macroeconomicsThird Edition

manfred grtner

an imprint of Front cover image: Getty Images www.pearson-books.com

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Third Edition

Macroeconomics is aimed at courses in intermediate macroeconomics, applied macroeconomics, and on the European economy.

manfred grtner is Professor of Economics at the University of St. Gallen, Switzerland.

Visit www.pearsoned.co.uk/gartner for a sophisticated, up-to-date, companion website including interactive macroeconomic models equipped with guided exercises, state of the art data analysis and display, multiple choice quizzes and more.

The third edition of Macroeconomics remains true to its guiding principle: understand and learn macroeconomic theory through applications of real-world issues and challenges facing the global economy.

Whats new

Macroeconomics of the global economic and financial crisis Recent events are a running theme in the business cycle chapters, featuring several case studies and boxes. Concepts that drifted to the edge of intermediate macroeconomics curriculums in recent years, such as liquidity traps, market psychology, risk premiums and deflation, receive renewed attention.

Monetary policy rules While the text retains its full treatment of money markets, using the LM curve, Chapter 3, Money and Interest Rates, has been thoroughly re-written to discuss the implications of monetary policy rules, such as the Taylor Rule, that many central banks have adopted. The chapter shows how the two approaches relate, offering instructors the option to emphasise one or the other in later chapters.

Extended bridge towards graduate macroeconomics The texts concluding chapters offer a bridge towards graduate macroeconomics, with Chapter 16 offering a serious introduction to the New Keynesian and Sticky Information Phillips Curves, and Chapter 17 introducing the real business cycle approach.

Glossary and notes on Nobel laureates A comprehensive Glossary of all relevant technical terms has been added to the book, as has a new appendix titled Economics Nobel prize winners and earlier giants, introducing students to the names and work of the greatest minds that have contributed to the concepts and models that form the backbone of this textbook.

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Macroeconomics

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Self-assessment questions to check your understanding, withinstant grading.

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MacroeconomicsTHIRD EDITION

Manfred GrtnerUniversity of St Gallen, Switzerland

A01_GART7904_03_SE_FM.QXD 4/8/09 3:46 PM Page iii

Pearson Education Limited

Edinburgh GateHarlowEssex CM20 2JEEngland

and Associated Companies throughout the world

Visit us on the World Wide Web at:www.pearsoned.co.uk

First published as A Primer in European Macroeconomics 1997Revised edition published as Macroeconomics 2003Second edition Macroeconomics published 2006Third edition Macroeconomics published 2009

Prentice Hall Europe 1997 Manfred Grtner 2003, 2006, 2009

The right of Manfred Grtner to be identified as author of this work has been asserted by him in accordance with the Copyright, Designs and Patents Act 1988.

All rights reserved. No part of this publication may be reproduced, stored in a retrievalsystem, or transmitted in any form or by any means, electronic, mechanical, photocopying,recording or otherwise, without either the prior written permission of the publisher or a licence permitting restricted copying in the United Kingdom issued by the Copyright Licensing Agency Ltd, Saffron House, 610 Kirby Street, London EC1N 8TS.

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ISBN: 978-0-273-71790-4

British Library Cataloguing-in-Publication DataA catalogue record for this book is available from the British Library

Library of Congress Cataloging-in-Publication DataGrtner, Manfred.Macroeconomics / Manfred Grtner. 3rd ed.

p. cm.ISBN 978-0-273-71790-41. Macroeconomics. I. Title. HB172.5.G365 2009339dc22

200900701710 9 8 7 6 5 4 3 2 112 11 10 09

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FOR DAVID, CHRIS, KAI,DENNIS AND LOU

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Guided tour of the book xivList of case studies and boxes xviPreface xixPublishers acknowledgements xxiii

1 Macroeconomic essentials 1

2 Booms and recessions (I): the Keynesian cross 34

3 Money, interest rates and the global economy 64

4 Exchange rates and the balance of payments 99

5 Booms and recessions (II): the national economy 124

6 Enter aggregate supply 150

7 Booms and recessions (III): aggregate supply and demand 181

8 Booms and recessions (IV): dynamic aggregate supply and demand 209

9 Economic growth (I): basics 240

10 Economic growth (II): advanced issues 272

11 Endogenous economic policy 306

12 The European Monetary System and Euroland at work 330

13 Inflation and central bank independence 361

14 Budget deficits and public debt 392

15 Unemployment and growth 421

16 Sticky prices and sticky information: new perspectives on booms and recessions (I) 453

17 Real business cycles: new perspectives on booms and recessions (II) 476

Appendix A: A primer in econometrics 504

Appendix B: Glossary 521

Appendix C: Economics Nobel prize winnersand earlier giants 535

Index 537

B R I E F C O N T E N T S

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Guided tour of the book xivList of case studies and boxes xviPreface xixPublishers acknowledgements xxiii

1 Macroeconomic essentials 11.1 The issues of macroeconomics 11.2 Essentials of macroeconomic accounting 71.3 Beyond accounting 21Chapter summary 26Exercises 27Recommended reading 29Appendix: Logarithms, growth rates and logarithmic scales 30

2 Booms and recessions (I): the Keynesian cross 342.1 The circular flow model revisited: terminology and overview 392.2 Income determination: a first look 442.3 Income determination: a second look 492.4 An intertemporal view of consumption and investment 52Chapter summary 59Exercises 60Recommended reading 62Applied problems 62

3 Money, interest rates and the global economy 643.1 The money market, the interest rate and the LM curve 653.2 Aggregate expenditure, the interest rate and the

exchange rate: the IS curve 773.3 The IS-LM or the global-economy model 83Chapter summary 93Exercises 94Recommended reading 96Applied problems 96

4 Exchange rates and the balance of payments 994.1 Globalization 1004.2 The exchange rate and the balance of payments 1024.3 Back to IS-LM: enter the FE curve 1064.4 Equilibrium in all three markets 114Chapter summary 119Exercises 119

C O N T E N T S

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x Contents

Recommended reading 121Applied problems 121

5 Booms and recessions (II): the national economy 1245.1 Fiscal policy in the MundellFleming model 1255.2 Monetary policy in the MundellFleming model 1285.3 The algebra of monetary and fiscal policy in the

MundellFleming model 1335.4 Comparative statics versus adjustment dynamics 1345.5 Adjustment dynamics with expected depreciation 1365.6 When prices move 1395.7 Todays exchange rate and the future 142Chapter summary 144Exercises 145Recommended reading 146Applied problems 147

6 Enter aggregate supply 1506.1 Potential income and the labour market 1516.2 Why is there unemployment in equilibrium? 1596.3 Why may actual output deviate from potential output? 173Chapter summary 176Exercises 177Recommended reading 178Applied problems 179

7 Booms and recessions (III): aggregate supply and demand 1817.1 The short-run aggregate supply curve 1827.2 The aggregate demand curve 1837.3 The AD-AS model: basics 1917.4 Policy and shocks in the AD-AS model 195Chapter summary 204Exercises 205Recommended reading 206Appendix: The algebra of the AD curve 206

8 Booms and recessions (IV): dynamic aggregate supply and demand 2098.1 The aggregate supply curve in an inflationincome diagram 2108.2 Equilibrium income and inflation: the DAD curve 2118.3 The DAD-SAS model 2128.4 Inflation expectations 2158.5 The DAD-SAS model at work 218Chapter summary 232Exercises 233Recommended reading 234Appendix: The algebra of the DAD curve 234

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Contents xi

Appendix: The genesis of the DAD-SAS model 235Applied problems 237

9 Economic growth (I): basics 2409.1 Stylized facts of income and growth 2409.2 The production function and growth accounting 2429.3 Growth theory: the Solow model 2499.4 Why incomes may differ 2519.5 What about consumption? 2549.6 Population growth and technological progress 2599.7 Empirical merits and deficiencies of the Solow model 264Chapter summary 267Exercises 268Recommended reading 269Applied problems 270

10 Economic growth (II): advanced issues 27210.1 The government in the Solow model 27310.2 Economic growth and capital markets 27610.3 Extending the Solow model and moving beyond 28410.4 Poverty traps in the Solow model 28610.5 Human capital 29010.6 Endogenous growth 294Chapter summary 299Exercises 300Recommended reading 301Appendix: A synthesis of the DAD-SAS and the Solow model 302Applied problems 302

11 Endogenous economic policy 30611.1 What do politicians want? 30611.2 Political business cycles 31011.3 Rational expectations 31411.4 Policy games 31611.5 Ways out of the time inconsistency trap 321Chapter summary 326Exercises 327Recommended reading 328Applied problems 328

12 The European Monetary System and Euroland at work 33012.1 Preliminaries 33112.2 The 1992 EMS crisis 33412.3 Exchange rate target zones 34012.4 Speculative attacks 34512.5 Monetary and fiscal policy in the euro area 348Chapter summary 354Exercises 355Recommended reading 356

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xii Contents

Appendix: The two-country MundellFleming model 356Applied problems 359

13 Inflation and central bank independence 36113.1 Inflation, central bank independence and the EMS 36213.2 Supply shocks and central bank independence 37013.3 Disinflations and the sacrifice ratio 37713.4 Lessons for European Monetary Union 385Chapter summary 387Exercises 388Recommended reading 389Applied problems 390

14 Budget deficits and public debt 39214.1 The government budget 39314.2 The dynamics of budget deficits and the public debt 39414.3 Maastricht, the budget and the central bank 40814.4 What is wrong with having deficits and debt? 41114.5 Does monetary union need budget rules? 412Chapter summary 416Exercises 417Recommended reading 418Applied problems 419

15 Unemployment and growth 42115.1 Linking unemployment and growth 42115.2 European unemployment 42415.3 Persistence in the DAD-SAS model 43915.4 Lessons, remedies and prospects 443Chapter summary 448Exercises 449Recommended reading 450Applied problems 450

16 Sticky prices and sticky information: new perspectives on booms and recessions (I) 45316.1 Reality checks: business cycle patterns and the

DAD-SAS model 45416.2 New Keynesian responses 45816.3 The Phillips curves and monetary policy rules

of current research 46316.4 Supply shocks in the DAD-SAS model 471Chapter summary 473Exercises 474Recommended reading 475

17 Real business cycles: new perspectives on booms and recessions (II) 47617.1 Real business cycle philosophy 477

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Contents xiii

17.2 A real business cycle model 47817.3 A graphical real business cycle 492Chapter summary 501Exercises 502Recommended reading 503

Appendix A: A primer in econometrics 504A.1 First task: estimating unknown parameters 505A.2 Second task: testing hypotheses 507A.3 A closer look at OLS estimation 509Appendix summary 519Exercises 520Recommended reading 520

Appendix B: Glossary 521

Appendix C: Economics Nobel prize winners and earlier giants 535

Index 537

Supporting resources

Visit www.pearsoned.co.uk/gartner to find valuable online resources.

Companion Website for students

Macroeconomic tutorials with interactive models, guided exercisesand animations, plus an interactive road map connecting key conceptsand models.

A data bank with macroeconomic time series for many countries,along with a graphing module.

Extensive links to valuable resources on the web, organized by chapter.

Self-assessment questions to check your understanding, with instantgrading.

Index cards to aid navigation of resources, plus chapter summaries,macroeconomic dictionaries in several languages, and more.

For instructors

Downloadable Instructors Manual including the solutions to chapterexercises and questions.

Downloadable PowerPoint slides of all figures and tables from thebook.

For more information please contact your local Pearson Education salesrepresentative or visit www.pearsoned.co.uk/gartner.

A01_GART7904_03_SE_FM.QXD 4/8/09 3:46 PM Page xiii

G U I D E D TO U R O F T H E B O O K

12 Macroeconomic essentials

CASE STUDY 1.1 Measuring income: gross domestic income vs gross domestic product

Income is a key variable in any economy, both asproposed in our theoretical models, and as mea-sured in reality. In our models we simply call it ag-gregate income, or output, and stick the label Yonto it. In reality, it can be measured in a numberof ways. The two most important and most fre-quently used definitions are gross domestic prod-uct (GDP) and gross national product (GNP). Grossdomestic product sums up what is being producedwithin the geographical borders of a country. Grossnational product is the term for all income receivedby the inhabitants of a country, no matter whetherit results from production at home or abroad. Thisis why it is often called gross national income (GNI)these days.

Which of these two measures of income is theproper one in a specific context depends onwhether we are modeling economic activity in ageographic region or the material well-being of agroup of people. In most models introduced in thisbook, the geographic region, say the UK, France,Europe or China, takes centre stage. Then theappropriate measure of income is GDP. In a fewinstances, though, such as when we talk about theeffects and the motives behind globalization, weneed to look at how people rather than regionsare affected, and thus cast an eye on GNP.

In the real world, the distinction between GDPand GNP is not seriously relevant for most coun-tries, as Figure 1.8 shows. In Europe, there is lessthan a handful of countries for which the differ-ence between GDP and GNP is much larger thanwhat may be attributed to measurement error. Atone end, Ireland stands out, in addition to Luxem-bourg, with a GNP that falls short of GDP by awhopping 15%. The reason is well known. By low-ering taxes aggressively in competition with otherEuropean countries for foreign capital since the1980s, Ireland succeeded in attracting foreign firmsand capital investment from abroad at a breath-taking pace. As a consequence, a substantial part ofthe Irish capital stock machines, buildings, com-puters, laboratories and more belongs to foreign-ers, or has been bought with foreign capital. Theearnings generated with this capital go to resi-dents of foreign countries, and are thus included inIrelands GDP, but not in its GNP.

The opposite applies to Switzerland. Here GNPexceeds GDP by 8%. This is because a substantial

part of Switzerlands savings has been investedabroad, in countries such as Ireland. The capital in-come generated by these investments interestearnings, dividends, rents or profits adds toSwitzerlands GNP, but is not included in its GDP.

Figure 1.9 compares the absolute levels of GDPand GNP for the selected group of countries. Themessage is that for most countries the difference isbarely visible, and we may not make a serious mis-take by using one of the measures instead of theother: say, if the other is not available. Even forSwitzerland and Ireland, the difference betweenthe two income aggregates appears less dramaticin Figure 1.9 than it did in Figure 1.8.

GNPGDP (%)

20IRL P A NL E I D GER DK GR USA F N S B JP UK CH

15

10

5

0

5

10

Gap GNPGDP, in % of GDP, 2004

Figure 1.8

0

10

20

30

40

50

Per

capi

ta in

com

e in

1,0

00 U

S do

llars

GDP

GNP

IRL P A NL E I D GER DK GR USA F N S B JP UK CH

GDP and GNP, 2004

Figure 1.9

78 Money, interest rates and the global economy

Working with graphs (part II)

I do not recommend learning the slopes of equilib-rium curves like LM by heart. Neither do I advisememorizing which factor shifts the graph whichway. As long as the economic reasoning behindsome market equilibrium is understood, slopes andshifts of curves can, in most cases, be worked outby simple thought experiments. Algebra or calcu-lus is not necessary.

For example, take the LM curve to demonstratethe nature of the thought process. Suppose youforgot how the graph slopes in the i/Y diagramand how it shifts when the money supply increases.Here is a way out.

The slope of a curve

1 Pick an arbitrary point A in the i/Y plane. As-sume that A is an equilibrium, i.e. a point on LM.(You may safely do that as, without any furtherinformation, you are free to position the LMcurve anywhere in the diagram.) See Figure 3.9.

2 Move horizontally from A to B. With i being thesame at A and B, but Y being larger at B, the de-mand for money at B is obviously higher than atA. Thus, as we are holding the money supplyconstant, B features an excess demand formoney. In other words, B is not on LM!

3 Starting from B, work out in which direction ihas to move in order to restore equilibrium. Asdemand is too high in B, i must change so as to

reduce money demand via higher opportunitycosts, i.e. it must rise. At some point such as C itwill have risen just enough to re-establish equi-librium.

4 Now that we have two points A and C on the LMcurve, we have identified the curves slope. Infact, we may draw the curve right through Aand C.

How does the curve shift?

1 As before, pick an arbitrary point A in the i/Yplane. Assume that it is an equilibrium point, i.e. it lies on LM. See Figure 3.10.

2 Assume that the money supply has been in-creased. Since the old money supply equalleddemand at A, A must now feature an excess sup-ply of money.

3 Holding i constant, work out whether Y has torise or to fall in order to raise money demandand thus re-establish equilibrium. Here the an-swer is, obviously, that Y has to rise. So thenew equilibrium point is found east of A say,at B.

4 As we could have started from any other pointon the old LM curve and obtained the samequalitative result, we may now conclude thatthe entire LM curve has shifted to the right intothe position of the new LM curve.

BOX 3.2

Inte

rest

rat

e i

Income Y

AB

C

LM curve

Supply < demand

Supply = demand

Supply = demand

Raising the interestrate re-establishesequilibrium

Raising incomecreates excessdemand

Figure 3.9

Inte

rest

rat

e i

Income Y

A B

Old LM curve

New LM curve

Supply = demand

Supply > demand

Supply = demand

Raising the moneysupply createsexcess supply atformer equilibriumpoint A

A is initially anequilibrium

Raising income raisesmoney demand;establishes newequilibrium at point B

1

2

Figure 3.10

108 Exchange rates and the balance of payments

The current account tracks net exports of goods and services. These wealready know from the above analysis of the goods market.

(4.2)

Figure 4.4, panel (a), shows the current account as a function of incomeand the interest rate. While the interest rate has no impact on the currentaccount (i is missing from equation (4.2)), CA deteriorates with a factor as income rises.

For given world income and real exchange rate, only one income level existswhich balances the current account. An algebraic expression for this is ob-tained by letting in equation (4.2) and solving for Y. This yields

Current account equilibrium (4.3)

All points that balance the current account lie on a vertical line in the plane, as shown in Figure 4.4, panel (b). As indicated in the graph, this

line shifts as its positioning parameters change. For example, if thereal exchange rate goes up, meaning that the home currency depreciates, ex-ports rise and imports fall. At the initial level of income, i.e. on the old

line, where there was by definition, we now face the dise-quilibrium situation Imports, which are too small at this new realexchange rate and the initial level of income, can only rise up to the nowhigher exports if domestic income increases. So what we need is a movementto the right to find a new current account equilibrium: after a real deprecia-tion a new equilibrium with can only be found to theright of the initial line. Therefore, a real depreciation moves the

line to the right. By analogous arguments we find that an increase inworld income moves to the right as well. The text in the white boxessummarizes these results.

CA = 0CA = 0

CA = 0CA = EX - IM = 0

EX 7 IM.EX = IMCA = 0

CA = 0

iY

Y =x1m1

YWorld +x2 + m2

m1 R

CA = 0

m1

CA K NX = EX - IM = x1YWorld + x2R - m1Y + m2R

Income Y

Currentaccountplane

Current account CA

0

(a) (b)

Interestrate i

Inte

rest

rat

e i

Income Y

CA = 0

Currentaccountdeficit

Currentaccountsurplus

Line shifts left as

Here the current accountis balanced (CA = 0)

R

Yworld

Line shifts right asRYworld

Figure 4.4 The current account worsens as rising income raises imports. The interest rate does not affect CA. The cur-rent account equilibrium line, therefore, projects as a vertical line onto the iY plane. An exchange rate depreciationor a rise in world income moves the CA plane up, shifting the CA 0 line to the right.

Note. Economists rarelywork with 3D graphs. Theyare used here and below toshow where the 2D graphson the right of Figure 4.4come from. If you have noproblem understanding the2D graph you can ignore the3D version.

Maths note. One euroinvested at home growsto (1 + i ) euro after oneperiod. If invested abroad it grows to (1 + iWorld)(1 + (Ee+1 E)>E ).Setting this equal to (1 + i )and subtracting 1 from bothsides gives interest parity as

Equation (4.4) simplifies thisby ignoring the involvedexchange rate gain on theinterest payment, which issmall under normalcircumstances.

+ i World E e+1 - E

E

i = i World +E e+1 - E

E

What to expectBullet points at thestart of each chaptershow what the readercan expect to learn,and highlight the corecoverage.

Key termsKey terms and conceptsin each chapter arehighlighted in colour,with definitions in themargin.

Case studiesEvery chapter contains one or more case studies that applycore concepts to recent experiences in Europe and in otherparts of the world.

BoxesBoxes in each chapterpresent useful guidanceto the reader and illus-trate the concepts.

Margin notesHelpful tips and guidance appear in the margins, giving mathsreminders, examples, rules, empirical notes and reality checks.

Enter aggregate supply

After working through this chapter, you will understand:

1 In more detail the meaning of potential income or output.2 How wages and employment are determined in the labour market.3 How regulations, trade unions, and other labour market characteris-

tics, or demographic features, may give rise to involuntary unemploy-ment which persists in the long run.

4 Why aggregate output produced by firms may temporarily exceed orfall short of the level of potential output produced in equilibrium (orthe long run).

What to expect

By now we have a good understanding of aggregate demand: that is, of whathappens on the economys demand side. This contrasts with our understand-ing of aggregate supply, the treatment of which so far has been, well, rathersimplistic. The only time we have explicitly touched upon the issue of firmslevel of output was when we discussed money in the circular flow model inChapter 1. There we considered two extreme cases of the aggregate supply(AS) curve, the line that indicates how much output firms produce at differ-ent price levels. For easy reference, Figure 6.1 replicates these two versions.The horizontal aggregate supply curve shown in panel (a) is the one we em-ployed in Chapters 25 in the context of the Keynesian cross, the IS-LMmodel and the MundellFleming model. It is usually referred to as theextreme Keynesian aggregate supply curve. It assumes there is slack and thepresence of one or more production factors in abundance. Then how muchfirms produce depends only on demand. At the given price level, firms supplyany level of output that is demanded. But then the price level never changes!How does this correspond with the real world where continuous pricechanges in the form of inflation are the rule rather than an exception? Quiteobviously, a horizontal aggregate supply curve cannot be the whole story.

Panel (b) in Figure 6.1 shows a vertical aggregate supply curve. Firms sup-ply potential output Y* no matter what the price level is. This curve is gener-ally referred to as the classical aggregate supply curve, for reasons that willbecome evident in a moment. The drawback here is that, unless we assumethat the AS curve shifts backwards and forwards all the time, only priceschange, but never income. This is clearly at odds with real-world observationsof business cycles, evidence of which was presented in Chapter 2. Again, avertical aggregate supply curve cannot be the whole story either.

C H A P T E R 6

The extreme Keynesianaggregate supply curve ishorizontal, stating that, at thecurrent price, firms are readyto produce any output thatis demanded. A refinedKeynesian aggregate supplycurve will be introduced later.

The aggregate supply curveshows the total quantity ofgoods and services supplied byall firms in the economy atdifferent price levels.

The classical aggregatesupply curve is vertical,stating that firms produce onlyone output Y*, no matter howhigh prices are.

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Chapter summary 59

CHAPTER SUMMARY

A countrys income at a given point in time is determined by the steady-state level of income, the deviation of potential income from steady-stateincome, and the deviation of income from potential income. The latter iscalled the business cycle.

In the circular flow model there exists one equilibrium level of income atwhich actual spending is exactly as planned. What sets this level of incomeapart from all other feasible income levels is that firms will try to set pro-duction to this very level to avoid having to invest or disinvest involuntarily.

An increase in autonomous expenditure, such as government purchases,generates an income increase that may vastly exceed the original stimulus.This multiplier effect occurs because the exogenous spending increase raisesincome and thus induces consumers to spend more and raise income evenhigher.

When the multiplier is large, small changes in government expenditure orother autonomous injections or leakages may cause sizeable booms orrecessions.

Factors that reduce the size of the multiplier are high marginal income taxrates and a high marginal propensity to import.

Consumption does not depend on current income only, but, more impor-tantly, on expected future income.

Multiplier effects apply fully only if consumers consider observed incomechanges to be permanent.

The multiplier becomes much smaller if observed income changes are con-sidered transitory.

Investment rises when expected future income rises and/or when the interestrate falls.

actual expenditure 40aggregate (planned) expenditure 40average income tax rate 49boom 35business cycle 35capital costs 56consumption function 49disposable income 49equilibrium income 47government purchases 43import function 49

Keynesian cross 45marginal income tax rate 49marginal propensity to consume 44multiplier 48net taxes 43permanent income 58potential income 35rate of return 56recession 35steady-state income 35transitory income 58

Key terms and concepts

60 Booms and recessions (I)

France

6,000

2,000

4,000

1900 1910 1920 1940

Real

GD

P

19601930 1950 1970 1980 1990

Figure 2.19

EXERCISES

2.1 Consider French real output between 1900 and1991 as given in Figure 2.19.Add your guess of the paths of steady-stateincome and potential income to the graph.

Two US economists, Arthur F. Burns and WesleyC. Mitchell, claimed half a century ago that thetypical business cycle lasts between six and thirty-two quarters.(c) Does this agree with your findings?

2.3 Consider an economy with the following data(note that I is planned investment, which maynot coincide with actual investment):

(a) Is this economys circular flow in equilibriumin the sense that firms do not have tochange inventories involuntarily?

(b) Translate the above data into a diagram withdemand on the vertical axis and income onthe horizontal axis.

Add the assumption .(c) Draw the aggregate-expenditure and

the actual-expenditure lines. Identifydemand-determined income in equilibriumin your graph and analytically.

(d) What happens to equilibrium income ifgovernment expenditure increases by 500units? Show your result in a graph and verifythat it is supported by the multiplier formulaof equation (2.9).

(e) Using a graph, show what happens if netexports fall from 250 to 100.

C = 0.75Y

NX = 250 Y = 1,000C = 750 I = 500 T = 0 G = 250

2.2 Figure 2.20 displays the evolution of real GDPbetween 1978 and 2002 for the United Statesand France.(a) Try to identify business cycles, marking peaks

and troughs on the graphs.(b) Identify the US position in 1991 in a diagram

with prices on the vertical axis and income onthe horizontal axis. Mark potential income,steady-state income and actual income.

4,000

7,000

Real

GD

P (b

illio

ns o

f U

S$)

6,000

5,000

8,000

9,000

10,000

1980 1984 1988 1992 1996 2000

Real

GD

P (b

illio

ns o

f FF

)

1980 1984 1988 1992 1996 2000

United States

4,000

7,000

6,000

5,000

8,000

9,000

10,000France

Figure 2.20

328 Endogenous economic policy

Models of political business cycles are surveyed inManfred Grtner (1994) Democracy, elections, andmacroeconomic policy: Two decades of progress,European Journal of Political Economy 10: 85109.

The empirical evidence is reviewed in Bruno S. Freyand Friedrich Schneider (1988) Politico-economicmodels of macroeconomic policy: A review of the em-pirical evidence, in Thomas D. Willett (ed.) Political

Business Cycles: The Political Economy of Money,Inflation, and Unemployment, Durham and London:Duke University Press, pp. 23975.

Applications to US presidential elections are dis-cussed in Ray C. Fair (1996) Econometrics andpresidential elections, Journal of Economic Perspec-tives 10(3): 89102.

Recommended reading

RECENT RESEARCH

The economy and US presidential elections

Ray C. Fair (1996, Econometrics and presidentialelections, Journal of Economic Perspectives 10(3):89102) offers a non-technical update of earlier

efforts to explain the Democratic Partys share byeconomic variables and what he calls incumbencyvariables. His new equation reads as follows:

APPLIED PROBLEMS

The economic variables highlighted in the equationall have a significant influence on the incumbentsre-election prospects: if income growth speeds up by 1 percentage point, his vote share rises by 0.65 percentage points. If inflation moves up by 1 percentage point, his vote share falls by 0.83 percentage points. There is an added bonus tohigh income growth. For each quarter in which itexceeds 2.9%, which represents good news, the voteshare rises by 0.99 percentage points. The equationexplains 96% of the variation in the DemocraticPartys vote share. It predicts the winner in 17 out ofthe 20 presidential elections since 1916 correctly. The

use of the I dummy variable serves to turn effects onthe Democratic vote share around when a Republicanholds the presidency. The d dummy variable serves tosever the link between inflation and good news, andthe vote during the world wars.

WORKED PROBLEM

Who wanted the euro? (part I)

Journalists and politicians closely monitored publicattitudes towards the single European currency.Table 11.3 gives the result of one such opinion poll

Endogenous variables:V Democratic Partys share of the two-party vote

Exogenous variables:Variable Coefficient t-value Explanationcnst. 0.468 (90.62) constantI -0.034 (1.26) Democrats are in White House (I = 1); Republicans are in White House (I = -1)I * d 0.047 (2.09) d = 1 if world war went on during last 15 quarters; else d = 0g3 * I 0.0065 (8.03) income growth during last 3 quarters (g3)p15 * I * (1 - d) -0.0083 (3.40) inflation during last 15 quarters (p15)n * I * (1 - d) 0.0099 (4.46) number of last 15 quarters with good news (meaning g 7 2.9).DPER 0.052 (4.58) Democratic President is running (DPER = 1);

Republican President is running (DPER = -1)DUR -0.024 (2.23) number of consecutive terms in office by incumbent party (negative for

Republicans)

R2 = 0.96; 20 presidential elections 191692

Applied problems 63

consumption almost perfectly. The marginal propen-sity to consume is found to be 0.71. The t-statistic of486.5 renders this coefficient highly significant.

It can be argued that parts of consumption spend-ing cannot be adjusted to changing income immedi-ately: your summer vacation that has been bookedsince the previous autumn; high car maintenancecosts that can only be reduced by selling the car at aloss; your second daughter who insists on takingballet lessons just like her older sister, and so on. Toallow for such adjustment lags we may suppose thatonly desired consumption C* is related to income,that is . If desired consumptiondrifts away from actual consumption, the responseof actual consumption only closes a fraction a of thisgap. Formally we may write .Substituting the above explanation of desired con-sumption for in the partial adjustment equationyields . Estimatingthis equation yields

The autoregressive coefficient (the one in front of) carries a t-statistic of 6.31, render-

ing it highly significant. The coefficient of disposableincome is also significant, but smaller than in our firstestimate above. Note, however, that it represents theproduct . Since is estimated at 0.78, we maycompute , which barely differsfrom the previous estimate. So while the long-run

c1 = 0.57>0.78 = 0.73aac1

0.22 = 1 - aC-1

R 2 = 0.999 Annual data 196191

(3.07) (6.31) (25.10)C = -1,830.6 + 0.22C -1 + 0.57(Y - T )

C = ac0 + (1 - a)C-1 + ac1(Y - T )C*

C - C-1 = a(C* - C-1)

C* = c0 + c1(Y - T)

Table 2.4

Year C Year C Year C

1960 14,561 22,520 1971 43,660 65,960 1982 335,448 475,2051961 15,919 25,151 1972 47,951 72,136 1983 387,170 553,1291962 17,967 28,215 1973 58,484 86,914 1984 443,268 634,6821963 21,017 32,109 1974 73,637 108,296 1985 498,048 706,2801964 22,784 34,988 1975 85,972 120,875 1986 551,868 782,3651965 24,366 37,708 1976 106,383 153,198 1987 606,889 858,3481966 26,873 40,973 1977 129,209 187,982 1988 670,883 953,4391967 29,767 45,192 1978 150,848 222,825 1989 740,267 1,037,6471968 31,762 49,082 1979 185,051 275,473 1990 806,593 1,137,2301969 34,838 54,302 1980 236,603 344,912 1991 881,171 1,231,5581970 39,992 60,652 1981 284,030 406,106

Y - TY - TY - T

marginal propensity to consume is the same asestimated above, the short-run effect is smaller. Ifdisposable income increases by 100,000L, consump-tion immediately goes up by 57,000L. This is not theend, however. One period later, consumption goes upby another , one period laterby another , and soon. So while the partial adjustment version of theconsumption function estimates the same overallresponse of consumption as the simple version, it sug-gests that the response is spread over a longer spanof time.

YOUR TURN

Consumption function in first differences

One thing to note in the above study of Italian con-sumption functions is that both consumption and dis-posable income show a clear upward trend duringthe thirty-one years considered here. This can be aproblem. Regressing two heavily trended variableson each other may give a statistically significant re-sult, although the two have nothing to do with eachother (a classic example is the negative correlationbetween the number of telephones and the numberof storks during the first half of the 20th century). In an attempt to alleviate this problem we maycompute first differences on both sides of the con-sumption function to obtain . Pleasecheck whether this formulation is supported by thedata.

C = c1(Y - T )

0.22 * 0.22 * 57,000 = 2,758.8L0.22 * 57,000 = 12,540L

To explore this chapters key messages further you are encouraged to use theinteractive online module found at

www.pearsoned.co.uk/gartner

Chapter summaryEach chapter ends with a bullet-pointsummary which highlights the materialcovered in the chapter and can be used asa quick reminder of the main issues.

Key terms and conceptsA list at the end of eachchapter of all the keyterms and concepts, forquick reference.

ExercisesExercises at the end of each chapter aregeared towards the chapters central ideasand consolidate the acquired knowledge.

Applied problemsThese optional problems show students howintermediate statistical skills may be appliedto the study of macroeconomics, and en-courage them to try for themselves.

Recommended readingEach chapter is supportedby an annotated recom-mended reading section,directing the reader to ad-ditional printed and elec-tronic sources in order togain an alternative per-spective, or to pursue atopic in more depth.

Companion website referencesA web reference is given at the end of eachchapter, guiding the student to useful andrelevant interactive resources on the companionwebsite to support their learning.

Guided tour of the book xv

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Case studies

1.1 Measuring income: gross domestic income vs gross domestic product 12

1.2 Central banks and the beginning subprime mortgage crisis of 200708 16

2.1 Income vs leisure time in France and the USA 432.2 How to pay for the war: Great Britain in 1940 513.1 Policy options during the financial crisis of 2008 904.1 Italys current account before and after the 1992 EMS crisis 1095.1 The 1998 Asia crisis 1316.1 Fords focus: an experiment in efficiency wages 1707.1 International evidence on the quantity equation and the

AD curve 1987.2 AD-AS in crises 2038.1 Deflation: inflations ugly sister 2238.2 Quantity equation, Fisher equation and purchasing power

parity: international evidence 2309.1 Growth accounting in Thailand 2489.2 Income in Eastern Europe during transition 2539.3 Income and leisure choices in the OECD countries 262

10.1 National incomes during the Second World War, east and west of the Atlantic 277

11.1 Elections and the economy 30911.2 Who wanted the euro? The role of past inflations 32512.1 German unification as a tug of war 33613.1 New Zealands Reserve Bank Act: a case from down under 36414.1 The rise and fall of Irelands public debt 40414.2 Who wanted the euro? The role of government debt 41014.3 Lessons from the BelgiumLuxembourg monetary union 41515.1 US vs European job growth: cutting the miracle to size 44416.1 The Canadian business cycle 45717.1 Technology change in Malaysia: the return of the Solow residual 496

Boxes

1.1 GDP as a measure of total output or income 61.2 Working with graphs (part I) 242.1 Actual income, potential income and steady-state income:

Great Britain in 1933 382.2 Big stock market crashes 553.1 Money and monetary policy 703.2 Working with graphs (part II) 783.3 Exchange rates 81

L I S T O F C A S E S T U D I E S A N D B OX E S

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List of case studies and boxes xvii

3.4 Money supply vs interest control in a changing world 874.1 Traditional vs new balance of payments terminology 1054.2 Forecasting the US dollar in 2004: an exercise in

predicting exchange rates 1124.3 Interest rates, default risk and the risk premium 1144.4 The IS-LM-FE model in a different dress 1174.5 Endogenous and exogenous variables 1175.1 The MundellFleming model under capital controls 1288.1 How to solve rational expectations models 2259.1 The mathematics of the CobbDouglas production function 247

10.1 An illustration of the income and distribution effects of globalization 282

10.2 Labour efficiency vs human capital: an example 29411.1 Political business cycle mathematics 31311.2 From the political business cycle to the inflation bias 32012.1 Convergence criteria in the Maastricht Treaty 34012.2 The Stability and Growth Pact 35214.1 Seignorage vs inflation tax revenue 40716.1 The mathematics of the New Keynesian Phillips curve 46517.1 A pocket guide to the history of macroeconomic thought 498A.1 The coefficient of determination: R2 513

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What makes this book unique?

This text reverses the usual priorities in intermediate macroeconomics instruc-tion. Here, the ultimate goal is not to simply to teach general macroeconomictheories, models and concepts, with real-world applications thrown in formotivation and excitement; rather, students work through this book towardsan understanding of the macroeconomic issues and challenges facing theglobal economy and individual countries. Macroeconomic concepts are taughtonly as they serve this end.

What is new in the third edition?

Whenever possible, graphs, tables and information in general were updated.Countless explanations have been improved, case studies brought up to dateor replaced, and new exercises added. Beyond that, major innovations in thisnew edition are:

The macroeconomics of the global economic crisis The third edition wasbeing prepared while this millenniums first global economic crisis, indis-putably the harshest in generations, unfolded and gained momentum. In theSpring of 2009, the jury is still out on how far incomes will plummet andhow long the downturn may last. But as experts in many trades are tryingto come to grips with what has happened, and what is yet to come, it isbecoming increasingly clear that current events will have a lasting impact onhow we teach macroeconomics. Curriculums will not have to be scrapped.Textbooks will not have to be rewritten. But the startling speed at whichdemand and employment are receding, and the sheer magnitude of change,has gravely tarnished belief in the self-healing power of the markets. Thiscalls for a revitalized interest in what can go wrong in financial and goodsmarkets, and when and how the government should step in to augment pri-vate demand when it is lacking. Acknowledging this, the texts business cyclechapters use the events of 20082009 very much as a running theme thatfeatures in several Case Studies and Boxes. Key concepts that are given newemphasis concepts that had drifted to the edge of, or even off the radar of,intermediate macroeconomics curriculums in recent decades are liquiditytraps, market psychology and risk premiums in various guises. A related con-cept that must be taken seriously, and makes an appearance, is deflation,with all the negative repercussions it may generate for the real economy.

Monetary policy rules While the text retains its full treatment of moneymarkets, where supply and demand interact in an explicit fashion andmatch on the LM curve, it now acknowledges that recent years have seenmany central banks adopt monetary policy rules. Chapter 3 has been thor-oughly rewritten to lay out in detail how the two approaches are related,

P R E FA C E

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xx Preface

thus offering instructors the option to emphasize one or the other in laterchapters.

An extended bridge towards graduate macroeconomics Oftentimes, studentsstruggle with the gap between what they learned in intermediate macroeco-nomics and the models that graduate macroeconomics rely upon. The textsconcluding chapters try to bridge this gap, with Chapter 16 offering a seri-ous introduction to the New Keynesian and Sticky Information PhillipsCurves, and Chapter 17 introducing the real business cycle approach. Herealso, empirical facts taken from current research are evaluated to explainthese concepts. Nevertheless, these chapters do stray from the books guid-ing philosophy, in that they focus on theory more than on issues. And sincethey include the books most demanding sections, they may certainly beskipped in courses where a majority of students do not plan to proceed tograduate school.

Glossary and notes on Nobel laureates In order to spare students the effortof searching for explanations in the main text, a comprehensive Glossary ofall relevant technical terms has been appended to the book. Another newAppendix, Economics Nobel prize winners and earlier giants, introducesstudents to the names and work of the greatest minds that have contributedto the concepts and models that form the backbone of this textbook.

Content

The texts main body comprises 17 chapters. Chapters 19 are fairly conven-tional in content, amounting to a streamlined, no-frills introduction to themacroeconomic concepts that are useful for discussion of contemporarymacroeconomic issues in the world economies. Essential macroeconomic con-cepts are introduced in the context of the circular-flow-of-income model. Stu-dents are then led via the Keynesian cross, the IS-LM, the MundellFlemingmodel and the aggregate demand-aggregate supply model to a fully dynamicaggregate demand-aggregate supply framework for analysing short- andmedium-term macroeconomic issues. Chapters on the supply-side topics ofunemployment and growth round out this predictable set of tools.

Chapters 10 and 11 extend the toolbox into areas that most intermediatemacroeconomics textbooks barely mention in passing. The first refines andextends the Solow growth model (introduced in Chapter 9) for a discussionof human capital and poverty traps, and concludes with a first glimpse atendogenous growth. Under the heading Endogenous economic policy, Chap-ter 11 then shows that politicians may steer the economy along courses notconsidered desirable from societys point of view, and discusses how institu-tions should be structured to reduce this risk.

Chapters 1215 explore issues at the heart of European and global mone-tary and economic integration. All major topics are addressed in these chap-ters: inflation, monetary unions, budget deficits and the public debt, andunemployment.

Chapters 16 and 17, thoroughly expanded for the third edition, offer asneak preview of what students might expect in macroeconomics courses atthe Masters level. They also make a serious effort to motivate students andexplain why current macroeconomic research has moved beyond the work-horse models of intermediate macroeconomics to study the potential of

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Preface xxi

macroeconomics models with explicit microfoundations of the real-business-cycle mould, or with sticky prices and information. To this end, stu-dents learn about the co-movement of macroeconomic variables, and whysticky prices or sticky information may perform better than sticky wages inexplaining empirically observed patterns. They also grasp the intuition behindreal-business-cycle dynamics, without the elaborate formal apparatus thatusually comes with it.

Learning features

The book has a user-friendly design, featuring margin notes and definitionsthat emphasize important concepts. Exercises geared towards each chapterscentral ideas consolidate the acquired knowledge. An extensive and innova-tive use of graphs facilitates access and enhances learning success. Every chap-ter contains one or more Case Studies that apply core concepts to recentexperiences in Europe and in other parts of the world. And all chapters featurelinks to our elaborate online material that includes interactive graphical ver-sions of the books key models, guided exercises, online tests, macroeconomicdata, and much more.

What courses does the book accommodate?

The organization of the book gives instructors various options:

Primarily, the text is designed for courses in undergraduate or intermediatemacroeconomics that on the one hand insist on providing a sound theoreti-cal foundation, but on the other also want to make a point of emphasizingapplications in the form of Case Studies or even, if so desired, elementarystatistical work.

The books first half can also be used for a self-contained short course inmacroeconomic theory whenever time does not permit working through avoluminous 600900-page macroeconomics text which has become thestandard.

Also, the book readily accommodates courses in Economic policy andApplied macroeconomics. Such courses may be organized around an appro-priate selection from the several dozen Case Studies and empirical applica-tions. Conveniently, as deemed necessary, students can be referred to therequired theoretical tools in the same textbook.

Finally, the book accommodates European studies courses that can be or-ganized around the applied topics discussed in Chapters 1215. Here also,should it be necessary to freshen up or expand previously acquired theoret-ical knowledge, such material is readily available in the same textbook.

Prerequisites

Ideally, students should approach this book with a Principles of economics courseunder their belt. The formal mathematical requirements are mild: anythingclose to the most basic mathematics training in high school should do. In fact,most of the formal manipulations are optional and either shown in marginnotes or in separate sections that supplement graphical arguments.

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xxii Preface

I am quite confident, though, that the book can also be adopted and usedsuccessfully if a principles course is missing and algebraic manipulations areavoided altogether. Dozens of Case Studies, some brief, some rather elaborate,provide ample ammunition for keeping up motivation, and the big payoffwaits in the later chapters of the book.

Finally, and though it may sound frivolous: I believe that the book is evensuited for self-study. The acquired knowledge will definitely be more fragileand lack depth compared with what can be achieved under the guidance of anexperienced instructor. But it should provide an up-to-date first foundationfor informed discussion of todays national and global macroeconomic issues.

Acknowledgements

This brings me to the people I want to thank for their contributions to what-ever merits this text may have. In the very first place, these are my students,who amaze me time and again. Most of all, teaching teaches the teacher. Stu-dents questions and curiosity constantly force me to refine explanations, andin the process very often make me understand things better myself.

It has been a joy to work with the professionals at Pearson Education, towhom I owe a big thank you. They helped and guided me, with unmatchedskill and great patience, in preparing this thoroughly extended third edition,and brought the book into its final shape: Georgina Clark-Mazo (senior editor),Linda Dhondy (proofreader), Pauline Gillett (editorial administrator), RobinLupton (editorial assistant), Ellen Morgan (acquisitions editor) and ChrisBessant (copy editor).

More than any other book of mine, this one would not even be close to whatit is without the talents and the enthusiasm of the people working with me at theUniversity of St. Gallens Institute of Economics. This new edition owes morethan I can express to Susanne Burri. She updated numerous graphs and tables,often with data for more than a dozen countries, scrutinized Exercises and CaseStudies, prepared most of the new Glossary, and, playing the devils advocate,challenging me on virtually everything I say between the front and the back cover.In the course of joint teaching ventures based on this textbook, Florian Jung of-fered criticism and many constructive suggestions that improved this edition. Healso accepted the responsibility for proofreading along with Pascal Bischof,Hanna Kpper, Bjrn Griesbach, Andreas Kleiner and Thomas Seiler. Frode Bre-vik performed the simulations reported in Chapter 17. And the interactive onlinematerial that augments the textbook continued to grow and shine thanks to theprogramming magic of Christian Busch and the maths skills of Frode Brevik. Iam deeply indebted to all of them; and to Gudrun Forster, for unparalleled ad-ministrative support and her eye for the big and the little things that contribute toa work atmosphere which helps us all deliver our very best.

I have also benefitted from the reviews commissioned by Pearson Educa-tion. Both those that offered applause and encouragement, and those thatwere more reserved, helped shape the book into a better teaching tool.

The mere writing of a textbook may mostly happen at the desk. But theenthusiasm, the creativity and the discipline that are essential for such a projectcome from beyond office doors. In this respect I owe much more to my wifeLouise and to our sons Dennis, Kai, Chris and David than they can possiblyknow.

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P U B L I S H E R S A C K N O W L E D G E M E N T S

We are grateful to the following for permission to reproduce copyright material:

Figure 9.2 from Penn World Tables, Figure 6.2; Figure 9.6 and Figure 12.1 fromEconomics, 1st edn, Prentice Hall Europe (K Case, R. Fair, M. Grtner andK. Heather 1999) Pearson Education Ltd; Figure 15.9 from Trade Unions inWestern Europe since 1945, 1st edn, Macmillan: New York (Ebbinghaus andVissner 2000) Macmillan; Figure 15.12 from http://www.wtrg.com/oil_graphs/oilprice1869.gif.

In some instances we have been unable to trace the owners of copyright mate-rial, and we would appreciate any information that would enable us to do so.

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Macroeconomic essentials

After working through this warm-up chapter, you will know:

1 What macroeconomics is all about, and how it relates to microeconomics.2 All you need to know about national income accounting, including

government budgets and the balance of payments.

3 What the circular flow model is, how to use it and what its limitationsare.

4 How money fits into the macroeconomy.5 Why economists need to use models, and why these simplified pictures

of the real world are useful.

6 How to work with graphs.

What to expect

1.1 The issues of macroeconomics

Economics is about how people use time and tools to produce what otherpeople want to buy and about the sometimes intricate choices that must bemade and the things that can go wrong.

The two major subdisciplines of economics are microeconomics and macro-economics. Microeconomics looks in great detail at how individuals makechoices as consumers, as employees, as entrepreneurs, as investors, or evenas politicians. Macroeconomics looks at the big picture, at the way things areand how they develop after we add everything up, in the whole economy or inlarge segments or sectors of the economy. Of course, microeconomics andmacroeconomics cannot lead separate lives. What happens in the macroecon-omy must be the result of all the individual decisions analysed and explainedin microeconomics. This is why the search for the microfoundations of macro-economics ranks high on todays research agenda. However, to model all thechoices of millions of different people and show how they interact to generatespecific macroeconomic outcomes is simply not feasible. It probably never willbe. Inevitably, at some point we have to resort to simplifications or abstractions:either by assuming, say, that all individuals are alike, which is what so-calledrepresentative agents models of the macroeconomy do; or by postulating rela-tionships between macroeconomic variables which are ad hoc in the sense thatthey only proxy the outcomes of individual choices, but nevertheless seem towork well in many real-world situations.

C H A P T E R 1

Microeconomics studiesindividual entities such asconsumers or firms.

Macroeconomics studies thewhole economy from a birds-eye perspective.

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2 Macroeconomic essentials

Key$905 or lessIncome brackets: $906$3,595 $3,596$11,115 $11,116 or more

19 out of the last 24 winnersof US presidential electionswere predicted by the stateof the economy

Income in many sub-Saharan countries isonly 2% of what it is inthe worlds rich countries

The economies of Chinaand India grow some10% each year. At suchrates, income doubles inabout seven years

New Zealands central bankgovernor is to be fired ifinflation exceeds 2%

1 out of 10Europeans isout of work

20% of Braziliansreceive 70% ofBrazils income

Figure 1.1 The map shows the huge differences that exist in the per capita incomes of the worlds nations in 2006.Other important macroeconomic variables and issues are reported in boxes: economic growth, unemployment,inflation, the distribution of income and the close link between the economy and politics.

Source: World Bank Key Statistics Online.

The foremost single measure of how an economy performs is the aggregatelevel of income. Presenting the world at a glance, Figure 1.1 gives an overview ofthis variable by classifying countries according to income per capita, which istotal income divided by population. Huge differences in per capita incomesexist. At the high end are the industrialized countries with annual incomes perhead of $20,000 to $50,000. Lowest are a number of countries in sub-SaharanAfrica with average annual per capita incomes of barely $100. To make mattersworse, the worlds poorest countries do not seem to be growing very much if atall. In stark contrast, the Asian tigers Hong Kong, Singapore, South Koreaand Taiwan have been growing at or near double-digit percentage ratesthroughout the 1980s and much of the 1990s. Other Asian nations, China andIndia most notably, by far the worlds most populous nations, seem poised tocopy this miracle. At such growth rates, incomes double in less than ten years.

Incomes given in Figure 1.1 are nominal incomes, i.e. incomes expressed incurrency (here US dollars) at current prices. If you want to compare incomesbetween countries, nominal incomes may not be the best data to look at.Neither should we rely on nominal income as an indicator of how a countrysincome evolved over time.

Measuring income growth over time in a single country is the simpler prob-lem. Note that nominal income is prices P times real income Y, that is .Now consider that US nominal income per capita grew by 22% from

in 2002 to in 2006. This does notnecessarily mean that US citizens could buy 22% more goods and services in

P2006 * Y2006 = $44,155Y2002 = $36,126P2002 *P * Y

Income is revenue derivedfrom work and assets, such aswages, interest, dividends andprofits.

Rule of 72. As a rule ofthumb, divide 72 by theannual income growth rate(in per cent) to learn in howmany years income doubles.Example: 72/9 8.

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1.1 The issues of macroeconomics 3

Table 1.1 Nominal and real income in 2006. The second column shows nominal income.Because prices differ substantially between countries (third column), real income, the amountof goods that income can buy, turns out quite differently, as shown in the fourth column.

2006 than they could in 2002. Possibly, the increase in nominal income mighthave been entirely due to a 22% rise in prices, with no real improvements in thepurchasing power of US incomes at all. Of course, this has not really been thecase. In fact, US prices rose by 12% from an index value of, say, 1 in 2002 to1.12 in 2006. To obtain 2006 real income (expressed in 2002 prices), we need todivide 2006 nominal income by the 2006 price level and multiply by 2002prices: .So while nominal income rose by 22%, real income grew by only 9%.

Similar issues, with one added complication, arise when comparing incomesbetween countries. Noting that per capita income in 2006 was $39,424 in theUnited States but $48,080 in Switzerland would only permit a meaningfulcomparison of purchasing power if one dollar bought the same in Switzerland asin the United States. Although $10.23 buys four Big Macs at $3.41 each in theUnited States, you need $15.60 to buy the same (at $5.20 each) in Switzerland.This price difference may have two causes: at 6.30 Swiss francs Big Macs maysimply be expensive in local currency; or the dollar may be undervalued, mean-ing it takes too many dollars to buy a Swiss franc. Our current knowledge doesnot put us in a position to sort this out. All we know is that a dollar buysfewer Big Macs in Switzerland than in the United States, and that we need totake this into account when comparing Swiss income to US income.

Table 1.1 summarizes our Big Mac example. Column 2 shows that in 2006nominal income per capita in Switzerland was almost $10,000 higher than inthe United States. In Poland it was less than a fifth of Switzerlands. Taking intoaccount the level of prices relative to the United States, the picture changessubstantially. In Switzerland, $48,080 buys what only $36,522 buys in theUnited States. So Switzerlands real income per capita is slightly lower thanAmericas. Prices in Poland are a little more than half as high as in the UnitedStates, and some 40% of what they are in Switzerland. Therefore, in terms ofreal income, Poland performs much better than it seems to perform in terms ofnominal income.

A statistical average, which is what income per capita is, is one thing. Theactual distribution of income may be quite another story. In Brazil, to give oneexample, the richest 20% of the population earn more than 60% of the nationsaggregate income. The poorest 20% earn as little as 3%. In Europe, high aver-age incomes conceal that almost one in ten of those who want to work do notfind a job. Good unemployment insurance and social security have so far pre-vented high unemployment from showing up in a deteriorating distribution ofincome. But welfare states are struggling and are quickly scaling down the roleof the government.

Y2006 = (P2006 * Y2006)>P2006 * P2002 = 44,155>1.12 * 1 = $39,424

Empirical note. World-widethe richest countries, with15% of the population,make some 80% of worldincome. The poorestcountries, with 57% of thepopulation, make 5% ofworld income.

Nominal income (per capita, in $) PY

Real income (in US purchasing power)Y

Price level (relative to US price level) P

Poland 8,182 0.58 14,221Switzerland 48,080 1.32 36,522United States 39,424 1 39,424

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4 Macroeconomic essentials

Netherlands NLPopulation 16.4 millionPer capita GNP 34,118Unemployment 3.2%Inflation 1.6%

European Union EUPopulation 495.09 millionPer capita GNP 24,854Unemployment 7.1%Inflation 2.3%

Portugal PPopulation 10.6 millionPer capita GNP 15,354Unemployment 8.0%Inflation 2.4%

KeyMembers of the European Union

United Kingdom UKPopulation 60.8 millionPer capita GNP 33,204Unemployment 5.3%Inflation 2.3%

Norway NPopulation 4.7 millionPer capita GNP 60,427Unemployment 2.6%Inflation 0.7%

Spain EPopulation 44.5 millionPer capita GNP 23,592Unemployment 8.3%Inflation 2.8%

Austria APopulation 8.3 millionPer capita GNP 32,631Unemployment 4.4%Inflation 2.2%

Greece GRPopulation 11.2 millionPer capita GNP 20,442Unemployment 8.3%Inflation 3.0%

Switzerland CHPopulation 7.5 millionPer capita GNP 41,329Unemployment 2.6%Inflation 0.8%

Italy IPopulation 59.1 millionPer capita GNP 25,982Unemployment 6.1%Inflation 2.0%

Sweden SPopulation 9.1 millionPer capita GNP 36,478Unemployment 6.1%Inflation 1.7%

Finland FINPopulation 5.3 millionPer capita GNP 33,912Unemployment 6.9%Inflation 1.6%

Germany DPopulation 82.3 millionPer capita GNP 29,451Unemployment 8.4%Inflation 2.3%

Denmark DKPopulation 5.4 millionPer capita GNP 42,160Unemployment 3.8%Inflation 1.7%

France FPopulation 63.4 millionPer capita GNP 29,846Unemployment 8.3%Inflation 1.6%

Ireland IRLPopulation 4.3 millionPer capita GNP 43,170Unemployment 4.6%Inflation 2.9%

Luxembourg LUXPopulation 0.48 millionPer capita GNP 75,286Unemployment 4.1%Inflation 2.7%

Belgium BPopulation 10.6 millionPer capita GNP 31,208Unemployment 7.5%Inflation 1.8%

Non-members of the European Union

In the United States the results of eighteen out of the twenty-two presiden-tial elections preceding 2008 could have been predicted simply by looking athow the economy was doing, as measured by key indicators such as incomegrowth and inflation. This implies a close link between macroeconomic per-formance and all the other (and, you may argue, more important) things inlife, not only because all these other things typically cost money, but because aprecondition for being in power and thus being able to realize ones dream,ideology or vision, in whatever field is a satisfactory economic performance.

New Zealands government made the headlines in the 1990s by putting aclause in the employment contract of its central bank governor that threatenshim with the sack if he allows inflation to exceed 2% annually. This reflects aserious concern for inflation, the rate at which prices grow. Many other nationsshare this concern, which points to inflation as a third important variable inthe macroeconomic context.

The world abounds with economic challenges and puzzles. These differfrom one part of the world to another, and they must be viewed in the context

Figure 1.2 The map provides 2006 data on the countries of Western Europe that formed the European Union at theturn of the millennium, or that had completed negotiations before choosing not to join. GNP is a measure of a coun-trys total income. Country names are followed by shorthand abbreviations that are used in the text.

Source: Eurostat.

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1.1 The issues of macroeconomics 5

Figure 1.3 This map provides basic 2006 data on recent and prospective EU members and some other countries forreference.

Sources: Eurostat, IMF, World Bank.

Estonia EEPopulation 1.3 millionPer capita GNP 11,581Unemployment 4.7%Inflation 6.7%

USAPopulation 301.6 millionPer capita GNP 33,594Unemployment 4.6%Inflation 2.9%

Japan JPPopulation 127.8 millionPer capita GNP 27,486Unemployment 3.9%Inflation 0.1%

Brazil BRPopulation 191.6 millionPer capita GNP 4,312Unemployment 9.3% (2007)Inflation 4.2%

China CNPopulation 1320.0 millionPer capita GNP 1,722Unemployment 4.2%Inflation 1.5%

Mexico MXPopulation 105.3 millionPer capita GNP 9,179Unemployment 3.8%Inflation 3.7%

India INPopulation 1123.3 millionPer capita GNP 693Unemployment 7.8%Inflation 5.8%

Russian Federation RUPopulation 141.6 millionPer capita GNP 5,516Unemployment 6.2%Inflation 9.7%

South Africa ZAPopulation 47.6 millionPer capita GNP 4,203Unemployment 24.2% (2007)Inflation 4.6%

KeyMembers of the European Union

Latvia LVPopulation 2.3 millionPer capita GNP 8,739Unemployment 6.0%Inflation 10.1%

Lithuania LTPopulation 3.4 millionPer capita GNP 8,277Unemployment 4.3%Inflation 5.8%

Slovenia SLOPopulation 2.0 millionPer capita GNP 16,684Unemployment 4.9%Inflation 3.8%

Turkey TRPopulation 69.7 millionPer capita GNP 6,869Unemployment 8.5%Inflation 8.8%

Romania ROPopulation 21.6 millionPer capita GNP 5,631Unemployment 6.4%Inflation 4.9%

Cyprus CYPopulation 0.8 millionPer capita GNP 19,983Unemployment 3.9%Inflation 2.2%

Bulgaria BGPopulation 7.7 millionPer capita GNP 3,763Unemployment 6.9%Inflation 7.6%

Malta MLPopulation 0.4 millionPer capita GNP 13,238Unemployment 6.4%Inflation 0.7%

Czech Republic CZPopulation 10.3 millionPer capita GNP 12,394Unemployment 5.3%Inflation 3.0%

Poland PLPopulation 38.1 millionPer capita GNP 8,061Unemployment 9.6%Inflation 2.6%

Hungary HUPopulation 10.1 millionPer capita GNP 10,041Unemployment 7.4%Inflation 7.9%

Croatia HRPopulation 4.4 millionPer capita GNP 8,441Unemployment 9.6%Inflation 3.2%

Slovak Republic SKPopulation 5.4 millionPer capita GNP 10,165Unemployment 11.1%Inflation 1.9%

Non-members of the European Union Prospective members of the European Union

of different institutions, cultures and historical backgrounds. Despite this, a setof macroeconomic principles and concepts exists which can, applied wisely, bebrought to bear on a variety of different issues. This book sets out to assemblesuch a basic macroeconomic tool-kit. While it focuses on and emphasizes whatis needed to understand and discuss the experiences and prospects in one partof the world, the European Union and its neighbours, the perspective is global,as indicated by the range of issues, case studies and data.

The European Union grew out of economic and political integration effortsthat started half a century ago. After the turn of the millennium it comprisesthe twenty-five member states shown in blue in Figure 1.3. Figures 1.2 and 1.3also provide some basic information on the member states economies, theeconomies of Norway and Switzerland, whose governments had embarked on

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6 Macroeconomic essentials

GDP as a measure of total output or income

How do modern economies measure total income(or output)? Usually it is done by means of a con-cept called gross domestic product (GDP). NominalGDP evaluates all final goods and services pro-duced in a country at current market prices. If 100pizzas and 5 Alfas are produced in a given calendaryear at prices of 10 and 30,000, respectively,GDP is . Impor-tant things to watch out for are the following:

Only count final products. If Alfa Romeo buystyres from an external supplier to put on its cars,you would not want to count tyres twice oncewhen Alfa Romeo buys them and again whenconsumers buy an Alfa, the price of which, ofcourse, includes the cost of tyres. As indicated,one way to avoid double counting is by includ-ing final products only. Another way is to countonly the value added at each stage during theproduction process.

Only count current production. If the originalAlfa owner resells her car next year, this obvi-ously does not represent output and incomegenerated during that period.

GDP increases, first, if more pizzas and/or Alfas arebeing produced, and second, if prices rise. Table 1.2illustrates these two possibilities.

In 2007 nominal GDP is 151,000. Real GDPdoes not evaluate output in terms of currentprices, but in prices in a given year. In terms ofwhat nominal GDP buys in 2007, real GDP in 2007of course is also 151,000. In 2008 nominal GDPhas risen to 182,000. Since prices are the same asin 2007, real GDP has also risen to 182,000: thebuying power of nominal GDP is at what 182,000would have bought in 2007. Finally, in 2009 nomi-nal GDP is at 244,000. But the increase is only dueto price increases. Production quantities are thesame as in 2008. This leaves real GDP unchangedat 182,000.

Sometimes total income is also measured as grossnational product (GNP). The difference betweenthe two concepts is that GDP refers to incomesgenerated within the geographical boundaries ofa country, no matter by whom. Instead, GNP meas-ures the incomes generated by the inhabitants of acountry, no matter in what country. So if a Spaniardliving in Barcelona owns Lufthansa stocks, theannual dividends she may receive are included inGermanys GDP, but in Spains GNP. For most coun-tries the difference between GDP and GNP is small.We will usually think of GDP when talking abouttotal income or output.

10 * 100 + 30,000 * 5 = 151,000

BOX 1.1

an integration path before voters rejected that option, plus a selection of othercountries from around the globe.

While European countries appeared reasonably homogeneous in terms ofper capita income from the world-wide perspective given in Figure 1.1, themore detailed information included in Figures 1.2 and 1.3 reveals some notabledifferences. These are not only the obvious differences in size and population,but also the differences in the standardized macroeconomic performance datamentioned earlier. Nominal per capita income, as measured by gross nationalproduct (GNP see Box 1.1), in Luxembourg was twice as high as in Germanyand four times that of Portugal; not to mention new members Bulgaria andRomania, where the ratio approached one to twenty. Unemployment ranged

Table 1.2 An illustration of nominal and real GDP

Pizzas Alfas

Year Price Quantity Price QuantityNominal GDP (in e)

Real GDP inprices of 2007

2007 10 100 30,000 5 151,000 151,0002008 10 200 30,000 6 182,000 182,0002009 20 200 40,000 6 244,000 182,000

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1.2 Essentials of macroeconomic accounting 7

Firms Households

Labour

Goods

from a (by current standards) tolerable 3.9% in Denmark to a more alarming13.8% in Poland. Inflation peaked in Bulgaria at 7.4%, but had ceased to be amajor problem in the majority of EU member states, where it remained wellbelow 3%. However, easier monetary policies in response to financial crisesand surging oil prices allowed inflation to make a modest comeback in 2008.

1.2 Essentials of macroeconomic accounting

The focal point of macroeconomics is the level of income. Incomes are paidout to factors of production that are employed by firms to produce goods andservices. This output is then put on the market for people to buy. The twomajor things that can go wrong in this process are as follows:

Firms may not use all available production factors to produce output, thusleaving factors idle in the form of unemployment or slack.

People may not want to buy all that is being produced, that is demand mayfall short of output.

Economists have analysed economies very much in terms of these two fail-ures: underutilization of production factors and/or insufficient (or excessive)demand. These will also be major themes in subsequent chapters of this book,as they lie at the heart of most prominent macroeconomic issues such as un-employment and inflation.

Before embarking on our task to assemble a set of macroeconomic tools andconcepts for analysing these and other macroeconomic issues, we need to clarifysome essential terminology and techniques.

The circular flow of income and spending

We start by looking at how economists measure income, and at how theydivide it into useful components to facilitate subsequent efforts to understandwhat determines income and what makes it change. For this purpose we em-ploy a preliminary stylized picture (or model) of the economy: the image ofcontinuous circular flows. This model, which we begin to build in Figure 1.4,identifies the key actors (or sectors) of an economy, and then proceeds todescribe and measure the interaction between them.

Factors of production are all resources used in theproduction of goods andservices: labour, capital goodssuch as machines, and naturalresources such as oil.

Figure 1.4 The circle shows that householdsfurnish firms with production factors suchas labour, and receive goods and servicesproduced by firms in return. (Please excuseus for describing something that flowsaround four corners as a circle!)

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8 Macroeconomic essentials

Firms Households

Labour

Income

Goods

Spending

Figure 1.5 The outer circle shows that theinner real flow of labour and goods isfinanced by a monetary flow of incomepayments from firms to households and ofhouseholds spending on the firms goods.

Suppose there are only two actors, households and firms. In an economywithout money economists call this a barter economy households andfirms interact through a continuous flow of real transactions. Householdsfurnish firms with labour (and usually also capital goods like machines andbuildings, or land). Firms use these factors of production, or resources, asthey are also called, to produce goods (and services). These goods flow backto the households, constituting compensation for having supplied the factorsof production.

It would not be very efficient if pizzerias were to compensate pizzaiolos withthe margaritas and calzones they baked, and if Alfa Romeo were to pay em-ployees with a brand new Alfa 147 every six months. In modern economies,firms pay households with money for using the factors of production. This re-lieves pizzaiolos of a tedious search for Alfa Romeo workers with just the rightcraving for pizza. Therefore, in the upper half of Figure 1.5, an appropriateamount of euros, pounds or kronas flows back to the households, completingthis transaction. In the lower half, households spend their money incomes onthe goods produced and put on the market by the firms. So in the end thecounter-clockwise circular flow of real transactions between households andfirms remains intact. It is now complemented by an outer circle flowing clock-wise which records the payments streams that compensate for the goods receivedand for the labour provided.

The outer circle has an important advantage over the inner one: it is easierto measure, since all transactions are denominated in the same measuringunits. This is not true for the inner circle. Typically, both the factors of pro-duction and the goods produced are very heterogeneous and cannot simply beadded up. Economists therefore focus on the outer circle of income and spend-ing to measure aggregate economic activity.

An important point to note is that one persons spending flowing fromright to left in the lower part of the outer circle is another persons income,received after completion of the upper part of the outer circle. So all spending

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1.2 Essentials of macroeconomic accounting 9

Firms Households

Spending: =C 100

Investment: =C 20

Saving: =C 20

Income: =C 100

Figure 1.6 If households save part of the income that they receive from firms, incomeleaks out of the circular flow. If firms buyinvestment goods that are not directlybeing financed out of current income,spending is injected into the circular flow.

must add up to the same amount to which all incomes add up. Total productionor aggregate output, the value of all goods and services produced by firms,may therefore be measured either by adding up all incomes, or by adding upall expenditures.

Figure 1.5 provided a very simple first picture, and there are a number ofcomplicating factors. For example, consumers may not, and typically do not,spend all their income. As Figure 1.6 illustrates, if households save 20 out ofan income of 100, only 80 arrives at the firms in demand for their goods.The 20 leak out of the circular flow system. On the other hand, the firmsproducts are not only bought by consumers. The pizza place may buy an Alfaand offer home deliveries. Such investment demand is typically not paid forout of current income (in fact, firms have no income) but is financed by bor-rowing money from banks. In this light, investments take the form of injectionsinto the income circle.

Figure 1.6, with its focus on bringing savings and investment into the pic-ture, illustrates how the basic circular flow model may be adapted to take intoaccount complications that arise in reality. We now take a big step and intro-duce all those leakages and injections that will play prominent roles in the re-mainder of this book. First, income received by households may not arrive atthe firms as demand for three main reasons:

1 People save. We have noted this point already. If people save part of theirincome, their consumption expenditures fall short of what they have pro-duced and received as income. Saving may thus be viewed as a leakage ofincome out of the circular flow system.

2 Governments levy taxes. The taxes that governments levy on citizens are a partof income which is prevented from turning into demand another leakage.

3 People buy foreign goods. Income earned at home which is used to buygoods produced in a foreign country constitute a third leakage of incomefrom the domestic circular flow system.

The expenditure approachmeasures aggregate outputas the sum of all spending. Theincome approach adds up allincomes instead.

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10 Macroeconomic essentials

Taxes

Saving

Imports

ExportsInvestment

Injections

Leakages

Governmentexpenditure

Totalincome

Totalexpenditure

T IM

Res

t o

f th

e w

orl

d

Go

vern

men

tse

cto

r

G

S

I EX

Figure 1.7 This diagram proceeds from the insight that all spending arrives somewhere else as income. In order forincome to create an equivalent level of spending, all leakages out of the circular flow, given in the upper part of thecircle, must be balanced by an equal amount of injections, given in the lower segment. Pairing leakages and injectionsin a meaningful way gives the circular flow identity , which always holds, except formeasurement error. Data for Britain in 2002 are (in billion): and . Total income, the width of the stream, was 1,079.3.

Source: Eurostat.

G = 450.4T = 432.5, S = 175.7, IM = 440.8, EX = 421.2, I = 177.5

(T - G) + (S - I) + (IM - EX ) = 0

But there is also more than one reason why demand from outside the circularflow may be directed towards domestic output. In fact, each of the leakagesdescribed above has a counterpart representing an injection into the circularflow:

1 Firms invest. As noted, firms build or buy new production facilities, newmachines, distribution networks and so on. These investments are typicallyfinanced via credit from banks or credit markets in general.

2 Government spending. Government spending on such things as public con-sumption, infrastructure or transfers paid to households or firms representsan injection from the outside into the income circle.

3 Foreigners buy our goods. If residents of foreign countries decide to buy do-mestically produced goods, this represents a last injection of demand intothe circular flow.

Figure 1.7 depicts the improved circular flow of income that allows forthese six categories of leakages and injections.Note that we build on the outer,clockwise flow of income and spending introduced in Figure 1.5 and refined inFigure 1.6. For the sake of clarity we will now refrain from identifying firmsand households in the circle. (To include them would complicate the picture

Note. In economics the terminvestment describespurchases of capital goods.This differs from the popularuse of the word which callspurchases of financial assets(say, stocks) out of savings(financial) investments.

Transfers are payments fromgovernments to individuals orfirms that do not involvegoods or services, such aswelfare payments or housingsubsidies.

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1.2 Essentials of macroeconomic accounting 11

since, for example, both firms and households buy imports which would en-tail separating out their respective imports.)

Leakages of spending are shown in the upper part of the circle, injectionsof spending in the lower part. Only if the sum of all leakages equals the sum ofall injections does total expenditure (measured at the end of the lower leg ofthe circle) exactly match total income (measured at the outset of the upperleg). But wouldnt leakages match injections only by pure chance? The answeris no. Quite the contrary: in the end, when we add everything up, leakages andinjections always match. Why is that?

Suppose that initially, with the amount of investment planned by firms,injections would fall short of leakages. Then spending tends to fall short ofsupplied output, and firms must add unsold output onto their existing stockof inventory. Whether they like it or not, they are forced to demand thatpart of output themselves which they cannot sell. In the opposite case, if de-mand exceeds output, either firms must draw down their existing inventory,or, if that is not feasible, that part of demand which exceeds supply remainsunsatisfied.

Now let investment not only be the purchase of machines, but also the ad-dition to stocks of inventory (which are classified as capital goods). Then theforced changes of inventory described in the previous paragraph always ren-der investment just high or low enough to make injections equal to leakages.So the bottom line is that, if investment is understood to include inventorychanges, the leakages and injections always balance, and the following equa-tion holds at all times:

(1.1)

Note that we have paired each leakage with an injection so as to yield a