Principles of Economics Sylvain Barde Spring term 2009-2010: Macroeconomics

Course Outline Week 1: Introduction Part 1: Equilibrium in the goods market and the money market Week Week Week Week Week

2: 3: 4: 5: 6:

The circular flow of income and the Keynesian multiplier The effect of government intervention through fiscal policy Money: economic functions and creation process The central bank and the money market equilibrium The IS-LM model

Part 2: Relaxing the fixed price hypothesis Week Week Week Week

7: The WS-PS model of the labour market 8: The phillips curve, the NAIRU, and the role of expectations 9: The AS-AD model 10: Supply side policies and labour market reform

Part 3: International trade and growth Week 11: Exchange rates and the Mundell-Fleming model Week 12: The Solow model of growth

References Blanchard, O. (2005): Macroeconomics. Prentice-Hall, 4th edn.

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Week 1 - Introduction Learning outcomes: - The macroeconomic approach - Systems of equations, variables and markets - An introduction to national accounting : output and inflation measures Reading: Chapters 1 and 2 of Blanchard (2005) Seminar material: No seminar material for this week, but make sure to do the reading !

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Week 2 - The circular flow of income and the Keynesian multiplier Learning outcomes: -

Understanding the concept of the circular flow of income The marginal propensities to consume and save Savings as a limiting factor to the circular flow The Keynesian spending multiplier

Reading: Chapter 3 of Blanchard (2005) Seminar material: Exercise 1: National accounting Why are the following statements incorrect? 1. GDP would be a better measure of welfare if it included the value of primary and intermediate goods as well as the value of final goods. 2. A logging company cuts a tree and sells it for 500  to a sawmill, which turns it into boards and timber worth a total of 1500 . The contribution of these companies to GDP is 2000 . 3. Toyota, the Japanese car manufacturer, has a major production plant in Onnaing (northern France). If production increases in this factory, then so does the Japanese GDP. 4. One can calculate National income (the sum of all income recieved in a country) by subtracting depreciation from GNP. Exercise 2: Decomposing real income and inflation The following tables gives information on quantities produced and prices on agricultural markets in country A: Year Price of wheat Quantity of bread Price of maize 2004 5 500 10 2005 5 1000 10 2006 7,5 1500 15 2007 15 1500 30

Quantity of butter 100 200 300 300

1. Using 2004 as the base year, calculate nominal GDP, real GDP and the GDP deflator. 2. Calculate the percentage growth of nominal GDP, real GDP and the GDP deflator for 2005, 2006 and 2007. 3. If the government of country A were to examine only the growth of nominal GDP, what could it conclude ? Explain the usefulness of being able to decompose nominal GDP.

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Week 3 - The effect of government intervention through fiscal policy Learning outcomes: -

The role of government The link between the budget deficit and the savings-investment gap Spending and tax multipliers The balanced budget multiplier

Reading: Chapter 3 of Blanchard (2005) Seminar material: Exercise 1: The consumption function The following data points represent the consumption of an economy: Income Consumption

1000 1500 2000 2500 3000 3500 4000 1000 — 1800 2200 — 3000 3400

4500 5000 — 4200

1. From the existing data points work out the autonomous consumption and the marginal propensity to consume (Hint: you can draw out a diagram if it helps you). 2. Using the values you found above, fill in the blanks. 3. What is the value of the spending multiplier in this economy ? Exercise 2: A simple model of aggregate demand The following equations describe the economy of Utopia (a country with no government or foreign trade !):   C = 250 + 0.8Y I = 150  Z =C +I where C is consumption, I is investment and Z is aggregate demand. 1. Substituting C and I into Z, write out the equation describing aggregate demand Z as a function of output Y . Draw the corresponding diagram. 2. What is the equilibrium condition in this economy ? Add this to your diagram. 3. Apply the equilibrium condition to the equation you found in q.1 and solve for the equilibrium output (Hint: make sure this corresponds to what you find graphically). 4. Suppose that I increases to 175. Find analytically and graphically the new equilibrium output. By how much has output gone up ? What is the size of the spending multiplier in this economy ?

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Week 4 - Money: economic functions and creation process Learning outcomes: - The nature of money and its functions - The creation of money through credit banking - The organisation of the banking system Reading: Chapter 4 of Blanchard (2005) Seminar material: Exercise 1: The Utopians get a government... Consider the following data points, derived from the consumption function of the Utopian economy. Income Consumption Investment

1500 1450 250

2000 2500 3000 3500 1850 2250 2650 3050 250 250 250 250

4000 3450 250

4500 3850 250

1. Work out the level of savings in the economy for each level of income. 2. Using only the information in the table and the savings, work out the equilibrium level of output. What condition did you use? 3. The Utopian government spends 200 with no taxation. What is the new level of output ? Exercise 2: The balanced budget multiplier Perform the following, detailing how you worked out the solutions: 1. 2. 3. 4. 5.

Calculate the tax multiplier for a marginal propensity to save of 0.25. Calculate the spending multiplier for a marginal propensity to save of 0.1. Calculate the tax multiplier for a marginal propensity to save of 0.8. If the spending multiplier is 7, what is the size of the tax multiplier ? If the tax multiplier is -4, what is the size of the spending multiplier ?

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Week 5 - The central bank and the money market equilibrium Learning outcomes: -

Financial markets The role of the central bank The control of money supply Modelling the money market

Reading: Chapter 4 of Blanchard (2005) Seminar material: Exercise 1: Questions on money Explain why the following statements are incorrect: 1. Money must be backed on an intrinsically valuable item. 2. The most important asset of a bank are the deposits of its customers. 3. If banks increase the money they hold as reserves, this increases the amount of money available in the economy. 4. Because they can create it from nothing, commercial banks can produce as much money as they want. Exercise 2: Banking and money Consider the following balance sheets: Bank A Assets Liabilities Reserves: 1000  Deposits: 8000  Loans: 7000 

Bank B Assets Liabilities Reserves: 600  Deposits: 6000 Loans: 5400 

1. Given a reserve ratio of 10%, how much excess reserves does Bank A hold ? 2. Is it in the bank’s interest to hold on to these excess reserves ? Explain your answer. 3. Given the reserve ratio and the size of the excess reserves, how much can it loan out to one of its customers ? To a customer of Bank B ? Explain why there is a difference. 4. Assuming the loan is made to a Bank B customer, explain how this affects Bank B’s balance sheet. How much money can Bank B now loan to its customers ? Comment on the total amount of money created from Bank A’s excess reserves. 5. Assuming we are still in the situation described by the balance sheets, one of Bank A’s customers purchases equipment worth 250  from a customer of Bank B. Can Bank A make the payment to Bank B and still meet the reserve ratio ? What does Bank A have to do to avoid this problem ?

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Week 6 - The IS-LM model Learning outcomes: -

Deriving the IS and LM curves Crowding out as a limit to the Keynesian multiplier Understanding the policy mix Limits of the IS-LM model: the problem of fixed prices

Reading: Chapter 5 of Blanchard (2005) Seminar material: Exercise 1: money market questions 1. Explain why a recession can cause the interest rates to fall, even if the central bank does not change money supply. 2. Explain why an excess money supply corresponds to an excess bond demand, and conversely why an excess supply of bonds corresponds to an excess demand for money. 3. Explain the inverse relationship between the interest rates and bond prices. 4. Using the answers given to the two previous questions, explain how the central bank can affect the interest rate through open market operations. Exercise 2: Modelling the money market Consider the following demand equations represent demand for real money balances (RMB) on the Utopian the money market: µ

M P

¶d = 1000 − 10000i + Y

¡ M ¢d 1

P

is the demand for RMB, Y is GDP and i is the normalised rate of interest (i = ⇔ 100% interest).

1. Explain what the determinants of demand for RMB are. What are the signs of these determinants ? 2. Assuming that © M the ª value of Utopian GDP is Y = 500, draw the RMB demand equation in P , i space. 3. The money supply in the Utopian economy is M s = 1000. Add this to your diagram. What is the equilibrium interest rate ? 4. The Utopian output increases to Y = 750. What happens to the demand for RMB ? Draw the new demand curve on the diagram. 5. If the objective of the Utopian central bank is to keep interest rates fixed, how does it have to modify its policy to achieve that objective ?

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Week 7 - The WS-PS model of the labour market Learning outcomes: -

The wage-setting equation The price-setting equation Equilibrium on the labour market The concept of a natural rate of unemployment The link between prices and unemployment

Reading: Chapter 6 of Blanchard (2005) Seminar material: Policy mix in the IS-LM model The following equations describe the goods and money markets of the Utopian economy:  Goods market  Z =C +I +G C = C0 + c1 (Y − T )  I = I0 + b1 Y − b2 i Parameter Value

C0 c1 150 0.5

Money market ½ ¡ M ¢s M = P¯ P ¢ ¡M d = d1 Y − d2 i P

I0 b1 b2 100 0.25 50

d1 2

d2 200

G 250

T 200

M/P 800

1. What is the equilibrium condition on the goods market ? Use it to derive the IS equation. What is the value of the spending multiplier ? 2. What is the equilibrium condition on the money market ? Use it to derive the LM equation. 3. Use LM to substitute the interest rate out of the IS equation, and solve for the equilibrium level of output Y ∗ . 4. Using the parameters provided, derive the linear functions describing IS and LM, and draw them on a diagram. 5. Using the parameters and formula you found in question 3, calculate the value of Y ∗ , then find the equilibrium interest rate i∗ (Hint : make sure the values you find correspond to your diagram). 6. Show, analytically and graphically, the effect on the equilibrium output Y ∗ and interest rate i∗ of a 75 a increase of G. What is the size of the increase in output compared to the increase in G, and how does it compare with the spending multiplier found in question 1 ? What policy should be carried out to maximise the multiplier effect ?

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Week 8 - The Phillips curve, the NAIRU, and the role of expectations Learning outcomes: -

From the WS-PS model to the phillips curve The ‘NAIRU’ definition of the natural rate of unemployment The role of inflation expectations Adaptative vs. rational expectations

Reading: Chapters 8 and 14 of Blanchard (2005) Seminar material: WS-PS excersise The wage setting curve (WS) is given by : W = P e · f (u, z) While the price-setting curve (PS) is given by : P = (1 + µ) · W 1. Explain how the WS curve predicts the macroeconomic wage level and detail its determinants. 2. Explain how the PS curve predicts the macroeconomic price level and detail its determinants. 3. As a simplification, we assume that the simplified WS curve W = P e (z − 0.05 × u) represents the wage-setting mechanism of the Utopian economy. Assuming that µ = 1/3 and z = 1, draw the WS and PS curves. 4. What is the natural rate of unemployment? Given the simplified WS curve, what is its equation ? Calculate its value. 5. On your diagram, show what happens if z increases to 1.25. What is the new value of the natural rate of unemployment ? What real life mechanisms could this increase in parameter capture ? 6. Given your answers to the two previous points, what can you conclude about the determinants of the natural rate of unemployment ? Is it fixed through time ?

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Week 9 - The AS-AD model Learning outcomes: -

Deriving the aggregate demand curve from IS-LM Deriving short run and long run aggregate supply from the phillips curve Okun’s law Supply and demand shocks in the AS-AD model

Reading: Chapters 7 of and 9-1,9-2 Blanchard (2005) Seminar material: Expectations and inflation Consider the following Phillips curve, where πt is the rate of inflation, πte is the expected rate of inflation and ut is the unemployment rate: πt = πte + 0.1 − 2ut 1. What is the structural level of unemployment in this economy ? 2. Assume that agents for no expectations on inflation, i.e. πte = 0 ∀t. At time t = 0, the economy is at the structural level of unemployment. At t = 1, the government wishes to reduce unemployment permanently to 3%. Calculate the annual rate of inflation in this economy for t = 1 to t = 10. 3. Do you think that this is this realistic ? Why ? 4. Redo question 2, but this time assume the following adaptative expectations : πte = πt−1 . 5. Is this an improvement on the initial ‘no expectations’ case ? 6. For both the ‘no expectations’ and adaptative expectations cases, plot the actual inflation and expected inflation. By comparing the two diagrams, what can you say about the systematic error made by the agents? Comment on the improvement brought by adaptative expectations.

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Week 10 - Supply side policies and labour market reform Learning outcomes: -

The rational expectations "revolution" in policy Lowering long-run inflation in the AS-AD model Lowering the natural rate of unemployment in the WS-PS model Policy analysis: Labour market reform and competition policy in France

Reading: Chapters 9-3 and 17-1 of Blanchard (2005) Seminar material: The complete AS-AD model The following system of equations represents the simplified Utopian economy: ½

Parameter Value

Y d = d0 − d1 P Y s = Yn + s1 P − s2

d0 1200

d1 s1 s2 200 100 250

Yn 700

1. Using your knowledge of the determinants of the aggregate demand (AD) curve, explain why it is a decreasing function of prices. 2. Conversely, why is the short run aggregrate supply (SRAS) curve an increasing function of prices ? 3. Draw the AD and SRAS curves in {Y, P } space (Hint : choose units of 100 for output Y ). How does one determine the LRAS ? What is it equal to here ? 4. What is the equilibrium output and inflation rate ? Is the economy in a short run or a long run equilibrium ? 5. The price of oil increases, so that the s2 parameter becomes s2 = 550. Work out how does this affect the equations in the model. Show this on the diagram. What situation is the economy in ? 6. The government wishes to use fiscal policy to address this shock. Given the state of the economy, what does it have to bring the economy back to the previous level of output ? What side-effects will this policy have ? 7. Is this conclusion the same if monetary policy is used instead ? 8. In order to minimise effects on inflation and the output gap, which curve needs to be modified ? What policies can achieve this ?

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Week 11 - Exchange rates and the Mundell-Fleming model Learning outcomes: -

Imports, exports and aggregate demand The savings-investment gap and the current accounts (Twin deficits) From IS-LM to the Mundell-Fleming model Fiscal and monetary policy under fixed and flexible exchange rates The incompatibility triangle

Reading: Chapters 19 to 21 of Blanchard (2005) Seminar material: Macro-economic policy analysis The following equation describes the phillips curve of the Utopian economy. As was the case in previous exercises, π is the rate of inflation, π e is the expected rate of inflation and u is the unemployment rate. µ is the rate of markup and z represents the strength of labour market institutions such as trade unions and unemployment benefits. We assume that expectations are formed rationally. Please note that all the percentages in this exercise are normalised. π = π e + µ + z − αu Parameter Value

µ z α 0.02 0.025 0.5

1. Does the natural rate of unemployment depend on the value of the expectations ? What is it equal to here ? 2. We assume that this economy is in a long run equilibrium, with π e = π = 0.06. Draw the long run and short run phillips curves corresponding to this equilibrium. 3. The central bank announces that it wishes to reduce long term inflation. It reduces the growth of money supply, reducing inflation from π = 0.06 to π = 0.02. Explain analytically and graphically what happens in the case where agents do not believe the central bank is committed to this target. What will the short run unemployment be equal to ? 4. Explain analytically and graphically what happens in the case where agents believe the central bank is committed to this target. In particular, explain why the timing of the policy might be important. 5. Using your answers to the previous questions, explain how this model illustrates the way monetary policy has been carried out in the last 2 decades. 6. The government finds that the long run rate of unemployment is too high compared to the desired performance of the economy, and wishes to reduce it. Is this possible using fiscal or monetary policy ? 7. Using your knowledge of the WS-PS model and the natural rate of unemployment, outline a policy that could reduce long run employment to 4%. Show this on the diagram. What side-effect does this policy have in terms of inflation, and how does this illustrate the role of coordination in policy ? 12

Week 12 - The Solow model of growth Learning outcomes: -

The stylised facts of growth Capital accumulation and steady state in the Solow model The concept of convergence The empirical side: mixed evidence

Reading: Chapters 10 to 12 of Blanchard (2005) Seminar material: Fixed exchange rates and the central bank The following equations describe the French foreign exchange market in the 1980’s, where the Franc was pegged to the Deutschmark. For simplicity, we assume that Germany is s the only commercial partner. Mtot , the aggregate money supply is composed of M s , the money supply from the banking sector and R, the foreign exchange reserves, which are used to control the exchange rate on a day to day basis. ½ s Mtot = M s + R Md = Y − d × i + ε Furthermore, capital flows between France and Germany ensure interest rate parity. ∆e corresponds to an appreciation of the Franc. i = i∗ + ∆e Parameter Value

Ms R Y d 300 100 450 10

i∗ 5

ε 0

1. Derive money demand as a function of the exchange rate variation by substituting the interest rate parity equation in the money demand equation. Using the params eter provided, draw it in {M, ∆e} space, as well as the Mtot equation. Are there any pressures on the exchange rate at equilibrium ? 2. The Bundesbank decides to increase its interest rate to i∗ = 10 in order to fight inflation. Show the effect this has on the demand for Francs. 3. What will be the effect on the interest rate if the French central bank does not react ? Given that only R can be modified to influence the exchange rate, show graphically and explain what the French central bank has to do to guarantee the fixed exchange rate. 4. Assuming that we are back at i∗ = 5, certain agents do not believe that the French central bank can guarantee the fixed exchange rate, and initiate a speculative attack which translates into a large negative shock on the exchange rate, with ε = −200. Show graphically and explain the effect on the demand for Francs. Is the French central bank able to react and guarantee the fixed exchange rate ?

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