Macroeconomics
V. Polito with C. Brendon
EC2065
2014
Undergraduate study in
Economics, Management,
Finance and the Social Sciences
This is an extract from a subject guide for an undergraduate course offered as part of the
University of London International Programmes in Economics, Management, Finance and
the Social Sciences. Materials for these programmes are developed by academics at the
London School of Economics and Political Science (LSE).
For more information, see: www.londoninternational.ac.uk
This guide was prepared for the University of London International Programmes by:
Dr Vito Polito, Lecturer, Cardiff Business School
Charles Brendon, Max Weber Fellow, European University Institute
This is one of a series of subject guides published by the University. We regret that due
to pressure of work the authors are unable to enter into any correspondence relating to,
or arising from, the guide. If you have any comments on this subject guide, favourable or
unfavourable, please use the form at the back of this guide.
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Contents
Contents
Chapter 1: Introduction........................................................................................... 1
Aims and objectives........................................................................................................ 2
Learning outcomes......................................................................................................... 2
Syllabus.......................................................................................................................... 2
The structure of the subject guide................................................................................... 3
How to use the subject guide.......................................................................................... 4
Essential reading............................................................................................................ 5
Further reading............................................................................................................... 7
Online study resources.................................................................................................. 10
Examination advice...................................................................................................... 11
Chapter 2: The IS–LM model.................................................................................. 13
Aims of the chapter...................................................................................................... 13
Learning outcomes....................................................................................................... 13
Essential reading.......................................................................................................... 13
Further reading............................................................................................................. 13
Works cited.................................................................................................................. 13
Introduction................................................................................................................. 14
The IS–LM model: key assumptions............................................................................... 15
The IS–LM model: behavioural equations and identities................................................. 16
Income accounting in a closed economy........................................................................ 19
The IS curve.................................................................................................................. 19
The LM curve................................................................................................................ 21
Equilibrium in the IS–LM model.................................................................................... 22
Fiscal and monetary policy in the IS–LM model............................................................. 23
Policy mixes.................................................................................................................. 25
Solutions to activities.................................................................................................... 26
A reminder of your learning outcomes........................................................................... 29
Sample examination questions...................................................................................... 29
Guidance on answering the sample examination questions........................................... 31
Chapter 3: Unemployment and the AD–AS model................................................ 33
Aims of the chapter...................................................................................................... 33
Learning outcomes....................................................................................................... 33
Essential reading.......................................................................................................... 33
Further reading............................................................................................................. 33
Introduction................................................................................................................. 34
The labour market: main definitions.............................................................................. 35
Labour market and classical unemployment.................................................................. 36
Hysteresis..................................................................................................................... 38
Frictional and structural unemployment......................................................................... 38
The natural rate of unemployment................................................................................ 39
Aggregate supply......................................................................................................... 41
The sticky-wage model................................................................................................. 43
The worker-misperception model................................................................................... 44
The sticky-price model.................................................................................................. 45
The Lucas islands model............................................................................................... 46
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EC2065 Macroeconomics
Aggregate demand....................................................................................................... 47
The AD–AS model........................................................................................................ 49
Monetary and fiscal policy in the AD–AS model............................................................ 50
Supply shocks............................................................................................................... 51
Solutions to activities.................................................................................................... 53
A reminder of your learning outcomes........................................................................... 57
Sample examination questions...................................................................................... 57
Guidance on answering the sample examination questions........................................... 58
Chapter 4: Inflation and the Phillips curve............................................................ 59
Aims of the chapter...................................................................................................... 59
Learning outcomes....................................................................................................... 59
Essential reading.......................................................................................................... 59
Further reading............................................................................................................. 59
Introduction................................................................................................................. 60
The inflation rate and the Phillips curve......................................................................... 61
Okun’s law................................................................................................................... 63
The AD–AS model (revisited): long run.......................................................................... 65
The AD–AS model (revisited): short run......................................................................... 67
Costs and benefits of inflation...................................................................................... 68
Costly disinflation policy............................................................................................... 70
Disinflation policy......................................................................................................... 71
Depression, liquidity trap, and deflation......................................................................... 73
Solutions to activities ................................................................................................... 75
A reminder of your learning outcomes........................................................................... 77
Sample examination questions...................................................................................... 78
Guidance on answering the sample examination questions........................................... 79
Chapter 5: Economic growth: stylised facts and the basic Solow model.............. 81
Aims of the chapter...................................................................................................... 81
Learning outcomes....................................................................................................... 81
Essential reading.......................................................................................................... 81
Further reading............................................................................................................. 81
Works cited ................................................................................................................. 82
Introduction................................................................................................................. 82
The algebra of economic growth................................................................................... 83
Measures of the wealth of a country............................................................................. 84
Stylised facts: OECD countries....................................................................................... 84
Stylised facts: rest of the world..................................................................................... 86
The neoclassical production function ............................................................................ 89
The Solow model: basic assumptions............................................................................. 91
The Solow model: the steady state................................................................................ 92
Comparative statics...................................................................................................... 95
Solutions to activities.................................................................................................... 99
A reminder of your learning outcomes......................................................................... 102
Sample examination questions.................................................................................... 102
Guidance on answering the sample examination questions......................................... 102
Chapter 6: Exogenous and endogenous theories of economic growth.............. 105
Aims of the chapter.................................................................................................... 105
Learning outcomes..................................................................................................... 105
Essential reading........................................................................................................ 105
Further reading........................................................................................................... 105
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Contents
Work cited................................................................................................................. 105
Introduction............................................................................................................... 106
Production with exogenous technology ...................................................................... 106
The Solow residual..................................................................................................... 107
The Solow model with exogenous technology............................................................. 108
The steady state......................................................................................................... 110
Comparative statics.................................................................................................... 112
The golden rule.......................................................................................................... 114
New growth theory.................................................................................................... 115
The AK model............................................................................................................. 116
Growth and human capital......................................................................................... 117
Solutions to activities.................................................................................................. 118
A reminder of your learning outcomes......................................................................... 123
Sample examination questions.................................................................................... 123
Guidance on answering the sample examination questions......................................... 124
Chapter 7: The open economy............................................................................. 127
Aims of the chapter.................................................................................................... 127
Learning outcomes..................................................................................................... 127
Essential reading........................................................................................................ 127
Further reading........................................................................................................... 127
Introduction............................................................................................................... 127
The balance of payments............................................................................................ 128
National income accounting in an open economy........................................................ 129
Nominal exchange rates............................................................................................. 129
The trade balance....................................................................................................... 133
The goods market in an open economy....................................................................... 134
Solutions to activities.................................................................................................. 137
A reminder of your learning outcomes......................................................................... 139
Sample examination questions.................................................................................... 140
Guidance on answering the sample examination questions......................................... 141
Chapter 8: The Mundell–Fleming model.............................................................. 143
Aims of the chapter.................................................................................................... 143
Learning outcomes..................................................................................................... 143
Essential reading........................................................................................................ 143
Further reading........................................................................................................... 143
Introduction............................................................................................................... 143
The balance of payments (BP ) curve and capital mobility............................................. 145
The Mundell–Fleming model with perfect and no capital mobility................................ 146
The Mundell–Fleming model under imperfect capital mobility and a
fixed exchange rate.................................................................................................... 148
The Mundell–Fleming model under imperfect capital mobility and a
flexible exchange rate................................................................................................. 149
Solutions to activities.................................................................................................. 152
A reminder of your learning outcomes......................................................................... 154
Sample examination questions.................................................................................... 154
Guidance on answering the sample examination questions ........................................ 155
Chapter 9: Theories of consumption................................................................... 157
Aims of the chapter.................................................................................................... 157
Learning outcomes..................................................................................................... 157
Essential reading........................................................................................................ 157
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EC2065 Macroeconomics
Further reading........................................................................................................... 157
Introduction............................................................................................................... 157
The Keynesian consumption function, and beyond....................................................... 159
The Fisher model of intertemporal consumption.......................................................... 160
Consumption, interest rates and income...................................................................... 162
The life cycle hypothesis (LCH).................................................................................... 164
The permanent income hypothesis.............................................................................. 166
The Ricardian equivalence proposition......................................................................... 167
The random-walk hypothesis....................................................................................... 168
Solutions to activities.................................................................................................. 169
A reminder of your learning outcomes......................................................................... 172
Sample examination questions.................................................................................... 172
Guidance on answering the sample examination questions......................................... 173
Chapter 10: Theories of investment.................................................................... 175
Aims of the chapter.................................................................................................... 175
Learning outcomes..................................................................................................... 175
Essential reading........................................................................................................ 175
Further reading........................................................................................................... 175
Introduction............................................................................................................... 175
No-arbitrage condition, real and nominal interest rates............................................... 176
IS–LM model, real and nominal interest rates.............................................................. 177
The bond market........................................................................................................ 179
Yield to maturity ........................................................................................................ 180
The stock market........................................................................................................ 181
The Keynesian theory of aggregate investment............................................................ 183
The accelerator model ................................................................................................ 184
The neoclassical model of investment.......................................................................... 185
Tobin’s q model of investment.................................................................................... 186
Keynesian versus neoclassical theory: the empirical evidence....................................... 187
Solutions to activities.................................................................................................. 188
A reminder of your learning outcomes......................................................................... 190
Sample examination questions.................................................................................... 191
Guidance on answering the sample examination questions......................................... 192
Chapter 11: Money demand and money supply.................................................. 193
Aims of the chapter.................................................................................................... 193
Learning outcomes..................................................................................................... 193
Essential reading ....................................................................................................... 193
Further reading........................................................................................................... 193
Introduction............................................................................................................... 194
Definition and functions of money.............................................................................. 194
The demand for money............................................................................................... 195
The Baumol–Tobin transactions demand model........................................................... 196
The Tobin speculative demand model.......................................................................... 197
Empirical evidence on money demand......................................................................... 198
Velocity and money demand....................................................................................... 198
Money supply............................................................................................................. 200
Instruments of monetary control................................................................................. 201
Solutions to activities.................................................................................................. 202
A reminder of your learning outcomes......................................................................... 204
iv
Contents
Sample examination questions.................................................................................... 205
Guidance on answering the sample examination questions......................................... 206
Chapter 12: Monetary policy............................................................................... 209
Aims of the chapter.................................................................................................... 209
Learning outcomes..................................................................................................... 209
Essential reading........................................................................................................ 209
Further reading........................................................................................................... 209
Introduction............................................................................................................... 210
Macroeconomic stability............................................................................................. 211
Active versus passive demand management policies.................................................... 212
Monetary policy: targets and instruments.................................................................... 214
Inflation targeting....................................................................................................... 216
Rules versus discretion................................................................................................ 217
Monetary policy rules................................................................................................. 220
Solutions to activities.................................................................................................. 222
A reminder of your learning outcomes......................................................................... 224
Sample examination questions.................................................................................... 224
Guidance on answering the sample examination questions......................................... 225
Chapter 13: Fiscal policy..................................................................................... 227
Aims of the chapter.................................................................................................... 227
Learning outcomes..................................................................................................... 227
Essential reading........................................................................................................ 227
Further reading .......................................................................................................... 227
Introduction............................................................................................................... 228
The arithmetic of the government budget constraint.................................................... 229
The Barro–Ricardo equivalence proposition................................................................. 230
The theoretical underpinning of fiscal policy................................................................ 233
Active versus passive fiscal policy................................................................................ 235
Rules versus discretion................................................................................................ 236
Seignorage and tax revenue........................................................................................ 239
Solutions to activities.................................................................................................. 241
A reminder of your learning outcomes......................................................................... 243
Sample examination questions.................................................................................... 244
Guidance on answering the sample examination questions......................................... 245
Appendix 1: Sample examination paper............................................................. 247
Appendix 2: Sample Examiners’ commentary..................................................... 251
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EC2065 Macroeconomics
Notes
vi
Chapter 1: Introduction
Chapter 1: Introduction
Welcome to course EC2065 Macroeconomics which is a 200 course
available on the Economics, Management, Finance and Social Sciences
(EMFSS) suite of programmes available through the University of London
International Programmes.
This course is designed to introduce you to the most influential and
compelling theories devised by macroeconomists in order to explain issues
related to the determination of output, unemployment and inflation.
Through this course you will acquire a logical and consistent framework
for understanding the main macroeconomic facts and events, and develop
the ability to employ the correct macroeconomic tool(s) to explain specific
macroeconomic issues and justify policy proposals.
This course is particularly relevant for those of you who want to go on to
careers in consulting in both the private and public sectors, public policy,
education, journalism, diplomacy, social science and international affairs.
It is also relevant for anyone interested in pursuing advanced study in
economics, as well as in related fields such as politics, philosophy and
economic history.
Macroeconomics is the art of imagining a simplified world, a
macroeconomic model, in which the interaction between households, firms
and policy makers determines the value of aggregate production, the total
number of people working in the economy, and the general price level. The
ultimate objective of this exercise of imagination is to examine how and to
what extent this simplified world might help to answer the following five
fundamental macroeconomic questions about the real world:
1. Why does output grow over very long periods of time?
2. Why is output growth not steady, but varies from year to year?
3. What determines the rate of unemployment?
4. Why do prices increase over time?
5. What should policy makers do to boost output growth, reduce
unemployment and control inflation?
What makes macroeconomics such a fascinating subject is that these
questions are – like it or not – a key part of our daily life. Not a day
passes without reports in the media about the impressive economic
growth performance in China, another music concert organised to raise
awareness about public debt in third world countries, some politician or
other worrying about the likely consequences of soaring oil prices, or a
commentator speculating about what is happening in the stock market. If
you are curious about any of these (and more) questions, this is the right
course for you!
As well as explaining the macroeconomic system, macroeconomists also
quantify what we understand (and sometimes do not understand) about
the behaviour of the economy in order to recommend specific policy
actions. This is another skill that you will acquire by studying this course.
For example, you will be able to assess whether or not, and by how much,
the interest rate should be changed in order to contain inflation; how
much an economy should save to maximise consumption; or whether or
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EC2065 Macroeconomics
not, and how much taxes and public spending should change in order to
help the economy recover after a recession.
Studying for this course will stimulate and develop your written
communication skills, as well as your ability to assess and think
analytically about everyday life events. These skills will prove to be
great assets in both your professional and personal development. I hope
you will enjoy spending your time reading and practising macroeconomics
as much as I did preparing this guide.
Aims and objectives
The aims of this course are to:
• show how our understanding of how economic systems operate has
evolved substantially
• explain why the growth rate of aggregate output varies from year to
year
• explain what determines unemployment and inflation in the short run
and in the long run
• discuss how macroeconomic policy might influence business cycles or
long-run growth.
Learning outcomes
At the end of this course and having completed the Essential reading and
activities, you should be able to:
• define and analyse the determinants of business cycles, long-run
economic growth, unemployment and inflation
• use and apply a wide range of economic models to analyse
contemporary and historical macroeconomic events, and formulate
and propose appropriate macroeconomic policies.
Syllabus
This course covers the main principles involved in the determination of
real income, employment and unemployment, the price level and inflation
in an open mixed economy, and the conduct of macroeconomic policy.
The main topics are:
• Aggregate demand in a closed economy: the determinants of
consumption, investment, demand for and supply of money; wealth
effects; the IS–LM model and policy prescriptions.
• Aggregate demand in an open economy: exchange rate regimes,
international trade and capital flows, and external balance; the IS–LM–
BP model and policy prescriptions.
• Aggregate demand, aggregate supply and the price level: the
aggregate demand curve; short- and long-run aggregate supply curves;
the aggregate demand-aggregate supply model and its applications
to the determination of the price level and real income, and demand
management policy; the neoclassical (Solow) growth model.
• Inflation and unemployment; models of inflation; costs of inflation;
counter-inflationary policy; full employment and the natural rate of
unemployment; types and causes of unemployment, and policies to
reduce them.
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Chapter 1: Introduction
The structure of the subject guide
The subject guide organises the material covered in the syllabus as follows:
Part 1: The short run
Chapter 2: The IS–LM model
Chapter 3: Unemployment and the AD–AS model
Chapter 4: Inflation and the Phillips curve
Part 2: The long run
Chapter 5: Economic growth: stylised facts and the basic Solow model
Chapter 6: Exogenous and endogenous theories of economic growth
Part 3: The open economy
Chapter 7: The open economy
Chapter 8: The Mundell–Fleming model
Part 4: Microfounded macroeconomic theories
Chapter 9: Theories of consumption
Chapter 10: Theories of investment
Chapter 11: Money demand and money supply
Part 5: Monetary and fiscal policy
Chapter 12: Monetary policy
Chapter 13: Fiscal policy
As you can see, the content of the syllabus has been divided thematically
into five different parts. Each part is then divided into several chapters.
• Part 1 is dedicated to the analysis of the economy in the short run and
it includes three chapters. Chapter 2 covers all the material related to
the analysis of aggregate demand in a closed economy and in the short
run, by employing the IS–LM model. Chapters 3 and 4 study short-run
fluctuations in output and inflation within the conceptual framework
of the AD–AS model.
• Part 2 includes Chapters 5 and 6, and is focused on the analysis of the
economy in the long run. In these two chapters we cover the topic
of economic growth from the perspective of the neoclassical (Solow)
growth model, as well as discussing the empirical and theoretical
underpinnings of endogenous growth models.
• Part 3 extends in Chapters 7 and 8 the analysis of aggregate demand
to the open economy, from the perspective of the Mundell–Fleming
(IS–LM–BP) model.
• Part 4 surveys microfounded theories of consumption (Chapter 9),
investment (Chapter 10), money demand and money supply (Chapter
11), in order to provide a more realistic and consistent description of
the demand side of the economy, but also to derive policy prescriptions
alternative to those suggested by the Keynesian theory.
• Part 5 concludes by focusing on the design and the conduct of
monetary (Chapter 12) and fiscal policy (Chapter 13), in particular
discussing the main issues surrounding the effectiveness of
macroeconomic policy which is used to maintain economic stability.
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EC2065 Macroeconomics
How to use the subject guide
As you can see from the syllabus, macroeconomics is a very broad subject
and there is a lot of material to cover. This subject guide aims to give you a
structured and systematic approach with which to engage in – and enjoy –
the course.
The best way to use the subject guide is to go through each chapter in the
sequential order proposed. I strongly advise you to study each chapter of
the guide using the following strategy:
Read the introduction first: Each chapter begins with a short
introduction that clarifies the contents of the chapter: how these relate
to the rest of the material in the syllabus, some background thoughts and
warnings that you may want to bear in mind before doing your reading,
and an outline of where to find the relevant reading material. You are
advised to read carefully the introduction to each chapter and then carry
out the reading suggested in the Essential reading list before undertaking
any other activity.
Do the required reading from the textbook(s): The reading is
divided into Essential reading and Further reading. Essential reading
normally refers to one or more chapters of the main textbook that you
must read in order to cover the topics included in the relevant chapter
of the guide. You are strongly advised to carry out the Essential reading
before passing on to any other activity, such as Further reading or studying
other sections of the chapter. The Further reading list includes a number
of optional books and articles that will enhance your knowledge and
understanding of the topic, and help you to prepare for the examination
more thoroughly.
Go through the summary of the material in the guide: Once
you have done the Essential reading from the textbook, you are ready to
go through the summary of the material covered in the relevant chapter
of the guide. The aim of the chapter is to give you a quick summary of
the material, focusing on the description of the macroeconomic model(s)
relevant to the chapter. The strategy by which a model is presented
consists (almost) always of:
• clarifying the macroeconomic issue that the model wants to answer
• specifying and discussing all underlying assumptions
• writing the model analytically
• determining the solution of the model either analytically, graphically,
or both
• assessing the policy implications
• thinking critically about the plausibility and limits of the model’s
implications.
Take an active role: The main purpose of this subject guide is to
engage you in active learning as much as possible. To this end,
throughout the discussion, I include in each chapter a number of
‘activities’. The objective of each activity is to encourage you to take
an active role in developing your understanding of the material. The
activities will involve carrying out a numerical exercise, solving specific
macroeconomic problems, thinking about the likely consequences of
changing specific parameters and assumptions, and reflecting upon the
policy implications of a model.
4
Chapter 1: Introduction
I include detailed discussions of all the activities at the end of each
chapter, so you can get immediate feedback on your understanding of the
material directly from the guide. I strongly advise you to try the questions
in each activity on your own, before looking at the solutions. The activities
and their solutions cover important aspects of the topic of the chapter, and
you should not omit them.
Learning outcomes and sample questions: Each chapter ends with
a restatement of the main learning outcomes and a number of questions
selected from past examination papers. Make sure you carefully read the
list of learning outcomes and that you feel you have achieved them before
moving on to the next chapter. The sample examination questions give
you a chance to assess your command of the tools discussed in the chapter.
You should always carry out these activities to check and enhance your
understanding of the material.
►Optional material: In several places in this guide, sections are
presented as ‘Optional material’. This is more advanced material for those
of you who wish to explore ideas further. This will help you to think like
an economist and to do well in the examinations. However, for those
who are finding the material in this guide challenging enough there is no
requirement for you to read these sections.
Essential reading
You should use at least one of the following textbooks:
Blanchard, O. and D.R. Johnson Macroeconomics. (Upper Saddle River, NJ:
Prentice Hall, 2012) sixth edition [ISBN 9780273766339]
(www.prenhall.com/blanchard).
Dornbusch, R., S. Fischer and R. Startz Macroeconomics. (New York: McGrawHill, 2011) eleventh edition [ISBN 9780071289252].
Mankiw, N.G. Macroeconomics. (Worth, 2012) eighth edition
[ISBN 9781464121678].
These are all excellent and widely adopted textbooks. Most of the material
in Parts I, II, III, IV (Chapter 11) and V of the subject guide is covered in
Blanchard and Johnson and Dornbusch et al., and I would strongly advise
you to use both these textbooks to prepare for this course. Unfortunately,
neither of these textbooks covers adequately the material in Chapters 9
and 10 of Part IV. Mankiw gives a good verbal description of each model
discussed in these two chapters, but it lacks analytical details. Pentecost
(see the Further reading list in the next section) provides an extended
coverage and you may want to use this textbook to study this part of the
syllabus.
The choice of textbook ultimately depends on your own preference. If you
are already familiar (and happy) with one of these books you may want to
carry on working with it. The main advantage of using a different book is
that you will acquire a different perspective on the subject.
If you do not know any of the above textbooks, ideally you should have
a careful look at each of them before choosing one. My advice is to start
by checking out the home page of each textbook on the website of its
publishers.
Blanchard and Johnson can be accessed at www.pearsonhighered.com/
blanchard. If you click on ‘Instructor resources’, you will be able to access
the table of contents of the book and a description of its main features.
You can also click on the link to the companion website to get an idea of
the available online facilities.
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EC2065 Macroeconomics
Dornbusch et al. can be accessed at www.mhhe.com/dornbusch11e Once
you access the web page of the book, you can read two sample chapters and
the table of contents. You can also access the learning centre by clicking on
the link Student Edition. This includes online quizzes for each chapter
of the book. You can submit your answers and receive a quick evaluation.
I particularly like ‘Economagic’, an economic time series data site that you
can access in order to engage in the empirical questions at the end of each
chapter.
Mankiw can be accessed following the links for Economics and then
Intermediate Macroeconomics at www.worthpublishers.com. You
will get a preview of the book, a description of its main features and the
table of contents, and be able to look at specific parts of the book. You can
easily surf through the site to become aware of the resources available. In
particular, you will find tests for self-assessments, tutorials and a number
of macroeconomic data. I doubt you will be able to resist the temptation of
playing the ‘Presidential game’, which will seriously test your macroeconomic
skills.
I find all these textbooks clear and very easy to read, and your choice of
textbook should ultimately depend on your macroeconomics background. I
particularly like the fact that each of them constantly relates macroeconomic
theory and models to real facts and events. If you already have a good
background in economics, you might find both Blanchard and Johnson
and Dornbusch et al. more stimulating. In addition, they are slightly more
advanced and include more analytical details than Mankiw, and provide a
treatment of the material consistent with the level required by this course.
Mankiw keeps the analytical details of the models to a minimum,
but gives you a clearer idea of the distinction between Classical and
Keynesian theories. If you have used Mankiw’s Principles of Economics at
the introductory level, you might find it natural to choose his textbook at
the intermediate level. However, be aware that Mankiw on its own is not
sufficient preparation for some parts of the syllabus, and, in the guide, you
are advised to look for fuller and more comprehensive treatments of these
parts by referring to the other textbooks.
A key skill, which you must acquire by studying for this course, is the
ability to write down and describe macroeconomic models analytically.
Unfortunately, each textbook adopts a different notation when referring
to variables and parameters, so you need to be careful when reading from
different sources. However, this should not discourage you from reading
from more than one textbook, which is a very good way to gain a deeper
understanding of the material. In this respect, you need to be aware that
this guide tries to follow – as much as possible – the notation employed by
Blanchard and Johnson.
Each of the textbooks listed above also has a study guide with detailed
explanations and many questions (see below). I strongly suggest that you
systematically consult the students guide(s) accompanying the textbook(s)
you choose, as this will facilitate the reading and give you a structured view
of the material covered in the textbook.
Detailed reading references in this subject guide refer to the editions of the
set textbooks listed above. New editions of one or more of these textbooks
may have been published by the time you study this course. You can use a
more recent edition of any of the books; use the detailed chapter and section
headings and the index to identify relevant readings. Also check the virtual
learning environment (VLE) regularly for updated guidance on readings.
6
Chapter 1: Introduction
Further reading
Please note that as long as you read the Essential reading you are then free
to read around the subject area in any text, paper or online resource. You
will need to support your learning by reading as widely as possible and by
thinking about how these principles apply in the real world. To help you
read extensively, you have free access to the VLE and University of London
Online Library (see below).
Other useful texts for this course include:
Blanchard, O. and D. Findlay Study guide [to accompany] Macroeconomics.
(Upper Saddle River, NJ: Prentice Hall, 2008) fifth edition [ISBN
9780132078337]. Student guide and tutorial for use with Blanchard’s
Macroeconomics.
Dornbusch, R., S. Fisher and R.Startz Macroeconomics – study guide. (New
York: McGraw-Hill, 2011) eleventh edition available online at www.mhhe.
com/dornbusch11e Student guide for use with Dornbusch–Fischer–Startz
Macroeconomics.
Estrin, S. and A. Marin. Essential readings in economics. (Basingstoke:
Macmillan Press, 1995) first edition [ISBN 9780312125110].
Mankiw, N.G. Macroeconomics – study guide. (Worth, 2012) eighth edition
[ISBN 9781464104930]. Student guide and workbook for use with
Mankiw’s Macroeconomics.
Pentecost, E. Macroeconomics: an open economy approach. (Basingstoke:
Palgrave Macmillan, 2000) first edition [ISBN 9780312233686].
Journals and websites
Unless otherwise stated, all websites in this subject guide were accessed in
March 2014. We cannot guarantee, however, that they will stay current and
you may need to perform an internet search to find the relevant pages.
Your preparation would benefit, substantially, if you get into the habit of
browsing through daily newspapers and weekly magazines such as:
• Wall Street Journal (http://online.wsj.com)
• Financial Times (www.ft.com)
• The Economist (www.economist.com)
Stimulating online reading and material for macroeconomists can often be
found on the following web pages:
• World Bank (www.worldbank.org), where you can access a wide
range of free downloadable documents, including project documents,
advisory works, and evaluations, formal and informal research papers,
and most Bank publications.
• Organisation for Economic Co-operation and Development
(www.oecd.org), which gives you free access to country surveys,
statistics and a large number of publications which cover a wide
variety of macroeconomic topics, including analyses of the major
macroeconomic trends and policies around the world.
• International Monetary Fund (www.imf.org), for another chance
to read about macroeconomic facts and events around the world,
including country surveys and statistics.
• National Bureau of Economic Research (www.nber.org), for a
very useful source of economic articles and data.
• European Commission (http://ec.europa.eu), for in-depth
information about European countries.
7
EC2065 Macroeconomics
Another skill you should acquire, through taking this course, is the habit
of reading articles in economic journals. To this end, the reading list for
each chapter will include references to articles that you may want to read
in order to enhance your understanding of the topic. Reading economics
articles is not always an easy task, even for experienced economists. You
are not expected to understand fully all the minute technical details of
the articles, but gaining a general sense of the main points is likely to be
beneficial.
To help you read extensively, all International Programmes students have
free access to the University of London Online Library where you will find
the full text or an abstract of some of the journal articles listed in this
guide. For further details, see Online study resources below.
As a student of macroeconomics, you may find interesting and accessible
economic articles in:
• Journal of Economic Literature (JEL)
• Journal of Economic Perspectives (JEP).
I advise you to access the Online Library and have a look at the latest
issues of the JEL and JEP, and browse through articles with titles that, first
and foremost, capture your curiosity.
If, before you start preparing to work on this course, you want to do a
review of the key macroeconomic concepts and models, I would advise
you to thoroughly revise the macroeconomics part of the EC1002
Introduction to economics subject guide.
For ease of reference, the following is a full list of all further
reading in the guide:
Alesina, Alberto ‘The political economy of the budget surplus in the United
States’, Journal of Economic Perspectives 14(3) 2000, pp.3–19.
Ball, Laurence and N.G. Mankiw ‘The NAIRU in theory and practice’, Journal of
Economic Perspectives 16(4) 2002, pp.115–36.
Barro, Robert ‘Are government bonds net wealth?’, Journal of Political Economy
82(6) 1974, pp.1095–17.
Barsky, Robert, B., and L. Kilian ‘Oil and the macroeconomy since the 1970s’,
Journal of Economic Perspectives 18(4) 2004, pp.115–34.
Baumol, William J. ‘Productivity growth, convergence, and welfare: What the
long-run data show’, American Economic Review 76(5) 1986, pp.1072–85.
Baumol, William J. ‘The transactions demand for cash: an inventory theoretic
approach’, Quarterly Journal of Economics 66 1952, pp.545–56.
Bernanke, Ben S. and Frederic S. Mishkin ‘Inflation targeting: a new
framework for monetary policy?’, Journal of Economic Perspectives 11(2)
1997, pp.97–116.
Besley, Timothy, and R. Burgess ‘Halving global poverty’, Journal of Economic
Perspectives 17(3) 2003, pp.3–22.
Blanchard, O. ‘European unemployment: the evolution of facts and ideas’, NBER
working paper, No. 11750, 2005.
Bosworth, Barry, and S. M. Collins ‘Accounting for growth: comparing China
and India’, Journal of Economic Perspectives 22(1) 2008, pp.45–66.
Calvo, Guillermo A., and F.S. Mishkin. ‘The mirage of exchange rate regimes for
emerging market countries’, Journal of Economic Perspectives 17(4) 2003,
pp.99–118.
Chari, V.V. and Patrick J. Kehoe ‘Modern macroeconomics in practice: how
theory is shaping policy’, Journal of Economic Perspectives 20(4) 2006,
pp.3–28.
Crowe, Christopher and Ellen E. Meade ‘The evolution of central bank
governance around the world’, Journal of Economic Perspectives 21(4) 2007,
pp.69–90.
8
Chapter 1: Introduction
Davis, Steven J., R.J. Faberman and J. Haltiwanger ‘The flow approach to labor
markets: new data sources and micro-macro links’, Journal of Economic
Perspectives 20(3) 2006, pp.3–26.
Easterlin, Richard A. ‘The worldwide standard of living since 1800’, Journal of
Economic Perspectives 14(1) 2000, pp.7–26.
Fischer, Stanley, R. Sahay and C.A. Végh ‘Modern hyper- and high inflations’,
Journal of Economic Literature 40(3) 2002, pp.837–80.
Friedman, Milton A theory of the consumption function. (Princeton, NJ:
Princeton University Press, 1957).
Friedman, Milton ‘The role of monetary policy’, American Economic Review
58(1) 1968 pp.1–17. Also in Estrin, S. and A. Marin, Chapter 10.
Hall, Robert, E. and Dale W. Jorgenson ‘Tax policy and investment behaviour’,
American Economic Review 57(3)1967, pp.391–414.
Hall, Robert, E. ‘Stochastic implications of the life cycle-permanent income
hypothesis: theory and evidence’, Journal of Political Economy 86(6) 1978,
pp.971–87.
Hoshi, Takeo and A. K. Kashyap ‘Japan’s financial crisis and economic
Stagnation’, Journal of Economic Perspectives 18(1) 2004, pp.3–26.
Hutchison, Michael ‘Japan’s recession: Is the liquidity trap back?’ Federal Reserve
Bank of San Francisco. FRBSF Economic Letter/Pacific Basin Notes. 2000–19,
16 June 2000 (available at www.frbsf.org/econrsrch/wklyltr/2000/el200019.html).
Jones, Charles I. Introduction to economic growth. (Norton, 2002) second
edition [ISBN 9780393977455] Chapters 1, 2.1, 3 and 4.
Jones, Charles I. ‘On the evolution of the world income distribution’, Journal of
Economic Perspectives 11(3) 1997, pp.19–36.
Keynes, John, M. 1936 ‘The state of long term expectations’, Chapter 12 of The
general theory of employment, interest and money. Also in Estrin, S. and
A. Marin, Chapter 15.
Lucas, Robert ‘Understanding business cycles’, in K. Brunner and A. Meltzer
(eds) Stabilization of the domestic international economy, 5, pp.7–29. Also
in Estrin, S. and A. Marin Essential reading in economics. (Basingstoke:
Macmillan Press, 1995) first edition [ISBN 9780312125110] Chapter 16.
Ludvigson, Sydney C. ‘Consumer confidence and consumer spending’, Journal
of Economic Perspectives 18(2) 2004, pp.29–50.
Mann, Catherine L. ‘Perspectives on the US current account deficit and
sustainability’, Journal of Economic Perspectives 16(3) 2002, pp.131–52.
Modigliani, Franco ‘Life cycle, individual thrift, and the wealth of nations’,
American Economic Review 76(3)1986, pp.297–313.
Modigliani, Franco ‘The monetarist controversy, or, should we forsake
stabilisation policies?’, American Economic Review 67(2) 1977, pp.1–17.
Also in Estrin, S. and A. Marin, Chapter 20.
Pentecost, E. Macroeconomics: an open economy approach. (Basingstoke:
Palgrave Macmillan, 2000) Chapters 6, 7 and 11.
Romer, David ‘Keynesian macroeconomics without the LM curve’, Journal of
Economic Perspectives 14(2) 2000, pp.149–69.
Romer, Paul M. ‘The origins of endogenous growth’, Journal of Economic
Perspectives 8(1) 1994, pp.3–22.
Sargent, Thomas J. and N. Wallace ‘Rational expectations and the theory of
economic policy’, Journal of Monetary Economics 2(2) 1976, pp.169–83.
Also in Estrin, S. and A. Marin, Chapter 19.
Svensson, Lars E. O. ‘Escaping from a liquidity trap and deflation: The foolproof
way and others’, Journal of Economic Perspectives 17(4) 2003, pp.145–66.
Södersten, Bo. and G. Reed International economics. (Basingstoke: Macmillan,
1994) Chapters 28.3 and 29.6.
Taylor, John B. ‘Reassessing discretionary fiscal policy’, Journal of Economic
Perspectives 14(3) 2000, pp.21–36.
9
EC2065 Macroeconomics
Tobin, James. ‘Inflation and unemployment’, American Economic Review 62(1)
1972, pp.1–18. Also in Estrin, S. and A. Marin, Chapter 11.
Tobin, James ‘Liquidity preference as behavior towards risk’, Review of Economic
Studies 25 1958, pp.65–86.
Zarnowitz, Victor ‘Theory and history behind business cycles: Are the 1990s
the onset of a golden age?’ Journal of Economic Perspectives 13(2) 1999,
pp.69–90.
Online study resources
In addition to the subject guide and the Essential reading, it is crucial that
you take advantage of the study resources that are available online for this
course, including the VLE and the Online Library.
You can access the VLE, the Online Library and your University of London
email account via the Student Portal at:
http://my.londoninternational.ac.uk
You should have received your login details for the Student Portal with
your official offer, which was emailed to the address that you gave on
your application form. You have probably already logged in to the Student
Portal in order to register. As soon as you registered, you will automatically
have been granted access to the VLE, Online Library and your fully
functional University of London email account.
If you have forgotten these login details, please click on the ‘Forgotten
your password’ link on the login page.
The VLE
The VLE, which complements this subject guide, has been designed to
enhance your learning experience, providing additional support and a
sense of community. It forms an important part of your study experience
with the University of London and you should access it regularly.
The VLE provides a range of resources for EMFSS courses:
• Self-testing activities: Doing these allows you to test your own
understanding of subject material.
• Electronic study materials: The printed materials that you receive from
the University of London are available to download, including updated
reading lists and references.
• Past examination papers and Examiners’ commentaries: These provide
advice on how each examination question might best be answered.
• A student discussion forum: This is an open space for you to discuss
interests and experiences, seek support from your peers, work
collaboratively to solve problems and discuss subject material.
• Videos: There are recorded academic introductions to the subject,
interviews and debates and, for some courses, audio-visual tutorials
and conclusions.
• Recorded lectures: For some courses, where appropriate, the sessions
from previous years’ Study Weekends have been recorded and made
available.
• Study skills: Expert advice on preparing for examinations and
developing your digital literacy skills.
• Feedback forms.
Some of these resources are available for certain courses only, but we
are expanding our provision all the time and you should check the VLE
regularly for updates.
10
Chapter 1: Introduction
Making use of the Online Library
The Online Library contains a huge array of journal articles and other
resources to help you read widely and extensively.
To access the majority of resources via the Online Library you will either
need to use your University of London Student Portal login details, or you
will be required to register and use an Athens login:
http://tinyurl.com/ollathens
The easiest way to locate relevant content and journal articles in the
Online Library is to use the Summon search engine.
If you are having trouble finding an article listed in a reading list, try
removing any punctuation from the title, such as single quotation marks,
question marks and colons.
For further advice, please see the online help pages:
www.external.shl.lon.ac.uk/summon/about.php
Examination advice
Important: the information and advice given in the following section
is based on the examination structure used at the time this guide
was written. Please note that subject guides may be used for several
years. Because of this we strongly advise you to check both the current
Regulations for relevant information about the examination, and the VLE
where you should be advised of any forthcoming changes. You should also
carefully check the rubric/instructions on the paper you actually sit and
follow those instructions.
The examination paper is designed to test both your understanding of the
topics in the syllabus and your ability to apply the relevant theories, or
models, to address actual macroeconomic issues. To get a feeling of the
content of the examination paper, you can access and look at examination
papers and Examiners’ commentaries for the last three years on the VLE.
The paper includes two sections, with individual questions having the
same format within each section.
In Section A (40 per cent of the total marks), you must answer eight out
of the 10 short questions. Usually, these are with a ‘True/False? Explain’
format. In this section you are expected not only to provide an answer, but
also to briefly justify it on the basis of the relevant theory. In answering
short questions, you are not expected to derive, analytically, the relevant
models in explaining your answers; a verbal or graphic (non-analytical)
approach is sufficient. An important point to remember is that, on average,
no more than eight minutes should be spent on any individual short
question: a good allocation of time among individual questions is always
one of the key factors for a successful exam response.
In Section B (carrying 60 per cent of the total marks), you have a choice of
three out of six long questions. Each long question is usually divided into
three parts, generally reflecting the following structure:
• Part (a) is quite general, requiring an illustration of the relevant theory
or model
• Part (b) is a straightforward application of the relevant theory or
model
• Part (c) is a more specific application or extension of the theory or
model.
11
EC2065 Macroeconomics
You should note that, in Section B, you are expected to be as precise as
possible in your answers and to derive, formally, the relevant models,
besides using a graphic and verbal approach. However, you are advised
not to spend more than 35 minutes on any individual long question.
When you prepare for the examination you should try not only to gain
knowledge of the topics in the syllabus, but also to acquire an ability
to apply the relevant ideas to address specific questions. You should be
careful to avoid mechanically reproducing algebra without providing
the economic intuition of the models and their implications. It is also
important to avoid leaving any individual questions unanswered.
Bear in mind that examination questions often refer to topics covered in
more than one chapter of the subject guide. As a result, it is essential that
you develop a good understanding of the connections between different
topics and, in particular, how to employ different tools and theories to
answer questions about specific macroeconomic issues. I will help you in
successfully developing this skill, as I have included in the subject guide
many activities in which you are asked to think and comment about the
alternative views of macroeconomic theories, and their related policy
prescriptions.
Remember, it is important to check the VLE for:
• up-to-date information on examination and assessment arrangements
for this course
• where available, past examination papers and Examiners’ commentaries
for the course which give advice on how each question might best be
answered.
12
Chapter 2: The IS–LM model
Chapter 2: The IS–LM model
Aims of the chapter
The focus of the chapter is on the IS–LM model, set out by Hicks (1937)
in response to Keynes’ The general theory of employment, interest and
money (1936) for analysing the aggregate demand and macroeconomic
stabilisation policy in a closed economy and with fixed prices. The IS–
LM model integrates the goods and the money markets and considers
under what conditions output and the interest rate are simultaneously in
equilibrium; what factors may determine short-run fluctuations; and how
macroeconomic policy can be employed to stabilise the economy in the
short run.
Learning outcomes
By the end of this chapter, and having completed the Essential reading and
activities, you should be able to:
• list and discuss the key equations of the IS–LM model
• describe the determinants of the intercept and the slope of both the IS
and the LM curves
• calculate the equilibrium level of output and the interest rate in a
closed economy with fixed wages and prices
• evaluate how any change in the variables and the parameters of the
IS–LM model alters the equilibrium levels of output and the interest
rate
• show how fiscal and monetary policies contribute to the determination
of output and the interest rate in the short run, and their use as tools
for macroeconomic stabilisation
• illustrate and exlain the Keynesian view of short-run fluctuations in
economic activity.
Essential reading
Blanchard, O. and D.R. Johnson Macroeconomics. (Upper Saddle River, NJ:
Prentice Hall, 2012) Chapters 3–5.
Dornbusch, R., S. Fischer and R. Startz Macroeconomics. (New York: McGrawHill, 2011) Chapters 9–11, Chapter 19 (pp.466–77).
Mankiw, N.G. Macroeconomics. (Worth, 2012) Chapters 11–12.
Further reading
Hoshi, Takeo and A. K. Kashyap ‘Japan’s financial crisis and economic
Stagnation’, Journal of Economic Perspectives 18(1) 2004, pp.3–26.
Ludvigson, Sydney C. ‘Consumer confidence and consumer spending’, Journal
of Economic Perspectives 18(2) 2004, pp.29–50.
Romer, David ‘Keynesian macroeconomics without the LM curve’, Journal of
Economic Perspectives 14(2) 2000, pp.149–69.
Works cited
Hicks, J.R. ‘Mr Keynes and the classics: a suggested interpretation’,
Econometrica 5(2) 1937, pp.147–59.
13
EC2065 Macroeconomics
Keynes, John M. The general theory of employment, interest and money.
(London, 1936) Chapter 12 ‘The state of long term expectations’.
Introduction
If you are using Blanchard and Johnson you should read Chapters 3–5 and
make sure you have a clear understanding of how to apply the IS–LM model
to the US recession in 2001 (Chapter 5). If you are using Dornbusch et
al. you should read Chapters 9–11, including the application of the IS–LM
model to the US recessions from the early 1980s to the recent crisis, and
the German economy after unification (Chapter 11). You should also make
sure that you understand the discussion in this chapter of the liquidity
trap in the context of the recent crisis. You may additionally find it useful
to read Sections 19.1 through 19.3 on the application of the IS–LM model
to the recent ‘Great Recession’ and to the Great Depression. If you are
using Mankiw, you should read Chapters 11 and 12; make sure that you
understand the application of the IS–LM model to the Great Depression and
to the financial crisis and economic downturn of 2008–09.
At this initial stage of the course you may find it very useful to revise
some basic national income accounting, as well as the definitions of key
macroeconomic variables such as GDP, inflation and unemployment.
Essentially, these topics are covered in Chapter 2 and Appendix 1 at
the end of the textbook in Blanchard and Johnson; Chapters 1 and 2 in
Dornbusch et al.; and Chapter 2 in Mankiw. You have already encountered
the IS–LM model in the EC1002 Introduction to economics subject
guide. As a result, you may benefit from revising the chapters on the goods
market, the money market, and general equilibrium in that subject guide
before studying the material of this chapter.
The IS–LM model combines the goods market, which determines the
equilibrium level of output, with the money market, which determines
the equilibrium level of real money, in order to determine under what
conditions they are simultaneously in equilibrium, and to assess the role
that fiscal and monetary policies may have in explaining real output
fluctuations.
The model focuses on the assessment of aggregate demand in the short
run, and in a closed economy. The short run is defined as the period
of time during which the price level is fixed (there is no inflation), in
the sense that it does not change in response to variations in other
macroeconomic variables. Recall that the price level can be thought of as
sluggish or sticky variable, since it does not respond immediately to
a macroeconomic disturbance. Instead the adjustment builds up gradually,
and it is fully completed after several years. In this respect, the long run
is a period of time long enough for prices to be considered fully flexible,
whereas the medium run is the period of time over which the price level
completes its adjustment to macroeconomic disturbances. The closed
economy assumption means that the model is studied without taking
into account the effect of foreign trade on domestic aggregate demand.
Therefore, the IS–LM model is useful in analysing the effects of
stabilisation policy on real output and the real interest rate, but it cannot
be employed to assess issues related to inflation, long-run unemployment,
and the exchange rate.
Because great attention is given to fiscal policy, it is important that you
have a clear understanding of some basic assumptions about the role
of the government in the economy, the links existing among different
fiscal variables, and the standard fiscal policy jargon. Here is a quick
14
Chapter 2: The IS–LM model
summary. The government provides public goods and services (e.g. health,
education, roads, defence) that the private sector would either underproduce or not produce at all. The government also redistributes resources
among households and firms. These activities can be financed either by
levying taxes on households and firms, or by issuing debt, or by issuing
money. The relationship between public spending, taxes, debt and money
is summarised by the government budget constraint (GBC), an
accounting identity that for every generic period t can be written as:
Gt + itBt–1 – Tt = ∆Bt + ∆Mt
where Gt is government spending in goods and services during year t; Bt–1
is government debt at the end of year t–1 or, equivalently, at the beginning
of year t; it Bt–1 measures the interest payments on government debt made
by the end of period t at the interest rate it;1 Tt computes tax revenue
net of transfers to households and firms during year t; the term ∆Bt =
Bt – Bt–1 is the change in debt during year t; and the term ∆Mt = Mt – Mt–1
is the change in money supply during year t. In the rest of this chapter
we will assume that the government cannot create money to finance
public spending, hence we will set ∆Mt= 0. We will return to the role
and implications of money financing in Chapters 12 and 13 of the subject
guide. The difference between government spending and tax revenue,
Gt–Tt, is referred to as the primary budget deficit. The term Gt + itBt–1 – Tt is
instead called the total budget deficit, as it includes interest spending. The
standard interpretation of the GBC is that any difference between total
spending and tax revenue must be balanced with a corresponding change
in the stock of debt. The government runs a balanced primary budget
when public spending is entirely financed through taxes, that is Gt = Tt.
We say that a balanced budget expansion or contraction of the fiscal sector
occurs when taxes and government spending either increase or decrease
by the same amount.
The term it Bt–1 implies that
the government issues bonds
at the beginning of each year
and makes interest payments on
that debt at the end of the year.
For this reason, at the end of
any period t interest spending
is given by the product of the
outstanding stock of debt at
the beginning of that period,
Bt–1 , and the interest rate that
applies in period t, it.
1
The IS–LM model: key assumptions
As stated in the introduction, the IS–LM model determines under what
conditions output and the interest rate are simultaneously in equilibrium
in the short run.
Output is determined in the goods market, which refers to the trade
market of all goods and services produced in an economy. The Keynesian
cross model, which you have already encountered in course EC1002
Introduction to economics, describes the goods market equilibrium
under the following assumptions:
• All firms produce the same goods, which are then used by consumers
for consumption and residential investment, by firms for fixed assets
investment, or by the government.
• Firms are willing to supply any amount of goods at the existing price
level.
• The economy is closed.
The second assumption is important because it implies that in the IS–LM
model aggregate supply has no effect on the equilibrium level of income,
which is determined by aggregate demand.2 This assumption will be
relaxed in Chapters 3 and 4 of the subject guide when we will study the
AD–AS model. The closed economy assumption will instead be relaxed in
Chapters 7 and 8, which focus on open economies.
The interest rate is determined in the money market. The Keynesian
Liquidity Preference theory, which you have already encountered in
According to the Keynesian
theory, in the short run firms
can change production at the
existing price level because
the marginal product of labour
is constant as a result of
spare capacity in the labour
market. This means that firms
can hire new workers at the
existing wage, which leaves
average costs (and thus prices)
unaffected.
2
15
EC2065 Macroeconomics
EC1002 Introduction to economics, describes money market
equilibrium under the following assumptions:
• The financial market includes only two assets: money and bonds.
• Money is a liquid asset, in the sense that it can be used to purchase
goods and services, and pays no interest.3
• Bonds are issued by the government, cannot be used for transactions,
but pay a positive nominal interest rate i.
3
At this stage of the course, you
can think of money as currency,
which consists of all coins and
notes in circulation in a country.
• Real wealth is fixed in the short run.
Bonds are defined as assets that pay a fixed amount of money (face
value) at a specific period of time (maturity).4 Individuals buy bonds at
a price lower than the face value. The difference between the price and
the face value of a bond is the gain for the bond holder. Since the face
value is fixed, the lower the price of a bond the higher is the gain for the
holder. The rate of return from investment in bonds, the nominal interest
rate, is calculated by dividing the gain from bonds by the current price.
Analytically, the relationship between the interest rate and the price of a
bond is written as:
i=
PB − PB
PB
=
PB
PB
More precisely, bonds that
pay only a specific amount of
money at maturity are called
zero-coupon, or discount bonds.
In contrast, bonds that also
pay specific amounts of money
(coupons) at regular intervals
of time before maturity, are
defined as coupon bonds.
4
− 1,
where PB indicates the face value of the bond and PB is the current price of
bonds. Thus, the interest rate and the price of bonds are, by construction,
inversely related: an increase in the price of bond, PB, is equivalent to a
reduction in the interest rate.
It is important that you clearly understand the difference between income
and wealth. Individuals earn income essentially from three sources:
labour, in the form of wages, real assets, in the form of rent, and financial
assets, in the form of interest and dividends. Income can either be spent to
purchase goods and services or saved to buy new assets. Wealth is defined
as the net value of all assets held by an individual, including their human
capital.5 If the level of consumption of an individual exceeds their income,
then this individual is defined as a net borrower.
Finally, it is important that you note the equilibrium conditions in the
financial market. These state that the demand for money, Md, must be
equal to the supply of money, Ms:
Md = Ms
and that the demand for bonds, Bd, must be equal to the supply of bonds, Bs:
Bd = Bs
In general, we know from Walras’ law that if there are n markets and
the first n–1 of these are in equilibrium, then the nth market must be in
equilibrium too. This means that we can choose to ignore one market in the
model, knowing that equilibrium there will be assured whenever it holds
generally elsewhere. For this reason, we ignore the bond market in what
follows, and make use only of the money market equilibrium condition.
The IS–LM model: behavioural equations and identities
The IS–LM model is based upon six behavioural equations, each describing
the determinants of one of the macroeconomic variables considered by
the model: consumption, investment, tax revenue, government spending,
money demand and money supply. I will here give a short description of
each equation, under the assumption that variables are linearly related.
16
We will return on the
distinction between income
and wealth in Chapter 9 of the
subject guide.
5
Chapter 2: The IS–LM model
Consumption, C, is defined as the value of goods and services purchased
by households. The linear consumption function, which depends positively
on income, Y, and negatively on taxes, T, can be written as:
C = c0 + c1 (Y–T) c0 ≥ 0, 0< c1<1
(2.1)
where the term Y–T indicates disposable income. The parameter c0
measures the level of consumption affected by factors other than
disposable income, such as borrowing, sale of real and financial assets,
etc. The value of c0 depends also upon consumers’ spending habits and
consumer confidence about current and future spending opportunities.
The parameter c1 is the marginal propensity to consume, namely
the increase in consumption resulting from one unit increase in disposable
income. Since 0 < c1<1, an increase in disposable income cannot be either
entirely saved, c1= 0, or entirely consumed, c1= 1. In turn, the value 1– c1
measures the marginal propensity to save, namely the increase in
saving resulting from an extra unit of disposable income.
Investment spending includes three broad categories: fixed business
investment carried out by firms, (i.e. purchases of newly produced real
assets, such as plant and machinery), residential investment carried out by
households (i.e. purchases of newly produced real estate properties such
as houses), and inventory investment (i.e. unsold goods and services and/
or unused materials).
Demand for investment depends positively on income (sales) and
negatively on the real interest rate, r, and it can be written as:
I = I + b1 Y – b2r,
b1 ≥ 0, b2 ≥ 0
(2.2)
where Ī is a constant that computes the effect on investment of any
variable other than income and the interest rate, whereas b1 and b2
measure the sensitivity of investment to income and the interest rate,
respectively.
Note that in economics, the symbol i normally indicates the nominal
interest rate, whereas the symbol r is used to indicate the real interest rate.
Nominal and real interest rates are linked by the Fisher equation:
i = r + �,
which shows that the nominal interest rate is equal to the sum of the
real interest rate and the rate of inflation, �.6 Since the Keynesian theory
assumes prices to be constant in the short run, the rate of inflation is equal
to zero, which implies that the real and the nominal interest rates are equal
in the short run, i = r. For this reason we can replace r with i in the demand
for investment equation when solving the model. Beware, Blanchard and
Johnson and Dornbusch et al. use the symbol i to indicate the real interest
rate in the IS–LM model, whereas Mankiw uses the symbol r.
Tax revenue depends upon the structure of the tax system. In general,
taxes can be levied either at fixed amounts (lump-sum taxes), or at specific
rates on income and consumption (proportional income and consumption
taxes). Consequently, the linear tax function can be written as:
(2.3)
T = T + τ 1Y + τ 2 C, τ 1 ≥ 0, τ 2 ≥ 0
This is an approximate
version of the equation only.
A more detailed discussion on
the Fisher equation and, more
generally, on the relationship
between inflation, nominal
and real interest rates will be
provided in Chapter 10 of the
subject guide.
6
where T indicates tax revenue raised through lump-sum taxes, and τ1 and
τ2 measure the average tax rates on income and consumption, respectively.
Government spending refers to the demand for goods and services of
the public sector and it can be generally described by the equation:
(2.4)
G = G + g1Y + g2 C ,
17
EC2065 Macroeconomics
where G represents the fixed component of government spending, while
g1and g2 measure changes in public spending proportional to variations in
income and consumption, respectively.
The demand for money, Md, is positively related to income and
negatively related to the nominal interest rate. The higher the level
of transactions, the more money is demanded for consumption and
investment by individuals, firms and the government. The interest rate
can be regarded as the opportunity cost of holding money. The higher the
interest rate, the higher is the cost of holding money rather than bonds,
and thus the lower is money demand. Analytically, real money demand is
described as:
d
M
= h 0 + h1Y − h 2 i,
P
h1 ≥ 0, h2 ≥ 0
(2.5)
where P indicates the price level, which is constant in the IS–LM model,
h0 measures the level of demand for money independent of income and
the interest rate, and the parameters h1 and h2 measure the sensitivity of
money demand to income and the interest rate respectively.
Note that equation (2.5) shows that demand for money is ultimately a
demand for real balances, Md P , rather than nominal balances, Md. The
underlying assumption behind this specification is that individuals are free
from money illusion, namely the tendency of individuals to think of
currency in nominal terms rather than taking into account its purchasing
power.
The supply of money, Ms, is assumed to be independent from the
interest rate and directly controlled by the central bank. The central
bank can change money supply through open market operations. An
expansionary open market operation occurs when the central
bank buys bonds to increase the money supply. When the central bank
buys bonds from the private sector, the excess demand for bonds raises
the price of bonds, in turn reducing the interest rate. This reduction in
the opportunity cost of holding money simutaneously increases money
demand. In contrast, a contractionary open market operation
occurs when the central bank sells bonds. As a result of excess supply the
bond price falls, the interest rate increases, and money demand decreases.
Analytically, real money supply, Ms P is written as:
Ms
M
= P ,
P
(2.6)
where M is the level of nominal money supply chosen by the central bank.
The description of the IS–LM model is completed by three key identities
that define the links between aggregate demand and the equilibrium level
of income.
Aggregate demand (Z) is equal to the sum of consumption, investment
and government spending:
(2.7)
Z = C + I + G.
Since aggregate income must always equal aggregate expenditure in a
closed economy, we have:
(2.8)
Y = Z.
Combination of (2.7) and (2.8) gives the fundamental income identity
for a closed economy:
(2.9)
Y = C + I + G,
which states that in equilibrium aggregate income must be equal to the
sum of the components of aggregate demand.
18
Chapter 2: The IS–LM model
Income accounting in a closed economy
The equilibrium output in the goods market can be alternatively retrieved
from the equality between saving and investment in the loanable funds
market.7 Consider again the income identity in equation (2.9):
Y = C + I + G.
Next, move C and G to the left-hand side of the equation and add and
subtract T to obtain:
(Y – T – C) + (T – G) = I.
The term on the left hand side is the total saving of the economy. In
particular, S = Y – T – C indicates private saving, measured by the
excess of income over taxes and consumption, whereas T – G is public
saving, measured by the primary budget surplus.8
Therefore, the equilibrium output in the goods market can be alternatively
determined by the condition ‘saving equals investment’:
(2.10)
S + T – G = I.
At this stage, make sure you are familiar with the concept, already
encountered in EC1002 Introduction to economics, of the ‘paradox
of thrift’ (or ‘paradox of saving’) which states that an exogenous increase
in saving, equivalent to lower consumption at any given income level,
leads to a lower equilibrium level of output and unchanged aggregate
saving so long as the interest rate stays constant.
This is consistent with the
original description of the goods
market provided by Keynes in
the General Theory, which you
have already encountered in
02 Introduction to economics.
Mankiw uses the Loanable
Funds market approach as well
to derive the IS curve.
7
Be careful with the notation,
if you are using Mankiw, as he
uses the symbol S to indicate
national saving (the sum of
private and public saving),
rather than private saving alone
as in Blanchard and Johnson
and Dornbusch et al.
8
Equation (2.10) gives an alternative way of writing the income identity
in a closed economy, by relating private saving to the budget deficit and
investment. The identity states that, in a closed economy, investment can
be financed by a combination of private and public saving. In addition,
changes in any of these three variables must necessarily affect at least one
of the other two. However, the identity is silent about the determinants of
changes in saving and investment, as well as the extent of their effect on
other macroeconomic variables.
Activity 2.1
In May 2008 The Economist Intelligence Unit predicted that in Singapore the budget
deficit would increase by 1 per cent of GDP (Source: Economic and financial indicators,
The Economist, 31st May, 2008). What can you infer from this prediction about private
saving and investment in Singapore?
The IS curve
The IS curve represents combinations of income and the interest rate,
such that the goods market is in equilibrium.
Analytically the IS curve is computed by replacing in the income identity
(2.9) the behavioural equations for consumption, investment, tax revenue
and government spending. The resulting equation has to be solved for the
interest rate as a function of income, as the IS curve is always plotted in
the income–interest rate space.
Before deriving the IS curve, I will simplify equations (2.3) and (2.4) by
assuming that government spending is exogenous (g1 = g2 = 0) whereas
taxes do not depend on consumption (τ2= 0). We then have:
i =
*
1
1 − c1 (1 − τ 1 ) − b1 *
(c − c1 T + I + G ) −
Y
b2
b2 0
(2.11)
19
EC2065 Macroeconomics
In the above expression the symbols i* and Y* denote equilibrium values.
Note we have used the assumption of fixed prices to replace the real
interest rate r with the nominal rate i. The slope of the IS curve in absolute
terms is negatively related to the marginal propensity to consume, c1, the
responsiveness of investment to output, b1, and the interest rate, b2; it is
positively related to the tax rate, τ1.
The larger the marginal propensity to consume, the flatter the IS curve,
since a given increase in investment caused by a reduction in the interest
rate, will then deliver a larger increase in income via the multiplier.
Similarly, the more interest-sensitive investment spending is, the flatter is
the IS curve, since a given reduction in the interest rate causes a relatively
large increase in investment spending, which results in a larger increase
in equilibrium income. An increase in b1 makes the IS curve flatter, since
investment spending responds more to income for any given interest rate,
and this amplifies the multiplier effect. Conversely, tax rate increases
make the IS curve steeper as they dampen the multiplier effect of higher
aggregate income on consumer expenditure.
The intercept of the IS curve depends upon the level of autonomous
spending, c0 − c1 T + I + G . An increase (reduction) of autonomous
spending shifts the IS curve upward (downward). Note also that the
position of the IS curve is affected by the responsiveness of investment to
the interest rate: the larger b2 the smaller the intercept of the IS curve.
If the central bank controls the interest rate, the equilibrium level of
income moves along the IS curve. An increase (decrease) in government
spending raises aggregate demand, thus shifting upwards (downwards)
the IS curve. The effect of changes in taxation depends upon the structure
of the tax system. If taxes are levied as lump-sums, then tax changes
can only change the position of the IS curve, without altering its slope.
However, if taxes are levied as a proportion of consumers’ income, any tax
policy change has an effect on the slope of the IS curve.
Activity 2.2
Consider an economy described by the following equations:
Aggregate consumption: C = 400 + 0.2(Y – T)
Aggregate investment: I = 120 – 10i
Government sector:
G = T = 100
a. Calculate the equilibrium level of income at any given level of interest rate.
b. What is the effect of an increase in the interest rate on the equilibrium level of
income?
c. Suppose the government increases lump-sum taxes T to 200. How does this affect
the equilibrium level of income?
d. Suppose instead that the government raises all its revenue by levying a proportional
tax on consumers’ income at the rate τ = 0.3, setting lump-sum taxes to zero. Discuss
what would be the effect in this case of an increase in the tax rate from 0.3 to 0.4 on
the equilibrium.
20
Chapter 2: The IS–LM model
Activity 2.3
In January 2008, fear of an imminent economic recession convinced the US central bank
(Federal Reserve) to cut the interest rate twice: initially by 0.75 of a percentage point and
subsequently by 0.5 of a percentage point.
a. Employ the IS curve in equation (2.11) to predict the likely effect of this policy on
the equilibrium level of income under the two following assumptions: (i) investment
spending is insensitive to changes in the interest rate and (ii) investment spending is
very sensitive to changes in the interest rate.
b. Can you think of any reason why investment spending could be relatively insensitive
to the interest rate?
The LM curve
The LM curve comprises combinations of the interest rate and income, for
which the money market is in equilibrium.
Analytically, the LM curve is computed combining the equations for
money demand (2.5) and supply (2.6). The resulting equation has to be
solved for the interest rate as a function of income, since the LM curve is
always plotted in the income-interest rate space. This yields the following
equation:
i
*
=
M  h1 *

 h0 −
+ Y.
h2 
P  h2
1
(2.12)
The slope of the LM curve depends on the sensitivity of money demand
to income and the interest rate, as measured by the coefficient h1/h2.
The more money demand is sensitive to income, relative to the interest
rate, the steeper the LM curve. If money demand does not respond to
the interest rate, h2=0, the LM curve is vertical. A vertical LM curve is
often referred to as the classical case. In contrast, if money demand is
very sensitive to the interest rate, h 2 = ∞, the LM curve is horizontal. In
this case it is not possible for the central bank to change the equilibrium
interest rate through variations in the money supply. The case of a
horizontal LM curve is often referred to as a liquidity trap.
Monetary policy affects the position of the LM curve. An expansionary
monetary policy shifts the LM curve downwards, since it increases the
liquidity in the money market and reduces the interest rate for any given
level of income. In contrast, a contractionary monetary policy shifts the
LM curve upwards, as it reduces the liquidity in the money market and
increases the interest rate at any given level of income.
It may be useful to recall that, at this stage of the subject, the conduct of
monetary policy is based upon the following simplifying assumptions:
1. The central bank has direct control over money supply through open
market operations.
2. The government issues bonds on behalf of the central bank; the central
bank does not directly issue bonds, but can only create money to buy
bonds issued by the government.
3. Individuals are always willing to trade bonds at some price (i.e. bond
demand from the private sector is unlimited).
To understand the link between monetary policy and money supply, you
may find it convenient to consider the simplified central bank balance
sheet in Table 2.1. The central bank’s assets are represented by bonds,
while the central bank’s liabilities are represented by the currency (money)
21
EC2065 Macroeconomics
held by the public. To increase the money supply, the central bank has to
purchase new bonds. This increases both assets (through the additional
bonds) and liabilities (through the new currency created and exchanged
for bonds). To reduce the money supply, the central bank sells bonds
for existing currency. This operation reduces assets (through the sale
of bonds) and liabilities (through the reduction of currency held by the
general public).
Central Bank
Assets
Liabilities
Bonds
Money
Table 2.1: Central bank balance sheet in a closed economy.
A more accurate description of the central bank’s balance sheet and the
mechanism of money creation will be provided in Chapter 11 of the
subject guide.
Activity 2.4
Consider the LM curve for an economy that is either in the liquidity trap or in a classical
case situation. In both cases:
a. Calculate the equilibrium interest rate if this is possible. If not, explain why not.
b. Describe the position of the LM curve in income – interest rate space.
c. Discuss the effect of a monetary expansion on the LM curve.
Equilibrium in the IS–LM model
The IS–LM model determines combinations of the interest rate and income
that simultaneously satisfy the equilibrium condition in the goods market
and in the money market. Analytically, the equilibrium level of output and
the interest rate are computed by combining the IS equation in (2.11)
with the LM equation in (2.12). For instance, if we replace the interest
rate in the IS equation with the right-hand side of the LM equation, the
equilibrium level of income is calculated as:
*
Y =
1

1 
M  
h2 b2
 b (c 0 − c 1 T + I + G ) − h  h0 − P   h b + h [1 − c (1 − τ ) − b ]  .
  1 2
2 
2
1
1
1 
 2
Note that the policy variables G and M both increase the equilibrium
level of income. Tax policy affects Y* negatively through the term c1 T
and the term c1 τ1. Therefore, expansionary fiscal and monetary policies
increase the equilibrium level of income. Conversely, fiscal and monetary
contractions reduce the equilibrium level of income.
Alternatively, you can compute the equilibrium level of the interest rate by
replacing the income level in the IS equation with the level of income from
the LM equation. This yields the following expression for the equilibrium
interest rate:
*

1 − c 1 (1 − τ 1 ) − b1

h1
i = (c 0 − c 1 T + I + G ) +
M 
h1

,
 h0 −

P  b 2 h1 + h 2 [1 − c 1 (1 − τ 1 ) − b1 ]

which shows that fiscal expansions and monetary contractions increase the
interest rate, whereas fiscal contractions and monetary expansions reduce
the interest rate.
Table 2.2 summaries the effects of monetary and fiscal policy on
equilibrium output and the interest rate.
22
Chapter 2: The IS–LM model
Fiscal policy
Monetary policy
Expansionary
Contractionary
Expansionary
Contractionary
Output
+
-
+
-
Interest rate
+
-
-
+
Table 2.2: Monetary and fiscal policy in the IS–LM model.
The table shows that the effect of fiscal policy, on output and the interest
rate, is symmetric in the sense that an expansionary fiscal policy increases
both output and the interest rate, while a contractionary fiscal policy
reduces both variables. In contrast, monetary policy has an asymmetric
effect on output and the interest rate: an expansionary monetary policy
increases output while reducing the interest rate, whereas a contractionary
monetary policy reduces output while increasing the interest rate.
Activity 2.5
Consider an economy in which the price level is equal to one and the goods and money
markets are described by the following equations:
Aggregate consumption: C = 400 + 0.2(Y – T)
Aggregate investment: I = 80 + 0.5Y – 10i
Government sector: G = T = 100
Money demand: Md = 100 + Y – 50i
Money supply: Ms = 100
a. Calculate the equilibrium level of income and interest rate, and describe your solution with a graph.
b. Compute the equilibrium level of consumption and investment.
c. Suppose government spending increases to 200. Compute the fiscal policy
multiplier (hint: this is the increase in Y divided by the increase in G).
Fiscal and monetary policy in the IS–LM model
Figure 2.1 provides a graphical illustration of the effect of fiscal and
monetary policy in the IS–LM model. In each panel, the initial equilibrium
is the point E1, which corresponds to the level of income Y1 and interest
rate i1. Panel A shows that a fiscal expansion affects both the goods and
the money market. In the goods market, the increase in aggregate demand
resulting from the fiscal expansion raises the equilibrium level of income.
Since the money supply is fixed, the increase in income increases money
demand, which can only be accommodated by an increase in the interest
rate. In turn, the increase in the interest rate causes a fall in investment
spending (crowding out effect), which partially offsets the initial
increase in income. The final equilibrium position is indicated in the
graph by point E2, but, in general, depends upon the slope of the LM curve
relative to the IS curve.
Conversely, Panel B shows that a fiscal contraction reduces the equilibrium
levels of income and interest rate. Note that the fiscal contraction reduces
aggregate demand and income in the goods market. The fall in income
causes a contraction in money demand, and money market equilibrium is
restored only by a fall in the interest rate. In turn, the fall in the interest
rate stimulates investment spending and contributes to partially offsetting
the initial reduction in income.
23
EC2065 Macroeconomics
Panel C shows that a monetary expansion shifts the LM curve
downwards. At the initial level of income, the interest rate drops
from i1 to i3, since the expansionary monetary policy operation raises
the price of bonds and reduces the interest rate. The fall in the interest
rate stimulates investment spending and increases output. Ultimately, the
equilibrium converges to point E2. In general, the flatter the IS curve, the
greater the monetary policy stimulus on output. Panel D shows how the
IS–LM equilibrium adjusts as a result of a monetary contraction.
B: Fiscal contraction
LM
E2
i2
E1
i1,3
i1,3
E3
E1
E3
E2
IS2
Y2
Y3
IS2
C: Monetary expansion
LM1
i3
E1
i1
LM2
i2
i2
Y1
Y2
Y3
Income
IS1
Income
D: Monetary contraction
Int.rate
Y1
0
Int.rate
LM
i2
IS1
i3
Int.rate
Int.rate
A: Fiscal expansion
LM2
E3
LM1
E2
i1
E1
E2
E3
IS
Y1,3
Y2
Income
IS
Y2
Y1,3
Income
Figure 2.1: IS–LM model: fiscal and monetary policy.
The effectiveness of monetary and fiscal policy – on the interest rate,
income, and unemployment – crucially depends on the relative slopes
of the IS and the LM curves. Broadly speaking, the flatter (steeper) the
IS curve is, the more (less) effective is monetary policy on output and
unemployment, relative to the interest rate. On the other hand, the flatter
(steeper) the LM curve is, the more (less) effective is fiscal policy on
output and unemployment relative to the interest rate.
Figure 2.2 illustrates four extreme cases. A liquidity trap occurs when the
public is prepared to hold any amount of money at the current interest
rate. This implies that money demand is horizontal in the real money–
interest rate space, and monetary policy is ineffective because changes
in the money supply do not alter income and the interest rate. As a
consequence, the LM curve is horizontal. If the economy is in a liquidity
trap, fiscal policy is very effective, as there is no crowding out effect on
investment following a fiscal expansion (Panel A). The classical case occurs
when money demand is entirely unresponsive to the interest rate, so that
the LM curve is vertical (Panel B). This is consistent with the classical
quantity theory of money, which states that nominal income, PY, is entirely
determined by the money supply. In this case, if we assume that the price
level is fixed then a monetary expansion has a one-to-one effect on real
income, whereas fiscal policy has no effect on income because the fiscal
expansion causes the interest rate to rise, reducing investment spending
one-for-one with the rise in government spending.9
The effectiveness of monetary policy depends upon the slope of the IS
curve. If investment is fully sensitive to the interest rate, then the IS curve
24
You should note, however,
that a typical classical model
of the entire economy does not
assume that prices are fixed.
When they are not, changes
to the money supply may only
have the ‘nominal’ effect of
changing the price level, P.
9
Chapter 2: The IS–LM model
Int. rate
A: Fiscal expansion and horizontal LM
E1
i1,2
LM
E2
Int. rate
is horizontal. This implies that an expansionary monetary policy will exert
all its effect (Panel C). Vice versa, if investment is completely insensitive
to the interest rate the IS curve is vertical, which implies monetary policy
ineffectiveness (Panel D).
B: Fiscal expansion and vertical LM
i2
E2
i1
E1
IS2
IS1
0
Y1
Y2
IS2
LM
Y1,2
Income
LM2
E2
E1
IS
Int. rate
Int. rate
i1,2
i1
i2
Y1
Y2
Income
D: Monetary expansion and vertical IS
C: Monetary expansion and horizontal IS
LM1
IS1
Income
IS
E1
LM1
LM2
E2
Y1,2
Income
Figure 2.2: Fiscal and monetary policy effectiveness.
Policy mixes
The IS–LM model shows that fiscal and monetary policies can be used
either in isolation, or simultaneously, to influence key macroeconomic
variables, such as the real interest rate and output. Since output and
employment are positively correlated, that is employment increases
(decreases) when output increases (decreases), fiscal and monetary policy
also influence the unemployment rate.
It is important that you know how to employ the IS–LM model to prescribe
the appropriate policy mix to achieve a specific macroeconomic outcome.
For instance, if the government and the central bank plan to increase
output, without changing the interest rate, this goal can be achieved
through a combination of expansionary fiscal policy and expansionary
monetary policy. The expansionary fiscal policy increases both output
and the interest rate, while the expansionary monetary policy increases
output, but reduces the interest rate (Figure 2.3, Panel A). Another
example occurs when policy-makers want to reduce the interest rate, while
keeping the level of output unaffected. This goal can be achieved through
a combination of expansionary monetary policy, which reduces the interest
rate and increases output, and a contractionary fiscal policy, which will
further contribute to the reduction in the interest rate while reducing
output (Figure 2.3, Panel B).
25
EC2065 Macroeconomics
Int. rate
i2
i1,3
B: Fiscal contraction and monetary expansion
LM1
E2
E3
E1
Int. rate
A: Fiscal and monetary expansion
LM1
LM2
IS2
i1
i2
E1
E2
i3
E3
IS1
Y1
Y2
Y3
Income
LM2
IS2
Y2
Y1,3
IS1
Income
Figure 2.3: Fiscal and monetary policy mix.
Activity 2.6
Consider the economy described in the previous activity. Suppose that
the government increases public spending from 100 to 200 with no
change in taxes.
a. Compute the new equilibrium level of output, under the assumption that the central
bank adjusts Ms to keep the interest rate constant at i = 22.4.
b. Compute the new equilibrium level of output, under the assumption that the central
bank keeps money supply constant at M = 100.
c. Compute the fiscal policy multiplier in each of the two cases above, and discuss your
result.
Solutions to activities
Activity 2.1
It is difficult to infer the likely effects of this forecast on private saving for two reasons.
First, under the identity in equation (2.10), the increase in the budget deficit may be
compensated by a fall in investment, leaving private saving unchanged, or it may lead
to a one-for-one increase in private saving, if investment is unaffected, or a
combination of both effects such that the excess of private saving over investment
(S–I) matches the budget deficit increase. The second reason why it is difficult to make
predictions about the likely response of private saving is that the identity in equation
(2.10) refers to a closed economy and this assumption does not appropriately describe
Singapore’s economy. In fact, in an open economy an increase in the budget deficit may
lead to a one-for-one fall in the trade balance, leaving unaffected both private saving and
investment. We will return to these issues in Chapter 7 of the subject guide.
Activity 2.2
a. The equilibrium level of income at any given interest rate is obtained as:
Y = 600 – 10i + 0.2Y = 750 – 12.5i.
b. The equilibrium level of income is negatively related to the interest rate:
∂Y
= − 12.5, which shows that, if the interest rate increases by 1
∂r
percentage point, then income reduces by 12.5 units.
c. If the government raises its revenue entirely through lump-sum taxes, then an
increase in taxation reduces the equilibrium level of income at any given interest rate.
Numerically, the new equilibrium level of income at any given interest rate is:
Y = 725 – 12.5i.
d. If the government raises its revenue entirely with a proportional income tax with
rate τ = 0.3, then the equilibrium level of income at any given interest rate is
approximately given by: Y = 721 – 11.63i. After the increase in the tax rate, the
26
Chapter 2: The IS–LM model
equilibrium level of income becomes approximately: Y = 705 – 11.63i. Hence, the tax
rate increase reduces the equilibrium level of income at any given interest rate. Note
that the increase in the tax rate also reduces the response of the equilibrium level of
income to changes in the interest rate.
Activity 2.3
a. In the IS curve equation (2.11), changes in the interest rate affect output through
investment spending, which mainly includes fixed business investment from firms and
residential investment from households. In principle, the more investment spending
reacts to changes in the interest rate, the more the interest rate cut should stimulate
investment, thus increasing aggregate demand and output. If investment spending is
insensitive to interest rate changes, the IS curve is relatively steep, so a given interest
rate cut determines a small increase in income. Conversely, if investment spending is
very sensitive to changes in the interest rate, the IS curve is relatively flat, so the same
interest rate cut determines a larger increase in income.
b. Investment may be relatively insensitive to interest rate changes if, for example, banks
do not pass the interest rate cut to customers, or if borrowing transaction costs, such
as mortgage fees, are relatively high.
Activity 2.4
a. The LM equation in (2.12) shows that when the economy is in a liquidity trap the
equilibrium interest rate is zero. Analytically, this can be seen from:

h
1 M
 h0
+ 1 Y * = 0.
 −
h2 → ∞ h 2
h2 P
h2 

lim i * = lim
h2 → ∞
In the classical case, the sensitivity of money to the interest rate is zero, h2 = 0.
Analytically, the implications for the equilibrium interest rate can be seen from the LM
by taking the limit:
h2 →0
{
(
M
1
h − + h1 Y
h2 0 P
{(
*
lim i = lim
h2 → 0
*
This object will equal +∞ whenever M < h0+h1Y *, and −∞ whenever
P
M > h +h Y *.
0
1
P
Since infinite interest rates are not an equilibrium outcome, the only possible
equilibrium occurs when M = h0+h1Y *. In this case the value of the nominal
P
interest rate remains undetermined, but there is a unique real money supply that
can obtain for any given output level. This reflects the fact that both the supply and
the demand for money are perfectly inelastic in the classical case so that the price of
money, the nominal interest rate, is not tied down in equilibrium.
b. The result in a. implies that when the economy is in a liquidity trap the LM curve is
positioned on the horizontal axis of the income – interest rate space, corresponding
to a zero interest rate. In contrast, in the classical case the LM curve is vertical in the
income – interest rate space, and it intercepts the horizontal axis at
.
* 1 M
– h0
Y =
h1 P
(
(
c. Recall that money supply affects the position of the LM curve through the term –1/
h2 × M/P. Since, in a liquidity trap, the coefficient –1/h2 equals zero, changes in
the quantity of money do not shift the LM curve. The public is prepared to hold any
amount of money at a zero interest rate, which implies that a change in money
supply cannot affect the equilibrium interest rate and income. Monetary policy is very
effective in the classical case. In particular, if h1 = 1, the increase in the equilibrium
27
EC2065 Macroeconomics
level of income, following a monetary expansion, is equal to the increase in the real
money supply.
Activity 2.5
a. The equilibrium level of income and the interest rate are computed by solving the
IS–LM system:
 IS : Y * = 400 + 0 . 2 Y * − 0 . 2 × 100 + 80 + 0 . 5Y *− 10 i * + 100

 LM : 100 = 100 + Y * − 50 i *.
Y * = 1120
.
This yields the solution  *
i = 22 . 4
To draw the graph, note that both IS and LM curves must pass through the
equilibrium point. In addition, the IS curve intercepts the vertical axis when
*
*
Y = 0 ⇒ i = 56, whereas the LM curve passes from the origin of the income –
interest rate space (see below).
*
b. In equilibrium, consumption equals C = 400 + 0 . 2 × 1120 − 20 = 604 ;
whereas investment equals I *= 80 + 0 . 5 × 1120 − 10 × 22 . 4 = 416.
c. After the increase in government spending, the IS–LM system becomes:
 IS : Y * = 400 + 0 . 2 Y *− 0 . 2 × 100 + 80 + 0 . 5Y * − 10 i * + 200

 LM : 100 = 100 + Y *− 50 i *
which yields the equilibrium values of income and interest rate
Y * = 1320
.
 *
 i = 26 . 4
The fiscal policy multiplier equals 2 ( i.e. (1320 – 1120)/100).
56
IS
Interest rate
LM
22.4
0
1120
Income
Activity 2.6
a. The new equilibrium level of output is obtained by solving the IS–LM system, with the
additional requirement that the interest rate is constant:
 i * = 66 − 0 . 03 Y *
⇒
 *
 i = i = 22 . 4
Y * ≅ 1453.3
.
 *
 i = 22 . 4
b. The new equilibrium level of output is computed by solving the new IS–LM system,
which includes the new IS equation and the original LM equation, since that is
computed keeping the money supply fixed at M = 100. As determined in the previous
activity in equilibrium:
28
Chapter 2: The IS–LM model
Y * = 1320
.
 *
 i = 26 . 4
c. Under the assumption of a constant interest rate, the fiscal policy multiplier is given
by:
∆Y
∆G
=
1453 . 3 − 1120
100
≅ 3 .3
In contrast, under the assumption of constant money supply, the fiscal policy
multiplier is equal to 2 (see previous activity). Fiscal policy is more effective in the
first case because, by expanding the money supply to keep the interest rate constant,
the central bank neutralises the crowding out effect on investment from the fiscal
expansion.
A reminder of your learning outcomes
Having completed this chapter, and the Essential reading and activities,
you should be able to:
• list and discuss the key equations of the IS–LM model
• describe the determinants of the intercept and the slope of both the IS
and the LM curves
• calculate the equilibrium level of output and the interest rate in a
closed economy with fixed wages and prices
• evaluate how any change in the variables and the parameters of the
IS–LM model alters the equilibrium levels of output and the interest
rate
• show how fiscal and monetary policies contribute to the determination
of output and the interest rate in the short run, and their use as tools
for macroeconomic stabilisation
• illustrate and explain the Keynesian view of short-run fluctuations in
economic activity.
Sample examination questions
Section A
1. In the IS–LM model, an increase in the money supply will always have
a positive impact on the level of output. True or false? Explain your
answer.
2. In the IS–LM model, if the demand for investment becomes less
responsive to changes in the interest rate, both monetary and fiscal
policy will become more effective. True or false? Briefly explain your
answer.
Section B
1. Suppose that, in a closed economy with fixed prices, investment
depends not only on the real interest rate, but also on the level of
output.
Would you expect the effect of output on investment to be positive or
negative? Explain.
If the effect of output on investment is assumed to be positive, how
would the value of the multiplier be affected?
29
EC2065 Macroeconomics
If the effect is assumed to be positive, how would the slope of the IS
curve be affected?
2. Consider a closed economy with fixed prices and wages and
underutilised capacity (refer to the IS–LM framework). What
combination of fiscal and monetary policy can produce a higher
level of output without affecting the interest rate, while keeping the
government budget balanced? Be specific about what instruments
could be used to implement the necessary policies.
Under what conditions could the use of monetary policy, alone,
be ineffective in the short run (i.e. it would not affect the level of
output)?
Under what conditions could the use of fiscal policy alone be
ineffective in the short run?
3. Suppose that, in a closed economy with fixed prices, consumption
depends not only on disposable income but also on the interest rate.
If the effect is assumed to be negative, how would the value of the
multiplier be affected, assuming that the central bank is controlling the
nominal interest rate?
If the effect is assumed to be positive, how would the slope of the IS
curve be affected?
30
Chapter 2: The IS–LM model
Guidance on answering the sample examination questions
Section A
1. The statement is false. In a closed economy, if money demand is highly
sensitive to the interest rate, the LM curve is horizontal, and its position
is not affected by changes in the money stock (liquidity trap). Also, if
investment demand is insensitive to the interest rate, the IS curve is
vertical, and output is unaffected by an increase in the money supply.
2. The statement is false: fiscal policy becomes more effective (intuitively,
the crowding out effect is now smaller), but monetary policy is less
effective (intuitively, changes in the money supply and the interest rate
will now have a smaller impact on investment). Graphically, the IS curve
becomes steeper.
Section B
1. The effect of output, on investment demand, can be expected to be
positive on the basis of accelerator-type models of investment demand,
whereby firms seek to maintain an optimal relationship between the
capital stock and the level of output. In addition, current output could
be taken by firms as an indicator of the future profitability of investment
projects.
If the effect of output on investment is assumed to be positive, the value
of the expenditure multiplier rises, since the multiplier will now reflect
the endogenous response of both consumption and investment.
If the effect of output on investment is assumed to be positive, the IS
curve becomes flatter, reflecting the larger sensitivity of equilibrium
income to changes in expenditure.
2. Balanced budget fiscal expansion and monetary expansion. You should be
explicit about what instruments could be used.
Liquidity trap (to be explained), investment demand insensitive to the
interest rate.
Vertical LM (classical case). Horizontal IS (fully sensitive investment). A
good answer should illustrate the economic intuition behind each case.
3. If the central bank is holding the interest rate fixed (by varying Ms), the
value of the multiplier is unaffected. This can be argued either formally,
deriving the formula for the expenditure multiplier, or intuitively, since
the multiplier cannot be affected by changes to interest sensitivity so long
as the interest rate is fixed.
If the effect of the interest rate on consumption demand is assumed to
be positive, the IS curve is steeper, as the positive effect on consumption
partially offsets the (negative) effect of the interest rate on investment.
31
EC2065 Macroeconomics
Notes
32
Chapter 3: Unemployment and the AD–AS model
Chapter 3: Unemployment and the
AD–AS model
Aims of the chapter
This chapter explores the short- and long-run determinants of
unemployment, output and the price level. We begin by describing the
labour market and the different components of unemployment, in order to
identify appropriate macroeconomic policies to reduce each of them. Next,
we derive the aggregate supply (AS) and the aggregate demand
(AD) curves and discuss alternative views about the slope of each curve
in the short run. The two curves are then combined to form the AD–AS
model, which is used to describe business-cycle fluctuations and assess
to what extent macroeconomic policy can be employed to stabilise the
economy in the short run.
Learning outcomes
By the end of this chapter, and having completed the Essential reading and
activities, you should be able to:
• explain the mechanism underlying the determination of the
equilibrium real wage and unemployment rate in the labour market
• recognise the main types and causes of unemployment, and the
appropriate macroeconomic policies to reduce them
• derive aggregate supply under imperfect competition in the labour and
product markets, and discuss the alternative interpretation of the AS
relationship
• compute the aggregate demand curve from the IS–LM model, and
clarify the determinants of its slope and position
• employ the AD–AS model in order to assess the determinants of
output, the price level and the interest rate over the business cycle
• appraise how monetary and fiscal policy can be used as stabilisation
tools in response to demand and supply shocks.
Essential reading
Blanchard, O. and D.R. Johnson Macroeconomics. (Upper Saddle River, NJ:
Prentice Hall, 2012) Chapters 6, 7 and 8 (pp.193–94).
Dornbusch, R., S. Fischer and R. Startz Macroeconomics. (New York: McGrawHill, 2011) Chapters 5, 7.1–7.5 and 10.4.
Mankiw, N.G. Macroeconomics. (Worth, 2012) Chapters 7, 10, 12.2 and 14.1.
Further reading
Ball, Laurence and N.G. Mankiw ‘The NAIRU in theory and practice’, Journal of
Economic Perspectives 16(4) 2002, pp.115–36.
Blanchard, O. ‘European unemployment: the evolution of facts and ideas’,
NBER working paper, No. 11750, 2005.
Davis, Steven J., R.J. Faberman and J. Haltiwanger ‘The flow approach to labor
markets: new data sources and micro-macro links’, Journal of Economic
Perspectives 20(3) 2006, pp.3–26.
33
EC2065 Macroeconomics
Lucas, Robert ‘Understanding business cycles’, in K. Brunner and A. Meltzer
(eds) Stabilization of the domestic international economy. 5, pp.7–29. Also
in Estrin, S. and A. Marin Essential reading in economics. (Basingstoke:
Macmillan Press, 1995) first edition [ISBN 9780312125110] Chapter 16.
Zarnowitz, Victor ‘Theory and history behind business cycles: Are the 1990s
the onset of a golden age?’ Journal of Economic Perspectives 13(2) 1999,
pp.69–90.
Introduction
If you are using Blanchard and Johnson you should read everything
in Chapter 6, including the end chapter appendix, and Chapter 7,
including the focus box on the empirical estimates on money neutrality.
At this stage, you may want to read also Chapter 13, which incorporates
technological progress within the AD–AS framework and looks at the effect
of technology shocks on unemployment and wage distributions. You are
strongly advised to read also the focus box on European unemployment in
Chapter 8. If you are using Dornbusch et al., you should read Sections 1 to
5 in Chapter 7 for unemployment. Section 4 in Chapter 10 and the whole
of Chapter 5 cover the relevant material of the syllabus for the AD–AS
model. If you are using Mankiw, you should read everything in Chapter 7
for unemployment. Chapter 10, Section 2 of Chapter 12 and Section 1 of
Chapter 14 together cover the relevant material for the AD–AS model. You
may find the material in Chapter 14 rather selective, and for this reason
you are advised to do some supplementary reading from the relevant
sections of Blanchard and Johnson or Dornbusch et al. on this topic.
This chapter is divided into two parts. The first part focuses on the labour
market under imperfect competition and shows how to determine the
equilibrium real wage and natural rate of unemployment. There are
four types of unemployment: classical (real wage), frictional (search),
structural (mismatch), and cyclical (Keynesian) unemployment. The sum
of classical, frictional and structural unemployment determines the socalled natural unemployment rate, which is broadly defined as the average
unemployment rate in the medium run. Understanding the alternative
components of unemployment is important, as it ultimately allows us to
correctly identify appropriate macroeconomic policies to reduce them.
Note that the guide defines as classical the unemployment caused by
wage rigidities in the labour market. This is in contrast to frictional
unemployment, which is caused by the time necessary to search and find
a job, and structural unemployment, which is caused by the mismatch
between workers’ needs and skills and job requirements. Blanchard and
Johnson are not explicit about this distinction, so you may want to rely
either on the guide or upon the other two textbooks. Also be aware that
Dornbusch et al. and Mankiw distinguish unemployment only as frictional
and structural, as they treat classical unemployment as part of structural
unemployment.
The second part of this chapter focuses on the description of the AD–AS
model, in order to assess the determinants of output and the price level
in the short and the long run. The AS curve is computed from the labour
market equilibrium condition, whereas AD is derived from the equilibrium
condition in the IS–LM model. Attention is given to the economic theories
underpinning the alternative slopes of the AS and the AD curves. Finally,
the AD–AS model is employed to explain business-cycle fluctuations,
and to assess how monetary and fiscal policy can be used to stabilise the
economy in the short run.
34
Chapter 3: Unemployment and the AD–AS model
It is very important that you are able to analyse the AD and the AS curves
both analytically and graphically, and to interpret how changes in any
variable or parameter of the two curves will affect their slope or position.
Confusion may arise about the slope of the short-run AS curve. In the
IS–LM model we took a very simplified view of price stickiness and
considered a situation in which prices are fixed. In this context, the shortrun AS is represented by a horizontal line in output-price space. However,
the appropriate view of price stickiness implies that prices slowly adjust, in
the short run, and the AS curve is positively sloped in output–price space.
The steepness of the AS curve determines the degree of price rigidity: the
flatter the AS curve is, the slower the price adjustment mechanism.
The labour market: main definitions
The labour market includes three categories of individuals: employed,
unemployed and inactive. The term employed refers to a person who is
currently working. Unemployed refers to a person who is not working
and is seeking a job. Inactive denotes a person able to work but not
seeking a job. The labour force, L, is the sum of employed, N, and
unemployed, U, people, and it is defined analytically as:
L = N + U.
The sum of the labour force and the inactive, I, defines the population of
working age PW, as:
PW = L + I = N + U + I.
The unemployment rate u is the ratio between unemployed and the
labour force:
U,
(3.1)
u=
L
whereas the employment rate e is defined as the ratio between employed
and the population of working age:
N .
(3.2)
e =
PW
Equations (3.1) and (3.2) show that there is not a one-for-one relationship
between changes in the rates of unemployment and employment, as these
two variables are connected by the so called participation rate, PR,
defined as the ratio between the labour force and the total population of
working age:
L .
(3.3)
PR =
PW
These definitions imply that:
u = 1−
e ,
PR
which shows that an increase in employment reduces the unemployment
rate to the extent that it is not offset by a rise in the participation rate. This
result is obtained by manipulating the unemployment rate as follows:
u =
U
L
=
L− N
L
=1−
N
L
=1−
N
PW
PW
L
=1− e
1
PR
.
The empirical evidence shows that the participation rate is not constant
over time, but it tends to increase during expansions and to fall during
recessions. The latter occurs because when the unemployment rate is high,
some unemployed people give up their job search and cannot be counted
as unemployed any more. These people are known as discouraged
35
EC2065 Macroeconomics
workers, namely people who do not look for work, but who would take
work if it was offered to them.
Because workers change their status over time, the labour market can
be characterised in terms of worker flows between the three states of
employed, unemployed and inactive. A specific unemployment rate
can be the outcome of a very active labour market with a high number
of separations and hires, or of a stagnant (sclerotic) labour market
with relatively few separations and hires. Labour market mobility is
measured by the proportion of unemployed leaving unemployment in a
specific period of time. The inverse of this measure defines the average
duration of unemployment, namely the average length of time
people spend in unemployment.
The empirical evidence suggests five basic stylised facts about
unemployment. First, the unemployment rate varies across countries and
over time. In the US the unemployment rate rose until the mid-1980s,
and fell afterwards. In Europe the unemployment rate was relatively low
during the 1950s and the 1960s, but it increased over the 1970s and the
1980s, and has been above the US rate over the last 20 years. Second,
unemployment is negatively correlated with the business cycle: it sharply
increases during recessions and it falls during expansions. Third, the
duration in unemployment also varies across countries and over time,
and it is correlated with the business cycle. In particular, unemployment
duration rapidly increases during recessions, whereas it reduces during
economic expansions. Fourth, the proportion of unemployed workers
finding jobs is low during downturns when unemployment is high. Finally,
the proportion of employed workers losing their jobs is high during
recessions when the unemployment rate is high.
Activity 3.1
Consider country A, in which there are 10 million unemployed people. Over a month 1
million unemployed people find a job and 4 million become inactive.
Country B has 10 million unemployed people and over the same period of time, 4
million unemployed people find a job and none becomes inactive.
Compute the size of total flows out of unemployment (as a percentage of
unemployment) and the average duration of unemployment in both countries.
Labour market and classical unemployment
In a competitive labour market the equilibrium real wage ensures
equality between workers’ labour supply and firms’ labour demand.
Panel A in Figure 3.1 describes the labour market in employment-real
wage space. The labour force is fixed and indicated by the vertical line
L. Labour supply, LS, is positively sloped because workers are ready to
substitute leisure for labour as the real wage increases (substitution
effect).1 Labour demand, LD, is negatively sloped because firms demand
labour until the marginal product of labour equals the real wage. An
increase in the employment level reduces the marginal product of labour,
and can be supported in equilibrium only by a corresponding fall in the
real wage.
The competitive real wage, WCE / P , determines the level of employment
N, and, in turn, the level of unemployment U = L – N. In a competitive
labour market, the real wage always adjusts to clear any excess of labour
supply and/or demand.
36
For simplicity we have
assumed the absence of
an income effect, namely
the tendency of highincome workers to reduce
labour supply when their
wage increases.
1
Chapter 3: Unemployment and the AD–AS model
Wage rigidities are defined as the failure of the real wage to adjust
to clear the labour market. More precisely, Panel B in Figure 3.1 shows
a wage rigidity holding the real wage above the competitive level,
resulting in a level of unemployment higher than the competitive one. The
unemployment caused by such wage rigidities is called classical or real
wage unemployment, and it is denoted in the figure with the symbol
UCL. It is the difference between the number of workers who are willing to
work at the given real wage, Ns, and the number who are able to find work,
N.
There are four main theories of wage rigidities and classical
unemployment: minimum-wage, collective bargaining, insiders-outsiders
and efficiency wages.
A: Competitive labour market equilibrium
WCE /P
LD
L
UCL
Real wage
Real wage
LS
B: Wage rigidity
N
Employed
L
W/P
WCE /P
LD
U
0
LS
0
N
U
NS
Employed
Figure 3.1: Labour market and classical unemployment.
Minimum-wage legislations set a legal minimum compensation that
firms must pay to their employees. Minimum wage laws result in a real
wage higher than the market clearing wage for those workers with low
marginal productivities and equilibrium wages, such as low-skilled and
young workers, who tend to receive part of their compensation as job
training and apprenticeships. There is an ongoing debate on whether or
not minimum wage laws are beneficial for the labour market and the
economy as a whole. Supporters argue that minimum wages increase
average living standards, create an incentive to work, do not increase
public spending, and stimulate consumption by increasing the purchasing
power of low-income people who tend to spend their entire wages.
Opponents of minimum wages believe that they ultimately increase
unemployment among young or unskilled workers, and should be replaced
by income tax credits. Low-income households can deduct the tax credit
from their tax payments and, if the credit exceeds the tax bill they can also
receive a money refund. The tax credit does not raise firms’ costs and is
less likely to deter them from hiring. However, it has the disadvantage of
increasing government spending, especially during economic slowdowns.
In many countries wages are the outcome of collective bargaining
between unions, firms’ associations and the government. The outcome
of the negotiation is known as wage accord, which consists of setting
a specific level for the real wage, then leaving firms free to decide how
many workers to hire at this wage. Collective bargaining results in wage
rigidities since the power of unions can push the negotiated real wage
above the equilibrium wage.
Efficiency wage theories argue that labour productivity is related to
worker compensation, and paying a wage above the market-clearing level
improves employee morale, thus increasing production. For this reason,
firms may be willing to pay a real wage that exceeds the equilibrium wage
in order to boost profits. A high wage may also be beneficial for firms in
37
EC2065 Macroeconomics
that it reduces the incentive for workers to quit, and thereby the cost of
advertising, screening, hiring and training new workers.
The final source of wage rigidity arises from the potential conflict of
interest between different groups of workers: insiders and outsiders.
Insiders are those workers already employed by firms, who are interested
in keeping real wages high. This clearly contrasts with the interest of those
unemployed – outsiders – since a wage reduction would increase their
chances of employment. A wage rigidity occurs if, within a union, the
bargaining power of insiders is greater than that of outsiders, as in this
case the insiders can keep the real wage above the equilibrium level.
Hysteresis
Hysteresis in the natural rate of unemployment occurs when the
unemployment rate remains very high over a prolonged period of time
(persistent unemployment).
Several theories can be advocated to explain this phenomenon. The first
view is the human capital decumulation theory. Unemployment
reduces both the quality of the labour force (loss of skills) and the
attitude of the unemployed towards their likelihood of finding a job
(discouragement). Consequently, the quality and quantity of human capital
that contributes towards overall production in an economy declines when
unemployment is high. This may affect the long-term unemployed,
people who have been out of work for long periods of time, and young
labour force entrants who lack experience during the formative years of
their life.
The second explanation of hysteresis in the natural rate is related to the
insider-outsider theory described at the end of the previous section. In
essence, when workers become unemployed they are no longer insiders
and become outsiders. Consequently, the unemployed do not have any
influence on the wage and employment negotiations of the remaining
insiders. This prevents the real wage from being reduced enough to
increase employment, in turn allowing high unemployment rates to persist
over long periods of time.
The third explanation of hysteresis in the natural rate is the physical
capital stock theory. This explanation is based on the empirical evidence
that high unemployment occurs during economic recessions with very low
physical capital formation. If capital and labour are complements in the
production function, low capital formation leads to low labour demand,
which in turn increases the natural unemployment rate. This is because
lower capital stock implies a lower marginal product of labour at any given
employment level. Hysteresis in the natural unemployment rate occurs
under this theory because after an economic recession it takes a long time
to rebuild the capital stock, hence for the full employment level to rise.
Frictional and structural unemployment
The unemployment rate is affected by the degree of mobility in the labour
market, which is characterised by people continuously finding and losing
jobs. The effect of labour force dynamics on the unemployment rate can
be formalised by denoting with l the fraction of employed people losing
their jobs in a specific period of time, and with f the share of unemployed
people finding a job over the same period of time. If the unemployment
rate is constant over the given horizon, and if we assume for simplicity
that the participation rate is fixed at 100 per cent then it must be true that:
38
Chapter 3: Unemployment and the AD–AS model
∆ u = 0 ⇔ lN = fU ,
which states that a constant unemployment rate over a specific period of
time can only occur if the number of employed people losing their jobs
equals the number of unemployed people finding new jobs during that
period. The definition of labour force, L = N + U, can be substituted into
the above to obtain:
l ( L − U ) = fU.
After dividing both sides of this expression by L and solving for u, the
unemployment rate becomes:
1
,
u=
(3.4)
1+ f / l
which shows that the unemployment rate increases as the rate of job
finding reduces, or the rate of job losses rises. Equation (3.4) implies that
any policy aiming at reducing the steady-state rate of unemployment must
either reduce the rate of job losses or increase the rate of job finding. In
this context, the unemployment rate can have two very different sources.
Frictional unemployment is caused by the time it takes workers
to search and find a job. Structural unemployment is instead the
outcome of a mismatch between, on the one hand, workers’ needs and
characteristics and, on the other hand, vacancy requirements. Factors that
determine structural unemployment are job locations, since job vacancies
and unemployed people may be located in different regions, and workers’
skills, since workers may be either over- or under-qualified to undertake
available jobs. Thus, the longer it generally takes workers to search and
find a job, the higher will be frictional unemployment, whereas the higher
the degree of mismatch, the higher will be structural unemployment.
Activity 3.2
Discuss which of the three types of unemployment – classical, frictional and structural –
each of the following policies can help to reduce:
a. an increase in the number of job centres
b. an increase in the number of retraining programmes
c. a reduction in unemployment benefit
d. a reduction in minimum wages and trade union power.
The natural rate of unemployment
The natural unemployment rate is defined as the sum of the
three components of voluntary unemployment: classical, frictional and
structural unemployment. It is a measure of the average or mediumrun unemployment rate, around which an economy fluctuates over the
business cycle. In the short run, the actual unemployment rate may differ
from the natural rate: during expansions the actual unemployment rate
is lower than the natural rate, whereas during recessions it is higher. The
difference between the actual and the natural rate of unemployment is
defined as cyclical or Keynesian unemployment.
An important way to analyse the natural unemployment rate is by use
of the WS–PS model. This requires two modifications to the previous
analysis of the labour market. First, the labour market has to be described
in unemployment–real wage space. In this space, the labour market is
characterised by a decreasing labour supply schedule and an increasing
labour demand schedule. Second, imperfect competition is introduced in
both the labour and product market, to evaluate how this affects labour
39
EC2065 Macroeconomics
demand, labour supply, and the real wage. In this context, the natural
unemployment rate is defined as the equilibrium unemployment rate in a
labour market with imperfect competition.2
Under imperfect competition, the labour supply curve is replaced by the
wage-setting relation, WS, which takes into account the bargaining
of workers in wage negotiations, whereas the labour demand curve is
replaced by the price-setting relation, PS, which takes into account
firms’ power to set the price level above marginal cost. Blanchard and
Johnson provide the following analytical description of the WS and the PS
curves:
e
WS : W = P F (u,z),
PS : P =( 1 + µ)W,
(3.5)
where W indicates the nominal wage, Pe is the expected price level, u is the
unemployment rate, z measures structural and institutional factors that
contribute to wage determination (i.e. the level of unemployment benefits,
labour market protection, minimum wage legislations, etc.) and u is the
markup, which reflects the degree of firms’ market power. The function
F is assumed to be decreasing in u, as higher unemployment reduces
workers’ ability to bargain for a high real wage.
You should refer to Chapter 6 in Blanchard and Johnson for a
comprehensive description of the WS–PS model. I will point out three
things about the WS–PS model. First, under perfect competition both z and
µ equal zero and the WS and the PS curves coincide with the competitive
market labour supply and demand curves, respectively. Second, the slope
of the PS curve is more generally likely to be positive in unemployment–
real wage space. However, the labour market can also be described under
an assumption that the marginal product of labour is constant, which
results in the PS curve being horizontal. This is the dominant assumption
in Blanchard and Johnson. Third, if F(u, z) is linear and equal to 1 + z –
αu, then the WS curve can be written as:
(3.6)
W = Pe (1 + z – αu),
where α is the response coefficient of the nominal wage to an increase in
unemployment.
The WS–PS model can be employed to compute, analytically, the natural
rate of unemployment un. To this end, note that the natural unemployment
rate is a medium-term concept, which holds when P = Pe. That is it is
calculated under the assumption that price expectations turn out to be
correct. Under this assumption, the nominal wage in equation (3.5) can be
replaced with the nominal wage in equation (3.6) to obtain:
1 = ( 1 + z − α un ) (1 + µ ).
This expression can be solved for the natural unemployment rate un as
follows:
un =
µ+z (l+µ) ,
α(l+µ)
(3.7)
which shows that increases in both z and µ raise the natural
unemployment rate. If µ is close to zero then this is well approximated by:
µ+z
un ≅ α
The concept of a natural unemployment rate implies natural levels of
employment and output. The natural level of employment, Nn, is
given by:
Nn = L(1 – un).
40
While this model will do a
good job at capturing factors
that affect classical and
structural unemployment it
focuses on the labour market
at a given point in time, and
so will not be so useful for
studying the flows into and out
of unemployment that make up
the frictional component of the
natural rate.
2
Chapter 3: Unemployment and the AD–AS model
If output is produced according to the production function:
Y = AN,
(3.8)
where A indicates the level of technology, then substitution of the natural
level of employment into the production function gives the natural level
of output:
Yn = ANn = AL(1 – un).
(3.9)
Activity 3.3
Explain why the phenomenon of hysteresis implies the existence of a relationship between
natural and cyclical unemployment, so that macroeconomic policies that aim at reducing
cyclical unemployment can also indirectly affect the natural rate of unemployment.
Activity 3.4
Consider an economy in which firms’ markup over cost is 10 per cent and the WS relation
is given by equation (3.5), with z = 0.01 and α = 1. Assume that the marginal product of
labour is constant.
a. Compute the real wage and the natural unemployment rate.
b. Calculate how the equilibrium real wage and the natural unemployment rate change
if the markup increases to 15 per cent. Discuss your result.
c. Keeping the markup at 15 per cent, calculate how the equilibrium real wage and the
natural unemployment rate change if the bargaining power of unions increases so
that z = 0.02. Discuss your result.
Aggregate supply
The AS relation describes how the price level adjusts over time in response
to changes in aggregate demand and income.
There are several approaches to the determination of the AS curve.
Blanchard and Johnson combine the WS and the PS curves and solves for
the price level. This yields the AS curve in equation (7.2) of Blanchard and
Johnson’s textbook.3 This expression looks quite different from the more
compact form for the AS curve used by Dornbusch et al. and Mankiw,
which is written as:
P = Pe + λ [Y − Yn ].
(3.9a)
This equation states that the deviation of the actual price level from the
expected price level, P – Pe, is proportional to the deviation of output
from its natural level, Y – Yn. The definition of the natural level of
unemployment implies that along the AS curve the price level equals its
expected value, P = Pe, when output equals its natural level, Y = Yn. If the
current level of output exceeds the natural level, Y > Yn, then the current
price level exceeds its expected level, P > Pe. In fact, we will see below
that the AS curve derived by Blanchard and Johnson can also be written in
this form.
For more details on
the analytical derivation
of the AS curve from
the WS–PS model, see
Blanchard and Johnson
pp.154–56.
3
Alternatively, the AS relation can also be solved for output to obtain the
so-called surprise-supply relation:
Y = Yn + µ(P – Pe),
where µ = 1/λ > 0 and the term P – Pe indicates surprise inflation. This
relation shows that output exceeds the natural level to the extent that
there is surprise inflation in the economy (i.e. the actual price level
exceeds the expected one).
41
EC2065 Macroeconomics
The parameter λ in equation (3.9a) measures the slope of the AS curve,
namely how quickly the price level changes in response to variations in the
output gap.
There are three possible scenarios, as illustrated in the first three panels of
Figure 3.2. Under the assumption of the IS–LM framework prices are fixed
and the AS curve is horizontal (panel A). In the long run (more than 5–10
years) prices are fully flexible and the AS curve is vertical at the natural
level of output (panel B). This is because the long-run equilibrium, in the
labour market, is defined in real terms, and changes in the price level have
no effect on the natural rate of unemployment, and thus the natural level
of output. The long-run AS curve is denoted in the guide as LRAS. In the
short run, nominal rigidities, and/or imperfect information, make the AS
curve positively sloped (panel C). The short-run aggregate supply curve is
denoted in the guide as SRAS.4
The position of the SRAS curve is determined by all the factors that
contribute to equilibrium in the labour market. In particular, an increase
in the expected price level makes workers bargain for higher wages (for
any given unemployment rate). The increase in the wage raises the actual
price that firms set. As a result, an increase in the expected price level
causes the AS curve to shift upwards (Figure 3.2, panel D).
A: AS with fixed prices
B: Long run AS
Price level
Price level
LRAS
AS
0
0
Output
C: Short run AS
D: Increased price expectations
0
A
Yn
Output
SRAS2
Price level
Price level
SRAS
Pe
Yn
Output
Pe2
Pe1
0
A2
SRAS1
A1
Yn
Output
Figure 3.2: The aggregate supply curve.
The AS relation in equation (3.9a) shows that the extent to which output
deviates from its natural level for any given deviation of prices from
expectations depends upon the steepness of the SRAS, as determined by
the magnitude of the coefficient λ. The smaller is λ, the more variable
output becomes relative to prices. There are four theories that explain why
output may deviate from its natural level in the short run: the sticky-wage
model, the worker-misperception model, the sticky-prices model, and the
imperfect information or Lucas ‘islands’ model. Each of these theories will
be discussed in the following four sections. It is important that you note
how each theory explains the positive slope of the AS curve as a result
42
The horizontal AS curve is also
referred to as the ‘Keynesian’
supply curve, whereas the
LRAS is also referred to as the
‘Classical’ supply curve.
4
Chapter 3: Unemployment and the AD–AS model
of a market imperfection: the sticky-wage and the worker-misperception
models focus on imperfections in the labour market, whereas the stickyprices and the imperfect information models focus on imperfections in the
product market.
Activity 3.5
Is the following statement true or false: ‘The aggregate supply curve is positively sloped
because when the price level increases firms want to sell more goods?’ Discuss your
answer.
The sticky-wage model
The sticky-wage model is grounded upon two assumptions. First,
nominal wages are sticky in the sense they cannot adjust quickly when
the economic conditions change, since they are fixed over long periods
of time. Second, collective bargaining determines only the level of the
nominal wage, whereas employment is determined by firms’ labour
demand, because workers agree to provide as much labour as the firms
wish to buy at the predetermined wage. This implies that, once the real
wage has been set according to the expected price level, then an increase
in the price level above the expected value leads to a fall in the real wage
and increases labour demand. In turn, the increase in employment raises
output, at least until the next wage negotiation. Analytically, the stickywage model is described by three equations:
e
Actual real wage: W = W × P ;
Pe
P
P
 W
W
− e ;
P
P


Labour demand: N − Nn = − 
Output: Y – Yn = A(N–Nn).
The first equation shows that the actual real wage W/P deviates (above
or below) from the predetermined real wage W/Pe to the extent that the
expected price level differs (lower or higher) from the actual price level,
Pe/P. The second equation shows that labour demand is inversely related
to the real wage. An increase in the price level above the expected level
increases employment, as it reduces real wages. The final equation shows
that output is above the natural level to the extent that firms hire a
number of workers higher than the natural employment level.
The sticky-wage model predicts that if after the negotiation the actual price
level equals the expected price level, P = Pe, then employment equals its
natural level, N = Nn, and consequently output equals its natural level,
Y = Yn . If, however, after the wage negotiation the price level is higher
than the expected one, P – Pe > 0, then it must be true that output exceeds
its natural level, Y – Yn > 0, since firms can employ a number of workers in
excess of the natural employment level, N – Nn > 0, at least until the next
wage negotiation. Vice versa, an unexpected fall in the price level raises the
real wage, making labour more expensive. The higher real wage induces
firms to reduce employment, and the reduced employment leads to a fall
in output. When contracts are renegotiated, workers accept lower nominal
wages to restore the original real wage, so employment rises. Therefore,
the sticky-wages model predicts that the longer the period over which
wages are negotiated, the flatter the SRAS. In addition, the model predicts
that real-wage fluctuations are negatively related to output fluctuations.
43
EC2065 Macroeconomics
The worker-misperception model
The worker-misperception model assumes that wages are fully
flexible, unlike the sticky-wage model, but workers have imperfect
information, in that they suffer from money illusion, so they temporarily
mistake nominal wage increases for real wage increases. Firms have
perfect information and their demand for labour depends on the actual
real wage, which is written as:
LD = LD(W/P).
Analytically, the supply of labour is described as:
LS = LS(W/Pe),
which shows that the quantity of labour supplied by workers depends
upon their expected real wage. This can also be written as:
W
W
P
=
× e ,
e
P
P
P
which shows that the expected real wage is given by the product between
the actual real wage and the misperception ratio P/Pe. If (P/Pe) >1 the
actual price level is higher than expected. Vice versa,
(P/Pe) < 1 the actual price level is lower than expected. The expression for
the expected real wage can be substituted into the labour supply curve to
obtain:
W P
LS = L S  × e  ,
P 
P
which shows that labour supply depends upon the degree of workers’
misperception of the price level P. Consequently, the position of the
economy following an increase in P depends upon whether or not workers
anticipate the increase in the price level. If they do, then
(P/Pe) = 1: neither labour supply nor labour demand change. The
nominal wage rises proportionally with the price level so that real wage,
unemployment and output remain unchanged.
If workers fail to anticipate the price-level increase, then firms can offer
higher nominal wages which workers mistake for higher real wages. This
causes an increase in labour supply, and allows firms to temporarily raise
output above the equilibrium level, at least until workers realise that
the real wage has not risen, so they revise their expectations and reduce
labour supply.
The worker-misperception model implies an AS curve that is positively
sloped in the short run. In particular, for given price expectations the more
elastic are the labour supply and demand schedules, the flatter will be the
SRAS.
The WS–PS model that Blanchard and Johnson use to derive the AS
curve in equation (7.2) of his textbook can be thought of as a more
complex version of this worker-perception model, in which the labour
supply relationship is replaced by the WS curve and the labour demand
relationship by the PS curve. Here we show how that model can deliver an
AS curve that is algebraically equivalent to (3.9a).
►Optional material: First of all we will reconcile the two descriptions
of the AS curve by showing that the compact form used by Dornbusch et
al. and Mankiw is equivalent to the expression derived from the WS–PS
model in Blanchard and Johnson. We will then use this compact form to
assess the AD–AS model in the rest of the chapter.
44
►This is more advanced
material for those of you who
wish to explore ideas further;
there is no requirement for you
to read these sections
Chapter 3: Unemployment and the AD–AS model
First, combine the linear WS curve in equation (3.6) with the PS curve to
obtain the following expression for the price level:
e
P = (1 + μ ) P (1 + z − α u).
Second, use equation (3.9) to write the AS curve in the output-price space
as follows:

Y .

P = (1 + µ) Pe 1 + z − α  1 −

AL  


(3.10)
Equation (3.10) is equivalent to the AS curve in equation (7.2) of
Blanchard and Johnson, with the only difference that we assumed a linear
WS curve. The AS curve in equation (3.10) shows that the price level and
output are positively related. The mechanism of price adjustment includes
the following four steps. First, an increase in output leads to an increase
in production which increases employment. Second, higher employment
results in lower unemployment. Third, the reduction in unemployment
leads to higher nominal wages through wage bargaining. Fourth, the
increase in the cost of production, due to higher nominal wages, forces
firms to raise prices above the expected level Pe.
When the unemployment rate is at the natural level ( P = Pe ⇔ u = un ),
the PS equation implies:
1
1
.
=
1+ µ =
Yn 
1 + z − αun

1+ z − α 1−

AL 

Using this, equation (3.10) can be written as:
1 + z − α  1 −



e 
P =P

1 + z − α 1 −




Y 

AL  
.
Yn  

AL  
Subtracting Pe from both sides in the above and rearranging gives:
α (l + µ)
AL
(Y – Y
which yields the compact form of the AS relation:
α (l +µ)
where λ = Pe
.
AL
n
(
P − Pe = Pe
,
P = Pe + λ [ Y −Yn ],
►End of optional material
The sticky-price model
The sticky-price model assumes that some firms cannot quickly change
prices as a result of variations in aggregate demand, because it is costly
to alter prices once they have been published in catalogues, menus and
price lists (menu costs). In particular, the aggregate price level can be
analytically described as:
P = sPe + (1 − s) [P+ α ( Y − Yn )],
where 0 ≤ s ≤ 1 is the share of firms with sticky prices setting the price
level according to their expectations; (1 – s) is the share of flexible price
firms, which can immediately change the price level in response to an
increase in demand above the natural level of output; and α > 0 is the
response coefficient of flexible prices to demand. If we first subtract P(1–s)
45
EC2065 Macroeconomics
from both sides of the above and then divide by s, the price level under the
sticky-price model becomes:
(1 − s ) α
( Y − Yn ).
s
This equation shows two features of the sticky-price model. First, a high
expected price level leads to a high actual price level; since firms that set
the price in advance expect a high price level, they will set high prices in
order to face future high costs. These high prices cause all other firms also
to set high prices. Second, the effect of changes in output on the price level
depends upon the proportion of firms with flexible prices, as measured
by the parameter (1 – s)/s. The lower s is, the steeper the SRAS, since
deviations of output from its natural level cause a greater share of firms to
change their prices.
P = Pe +
Activity 3.6
The empirical evidence in the US suggests that real wages are mildly pro-cyclical, since
they tend to increase when the economy expands. Discuss whether or not the predictions
of the sticky-wage model and the sticky-price model, about the correlation between real
wages and output, are consistent with this evidence.
The Lucas islands model
► Optional material: The Lucas islands or the imperfect
information model considers an economy which includes many (N)
little producers each working and producing on isolated islands. In any
period t, the output produced by each individual i, Yit, depends positively
on the difference between the local price on their island, Pit, and the
expected aggregate price level given the information currently available,
Et[Pt]. Analytically, this is written as:
i
i
i
Yt = Yt + β (Pt − Et [Pt ]),
β >0
where Y t i is the average output produced by individual i and the operator
Et–j[Pt], for j ≥ 0, denotes the expectation conditional on information
available until period t–j of the price level in period t. By definition, the
aggregate price level is given by the average price level across all islands:
Pt =( ∑
N
i=1
Pt )/N.
i
Local producers have imperfect information, in that they are only aware
of the price of the product that they produce. Consequently, in any period
t they forecast the aggregate price level by taking a linear combination
of the price on their island and their expected price level given the
information available until the previous period:
i
Et [ Pt ] = θ Pt + (1 − θ )Et–1 [Pt ],
where the operator Et–1[Pt]denotes the expectation conditional on
information available until period t–1 of the price level in period t, and θ is
the weight attached to the local price. The latter is given by:
σ2 ,
θ= 2
σi + σ 2
where σ2 and σi2 denote the variance of the aggregate and the local price
levels, respectively. The supply curve of producer i can then be re-written
as:
Yti = Yti + β (1− θ )(Pti − Et–1 [ Pt ]).
i
N
Consequently, the aggregate supply, Y t = ( ∑ Y t ) / N , is obtained as:
i=1
46
►This is more advanced
material for those of you who
wish to explore ideas further;
there is no requirement for you
to read these sections.
Chapter 3: Unemployment and the AD–AS model
 σ2
Yt = Yt + β  2 i 2
σ + σi
 i

 (Pt − Et–1 [ Pt ]).


This can be solved for P as:
2
+σ
−1  σ
Pt = E t − 1 [ Pt ] + β  i 2
 σi
2

 (Yt − Yt )


The model distinguishes absolute changes in the price level, which occur
when all prices of produced goods increase by the same proportion, from
relative changes in the price level, which occur when the price of some
goods increase more than others.
A relative change in the price level makes the producers of the more
expensive goods better off, as their price is increasing relative to the
overall price level. Both the real and the nominal income earned by these
producers increase. When an absolute change in the price level occurs, all
producers are affected equally and only their nominal incomes increase,
while real incomes remain constant.
Imperfect information means that producers cannot distinguish relative
changes in the price of the product that they produce from changes in the
overall price level. Because of imperfect information, when the producer
sees an increase in Pti, they do not know whether this is caused by goods
increasing in price relative to all other goods or by general inflation,
but the producer will always attach some positive probability to it being
a relative price change. As a result, the producer works more and this
increases the level of output even when the only change is a rise in the
general price level. The Lucas islands model predicts that the higher the
volatility of relative prices by comparison with aggregate prices, the flatter
the SRAS.
Activity 3.7
Consider the sticky-wage, the sticky-price, the worker-misperception, and the Lucas
islands models. Discuss the source of imperfection that generates the positive slope of the
AS curve under each model. Does the labour market clear under any of these models?
◄ End of optional material.
Aggregate demand
The AD relation defines combinations of the price level and income such
that the goods and money markets are simultaneously in equilibrium.
Analytically, the AD relation is obtained by substituting into the equation
for the IS curve the equilibrium interest rate determined from the LM
curve.5 Using the IS and the LM curve defined in equations (2.11) and
(2.12) in Chapter 2 of the subject guide, the AD relation can be written as:
h 2b 2
1 M
h
1
×  (c 0 − c 1 T + I + G ) − 0 +
h1b 2 + h 2 [1 − c 1 (1 − τ 1 ) − b1 ]  b 2
h2
h2 P
This is a very generic and (apparently) complicated expression. However,
if you set m = [1 − c 1 (1 − τ 1 ) − b1 ] to indicate the parameters of the
*
Y =
.


For a detailed description
of the derivation of the AD
curve from the IS–LM model,
see Blanchard and Johnson
pp.156–69.
5
multiplier and A= (c 0 − c 1 T + I + G ) to denote the level of autonomous
spending, then the AD curve can be written in the more compact form:
h2b2
h
1 M 
*
1
,
Y =
×
A− 0 +
h1b 2 + h 2 m  b 2
h2
h 2 P 
which can be further rearranged as:
47
EC2065 Macroeconomics
h2b2
h 
b2
M
1
A− 0+

h1b 2 + h 2 m  b 2
h 2  ( h1b 2 + h 2 m ) P
*
Y =
(3.12)
Equation (3.12) gives the basic equation for the AD curve in a closed
economy. There are several things that you may want to bear in mind at this
stage.
First, note that in equation (3.12), unlike equation (2.12) in Chapter 2, the
price level is not fixed. The AD curve evaluates the goods and money market
equilibrium conditions in the short run, during which prices are sticky but
not entirely fixed.
Second, equation (3.12) shows that the position of the AD curve depends
on the level of autonomous spending, and it is generally affected by fiscal
policy and monetary policy (T, G, M, τ1) and private sector behaviour, as
summarised by the parameters c0, c1, b1, b2, h1 and h2. In particular, fiscal
and monetary expansions shift the AD curve upwards, as they increase
equilibrium income in the IS-LM model. Conversely, fiscal and monetary
contractions shift the AD curve downwards.
Figure 3.3 displays the link between the IS–LM model and the AD curve.
Panel A shows that a fiscal expansion shifts the IS curve to the right, thus
increasing the equilibrium level of income from Y1 to Y2. At any price level P,
the AD curve shifts horizontally, to the right, by the same increase in output
implied by the IS–LM model. Panel B shows that a reduction in consumer
confidence – as measured by the parameter c0 – shifts the AD curve to the
left, so that the reduction in income at any price level P in the AD diagram
is equal to the reduction in the equilibrium level of income observed in the
IS–LM diagram.
i2
i1
B: Fall in consumer confidence
LM
A2
A1
IS2
Interrest rate
Interrest rate
A: Fiscal expansion
i1
i2
LM
A1
A2
IS1
IS1
P
Y1
Y2
A2
A1
P
AD1
0
Y1
Y2
0
Income
Price level
Price level
0
IS2
Y2
Y1
A1
A2
AD2
Income
Income
AD2
0
Y2
Y1
AD1
Income
Figure 3.3: The AD curve.
Finally, it is important that you have a clear understanding of the theoretical
explanations provided for the negative slope of the AD curve. To this end
remember that the AD curve is derived from the simultaneous equilibrium in
the goods and the money markets. The variable that links these two market
is the interest rate, which affects investment in the goods markets, through
the parameter b2, and money demand in the money market, through the
parameter h2. In general this results in a negatively-sloped AD curve because
of the Keynes effect: when the price level rises the value of
48
Chapter 3: Unemployment and the AD–AS model
Ms
P
falls. In order for the money market to clear, the opportunity cost of
holding money must then rise – that is, the interest rate must increase. The
increase in the interest rate reduces demand for investment and, in turn,
output.
There are two situations in which this mechanism fails to work. In both
cases, the AD curve is vertical. The first case occurs when investment does
not respond to changes in the interest rate, (i.e. b2 = 0). The AD curve is
vertical because, in this case, the increase in the interest rate due to a rise in
the price level is not transmitted to output, as demand for investment does
not respond to changes in the interest rate. Consequently, output does not
change as the price level changes. The AD curve is also vertical when the
economy is in a liquidity trap (i.e. h2 = ∞). In this case, a rise in the price
level still reduces real money balances. However, this has no effect on this
interest rate because the demand for real money balances is perfectly elastic.
Thus variations in the price level have no effect on investment and output.
Yet even in these extreme cases it has been argued that the AD curve may
have a negative slope. This is because of the so-called Pigou or wealth or
real balances effect. Suppose the level of consumption itself depends
upon the level of real balances. Then when the price level increases,
the real value of money falls, in turn reducing consumer spending and
output. As a result, a change in the price level will have a direct effect
on aggregate demand, through consumption. In particular, an increase
in real money balances due to a reduction in prices causes a rightward
shift in the IS curve, alongside the usual downward shift of the LM curve.
To the extent that consumption depends upon real balances, the Pigou
effect compounds the Keynes effect. Consequently, the AD curve is flatter
with the Pigou effect than under the Keynes effect alone. In addition,
under the Pigou effect the AD curve is negatively sloped regardless of the
sensitivity of investment and money demand to changes in the interest
rate. Therefore, with the addition of the Pigou effect, the AD curve cannot
be vertical.6
Activity 3.8
Discuss the impact on the slope and/or the position of the AD curve of a change in:
i. the marginal propensity to consume, and
ii. the sensitivity of money demand to the interest rate.
In an open economy a
change in the price level
affects aggregate demand
through a third channel: the
real exchange rate effect.
We will discuss this channel
further in Chapter 7 of the
subject guide.
6
The AD–AS model
The AD and the AS relations can be employed to determine the general
equilibrium in the economy, namely the price and output levels that
simultaneously clear the goods, the money and the labour markets. In the
short run equilibrium occurs when the AD curve equals the SRAS. This
may occur at any price and output level. In the long run, the economy is in
equilibrium when the AD curve equals the LRAS. Because in the long run
output is fixed at its natural level, the long-run equilibrium is consistent
with any price level along the LRAS.
The short-run equilibrium condition determines the actual price level
as well as the actual level of output, whereas the long-run equilibrium
condition determines the long-run price level alone, since long-run output
is determined within the labour market. In the short run, the actual price
level normally differs from the expected level. For this reason, the short49
EC2065 Macroeconomics
run equilibrium is not stable over time, and output adjusts until P = Pe.
More precisely, if the actual price level exceeds the expected one, wage
setters increase their wage demands as their price expectations increase,
which in turn shifts the SRAS upwards. This process of medium-run
adjustment continues until the SRAS equals the AD curve at P = Pe (i.e.
until the economy reaches the long-run equilibrium).
It is very important that you are able to describe both graphically and
using words the adjustment mechanism in the AD–AS model. This is
described in great detail in any of the main textbooks, so I will not provide
any further discussion in the guide. The important thing to note at this
stage is that the economy has a built-in adjustment mechanism, so that
output returns, sooner or later, to its natural level once either a negative or
a positive shock hits the economy.
Activity 3.9
Consider an economy in which the AD curve is: Y = 10 + G – P, and the AS curve is
P – Pe = 0.5(Y – Yn), where G indicates government spending, P is the actual price
level, Pe is the expected price level, Y is actual GDP, and Yn is the natural level of GDP. In
addition G = 50 and Yn = 25.
a. Calculate the expected price level at the long-run equilibrium. Plot in output–price
level space (i) the aggregate demand curve; (ii) the short-run aggregate supply curve
(SRAS), assuming price expectations are consistent with long-run equilibrium; and (iii)
the long-run aggregate supply (LRAS) curve.
b. Suppose the economy starts from its equilibrium position, and an adverse
demand shock reduces aggregate demand by five units at each price level. Compute
the new AD curve and calculate the new short-run levels of output and price.
c. Briefly, describe why the economy adjusts to a new long-run equilibrium, and
calculate the expected price level at the new long-run equilibrium.
Monetary and fiscal policy in the AD–AS model
The AD–AS framework is, mostly, employed to assess the effectiveness of
macroeconomic policy as a tool to stabilise the economy over the business
cycle. I will briefly state in the guide the main results, as extensive
discussion is provided in all three textbooks in the Essential reading list.
A first important prediction of the model is known as classical
dichotomy, which states that in the long run all real variables in the
economy, such as aggregate real output, unemployment and real wages,
are determined independently of monetary policy, which can only affect
the long-run price level. Consequently, the AD–AS model predicts that in
the long run monetary policy is neutral, in the sense that it can only
alter output, unemployment and the interest rate in the short run. In the
long run a monetary expansion results in an increase in the equilibrium
price level alone, since the increase in the price level fully offsets the initial
nominal money supply expansion.
In the short run, monetary policy can still affect cyclical unemployment:
long-run neutrality does not imply that monetary policy is useless. A
monetary expansion increases output and reduces the interest rate in
the short run, therefore it can be successfully employed to speed up the
recovery from a recession. Moreover, by reducing more quickly cyclical
unemployment, an expansionary monetary policy can also, indirectly,
influence the natural unemployment rate, by limiting the increase in
unemployment due to hysteresis arising from the dependence of the
natural unemployment rate on the history of cyclical fluctuations.
50
Chapter 3: Unemployment and the AD–AS model
The AD–AS model predicts that, in contrast with monetary policy, fiscal
policy is non-neutral, as it affects the long-run equilibrium interest rate and
thus demand for investment. A fiscal contraction reduces both output and
the price level in the short run. Contemporaneously, the fall in the price
level increases the real money supply, in turn reducing the equilibrium
interest rate in the money market. This is compounded by the usual
reduction in interest rates that follow a fiscal contraction in the IS–LM
model. The result is an increase in the demand for investment, offsetting
some of the fall in output. In the long run the fiscal contraction has no
aggregate effect on output, which returns to its natural level as price
expectations adjust. But the effect on investment remains: it has filled the
gap left by lower government expenditure.
The AD–AS model suggests that macroeconomic policy can be effectively
employed as a tool for economic stabilisation (demand management or
fine-tuning policy). Macroeconomic fluctuations can be regarded as the
outcome of demand (IS and LM) shocks, namely unexpected changes in
the private sector demand for consumption and investment. These shocks
cause output to deviate, temporarily, from its natural level, and the actual
price level to differ from the expected level. As discussed at the end of the
previous section, the market already has an adjustment mechanism which
tends to stabilise the economy in the medium run. However, monetary and
fiscal policy can be employed to accelerate the medium run adjustment and,
therefore, reduce macroeconomic fluctuations.
Finally, you need to be aware that the magnitude of demand shocks, and,
in turn, the effectiveness of macroeconomic policy as a stabilisation tool
in the short run, ultimately depend upon the degree of price flexibility, as
represented by the slope of the SRAS. In principle, if prices are extremely
flexible (SRAS relatively steep) macroeconomic actions are relatively
ineffective, but the effects of demand shocks will also be less problematic as
the economy is able to adjust quickly on its own. In contrast, the flatter the
SRAS is, the greater the destabilising effects of macroeconomic shocks, and
also the greater the effectiveness of macroeconomic policy as a stabilisation
tool.
Activity 3.10
Consider the economy described in the previous activity. Suppose that, as the economy is
hit by the negative demand shock, the government increases public spending by two units.
Compute and discuss the effect of this policy in the short and in the long run.
Supply shocks
Supply shocks are unexpected changes in the position of the AS curve.
A negative supply shock, such as an increase in the price of oil or
other raw materials, increases the price level for any value of output. A
positive supply shock, such as the discovery of a new and more efficient
production technology, reduces the price level for any level of output. It is
important that you have a good understanding of:
i. how supply shocks may affect the economy over the business cycle, and
ii. to what extent macroeconomic policy can (and should) be employed in
response to supply shocks.
Panel A in Figure 3.4 describes a (permanent) negative supply shock. The
economy is initially in equilibrium at point A, where output equals the
natural level Yn,1, the actual price level P1 corresponds with the expected
price level Pe1, and the interest rate – in the IS–LM diagram – equals i1. The
51
EC2065 Macroeconomics
negative supply shock increases firms’ production costs, inducing them to
set higher prices. This results in the SRAS shifting upwards from SRAS1
to SRAS2. Contemporaneously, in the labour market the PS curve falls
down, reflecting lower labour productivity which results in a permanent
increase in the natural unemployment rate. The increase in the natural
unemployment rate leads to a fall in the natural level of output to Yn,3,
with the LRAS shifting to the left from LRAS1 to LRAS3. The new short-run
equilibrium is at point B, which entails higher output relative to the new
long-run level, Y2 > Yn,3, and a new price level P2 which is higher than the
expected price level Pe1. The SRAS begins to shift upwards until it reaches
the new long-run equilibrium at C. Contemporaneously, in the IS–LM
diagram the increase in the price level reduces real money balances, and the
LM curve shifts upwards until it reaches the new equilibrium position at C.
In sum, a negative supply shock reduces output, increases the price level,
and raises the interest rate.
Panel B in Figure 3.4 describes a (permanent) positive supply shock. The
economy is initially in equilibrium at point A, where output equals the
natural level Yn,1, the actual price level P1 corresponds with the expected
price level Pe1, and the interest rate – in the IS–LM diagram – equals i1.
The positive supply shock reduces firms’ production costs, causing a lower
aggregate price level to be set. This results in the SRAS shifting downwards
from SRAS1 to SRAS2. Contemporaneously, in the labour market the PS curve
shifts upwards, resulting in a permanent fall in the natural unemployment
rate. The reduction in the natural unemployment rate leads to an increase
in the natural level of output to Yn,3, with the LRAS shifting to the right from
LRAS1 to LRAS3. The new short-run equilibrium is at point B, which entails
lower output relative to the new long-run level, Y2 < Yn,3, and a new price
level P2 which is lower than the expected price level P e1. The SRAS begins
to shift downwards until it reaches the new long-run equilibrium at C.
Contemporaneously, in the IS–LM diagram, the fall in the price level raises
real money balances and the LM curve shifts downwards until it reaches the
new equilibrium position at C. Therefore, a positive supply shock increases
output, reduces the price level and decreases the interest rate.
Note that, in general, the AD and the IS curves are also likely to respond
to supply shocks. An increase in the price of oil may lead firms to reduce
demand for investment and may also determine a fall in consumption, as it
redistributes income from oil consumers to oil producers. Public spending
may also be affected as governments may decide to increase investment
in energy-efficient projects or pursue investment in alternative sources of
energy. Positive supply shocks are also likely to affect the AD and the IS
curves, even though this depends on the source of the shock. On the one
hand, a shock resulting in a widespread diffusion of new discoveries and
inventions increases the likely rate of future growth, and, in turn, raises
consumer and business confidence. This type of shock is likely to increase
current consumption and demand for investment, and thus to cause a
rightward shift in the IS and AD curves. In contrast, a positive supply shock
due to a new technology that makes firms more efficient may lead to a fall
in labour demand, and undermine consumer confidence. As a result, both
the IS and AD curves would shift to the left.
52
Chapter 3: Unemployment and the AD–AS model
A: Negative supply shock
B: Positive supply shock
LM1
LM2
LM1
C
i3
i2
i1
Interest rate
Interest rate
LM3
A
A
i1
i2
i3
C
IS
0
0
SRAS3
LRAS1
C
SRAS1
B
A
Pe1 = P1
Output
LRAS1
SRAS2
Price level
Price level
Pe3 = P3
P2
IS
Output
LRAS3
Pe1 = P1
P2
Pe3 = P3
SRAS1
LRAS3
SRAS2
A
SRAS3
B
C
AD
0
Yn,3 Y2 Yn,1
LM2
LM3
Output
AD
0
Yn,1 Y2 Yn,3
Output
Figure 3.4: Supply shocks and medium-run adjustment.
An important question is whether, and to what extent, macroeconomic policy
can be used in response to supply shocks. Positive supply shocks increase
output and reduce the price level, which is not regarded as a negative
outcome, as most people like higher output and lower prices. The issue is
more complicated for negative supply shocks, since they lead to stagflation,
that is a period of economic recession accompanied by an increase in the
price level. Fiscal or monetary expansions would help the recovery of output,
but also further increase the price level. Vice versa, fiscal and monetary
contractions would contribute to reducing the price level, but would further
depress output. We will return to this difficult trade-off in Chapter 12.
Activity 3.11
Consider an economy that starts at the natural level of output. Assume that the economy is
hit by a permanent adverse supply shock.
i. What is the effect on the unemployment rate in the short and the long run?
ii. How is the real wage affected by the shock?
Assume now that the adverse supply shock is temporary.
i. What is the effect on the unemployment rate in the short and the long run?
ii. How is the real wage affected by the temporary adverse supply shock?
Solutions to activities
Activity 3.1
This activity points out that a shorter average duration of unemployment does not
necessarily imply that more unemployed people find a job. In country A the average
flow is: ∆ U = 1 + 4 = 0 . 5 ;
U
10
and the duration of unemployment is: 1/0.5 = 2 months. In country B the average
4
∆U
=
= 0 .4 ;
flow is:
10
U
and the duration of unemployment is: 1/0.4 = 2.5 months. Therefore, even though more
unemployed people find a job in country B, the duration of unemployment is longer than in
country A.
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EC2065 Macroeconomics
Activity 3.2
An increase in the number of job agencies improves information about job vacancies. This
facilitates the matching between unemployed people and jobs, thus reducing frictional
unemployment. An increase in retraining programmes helps to reduce the mismatch
between the skills of the unemployed and those people required by new jobs, thus
reducing structural unemployment. In principle, a reduction in unemployment benefits
can help to reduce frictional unemployment by raising the incentives for the unemployed
to search for work. A reduction in minimum wages and trade union power can help to
reduce classical unemployment.
Activity 3.3
Hysteresis is the increase in the share of long-term unemployed people during economic
recessions. This may be the outcome of a loss of skills by unemployed people, a
discouraged workers effect, or insider workers’ pressure to refrain from wage reductions
during recessions. The higher cyclical unemployment is, the higher the probability that the
unemployed lose skills, abandon searching for jobs, and reduce their bargaining power
relative to the employed. Consequently, the higher cyclical unemployment is the greater
the likelihood of hysteresis effects. For this reason, demand-management policies, which
aim at reducing actual unemployment, may also reduce unemployment persistency and
thus, indirectly, reduce the natural rate of unemployment.
Activity 3.4
a. The real wage is obtained from the PS relation as follows:
W
P
=
1
1+ µ
=
1
1 + 0 .1
≅ 0 . 91.
This can be substituted into the WS relation to compute the natural unemployment
rate as follows:
W
P
1 
W 
1+ z −
 ≅ 1 + 0 . 01 − 0 . 91 = 0 . 1
α
P 

= 1 + z − αu n ⇔ u n =
b. The increase in the markup reduces the equilibrium real wage to:
W
P
=
1
1+ µ
=
1
1 + 0 . 15
≅ 0 . 87.
Consequently, the natural unemployment rate increases to:
un =
1 
W 
1 + z −
 ≅ 1 + 0 . 01 − 0 . 87 = 0 . 14.
α
P 
The increase in the markup reduces labour demand, as the PS curve shifts downward.
This fall in labour demand increases unemployment and reduces the real wage.
c. Since the marginal product of labour is assumed to be constant, the increase in the
unions’ bargaining power does not affect the equilibrium real wage. However, the
natural unemployment rate rises to
un =
54
1
α
W

1 + z −
P


 ≅ 1 + 0 . 02 − 0 . 87 = 0 . 15.

The greater is unions’ power, the higher is the wage set by wage setters, at any level
of unemployment. However, the equilibrium wage is fixed at the level determined
by the PS relation. For this reason labour demand falls as z rises, and the natural
unemployment rate increases just sufficiently for workers to continue bargaining for
the original real wage of 0.87 in equilibrium.
Chapter 3: Unemployment and the AD–AS model
Activity 3.5
This activity clarifies the difference between the AS curve and the supply curve that you
have encounterd in other 200 courses. The AS curve plots the combinations of the price
level and output consistent with equilibrium in the labour market, given the expected
price level. It slopes upwards because higher output implies a lower unemployment rate,
which leads to higher wages and, thus, to a higher price level. The AS curve does not
slope upwards because firms want to supply more goods when the price level is higher.
Activity 3.6
The sticky-wage model predicts that the real wage should be counter-cyclical. An
unexpected increase in the price level reduces real wages, as nominal wages are rigid.
In turn, the reduction in the real wage raises labour demand and increases employment
and output. In contrast, sticky-price theories suggest that the real wage should be neither
pro-cyclical nor counter-cyclical: departures of output from its natural level are caused by
rigidities in the price of goods, not labour. This means that the sticky-price model comes
closer to explaining the mild pro-cyclicality of US real wages, though it must still rely on
other factors to fully account for the data.
Activity 3.7
The sticky-wage and the worker-misperception models focus on imperfections in the
labour market: the former assumes that nominal wages adjust slowly, whereas the latter
assumes that workers confuse nominal wage changes with real wage changes.
The sticky-price and the imperfect information models focus on imperfections in the
product market: the sticky-price model assumes that the prices of goods adjust slowly,
whereas Lucas’s model assumes that producers confuse changes in the aggregate price
level with changes in the local price level.
The labour market clears under the sticky price and the Lucas model, whereas it does not
clear under the sticky-wage model. Under the worker-misconception model the labour
market clears but at an equilibrium that workers will no longer be content to uphold once
their misconceptions about the price level have been remedied.
Activity 3.8
An increase in the marginal propensity to consume, as measured by the parameter c1,
increases the value of the Keynesian multiplier, corresponding to a reduction in the object
m in (3.12). This causes the AD curve to become flatter, as output is now more sensitive
to changes in real money balances. The curve will also shift out slightly, though this effect
will be offset somewhat by a reduction in the value of A (in which c1 features negatively).
The sensitivity of money demand to the interest rate, as measured by the parameter h2,
affects the slope of the LM curve. The less sensitive money demand is to the interest
rate, the steeper the LM curve. As shown in equation (3.12), this parameter affects both
the slope and the position of the AD curve: the less sensitive money demand is to the
interest rate, the bigger the change in income implied by a given change in the price
level, and the flatter the AD curve. It can also be shown that higher values for h2 increase
the constant term in (3.12), shifting the AD curve outwards. An important special case
occurs when h2 = ∞. In this case the economy is in a liquidity trap so that the LM curve
is flat and the AD curve is entirely vertical. A change in the price level affects real money
balances but has no effect on output and the interest rate.
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EC2065 Macroeconomics
Activity 3.9
a. In the long run P = P e and Y = Yn. Imposing these conditions in the AD curve yields
the expected price level:
Yn = 10 + G − P e
25 = 10 + 50 − Pe ⇔ Pe = 35.
The AD curve is obtained from P = 10 + G – Y, which has slope –1 and intercepts
the vertical axis at P = 60. The LRAS is vertical at Yn = 25. The SRAS passes through
the point (Yn , Pe) = (25,35) and intercepts the vertical axis at P = 22.5.
b. The new AD curve is obtained as:
P = 10 + G − Y − 5
P = 5+G −Y
P = 55 − Y .
The new short-run equilibrium is computed by solving the system:
 SRAS : P = 35 + 0. 5 (Y − 25 ) ,

 AD : P = 55 − Y
 P ≅ 33. 3
which yields: 
Y ≅ 21. 7
c. The expected price level at the new long-run equilibrium is computed by imposing
P = Pe and Y = Yn in the AD curve P = 55 – Y, which yields: Pe = 55 – 25 = 30.
The economy adjusts because at the short-run equilibrium of part b the actual price
level is below its expected value, which must result in expectations changing over
time.
Activity 3.10
The increase in public spending partially offsets the fall in demand due to the reduction in
consumer confidence. As a result, the new AD curve is obtained as:
P = 57 – Y
The new short-run equilibrium is computed by solving the system:
 SRAS : P = 35 + 0.5 ( Y − 25 ) .

 AD : P = 57 − Y
 P = 34
which yields: Y = 23 .

In the long run the economy converges to the natural level of output. The new expected
price level is obtained from the AD curve P = 57 – Y, which yields:
P e = 57 – 25 = 32. Therefore, the government intervention contains the loss in output
due to the adverse demand shock, and contributes to reducing the business cycle
fluctuation.
Activity 3.11
A permanent adverse supply shock raises the unemployment rate in the short run, and it
also permanently increases the natural unemployment rate. Recall that as a result of the
shock the PS curve shifts downwards, because of lower productivity. As a result, the real
wage permanently falls following the adverse supply shock. If the shock is only temporary,
the unemployment rate will increase only in the short run; in the long run it returns to the
natural rate. The behaviour of the real wage depends on the model of aggregate supply
used, but it falls only in the short run if at all.
56
Chapter 3: Unemployment and the AD–AS model
A reminder of your learning outcomes
Having completed this chapter, and the Essential reading and activities,
you should be able to:
• explain the mechanism underlying the determination of the
equilibrium real wage and unemployment rate in the labour market
• recognise the main types and causes of unemployment, and the
appropriate macroeconomic policies to reduce them
• derive aggregate supply under imperfect competition in the labour and
product markets, and discuss the alternative interpretation of the AS
relationship
• compute the aggregate demand curve from the IS–LM model, and
clarify the determinants of its slope and position
• employ the AD–AS model in order to assess the determinants of
output, the price level and the interest rate over the business cycle
• appraise how monetary and fiscal policy can be used as stabilisation
tools in response to demand and supply shocks.
Sample examination questions
Section A
1. ‘The introduction of employment protection legislation (making it
harder for firms to dismiss workers) lowers the rate of unemployment.’
True or false? Briefly explain your answer.
2. ‘If there is a real balance effect then the classical dichotomy and the
neutrality of money cannot hold.’ True or false? Briefly explain your
answer.
3. ‘If a component of government expenditure is automatically increased
when output falls then the AD curve becomes steeper.’ True or false?
Briefly explain your answer.
Section B
1. Answer each of the following:
a. Why is the aggregate demand curve downward-sloping?
b. Under what circumstances could the aggregate demand curve be
vertical?
c. What are the implications of proportional taxes, as opposed to
lump-sum taxes, for the sensitivity of output to aggregate demand
shocks and the cyclical behaviour of the government budget?
57
EC2065 Macroeconomics
Guidance on answering the sample examination
questions
Section A
1. The statement is false. This is because the effect of the introduction
of employment protection legislation on the unemployment rate is,
in principle, ambiguous. On the one hand, employment protection
legislation could reduce the unemployment rate, as it can lead firms
to keep more workers employed than they would have otherwise
done. On the other hand, the introduction of employment protection
legislation could increase the unemployment rate, since it should
reduce the propensity of firms to hire. This is because they fear that
such decisions will be difficult to reverse in the future.
2. The statement is true. If consumption depends upon real balances,
then the relative values of M and P, which are nominal variables, will
have a long-run impact on aggregate consumption, a real variable.
This is inconsistent with the classical dichotomy, which requires that
real variables should be independent of nominal variables.
3. The statement is true. If a component of government expenditure
responds negatively to changes in output, then the income multiplier
falls. This makes the AD curve steeper.
Section B
1. a. In a closed economy, the negative slope of the aggregate demand curve reflects the fact that a rise (fall) in the price level implies a
lower (higher) real money stock and, under normal conditions,
a lower (higher) level of output in equilibrium (via the Keynes
effect). An alternative explanation of the negative slope of the AD
curve is provided by the Pigou effect, which assumes that aggregate
consumption depends on real money balances. Consequently, a fall
in the price level increases real money balances, and thus aggregate
consumption and output.
b. The aggregate demand curve would be vertical either in the
liquidity trap case (LM horizontal) or if investment is insensitive to
the interest rate (IS vertical), abstracting from wealth effects and
foreign trade. (For more details, see the section entitled ‘Aggregate
demand’ in this chapter of the guide).
c. Proportional income taxes imply a lower income multiplier and
thus lower responsiveness of the economy to demand shocks (the
AD curve is steeper and shifts by less for any given change in the
autonomous components of expenditure). On the other hand, in the
presence of proportional taxes, as opposed to lump-sum taxes, the
budget deficit becomes counter-cyclical.
58
Chapter 4: Inflation and the Phillips curve
Chapter 4: Inflation and the Phillips curve
Aims of the chapter
This chapter focuses on the links between output and inflation in the long
run and over the business cycle. We revise the Phillips curve and how
economists’ view of the inflation–unemployment trade-off has changed
over time. Next, we exploit the link between the Phillips curve and the
SRAS to revisit the AD–AS model in output-inflation space. This yields a
complete new model of inflation, which is employed to assess the likely
impact of disinflation policies under alternative assumptions about the
mechanism of expectations formation.
Learning outcomes
By the end of this chapter, and having completed the Essential reading and
activities, you should be able to:
• illustrate the derivation of the Phillips curve and discuss its alternative
interpretations
• describe the links between the Phillips curve, Okun’s law, and the SRAS
relation
• employ the AD–AS model in output-inflation space to describe the
behaviour of the economic system in the long run and over the
business cycle
• list and discuss the different costs and benefits of inflation
• illustrate the quantity theory of money, and its long-run implications
for monetary policy
• discuss the relevance of the Lucas critique, and the role of rational
expectations within disinflation policy
• describe the short- and long-run implications for macroeconomic
policy of inflation expectations.
Essential reading
Blanchard, O. and D.R. Johnson Macroeconomics. (Upper Saddle River, NJ:
Prentice Hall, 2012) Chapters 8 (including end-of-chapter appendix), 9 and
24.2.
Dornbusch, R., S. Fischer and R. Startz Macroeconomics. (New York: McGrawHill, 2011) Chapters 6, 7.1–7.2 and 7.6–7.8, 11.1–11.2 and 19.2–19.3.
Mankiw, N. G. Macroeconomics. (Worth, 2012) Chapters 5.1, 5.5, 12.3 and
14.2.
Further reading
Barsky, Robert, B., and L. Kilian ‘Oil and the macroeconomy since the 1970s’,
Journal of Economic Perspectives 18(4) 2004, pp.115–34.
Svensson, Lars E. O. ‘Escaping from a liquidity trap and deflation: The foolproof
way and others’, Journal of Economic Perspectives 17(4) 2003, pp.145–66.
Tobin, James. ‘Inflation and unemployment’, American Economic Review 62(1)
1972, pp.1–18. Also in Estrin, S. and A. Marin, Chapter 11.
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EC2065 Macroeconomics
Introduction
If you are using Blanchard and Johnson, the relevant material on the
Phillips curve is in Chapter 8 (including the appendix). Section 2 in
Chapter 9 covers the relevant material on liquidity traps, and the difficulty
of providing policy stimulus in the face of a very severe recession such
as that which followed the recent global financial crisis. The rest of the
chapter discusses the financial aspects of the crisis in more detail, and is
optional. Finally, you should read Section 2 in Chapter 24 on the costs and
benefits of inflation.
If you are using Dornbusch et al., Chapter 6 includes the relevant material
on the Phillips curve. Chapter 7 discusses the links between inflation
and unemployment in the first two sections, whereas Sections 6 to 8
focus on the optimal inflation rate. You should also read the first two
sections in Chapter 11, as they include some discussion about monetary
policy effectiveness when the economy is in a liquidity trap, including a
description of unconventional measures taken by the Federal Reserve in
the USA when interest rates reached zero in the wake of the 2008 crisis.
Sections 2 and 3 in Chapter 19 look at the Great Depression and are
optional.
If you are using Makiw, Section 1 of Chapter 5 sets out the basic quantity
theory of money, while the relevant material on the costs and benefits of
inflation is contained in Section 5 of Chapter 5. Section 3 of Chapter 12
discusses the effects of deflation in the context of the Great Depression,
and the role of stabilisation in the context of the more recent financial
crisis. Make sure that you read the box explaining the liquidity trap.
Chapter 14.2 covers the relevant material on the Phillips curve. The
material for this chapter is treated in a rather selective way in Mankiw, and
you may want to integrate some of the reading from either Blanchard and
Johnson or Dornbusch et al.
This chapter covers the section of the syllabus on the determination of
the inflation rate and the assessment of disinflation policy. It begins by
revising the definition of the inflation rate and the alternative versions of
the Phillips curve. It is very important that you have a good understanding
of the empirical evidence on the inflation-unemployment trade-off before
and after the 1970s, and that you can relate the changes in the empirical
evidence to the alternative analytical formulations of the Phillips curve.
We focus on the link between the Phillips curve and the SRAS relation, and
show how they are related through the so-called Okun’s law. This allows
us to revisit the AD–AS model within output-inflation space. The new
framework provides a more plausible description of the economy over the
business cycle, as it predicts that economies during downturns should go
through a phase of disinflation, rather than deflation as predicted by the
basic AD–AS model developed in the previous chapter. Throughout the
discussion, we emphasise that business-cycle fluctuations are automatically
dampened by movements in the inflation rate, and that the effectiveness
of the adjustment mechanism, in turn, increases with the degree of price
flexibility. We have also seen, in the previous chapter, how monetary and
fiscal policy can be employed to further reduce economic fluctuations and
to speed up the adjustment mechanism.
The inflation model developed in this chapter is then employed to analyse
the role and the effectiveness of a disinflation policy. We revise three
alternative views of the model. The traditional view is based upon the
assumption that the mechanism adopted by the private sector to form
60
Chapter 4: Inflation and the Phillips curve
inflation expectations is backward looking (adaptive expectations). In this
case, disinflation can only be achieved at the cost of high unemployment
in the short run. We explain how the traditional approach was challenged
by the famous ‘Lucas critique’, which argued against the use of backwardlooking models to predict the likely effects of policy changes. The second
model of disinflation is based upon Lucas’s view that if the private sector
has rational expectations then disinflation can be achieved at zero cost,
provided that monetary authorities are credible. Finally, we discuss the
Fischer–Taylor view of disinflation policy in the presence of nominal
rigidities, which shows that disinflations could be costly even with credible
monetary authorities.
The chapter concludes by focusing on situations which can explain
persistence in business-cycle fluctuations, by considering the role played
by inflation expectations during recessions, and when economies are in
liquidity traps.
It is essential, at this stage of your study, that you understand the
difference between the level and the growth rate of a variable, and, in the
specific case of this chapter, the different roles played by the price level
and the inflation rate. The level of a variable indicates the value that it
takes in a specific period of time. The growth rate indicates the speed
at which the level changes over time. Inflation is defined as a persistent
increase in the price level (i.e. a positive growth rate of prices). Note also
that an assumption that expected inflation equals lagged inflation is not
equivalent to an assumption that the expected price level equals the price
level. The two only coincide if the lagged inflation rate is zero.
The inflation rate and the Phillips curve
The relationship between inflation and unemployment is known as the
Phillips curve. It follows from the AS relationship that we studied in the
previous chapter. As we saw there, there are at least four different ways
to understand aggregate supply. Here we focus on the WS–PS approach
presented by Blanchard and Johnson, which is an advanced version of
the worker misperception model. Chapter 14 of Mankiw shows how the
Phillips curve follows from alternative models of aggregate supply. We
start with equation (7.2) in Blanchard and Johnson, which is reported
below for convenience:
Pt = Pte(1+μ)(1 + z – αut).
The appendix at the end of Chapter 8 in Blanchard describes how to derive
from the above expression the following (approximate) expression for the
inflation rate:
πt = πte + (μ + z ) – αut, (4.1)
which can alternatively be written as:
πt = πte – α(ut – un),
where πt is the actual inflation rate in period t, πte is the expected inflation
rate in period t, and we have used the approximation from (3.7):
αun ≅ μ + z. The solution to equation (4.1) depends upon the mechanism
by which expectations are formed. In the special case of adaptive
expectations, inflation is forecast according to an autoregressive
equation, te = θ t − 1 for some parameter θ, and the inflation rate
becomes:
t = θt − 1 − α (u t − u n ),
(4.2)
which shows that the current period rate of inflation is a function of the
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EC2065 Macroeconomics
previous period rate of inflation as well as the deviation of unemployment
from its natural rate. It is essential that you are aware that equations (4.1)
or (4.2) give two functional forms for the determinants of the inflation
rate, and very important that you fully understand how changes in any of
the parameters of the two expressions affect the inflation rate.1
The Phillips curve was first discovered by Alban William Phillips2 in
1958. Phillips observed an inverse empirical relationship between the
annual rate of inflation and the annual unemployment rate in the United
Kingdom from 1861 to 1957. The same negative relationship was found
by Robert Solow and Paul Samuelson in the US using data from 1900 to
1960. The inflation–unemployment trade-off also held throughout the
1960s, with the constant decline of the unemployment rate in that period
being associated with a steady rise in the rate of inflation.3
It is essential that you are aware of the differences between the original
and the modern Phillips curves, as well as the reasons behind the
breakdown of the Phillips curve which occurred at the end of the 1960s.4
The original Phillips curve is analytically obtained by setting πet = 0 in
equation (4.1) or, alternatively, θ = 0 in equation (4.2). This yields the
expression:
(4.3)
t = ( μ + z ) − α u t ,
which suggests that there is a linear relationship between unemployment
and inflation, with negative slope equal to α and intercept given
by μ + z. The coefficient a measures the extent of the trade-off
between unemployment and inflation and has a very important policy
interpretation: a macroeconomic policy that reduces the unemployment
rate by 1 per cent increases inflation by α per cent. Conversely, a policy
aiming at reducing inflation by 1 per cent results in an increase in
unemployment of 1/α per cent.
The modern Phillips curve allows instead for the expected inflation rate to
be different from zero. It is obtained by rewriting equation (4.1) as:
e
t − t = − α (u t − u n ) ,
(4.4)
which shows that the current inflation rate depends upon the expected
inflation rate and the deviation of unemployment from its natural rate.
Under adaptive expectations, expected inflation is proportional to past
inflation, and the Phillips curve is analytically described by equation (4.2).
Figure 4.1 gives a graphical analysis of the properties of the Phillips curve
in equation (4.4). Panel A shows that the curve is downward-sloping in
unemployment-inflation space, and that expected inflation is constant
along the Phillips curve at the rate π e, which occurs when ut = un. Panel B
shows that, given the natural unemployment rate, any increase in expected
inflation shifts the Phillips curve upwards, one-for-one. Panel C shows the
effect of an economic expansion on the Phillips curve. The economy starts
from the equilibrium position A1. After the expansion the unemployment
rate falls below the natural rate, u1 < un, and the economy moves to
point B along the original Phillips curve, PC1. At point B actual inflation
exceeds expected inflation, π2 > π 1e. As a result, inflation expectations
increase. For the case illustrated, the new level of inflation expectations
is πe2 = π2, corresponding to the curve PC2. Long-run equilibrium is now
possible only at the point A2, with a higher rate of inflation than originally
and unemployment back at the natural rate. Therefore, the modern
Phillips curve predicts that after an economic expansion, inflation and
the unemployment rate both increase as the economy returns to the
natural unemployment rate. Conversely, panel D shows that as a result
62
For further details, see Section
8.1 in Blanchard and Johnson.
1
2
William Phillips studied
sociology at LSE from 1946
before becoming interested
in economics. He was offered
a teaching position at LSE in
1949 and became Professor of
Economics in 1958.
3
The empirical evidence
about the Phillips curve is well
documented in all three main
textbooks. You should look
carefully at Figures 8.1–8.5 if
you are using Blanchard and
Johnson, Figures 6.2–6.4 and
6.6 if you are using Dornbusch
et al., and Figure 14.3 if you are
using Mankiw.
4
Section 8.2 in Blanchard and
Johnson provides an accurate
description of the history of the
Phillips curve, and you should
refer to this chapter for any
further detail.
Chapter 4: Inflation and the Phillips curve
of an economic recession unemployment is higher than the natural
rate and expected inflation falls, which leads the Phillips curve to shift
downwards. While the economy recovers from a recession both inflation
and the unemployment rate decrease, until unemployment returns to its
natural rate. From a policy perspective, equation (4.4) implies that the
attempt of policy makers to maintain the unemployment rate permanently
below the natural rate leads to ever-increasing inflation, since expected
inflation will continue to rise, and the Phillips curve will continue to shift
upwards. Consequently, macroeconomic polices aimed at keeping output
permanently above its natural level are ultimately unsustainable because
they yield an ever-increasing inflation rate. Furthermore, panel C in Figure
4.1 helps to explain the empirical breakdown of the original Phillips
curve during the 1970s. Throughout that period, continuous changes in
inflation expectations caused the Phillips curve to shift over time, so that
econometricians were, ultimately, collecting inflation and unemployment
rate observations from different Phillips curves. Therefore the 1970s data
could not display the stable inflation–unemployment trade-off observed
until the 1960s.
B: Increase inflation expectations
Inflation
Inflation
A: Phillips curve
e
e2
PC2
e1
PC
un
Unemployment
C: Upward shift
D: Downward shift
A2
B
A1
PC2
PC1
0
u1
un
0
Unemployment
Inflation
Inflation
0
2 = e2
e1
PC1
un
Unemployment
PC1
PC2
e1
2 = e2
0
A1
A2
B
un
Unemployment
u1
Figure 4.1: The modern Phillips curve.
Activity 4.1
Show that if output is produced according to the function Yt = ANt then the Phillips curve
in equation (4.4) is equivalent to the SRAS relation π t = π te + λ (Yt − Y n ) , for some
parameter l.
Okun’s law
Okun’s law is the name given to the relationship between changes in the
unemployment rate and percentage changes in aggregate output.
Okun’s relation can be written as:
Yt − Y n
= − γ (u t − u n ),
Yn
which posits that if unemployment is one percentage point higher than its
natural level, then aggregate output is γ per cent lower than its natural level.
The above can be equivalently written as:
63
EC2065 Macroeconomics
Yt − Y n = − δ (u t − u n ),
(4.5)
where the coefficient δ = γY n measures how deviations of unemployment
from the natural rate affect the output gap.
► Optional material: Analytically, Okun’s law can be derived starting
from the following generic aggregate production function:
γ
Yt = AN t ,
where A indicates technological progress, Nt employment, and γ is a
parameter indicating the returns to scale of labour. The definition of
employment, Nt = L(1– ut), can be substituted into the production function
to obtain:
γ
γ
Y t = AL (1 − u t ) .
Taking the logarithm of the above expression yields:
ln Yt = ln A + γ ln L + γ ln (1 − ut ) ≅ ln A + γ ln L − γ ut ,
where we have used the approximation ln (1 − ut ) ≅ − ut.5 At the natural
level of output it must be true that:
ln Yn ≅ ln A + γ ln L − γ un.
Subtracting this expression from the previous one yields:
Since
ln Yt − ln Y n = − γ (u t − u n ).
ln Yt − ln Y n ≅
Yt − Y n
Yn
the expression for Okun’s law is obtained. End of optional material◄
In general, since it relates output and unemployment, Okun’s law
translates the upwards-sloping SRAS curve into the downwards-sloping
Phillips curve in equation (4.4), or vice versa. Since Okun’s law in
equation (4.5) implies that:
1
u t − u n = − (Yt − Y n ),
δ
the SRAS relation can be written as:
e
t− t =
α
δ
(Yt − Y n ),
or equivalently:
e
t − t = λ (Yt − Y n ),
which shows that Okun’s law ultimately relates the slope of the SRAS
and the Phillips curves. Consequently, it is easy to distinguish the shortrun Phillips curve (SRPC), which is negatively sloped and described by
equation (4.4), from the long run Phillips curve (LRPC), which is vertical
in inflation-unemployment space at ut = un.
Figure 4.2 gives a graphical representation of the relation between the
Phillips curve and aggregate supply. Panel B shows that for a given level
of expected inflation, �e1, output can exceed its natural level (Y2 > Yn)
only temporarily, since in the long run the SRAS curve shifts upwards,
from SRAS1 to SRAS2. Correspondingly, panel A shows that the inflation–
unemployment trade-off can only be temporary. Attempts to sustain an
unemployment rate below the natural level, u2 < un, lead to increased
inflation in the short run. In the long run actual inflation settles at the
higher expected rate, as the short-run Phillips curve shifts upwards from
SRPC1 to SRPC2. Therefore, there is no inflation-unemployment trade off in
the long run.
64
►This is more advanced
material for those of you who
wish to explore ideas further;
there is no requirement for you
to read these sections.
5
This is valid so long as
the unemployment rate is
reasonably close to zero.
Chapter 4: Inflation and the Phillips curve
A: Phillips curve
B: Aggregate supply
LRAS
B
e2
A2
A1
e1
SRPC2
Inflation
Inflation
LRPC
A2
e2
e1
0
u2
un
Unemployment rate
A1
SRAS2
SRPC1
B
SRAS1
0
Yn Y2
Output
Figure 4.2: Phillips curve and aggregate supply.
The theoretical version of Okun’s law, derived in equation (4.5), is slightly
different from the empirical version sometimes taken to data, given by:
u t − u t − 1 = − β ( g Yt − g Yn )
(4.6)
where gYt and gYn are growth rates of actual and natural output. This
version of Okun’s law states that changes in the unemployment rate over a
specific period of time depend upon the difference between the actual and
the natural growth rate of output. The unemployment rate is unchanged if
output grows at the natural rate. The focus of the empirical analysis is on
estimating β. In the USA, the empirical estimates, based on annual data,
suggest that β = 0.4, (i.e. a one percentage point fall in the unemployment
rate is approximately associated with a 2.5 per cent increase in output).
However, this result is not constant across countries and over time. For
instance, over the period 1960–1980 the estimated β was about 0.15 in
the United Kingdom, and 0.02 in Japan, whereas in the subsequent period
1980–2003 the estimated β increased to 0.54 in the United Kingdom, and
to 0.12 in Japan.
The magnitude of β depends on how firms adjust their labour demand
in response to production fluctuations, which in turn is affected by the
degree of job security and labour market regulation. In principle, low
estimates of β are associated with high levels of job security. Therefore the
increase in the values of β estimated in the United Kingdom and Japan
could be explained by labour market reforms aimed at weakening the legal
restrictions on hiring and firing, undertaken in both of these two countries
since the early 1980s.
Activity 4.2
Assume that aggregate output is produced according to the production function Y = N.
Determine the coefficient of Okun’s law in this case. Discuss your result.
The AD–AS model (revisited): long run
The aggregate demand relation was derived in equation (3.12) of the
previous chapter, and it is rewritten in a more compact form below as:
M ,
Y = B +φ
P
where the coefficient
B =
h2b2
h 
1
A− 0

h1b 2 + h 2 m  b 2
h2 
captures the effects of fiscal policy and private sector shocks on the
position of the AD curve, and the parameter
65
EC2065 Macroeconomics
φ =
b2
( h1b 2 + h 2 m )
measures the response of aggregate demand to changes in nominal money
and the price level or, equivalently, changes in the real money supply.
Suppose for simplicity that B ≅ 0 holds. Then we can take logorithms of
both sides of the AD relationship for periods t–1 and t, to obtain:
ln Yt − lnYt − 1 = ln M t − ln M t − 1 − (ln Pt − ln Pt − 1 ),
which is equivalent to:
g Yt = g Mt − πt.
(4.7)
This equation expresses aggregate demand in terms of growth rates
showing that the growth rate of real output, gYt, is equal to the difference
between the growth rate of the nominal money supply, gMt, and the
inflation rate, �t. As a result, real output grows to the extent that
growth in the nominal money supply exceeds inflation, gMt – �t > 0, or,
equivalently, to the extent that the real money supply grows.
We can now employ the Phillips curve of equation (4.4), the empirical
Okun’s law of equation (4.5), and the aggregate demand relationship
in (4.7), to provide a full and new description of the behaviour of the
economy in the long run and over the business cycle.
In the long run, the following propositions are true:
1. By definition, the unemployment rate is constant and equal to the
natural rate: ut = un.
2. The growth rate of output is constant and equal to the natural rate:
gy = gy
t
n
3. The inflation rate is entirely determined by the growth rate of the
nominal money supply. Aggregate demand implies that: π t = gM − gY
n
t
where gy is a constant.
n
4. The inflation rate is constant only if the central bank maintains
a constant growth rate of the nominal money supply, gM =gM:
t
π t = π t −1 = π = g M − g Y n .
5. A constant inflation rate is consistent with the unemployment
rate being equal to the natural rate, and actual inflation being
equal to expected inflation. In fact, the Phillips curve shows that:
e
π t = π t −1 = π = π ⇒ u t = u n .
This analysis implies that in the long run inflation is entirely determined
by monetary policy. The natural rate of unemployment and the natural
level of output are determined by equilibrium in the labour market. In
other words, money is neutral in the long run, in the sense that
nominal money growth has no long-run effect on real variables, such as
output, investment and unemployment.
Activity 4.3
Show that the proposition of long run money neutrality can be obtained by assuming
constant output and money velocity in the equation of the quantity theory of money.
66
Chapter 4: Inflation and the Phillips curve
The AD–AS model (revisited): short run
The behaviour of the economy over the business cycle is described
in Figure 4.3. Panel A considers the adjustment mechanism after an
economic expansion. Suppose the initial equilibrium is at point A1: output
is at the natural level Yn, the rate of nominal money growth equals the
inflation rate, actual inflation equals expected inflation, π1 = π1e , and the
equilibrium interest rate, in the IS–LM diagram, equals i1 Suppose, next,
that the economy is hit by a positive demand shock, caused for example
by an expansionary monetary policy. As a result, the LM curve shifts
downwards and the interest rate reduces to i1' , output increases to Y1', and
the short run equilibrium moves to A1' on the SRAS1.6 Okun’s law implies
that the increase in output causes the unemployment rate to fall below
the natural rate. From the Phillips curve it follows that inflation begins
to increase. The demand equation in (4.7) shows that the increase in
inflation reduces real money growth, which shifts the LM curve upwards
until the natural level of output is restored. Contemporaneously, also the
Phillips curve and the SRAS shift upwards until the economy returns to its
long-run equilibrium position at point A2, where expected inflation is in
line with the higher inflation rate π2 = π2e . Panel B shows the adjustment
of the economy to a negative shock, caused by a monetary contraction.
The economy starts from an equilibrium position at A1, at which output
is at its natural level. Next, the demand shock reduces output below its
natural level and unemployment increases above the natural rate. The
short run equilibrium in the economy shifts to point A1' along the initial
SRAS (Phillips) curve.7 The Phillips curve predicts that inflation will begin
to decline, and this increases the growth rate of the real money stock. The
increase in the growth rate of real money shifts the LM curve downwards
until the natural level of output is restored. Contemporaneously, inflation
declines as the SRAS (Phillips) curve shifts downwards to point A2, where
the expected inflation rate equals the lower inflation rate π2 = π2e .
There is an essential point that needs to be clarified at this stage. Even
though, from a graphical point of view, the adjustment mechanism in
the revised AD–AS model looks similar to that described in the previous
chapter of the subject guide, the two mechanisms are conceptually very
different. In the basic AD–AS model developed in the previous chapter,
with no inflation and a fixed money supply, an adverse shock drives
output below its natural level and causes a decline in the price level,
which in turn increases the real money supply.8 The increase in the real
money supply shifts the LM curve to the right until the natural level of
output is restored. Therefore, this adjustment mechanism implies that
while the economy recovers from a recession the price level decreases
(i.e. the economy experiences a deflation). The problem with this type
of adjustment mechanism is that deflation is seldom observed in the real
world. In contrast, the adjustment mechanism developed in this chapter
exploits the Phillips curve in equation (4.4), which implies that during
recoveries from recession economies experience disinflation (i.e. a
decrease in inflation, which is a hypothesis consistent with the empirical
evidence).
6
Note that Figure 4.3 assumes
that the price level increases
as a result of the monetary
expansion in the very short
run. If the price level did not
change following the monetary
expansion, the LM curve would
have shifted further down and
the short-run equilibrium would
have been to the right of point
A1' . For further comments, see
Figure 7.8 in Blanchard and
Johnson.
7
As in panel A, it is assumed
that the price level falls as
a result of the monetary
contraction. If the price level did
not, the LM curve would have
shifted further up and the shortrun equilibrium would have
been to the left of point A1' .
Recall that the AD–AS model
developed in the previous
chapter assumes that the
nominal money stock is
constant, which implies that the
price level is also constant in
the medium run. In other words,
that version of the AD–AS
model assumed the inflation
rate to be equal to zero.
8
67
EC2065 Macroeconomics
A: Expansion
B: Contraction
LM1’
LM1
A’1
i’
IS
0
IS
Output
LRAS
SRAS2
’1
A’1
A1
AD2
Inflation
SRAS1
1 = e1
A1
0
A2
2 = e2
1 = e1
’1
Yn
Y1’
SRAS1
A1
A’1
SRAS2
A2
2 = e2
AD1
AD2
AD1
0
LM1
A’1
i 1’
i1
Output
LRAS
Inflation
Interrest rate
i1
Interest rate
LM1’
A1
0
Output
Y1’
Yn
Output
Figure 4.3: AD–AS model (revisited) and business cycle.
Activity 4.4
Consider the economy described by the following equations:
u t − u t − 1 = − β ( g Yt − g Yn )
Okun’s law
Phillips curve
t − t −1 = − (u t − u n )
Aggregate demand
g Yt = g Mt − t
Consider the following estimates for the USA, the United Kingdom, and Japan:
β
gYn
un
πt
USA
0.4
3%
5%
4%
United Kingdom
0.54
3%
6%
2%
Japan
0.12
5%
2%
0.1%
The first column gives the estimated slopes of Okun’s law, the second gives the average
growth rates of output, the third the estimated natural unemployment rates, and the last
column lists actual inflation rates. Assume that unemployment has been equal to the
natural rate in periods t–1 and t. Compute in each country:
a. The growth rate of output in period t.
b. The growth rate of the money supply in period t.
c. Suppose that in period t+1 the growth rate of the money supply increases by 1 per
cent in each country. Calculate in each country the short- and long-run effects of this
policy on output growth and inflation.
Costs and benefits of inflation
Economists normally distinguish between the costs of expected inflation
and the costs of unexpected inflation. Expected inflation is an increase
in price level that is perfectly anticipated by the private sector and is,
therefore, taken into account in economic transactions. The costs arising
from anticipated inflation are ‘shoe-leather’ costs, menu costs, changes
in relative prices, and tax distortions. When inflation rises, the nominal
interest rate increases, thus increasing the cost of holding money. For this
reason people want to hold less money and make more trips to banks
in order to withdraw small quantities of cash. The cost of these trips is
normally referred to as shoe-leather costs. Menu costs are the costs
68
Chapter 4: Inflation and the Phillips curve
of updating catalogues, vending machines, cash registers, etc., due to the
general increase in the price level. If the price of some goods increases
more than others, then inflation changes relative prices of goods, thus
altering consumption patterns. If price increases between different goods
are staggered, so that the price of one may increase some months after
another in response to the same general inflationary trend, then relative
prices in the economy are likely to be constantly changing, and this can
be a source of inefficient resource allocation. Finally, inflation causes tax
distortions to the extent that the tax system is not perfectly indexed. The
rise in inflation may increase taxpayers’ nominal incomes. If tax brackets
are not updated to take into account inflation, some people are taxed more
as a result only of a nominal, rather than a real, increase in income.
Unexpected inflation refers to unanticipated future increases
in the price level, which are not taken into account in economic
transactions. The main costs arising from unanticipated inflation are due
to the redistribution of wealth between debtors and creditors. Wealth
redistributions arise because inflation erodes the real value of assets
and liabilities fixed in nominal terms, such as money, long-term bonds,
fixed-term mortgages, saving accounts, insurance contracts, and fixed
pensions. Unanticipated inflation implies that debtors (mortgage holders
or bond issuers) pay less than expected in real terms, and creditors
(mortgage issuers or bond holders) receive less than initially anticipated.
For this reason, the higher the inflation variability is, the higher the price
uncertainty faced by creditors and debtors, and the more likely are these
unexpected wealth redistributions. Moreover, the empirical evidence
suggests that high inflation rates are often associated with higher inflation
volatility, which increases the likelihood of unexpected, and potentially
large, wealth redistributions. Of course, wealth redistributions are not a
‘cost’ for everybody: debtors are likely to welcome unexpected inflation as
it increases their net wealth.
Although this discussion might suggest that the ideal inflation rate should
be zero, most economists believe that the optimal rate is instead positive,
though low. This is because a low inflation rate brings at least three types
of benefits to an economy. First, inflation brings positive revenue to the
government through the printing of money – seignorage – which can
be used either to lower the budget deficit or to decrease other taxes. The
seignorage income is, however, quantitatively very low unless the inflation
rate is very high. Second, a positive rate of inflation allows central banks
to achieve low if not negative real interest rates, which could help
the recovery from an economic recession. Finally, positive actual and
expected inflation allows firms to cut real wages without reducing
nominal wages, by ensuring that workers’ nominal wages increase less
than the inflation rate (money illusion).
Activity 4.5
Consider two countries A and B. In both countries firms’ net revenue Pr is equal to the
difference between income and the cost of borrowing, as described by the following
equation:
Pr = y – ik
where y denotes real income, i is the nominal interest rate, and k is capital borrowed by
firms to finance production. In both countries a corporate income tax is levied at the rate
τ on firms’ real income. However, the government in country A allows firms to deduct
nominal interest payments from this income before taxing it whereas the government in
country B allows firms to deduct only real interest payments on borrowing.
69
EC2065 Macroeconomics
a. Calculate the after-tax net revenue in both countries.
b. Use your results to argue that firms in country B should be more averse to inflation
than firms in country A.
c. Use your results to show that the government of country A will be less willing to
tolerate domestic inflation than the government of country B.
Costly disinflation policy
The Phillips curve in equation (4.2) suggests that in order to reduce the
inflation rate an economy must go through a period of low output and
high unemployment. Panel B in Figure 4.3 shows that if the central bank
wants to reduce the inflation from a high rate �1 to a lower rate �2, this
can only be achieved at the cost of an economic recession, Y'1 < Yn. In
other words, the model suggests that disinflation is costly: any policy
aimed at reducing the inflation rate in the medium run comes at the
cost of higher unemployment in the short run. The sacrifice ratio is
a measure of the cost of disinflation policy. It computes the cumulative
loss in employment required to achieve a given reduction in the price
level, measured as a proportion of the achieved reduction in inflation.
Analytically, the sacrifice ratio, SR, is written as:
u − un
u − un
.
SR = − t
=− t
t − t −1
∆ t
For example, suppose that the Phillips curve in equation (4.2) is estimated
to be given by:
1
(u t − u n ) ,
2
where the time subscript t indicates end-of-year observations. Therefore,
the estimated Phillips curve suggests that a 1 per cent annual reduction
in inflation, �t – �t–1 = –1, requires a 2 per cent short-run loss in terms of
unemployment, ut– un = 2. In other words, the sacrifice ratio implied by
the estimated Phillips curve is equal to:
t − t −1 = −
SR = −
ut − un
∆ t
=−
2
–1
= 2.
The total cost of a disinflation policy can be measured by multiplying the
sacrifice ratio by the number of percentage points by which the central
bank wishes to reduce inflation. For instance, if the sacrifice ratio is 2, then
reducing inflation by 5 percentage points requires a cumulative increase
in the unemployment rate 10 percentage points above the natural rate.
Although policy-makers cannot affect the overall cost of disinflation policy,
which is ultimately determined by the slope of the Phillips curve, they
have control over the length of the resulting recession, which ultimately
depends upon how quickly the central bank wants to reduce inflation.
This is illustrated in Figure 4.4, which considers an economy in which
the central bank wants to reduce the inflation rate from 5 to 3 per cent,
assuming a sacrifice ratio of 2. Panel A shows that if the central bank
wants to achieve the lower inflation target in one year, then the economy
has to go through a one year deep recession (point B) with unemployment
4 per cent higher than the natural level. Alternatively, panel B shows that
if the central bank wants to adopt a more gradual approach and reduce
inflation by one percentage point per year (points B and C), the economy
will go through a two-year recession, with unemployment 2 per cent
higher than the natural level each year.
Ultimately, the speed of the adjustment and the length of the recession
depend upon central bank preferences. Note also that the linearity of the
70
Chapter 4: Inflation and the Phillips curve
Phillips curve implies that the sacrifice ratio for reducing inflation, from 5
to 3 per cent, is independent of the speed of the adjustment. As a result, a
cold-turkey or shock therapy policy, which consists of rapidly reducing
the rate of inflation to the new low level, yields the same sacrifice ratio
of a more gradual policy, which entails a longer period of disinflation.
This result does not hold if the Phillips curve is non-linear. The empirical
evidence suggests that the Phillips curve may be convex, which implies
that the inflation-unemployment trade-off changes with the unemployment
rate and, in particular, that inflation becomes less sensitive to changes in
unemployment the higher the unemployment rate.
Activity 4.6
Consider an economy in which the unemployment rate is at the natural rate and the inflation
rate is 10 per cent. Suppose that the domestic central bank wants to reduce inflation to 5
per cent. Starting from year t the central bank reduces the money supply in such a way that
unemployment remains above the natural rate by one percentage point each year. After 5
years the inflation rate reaches the new target of 5 per cent. Compute the sacrifice ratio of
this policy. What is the slope of the Phillips curve of this economy, assuming that it is linear?
A: Cold-turkey policy
B: Gradual policy
A5
e= 5
PC ( = 5)
e
A3
e= 3
0
LRPC
B
PC (e = 3)
un
un + 4
Unemployment rate
Inflation
Inflation
LRPC
A5
e= 5
B
e= 4
e= 3
PC (e = 5)
PC (e = 4)
PC (e = 3)
un
un + 2
Unemployment rate
A3
0
C
Figure 4.4: Costly disinflation policies.
Disinflation policy
In the mid-1970s, the economist Robert Lucas challenged the traditional view
that inflation could only be reduced at the cost of higher unemployment and
that the speed of the deflation had no effect on the sacrifice ratio. Lucas first
argued that the use of a model such as the AD–AS with adaptive expectations
to predict the consequences of a disinflation policy is bound to provide
misleading forecasts, since the estimated Phillips curve and Okun’s law
depend on historical data, and policy changes are likely to alter the observed
relationships between variables. In particular, policy changes may alter both
the response of unemployment to output, and inflation expectations, thus
changing both the slope and the position of the Phillips curve. This argument
is known as the Lucas critique.
Lucas went on to argue that a disinflation policy could be costless, if
monetary authorities are credible and people have rational expectations. In
the Phillips curve of equation (4.2) expected inflation is based on lagged
inflation. Consequently, disinflation automatically leads to short-run high
unemployment. However, rational expectations do not consider past inflation,
but are formed according to the best predictions that the private sector could
make about the future evolution of the price level given the information
available about the state of the economy and economic policy. The Phillips
curve in equation (4.4) suggests that if the central bank could convince
wage setters that it intended to reduce inflation in the future, wage setters
might expect inflation to be lower in the future than in the past. If the
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EC2065 Macroeconomics
central bank announces a lower inflation target, and wage setters find it
credible, disinflation could be achieved without any short-run increase in
the unemployment rate. In other words, the sacrifice ratio is zero when
monetary authorities are credible, and the policy prescription arising from
Lucas’ view is that central banks can and should pursue fast disinflation
policies. Analytically, the Lucas argument is illustrated by combining the
Phillips curve in equation (4.4),
e
t − t = − α (u t − u n)
with expectations given by:
te = .
where is the inflation target announced by the central bank. Therefore,
if the inflation target is credible, the Phillips curve is described by:
t − = α(Ut – Un).
This suggests that monetary authorities can have full control over the
position of the Phillips curve, provided that (i) their policy actions
(and announcements) are credible and (ii) people incorporate the
target inflation rate into their expectations. Figure 4.5 gives a graphical
illustration of costless disinflation policy by considering an economy in
which, as in Figure 4.4, the central bank wants to reduce the inflation rate
from 5 to 3 per cent. If monetary policy is credible, once the central bank
announces the new lower inflation target, the Phillips curve immediately
shifts downwards and the economy adjusts to the new equilibrium at A3, in
which actual inflation equals the lower 3 per cent target.
In contrast to the Lucas argument, Stanley Fischer and John Taylor have
argued that the presence of nominal rigidities implies that even credible
disinflations could be costly. Fischer emphasised that inflation is already
built into existing wage agreements and cannot be reduced without cost.
Taylor pointed out that wages are not all set simultaneously, but instead
are staggered over time. The existence of staggered contracts implies that
wages (and hence prices) can adjust only slowly to changes in policy. As
a result, a too-rapid reduction in nominal money growth would lead to
a less than proportional decrease in inflation. The consequent decline in
the real money stock would lead to a recession and an increase in the
unemployment rate. The policy prescription arising from the nominal
rigidities view is that the central bank should implement disinflation
policies slowly.
Analytically, the Fischer–Taylor view implies that the inflation target
announced by the central bank affects inflation expectations only partially,
and the mechanism of expectation formations is described by:
e
t = λ + (1 − λ ) t −1
where the parameter λ can be thought of as meaning the extent of central
bank credibility. If λ = 1, then monetary policy is entirely credible and
disinflation can be pursued at zero cost. Vice versa, λ = 0 implies that
monetary authorities are not credible and disinflation policy is costly.
72
Chapter 4: Inflation and the Phillips curve
Inflation
LRPC
= 5
A5
= 3
A3
PC(e = 5)
PC(e = 3)
0
un
Unemployment rate
Figure 4.5: Costless disinflation policy.
Activity 4.7
Consider an economy in which the current inflation rate is 5 per cent and the government
is planning to undertake a policy to reduce inflation to 2 per cent in one year. Suppose
that the government estimates the Phillips curve to be:
π t− π te = − (u t − un ),
where time subscripts refer to annual data. In addition, the government believes that
inflation expectations are formed according to:
e
t = λ + (1 − λ ) t − 1 ,
but it does not know the exact value of λ.
a. Compute the range of likely costs of the disinflation policy that the government
is about to undertake. Discuss your result.
b. Aside from the exact value of λ, is there any other factor that makes the final
outcome of the planned policy uncertain?
Depression, liquidity trap, and deflation
The revised AD–AS model can be employed to describe the effect that
inflation expectations may have on business cycle fluctuations. In
particular, the model developed in this chapter can explain why recessions
can turn into economic depressions (i.e. prolonged periods in which
output is below its natural level and the unemployment rate is persistently
higher than the natural rate). Panel A in Figure 4.6 illustrates the basic
adjustment mechanism following an adverse demand shock which reduces
output below the natural level at A1. In this situation the AD–AS model
predicts that the economy will go through a phase of disinflation which
increases real money balances. The increase in real money balances
shifts the LM curve downwards until the economy converges back to the
natural level of output at a lower interest rate. To understand why the
recession described in panel A may turn into a depression, recall that the
IS curve responds to changes in the real interest rate, whereas the LM
curve responds to the nominal interest rate. In addition, the Fischer effect
implies that the real interest rate is equal to the difference between the
nominal interest rate and the expected inflation rate, which may also be
affected by negative demand shocks. Consider the case depicted in panel
B of Figure 4.6. Suppose an adverse demand shock drives output below
its natural level and the unemployment rate above the natural rate, so
that the economy moves to A1. The Phillips curve predicts that inflation
falls, so that the real money supply rises and under the basic adjustment
mechanism this tends to move the economy from A1 to A2. However, the
fall in inflation leads also to a fall in expected inflation, which tends to
increase the real interest rate for any given nominal rate. The increase in
the real interest rate tends to reduce output, as it shifts the IS curve to the
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EC2065 Macroeconomics
left and equilibrium to point B. Therefore, the net adjustment effect is, in
principle, ambiguous, as it depends on whether the LM effects dominate
the IS effects. The economy could adjust along the new IS curve and
return to the natural level of output at a slower pace than that predicted in
panel A.
A: Recession
B: Depression
A1
i1
i2
i3
LM2
LM3
IS1
LM1
Interest rate
Interest rate
LM1
i1
i2
IS1
D: Liquidity trap and deflation
LM1 LM2 LM3
IS2 IS1
Interest rate
Interest rate
A2
Y2 Y1 Yn
Output
0
C: Liquidity trap
IS1
B
LM2
IS2
Y 1 Y2 Yn
Output
0
A1
LM1
∆e < 0
A1
A2 A1
A2
0
Y1 Y2
Yn
Output
0
Y2 Y1
Yn
Output
Figure 4.6: Economic depressions, liquidity trap, and deflation.
Alternatively, the economy could also continue to diverge from the natural
level of output, since the increase in unemployment leads to a further fall
in inflation which may reduce expected inflation even more, and in turn
cause the IS curve to shift further away from equilibrium. In this scenario
the effectiveness of monetary policy is limited by the fact that the nominal
interest rate cannot fall below zero. In other words, monetary expansions
are ineffective after the equilibrium nominal interest rate reaches zero,
since the economy falls into a liquidity trap.9 As already described in
Chapter 2 of the subject guide, when the market clearing nominal interest
rate is zero, the extra liquidity generated by a monetary expansion ends
in a trap in the sense that people are indifferent between holding their
wealth in money and bonds at the zero nominal rate. This situation
implies that the segment of the LM curve corresponding to a zero nominal
interest rate is flat in output-interest rate space. An increase in the nominal
money supply shifts the entire LM curve to the right, so that the horizontal
segment at the zero nominal interest rate gets even longer. This situation is
illustrated in panel C of Figure 4.6. The short-run equilibrium is described
by the intersection between the IS and the LM curves at point A1, so that
the short run equilibrium level of output Y1 is lower than the natural
level of output. Suppose a monetary expansion shifts the LM curve to the
right, so that the new equilibrium level of output Y2 corresponds to a zero
nominal interest rate.10 Once the economy reaches the new equilibrium
at A2 any further monetary policy has no power to stimulate the economy,
as an increase in the nominal money supply cannot reduce the nominal
interest rate further, and output does not increase further than Y2.
The adjustment mechanism becomes even more complicated when
people begin to expect deflation. Panel D in Figure 4.6 shows the case of
an economy that is in a liquidity trap and in recession. Suppose that the
economy has been in recession for some time, so that after a period of
disinflation the price level begins to decrease (deflation). The deflation
74
9
Note that the liquidity trap
does not have to be at zero
interest rate, but can occur
when the interest rate is
positive but very low, as it was
during the Great Depression
and more recently in Japan.
As pointed out in the previous
note, a liquidity trap can occur
when the interest rate is
positive but very low. For this
reason, the diagram in panel
C could also have been drawn
to reflect an LM curve with a
horizontal part at a low, but not
zero interest rate.
10
Chapter 4: Inflation and the Phillips curve
may lead the private sector to expect prices to further decrease in the
future. As a result, the real interest rate increases, in turn reducing
investment spending. The increase in the real interest rate shifts the
IS curve to the left, creating the possibility of a prolonged economic
downturn. In this situation the economy gets into a vicious cycle:
monetary policy is powerless and low output leads to more deflation,
which in turn further reduces output via the real interest rate.
Activity 4.8
Consider an economy which is in long run equilibrium. Suppose that the central bank
increases the growth rate of the money supply. Discuss the short-run effects of this policy
on:
a. the actual and the expected inflation rate
b. the position of the IS curve
c. the position of the LM curve
d. the equilibrium level of income and the nominal interest rate.
Solutions to activities
Activity 4.1
Recall that if output is produced according to Yt = ANt the unemployment rate is related
to output through
Y
ut = 1 − t
AL
Y
Y 

e
As a result, the Phillips curve is written as: t − t = − α 1 − t − 1 + n  ,
AL 
AL

Y 
 Yt
− n .
AL
AL


e
which yields: t − t = α 
If we define λ =
α
, we have the desired result.
AL
Activity 4.2
Okun’s law can be derived by noting that Yt = Nt = L (1 − ut), so:
Yt – Yn = – L(ut– un)
or:
Yt – Yn
Yn
=
–L
Yn
(ut – un) = –
Thus the coefficient is
1
(1 – un)
1
(1 – un)
(ut – un)
, which will be close to one for small values of un. This is
consistent with the result (in the optional material) that if the production function
satisfies Y = ANλ then the coefficient in Okun’s law will approximately equal λ.
Here λ = l.
Activity 4.3
The quantity theory of money states that nominal GDP is proportional to the nominal
money stock. Its central equation is written as:
Pt Yt = V t Mt ,
where P is the price level, Y is real GDP, M is the money stock, V is money velocity, and
all variables are observed in period t. Taking the logarithm of both sides in the above
expression yields:
ln Pt + ln Yt = ln Vt + ln M t .
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EC2065 Macroeconomics
After taking the same relationship at t–1 and subtracting, we have:
ln Pt − ln Pt − 1 + ln Yt − ln Yt − 1 = ln V t − ln V t − 1 + ln M t − ln M t − 1 ,
or equivalently:
t + g Yt = g Vt + g Mt ,
where gVt is the growth rate of velocity. Under the assumption that real GDP and the
velocity of money are constant over time, gYt = gVt= 0, the quantity theory of money
implies:
t = gMt ,
which posits that inflation is only determined by changes in the money stock. This is
consistent with the classical dichotomy prediction that money growth cannot affect real
GDP growth.
Activity 4.4
a. Consider the case of the USA. With a constant unemployment rate between t–1 and
t, Okun’s law suggests that output will have grown at the natural rate of 3 per cent.
Similar logic gives for the United Kingdom gYt = 3% and for Japan gYt = 5%.
b. The growth rate of the money supply is computed from the aggregate
demand relation. In the USA: g Mt = g Yt + t = 3 % + 4 % = 7 %. In
the United Kingdom: gMt = gYt + t = 3 % + 2 % = 5 % . Finally, in Japan:
gMt = 5 % + 0 . 1 % = 5 . 1 %.
c. The increase in money supply growth in the long run raises inflation one-for-one in all
countries, with no effect on output and unemployment. Outcomes in period t+1 can
be determined by solving the system of three simultaneous equations given by Okun’s
law, the Phillips curve and the aggregate demand relationship, given the specified
values for gyn, un and πt, and the values for gMt+1 and ut implied in parts a and b. For
the USA, gMt+1 = 8%, which gives: πt+1 ≅ 4.3% and gyt+1 ≅ 3.7%. For the UK, gMt+1
= 6%, which implies πt+1 ≅ 2.4% and gyt+1 ≅ 3.6%. For Japan, gMt+1 = 6.1%, giving
πt+1 ≅ 0.2% and gyt+1 ≅ 5.9%.
Activity 4.5
a. Since in country A firms can deduct the nominal cost of borrowing, their after tax
revenue is: Pr A = ( y − ik )(1 − τ ) . In country B firms are only allowed to deduct the
real interest payments on debt. If i = r + �, then their after tax revenue is:
PrB = y − ik − τ ( y − rk)
= y − ik − τ ( y − ik + k)
= ( y − ik) (1 − τ ) − τ k.
b. The difference between the two after tax revenues is PrB − PrA = −τ k which
shows that firms in country B are relatively worse off the higher is inflation. For this
reason, they can be expected to be more inflation-averse than firms in country A.
c. The tax revenue of the government of country B is τ(y – ik + πk) = τ(y – rk). The
revenue of the government of country A is instead τ(y – rk – πk). Thus government
revenues are reduced by inflation in country A, whereas in country B they are not.
Activity 4.6
The sacrifice ratio is given by: SR = −
5
∆u
=−
=1 .
∆
−5
As a result, the slope of the Phillips curve in the economy is equal to –1, since a 1 per
cent annual reduction in inflation increases unemployment 1 per cent above the natural
rate.
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Chapter 4: Inflation and the Phillips curve
Activity 4.7
a. If λ = 1, then the disinflation policy is costless as the private sector will entirely
embody the lower inflation target into its expectations. If λ = 0, then the estimated
Phillips curve predicts: 2 − 5 = −(ut − un ) , which implies a sacrifice ratio:
SR = −
∆u
∆
= −
(5 − 2 )
(2 − 5 )
=1
As a result, the economy should go through a recession with unemployment 3 per
cent above its natural rate. Since the government does not know the true value of λ
it can only expect a cost – in terms of higher unemployment – ranging from zero to 3
per cent.
b. The estimates of the government are correct as long as the implementation of
the policy does not alter the estimated slope of the Phillips curve. The use of the
estimated Phillips curve to predict the likely effects of the disinflation policy
potentially incurs the Lucas critique.
Activity 4.8
a. The increase in money supply growth should raise both actual and expected inflation,
particularly if expectations are rational.
b. The increase in expected inflation implies that the IS curve shifts upwards in income–
nominal interest rate space. However, the IS curve does not shift in income–real
interest rate space.
c. In the short run, real money balances are likely to increase due to the faster money
supply growth, causing the LM curve to shift downward.
d. Income is likely to increase in the short run. The effect on the nominal interest rate is
in principle ambiguous: the nominal interest rate tends to increase because of the IS
effect, but it tends to reduce because of the LM effect.
A reminder of your learning outcomes
Having completed this chapter, and the Essential reading and activities,
you should be able to:
• illustrate the derivation of the Phillips curve and discuss its alternative
interpretations
• describe the links between the Phillips curve, Okun’s law, and the SRAS
relation
• employ the AD–AS model in output-inflation space to describe the
behaviour of the economic system in the long run and over the
business cycle
• list and discuss the different costs and benefits of inflation
• illustrate the quantity theory of money, and its long-run implications
for monetary policy
• discuss the relevance of the Lucas critique, and the role of rational
expectations within disinflation policy
• describe the short- and long-run implications for macroeconomic
policy of inflation expectations.
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EC2065 Macroeconomics
Sample examination questions
Section A
1. ‘An economy undergoing deflation cannot have a negative real
interest rate.’ True or false? Briefly explain your answer.
2. ‘Inflation is still costly even when it is fully anticipated.’ True or false?
Briefly explain your answer.
Section B
1. Answer each of the following:
Suppose the government or central bank has announced an inflation
target, and that the actual rate of inflation exceeds the target in a
particular year, but was below target in the previous year. Using some
of the theories that have been put forward to explain the short-run
Phillips curve, discuss how the level of unemployment in the short
term could be affected by the following:
a. whether expectations are formed rationally or not
b. inflation has been very volatile in the past
c. there is a large rise in the prices of oil and other commodities.
78
Chapter 4: Inflation and the Phillips curve
Guidance on answering the sample examination
questions
Section A
1. The statement is true. The real interest rate equals the difference
between the nominal interest rate and the inflation rate. The nominal
interest rate cannot be negative, so the real rate can only be negative if
inflation is positive.
2. The statement is true. There are at least four costs associated with
anticipated inflation: ‘shoe-leather’ costs, menu costs, changes in
relative prices, and tax distortions (for further details, see the section
entitled ‘Costs and benefits of inflation’ in this chapter of the subject
guide).
Section B
e
1. The Phillips curve is described by the equation t − t = − α (u t − u n )
which means that deviations of the unemployment rate from its
natural level depend upon the gap between actual and expected
inflation. Note that if we denote the inflation target with , we know
from the information provided that current inflation is higher than
the target, t > , whereas previous period inflation was below the
announced target, t −1 < .
a. Lucas’s argument on the cost of disinflation policy implies that if
expectations are rational and the target announced by the central
bank is credible, then expected inflation equals the inflation target
and unemployment must currently be below the national rate since
actual inflation is above target. If expectations are not rational
but adaptive, then inflation expectations will coincide with lagged
inflation. Since this is below target, in this case unemployment
must be even further below the natural rate in the short term. If
expectations are rational then the central bank knows that current
inflation above target can be dealt with by a costless disinflation in
the future, whereas adaptive expectations imply that this can only
be achieved at the cost of future employment (the magnitude of
which depends on the slope of the Phillips curve). Note that even
under rational expectations and policy credibility, the disinflation
policy may be costly in the presence of nominal rigidities and
staggered contracts (Fischer and Taylor model of disinflation).
b. High inflation volatility is often associated with high inflation.
However, the effect of past inflation volatility on unemployment in
the short run depends again on whether or not the private sector
has rational expectations and the new inflation target announced
by the central bank is credible. In general more volatile inflation
should make people worry of forming their inflation expectations
by a simple adaptive process (for further details, see the section
entitled Disinflation policy in this chapter of the subject guide).
c. A large rise in the prices of oil and other commodities typically
increases unemployment in the short run. Such price increases
shift up the short-run AS curve, and together with reduced
demand, this leads to higher unemployment, at least in the short
term. These effects are greater the more sudden and the more
pronounced are the price increases, and are amplified by the
impact of higher prices on consumer and business confidence.
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Notes
80