 2018). Similarly
unclear results are provided by the work of Glick and Rose (NBER 2015, and European Economic
Review 2016).
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achieve a lower inflation rate. This is achieved in two ways. Firstly, the fixed
exchange rate stabilizes import prices. A devaluation of the domestic currency
can otherwise quickly lead to a imported inflation rate if products traded internationally in dollars become more expensive domestically due to the devaluation.
Secondly, the central bank thus limits the possibility of an overly expansive monetary policy — this would run counter to the fixed exchange rate. To a certain
extent, it disciplines itself. This consideration also leads us to an explanation of
what determines the nominal exchange rate in the medium term.
Let us again recall the definition of the real exchange rate from equation (9.17). If
all goods were internationally tradable without trade costs, the price expressed
in the same currency would have to be the same everywhere, i.e. the following
would apply: ε = 1. In practice, this is not the case, as there are trade costs.
However, if these do not change too much over a few years, an increase in the
foreign price level (P∗ ) must tend to be accompanied by a devaluation of the
foreign currency (formally a reduction of E). In other words, a lower domestic
inflation rate should lead to an appreciation of the domestic currency. Let us
assume that the Apple iPhone costs 900 CHF in Switzerland and 900 US dollars
in the USA at an exchange rate of 1:1. If the price then rises to 1’800 US dollars
due to inflation in the USA, the nominal exchange rate must fall to 1 CHF to 2 US
dollars.
In Figure 9.8 we test the relationship between inflation rates and changes in exchange rates. For each country shown, we see the inflation rate (based on the
consumer price index) from 2000 to 2019 relative to the US: values greater than
one on the horizontal axis mean that a country had a higher inflation rate than
the US. On the vertical axis, we see the change in the exchange rate against the
US dollar. Values greater than one mean a devaluation against the dollar. The
very clear statistical correlation, which is close to the 45-degree line as in theory, strongly supports the correlation postulated above: countries with a high
inflation rate tend to have a depreciating currency.
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Figure 9.8: Inflation and change in the exchange rate
While we compare the inflation rate with the change in the exchange rate between
two years for a larger number of countries in Figure 9.8, we can alternatively
compare the purchasing power parity with the exchange rate. Figure 9.9 shows
how the PPP conversion rate to the US dollar and the exchange rate to the US
dollar have changed for Switzerland and the UK (or for the Swiss franc and the
British pound). A downward movement corresponds to an appreciation against
the dollar. If the exchange rate (PPP) is below the PPP line, this tends to indicate
a depreciation. We see, for example, that the Swiss franc appreciated very rapidly
from around 2001. As the price levels did not diverge that much, a slowdown
in the appreciation was to be expected from 2010. Figure 9.9 thus also indicates
that the exchange rate will develop in the medium term in the same way as we
assume based on the previous considerations: if the inflation rate in one country
is higher than in another, its currency tends to depreciate.
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Figure 9.9: Purchasing power parity and change in the exchange rate
In addition to inflation rates, there are also other economic variables that can
tend to predict changes in exchange rates. These include a country’s public budget. If a nation has a persistent budget deficit, there is an incentive to reduce
the growing national debt through inflation. Current account deficits are also an
indicator of exchange rate changes. A country with a persistent current account
deficit needs more foreign currency than it earns. It can therefore be expected
that the domestic currency will tend to depreciate, as there is an excess supply of
domestic currency. Conversely, the Swiss franc also appreciates because Switzerland exports more goods and services than it imports. The Swiss would like to
exchange the euros and US dollars earned in the process into domestic currency,
which means that the franc will tend to appreciate. This is supported by the
fact that Switzerland, as an economically and politically stable country, is attractive for foreign investment. This also increases the demand for Swiss francs and
contributes to the appreciation.
So what are the implications of all these considerations for a country’s exchange
rate policy? Firstly, the advantages and disadvantages of a flexible or fixed exchange rate must be weighed up in the respective country-specific context. Subsequently, the positive and negative effects of a devaluation or revaluation must
also be taken into account when influencing the exchange rate. In our modeling
framework, a devaluation of the domestic currency leads to a stimulation of the
economy due to higher exports and lower imports. However, not all countries
can logically pursue this strategy of competitive devaluation at the same time, as
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currencies are always priced against each other. After the 2008 financial crisis,
central banks in the US, Japan, the UK and the Euro area tried this one after
the other. In general, there are few examples of countries that have successfully
devalued their currencies. In 1993, China had low foreign debt, was not particularly dependent on imports and already had a substantial industrial sector.
Devaluation could be described as a success in this case. But this is the exception
that proves the rule: a country cannot devalue itself to prosperity. On the one
hand, a devaluation of the domestic currency causes a deterioration in the Terms
of Trade — as with a company that lowers its prices. On the other hand, a repeated devaluation can lead to further devaluation expectations, which can then
be self-fulfilling. This can be the trigger for a exchange rate crisis such as that
experienced by Argentina in 2018/2019, Turkey from 2018 or Pakistan in 2019. A
devaluation spiral such as in these countries can only be broken if the domestic
central bank — possibly with the support of the International Monetary Fund —
is able to stabilize the exchange rate by purchasing its own currency and sufficient foreign currency reserves. Temporary restrictions on international capital
movements can also contribute to stabilization, although their enforcement and
signalling effect are problematic.
9.4.3 Peculiarities in Poorer Countries
As already mentioned, many of the exchange rate policy questions must be
answered in a country-specific context. Particularly in the case of poorer and
smaller economies, some special features must be taken into account. These include the difficulties these countries have in participating in the international
financial market. David Lubin describes these in great detail in his book “Dance
of the Trillions”, published in 2018. The core thesis is that international financial flows are, firstly, largely determined by the financial conditions in the USA
and, secondly, are gigantic in relation to the size of some economies. If the US
Federal Reserve lowers interest rates, a great deal of financial capital looks for
more attractive locations around the world. For small, poorer economies, this
can cause a large import of capital within a very short space of time. However,
the boom this triggers (hence the title of the book “Dance of the Trillions”) only
lasts until interest rates in the USA rise again. Exposed to the large international
financial flows, the exchange rates of individual countries can therefore fluctuate
very strongly. Only with sufficiently large foreign exchange reserves can they
stabilize their exchange rates. China, for example, learned this lesson from the
Asian crisis in 1997 and increased its foreign exchange reserves from around USD
170 billion in 2000 to USD 3’800 billion in 2014.
This is linked to the problem of so-called twin deficits (twin deficits). We already
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know the equation from chapter 2 (more precisely page 76)
I = S + (T − G) + ( I M − X )
(9.19)
I − S = (T − G) + ( I M − X )
(9.20)
If we rewrite this, we get
While in a closed economy without a state, investments must correspond to savings, a twin deficit can occur in practice: There are countries that have both a government budget deficit (T − G < 0) and a current account deficit (I M − X < 0).
As Figure 9.10 shows, these include the USA, Pakistan, Egypt and Turkey.
Figure 9.10: Current account and budget balance in selected countries
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In the case of the USA, there has been a twin deficit (with brief interruptions)
since the 1980s. This tends to be easier to cope with due to the so-called exorbitant
privilege — the US dollar is the reserve currency of the international financial
system.10 For poorer countries, however, a twin deficit can be very problematic.
In order to finance the budget deficit, the state has to take on debt. This is
often more favorable if the government bonds are denominated in US dollars
instead of the domestic currency. Due to the devaluation risk of a rather weak
currency such as the Turkish lira or Argentinian pesos, international investors
demand a corresponding premium if the government bonds are not denominated
in dollars. However, if a state takes on debt in foreign currency, it still receives its
tax revenue in domestic currency. This results in a debt whose value in relation
to the source of revenue can rise sharply in the event of a currency devaluation. If
devaluation pressure actually occurs, the country also needs its foreign currency
to stabilize the exchange rate. Due to the logic described in connection with
equation (9.18), this can quickly become very expensive. For example, the Turkish
central bank used up almost all of its foreign currency holdings in less than two
years when the Turkish lira came under pressure from 2018 onwards.11 Debt in
foreign currency can therefore be very problematic — also because the breaking
point is unpredictable. As the German economist Rüdiger Dornbusch (1942–2002)
said in a PBS Frontline interview in 1995: “The crisis takes a much longer time
coming than you think, and then it happens much faster than you would have
thought. [...] It took forever and then it took a night.”
9.4.4 International Economic Cycles
Economic openness towards other countries also means that developments in
other countries influence the domestic economy. A decline (or slower growth)
of Y ∗ in an important trading partner such as Germany reduces (slows down)
Swiss exports and thus reduces Swiss GDP overall. Graphically, the IS curve in
Figure 9.5 shifts to the left.
This mechanism transfers economic cycles from one country to another. As studies by Kiminori Matsuyama, for example, show, greater bilateral trade leads to a
synchronization of business cycles. We can also illustrate this with data. In Figure 9.11 we see around 25’000 pairs of countries represented as dots. For each,
10 Pierre-Olivier Gourinchas, Hélène Rey and Nicolas Govillot discussed this exorbitant privilege
in a highly regarded study (IMES Discussion Paper 2010-E-20). They show why the USA is
at the center of the financial system and therefore has an exorbitant obligation in addition to
the privilege of being able to borrow more extensively: with the US dollar, it offers a kind of
insurance benefit, which is particularly valuable in times of crisis.
11 The development is described in the article “As the lira slides, what will Turkey’s central bank
do?”, published in the magazine The Economist on 15 August 2020.
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the horizontal axis shows how important the other country is as a trading partner
— the share of total foreign trade. The correlation coefficient for the GDP growth
rates of the two countries is plotted on the vertical axis.12 The positive correlation
between the two variables supports the theory that closer economic integration
tends to go hand in hand with a synchronization of business cycles.
Figure 9.11: Bilateral trade and synchronous business cycles
9.4.5 The Dutch Disease
The distinction between a closed and an open economy is also important in many
other developments. For example, most people will perceive it as great good fortune if valuable raw materials such as oil are found in their home country. Such
a find would enrich the country and could benefit all its inhabitants. In practice,
however, how the oil revenues are distributed plays a role. Norway and Equatorial Guinea show very different developments here. On the other hand, the
effects of the discovery of raw materials must be assessed in terms of the overall
economy. In the 1960s, large natural gas deposits were discovered in the Netherlands. The extraction and export of natural gas had two key consequences for
the Dutch economy. Firstly, the booming natural gas sector drew resources such
12 The partner country’s share of foreign trade is from 2010 and the observation period for GDP
growth covers the years 2000 to 2019. The correlation is statistically highly significant (t-statistic
15.4) and the estimated regression coefficient suggests that increasing the trade share by one
percentage point increases the correlation by 0.02.
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as labor away from other sectors. This development, known as the resource movement effect, is necessary to extract the natural gas, but is detrimental to the rest
of the economy. The second effect is the so-called spending effect. The booming
natural gas sector was able to pay high wages, which also drove all other sectors
to raise wages (if they wanted to keep their skilled labor). In addition, the export
of natural gas increased the demand for Dutch guilders, which led to a real appreciation of the guilder and thus worsened the international competitiveness of
other Dutch export industries.
The result was a contraction of the industrial sector in the Netherlands. This is
why this case is also known as the Dutch disease. Similar developments have
occurred in many countries, be it in Australia due to the commodity boom of
the last twenty years or Russia’s exports of oil and gas in the same period. In
an open economy, a commodity discovery is therefore not an unqualified gain
for the country. And from a macroeconomic point of view, the considerations
relating to the Dutch disease can also be applied to related developments. As
Max Corden and Peter Neary pointed out back in 1982 in the Economic Journal,
there is a similar logic when we look at booming sectors in Ireland, Japan or
Switzerland. These also attract resources and can contribute to an appreciation
of the domestic currency.
9.5 Summary
In this chapter, we have looked at the economic effects of economic openness towards foreign countries. Firstly, we were able to extend the familiar IS-LM model
to include international trade in goods and services. Both the Mundell-Fleming
and the IS-LM-IP models help us to understand economic developments in an
internationally integrated economy. Interest rate parity is particularly important
in this context, as it is a key determinant of exchange rates. We have also analyzed the effects of economic openness on economic policy. Firstly, it became
clear that the consequences of expansionary fiscal and monetary policy in an
open economy differ from those in a closed economy. In addition, the exchange
rate regime (fixed or flexible) plays a central role. On the one hand, this gives
economic policy a further opportunity to exert influence. On the other hand,
however, it also restricts the scope for economic policy. In any case, it remains
clear that we can only understand economic developments if we take aspects of
international interdependence into account.
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Part IV
The LongTerm
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In the fourth and final part of the book, we turn our attention to economic growth
in the long term. While it is mainly short-term developments that are documented and discussed in the media, economic cycles appear rather insignificant
in the long term. However, economic growth rates over decades are decisive
for the prosperity of the people in a country. As Figure 10.1 shows, today’s
prosperity in countries such as the USA or Switzerland has been built up over
generations. In 1900, people in all the countries shown were still poorer than in
Indonesia today. And up until 1950, per capita income in Argentina was at a
similar level to that in Switzerland. These widely divergent developments raise
many questions. What drives economic growth in the long term? How can we
understand the differences across countries? What are the implications for the
design of economic policy?
Figure 10.1: Development of GDP per capita since 1900
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The numbers from Figure 10.1 also show that long-term economic growth is by
no means natural. There are many countries that have not yet reached a high
income level. According to data from the World Bank, eleven of 186 countries
had a GDP per capita of less than USD 2’000 in purchasing power parities in
2019. In Burundi and the Central African Republic, it was even below USD 1’000.
While 58 countries had a GDP per capita of between USD 2’000 and USD 10’000,
there were 93 nations with a level of USD 10’000 to USD 50’000 and 24 countries
with a per capita income of over USD 50’000. The example of China also shows
how difficult and slow it is to rise to very high levels of prosperity. Despite
enormous economic growth since 1978 — the Chinese economy has grown by a
factor of 39 since then — per capita income today is only around a quarter of the
American level. Nevertheless, the Chinese economy is a particularly interesting
case for economists. How did it manage to maintain annual economic growth at
4% or more for decades? Would something similar be possible in Switzerland or
the USA?
Would such high economic growth even be desirable? This is a complex question and a distinction must certainly be made between rich and poor countries.
It is almost exclusively in highly-developed countries that the usefulness of economic growth is questioned. For many poorer countries, material needs take
center stage. We have already seen in Chapter 1 of this book that a country’s
per capita income correlates very strongly with life expectancy, infant mortality rates and educational opportunities. Of course, the causality works in both
directions: a high life expectancy increases the incentive to invest in education,
which in turn benefits per capita GDP. Nevertheless, the importance of economic
growth remains high, even for rich countries. For Switzerland, one per cent GDP
growth with a constant population means an increase in prosperity of around
seven billion francs or around 800 francs per inhabitant. In the words of Nobel Prize winner Robert Lucas: “Once you start thinking about growth, it’s hard
to think about anything else. There are also non-material reasons for economic
growth. Without a continuous increase in GDP per capita, the economy ultimately degenerates into a zero-sum game: one man’s gains are another man’s
losses. This results in a completely different political discussion. Ludwig Erhard, former Minister of Economics and Chancellor of the Federal Republic of
Germany, wrote in his book “Wohlstand für Alle” (1957): “It is much easier to
grant each individual a bigger piece of an ever-growing cake than to want to
make a profit from a dispute over the distribution of a small cake.” Accordingly,
Benjamin M. Friedman showed in his 2005 book “The Moral Consequences of
Economic Growth” that even in established democracies, xenophobia and antidemocratic developments increase when the economy stagnates or even falls:
“The attitude of people toward themselves, toward their fellow citizens, and to310
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ward their society as a whole is different when their living standard is rising than
when it is stagnant or falling.”
In a sense, it is the absence of long-term growth that demonstrates its importance.
Even in highly developed countries such as Japan, economic stagnation has a
number of negative consequences.1 It is therefore worth taking a closer look
at the long-term economic development. To do this, we will first take a look
at the data and consider a series of stylized facts. This reveals a number of
developments that we would then like to analyze in a structured manner. To
do this, we use the growth accounting approach and the Solow model in this
chapter. In Chapter 11 we then look at innovations and institutions. We also
discuss economic policy measures that promote long-term economic growth. We
leave out two aspects in the long term: demand and money. Instead, the focus is
on the supply and production side and on real variables.
10.1 GDP Growth in the Long-term
BIP
We now turn one last time to the graph of a country’s economic development.
Figure 10.2 is already familiar to us from Chapters 0 and 7. In a sense, it has
accompanied us throughout the textbook. Now that we know the short-term
fluctuations of GDP and the medium-term level (Yn,t at a given time t), let us
turn to the long-term economic development and analyze what determines the
slope of the dashed trend line. In other words, we want to understand how
countries can increase their GDP in the long term.
sw
up
dow
ntu
rn
e
n
trendli
n
recessio
up
sw
in
g
boom
in
g
GDP
n
recessio
time
Figure 10.2: Schematic representation of the development of GDP
While we see a trend line with a positive slope in Figure 10.2, this is not necessar1 For example, the Financial Times described on 30 November 2020 that optimism and the willing-
ness to take risks have fallen sharply in Japan due to economic stagnation.
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ily the case in practice. Economic poverty is the norm in many places, both historically and today. It is therefore less necessary to explain why some countries
are poor. Rather, we need to study the favorable exceptions and draw lessons for
all countries. To do this, we need to switch from a demand perspective to a supply perspective, because in the long term, GDP is not determined by the demand
for goods and services, but by the resources and technologies used for production. As can already be seen in Figure 10.2, the GDP of an economy is based on
its production potential in the long term. As we have determined the production
potential (Yn ) in the analysis of the medium term in such a way that the production factors were utilized, we can leave out aspects such as unemployment when
analyzing the long term.
From a historical perspective, economic growth is a fairly recent phenomenon.
As Figure 10.3 shows, there was practically no sustained increase in per capita
income between the years 0 and 1800. Although there were always periods in
which new technologies temporarily and regionally enabled higher economic
output, this was offset by stronger population growth. As Oded Galor points out
in his 2005 book “Unified Growth Theory”, population density is therefore a superior indicator of material prosperity in times before the Industrial Revolution.
Figure 10.3: Development of GDP per capita since the birth of Christ
According to his theory, the sudden increase in growth rates in the 18th century was the result of a very long-term process, not a technological shock. Why
the economic rise began in Europe is still disputed among researchers. As Nico
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Voigtländer and Hans-Joachim Voth (Review of Economic Studies, 2013) pointed
out, this was not necessarily to be expected. The continent was politically fragmented, torn apart by constant military conflicts, characterized by a low level
of education and ruled by feudal elites. China, on the other hand, was already
a united country, had a functioning bureaucracy, many innovations and inventions. But even in 1700, before the Industrial Revolution, per capita income in
Europe was higher. Voigtländer and Voth argue that it was precisely Europe’s
disadvantages — the plague in the 14th century, the large cities with miserable
living conditions, the frequent wars and the diseases that spread through trade
— that favored Europe’s economic development. Their argument is that all these
disadvantages primarily killed people. As a result, labor was scarce and wages
were higher.
This example also shows how important it is to differentiate between short and
(very) long-term economic effects. In addition, the chains of effects must be seen
in their respective contexts. Even if wars in Europe used to be useful in the long
term, this was no longer the case at the latest at the beginning of the 20th century
and the invention of much more effective weapons. In addition, it becomes clear
once again that the rise to a high income level takes a very long time. Based on the
data from Figure 10.3, we must note that only in 1924 did one country (Australia)
reach the level of USD 10,000 (in today’s prices). And it was only in 1974 that two
countries (Kuwait and Qatar) reached the level of USD 50,000 for the first time.
Apart from other oil countries and smaller states such as Luxembourg, Ireland,
Singapore and Switzerland, only the USA has reached this level.
If we remember the rule of 72 from chapter 1, it applies that with a constant
growth rate, a doubling occurs after x years, where x = 72/(annual growth rate).
So even if GDP per capita increases by 3 per cent annually, a country needs 24
years to double. In a century, you therefore achieve an increase by a factor of
16. With slower growth of 2 % per year, GDP per capita increases eightfold. In
the USA, this fits quite well, as per capita income has risen from around USD
8,000 in 1921 to around USD 58,000 (in 2011 prices) in 2021. Figure 10.4 shows
this graphically, whereby the short-term economic cycles — with the exception of
the Great Depression in the 1930s — are surprisingly small compared to constant
growth of 1.65 %.
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Figure 10.4: Development of GDP per capita in the USA since 1850
The development of GDP per capita in the USA also illustrates how long it takes
for a country to reach a high level of prosperity. Even with high growth rates, it
takes generations to turn a poor nation into a rich one. It was all the more absurd,
for example, when Husni az-Za’im announced shortly after coming to power in
Syria in 1949: “Give me five years and I will turn Syria into a second Switzerland.
He only remained in office for four and a half months, but he wouldn’t have
made it anyway. According to data from the Maddison Project Database 2020, per
capita income in Syria was around 3’800 US dollars in 1950. By 1981, it had risen
to just under USD 11’000, only to fall again to around USD 3’300 by 2018. By
comparison, per capita GDP in Switzerland was already around USD 11’000 in
1950 and rose steadily to over USD 60’000 in 2018.2
In order to better understand and visualize exponential growth processes, scientists like to use logarithmic scales. Based on the simple logarithm rules, we
know: ln( x ∗ a) = a ∗ ln( x ). An exponential relationship thus becomes a linear
one. Graphically, this results in a straight line if the annual growth rate is constant. Figure 10.5 illustrates this for Germany. Similar to the USA, we also see
very stable growth here in the long term, albeit with a marked slump due to
world wars, the global economic crisis and hyperinflation.
2 The quote comes from the book “Weltgeschichte to go” by Alexander von Schönburg. Per capita
income is expressed in US dollars with the purchasing power of 2011.
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Figure 10.5: Logarithmized development of GDP per capita in Germany
In Figure 10.6 we compare the development of Germany with other countries.
We can see, for example, that economic growth in the USA or Switzerland has
been very steady for decades.
Figure 10.6: Logarithmic development of GDP per capita since 1900
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What is also striking in Figure 10.6 is how serious the slump in annual economic
output can be. For example, per capita income in Germany fell by around 64%
between 1944 and 1946 due to the Second World War. Equally striking is a development in China. The policy pursued there between 1958 and 1961 under
the name "Great Leap Forward" not only caused a famine with up to 45 million
deaths, but also reduced per capita GDP from around USD 1’073 to USD 799.
Any subsequent growth therefore fell to a lower base.3
3 An analogy can be made here with the realization of the American investor Warren Buffett, who
expressed his two rules of investing as follows: “Rule Number One: Never Lose Money. Rule
Number Two: Never Forget Rule Number One.”
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Practice box 10.1: Major crises
Historically, practically every country has experienced periods of major economic upheaval. In addition to wars, the property market is often the trigger for sharp economic
downturns. Examples include Japan in 1990, Switzerland in 1991 and the USA in 2007.
Why is the bursting of a property bubble so damaging to the economy? A lot of money is
tied up in the property market. It is also supposedly invested at low risk and tied up with
credit leverage. Declines in property prices therefore have a direct impact on bank balance
sheets. And if these are negatively affected, this has a knock-on effect on lending, which
in turn affects the economy as a whole.
The extent of major crises is considerable. In the USA, GDP fell by more than 30 per cent at
the beginning of the 1930s compared to the previous peak. Germany experienced a slump
of almost two thirds as a result of the Second World War. Switzerland also experienced a
decline of more than 25 per cent at the beginning of the 1920s.
To summarize, we can say so far that countries differ very significantly in their
GDP per capita. Growth rates also vary greatly over time and across countries.
And without major disruptions such as wars, depressions or natural disasters,
growth is often very constant. The question arises as to whether there are economic models that can explain these observations. Before we turn to these, however, we must first analyze the drivers of long-term economic growth.
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10.2 Determinants of Growth
What determines the long-term economic development of a country? There are
many aspects that can be mentioned when answering this question. Particularly
with the advent of greater computing power in the 1990s, attempts were made
to provide clarity on the basis of data analyses. Studies such as that by Robert
J. Barro (Quarterly Journal of Economics, 1991) were based on data for dozens of
countries over a period of decades and found that GDP growth correlates negatively or positively with various variables. For example, the data analyses showed
that political stability is conducive to economic development. However, from today’s point of view, the very limited statistical methods allow for hardly any
meaningful findings. As early as 1997, Xavier Sala-i-Martin (American Economic
Review) showed that economic growth theories do not allow a clear description of
which factors determine economic development. Consequently, it is also unclear
which empirical model should be estimated. Sala-i-Martin therefore tested every
possible specification — his study is entitled “I just ran two million regressions”.
However, such an approach does not provide truly reliable results. We must
therefore approach the problem in a different way.
The so-called Growth Accounting approach provides a systematic view of the
drivers of economic development. It is based on the following idea: production in
a country increases over time if either more means of production are available or
these are utilized more productively. Following Aymo Brunetti (“Volkswirtschaftslehre”, 2013, p.161), we can therefore visualize the sources of economic growth
as shown in Figure 10.7. A higher GDP per capita can be achieved if more hours
are worked and / or if more is produced per hour worked, i.e. if labor productivity increases. The latter is possible if workers have more and better machines at
their disposal (more real capital), if they have better skills (more human capital)
or if the production process is more efficient (more knowledge). And the number
of hours worked can be increased by either employing more people or increasing
the average number of hours worked per person. Economists summarize these
aspects with three sources of growth: labor, capital and technology. Exogenous
factors (such as climatic conditions) as well as economic policy (such as reducing
bureaucracy) have a certain influence on all three.
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Growth in GDP per capita
More production per hour worked (higher labor productivity)
More hours worked
More hours
per laborer
More laborers
More real capital
(investment)
Labor
More human capital
(education)
Capital
More knowledge
(tech. progress)
Technology
External Factors and Economic Policy
Figure 10.7: Sources of long-term growth
An economy produces goods and services by transforming resources into output.
In growth theory, a production function is assumed that contains two factors of
production: Capital (K) and labor (L). These are used with a so-called total factor
productivity (TFP) so that we obtain GDP:
GDP = Y = F ( TF P, K, L)
+
+ +
(10.1)
Attentive readers will notice that we use the letter L instead of N for the factor
labor. In chapter 5 we assumed that only a part of the total potential labor (L)
is employed. In the analysis of the long term, however, we leave out the aspect
of unemployment (the economy produces according to its structural potential)
and therefore set L = N. We will specify the function F ( TFP, K, L) in more detail
shortly. For now, we will keep it general and take a closer look at the three drivers
of long-term economic growth.
All of the factors analyzed in the early empirical work in the 1990s can be related to L, K, and TFP. For example, political stability increases the incentive to
invest and thus increases the capital stock. The division into three drivers thus
structures the analysis. A much-noticed application of the growth accounting
approach can be found in the article “The myth of Asia’s miracle”, which the
American economist Paul Krugman published in the journal Foreign Affairs in
1994. Among other things, the article explained that the high economic growth
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of the so-called Asian tiger economies (Hong Kong, Korea, Singapore, Taiwan) is
very much based on the increase in inputs (K and L) and less on better technology. It is therefore by no means an “economic miracle” that is difficult to explain.
Krugman based his explanation largely on the study by Alwyn Young (Quarterly
Journal of Economics, 1995), which states: “Once one accounts for the dramatic
rise in factor inputs, one arrives at estimated total factor productivity growth
rates that are closely approximated by the historical performance of many of the
OECD and Latin American economies. While the growth of output and manufacturing exports in the newly industrializing countries of East Asia is virtually
unprecedented, the growth of total factor productivity in these economies is not.”
Alwyn Young’s study simply applied the growth accounting approach and therefore began with the remarkable sentence “This is a fairly boring and tedious
paper, and is intentionally so”. Long-term GDP growth is therefore possible in
three ways, with Paul Krugman coining the English terms:
• a greater input of labor L: perspiration
• a larger capital stock K: sacrifice
• a higher total factor productivity TFP: inspiration
In the first case, more labor or more hours worked are required, which is why
Krugman uses the term ‘perspiration’. However, these working hours must be
performed in the official sector of the economy, i.e. not in the shadow economy
or home-based work. Especially in underdeveloped economies, a high growth
rate can be achieved — largely on paper — by moving people from domestic
agriculture to industrial production. As already described in Chapter 1, GDP
only measures all those activities that are priced in a market economy. A Chinese
rice farmer therefore only contributes to GDP if he sells his harvest on the market
and does not consume it himself.
The second driver, the higher capital stock, includes additional machinery as
well as better infrastructure. This physical capital increases the productivity of
working people. As building up the capital stock means foregoing current consumption, Krugman refers to the second driver as ‘sacrifice’. For example, a
student who forgoes a holiday trip can buy a new laptop and thus increase their
productivity.
The third driver is described quite vaguely as higher factor productivity. Ultimately, this includes everything that makes the two factors of production (labor
and capital) more productive. This includes technological advances, inventions,
but also better management.4 The much-discussed artificial intelligence (artificial
4 Nicholas Bloom, Raffaella Sadun and John Van Reenen published the CEP Discussion Paper 1433
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intelligence) also contributes to this. If, for example, new algorithms allow computers to analyze images from a computer tomography (CT) scan independently,
this allows radiologists to concentrate on other activities. For example, they can
explain the results of the CT scan to patients in more detail. In this way, better
technology enables more services to be provided with the existing labor force.5
Two observations are important here. Firstly, that not every innovation increases
productivity (inventions such as social media, for example, have tended to be
detrimental; in research, this is also referred to as leisure-enhancing innovations).
And secondly, that innovations can also come from abroad — which emphasizes
the importance and benefits of openness to foreign countries in addition to the
considerations from chapters 8 and 9.
Practice box 10.2: Limits to growth
It is often argued in discussions that infinite growth is not possible in a world with finite
resources. The origin of this idea can perhaps be dated back to 1972, when the so-called
Club of Rome presented a highly regarded study at the St.Gallen Symposium, which later
sold over 30 million copies as a book. The authors predicted an end to growth in view
of finite natural resources. In particular, they referred to the scarcity of arable land and
limited natural resources (such as oil), which do not allow for exponential population or
economic growth.
Among economists, these considerations have never received much attention, let alone
changed textbook opinion. Why? Firstly, the report of the Club of Rome mostly assumes
constant productivity (see for example graph 10 on page 50 in the book). Under this
assumption, the Solow model does not predict infinite growth either. Secondly, sustainable
economic growth is also possible with limited resources, as many innovations lead to lower
resource consumption. The scarcity of resources ultimately leads to an increase in their
prices, which can either increase supply (e.g. through additional oil drilling or fracking) or
lead to innovations that reduce demand (e.g. wind power or electric cars). If the price of oil
rises, for example, it is worth extracting more oil using new methods or generating energy
using alternative technologies. From this economic perspective, it is not surprising that the
much-predicted peak oil production has never materialized and supplies will never run
out. Before we actually run out of oil, the rise in prices will have made alternative energy
sources sufficiently attractive. The concept of sustainability must also be used with these
considerations in mind.
in 2017, in which they discuss in detail how better management approaches can be interpreted
as a technology.
5 This increases the real GDP. Whether the nominal GDP also increases depends on the price effects:
how much cheaper the evaluation of the CT becomes and how much the radiologist can charge
for the consultation.
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If we apply the analytical framework of growth drivers to practice, we obtain the
figures from Figure 10.8. This shows us what determined economic growth in
Germany, Japan, the UK and the USA in the three selected periods. It is striking
that the relative importance varies across countries and time. In addition, the
relevance of capital accumulation has tended to decline in more recent years. We
will look at this aspect in more detail later in the chapter on the Solow model.
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Figure 10.8: Growth drivers for selected countries
We can also use the growth accounting approach to analyze three other developments: the rise of China, the problems of demographics and the forecasts for
economic growth in the future. Let us start with China’s sustained high GDP
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growth. Since 1980, the Chinese economy has grown enormously. Figure 10.9
shows a comparison with other so-called emerging markets and highly developed
countries. None of these countries has grown anywhere near as strongly as
China.6
Figure 10.9: GDP growth from 1980 to 2022
If we want to explain China’s economic rise, we can use the Growth Accounting approach and analyze how much TFP, K, and L have contributed. Barry
Bosworth and Susan M. Collins (Journal of Economic Perspectives, 2008) estimated
that China’s GDP grew by 9.3 % annually between 1978 and 2004. Of this, 2.0 percentage points were attributable to higher labor input and 3.2 percentage points
to the growing capital stock, 0.3 percentage points to education and 3.6 percentage points to TFP. Without population growth and capital accumulation, GDP
would therefore not have increased tenfold in the 26 years (1.09326 ), but only
by a factor of 2.5. This is relevant insofar as both the population trend and the
growth spurt due to capital accumulation will change significantly in the future.7
We will look at the second aspect shortly. First, however, we turn to demographics.
Like most highly developed countries, China is facing a major demographic chal6 China’s outstanding economic figures have been criticized for years. Even if there is no doubt
about its fundamental rise, research by Luis R. Martínez (Journal of Political Economy, 2022)
suggests that autocracies tend to publish embellished GDP figures.
7 A relatively recent evaluation of the drivers of economic growth in China was published by the
European Central Bank in 2018 under the title “The transition of China to sustainable growth”.
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lenge. During the 1980s and 1990s, the working-age population often grew by
double-digit percentages. However, as can be seen in Figure 10.10, this is no
longer the case. On the contrary, the number of people between the ages of 20
and 64 will continue to fall. This raises the question of whether GDP growth will
also be lower as a result.
Figure 10.10: Growth rate of the working-age population
A key consequence of the demographic trend is that the dependency ratio will
increase. This refers to the proportion of young and older people in relation to
those of working age. Roughly speaking, the latter generate the wealth that is
then available to everyone.8 The more children or senior citizens it has, the less
favorable it is for economic development. Looking at the figures in Figure 10.11,
it is hardly surprising that the Japanese economy boomed until 1990 or that
China has enjoyed strong economic growth since the late 1970s. However, in
2021 there is an upward trend for all the countries shown. In 1980, there were
only two countries in the world with a shrinking working population and both
were characterized by wars: Syria and Afghanistan. In 2020, however, there were
8 It is debatable at what age one should draw the line. Often 15-64 year olds are used as people of
working age. Nowadays, however, many do not start their working life until they are 20 years
old or later. In Switzerland, the labor force participation rate rises from 23% for 15-year-olds to
71% for 20-year-olds and 94% for 28-year-olds. According to data from the Federal Statistical
Office (FSO numbers je-d-03.02.00.01.02 and je-d-03.02.01.07.01.01), the labor force participation
rate in the 55-64 age group was around 77% in 2020, while it was already only around 27% for
66-year-olds and less than 15% for the over-70s.
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over forty countries with a shrinking labor force, including major nations such as
China, Italy and Japan.
Figure 10.11: Dependency ratio in selected countries
In the context of growth accounting and equation (10.1), we can state that the development of the labor force represents a kind of baseline for economic growth.
If the growth rate of the working-age population falls, this will ceteris paribus reduce the growth rate of GDP. In China, economic growth has slowed significantly
since 2010 — at the same time as the development of the dependency ratio has
reversed. The demographic trend will also mean that the Chinese economy will
grow less strongly in future than GDP in India, for example, where the working
population will continue to grow until 2050.
An increase in the birth rate is hardly helpful in countering the demographic
trend. It has a very delayed effect and has very little quantitative impact: only
after twenty years will there be a small percentage of additional labor force. Immigration can increase the labor force more quickly. However, in addition to
the familiar problems associated with this (integration, acceptance, brain drain
in countries of origin, family reunification), there is also a quantitative problem
here. Germany would need around ten million immigrants by 2050 to maintain
its labor force at the current level of around 50 million. In the case of China, as
many as 160 million immigrants would be needed over a period of 30 years. Alternative policy options include actively integrating more women into the labor
market, postponing regular retirement or relying on alternative growth drivers
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(capital, technology). The good news is that the latter is not unlikely. For example, the work of Daron Acemoglu (Review of Economic Studies, 2002) generally
shows that technological change is always orientated towards pressing problems.
Demographic developments will make labor increasingly scarce, so that its price
will rise and companies will have an additional incentive to develop labor-saving
technologies.9
The last application of growth accounting takes into account the demographic
development of countries. Like other institutions, the Organization for Economic
Co-operation and Development (OECD) regularly estimates the future development
of GDP in many countries. We can see the numbers in Figure 10.12. Such forecasts take into account the three drivers of long-term GDP growth. Accordingly,
it is not surprising that the OECD expects stronger growth for India than for
China. And countries such as Japan or Italy with a shrinking labor force will
probably only see weak economic growth in the future. Finally, a comparison
of Switzerland with the USA shows that countries with similar demographics
and a comparably high capital stock per capita also achieve a very similar GDP
growth rate. Productivity growth is also likely to be similar, as both countries
have high-quality educational institutions, spend a similar amount on research
and development and new technologies spread across countries.
Figure 10.12: forecast of GDP development in selected countries
9 In the book “The Great Demographic Reversal”, published in 2020, Charles Goodhart and Manoj
Pradhan argue that the trends in the working population outlined above will also have a positive impact on the inflation rate.
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10 Long-term Economic Growth
10.2.1 Cobb-Douglas Production Function
So far, we have only described the relationship between GDP growth and its three
drivers (labor, capital, productivity) very vaguely with equation (10.1). However,
it is worth setting out a mathematically more precise definition here. This is
based on the work of the two American economists Charles Cobb (1875–1949)
and Paul Douglas (1892–1976). In 1928, they explained in the American Economic
Review that the Cobb-Douglas production function, which was later named after
them, describes the relationship between inputs (especially labor and capital) and
the quantity produced. We can represent it as follows:
Y = TFP ∗ K1−α ∗ Lα
(10.2)
where α describes the income share of the factor labor. To show this, we form the
marginal product of labor
∂Y
= α ∗ TFP ∗ K1−α ∗ Lα−1
∂L
(10.3)
In a competitive market, this corresponds to the wage w and the total labor
income (wL) in relation to the national income (Y) corresponds to
wL
α ∗ TFP ∗ K1−α ∗ Lα−1 ∗ L
=α
=
Y
TFP ∗ K1−α ∗ Lα
(10.4)
The income share of the production factor labor is usually quite stable, as Nicholas
Kaldor (Economic Journal, 1957) already pointed out. While it has recently fallen
in some countries — see Loukas Karabarbounis and Brent Neiman (Quarterly
Journal of Economics, 2014) — we assume it to be constant here in the textbook. In
most cases, it is around a value of 2/3 in practice, so that we can set α = 2/3 in
equation (10.2).
The Cobb-Douglas production function has other very useful properties. Firstly,
it has constant returns to scale: if we increase both production factors by any
factor λ > 0, the quantity produced increases by the same factor. Simply put:
with twice as much labor input and capital, we produce exactly twice as much.
Formally, this means
λY = TFP ∗ (λK )1−α ∗ (λL)α
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(10.5)
10 Long-term Economic Growth
Secondly, in the Cobb-Douglas production function, we have diminishing marginal
returns. This means that each additional unit of labor (or each additional machine) increases the quantity produced by a smaller amount than the previous
one. Formally, this can be seen in the marginal products of labor and capital:
MPL = ∂Y/∂L = α ∗ TFP ∗ (K/L)1−α = α ∗ Y/L
(10.6)
MPK = ∂Y/∂K = (1 − α) ∗ TFP ∗ ( L/K )α = (1 − α) ∗ Y/K
(10.7)
and
where MPL stands for marginal product of labor and MPK for marginal product of
capital. If we form the derivative of MPL and MPK to L and K respectively, we
recognize the decreasing marginal products:
∂2 Y/∂K2 = − MPK · α/K < 0 as well ∂2 Y/∂L2 = − MPL · (1 − α)/L < 0
(10.8)
What does this mean in practice and why is such a mathematical property desirable for the production function? Let us assume we have 20 machines and 100
workers in a company’s production process and can produce a total of 1’000 units
of output. What would happen if we now had 120 workers — with an unchanged
number of machines and constant factor productivity? The additional 20 workers would have to share the existing 20 machines with the other 100 workers, so
that each worker would tend to be less productive than before. Instead of five, six
workers now have to share one machine. As this ratio worsens with an increasing
number of workers, the marginal product of labor is reduced. Conversely, if we
increase the number of machines but keep the number of workers constant, each
worker becomes more productive (he has more machines at his disposal), but
this effect also diminishes as the number of machines increases: the first machine
makes a worker much more productive, the second machine still substantially
increases his productivity, but the tenth or hundredth machine hardly makes any
difference.
The Cobb-Douglas production function reflects exactly this logic. Let us assume
that TFP = 1, L = 100 and K = 20. If Y = TFP ∗ K1/3 ∗ L2/3 , we get a GDP of 58.5
(= 201/3 ∗ 1002/3 ). Let us imagine that the capital stock is doubled to 40. What
happens to the GDP? A simple calculation shows: GDP = 1 ∗ (2 ∗ 20)1/3 ∗ 1002/3 ,
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which is 73.7 or exactly 21/3 = 1.26 times the previous GDP. A doubling of the
capital stock therefore does not lead to a doubling of GDP.
Theory box 10.1: Production function with diminishing marginal utility
production
marginal return
In macroeconomics, we usually assume a production function that has diminishing
marginal returns (also called marginal products) with regard to the individual factors of
production (labor or capital input). This can be represented graphically as follows
capital stock
capital stock
If the marginal return on capital decreases, production growth will eventually come to a
standstill due to capital accumulation. We will also see this realization in the Solow model.
To illustrate the practical relevance of diminishing marginal returns, we can apply
equation (10.9) to China’s economic development since 1978. In the early phase
of the rise, the increase in GDP was mainly achieved through factor accumulation
(increase in K and L). Similar to the Asian tiger economies (Hong Kong, Korea,
Singapore, Taiwan), K and L also acted as growth drivers in China. We already
know the demographic development from Figure 10.10. In addition, the productivity of workers could be improved through the development of infrastructure
and increased equipment with machines. However, this capital accumulation is
contributing less and less to growth in China, as the infrastructure, for example,
is already at a high level in many cases. As in theory, diminishing marginal returns also occur in practice. We can see this in Figure 10.13: for years, China has
had to build up more and more capital in order to increase GDP by one unit.
As in other, more developed economies, this means that China must increasingly
focus on increasing TFP as a growth driver.
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Figure 10.13: Decreasing marginal return on capital in China
This is linked to the realization that economic growth is often brought to a higher
level temporarily by one-off effects. In his 2020 book “The Decadent Society” (page
34/35), Ross Douthat describes how these were very important in the past, but
cannot be replicated. You can only create a new, improved infrastructure once —
after that it is there and can be further expanded and improved, but this no longer
has the same effect. The first train connection between two major cities or the
first highway route deliver enormous economic gains. As a rule, any expansion
of these is far less welfare-enhancing. It is similar with education: the literacy
rate has increased to almost 100% in the past — more is not possible. In the
words of Ross Douthat: “This kind of change, from an unschooled population to
an educated one, can really happen only once.” Of course, further improvements
in educational attainment are possible, but it is debatable whether these will be
proportionately as significant. We discuss this in more detail in Chapter 11.
Since the Cobb-Douglas production function is written down in multiplicative
form, we can logarithmize it and calculate the differences (see box). This results
in
%∆Y = %∆TFP + (1 − α) ∗ %∆K + α ∗ %∆L
(10.9)
where %∆Y = ∆Y/Y describes the percentage change in GDP. Growth of GDP
can therefore be broken down into percentage changes of total factor productiv-
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ity, the capital input and labor input. In practice, economists measure the changes
in GDP, labor hours and capital employed from year to year. These figures are
used to calculate the change in total factor productivity as a residual. In honor
of the American economist Robert Solow (1924–2023), it is also referred to as
the Solow residual (Sowol residual). Put simply, TFP captures everything that we
do not capture with K and L. As Moses Abramovitz (American Economic Review,
1956) put it, this is in some respects a “measure of our ignorance”.
Theory box 10.2: Log-linearizing the Cobb-Douglas function
Let us look at the Cobb-Douglas production function
Y = TFP ∗ K1−α ∗ Lα
(10.10)
ln Y = ln TFP + (1 − α) ∗ ln K + α ∗ ln L
(10.11)
If we logarithmize this, we get
If we now consider deviations from an initial level, which we denote by means of variables
with asterisks (Y ∗ , TFP∗ , K ∗ , L∗ ), we can set up the Taylor expansion:
ln Y ∗ +
1
1
(Y − Y ∗ ) = ln TFP∗ +
( TFP − TFP∗ )
Y∗
TFP∗
1
+ (1 − α) ∗ ln K ∗ + ∗ (K − K ∗ )
K
1
+ α ∗ ln L∗ + ∗ ( L − L∗ )
L
(10.12)
Since ln Y ∗ = ln TFP∗ + (1 − α) ∗ ln K ∗ + α ∗ ln L∗ , these terms are canceled out and what
remains is
1
1
1
1
(Y − Y ∗ ) =
( TFP − TFP∗ ) + ∗ (K − K ∗ ) + ∗ ( L − L∗ )
Y∗
TFP∗
K
L
Let us define percentage changes as
%∆X =
X − X∗
X∗
(10.13)
(10.14)
this results in
%∆Y = %∆TFP + (1 − α) ∗ %∆K + α ∗ %∆L
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(10.15)
10 Long-term Economic Growth
10.3 The Solow Model
Now that we know the drivers of long-term economic growth, we can turn our attention to the associated growth theory. We will use the same conceptual framework and analyze individual aspects in detail. This includes the best-known
model, which was developed in the 1950s. In the period after the Second World
War, economic growth was primarily associated with the development of infrastructure and ever better and more complex machines. The so-called Solow
model therefore also focused on building up the capital stock as a driver of GDP
growth. It was developed independently by the American economist Robert Merton Solow (Quarterly Journal of Economics, 1956) and the Australian economist
Trevor Winchester Swan (Economic Record, 1956).10 They extended earlier work
by Roy F. Harrod (Economic Journal, 1939 and Evsey Domar (Econometrica, 1946).
Before we take a closer look at how the build-up of the capital stock leads to
higher GDP, let us first consider the relationship in practice. If we divide equation (10.2) by L and denote the per capita units with lower-case letters, the following applies
Y/L = TFP ∗ K1−α ∗ Lα ∗ L−1 = TFP ∗ K1−α ∗ L−(1−α)
= TFP ∗ (K/L)
1− α
= TFP ∗ k
(10.16)
1− α
The per capita income in the economy thus depends on productivity (TFP) and
the capital stock per capita (k). According to the theory, richer countries should
therefore have a larger capital stock. Michael Berlemann and Jan-Erik Wesselhöft
(Review of Economics, 2014 and 2017) have estimated the capital stock in a comparable form for over a hundred countries. If we relate their figures to the per capita
income of the countries, we obtain Figure 10.14. It can be seen that Switzerland
has a higher capital stock per capita than the USA, Germany or China. In addition, we find a positive correlation between capital stock and GDP per capita
both in a country comparison and over time.
10 The term Solow-Swan model is also sometimes used.
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Figure 10.14: Capital stock and GDP per capita
10.3.1 Modeling
In order to analyze the relationship between capital accumulation and economic
growth in more detail and to gain insights into economic policy, we now turn to
the Solow model. This explains growth as a process of accumulation of physical
capital towards a long-term equilibrium between investment and depreciation, a
so-called growth equilibrium or steady state.
In an economy, there is a capital stock Kt at every point in time t, which changes
for two reasons. The capital is used for the production of GDP (Yt ). Part of
the production is consumed and the rest is saved and invested. Investment (It )
increases the capital stock. However, part of the capital stock decays every year,
as machines only have a limited lifespan. We use δ to denote the part of the
capital stock that is depreciated. The change in the capital stock is therefore
calculated as
δKt = It − δKt or Kt+1 = Kt + δKt = (1 − δ)Kt + It
(10.17)
Graphically, we can show the relationships between capital stock, production,
savings, investment and depreciation as in Figure 10.15. It should be noted that
savings are a flow variable, whereas the capital stock is a stock variable.
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Yt = F (Kt , Lt )
production/
income
capital stock
Kt+1 = Kt + ∆Kt
It = St = sYt
change in
capital stock
∆Kt = It − δKt
savings/
investments
Figure 10.15: Structure of the Solow model
Since we focus on the development of the capital stock in the Solow model, we
can make the simplifying assumption that the labor population remains constant
over time (Lt = L) and that technology does not change either (TFPt = TFP). We
will take up both aspects later in the chapter and discuss what changes if they
are not constant. If we set TFP = 1, this results in the simple production function
yt = f (Kt /L) = k1t −α
(10.18)
The per capita income (yt = Yt /L) depends on the per capita capital stock (k t =
Kt /L) — we omit the time index from Lt as we assume the labor population to
be constant. In our notation, f (·) describes a production function that depends
only on the per capita capital stock. Economic growth is therefore the result of
capital accumulation.
10.3.2 Changes in the Capital Stock
We already know that the capital stock of the economy is increased by investments. This in turn can be financed by private or state savings and capital imports
from abroad. We already know the equation (9.20) (page 304) from chapter 9:
I − S = (T − G) + ( I M − X )
(10.19)
In order to focus on the essential aspects, we omit both the state and the foreign
country and set T = G and I M = X. This can also be justified by the fact that
we are analyzing the long term and that the state budget must balance in the
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long term and exports cannot permanently exceed imports. These considerations
result in the simple equation: I = S.
If we also assume that people save a fixed portion of their income, then St = sYt
or It = sYt . In our model, the propensity to consume and save are therefore
exogenous, i.e. not explained in the model.11 We also consider the share δ of
capital that is lost each year through depreciation to be exogenous. This results
in the development of the capital stock over time as:12
Kt+1 = (1 − δ)Kt + It
(10.20)
If we divide by L and replace It with sYt , we get
K t +1
Kt
Yt
= (1 − δ ) + s
L
L
L
We can transform this and replace Yt /L with f (Kt /L) so that
!
K t +1
Kt
Kt
Kt
−
= sf
−δ
L
L
L
L
(10.21)
(10.22)
Expressed verbally, this equation can be understood as follows. The change in the
capital stock per capita (left-hand side) corresponds to the savings per worker (=
investment) minus the depreciation of capital per worker. If the investment per
worker is greater (smaller) than the depreciation, then the change in the capital
stock per capita is positive (negative). The capital stock per capita is sometimes
also referred to as capital intensity.
As discussed earlier, the production function has diminishing marginal returns.
Each additional unit of capital thus increases GDP by an ever smaller amount.
However, while capital has diminishing marginal returns, depreciation per worker
increases proportionally with the capital stock per capita. If capital stock and
production are small, then investment exceeds depreciation. Consequently, the
capital stock grows. We can see this in Figure 10.16: as long as the capital stock
11 Based on the work of Frank Plumpton Ramsey (Economic Journal, 1928), David Cass (Review of
Economic Studies, 1965) and Tjalling Koopmans (1965) developed the so-called Ramsey-CassKoopmans model. In this model, consumption and saving decisions are microfounded, i.e.
based on household optimization.
12 We present the Solow model here in discrete time, thus distinguishing individual periods. As
an alternative form of representation, there is the Solow model in continuous time. Depending
on the modeling approach, this is mathematically more elegant, but is not discussed here.
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10 Long-term Economic Growth
per capita is below K ∗ /L, investment exceeds depreciation. Net investment (C–
D) is then positive and the capital stock per worker increases.
production per worker Y/L
depreciation: δ ∗ Kt /L
production per worker: f(Kt /L)
Y∗
L
•
>
B
C
D
>
>
•
investments per worker: sf(Kt /L)
•
•
production per worker (A—B)
•
.
.
Investments per worker (A—C)
.
amortisation (A—D)
A
K0
L
>>>
capital stock per worker K/L
K∗
L
starting point
Figure 10.16: Development of the capital stock in the Solow model
But what happens when we reach the point K ∗ /L? With this capital stock per
capita, investments are just as high as depreciation. This means that net investment is zero and the capital stock no longer changes. We therefore speak of a
stable state or steady state of the economy. As we have set up the model, the economy always converges to the steady state K ∗ /L or Y ∗ /L regardless of its starting
point. This is illustrated in Figure 10.17. If the capital stock per worker (K/L)
is above K ∗ /L, depreciation exceeds investment, which is why the capital stock
falls. The reverse is true if the economy is below K ∗ /L.
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10 Long-term Economic Growth
production per worker Y/L
depreciation: δKt /L
production per worker: f(Kt /L)
Y∗
L
>
B
C
D
>
<<
=
⇐
investments per worker: sf(Kt /L)
•
•
•
>
•<
=⇒
•
A
capital stock per worker K/L
K∗
L
K0
L
Figure 10.17: The steady state in the Solow model
Mathematically, we find the steady state by setting investment per capita equal to
depreciation. Since the former equals savings, the following applies:
s f (K ∗ /L) = δK ∗ /L
(10.23)
We can solve this equation for K ∗ . However, the question arises as to how long the
process to the steady state takes. Robert Barro and Xavier Sala-i-Martin (Journal of
Political Economy, 1992) have estimated that the gap between the current income
and the steady state income is reduced by around 2% per year.
10.3.3 Comparative Statics
Now that we have determined the equilibrium of the economy, we can analyze
how some model parameters influence the steady state. In particular, the question
arises as to how the aspects assumed to be exogenous, such as the savings rate,
productivity and the depreciation rate, affect the steady state. We will look at all
three parameters in detail below.
First, we consider the case where investment is increased by an increased savings
rate. As Figure 10.18 shows, a country with a higher savings rate in the steady
state achieves a higher level of production per worker. However, we also see that
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the growth caused by an increase in the savings rate is only temporary. If we start
with the capital stock K0 and increase the savings rate from s0 to s1 , investment
rises to the level of point C. As this is significantly higher than depreciation
(point A), the capital stock and therefore production increase rapidly. In the
process of approaching the new steady state with K1 , however, growth slows down
as net investment becomes increasingly smaller. We can also see this in the lower
part of the Figure 10.18.
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production per worker Y/L
depreciation: δKt /L
production: f( KLt )
Y1
L
>
B
Y0
L
C
A
>
>
>
>>
•
D
•
investment at s1 : s1 f(Kt /L)
•
investment at s0 : s0 f(Kt /L)
•
•
>>>
K0
L
K1
N
capital stock per worker K/L
production per worker Y/L
Connected to the saving rate s1 > s0
Y1
L
Y0
L
Connected to the savings rate s0
time t
t
Figure 10.18: Higher investments in the Solow model
In practice, according to data from the World Bank, there are major differences
in the savings rates of individual countries. While China had a very high ratio of around 44% (measured against GDP) in 2019, Switzerland (35%), Germany
(27%) and the USA (18%) had significantly lower savings ratios. How these differences are to be assessed in economic terms is unclear a priori. There is no doubt,
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10 Long-term Economic Growth
however, that the high Chinese savings rate — and the associated decades-long
reduction in consumption — has contributed significantly to economic growth in
China. The assessment of high savings and investment rates is also made more
difficult in practice by the fact that, although in the model every investment increases the future capital stock, in practice a distinction must be made between
different forms of investment. It is best to look at whether these increase a country’s production capacity. Better infrastructure or new high-tech machinery are
more beneficial in the long term than a property boom, especially if the latter is
merely the result of rising prices. In the USA, for example, the dot-com boom
in the 1990s was beneficial despite some exaggerations, while the boom in the
property sector was very damaging until the financial crisis. Not every investment boom is therefore to be welcomed economically, as Ruchir Sharma (“Ten
Rules of Successful Nations”, 2020, pages 104 and 112–116) explains.
As the diminishing marginal product must be taken into account when building
up capital, it is more important for highly developed countries to increase productivity. We have also assumed this to be exogenous in our Solow model. But
what happens if we increase TFP? Figure 10.19 presents the answer. The steady
state of the economy increases from Y0 to Y1 . This has two causes. Firstly, the
better technology enables a higher GDP and secondly, the capital stock in the
steady state increases. This distinction must also be taken into account when applying the growth accounting approach. If we observe — as in Figure 10.8 — that
the increase in the capital stock has contributed to GDP growth, the underlying
cause may lie in the improved technology.
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10 Long-term Economic Growth
production per worker Y/L
δKt /L
f 1 (Kt /L)
f 0 (Kt /L)
growth due to
D
•
Y1
L
better technology
•
B
•
Y0
L
s f 1 (Kt /L)
C
growth due to
•
s f 0 (Kt /L)
greater K/L
A
•
>>>
K0
L
K1
L
K/L
Figure 10.19: Better technology in the Solow model
Another observation with regard to Figure 10.19 is that the higher the capital
stock, the more important a better technology becomes. We see this when we
compare the two production functions shown f 0 and f 1 (the latter with the better
technology). At small levels of K/L there is hardly any difference. However, the
larger the capital stock, the greater the difference between f 0 and f 1 .
As a final example of comparative statics, we consider the case of a higher depreciation rate. We also assumed the parameter δ to be exogenous. What would
happen if machines had to be replaced more frequently (i.e. depreciated faster)
can be seen in Figure 10.20. Unsurprisingly, the capital stock and GDP fall in the
steady state, as it has now become more expensive to build up capital.
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production per worker Y/L
depreciation after δ1 Kt /L
production f(Kt /L)
B
•
Y0∗
L
<
Y1∗
L
<
<
depreciation before δ0 Kt /L
B’
•
•
•
investment sf(Kt /L)
A
A’
>>>
K0
L
K1
L
capital stock per worker K/L
Figure 10.20: Higher amortisation rate in the Solow model
10.3.4 Model Statements vs. Reality
How well is the very simple Solow model able to explain the actual income differences in the world? According to equation (10.18), GDP per capita (y) only
depends on the capital stock per capita (k) if all countries use the same technology, i.e. TFP = 1. If we take the value 1/3 for the income share of the production
factor capital, we can create a model prediction for each country. Data from
the Penn World Tables allow us to compare actual per capita incomes with those
predicted by the simple Solow model.
In Figure 10.21 we see numbers from the year 2019 for all countries with a population of at least five million, with the USA serving as a reference.13 We see
that the Solow model over-predicts GDP per capita for all countries except Singapore. Japan, for example, has the same capital stock per capita as the USA
and should therefore have a comparably high per capita income. However, this
is actually almost 40% lower. According to the model, Switzerland should be
21% richer than the United States. In reality, however, the Swiss income level is
only 11% higher. For poor countries, the diminishing marginal return on capital
(1 − α = 1/3) means that the model overestimates the actual per capita income.
13 The graph is based on the very readable textbook “Macroeconomics” by Chad Jones.
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India, for example, with a per capita capital stock of 12% of the American level,
should achieve an income that is half as high as in the USA ((0.12)1/3 = 0.49). In
reality, however, India’s GDP per capita is just 10% of the American level.
Figure 10.21: Comparison of predicted and actual GDP per capita
What do we learn from this comparison with reality? The very simple Solow
model can only explain the actual economic data to a very limited extent. In
particular, the simplifying assumptions such as equal productivity in all countries
(TFP = 1) are at odds with reality. We therefore need to extend the model if we
want to gain a better understanding of global income differences.
10.3.5 Convergence
An important statement of the Solow model is that the steady state is the same
for all countries, provided they have the same technology (more precisely the
production function f ), savings rate and depreciation rate. In addition, according to the Solow model, less developed countries should have higher economic
growth: As already seen in the lower graph of Figure 10.18, GDP increases faster
the further away the economy is from its steady state. These model statements
can be easily analyzed using data. Is there really robust empirical evidence that
GDP growth is negatively correlated with the GDP level? Figure 10.22 shows
GDP per capita for almost all countries in the world in 1960 and 2019. We use
the USA as a benchmark, normalizing the values to 100 in each case. It can be
seen that the USA had one of the world’s highest per capita incomes in the data
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set in 1960. Today, there are some countries — Ireland, Luxembourg, Singapore
or Switzerland — with a higher GDP per capita. If there were a general convergence towards the same income level, we should see (almost) all country points
above the 45-degree line. However, this is not the case. Although there are success stories such as Singapore, South Korea and China, some countries that were
much poorer than the USA in 1960 have now fallen even further behind.
Figure 10.22: Worldwide convergence in practice
However, comparing all countries as shown in Figure 10.22 is not a good test of
the Solow model. This states that convergence only occurs if the countries do not
differ in terms of their characteristics (production function, savings rates, etc.).
Robert Barro and Xavier Sala-i-Martin (Journal of Political Economy, 1992) therefore distinguish between two forms of convergence. The idea of unconditional
convergence is rejected, as in Figure 10.22. It is not the case that all countries reach
the same steady state. On the other hand, Barro and Sala-i-Martin find evidence
for conditional convergence: Countries reach the same steady state if the country
parameters are identical.14 As in the Solow model, the steady state depends on
the fundamental characteristics of the respective economy. So if we only look at
countries in Europe or, like Barro and Sala-i-Martin, only at the US states, we find
evidence of convergence: the growth rate is higher in poorer countries or states.
This is also shown in Figure 10.23.
14 In growth theory, the term club convergence is also commonly used.
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Figure 10.23: Convergence in EU-27 countries and Switzerland
The empirical analyses thus tend to speak in favor of the Solow model. Essentially, they confirm the model statement that comparable countries strive for a
similar steady state. Some observations from practice also fit with this. For example, the so-called economic miracles in Europe and Japan after the Second World
War can be explained by the Solow model. The wars destroyed a great deal of
capital, i.e. infrastructure and machinery. However, as production processes were
not lost in many cases and a new political stability was achieved, this resulted
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in high GDP growth. However, the fundamental characteristics (and steady state)
remained. We can understand the rapid economic growth in the Asian tiger
economies in a similar way. The favorable economic conditions and the import
of technology from abroad ensured very high growth in per capita income at
times. However, it is not only the successes that can be explained by the Solow
model; we can also categorize the failures. These include the economic stagnation in sub-Saharan African countries. In the context of the Solow model, it can
be argued that these countries have a low steady state — due to unstable political situations, weak institutions, poor education, poor health systems, corruption
and high population growth. As illustrated in Figure 10.24, per capita income
in some African countries has stagnated at less than 5% of the American level
for decades. Even in very populous countries such as Ethiopia, the Democratic
Republic of Congo, Nigeria and Tanzania — which together comprise almost half
a billion people — the average income today is less than a tenth of the American
level.
Figure 10.24: Income levels in selected African countries
10.3.6 Golden Rule
So far, we have always analyzed how economies can achieve higher GDP in the
long term. However, we can ask whether a maximum GDP makes sense at all.
As with individuals, maximizing income is an unconvincing strategy for entire
nations. Ultimately, this is only a means to an end: it allows for higher consump347
10 Long-term Economic Growth
tion. In the Solow model, we deliberately did not look at the demand side. In
this respect, we cannot make any statement on the question of whether a higher
GDP per capita always makes people happier. However, it is possible to look at
the Solow model from a different perspective. People are faced with a trade-off:
they can consume less today, save and invest more in order to be able to produce
and consume more in the future thanks to additional capital. Put simply, they
can eat a smaller slice of the cake today and thus have a bigger cake in the future.
Based on this consideration, we can determine what the maximum consumption
in the steady state is or which steady state maximizes consumption. We can see this
steady state and the corresponding capital stock (KGold ) graphically in Figure 10.25.
Consumption results from the difference between production and investment
(which corresponds to savings). In the steady state, investment is exactly equal
to depreciation. We therefore find the steady state with maximum consumption
if we maximize the distance between the production function and depreciation,
graphically speaking. We recognize that with a small capital stock, the slope
of the production function (we refer to this as the first derivative: f ′ (Kt /L)) is
greater than the slope of the depreciation line (slope given by δ). Since capital
has a diminishing marginal return, there is a capital stock from which the slope
of f (Kt /L) is equal to δ. This is then the capital stock that maximizes consumption. Formally, the following applies
f ′ (K gold /L) = δ
(10.24)
whereby economists also refer to the golden rule. Therefore, we use the word
’gold’ as an index. We can determine the slope of the production function on the
basis of equation (10.18): it is (1 − α). Since the income share of the labor factor
(that is α) is around 2/3 in practice, a country should therefore invest around
one third of its gross domestic product in order to follow the golden rule and
maximize consumption.
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Y/L
depreciation δK/L
production f(Kt /L)
d f (k )/dk=δ
•
investments sGold f(Kt /L)
Cmax
•.
investments
KGold /L
capital intensity K/L
Figure 10.25: Golden Rule in the Solow Model
10.4 Extensions of the Simple Solow Model
When we described the structure of the Solow model, we made two very simplifying assumptions. Firstly, we assumed the working population to be constant
and secondly, we did not consider annual changes in technology. Formally, we
have assumed that both labor input (L) and productivity (TFP) are constant. To
conclude the chapter, we briefly discuss what the Solow model looks like with
population growth and technological progress. For this purpose, we assume that
the production function is henceforth given by
Y = F (K, A ∗ L)
(10.25)
This formulation makes the simplifying assumption that a better technology (A)
only makes the production factor labor more productive (therefore we no longer
write TFP). Production therefore depends on the capital input and the labor
input multiplied by the state of the art. A doubling of productivity thus enables
a country to produce the same output with half as many workers. Furthermore,
we assume that the population (L) grows annually by a fixed percentage (n) and
that productivity (A) increases by a fixed percentage (g).
Lt+1 = (1 + n) Lt as well as At+1 = (1 + g) At
(10.26)
It is useful to rewrite the model and express all variables in per labor efficiency
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units (i.e. A ∗ L) instead of per capita (i.e. per unit L). So far we have used lower
case for the per capita variables. Now we define
k = K/( A ∗ L) as well as y = Y/( A ∗ L) = f (k )
(10.27)
How is the steady state determined in the Solow model with population growth
and technological progress? Once again, a steady state is characterized by the fact
that k is constant. This is now the capital stock per labor efficiency unit. So that
this does not change, the growth of K must correspond to the growth of A ∗ L.
In other words, we need to build up capital every period to compensate for three
aspects: Depreciation, population growth and new technology. The volume of
investment required to keep capital stock per effective labor constant is also called
break-even investment. We describe it formally as I BE = s BE Y. To determine it,
we start with the consideration that in the steady state the growth rate of the
capital stock (gK ) must correspond to that of the population and technological
progress: or expressed in effective labor units: To determine the steady state, we
start with the definition of k t :
K t +1
(1 − δ)Kt + sYt
=
A t +1 ∗ L t +1
(1 + g ) A t ∗ (1 + n ) L t
1
(1 − δ)Kt + sYt
=
∗
(1 + g ) ∗ (1 + n )
At ∗ Lt
"
#
1
=
∗ (1 − δ)k t + syt
(1 + g ) ∗ (1 + n )
k t +1 =
(10.28)
Here we use the change in the capital stock in the first line: (1 − δ) remains from
the capital stock of the previous period and the savings (sYt ) are invested. In the
last line, we use the fact that lowercase letters are defined per labor efficiency unit
(At ∗ Lt ). If we form the derivative of k t+1 according to g, n or δ, we recognize
that all three are negative. For a steady state, however, the following must apply:
k t+1 = k t . We therefore replace yt in equation (10.29) with k1−α and solve for k
(since k t and k t+1 are identical in the steady state, we first replace both with k):
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"
#
1
1− α
k=
∗ (1 − δ)k + sk
(1 + g ) ∗ (1 + n )
[(1 + g) ∗ (1 + n)]k = sk1−α + (1 − δ)k
(1 + g + n + ng)k − (1 − δ)k = sk1−α
(n + g + δ + ng)k = sk1−α
(n + g + δ + ng) = sk−α
(n + g + δ + ng)α = sα k
k=
k∗ =
n + g + δ + ng
s
!1/α
s
n+g+δ
!1/α
(10.29)
where we write k∗ in the last step, since it is the steady state. We also neglect the
expression ng, as this is typically very small. From equation (10.29) it follows
that the capital stock per labor efficiency unit increases with the savings rate (s)
and decreases in the parameters n, g and δ. Graphically, we can visualize the
Solow model with population growth and technological progress as shown in
Figure 10.26. In the steady state (point A), production is not constant, but production per unit of labor efficiency is.
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required investment (δ + g + n) ∗ k
production per labor efficiency unit (y)
production f (k)
y∗
A
•
Investment s f (k )
•
k∗
capital per labor efficiency unit (k)
Figure 10.26: Steady state in Solow model with extensions
We can now use comparative statics to analyze how, for example, an increase
in population growth (an increase from n to n′ ) affects the steady state. This
is shown in Figure 10.27: if n increases, then y∗ decreases — the steady state
is at point A′ instead of A. Is population growth therefore a bad thing? As
with any statement in a model, it is first necessary to understand this within
the framework of the model and then to discuss the underlying assumptions.
The Solow model shows us a problem with population growth: Growth through
capital accumulation is made more difficult because additional capital must be
constantly built up, if only to keep the capital stock per capita constant. However,
we have also assumed in the model that, for example, the rate of technological
progress (g) is independent of population growth (n). In practice, however, it can
be argued that a larger population will also generate more ideas. This should
tend to accelerate technological progress.15
15 For example, the Unified Growth Theory developed by Oded Galor is based on the idea that
population growth promotes the rate of technological progress. However, this in turn increases
the incentive to invest in education: the more technologically advanced a country is, the more
worthwhile it is to have a good education. Parents will therefore tend to invest more in their
children’s education. As this is associated with costs, they decide to have fewer children. As a
result, population growth decreases in the medium to long term.
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with n′
required investments (δ + g + n) ∗ k
production per labor efficiency unit (y)
production f(k)
A
•
y∗
y′∗
A’
•
•
•
investment sf(k)
B
B’
k′∗
k∗
capital per labor efficiency unit (k)
Figure 10.27: Higher population growth in the Solow model
We now know the steady state of the extended Solow model. However, what we
are actually interested in is the GDP (Y) and the per capita income (Y/L). Since
y∗ = k∗α and Y/L = (Y/AL) ∗ A = y ∗ A, the following applies to GDP per
capita:
!
Y
s
= y∗A = A∗
(10.30)
L
n+g+δ
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For per capita income to rise in the long term, A must increase, so technological
progress (g > 0) is necessary. And GDP increases in the long term either through
population growth or technological progress:
!
s
(10.31)
Y = L∗A∗
n+g+δ
The Solow model thus predicts that sustainable growth will only occur if the two
variables that are assumed to be exogenous change. This is another reason why
we will look at more recent growth theories in Chapter 11 — especially those that
can explain technological progress itself. Before that, we will briefly summarize
how the variables of the Solow model develop in the steady state:
Variable letter
variable
growth rate
k
capital per labor efficiency unit
0
y
Production per labor efficiency unit
0
K/L
capital per worker
g
Y/L
output per worker
g
L
labor
n
K
capital
g+n
Y
production
g+n
Table 10.1: Solow model with population and technology growth
We can understand the individual lines as follows: The steady state is characterized by the fact that k is constant. However, this means that y = k1−α no longer
changes. The capital stock per worker K/L = A ∗ k and GDP per worker Y/L
grow at the rate of technological progress (g). And the capital stock (K) and
GDP (Y) grow with the sum of g and n.
10.5 Summary
In this chapter, we have determined the drivers of long-term economic growth.
A country’s GDP increases in the long term if more factors of production (labor,
capital) are available or total factor productivity increases. We have analyzed this
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consideration in detail in the Solow model, which focuses on the capital stock.
The key findings of the simple Solow model are that it can explain a number of
important developments — such as convergence or so-called economic miracles
— well. However, the Solow model strongly reflects the post-war phase, in which
economic growth was achieved in particular through the accumulation of capital.
As this has a diminishing marginal impact, technological progress is needed to
achieve long-term increases in per capita income. Yet, because this technological
progress is exogenous in the Solow model, i.e. it is not explained in the model,
we must take a closer look at how it is determined in the next section.
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We already know from Chapter 10 what determines a country’s long-term GDP
growth. However, the Solow model — even with the additions of exogenous
population and technology growth — does not provide a satisfactory analytical
framework. As already shown in Table 10.1, per capita income grows in the
long term at the rate of technological progress (g), which we do not explain in
the model. Economists therefore speak of an exogenous growth model. To really
get a good understanding of long-term prosperity growth, we therefore need to
analyze what determines the rate of technological progress in a country.
Here too, it is worth categorizing the economic explanations chronologically. The
Solow model was developed in the 1950s, a time when the build-up of the capital stock was central to economic growth. The possibilities of empirical analysis
in macroeconomics were still limited at the time. This changed in the 1980s at
the latest. However, when economists tried to explain GDP data using the Solow
model, they realized that productivity growth explained most of the GDP growth.
From a theoretical point of view, this is unpleasant, as productivity growth was
assumed to be exogenous in the model. In other words, the Solow model and its
application to actual data show that we need to take a closer look at productivity. To this end, in Chapter 11 we will look at the so-called endogenous growth
theories. This will analyze the process of technology development in more detail. We will also analyze how new production technologies can be adopted from
abroad. Both the domestic development of new technologies and their successful
adoption from abroad and application at home require a favorable economic environment. In Chapter 11 we therefore also look at what the necessary economic
conditions are for a high per capita income. Building on this, we will then discuss
the role of the state in long-term economic growth and which policy measures
increase prosperity. We will focus in particular on the problems of developing
countries.
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11.1 Endogenous Growth Theories
In the Solow model we are familiar with, there is no sustainable growth without
permanent improvements in technology, i.e. without constantly higher TFP. De
facto, however, highly developed countries have had rising per capita incomes
for over 200 years. How can we explain this sustained growth in the modeling
framework? A first possibility would be to say that all countries in the world are
still far enough away from their long-term steady state. But even then, the Solow
model (with constant TFP) would predict that economic growth slows down over
time. However, this contradicts the observations in practice.
As a second approach, we could revise the model assumptions. The “core problem” in the Solow model is the diminishing marginal return to capital. These
are eliminated in the so-called AK model by not distinguishing between capital
accumulation and technological progress. In principle, physical capital (such as
machinery) and human capital (education, knowledge) are summarized in the
model. The production function is then simply Y = AK, where A is a parameter and we leave out the labor input. The capital stock (consisting of physical
capital and human capital) changes over time due to savings and depreciation:
Kt+1 = sY − δK. In the long term, GDP (Y) grows at the same rate as K. Sustained economic growth is therefore maintained by saving a large proportion of
GDP and using part of the savings to finance technological progress in the form
of increasing human capital.
Although the AK model provides a mathematical solution, it does not provide
a satisfactory explanation for the process of technological progress. The third
option is therefore models that explain the increase in productivity in the model.
Economists speak of endogenizing productivity, i.e. viewing it as an endogenous variable. The so-called endogenous growth theory (also known as the new
growth theory) aims to determine how economic activities lead to technological
progress and how this results in long-term economic growth.
A central and somewhat paradoxical challenge of the new growth theory was
to maintain diminishing returns to scale in the production function on the one
hand and to get rid of them on the other. On the one hand, diminishing returns
to scale ensure that the assumption of perfect competition can be maintained in
the model. On the other hand, diminishing returns to scale prevent sustainable
growth through the accumulation of capital. A key solution was to introduce
externalities into the model. Economists use this term to describe interdependencies (mutual dependencies) between different actors that are not taken into
account (i.e. internalized) when making decisions. The classic example of an
externality is environmental pollution: an economic activity causes the pollution
of groundwater with chemicals, for example. This harms other people, but the
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damage caused is not taken into account in the decision to pollute the groundwater. In this case, economists speak of a negative externality. The opposite case
of a positive externality also exists, for example in the case of an apple farmer
whose agricultural activities are beneficial for a nearby beekeeper.1
The new growth theory applies the approach of positive externalities and uses
various explanations, some of which are very similar. For example, there can
be spillovers: the innovation of one company also benefits other companies in
the future — figuratively speaking, some of the newly created knowledge spills
over into other companies. Since this was not intended, it is an externality. In
addition to physical capital and labor, existing technical knowledge (know-how)
is also used in the production of goods. Each individual company can create
private knowledge, which is used in production in addition to the freely available
public knowledge. As this increases productivity, companies are incentivized to
create new knowledge. However, this knowledge does not remain private, but
increases the productivity of all companies in the future. In this way, Paul Romer
(Journal of Political Economy, 1986) obtained decreasing marginal returns at the
firm level in his model, but increasing returns in the economy as a whole. Similar
considerations can also be found in the studies by Kenneth J. Arrow (Review of
Economic Studies, 1962) and Robert E. Lucas (Journal of Monetary Economics, 1988).
While Romer located the externality in knowledge, Arrow found it in capital
itself and Lucas introduced it in connection with human capital. This raises the
question of where knowledge should ultimately be located in the model, in books
or within individuals. In both cases, however, it also reaches other companies
over time.
While Romer took an aggregate perspective in his 1986 study, in a subsequent
paper (Journal of Political Economy, 1990) he analyzed the incentive of firms to
invest in knowledge in more detail. They can invest resources in research and
development (R&E or R&D for research and development) and thereby gain the
opportunity to produce new and better products. The blueprints for these new
products are patent-protected, which at times enables monopoly profits and thus
justifies the expenditure on R&D. As in Romer’s model in 1986, some of the
newly created knowledge is passed on to other companies. This happens because patent protection requires knowledge to be disclosed, patents expire over
time or other companies generally adopt some unprotectable ideas. In this way,
the pursuit of profit by each individual company unintentionally contributes to
increasing the overall level of knowledge in the economy. We thus again obtain a
positive externality. Permanent growth can now be possible for two reasons. Ei1A
detailed explanation can be found in Martin Kolmar’s book “Grundlagen der
Mikroökonomik”, published in 2021, from page 119 onwards.
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ther research creates more and more intermediate products (or, in an alternative
interpretation, more and more machines) that make production more efficient.
In this case, we speak of process innovations. Alternatively, research creates more
and more (not necessarily better) products that increase prosperity because consumers like a wide variety of products. This is referred to as product innovation.
The increasing number of products, all of which are produced with decreasing
marginal utility, means that the entire capital stock is utilized in a larger number
of productions. In this way, the economy prevents a slowdown in growth. As in
the Solow model, there are diminishing marginal returns, but production starts
at zero for each new product. In addition, the capital input for each product is
also reduced (and thus the marginal returns increased) when a new product is
developed.
The subsequent studies of endogenous growth theory differ from Romer (1990)
in that the products are no longer of the same quality. Instead, F&E expenditure leads to an improvement in product quality. Companies that offer better
quality can charge higher prices than others — products of different quality are
only partially substitutable in the models. As with smartphones, consumers are
more willing to pay for the best quality. Each newly created product thus displaces older variants from the market. This process of displacement can be found
in the study by Philippe Aghion and Peter Howitt (Econometrica, 1992), which
was based on the work “Capitalism, Socialism and Democracy” by the Austrian
economist Joseph Schumpeter (1883–1950), published in 1942. It states: “The
opening of new markets, foreign or domestic, and the organizational development from the handicraft business and the factory to such corporations as U.S.
Steel illustrate the same process of an industrial mutation — if I may use this biological expression — which is incessantly revolutionizing the economic structure
from within, constantly destroying the old structure and incessantly creating a
new one. This process of creative destruction is the essential fact of capitalism.”
We therefore also speak of the Schumpeterian growth theory.
A central implication of Schumpeterian growth theory is that economic growth
is positively dependent on investment in research. The more resources a country invests in R&D, the higher productivity growth should be and therefore the
higher the increase in GDP. However, as early as 1995, Charles I. Jones (Quarterly
Journal of Economics) showed that this model prediction is not consistent with empirical observations. There are a number of approaches to address this problem.
Firstly, Jones shows in a separate study (Journal of Political Economy, 1995) that
this scale effect can be eliminated in the model. Alwyn Young (Journal of Political
Economy, 1998) also chooses this approach and models an economy in such a way
that there are both quality improvements and an increasing variety of products.
In this way, larger research expenditure is spread over a steadily increasing num359
11 Innovation and Institutions
ber of products. A recent contribution to this debate comes from Nicholas Bloom,
Charles I. Jones, John Van Reenen and Michael Webb (American Economic Review,
2020). These economists argue that research productivity has steadily declined.
Therefore, despite increasing research expenditure and more labor engaged in research, there is no increase in TFP growth. Benjamin F. Jones already provided a
theoretical explanation for this in 2009 in the Review of Economic Studies: the more
knowledge has been accumulated in a society, the longer it takes an individual
to achieve improvements on the research front even through innovation. In this
context, Jones speaks of a “burden of knowledge” and shows that specialization
and teamwork have therefore become more important.
A look at the data shows the significant reduction in productivity growth in many
highly developed countries since the financial crisis in 2008. In Figure 11.1 we see
Total Factor Productivity (TFP) above, using 2015 as a reference. This is the overall efficiency with which labor and capital are used together in the production
process. According to the OECD, changes in TFP reflect the impact of changes
in management practices, organizational changes, general knowledge, network
effects, spillover effects of production factors, economies of scale, the impact of
imperfect competition and measurement errors. TFP growth is measured as the
residual, i.e. the part of GDP growth that cannot be explained by changes in
labor and capital input. In the lower graph of Figure 11.1 we see GDP per hour
worked. This is a measure of labor productivity. It measures how efficiently labor input is combined with other production factors and used in the production
process. According to the OECD, labor productivity only partially reflects the
productivity of labor in terms of the personal skills of workers or the intensity
of their input. The relationship between output and labor input depends to a
large extent on the availability and use of other inputs (e.g., capital, intermediate inputs, changes in efficiency). While Germany and Switzerland show a clear
slowdown after 2008 in both graphs, productivity has stagnated in countries such
as the UK and Italy.2
2 It can be argued that measuring productivity is extremely difficult. Robert Solow already wrote
in 1987 in the New York Times: “You can see the computer age everywhere but the productivity
statistics.” In her 2014 book “GDP: A Brief but Affectionate History” (page 87), Diane Coyle
also points out that the word productivity refers to products. However, productivity is more
difficult to measure for services, which nowadays make up the lion’s share of GDP. Even quality
improvements can only be partially taken into account, as William Nordhaus explained in 1998:
“Do Real-Output and Real-Wage Measures Capture Reality? The History of Lighting Suggests
Not”.
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Figure 11.1: Development of productivity since 1990
The slowdown in productivity growth is problematic for several reasons. Firstly,
we already know that most highly developed countries are facing a demographic
development that will tend to make economic growth more difficult. Secondly,
we know from the growth models discussed that productivity growth is necessary for long-term economic growth. In this context, it is striking that spending
on research and development as a percentage of GDP has only increased partially
and to a limited extent. As Figure 11.2 shows, Switzerland and Germany are also
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in a better position in this respect than France or Italy, for example. It also shows
how much China has increased its research expenditure.
Figure 11.2: Expenditure on research and development since 1990
11.2 The Business Environment
It is also worth looking at a country’s economic development from other perspectives. As Roger Martin wrote in his 2007 book "The Opposable Mind", it is
important to apply integrative thinking. Relationships are rarely monocausal and
linear; instead, a multitude of factors often interact in a non-linear way and thus
shape the outcome. Italy’s economic stagnation for around 25 years is a good
example of this. Few economists would assume that an increase in spending on
research and development would lead directly to higher economic growth. For
example, Eric A. Hanushek and Ludger Woessmann (Journal of Economic Growth,
2012) have already documented that it is not spending on education but its effectiveness that has an impact on economic development.
For a country to flourish economically in the long term, it must provide a business environment that sets the right incentives. In other words, it takes a lot
for a country to be economically successful. This includes a talented and welleducated workforce, a highly developed infrastructure, competition between companies, but also a supportive culture and favorable values (even if this is some-
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times difficult to measure).3 None of this can be bought from Amazon with
next-day delivery. All of this has to be painstakingly built up and maintained
over years, decades and generations. In order not to lose track of the complexity,
there are a few approaches that we will briefly discuss below.
11.2.1 Porter's Diamond
When the Iron Curtain fell in 1990 and many Eastern European countries were
suddenly able to shape their own economic policy after decades of being tied to
the Soviet Union, many politicians asked themselves what it would take to be
as successful as the USA or West Germany, for example. At this moment, the
study “The Competitive Advantage of Nations” by Michael Porter (Harvard Business Review, 1990) suggested itself. In it, Porter begins with the words “National
prosperity is created, not inherited. It does not grow out of a country’s natural endowments, its labor pool, its interest rates, or its currency’s value”. His
analysis is based on a business perspective. When we talk about economically
successful countries, we mean those with a high per capita income. This GDP is
primarily generated in companies. The prosperity of a country like Switzerland
therefore depends to a large extent on the fact that a large number of high-quality
and internationally competitive companies are based in Switzerland. These companies maintain their position by constantly innovating. To explain Switzerland’s
persistently high standard of living, we need to understand what motivates and
enables the companies there to be innovative.4
Michael Porter summarizes his central idea in a few sentences: “To innovate,
companies must have access to people with appropriate skills and have home
demand conditions that send the right signals. They must also have active domestic rivals who create pressure to innovate. Another precondition is company
goals that lead to sustained commitment to the industry”. He then presents the
four decisive elements of an economy that he describes in the form of a diamond.
His model is therefore also referred to as Porter’s Diamond. We see it illustrated
in Figure 11.3, where the arrows show that each element influences the others
and it is therefore not enough for a country to focus on just a few elements. This
is why an economy is generally referred to as a chain-link logic: The overall performance depends on the weakest link in the chain. Richard Rumelt describes
this logic very clearly in his book “Good Strategy, Bad Strategy”: When the space
3 The last point includes the aspect of cooperation.
No country can be economically successful
if the population is fragmented into many small groups that are hostile to each other. Values
such as honesty and respect also ensure that many economic transactions can be carried out
more efficiently and easily.
4 James Breiding described Switzerland’s economic history from this perspective with numerous
examples. His work “Swiss Made” was published in 2013.
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shuttle Challenger broke apart just 73 seconds after launch in 1986, the cause was
a faulty O-ring, a simple ring-shaped sealing element. Any improvement to the
space shuttle would have been useless until the problem with the O-ring was
solved. The same applies to economies: the weakest elements determine the
overall performance.
Firm strategy, corporate structure, and rivalry
Factor input
conditions
Demand
conditions
Related and supporting industries
Government
Chance
Figure 11.3: Representation of Porter’s Diamond
Briefly summarized, four elements characterize a successful business environment. Firstly, companies often need special production factors — such as highly
specialized engineers, watchmakers or designers — so that they can continuously
develop and produce high-quality and innovative products. It is therefore not
enough for a country to have a good infrastructure or generally well-educated
people. These are necessary, but not sufficient conditions for economic success.
Moreover, the necessary production factors are generally not naturally available,
but have to be created or developed.5 The mere existence of resources does not
guarantee large-scale production. For example, the Soviet Union was perhaps
the most resource-rich country. It also had a highly educated labor force and
electricity consumption was even higher than in the USA. However, much lower
efficiency and productivity ensured that the country never reached the level of
prosperity of the USA, as Thomas Sowell explains in his book “Basic Economics”
(pages 4 and 23). At this point, we can make a brief reference to trade theory.
5 The presence of natural resources can even be detrimental to development, as Jeffrey D. Sachs
and Andrew M. Warner (European Economic Review, 2001) point out.
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Whereas in the models of David Ricardo and Heckscher and Ohlin we took the
productivity and endowments of countries as given in a simplified way, this is
an important point in Michael Porter’s work. The relevant production factors are
not simply available for successful nations, but must be actively generated.
The second element we find in Figure 11.3 is the demand factors. From Michael
Porter’s perspective, it is necessary for consumers to critically evaluate goods
and services, suggest improvements and be prepared to pay for them. This can
be linked to endogenous growth theories in that this consumer attitude increases
innovation activities. The willingness to pay increases the incentive for research
and development work and customer feedback increases the targeted precision
of this work. For example, the demand for environmentally friendly products in
Scandinavian countries has strengthened a specialized industry early on, which
is now very successful in the form of companies such as the wind turbine manufacturer Vestas Wind Systems (market capitalization of around CHF 30 billion
in May 2023). The best-known example here is the German car industry: without the pronounced preference of many customers, German car manufacturers
would not have been able to occupy a leading position in the global market for
decades. High productivity is necessary for this commercial success and this is
the result of continuous innovation. In line with trade theory, Michael Porter emphasizes the importance of the domestic market. Due to substantial trade costs
(transport, customs duties, language barriers, etc.), it is better if the relevant demand exists domestically.
The third element in Porter’s Diamond describes the related and supporting industries. This is based on the idea that every company is dependent on suppliers.
As early as 1958, Leonard Read described in the essay “I, Pencil” that even in
the manufacture of a product as simple as a pencil, thousands of industries are
ultimately involved.6 The presence of high-quality suppliers is therefore advantageous for successful companies. Clusters such as Silicon Valley or Massachusetts
Route 128 are ideal locations. Ideas and innovation can transfer quickly from one
company to another, partly because talented employees often change employers.
Porter sees the broad aspect of corporate strategy, corporate structure and rivalry
as the fourth building block for a successful business environment. On the one
hand, he addresses the point that companies must be in competition in order to
be continuously innovative. Porter therefore rejects national champions that are
protected and subsidized by the state. On the other hand, it is also important
to note that not every industry fits in with the cultural values of a country. For
example, it is in the nature of things that some industries only produce incremen6 The pencil consists only of wood, graphite, paint, aluminum and an eraser, but the wood alone
requires many tools, which consist of many elements, which in turn can only be obtained if
other tools are used.
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tal innovations, while others regularly undergo major upheavals. The fact that
Europeans have a higher preference for stability and a lower risk appetite compared to Americans is therefore one explanation for the fact that IT companies
find better framework conditions in the USA.
In addition to the four elements of the diamond, two other aspects play a role.
Firstly, politics can influence all four elements. By providing a good public infrastructure and high-quality educational facilities, but also through an effective
competition policy, a government makes a strong contribution to economic success. However, chance can also benefit a country. One example is the Swiss
watch industry, which owed its rise in part to the Huguenot religious refugees
who came to Geneva from 1550 and brought with them a wealth of expertise.
This influx of expertise from abroad continued into the 20th century, for example when the founder of Rolex, Hans Wilsdorf, moved his company headquarters
from London to Biel (Canton of Bern) in 1915 because Great Britain was imposing
high import duties.
11.2.2 Institutions
Tarun Khanna and Krishna G. Palepu provide a different approach to understanding a successful economy in their book “Winning in Emerging Markets”
published in 2010. Their considerations begin with the fact that although Saudi
Arabia and France have a very similar GDP per capita, the French economy is
much better developed. But what exactly characterizes a highly developed economy? Khanna and Palepu’s core idea begins with the fact that economic transactions between buyers and sellers are often hampered by information asymmetries
and disincentives. For example, if someone wants to sell his used car, he might
not disclose all known defects to potential buyers. As buyers are aware of their
information disadvantage, institutions are needed for a deal to materialize at all.
In our example, the buyer could sue the seller in court if the seller knowingly
concealed relevant information.
Khanna and Palepu categorize the institutions necessary for a successful economy as shown in Table 11.1. These are made up of private companies and state
institutions, both of which are conducive to the functioning of markets. Let us
look at an example. An entrepreneur from Zurich wants to get to know a new
potential business partner from Pittsburgh in the US. To do this, he flies to the
USA, spends a few days there and then returns. This ordinary process is facilitated by a variety of institutions. Searching for a cheap flight is just as easy
thanks to Expedia or Kayak as finding a suitable hotel thanks to Booking.com or
Trivago. Reservations and payments are also no problem thanks to Mastercard
and VISA. If problems do arise, the entrepreneur could, if necessary, sue for a
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refund through the courts. On site in Pittsburgh, he can also get into a taxi with
a complete stranger, as they are only allowed to offer their services if they have
passed a corresponding test. In all the many transactions associated with business travel, the institutions intervene in a certain way between buyer and seller
and simplify the transaction.
Institution
Function
Examples
Credibility booster
certification
ISO, AACSB, ETS
market Research,
Rating Agencies,
Analysts & Consultants
information provision
Aggregators & Distributors
Transaction facilitators
matching services
provision of a
TripAdvisor
supermarkets, universities
stock exchange, eBay
transaction platform
Arbitrators
dispute resolution
Regulators
develop
courts
FDA, BAG
rules and laws
Table 11.1: Institutions in the model framework of Khanna and Palepu
Institutions are therefore of great importance for a well-functioning economy.
These include both formal and informal institutions. However, the need for such
institutions can vary and also depends on the norms and values in a society.
Ultimately, laws and regulations only act as a substitute for values to a limited
extent. A society in which, for example, property rights are not recognized by
many or respectful treatment is not the norm will have difficulties in building a
successful economy. In many transactions, it is possible to reduce disputes with
contracts and their enforceability in court. But on the one hand, there is the socalled problem of incomplete contracts (good lawyers often find legal loopholes)
and on the other hand, enforcing rights also involves costs. Although many
passengers have to receive compensation from the airline in the event of delays
in Europe, the airline can deliberately make the process more complicated in
order to reduce the amount of money it has to pay back. For this reason, there
are companies such as AirHelp, which buy back the passengers’ claims for a fee
and then sue them collectively. Although this makes compensation possible, from
an economic point of view, many resources are used that could be put to other
uses. The situation is similar with the courts, the police or the military: valuable
resources must also be used for these. Institutions are therefore important for an
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economically successful country, but they are by no means free.
The importance of institutions and an economic environment that promotes innovation is also illustrated by numerous examples in the book "The Journey of
Humanity" (pages 147ff. and 182ff.), which was published by Oded Galor in
2022. In addition to Khanna and Palepu, many economists have addressed the
question of which institutional conditions are important for the successful development of an economy. In this context, an extensive literature emphasizes
enforceable property rights, high-quality infrastructure, easy access to financial
markets, efficient public administration, openness to international trade and an
independent judiciary. This variety of aspects is summarized in an index by the
World Bank’s Doing Business Index or the World Economic Forum’s (WEF) Global
Competitiveness Report, among others. As Figure 11.4 shows, a poorer position in
these rankings correlates with a low GDP.
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Figure 11.4: Correlation of World Bank and WEF Index with GDP per capita
11.2.3 Geography
While many of the aforementioned aspects of a successful economy can be influenced, at least to some extent, by politics and society, this does not apply to all of
a country’s characteristics. Geography in particular is essentially unchangeable
for a nation. The question therefore arises as to whether long-term economic
success is not also largely determined by geographical aspects. For example, if
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we look at the per capita income and the average height above sea level for each
country with more than five million inhabitants, the result is Figure 11.5. It is
noticeable that, with the exception of Switzerland, all countries with an average
altitude of over 1,000 meters achieve a medium income level at best. Nations
with a particularly high altitude, such as Nepal, Kyrgyzstan or Tajikistan, are
characterized by a very low per capita income. Is there more than a coincidence
behind this correlation?
Figure 11.5: height above sea level and per capita income
The correlation between geographical latitude and average per capita income is
particularly well known among economists. Figure 11.6 shows that countries
near the equator have a relatively low GDP per capita. As Matti Kummu and
Olli Varis (Applied Geography, 2011) document, there is a similar correlation with
many other variables, such as life expectancy.
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Figure 11.6: Geographic latitude and per capita income
In his book “Wealth, Poverty and Politics”, published in 2015, Thomas Sowell
discusses the influence of geography on an economy. He clarifies several important aspects. Firstly, there is an enormous variation in geographical conditions
and certain phenomena are limited to a few regions. For example, tornadoes
are found almost exclusively in the USA. And even within the USA, they only
occur in some of the states. Secondly, the combination of several geographical
conditions is often decisive. In addition to temperature (average, maximum and
minimum values), precipitation and nutrients in the soil also play an important
role in agricultural utilization. Even in the case of rivers, which are generally
economically valuable due to their transport possibilities, other aspects are important: the Congo River, for example, is far less suitable for navigation than the
Rhine or the Mississippi due to numerous rapids and very irregular rainfall.7
Thirdly, the effect of certain geographical conditions on the economy changes
over time. In developed countries, differences in altitude in rivers can be used in
part to generate electricity and shipping traffic can continue to be made possible,
for example in Birsfelden near Basel. The economic benefits of raw materials
also change over time. For example, palladium deposits were irrelevant for centuries — the metal was only discovered in 1802. And it only gained economic
value with the advent of catalytic converters, fuel cells and other products. While
7 For this reason, statistics on navigable river kilometers are quickly misleading. It is of relatively
little economic benefit if rivers are not continuously navigable — i.e. without geographical and
temporal interruptions.
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the metal cost less than 100 dollars at the beginning of the 1990s, it was traded
for over 3’000 US dollars in 2021. The metal only became so valuable thanks to
technological progress.
It is therefore hardly surprising that poor countries are geographically concentrated in individual regions and that major cities are often located by the sea or
large rivers. Per capita income in countries with direct access to the sea (i.e.,
not landlocked) is also around 50% higher than in nations that do not have this
access. Several studies by Jeffrey Sachs document these statistical correlations between geographical aspects and economic development. However, the challenge
for economists is to establish a causal link between geography and the economy.
Daron Acemoglu and James A. Robinson point out in their 2012 book “Why Nations Fail” that Mexico and the USA or even North and South Korea have very
similar geographical conditions close to the border. The fact that income levels
are nevertheless very different can be explained by different institutions. So does
geography hardly play a role? This thesis is contradicted by a study published
in 2016 by Thomas Barnebeck Andersen, Carl-Johan Dalgaard and Pablo Selaya
in Review of Economic Studies, in which a causal relationship between geography
and economic development was demonstrated. The authors used the fact that
ultraviolet radiation differs greatly around the world and is the main reason why
cataracts occur in countries near the equator, even in younger people. Although
the disease is now easily treatable, it may have historically slowed economic development in some countries.
To summarize, it can be said that a country’s geography can make its economic
development easier or more difficult. For some nations, geography is a permanent advantage or disadvantage. This can be measured, for example, by how far
each country is geographically from global GDP. To do this, multiply the distance
to each partner country by its share of global GDP and add up all the figures.
The result is Figure 11.7. European countries in particular have a geographical
advantage: a company in Switzerland can trade relatively easily with other rich
nations in Europe, but there are also overlapping office hours with New York and
Beijing. In contrast, South Africa, for example, is many thousands of kilometers
away from any highly developed country.
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Figure 11.7: Geographic distance to world GDP
11.3 Long-term Growth Policy
Now that we have a fairly comprehensive understanding of what shapes a country’s long-term economic success, we can turn to the question of how policy can
positively influence this. As a first step, we can answer this question using the
growth accounting approach. To do this, we are guided by Figure 10.7 from
page 319. Both exogenous factors (geographical location, climatic conditions,
raw material deposits, etc.) and economic policy have an influence on the three
drivers of long-term economic growth: labor, capital and technology.
In order to increase economic labor input, a government can, for example, reduce
income tax, increase the maximum working hours (currently around 54 hours per
week in Switzerland, Article 9 ArG, as well as Articles 2 and 22 ArGV 1), raise
the retirement age or abolish public holidays, taking into account the associated
trade-offs. When considering such measures, it is important to bear in mind that
there are other political and social objectives in addition to increasing GDP. Moreover, an increase in working hours can have a negative impact on productivity.
In addition to increasing working hours, there is also the possibility of increasing
the labor force participation rate. A variety of political measures can contribute
to this (making labor law more flexible, subsidies for daycare centers, publicly
funded training and education measures and reintegration programs), but the
corresponding trade-offs must also be taken into account.
Government decisions also play a central role with regard to capital accumulation, which can be achieved through both private and public investment. Firstly,
the provision of high-quality physical and digital infrastructure by the state con-
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tributes directly to increasing the capital stock. This increases the production
potential of an economy, as goods can be transported faster and more cheaply,
for example. A state can increase the incentives for private investment through
fiscal policy — such as changes in the tax treatment of investments — or the
provision of so-called social capital (property and contractual rights, political
stability). The latter plays a particularly important role in developing countries:
it is often the absence of social capital that highlights its significance.
The third factor influencing long-term economic growth in the growth accounting
approach is technology growth. Here, too, economic policy measures play a
decisive role. Since new technologies can be developed in both the private and
public sectors, both targeted patent protection — which strengthens incentives
for innovation while at the same time allowing competition — and support for
training and basic research at universities contribute to long-term GDP growth.
With all economic policy measures to increase GDP growth, a distinction must
be made between level effects and growth effects. The abolition of a public holiday, for example, permanently increases the level of GDP ceteris paribus, but only
leads to a one-off increase in the GDP growth rate — in the very year of abolition. In addition, the policy measures must always be analyzed in the respective
country-specific context. While infrastructure development and the strengthening of property rights in developing countries can make a major contribution to
long-term economic development, for example, a different focus must be set in
rich countries because the infrastructure there is usually very highly developed
and property rights are protected.
The new (endogenous) growth theory also provides important insights for the
design of economic policy in terms of long-term growth. Essentially, the aim is
to strengthen the incentives for innovation — and thus for increasing productivity. In order for new technologies to be developed, well-trained skilled labor is
needed first. Promoting a high general level of education, but also supporting top
universities, can make a contribution here.8 While endogenous growth theory essentially models knowledge generation within private firms and their incentive
to maximize profits, Paul Romer wrote (Journal of Political Economy, 1990, p.72):
“This does not mean that everyone who contributes to technological change is
motivated by market incentives. An academic scientist who is supported by government grants may be totally insulated from them. The premise here is that
market incentives nonetheless play an essential role in the process whereby new
knowledge is translated into goods with practical value. Our initial understand8 A high level of education is not to be equated with a long period of education (years of schooling)
or a large proportion of people with a university degree. On the one hand, such indicators have
an upper limit and, on the other hand, the skills and knowledge actually acquired are decisive.
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ing of electromagnetism arose from research conducted in academic institutions,
but magnetic tape and home videocassette recorders resulted from attempts by
private firms to earn a profit.” There is ultimately both a private and a social
return on innovation, which raises questions about the role of the state. Since,
as we have seen, innovations can be viewed as an externality, the considerations
familiar from microeconomics can also be applied here. These include the work
of the British economist Ronald Coase (1910-2013), in particular his ideas first
described in 1960 in the Journal of Law and Economics, which are now known as
the Coase theorem.
The central incentive for companies to be innovative is that they gain a temporary
advantage over competitors due to patents (or other difficulties of imitation).
This manifests itself in improved pricing power and the associated profits. This
is precisely the logic behind economic policy considerations in the context of
the new growth theory. Patents change the properties of goods. Economists
divide the latter into four groups, depending on whether they are rivaling and/or
excludable.9 In Tabelle 11.2, knowledge that is freely accessible to the public,
such as mathematics, falls into the category of public goods: anyone can use this
knowledge without restricting its use by others. Knowledge with expired patent
protection also falls into this category, having previously belonged to the club
goods due to its exclusivity.
rivaling
not rivaling
excludable
private goods
club goods
non-excludable
common goods
public goods
Table 11.2: Classification of goods
However, the strengthening of patent protection must be critically analyzed with
regard to its incentive effect. In particular, competition between companies must
not be weakened too much. Philippe Aghion describes the relationship between
competition and innovation as an inverted U in his book “The Power of Creative
Destruction” (page 61), published in 2021: The innovation rate is highest when
competition is moderately strong, but low if competition is too strong or weak. It
is therefore important to find a balance between incentives to innovate and incentives to form monopolies. This finding is based on a study by Philippe Aghion,
Nick Bloom, Richard Blundell, Rachel Griffith and Peter Howitt (Quarterly Journal
9 Many goods are not rivaling up to a certain number of customers.
For example, a few dozen
people can easily watch a film at the cinema at the same time, but not an unlimited number.
Common goods include a lake, for example, where overfishing is possible.
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of Economics 2005), among others. Successful economic policy increases the incentive of high-quality companies to be even more innovative and at the same time
prevents established companies from blocking the market entry of new competitors. A balance must therefore be struck between the intensity of competition,
innovation and growth. In this context, we can also refer to Chapter 5, where we
have already learned about the relationship between competition and production
levels. The higher the mark-up, the lower the structural GDP.10
In addition to competition policy, economic policy also contributes to long-term
economic growth. However, there are again some conflicting objectives to consider. In times of economic downturns and recessions, fiscal and monetary policy
offer the opportunity to increase GDP in the short term. We already recognized
this in Chapter 4. However, Chapters 5 to 7 also showed us that the effects in
the medium term can be very different. Now that we also know the drivers of
long-term economic growth, we can also look at economic policy from this perspective. Economists often refer to two phenomena in this context. On the one
hand, there is the so-called cleansing effect of recessions. This is based on the
idea that profits are just as important in an economy as losses. The latter force
companies to stop using resources and producing things that consumers do not
want. In a sense, a recession destroys the worse firms and the factors of production (labor and capital) tied up in them are then available to the better firms. If
economic policy prevents this process, so-called zombie firms can emerge. These
are companies that can only maintain unprofitable business operations because
interest rates are kept very low (through expansionary monetary policy).11 What
are the arguments in favor of an economic policy with regard to long-term economic development? Economists point to the economic scars that a deep recession
can leave behind. For example, if many people lose their job with no prospect
of returning to the labor market in the near future, this can have lasting psychological and health consequences.12 This would then result in a decrease in
the natural production level (Yn ). The propensity to take risks — an important
aspect when it comes to setting up new companies or developing technologies —
10 Thomas Philippon sheds light on this aspect in his book “The Great Reversal”, published in 2019,
where he shows that a weakening of competition has taken place in the US and has far-reaching
consequences.
11 Since zombification means that a lot of capital remains tied up in unproductive companies,
the real interest rate (= marginal product of capital) in the economy is also low. And since
this determines the level of nominal interest rates in the Taylor rule, the process can be selfreinforcing.
12 The empirical results on this vary considerably. For example, Micha Kaiser, Mirjam Reutter,
Alfonso Sousa-Poza and Kristina Strohmaier (Economics and Human Biology, 2018) use detailed
data from Germany and document that an increase in the regional unemployment rate increases
the number of smokers, but does not lead to an increase in smoking intensity among existing
smokers.
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can also be permanently reduced by a strong recession. Ulrike Malmendier and
Stefan Nagel documented this correlation in 2011, for example, in the Quarterly
Journal of Economics.
As a final economic policy measure to support long-term growth, we consider
openness towards foreign countries. This can support a country’s economic development in a variety of ways. Firstly, exchange with foreign countries also
favors the spread of ideas across national borders. The industrial revolution in
the USA, for example, was largely initiated by Samuel Slater, a British industrialist who brought the ideas of a spinning machine to America. The same exchange
of ideas is also taking place today: For example, the more Swiss companies export their products to China or import goods from there, the more likely it is
that new developments from China will be brought to Switzerland. In addition
to this form of imitation, there is also a positive effect of economic openness on
innovation. As early as 1966, Jacob Schmookler wrote in his work “Invention and
Economic Growth” (p.206) that the motivation for innovation is often the pursuit
of profit (“invention is largely an economic activity which, like other economic
activities, is pursued for gain”). According to Schmookler, the size of the market
plays a decisive role here: “The amount of invention is governed by the extent
of the market”. Based on these considerations, economists speak of a market
size effect: The larger the market in which a company can profitably sell a new
technology, the greater the incentive to innovate.13 At the same time, openness
towards competitors from abroad also ensures that domestic companies are constantly under pressure and thus remain innovative themselves. The efficiency of
research expenditure can also be increased through international co-operation, as
unnecessary redundancies can be reduced, for example.
13 Daron Acemoglu and Joshua Linn empirically analyzed and confirmed this hypothesis in 2004
in the Quarterly Journal of Economics.
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Theory box 11.1: Income inequality and economic growth
In this book, we are only concerned with GDP per capita and leave out the variation in
income across people — i.e. income inequality. This should not be interpreted as meaning
that this aspect is of little importance. Income inequality receives a great deal of attention
both in the political debate and in economic research. However, a detailed analysis would
go beyond the scope of this book. Still, there is a connection between income distribution
and the long-term economic development of a country. Firstly, rich people have a higher
savings rate than poorer people, which is why high income inequality can have a positive effect on economic growth. In addition, Reto Föllmi and Josef Zweimüller (Review of
Economic Studies, 2006) show that the incentive to innovate is influenced by income distribution. A large group of very rich people with a correspondingly high willingness to pay
for innovative goods tends to strengthen product innovations, while a large middle class
increases the incentive for process innovations (better manufacturing processes that reduce
the production costs of existing goods). However, high income inequality also has a variety of negative effects on economic growth. For example, poorer population groups may
be denied access to education. As many potential inventors do not grow up in wealthy
families, the overall economic innovation rate can be increased by a more even distribution
of income. However, the effects of income inequality on economic growth ultimately also
depend on country-specific circumstances. As early as 1993, Oded Galor and Joseph Zeira
showed in the Review of Economic Studies that the effect can be both positive and negative.
11.3.1 Developing Countries
Economic miracles such as those in Europe and Japan after the Second World
War received much attention in growth theory. The Asian tiger economies’ race
to catch up is also discussed in detail. Equally important, however, are the numerous examples of countries that did not experience an economic upturn. The
fact that many boom phases are only of limited duration should also prompt us
to question overly optimistic forecasts for the future. Of the 200 or so countries
for which the International Monetary Fund reports data, only around 40 were
considered highly developed (advanced economies) in 2016. This alone shows how
difficult and therefore unlikely economic prosperity is. Developments in the socalled BRICS countries or the history of Argentina also illustrate how difficult it is
for nations to be economically successful.14 If we look at data from the Maddison
Project from 1850 onwards, we can identify dozens of so-called great stagnations,
14 BRICS stands for the initials of the five countries Brazil, Russia, India, China and South Africa.
At the end of 2001, Jim O’Neill, then chief economist at Goldman Sachs, coined this term for
what he considered to be the most important emerging economies. However, as only India and
China developed very positively, critics called it a Bloody Ridiculous Investment Concept.
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i.e. years-long periods in which a nation’s GDP per capita stagnates or even falls.
While Switzerland last experienced this during the First World War, there are
also numerous examples for the period from 2000 onwards — from Argentina to
Greece and Zimbabwe. Less developed countries in particular are disproportionately often characterized by economic crises. In a study of 150 years of data, Andrew Tilton (“Still Wading through Great Stagnations”, Goldman Sachs Global
Investment Research, 17 September 2014) found that dozens of so-called great
stagnations: year-long periods in which a nation’s GDP barely grows compared
to other countries. But what exactly is preventing so many countries, especially
many populous ones, from rising? Figure 11.8 shows the share of the global population and per capita income (in purchasing power parities and US dollars in
2011) for each country based on data for 2018.15
Figure 11.8: World population by income level in 2018
If we recall the rule of 72 known from Chapter 1, it quickly becomes clear why
catch-up processes take a very long time. China, for example, had a per capita
income of around USD 15’000 in 2018, while the Central African Republic stood
at around USD 950. Even with 4.8% growth in GDP per capita — this would
be an extremely high growth rate — these figures only double every 15 years
(remember: 72/4.8 = 15). Only after three decades would China have reached
an income level like the USA in 2018. And the Central African Republic would
be at just USD 3’800 despite 30 years of uninterrupted very high growth. This is
15 For better visualisation, countries with a per capita income of over USD 80,000 have been left out
of Figure 11.8. The data comes from the World Bank (SP.POP.TOTL and NY.GDP.PCAP.PP.KD).
A graphic from the article “The dragon takes wing” from the magazine The Economist from 1
May 2014 was used as a template. I would like to thank Piotr Lukaszuk for creating the figure.
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a quadrupling of the initial figure, but also shows that prosperity can generally
only be built up over many generations.
The economic stagnation of many poor countries is surprising on the one hand,
but not surprising on the other. Let us start by considering why a catch-up process could be expected. One implication of the Solow model is that capital should
tend to flow from rich to poorer countries (Robert Lucas, American Economic Review, 1990). However, this is only the case to a limited extent, as the marginal
product of capital (or simply the return on investment) does not only depend
on the existing capital stock as in the Solow model. At the same time, however,
the catching-up process should be favored by the fact that imitation is easier
than innovation. Today’s poor countries face the challenge of escaping poverty
in a different environment than the highly developed countries of decades ago.
Much can be learned from the latter on the one hand and technologies can be
adopted on the other.16 After the Second World War, for example, Europe was
able to imitate the USA and in recent decades China has been able to implement technologies from the West. This mechanism can lead to convergence —
but only if the economic environment is generally favorable to growth. In this
case, the catch-up process can even benefit from the so-called Law of the handicap
of a head start. This is based on the idea that emerging countries can sometimes
adopt new technologies even faster than rich nations. For example, some African
countries have opted directly for mobile phones instead of landlines and, unlike
in the USA, the expansion of fibre optic networks in Romania has not met with
resistance from copper line operators.
In principle, developing countries should benefit from economic openness, as this
allows new technologies and investments to come from outside. It also allows
local labor to work abroad and send money home (this is known as remittances) —
in this case, gross national income would be higher than gross domestic product.
However, openness towards foreign countries also harbors risks. In particular,
the sometimes highly volatile international capital flows can cause instability
in many ways, as David Lubin describes in his book "Dance of the Trillions",
published in 2018. This is one of the reasons why many poorer countries are
often only partially able to catch up with richer countries. In addition, these
countries have often specialized in homogeneous raw materials and agricultural
products (commodities). Trade data from the United Nations, for example, shows
that in four out of five African countries, more than 60% of physical exports are
such commodities. As these goods fluctuate greatly in price, this creates additional
instability in poor countries.
Some economists talk about being caught in the middle income trap. This term
16 Economists speak of a demonstration effect or copycat economics.
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was coined in 2005 by the two World Bank economists Indermit Gill and Homi
Kharas. They used it to describe the empirical observation that the growth rate
of per capita income in emerging nations often declines sharply from a level
of around USD 16,000. These countries then have the problem that they are
no longer internationally competitive in the production of labor-intensive goods,
such as textiles, due to low wages. At the same time, they are not yet competitive
compared to highly developed countries when it comes to more complex goods.
As a result, the countries remain stuck at a medium level (relative to the USA),
as Figure 11.9 illustrates. It should be noted that the USA was set at 100% for
both 1960 and 2019. The upper and lower limits for a middle income level can
be defined in different ways — here they are set at 5 and 30% of the US level
respectively. It can be seen that countries such as Turkey, Mexico and Chile were
at a middle income level in both 1960 and 2019.
Figure 11.9: The middle income trap in the data
Figure 11.9 also shows that even over a period of more than fifty years, only a
small number of countries has made the leap to become a wealthy nation. In
contrast, many other hopefuls — such as the BRICS countries with the exception of China — have often been disappointments. The Austrian writer Stefan
Zweig (1881–1942) formulated it as early as 1941 as follows: “Brazil is the country of the future and always will be.” But what can developing countries do
to achieve a higher per capita income? One approach that has been pursued
for a long time since the 1980s is described by the term Washington Consensus.
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This term, coined by the British-American economist John Williamson, summarizes ten policy measures that were emphasized at the time by three institutions
based in Washington D.C.: the World Bank, the International Monetary Fund
and the US Treasury Department. The following measures were recommended
to make poorer countries more economically successful: Fiscal discipline, investment in education and infrastructure, tax reforms, leaving interest and exchange
rates largely to market forces, trade liberalization including opening up to foreign direct investment (FDI), privatization of public enterprises, deregulation and
ensuring property rights.
Many of these measures are in line with considerations that we have already
seen in chapters 10 and 11. But how successful were they in practice? John
Williamson himself summarized it soberly: “disappointing, to say the least”. The
core problem was that a universal way was to be shown for underdeveloped
countries to increase prosperity. But such “one-size-fits-all solutions” ignore important national circumstances and characteristics. In addition, many economic
policy measures do not necessarily achieve the desired effects, but rather depend
on the circumstances being favorable. Without the rule of law and competition
control, the privatization of public companies simply leads to private monopolies
or oligarchy. As with economic policy ideas in general, the exact transmission
mechanism (how exactly a measure achieves its goal) must be taken into account.
If even one link in the assumed transmission mechanism is weak or faulty, the
hoped-for results will not materialize. Trade liberalization is an example of this.
The basic idea here is that opening up to foreign companies leads to inefficient
domestic companies disappearing from the market. The production factors (labor, capital or even land) tied up in them can then be used more productively in
other sectors. However, these new sectors require, for example, a better legal system or higher quality institutions. There is also the question of whether the labor
market is sufficiently flexible. Otherwise, existing industries will be destroyed
without new ones being created. But to really alleviate poverty, prosperity is
needed and this is mostly generated in successful companies.
11.4 Summary
Building on the considerations from Chapter 10, we now have a broader understanding of what determines a country’s long-term economic success. In particular, we have looked at the new growth theory, but we have also learnt about
alternative approaches to analyzing the economic environment. These provide a
basis for the design and discussion of economic policy measures that should have
a positive influence on long-term development. Technological progress is needed
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to achieve sustainable economic growth. However, new ideas and technologies
are only developed if both the incentives and the framework conditions are in
place. If this is the case, both private companies and the state play an important
role. In this respect, economic success in the long term depends in particular on
institutions and the organization of the economic environment.
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In the final chapter, we want to summarize the key findings from the previous
chapters and take stock: what can we say about macroeconomic topics and issues at the end of the book? It is also important to apply the findings to current
problems and challenges. Will we now be able to better analyze current economic policy debates? Finally, a brief outlook on further issues in the field of
macroeconomics and economics in general will be given.
12.1 Central Findings
In most cases, the media report on short-term developments, in particular on
the short-term fluctuations in economic performance, which we have analyzed in
detail in the first four chapters. When GDP growth slows down or even enters a
recession, there are often calls for government intervention in the form of expansionary fiscal and monetary policy. With the IS-LM model, we have familiarized
ourselves with the conceptual framework that motivates these calls. However, we
are also aware from Chapters 5 to 7 that there are limits to government stimulus
that the IS-LM model is not able to model. Economic policy is often compared
to doping by commentators.1 The comparison is valid insofar as economic policy is similar to medicine. Although it is often relatively easy to take away a
patient’s pain — many painkillers are highly effective — the primary aim is to
combat the causes and not the symptoms. What is important is the general or
structural level. Let us consider at two patients who go to the doctor because
of severe pain. The first is basically healthy and in good physical condition, but
has broken his arm. The second, on the other hand, is malnourished and in very
poor condition due to years of drug use. A doctor can relieve the pain in both
of them in the short term with an appropriate painkiller. However, this does not
solve the actual cause. The first patient needs treatment for a temporary problem
1 The Neue Zürcher Zeitung, for example, ran the headline on 6 May 2021: “America’s economy is
running like doped”.
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(the broken arm) and it makes sense to use painkillers temporarily. The second
patient, on the other hand, has structural problems that require comprehensive
treatment. Here, too, painkillers — for example, for withdrawal symptoms —
can support medical healing. In both cases, doctors will try to solve the cause of
the health problems, not just alleviate the symptoms. The latter would be similar
to palliative care. The analogy with economics is that politics can almost always
stimulate the economy in the short term. However, such stimuli are not free,
must be constantly increased in dose and are of little help in the medium and
long term. The structural aspects must also be addressed. These considerations
are discussed in greater depth in Chapter 7.
It is therefore not enough to rely on fiscal or monetary policy stimulus to achieve
lasting economic success. Rather, we must raise the structural production level
of the economy. Prosperity has to be earned anew year after year and, as we now
know, an economy always returns to its structural level in the medium term.
The most important goal of economic policy is therefore to raise this level. We
have described this idea using the long-term trend line of GDP and analyzed
in Chapters 10 and 11 what determines the slope of the trend line. It turned
out that a successful economic environment is characterized by many mutually
influencing elements. For example, even if a country has many raw materials
or a large number of university graduates, this is not a sufficient condition for
high prosperity. And since per capita income has to be earned anew every year
— and countries are in competition with each other — it can happen that some
countries are very successful at times, but then fall behind again. Figure 12.1
shows the position of six selected countries in the global GDP per capita ranking
over a period of 70 years. The rise and fall of Japan, the continued success of the
USA and Switzerland, but also the enormous rise of Singapore are striking.
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Figure 12.1: Ranking of countries by GDP per capita
12.1.1 Analysis with Economic Theories
A central element of this textbook is the analysis of economic problems within
the framework of economic theories. As explained at the very beginning, the use
of mathematical models has its advantages and disadvantages. On the one hand,
they structure the analysis and transparently show the assumptions that are used
to derive economic policy statements. On the other hand, the limitations of economic models must always be taken into account when applying them. These
result from the simplifying assumptions that are necessary for every model.
In the first four chapters, we have very much adopted the so-called Keynesian
perspective. Based on the work of John Maynard Keynes — in particular the General Theory of Employment, Interest and Money published in 1936 — demand plays
the decisive role.2 While all economists see markets as an interplay of supply and
demand, two questions arise. Firstly, does demand drive supply or, conversely,
does supply drive demand? Secondly, what mechanism balances supply and demand? With regard to the first question, a distinction must be made between the
neoclassical and the Keynesian approach. In neoclassical theory, Say’s theorem
applies, according to which every supply seeks out its demand. The decisive
factor here is the price, which is also called the interest rate or wage, depending
2 The Austrian economist Friedrich August von Hayek (1899–1992) was very critical of the General
Theory. Rather, he saw it as a special theory for special circumstances, i.e. the Great Depression
of the 1930s.
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on the market. If supply exceeds demand, the price falls. As a result, the quantity demanded increases and a market equilibrium results. Keynes, on the other
hand, saw this flexibility as limited in practice. Even though the concept of sticky
prices later associated with him does not appear in his General Theory, Keynes saw
prices as having limited flexibility. They do move, but not fast enough. And if the
adjustment via prices does not take place (sufficiently), an adjustment must take
place via quantities. For example, if the demand for labor falls and wages do not
fall (fast enough), employment in the labor market will fall. The fact that there
is an adjustment via prices in the medium and long term is not very favorable
in the short term. So if the economic results are weighted heavily in the short
term, fiscal and monetary policy measures appear very attractive. We have also
recognized this result in the IS-LM model.
Some readers will also have noticed that in Chapter 2 we did not have the equation S(i ) = I (i ). This plays a central role in neoclassical economics, where the
supply of savings and the demand for them (by investors) are equalized via the
interest rate. However, Keynes did not see the motive for saving primarily in
investing, but in caution and uncertainty. People forego current consumption
and hold cash instead — for reasons of prudence, but also because of uncertainty
about the future. Savings therefore have only a small effect on the interest rate
level (conversely, the interest rate level has little influence on savings (see footnotes in chapter 2.3.1). In the IS-LM model, however, the interest rate plays two
roles. Firstly, it balances money demand and supply (L(Y, i ) = M) and secondly,
it influences private investment. At the second point, Keynes would be more
skeptical, as investment also depends on many other aspects, such as the animal spirits he emphasized. His preference for increasing government spending
(G) to stimulate the economy in a recession also follows from this consideration.
The central bank can lower interest rates, but this will have little effect if many
investors are skeptical about the future.
Throughout the book we have increasingly turned to the supply side, first by
extending the IS-LM model to the IS-LM-PC model, then by discussing long-run
economic growth. The change from the demand to the supply side perspective
took place at the same time as the time horizon changed. The aim of this structure in the textbook is to show that different aspects should be emphasized and
different models used depending on the time horizon. John Maynard Keynes
wrote in his book A Tract on Monetary Reform published in 1924: “The long run is
a misleading guide to current affairs. In the long run we are all dead. Economists
set themselves too easy, too useless a task if in tempestuous seasons they can only
tell us that when the storm is past the ocean is flat again.” He thus expressed
the view that the long-term perspective is by no means irrelevant (the expression “in the long run we are all dead” is often wrongly interpreted in this way),
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but that it must be supplemented by an analysis of the short term. It is not
enough to say that every economic downturn is only a temporary phenomenon
— especially when the recession is very deep and unemployment is persistently
high. Economists also need an answer to the question of what can stimulate the
economy in the short term.
Over generations, economists have developed theories to help policy makers categorize macroeconomic developments. However, as already emphasized, it is
important to use these theories bearing in mind their limitations. The theories
and models discussed in this book are ultimately based on data and observations
from practice. As is so often the case in science, there is also the problem that
we only have data for the past, but have to make decisions for the future. For
example, if we assume that private investments are primarily dependent on the
interest rate, this may be true for the past. But the future will show whether
this correlation is still as strong in the future and whether the statements derived
from the model are still as accurate. It is therefore important to take the findings
from the past and adapt them to future developments. In the words of a Japanese
proverb: “The same man never steps into the same river twice. The man is different and the river is different.” Economics has adopted many methodological
approaches from the natural sciences, especially physics. However, the behavior
of people is less easy to predict than the behavior of atoms or chemical elements.
Conversely, economists have the advantage of being able to ask their object of
analysis about their motives (e.g. “Why don’t you invest, but keep a large part
of your savings in cash?) Physicists do not have this form of insight.
12.1.2 The High Prosperity of Switzerland
At the beginning of this textbook, we looked at Figure 0.1 (page 11). This showed
that Switzerland has a very high income level by international standards, even
taking into account the high price level. As GDP per capita is considered the
most important target figure in macroeconomics, we can now pose the question
again: Why does Switzerland have such a high income level, which is significantly higher than the German, French or Chinese level? Which models and
findings from this book help us to answer this question?
Firstly, we know that the high level of prosperity in Switzerland was not created
in just a few years. The basis of economic success — the high-quality infrastructure, the good level of education, the political stability, the many world-class
companies — was created over generations. It is therefore clear that the answer
to the question must essentially be based on the theories from chapters 10 and 11.
So if we want to understand why income levels in Switzerland are so high, we
need to talk about aspects such as innovation, geography and the high capital
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stock. In practice, we find a combination of many favorable conditions and developments. The high per capita income is mostly generated in leading global
companies such as Nestlé, Roche, Novartis, Zurich Insurance Group, ABB or
Glencore. However, these companies are not located in Switzerland by chance.
Rather, it is the favorable economic conditions that speak in Switzerland’s favor. And it also helps that Switzerland is a relatively small country. Of the ten
highest-income (independent) countries according to the International Monetary
Fund, only the USA had a population of more than ten million in 2021. The other
countries include Luxembourg, Singapore, Ireland, Qatar, Switzerland, Norway,
Brunei, San Marino and Denmark. It is often easier for small countries to achieve
a high level of income, as a few successful industries are sufficient. In the case of
Switzerland, these are the pharmaceutical industry, the financial sector, but also
the transit trade in raw materials, which is not very visible domestically. In addition, public administration can be more efficient and there is less heterogeneity
at home — which, however, increases dependence on foreign countries. Small
countries are more dependent on good relations with foreign countries for their
economic success.3 It is therefore a great advantage for Switzerland to have very
successful partner countries in its immediate geographical neighborhood.
Of course, Switzerland’s high per capita income is only an average figure for the
population. As we already know, this says little about the distribution of wealth.
In Switzerland, however, it is clear that although there are large differences in
income and wealth, the income level is relatively high even among the poorer
groups. Figure 12.2 shows that even those people who are among the poorest
5% in Switzerland (i.e. in a national comparison) are among the top 30% of the
world’s population in an international comparison. In other words, even the
poorer population groups in Switzerland are materially better off than almost
everyone in India, China or Brazil.4 The Serbian-American economist Branko
Milanovic commented on this in an interview in 2014: “Something like 60 per
cent of your income is determined at birth and then 20 additional per cent by
how rich are your parents.”
3 Dependence on foreign countries limits the possibility of small countries enriching themselves
at the expense of larger nations. Although they can gain a certain tax base from abroad through
low tax rates, large countries generally have the ability to limit this.
4 The very low income level at the lower end of the distribution in Brazil explains why, for example, many people there are still suffering from hunger in 2021, as the magazine The Economist
reported on 15 May.
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Figure 12.2: Income inequality within and between countries
12.2 Current Macroeconomic Debates
The findings from this textbook also help us to better analyze and discuss many
current macroeconomic problems. This is briefly illustrated below using three
examples.
(1) Economic recovery after the corona crisis
In 2020, the global economy experienced a worldwide pandemic due to the previously unknown coronavirus SARS-CoV-2, which is estimated to have caused
several million deaths. This was also associated with a very abrupt economic
slump. Figure 12.3 shows this for some selected countries, with the GDP for 2019
normalized to 100 in each case. In the case of Italy in particular, GDP fell sharply
by around ten per cent and the forecast in April 2021 was that the country would
not return to pre-crisis levels until 2024. A comparable slump had previously
occurred in the wake of the global financial crisis in 2009, when the growth rate
in some countries fell permanently and there were no catch-up effects after the
crisis in the USA, for example. US GDP did not return to the previous trend after
2009, but remained at a permanently reduced level.
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Figure 12.3: GDP slump during the coronavirus crisis 2020
The rapid economic recovery in many countries after the coronavirus crisis in
2020 indicates a so-called V-shaped recession. A slower recovery, such as in Italy,
is described by economists as U-shaped. There are also W-shaped recessions
(two successive slumps in GDP) and L-shaped recessions (no recovery after the
slump). A very expansive fiscal and monetary policy also contributed to the
rapid recovery in GDP from 2021. As in previous years (see Figure 12.4), this was
significantly stronger in the US than in European countries. The interest rate cut
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was also greater in the USA in 2020 and 2021 (in the Euro area, the interest rate
level was already 0.0% in 2019, while it was around two percentage points above
zero in the USA) and the budget deficit was much more pronounced.
Figure 12.4: Fiscal and monetary policy measures from 1995–2021
The economic policy measures taken during the coronavirus crisis raise the familiar question of how much the state should intervene to provide support in
a recession. From the discussions in earlier chapters, we know what speaks for
and against economic stimulus programs.
(2) Exceptionally expansionary fiscal and monetary policy
What is striking about fiscal and monetary policy in 2020 and 2021 is its scale.
The central bank balance sheets have grown massively as a result of a sustained
expansionary monetary policy, as Figure 12.5 illustrates. This extraordinary development was not without consequences, as we have already seen in Chapter 6.
Asset prices have risen very sharply, particularly on the property and stock markets. The persistently low interest rates have also increased the incentives for
governments and private actors to take on very high levels of debt.
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Figure 12.5: Central bank balance sheets since 2000
However, criticism of the developments of recent years — in particular the increase in global debt — is by no means new. As early as 1946, Henry Hazlitt
wrote in the book Economics in One Lesson: “There are men regarded today as
brilliant economists, who deprecate saving and recommend squandering on a
national scale as the way of economic salvation; and when anyone points to what
the consequences of these policies will be in the long run, they reply flippantly,
as might the prodigal son of a warning father: ’In the long run we are all dead.’
And such shallow wisecracks pass as devastating epigrams and the ripest wisdom.” The low interest rates since the financial crisis are the result of a very
expansive monetary policy and have a similarly distorting effect as other government interventions in the price mechanism: the incentives for public and private
debt increase, there is a higher risk appetite among investors (search for yield) and
a larger number of zombie companies emerge — with negative consequences for
productivity growth, as resources remain inefficiently tied up in the unprofitable
companies. The latter would be less of a problem if economic growth were fundamentally high. However, this has not been the case in many major economies
for some time.
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(3) Low and falling GDP per capita growth rates
GDP per capita is regarded as the central economic variable. However, if we
look at Figure 12.6, we can see that per capita income in some countries, such
as Italy or Japan, has hardly grown at all for around twenty years. Although
there was no recession in the USA for around ten years after the financial crisis,
economic growth was lower than in previous decades. And in China, a number of
indicators also suggest that GDP growth will continue to slow. There are several
possible explanations for the developments in Figure 12.6. We are familiar with
the drivers of long-term economic growth from Chapters 10 and 11. In particular,
we know that productivity development is of central importance, but that growth
rates in many countries have been relatively low for years (Figure 11.1). This
development can be explained by lower research productivity (Nicholas Bloom
et al., American Economic Review, 2020), declining competition (Thomas Philippon,
The Great Reversal, 2019), but also negative developments in the education sector.
Figure 12.6: GDP per capita growth over 10-year periods
12.3 Outlook
If we look beyond current developments, the question arises as to future economic trends. Is it possible to identify some macroeconomic trends for the future
based on the insights gained from this book? In particular, it may be of interest
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to many economic policy-makers, but also to many entrepreneurs and managers,
where the greatest opportunities for growth will be in the future. We can start by
looking at previous decades. As can be seen in Figure 12.7, the USA and Japan
made the largest contribution to global economic growth in the 1990s. In the
two decades that followed, China and the USA were the most important nations.
This is unlikely to change for the period from 2020 to 2027. It is striking that
India, large European nations and emerging economies such as Iran, Brazil and
Indonesia are also likely to make a substantial contribution.
Figure 12.7: Contribution to global GDP growth
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China’s high growth figures in recent years are also evident when we look at the
global economy. As Figure 12.8 illustrates, the rise of Asia and China in particular
is remarkable. While Asian countries produced around 20% of global GDP in
1980, this figure has already risen to over 40% in 2020. According to forecasts, the
economic weighting will continue to shift towards Asia in the future if countries
such as China, India and Indonesia develop favorably. Conversely, the relative
importance of the USA and Europe will potentially continue to decline.
Figure 12.8: Shares of global GDP growth in the period 1980–2027
The development of the global economy is also strongly influenced by demographic trends. While GDP forecasts are generally associated with a high degree
of uncertainty, forecasts of future population figures (which are easier to make)
are considered to be very reliable. If we look at the numbers in Figure 12.9, we
can see an increase in the African population in particular. While the population
of Europe was still around twice as high as that of Africa in 1970, the ratio has
reversed by 2020. And by 2050, the UN expects the ratio to develop to almost 4:1.
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Figure 12.9: Shares of the world population in the period 1950–2050
The global economy is therefore in a constant state of upheaval. And other developments such as climate change or the macroeconomic trends described above
will also present political decision-makers, entrepreneurs and citizens with the
problem that we described at the beginning of the book: We cannot escape the
economic issues and their complexity. They determine our prosperity in many
different ways. However, in order to navigate successfully through the complexity of macroeconomic issues, a reliable compass is very helpful. I hope that this
textbook can contribute to this.
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Data Sources
Data is invaluable for many economic analyses and discussions. Many aspects
of this textbook are also illustrated with data. Therefore, a number of useful
data sources are listed below, most of which are freely accessible. The sorting is
alphabetical.
CEPII: The Centre d’Études Prospectives et d’Informations Internationales (CEPII for
short) offers a wide range of processed statistics. Numerous data are offered,
particularly in the field of international trade.
Economist: The weekly magazine The Economist offers articles on current economic topics as well as an overview of important indicators on the last pages.
Information on GDP, unemployment rate, inflation, foreign trade, interest rates
and exchange rates is provided for the most important economies. The same data
is also available online as Economic and financial indicators.
International Monetary Fund: The specialised agency of the United Nations
known as the IMF (International Monetary Fund) provides a wide range of macroeconomic data. In addition to the International Financial Statistics (IFS), the World
Economic Outlook is an excellent database for macroeconomic analyses.
National statistical offices: Every country has a national statistics office that
regularly provides a wide range of data. For Switzerland this is the Federal Statistical Office, for Germany the Federal Statistical Office. The European Union
offers a comprehensive collection of data with Eurostat. For the USA, we recommend the database of the Federal Reserve Economic Data (FRED for short), which
also offers data for other countries in some cases. The Bureau of Economic Analysis
also provides many statistics on the American economy. In addition to the general statistics, there are also annual reports on the state of the economy in many
countries, such as the annual report of the German Council of Economic Experts
in Germany and the Economic Report of the President of the Council of Economic
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Advisers in the USA. At a European level, the Report on the European Economy by
CESifo is a comparable source of information.
OECD: The Organisation for Economic Co-operation and Development is an association of currently 37 member countries, most of which have a high per capita
income. As part of OECD.Stat, the organisation also provides a large number
of economic statistics for member countries. In addition, the OECD Economic
Outlook provides an overview of macroeconomic developments twice a year.
Penn World Tables: Currently in version 10.01, the Penn World Tables is a database
with information on income, output, input and productivity for 183 countries
between 1950 and 2019. The name goes back to the original developers Robert
Summers, Irving Kravis and Alan Heston from the University of Pennsylvania.
World Bank: The Washington DC-based organisation offers a large amount of
information in its World Bank Open Data database. Data spanning several decades
can be found for almost all countries in the world and many macroeconomic
variables.
United Nations: In addition to the UNdata database, which primarily contains
population data, the United Nations (UN) also offers the Comtrade database,
which is the most important international source of data on international trade.
Some of the data provided there can also be obtained via World Integrated Trade
Solutions (WITS).
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Alternative Textbooks on Macroeconomics
Economists have a very good understanding of the effects of competition: while
competition may seem unattractive for individual suppliers, competition between
suppliers is generally beneficial for the economy as a whole. With this in mind,
it should be noted that there are a large number of alternative books in addition
to this textbook. Some of these choose different explanatory approaches and
thematic focuses. It is therefore recommended that you also take a closer look at
these textbooks. Below is a short selection of books worth reading:
Olivier Blanchard: The book “Macroeconomics” follows a similar content logic
as my textbook. Various topics such as the financial crisis or political economy
are discussed in more detail — often with examples from the USA and Germany.
Aymo Brunetti: Written with a special focus on Switzerland, the book “Economics” explains economic topics and interrelationships in easy-to-understand
language. Technically less demanding than this textbook, Brunetti covers a variety of micro- and macroeconomic aspects.
Bernhard Felderer & Stefan Homburg: The textbook “Macroeconomics and
New Macroeconomics” has existed since 1984 and is considered a classic in the
German-speaking world. It pays particular attention to the various economic
theories.
Gregory Mankiw: Perhaps the best-known current textbook on macroeconomics
with the simple title “Macroeconomics” is by Greg Mankiw, who taught the introductory economics course (Ec 10) at Harvard University for fourteen years.
David Miles, Andrew Scott and Francis Breedon: The 2014 textbook “Macroeconomics — Understanding Global Economic Interrelationships” goes into great
detail on many aspects, from stock markets to government debt, and illustrates
these using comprehensive empirical illustrations.
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Acknowledgments
This textbook would not have been possible without the support of a large
number of people. During my own studies of economics at the Universities
of Mannheim, St.Gallen, San Diego, Berkeley and Princeton, I was able to learn
a lot about economics and macroeconomics from dozens of people. As a lecturer at the University of St.Gallen, I have benefited for years from the insightful
exchange and collaboration with colleagues.
The textbook was primarily created for the Macroeconomics I course, which I
have been teaching together with Reto Föllmi and Guido Cozzi since 2020 and
which is supported by Magnus Hoffmann. Ideas from the MBA course Global
Business Environment, which I taught for a time with Simon Evenett, can also be
found in the textbook.
Sara Fontanet supported me in the design of some of the theoretical graphics
while Jason Rosenthal supported translation of the book into English. Countless
feedback and questions from students have helped to present the course material
in a more understandable way. In addition, several people — especially Magnus
Hoffmann and Paul Legge — proofread earlier versions of the textbook. My
sincere thanks to all those who have supported me.
Stefan Legge, May 2024
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