economics - macroeconomics, 2nd edition - (manfred gartner) pearson prentice hall 2006

An imprint of

Grtner

macroeconom

ics

secondedition

Macroeconomics, second edition, applies a rigorous, comprehensive approach to the subject.The new edition has been thoroughly updated, refined and expanded, whilst keeping thedistinctive real-world focus and blend of theory and application so successful in the firstedition.

Features: Puts macroeconomic issues and challenges on centre stage, then develops the tools

needed to understand and address them Unique and exciting mix of theory, analysis and policy issues Takes students from macroeconomic basics to cutting-edge research topics Integrated case studies provide extensive coverage of European and global issues Supported by a world-class companion website at www.pearsoned.co.uk/gartner offering

a unique blended learning experience. The site includes: an unsurpassed range of interactive models equipped with guided exercises interactive applets for state of the art data analysis and display a graphical road map emphasizing a coherent view of models and concepts online quizzes, weblink lists and summaries

New to this edition: All new chapter introducing real business cycles and sticky prices Comprehensive update of institutional developments and data, including the expansion of

the European Union Additional case studies further expand the texts global perspective

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

Manfred Grtner is Professor of Economics at the University of St. Gallen, Switzerland.

Manfred Grtnersecond editionThis text will prove a boon to the hard-pressed lecturer and students of intermediatemacroeconomics with its engaging and student-friendly manner and its invaluable

application of theory to real-world problems. Gordon Douglass, University of Dundee, UK

The book is well written, and provides a nice mix of theory, analysis, and policy issues. Theforemost reason for adopting this book, however, is that it is written from a European

perspective, uses empirical examples from the EU, provides institutional background of the EU,and presents policy issues relevant to the EU. Prof. dr. Eric J. Bartelsman, Vrije Universiteit,

Amsterdam and Tinbergen Institute, The Netherlands

Both student-friendly and engaging. Certainly not dull. Prof. dr. Gerard H. Kuper, Universiteit Groningen, The Netherlands

Additional student support atwww.pearsoned.co.uk/gartnerwww.pearson-books.com

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Macroeconomics

Visit the Macroeconomics, second edition Companion Website atwww.pearsoned.co.uk/gartner to find valuable student learningmaterial including:

Macroeconomic tutorials with interactive models, guided exer-cises, and animations, plus an interactive road map connectingkey concepts and models

A data bank with macroeconomic time series for many coun-tries, along with a graphing module

Extensive links to valuable resources on the web, organized bychapter

Self assessment questions to check your understanding, withinstant grading

Index cards to aid navigation of resources, plus chapter sum-maries, macroeconomic dictionaries in several languages, andmore.

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MacroeconomicsSECOND EDITION

Manfred GrtnerUniversity of St Gallen, Switzerland

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Pearson Education Limited

Edinburgh GateHarlow Essex 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 2006

Prentice Hall Europe 1997 Manfred Grtner 2003, 2006

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

All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by any means, electronic, mechanical, photocopying,recording or otherwise, without either the prior written permission of the publisher or alicence permitting restricted copying in the United Kingdom issued by the Copyright LicensingAgency Ltd, 90 Tottenham Court Road, London W1T 4LP.

All trademarks used herein are the property of their respective owners. The use of any trademark in this text does not vest in the author or publisher any trademark ownershiprights in such trademarks, nor does the use of such trademarks imply any affiliation with orendorsement of this book by such owners.

ISBN-13: 978-0-273-70460-7ISBN-10: 0-273-70460-5

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

Library of Congress Cataloging-in-Publication DataA catalog record for this book is available from the Library of Congress

10 9 8 7 6 5 4 3 2 110 09 08 07 06

Typeset in Sabon 10/12 by 59Printed by Ashford Colour Press Ltd., Gosport

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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 33

3 Money, interest rates and the global economy 62

4 Exchange rates and the balance of payments 90

5 Booms and recessions (II): the national economy 115

6 Enter aggregate supply 141

7 Booms and recessions (III): aggregate supply and demand 172

8 Booms and recessions (IV): dynamic aggregate supply and demand 198

9 Economic growth (I): basics 228

10 Economic growth (II): advanced issues 259

11 Endogenous economic policy 293

12 The European Monetary System and Euroland at work 317

13 Inflation and central bank independence 348

14 Budget deficits and public debt 380

15 Unemployment and growth 409

16 Real business cycles and sticky prices: new perspectives on booms and recessions 442

Appendix: A primer in econometrics 481

Index 499

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 20Chapter summary 25Exercises 26Recommended reading 28Appendix: Logarithms, growth rates and logarithmic scales 29

2 Booms and recessions (I): the Keynesian cross 332.1 The circular flow model revisited: terminology and overview 382.2 Income determination: a first look 432.3 Income determination: a second look 482.4 An intertemporal view of consumption and investment 51Chapter summary 56Exercises 57Recommended reading 59Applied problems 59

3 Money, interest rates and the global economy 623.1 The money market, the interest rate and the LM curve 633.2 Aggregate expenditure, the interest rate and the exchange rate:

the IS curve 703.3 The IS-LM or the global economy model 75Chapter summary 84Exercises 85Recommended reading 87Applied problems 87

4 Exchange rates and the balance of payments 904.1 Globalization 914.2 The exchange rate and the balance of payments 934.3 Back to IS-LM: enter the FE curve 974.4 Equilibrium in all three markets 105Chapter summary 110Exercises 110

C O N T E N T S

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x Contents

Recommended reading 112Applied problems 112

5 Booms and recessions (II): the national economy 1155.1 Fiscal policy in the MundellFleming model 1165.2 Monetary policy in the MundellFleming model 1195.3 The algebra of monetary and fiscal policy in the

MundellFleming model 1245.4 Comparative statics versus adjustment dynamics 1255.5 Adjustment dynamics with expected depreciation 1275.6 When prices move 1305.7 Todays exchange rate and the future 133Chapter summary 135Exercises 136Recommended reading 137Applied problems 138

6 Enter aggregate supply 1416.1 Potential income and the labour market 1426.2 Why is there unemployment in equilibrium? 1506.3 Why may actual output deviate from potential output? 164Chapter summary 167Exercises 168Recommended reading 169Applied problems 170

7 Booms and recessions (III): aggregate supply and demand 1727.1 The short-run aggregate supply curve 1737.2 The aggregate demand curve 1747.3 The AD-AS model: basics 1827.4 Policy and shocks in the AD-AS model 186Chapter summary 193Exercises 194Recommended reading 195Appendix: The algebra of the AD curve 195

8 Booms and recessions (IV): dynamic aggregate supply and demand 1988.1 The aggregate-supply curve in an inflationincome diagram 1998.2 Equilibrium income and inflation: the DAD curve 2008.3 The DAD-SAS model 2018.4 Inflation expectations 2048.5 The DAD-SAS model at work 207Chapter summary 220Exercises 221Recommended reading 222

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Contents xi

Appendix: The algebra of the DAD curve 222Appendix: The genesis of the DAD-SAS model 223Applied problems 225

9 Economic growth (I): basics 2289.1 Stylized facts of income and growth 2289.2 The production function and growth accounting 2309.3 Growth theory: the Solow model 2379.4 Why incomes may differ 2399.5 What about consumption? 2419.6 Population growth and technological progress 2469.7 Empirical merits and deficiencies of the Solow model 251Chapter summary 255Exercises 255Recommended reading 257Applied problems 257

10 Economic growth (II): advanced issues 25910.1 The government in the Solow model 26010.2 Economic growth and capital markets 26310.3 Extending the Solow model and moving beyond 27110.4 Poverty traps in the Solow model 27310.5 Human capital 27710.6 Endogenous growth 281Chapter summary 286Exercises 287Recommended reading 288Appendix: A synthesis of the DAD-SAS and the Solow model 289Applied problems 289

11 Endogenous economic policy 29311.1 What do politicians want? 29311.2 Political business cycles 29711.3 Rational expectations 30111.4 Policy games 30311.5 Ways out of the time inconsistency trap 308Chapter summary 313Exercises 314Recommended reading 315Applied problems 315

12 The European Monetary System and Euroland at work 31712.1 Preliminaries 31812.2 The 1992 EMS crisis 32112.3 Exchange rate target zones 32712.4 Speculative attacks 33312.5 Monetary and fiscal policy in the euro area 336

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xii Contents

Chapter summary 341Exercises 343Recommended reading 344Appendix: The two-country MundellFleming model 344Applied problems 346

13 Inflation and central bank independence 34813.1 Inflation, central bank independence and the EMS 34913.2 Supply shocks and central bank independence 35813.3 Disinflations and the sacrifice ratio 36513.4 Lessons for European Monetary Union 373Chapter summary 375Exercises 376Recommended reading 377Applied problems 378

14 Budget deficits and public debt 38014.1 The government budget 38114.2 The dynamics of budget deficits and the public debt 38214.3 Maastricht, the budget and the central bank 39614.4 What is wrong with having deficits and debt? 39914.5 Does monetary union need budget rules? 400Chapter summary 404Exercises 405Recommended reading 406Applied problems 407

15 Unemployment and growth 40915.1 Linking unemployment and growth 40915.2 European unemployment 41215.3 Persistence in the DAD-SAS model 42815.4 Lessons, remedies and prospects 432Chapter summary 437Exercises 438Recommended reading 439Applied problems 439

16 Real business cycles and sticky prices: new perspectives on booms and recessions 44216.1 Reality check: business cycle patterns and theDAD-SAS model 44316.2 New Keynesian responses 44716.3 Real business cycles 454Chapter summary 478Exercises 479Recommended reading 480

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Contents xiii

Appendix: A primer in econometrics 481A.1 First task: estimating unknown parameters 482A.2 Second task: testing hypotheses 484A.3 A closer look at OLS estimation 486Appendix summary 496Exercises 497Recommended reading 497

Index 499

Supporting resources

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

Companion Website for students

Macroeconomic tutorials with interactive models, guided exercises,and 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, organised 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.

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

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 illustrate the concepts.

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

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Chapter summaryEach chapter ends with a bullet-pointsummary which highlights the materialcovered in the chapter and can be used as a 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, andencourage them to try for themselves.

Recommended readingEach chapter is supportedby an annotatedrecommended readingsection, directing thereader to additionalprinted and electronicsources in order to gainan alternative perspective,or to pursue a topic inmore 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 studies1.1 Germanys current account before and after unification 122.1 Income vs leisure time in France and the USA 422.2 How to pay for the war: Great Britain in 1940 503.1 Liquidity traps and Japans prolonged recession 824.1 Italys current account before and after the 1992 EMS crisis 1005.1 The 1998 Asia crisis 1226.1 Fords focus: an experiment in efficiency wages 1617.1 International evidence on the quantity equation and the

AD curve 1898.1 Quantity equation, Fisher equation and purchasing power

parity: international evidence 2189.1 Growth accounting in Thailand 2369.2 Income and leisure choices in the OECD countries 249

10.1 National incomes during the Second World War, east and west of the Atlantic 264

11.1 Elections and the economy 29611.2 Who wanted the euro? The role of past inflations 31212.1 German unification as a tug of war 32313.1 New Zealands Reserve Bank Act: a case from down under 35114.1 The rise and fall of Irelands public debt 39214.2 Who wanted the euro? The role of government debt 39814.3 Lessons from the BelgiumLuxembourg monetary union 40315.1 US vs European job growth: cutting the miracle to size 43316.1 The Canadian business cycle 44616.2 Technology change in Malaysia: the return of the Solow residual 473

Boxes

1.1 GDP as a measure of total output or income 61.2 Working with graphs (part I) 232.1 Actual income, potential income and steady-state income:

Great Britain in 1933 373.1 Money and monetary policy 643.2 Money versus interest rate control 683.3 Working with graphs (part II) 713.4 Exchange rates 733.5 Money supply vs interest control in a changing world 794.1 Traditional vs new balance of payments terminology 964.2 Forecasting the US dollar in 2004: an exercise in predicting

exchange rates 1034.3 Interest rates, default risk and the risk premium 105

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

4.4 The IS-LM-FE model in a different dress 1084.5 Endogenous and exogenous variables 1085.1 The MundellFleming model under capital controls 1198.1 How to solve rational expectations models 2139.1 The mathematics of the CobbDouglas production function 2359.2 Does faster growth mean catching up? 254

10.1 An illustration of the income and distribution effects of globalization 269

10.2 Labour efficiency vs human capital: an example 28111.1 Political business cycle mathematics 30011.2 From the political business cycle to the inflation bias 30712.1 Convergence criteria in the Maastricht Treaty 32712.2 The Stability and Growth Pact 34013.1 The SAS curve under fixed and flexible exchange rates 35514.1 Seignorage vs inflation tax revenue 39516.1 A pocket guide to the history of macroeconomic thought 475A.1 The coefficient of determination: R2 490

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What makes the book unique?

This text was shaped by its aim to turn the usual priorities in macroeconom-ics instruction upside down. Here, the ultimate goal is not simply to teachmacroeconomic theories and concepts, with real-world applications sprinkledin for motivation and excitement; rather, students work through this booktowards an understanding of the macroeconomic issues and challenges facingthe world economy and individual countries. Macroeconomic concepts aretaught only as they serve this end. Instead of dwelling on such topics as thelife-cycle versus the permanent-income explanation of consumption behav-iour, or elaborating on fifty ways to motivate the aggregate supply curve,this book devotes more space than in any other macro text to issues of politi-cal economy: why do policy makers make the choices they do and how arethese affected by different institutional settings?

An original item not found in other intermediate texts is the Primer ineconometrics placed in an optional appendix at the end of the book. Its pur-pose is to underscore the point that macroeconomics is about the real world.While this is already stressed by the examination of numerous case studiesthroughout, this appendix goes one step further by conveying an intuitiveunderstanding of basic statistical concepts used in data analysis. Applied-problem sections after each chapter provide opportunities to put these con-cepts to work, discussing recent research, guiding through worked problems,and making students embark on small projects of their own. Such earlyhands-on experience with econometric work, when combined with a user-friendly software package, may give students the orientation and motivationfor the more serious statistical work to come later in the curriculum.

Content

The texts main body comprises 16 chapters. The first half of the book isfairly conventional, amounting to a streamlined, no-frills introduction to themacroeconomic concepts that are useful for discussion of contemporarymacroeconomic issues in the world economies. Essential macroeconomicconcepts are introduced in the context of the circular-flow-of-income model.Then students are led via the Keynesian cross, the IS-LM, the Mundell-Fleming and the aggregate demand-aggregate supply model to a fullydynamic aggregate demand-aggregate supply framework for analysing short-and medium-run macroeconomic issues. Chapters on the supply-side topicsof unemployment and growth round out this conventional set of tools.

Chapters 10 and 11 extend the tool-box into areas that most intermediatemacroeconomics textbooks barely mention in passing. The first refines andextends the Solow growth model (introduced in Chapter 9) for a discussion

P R E FA C E

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xx Preface

of human capital and poverty traps, and concludes with a first glimpse atendogenous growth. Under the heading Endogenous economic policyChapter 11 then shows that politicians may steer the economy along coursesnot considered desirable from societys point of view, and how institutionsshould be shaped to reduce this risk.

Chapters 1215 explore issues from the heart of European and globalmonetary and economic integration. All major topics are addressed in chap-ters on inflation, monetary unions, budget deficits and the public debt, andunemployment.

Chapter 16, all new to this edition, offers a sneak preview of what stu-dents might expect in macroeconomics courses on the masters level. And itmakes a serious effort to motivate and explain why current macroeconomicresearch has moved beyond the workhorse models of intermediate macroeco-nomics to study the potential of macroeconomics models with explicit micro-foundations of the real-business-cycle mould, or with sticky prices. To thisend, students learn about the co-movement of macroeconomic variables, andwhy sticky prices may perform better than sticky wages in explaining empiri-cally observed patterns. They also grasp the intuition behind real-business-cycle dynamics, without the elaborate formal apparatus that usually comeswith 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. Everychapter contains one or more case studies that apply core concepts to recentexperiences in Europe and in other parts of the world.

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 500800 page macroeconomics text which has become thestandard.

Also, the book readily accommodates courses in Economic policy andApplied macroeconomics. Such courses may be organized around anappropriate selection from the several dozen case studies and empiricalapplications. Conveniently, as deemed necessary, students can be referredto the required theoretical tools in the same textbook.

Finally, the book accommodates European studies courses that can beorganized around the applied topics discussed in Chapters 1215. Here also,

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Preface xxi

should it be necessary to freshen up or expand previously acquired theoreti-cal knowledge, such material is readily available in the same textbook.

Prerequisites

Ideally, students should approach this book with a Principles of economicscourse under their belt. The formal mathematical requirements are mild: any-thing close to the most basic mathematics training in high school should do.In fact, most of the formal manipulations are optional and either shown inmargin notes or in separate sections that supplement graphical arguments.

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 foundation forinformed discussion of todays national and global macroeconomic issues.

A text for Europe and beyond

Reflecting my own roots, expertise and work environment, this text has astrong European flavour. The supplied box of tools and concepts has thus beenclearly assembled with an eye to enhancing the understanding of key issues sur-rounding European economic and monetary integration. But the potential ofthese tools to explain macroeconomic problems is a lot more universal thanthis might insinuate. While institutions may vary around the world, and oneregion may face quite different challenges than another, the basic conceptsneeded to understand and analyse macroeconomic issues remain surprisinglysimilar. The tools assembled here, therefore, not only served me well whenteaching open economy macroeconomics in Europe, but also when lecturing onother continents. This personal experience is underscored by the fact thatalmost a third of the close to 100 adoptions of the first edition originated fromoutside Europe.

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.Students questions and curiosity constantly force me to refine explanations,and in the process very often make me understand things better myself. In thesame vein, I thank my colleagues at the University of St Gallen, who over theyears allowed me to tap their expertise, experience and creativity in jointteaching ventures. Special thanks go to Jrg Baumberger, to whom I owe theidea for the case study derived from Keynes How to Pay for the War inChapter 2 and many other suggestions for improvement.

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xxii Preface

I doubt that the book would have been written if it were not for PradeepJethi. Then commissioning editor, he lured me into this project at an annualconference of the European Economic Association more than a decade ago,in Maastricht among all places. I want to thank him, and the professionalscurrently with Pearson Education who helped and guided me in preparingthe current, thoroughly extended new edition of this book: Annette Abel(proofreading), Anita Atkinson (senior editor), Patrick Bonham (freelancecopy editor), Rachel Byrne (acquisitions editor), Paula Harris (senior acquisi-tions editor) and Stephanie Poulter (editorial assistant).

More than any previous book of mine, this one could not nearly be whatit is without the help and the enthusiasm of the people working with me atthe time it was written or revised. While the contributions of Monika Btler,Philipp Harms, Adrienne Schaer, Martin Peter and Caroline Schmidt to pre-vious editions still show in this new edition, Mariko Klasing and Nadja Wirzprovided invaluable support in updating data, devising new exercises andscrutinizing new case studies, and accepted the responsibility for proofread-ing. Frode Brevik performed the simulations included in the new Chapter 16.And the interactive online material that augments the textbook continues togrow and shine thanks to the programming magic of Christian Busch, andthe math skills of Frode Brevik.

I have also benefitted from the reviews commissioned by PearsonEducation. Both those that offered applause and encouragement, and thosethat were more reserved or even critical of certain aspects helped shape thebook 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 so essential for such aproject come from beyond office doors. In this respect I owe much more tomy wife Louise and to our sons Dennis, Kai, Chris and David than they canpossibly know.

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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 copyrightmaterial:

Figure 9.6 Reprinted from Economics, Prentice Hall Europe 1999 by Case,Fair, Grtner & Heather, and Figure 12.1 Adapted from Economics, PrenticeHall Europe 1999 by Case, Fair, Grtner & Heather. With permissionfrom Pearson Education Ltd.

In some instances we have been unable to trace the owners of copyrightmaterial, and we would appreciate any information that would enable us todo 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 microeco-nomics.

2 All you need to know about national income accounting, includinggovernment 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 picturesof 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 analyzed and explainedin microeconomics. This is why the search for the microfoundations ofmacroeconomics ranks high on todays research agenda. However, to modelall the choices of millions of different people and show how they interact togenerate specific macroeconomic outcomes is simply not feasible. It probablynever will be. Inevitably, at some point we have to resort to simplifications orabstractions: either by assuming, say, that all individuals are alike, which iswhat so-called representative agents models of the macroeconomy do; or bypostulating relationships between macroeconomic variables which are ad hocin the sense that they only proxy the outcomes of individual choices, but nev-ertheless seem to work 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

Figure 1.1 The map shows the huge differences that exist in the per capita incomes of the worlds nations in 2003.Other important macroeconomic variables and issues are reported in boxes: economic growth, unemployment, infla-tion, the distribution of income and the close link between the economy and politics.

Source: World Bank Atlas, 2004, The World Bank.

Key$765 or lessIncome brackets: $766$3,035 $3,036$9,385 $9,386 or more

19 out of the last 23 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

Asias tigers used togrow at 8% annually. Atthis rate income doublesin less than ten 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

The foremost single measure of how an economy performs is the aggregatelevel of income. Presenting the world at a glance, Figure 1.1 gives anoverview of this variable by classifying countries according to income percapita, which is total income divided by population. Huge differences in percapita incomes exist. At the high end are the industrialized countries withannual incomes per head of $20,000 to $40,000. Lowest are a number ofcountries in sub-Saharan Africa with average annual per capita incomes ofbarely $100. To make matters worse, the worlds poorest countries do notseem to be growing very much if at all. In stark contrast, the Asian tigers Hong Kong, Singapore, South Korea and Taiwan have been growing at ornear double-digit percentage rates throughout the 1980s and much of the1990s. Other Asian nations, China and India most notably, by far the worldsmost populous nations, seem poised to copy this miracle. At such growthrates 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 simplerproblem. Note that nominal income is prices P times real income Y, that isP * Y. Now consider that US nominal income per capita grew by 24% fromP1994 * Y1994 = $25,860 in 1994 to P1998 * Y1998 = $32,175 in 1998. Thisdoes not necessarily mean that US citizens could buy 24% more goods and

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


1.1 The issues of macroeconomics 3

services in 1998 than they could in 1994. Possibly, the increase in nominalincome might have been entirely due to a 24% rise in prices, with no realimprovements in the purchasing power of US incomes at all. Of course, thishas not really been the case. In fact, US prices rose by 10% from an indexvalue of, say, 1 in 1994 to 1.1 in 1998. To obtain 1998 real income(expressed in 1994 prices), we need to divide 1998 nominal income by the1998 price level and multiply by 1994 prices: Y1998 = (P1998 * Y1998)/P1998 *P1994 = 32,175/1.1 * 1 = $29,240. So while nominal income rose by 24%,real income grew by only 13%.

Similar issues, with one added complication, arise when comparing incomesbetween countries. Noting that per capita income in 1998 was $29,240 in theUnited States but $39,980 in Switzerland would only permit a meaningfulcomparison of purchasing power if one dollar bought the same in Switzerlandas in the United States. Although $10 buys four Big Macs at $2.50 each in theUS, you need $14.60 to buy the same (at $3.65 each) in Switzerland. Thisprice difference may have two causes: at 6.30 Swiss francs Big Macs may sim-ply be expensive in local currency; or the dollar may be undervalued, meaningit 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 1998nominal income per capita in Switzerland was more than $10,000 higher thanin the United States. In Poland it was a tenth of Switzerlands. Taking intoaccount the level of prices relative to the United States, the picture changessubstantially. In Switzerland, $39,980 buys what only $26,876 buys in theUnited States. So Switzerlands real income per capita is slightly lower thanAmericas. Prices in Poland are half as high as in the United States, and a thirdof what they are in Switzerland. Therefore, in terms of real income, Polandperforms much better than it seems to perform in terms of nominal income.

A statistical average, which is what income per capita is, is one thing. Theactual distribution of income may be quite another story. In Brazil, to giveone example, the richest 20% of the population earn almost 70% of thenations aggregate income. The poorest 20% earn as little as 2%. In Europe,high average incomes conceal that almost one in ten of those who want towork do not find a job. Good unemployment insurance and social securityhave so far prevented high unemployment from showing up in a deteriorat-ing distribution of income. But welfare states are struggling and are quicklyscaling down the role of the government.

Empirical note.World-widethe richest countries, with15% of the population, makesome 80% of world income.The poorest countries, with57% of the population, make5% of world income.

Table 1.1 Nominal and real income in 1998. The second column shows nominal income.Because prices differ substantially between countries (third column), real income, theamount of goods that income can buy, turns out quite differently, as shown in the fourthcolumn.

Nominal income Price level Real income (per capita, in $) (relative to US price level) (in US purchasing power) PY P Y

Poland 3,910 0.52 7,543Switzerland 39,980 1.49 26,876United States 29,240 1 29,240



In the United States the results of eighteen out of the twenty-two presidentialelections preceding 2004 could have been predicted simply by looking at howthe economy was doing, as measured by key indicators such as income growthand inflation. This implies a close link between macroeconomic performanceand all the other (and, you may argue, more important) things in life, not onlybecause all these other things typically cost money, but because a preconditionfor being in power and thus being able to realize ones dream, ideology orvision, 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 reflectsa serious concern for inflation, the rate at which prices grow. Many othernations share this concern, which points to inflation as a third importantvariable in the macroeconomic context.

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

Figure 1.2 The map provides 2003 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: IMF, International Financial Statistics, and World Bank, World Development Indicators, 2004.

Netherlands NLPopulation 16.2 millionPer capita GNP $26,310Unemployment 3.8%Inflation 2.1%

European Union EUPopulation 465.98 millionPer capita GNP $17,932Unemployment 9.1%Inflation 2.9%

Portugal PPopulation 10.2 millionPer capita GNP $12,130Unemployment 6.3%Inflation 3.3%

KeyMembers of the European Union

United Kingdom UKPopulation 59.3 millionPer capita GNP $28,350Unemployment 4.9%Inflation 2.9%

Norway NPopulation 4.6 millionPer capita GNP $43,350Unemployment 4.3%Inflation 2.5%

Spain EPopulation 41.1 millionPer capita GNP $16,990Unemployment 11.3%Inflation 3.0%

Austria APopulation 8.1 millionPer capita GNP $26,730Unemployment 4.3%Inflation 1.3%

Greece GRPopulation 10.7 millionPer capita GNP $13,720Unemployment 9.3%Inflation 3.6%

Switzerland CHPopulation 7.3 millionPer capita GNP $39,880Unemployment 3.8%Inflation 0.6%

Italy IPopulation 57.6 millionPer capita GNP $21,560Unemployment 8.6%Inflation 2.7%

Sweden SPopulation 9.0 millionPer capita GNP $28,840Unemployment 5.6%Inflation 1.9%

Finland FINPopulation 5.2 millionPer capita GNP $27,020Unemployment 9.0%Inflation 0.9%

Germany DPopulation 82.6 millionPer capita GNP $25,250Unemployment 9.6%Inflation 1.05%

Denmark DKPopulation 5.4 millionPer capita GNP $33,750Unemployment 5.6%Inflation 2.1%

France FPopulation 59.7millionPer capita GNP $24,770Unemployment 9.4%Inflation 2.1%

Ireland IRLPopulation 3.9 millionPer capita GNP $26,960Unemployment 4.6%Inflation 3.5%

Luxembourg LUXPopulation 0.45 millionPer capita GNP $43,940Unemployment 3.7%Inflation 2.1%

Belgium BPopulation 10.3 millionPer capita GNP $25,920Unemployment 8.0%Inflation 1.6%

Non-members of the European Union


1.1 The issues of macroeconomics 5

different institutions, cultures and historical backgrounds. Despite this, a set ofmacroeconomic 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 integrationefforts that started half a century ago. After the turn of the millennium itcomprises the twenty-five member states shown in blue in Figure 1.3. Figures1.2 and 1.3 also provide some basic information on the member stateseconomies, the economies of Norway and Switzerland, whose governments

Figure 1.3 This map provides basic 2003 data on recent and prospective EU members and some other countries forreference.

Source: IMF, International Financial Statistics, and World Bank, World Development Indicators, 2004.

Estonia EEPopulation 1.4 millionPer capita GNP $4,960Unemployment 10.2%Inflation 3.6%

USAPopulation 291.0 millionPer capita GNP $37,610Unemployment 6.0%Inflation 2.3%

Japan JPPopulation 127.2 millionPer capita GNP $34,501Unemployment 5.3%Inflation -0.3%

Brazil BRPopulation 176.6 millionPer capita GNP $2,720Unemployment 12.3%Inflation 8.5%

China CNPopulation 1288.4 millionPer capita GNP $1,100Unemployment 7.3%Inflation -3.0%

India INPopulation 1064.4 millionPer capita GNP $530Unemployment 9.5%Inflation 3.8%

Russian Federation RUPopulation 143.4 millionPer capita GNP $2,610Unemployment 8.1%Inflation 15.8%

South Africa ZAPopulation 45.3 millionPer capita GNP $2,780Unemployment 28.4%Inflation 5.9%

KeyMembers of the European Union

Latvia LVPopulation 2.3 millionPer capita GNP $4,070Unemployment 10.4%Inflation 1.9%

Lithuania LTPopulation 3.5 millionPer capita GNP $4,490Unemployment 12.7%Inflation 0.3%

Slovenia SLOPopulation 2.0 millionPer capita GNP $11,830Unemployment 6.50%Inflation 7.5%

Turkey TRPopulation 70.7 millionPer capita GNP $2,800Unemployment 10.5%Inflation 25.5%

Romania ROPopulation 21.7 millionPer capita GNP $2,260Unemployment 7.0%Inflation 22.5%

Cyprus CYPopulation 0.77 millionPer capita GNP $12,320Unemployment 4.5%Inflation 4.0%

Bulgaria BGPopulation 7.8 millionPer capita GNP $2,130Unemployment 17.80%Inflation 5.8%

Malta MLPopulation 0.4 millionPer capita GNP $10,220Unemployment 8.00%Inflation 0.5%

Czech Republic CZPopulation 10.2 millionPer capita GNP $6,740Unemployment 7.8%Inflation 1.8%

Poland PLPopulation 38.2 millionPer capita GNP $5,270Unemployment 19.2%Inflation 1.9%

Hungary HUPopulation 10.1 millionPer capita GNP $6,330Unemployment 5.8%Inflation 5.3%

Slovak Republic SKPopulation 5.4 millionPer capita GNP $4,900Unemployment 17.5%Inflation 3.3%

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



had embarked on an integration path before voters rejected that option, plusa selection of other countries 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 Figure 1.2 reveals some notable differ-ences. These are not only the obvious differences in size and population, butalso in the standardized macroeconomic performance data mentioned earlier.Nominal per capita income, as measured by gross national product (GNP see Box 1.1), in Luxembourg is more than three times as high as in Greece orin Portugal, not to mention new members like Latvia or Lithunania, where

GDP as a measure of total output or incomeBOX 1.1

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 producedin a country at current market prices. If 100 pizzasand 5 Alfas are produced in a given calendar yearat prices of e10 and e30,000, respectively, GDP is10 100 30,000 5 = e151,000. Importantthings to watch out for are the following:

Only count final products. If Alfa Romeo buystyres from an external supplier to put on itscars, you would not want to count tyres twice once when Alfa Romeo buys them and againwhen consumers buy an Alfa, the price ofwhich, of course, includes the cost of tyres. Asindicated, one way to avoid double counting isby including final products only. Another way isto count only the value added at each stageduring the production 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 1illustrates these two possibilities.

In 2004 nominal GDP is e151,000. Real GDPdoes not evaluate output in terms of currentprices, but in prices in a given year. In terms ofwhat nominal GDP buys in 2004, real GDP in 2004of course is also e151,000. In 2005 nominal GDPhas risen to e182,000. Since prices are the same asin 2004, real GDP has also risen to e182,000: thebuying power of nominal GDP is at what e182,000would have bought in 2004. Finally, in 2006 nomi-nal GDP is at e244,000. But the increase is only dueto price increases. Production quantities are thesame as in 2005. This leaves real GDP unchangedat e182,000.

Sometimes total income is also measured asgross national product (GNP). The differencebetween the two concepts is that GDP refers toincomes generated within the geographicalboundaries of a country, no matter by whom.Instead, GNP measures the incomes generated bythe inhabitants of a country, no matter in whatcountry. So if a Spaniard living in Barcelona ownsLufthansa stocks, the annual dividends she mayreceive are included in Germanys GDP, but inSpains GNP. For most countries the differencebetween GDP and GNP is small. We will usuallythink of GDP when talking about total income oroutput.

Table 1 An illustration of nominal and real GDP

Pizzas AlfasNominal GDP Real GDP in

Year Price Quantity Price Quantity (in e) prices of 2004

2004 10 100 30,000 5 151,000 151,0002005 10 200 30,000 6 182,000 182,0002006 20 200 40,000 6 244,000 182,000


1.2 Essentials of macroeconomic accounting 7

the ratio is one to ten. Unemployment ranges from a tolerable, by currentstandards, 3.7% in Luxembourg to an alarming 19.2% in Poland. Inflationis currently a minor problem, remaining below 3% in most countries. It isthe highest in Slovenia with 7.5%.

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 goodsand services. This output is then put on the market for people to buy. Thetwo major 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 demandmay fall short of output.

Economists have analyzed 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 thisbook, as they lie at the heart of most prominent macroeconomic issues suchas unemployment and inflation.

Before embarking on our task to assemble a set of macroeconomic toolsand concepts for analyzing these and other macroeconomic issues, we needto clarify some 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 weemploy a preliminary stylized picture (or model) of the economy: the imageof continuous circular flows. This model, which we begin to build in Figure1.4, identifies the key actors (or sectors) of an economy, and then proceeds todescribe and measure the interaction between them.

Factors of production are allresources 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 such as labour, and receive goods and servicesproduced by firms in return. (Please excuseus for describing something that flowsaround four corners as a circle!)

Firms Households

Labour

Goods



Suppose there are only two actors, households and firms. In an economywithout money economists call this a barter economy households andfirms would interact through a continuous flow of real transactions.Households furnish firms with labour (and usually also capital goods likemachines and buildings, or land). Firms use these factors of production, orresources, as they are also called, to produce goods (and services). Thesegoods flow back to the households, constituting compensation for havingsupplied the factors of production.

It would not be very efficient if pizzerias were to compensate pizzaioloswith margaritas and calzones and if Alfa Romeo were to pay employees witha brand new Alfa 147 every six months. In modern economies, firms payhouseholds with money for using the factors of production. This relievespizzaiolos of a tedious search for Alfa Romeo workers with just the rightcraving for pizza. Therefore, in the upper half of the graph given in Figure1.5, an appropriate amount of euros, pounds or kronas flows back to thehouseholds, completing this transaction. In the lower half, householdsspend their money incomes on the goods produced and put on the marketby the firms. So in the end the counter-clockwise circular flow of realtransactions between households and firms remains intact. It is nowcomplemented by an outer circle flowing clockwise which records thepayments streams that compensate for the goods received and for thelabour 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 simplybe added up. Economists therefore focus on the outer circle of income andspending 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

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 income payments from firms to households and ofhouseholds spending on the firms goods.



must add up to the same amount to which all incomes add up. Total produc-tion or aggregate output, the value of all goods and services produced byfirms, may therefore be measured either by adding up all incomes, or byadding up all 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 e20 out ofan income of e100, only e80 arrives at the firms in demand for their goods.The e20 leaks 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 ofinjections into 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 takeinto account complications that arise in reality. We now take a big step andintroduce all those leakages and injections that will play prominent roles inthe remainder of this book. First, income received by households may notarrive at the 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 haveproduced and received as income. Saving may thus be viewed as a leakageof income out of the circular flow system.

2 Governments levy taxes. The taxes that governments levy on citizens are apart of income which is prevented from turning into demand anotherleakage.

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.

Firms Households

Spending: =C 100

Investment: =C 20

Saving: =C 20

Income: =C 100

Figure 1.6 If households save part of theincome that they receive from firms, incomeleaks out of the circular flow. If firms buyinvestment goods that are not directly beingfinanced out of current income, spending isinjected into the circular flow.



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 injec-tions in a meaningful way gives the circular flow identity (T - G) + (S - I) + (IM - EX) = 0, which always holds. Datafor Britain in 2002 are (in billion): T = 432.5, S = 175.7, IM = 440.8, EX = 421.2, I = 177.5 and G = 450.4. Total income,the width of the stream, was 1,079.3.

Source: Eurostat.

But there is also more than one reason why demand from outside the cir-cular flow may be directed towards domestic output. In fact, each of theleakages described above has a counterpart representing an injection into thecircular flow:

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 publicconsumption, infrastructure or transfers represents an injection from theoutside into the income circle.

3 Foreigners buy our goods. If residents of foreign countries decide to buydomestically produced goods, this represents a last injection of demandinto the 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 theouter, clockwise flow of income and spending introduced in Figure 1.5 and

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.



refined in Figure 1.6. For the sake of clarity we will now refrain from identi-fying firms and households in the circle. (To include them would complicatethe picture since, for example, both firms and households buy imports whichwould entail separating out their respective imports.)

Leakages of spending are shown in the upper part of the circle, injections ofspending in the lower part. Only if the sum of all leakages equals the sum of allinjections does total expenditure (measured at the end of the lower leg of thecircle) exactly match total income (measured at the outset of the upper leg).But wouldnt leakages match injections only by pure chance? The answer is no.Quite the contrary: in the end, when we add everything up, leakages and injec-tions 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 being forced to demandthat part of output themselves which they cannot sell. In the opposite case, ifdemand exceeds output, either firms must draw down their existing inven-tory, or, if that is not feasible, that part of demand which exceeds supplyremains unsatisfied.

Now let investment not only be the purchase of machines, but also theaddition to stocks of inventory (which are classified as capital goods). Thenthe forced changes of inventory described in the previous paragraph alwaysrender investment just enough to make injections equal to leakages. So thebottom line is that, if investment is understood to include inventory changes,the leakages and injections always balance, and the following equation holdsat all times:

(1.1)

Note that we have paired each leakage with an injection so as to yield ameaningful total, and to comply with Figure 1.7: S - I is domestic private netsavings; T - G is public net savings (called the budget surplus), measuringthe interactions between the domestic economy and the government sector;IM - EX are net imports, the countrys balance of trade in goods and serv-ices with the rest of the world.

As we shall see in subsequent chapters, the circular flow identity is anextremely effective gadget in any trained economists tool-box. But it canalso be very misleading if used in an uninformed way, that is withoutresolving the ambiguities in cause and effect that are often present inmacroeconomics.

One example of such uninformed use would be to rearrange equation (1.1)so as to yield

(1.2)

and then conclude that in order to raise what is perceived to be insuffi-cient investment by 10 billion, all the government must do is raise taxes by10 billion.

A look back at Figure 1.7 reveals that this recommendation naivelyassumes that increasing the tax leak leaves all other leakages and all injec-tions except I unaffected, thus forcing investment to rise with taxes. Without

I = S + T - G + IM - EX

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

Note. It is more common tocall EX - IM = NX netexports or, as anapproximation, the currentaccount (CA).



CASE STUDY 1.1 Germanys current account before and after unification

Germanys traditional current account surpluses,which had culminated at 4.8% of GDP in 1989, dis-appeared after unification. In the first full calen-dar year after the two Germanies had merged thecurrent account dropped from a regular surplusinto a deficit the size of about 1% of GDP (seeFigure 1(a)).

The circular flow model and the identity ofleaks and injections, S - I + T - G + IM - EX = 0,provides a first clue as to what had happened.First note, however, that while we are treating thecurrent account CA and net exports NX as syn-onyms in Chapter 1, and throughout most of thetext, this is only an approximation. The main dif-ference between the two aggregates in reality isthat the current account also includes transfersacross borders that are not related to the exportand import of goods and services. Examples areaid to developing countries, a Turkish family livingin Germany sending money to their parents inAnkara, or the contributions of the German gov-ernment to international organizations such asNATO, the United Nations, or the European Union.Since such things also constitute leakages out ofthe circular flow of income, the current account isactually a more precise measure of a countrys netleakages to the rest of the world than net exports.

It is often argued that the dramatic shift inGermanys current account was the result of risinggovernment budget deficits triggered by publicinvestment in East Germanys infrastructure andtransfer payments to the East. This interpretationis often motivated by comparing West Germanyslast full budget in the year before unification,1989, with the years that followed. This impliesthat unification drove a more or less balancedgovernment budget into deficit by some 3% ofGDP. Panel (b) in Figure 1 shows that this is a mis-leading story. The year 1989 is clearly atypical,given that the budget had been in deficit for yearsbefore and exceeded 2% of GDP in 1988 already.Ignoring 1989 as exceptional, unification increasedthe budget deficit only by about one percentagepoint from 2% to 3% of GDP.

In terms of the circular-flow identity: while theincrease of the budget deficit G T may havecaused the current account to deteriorate, itsmagnitude of one percentage point only partlyexplains the change in the current account bysome 5 percentage points. What seems to have Figure 1

586 87 88 89 90 91 92 93 94 95

Year(a) Current account deficit (CA ~= IM EX)

4

3

2

1

0

1

2

% o

f G

DP

486 87 88 89 90 91 92 93 94 95

Year(b) Government budget surplus (T G)

3

2

1

0

2

% o

f G

DP

186 87 88 89 90 91 92 93 94 95

Year(c) Private net savings (S I)

3

4

5

6

7

% o

f G

DP

2

mattered much more is the change in private netsavings S I documented in panel (c) of Figure 1.



an economic understanding of what determines the decisions of investors,consumers, exporters and importers, other equally valid (or invalid) interpre-tations would be the following:

Raising taxes reduces savings by an equal amount (since equation (1.1)could be rearranged to yield S = I - T + G - IM + EX) but leaves invest-ment unaffected.

Raising taxes reduces imports (from IM = I - S - T + G + EX). Raising taxes raises exports (from EX = S - I + T - G + IM).

What sets these assertions apart is which variables are held fixed and whichones we allow to change after we changed T. Each version was arbitrary.Without an understanding of how investment, savings, import and exportdecisions are being made, there is no way of telling what will actually happenafter a tax increase. It is possible that several of the other leaks and injectionsmay change after T rises. To complicate things further, even the width of thecircular flow stream, which measures the income level, may be affected bythe tax increase.

So if it is to be used in the context of economic analysis, the circular flowequation needs to be combined with thorough economic reasoning. This willbe enlarged upon in subsequent chapters. As it is, the circular flow identity

Case study 1.1 continued

While private savings exceeded investment bysome 6% of GDP before unification, this differ-ence dropped to about 2% after unification. Thisaccounts for the remaining change in the currentaccount that was not explained by the change inthe government budget deficit.

Of course, the change in private net savings alsoreflects government policies towards the easternpart of Germany. Net savings did not fall becausesavings fell, but because investment increased dueto investment bonus packages put into action bythe Kohl government. Figure 2 shows that savingswere still about the same in 1995 as they had beenten years earlier, while investment had risen byabout 4 percentage points.

Using stylized, rounded numbers for the timebefore and after unification Table 1 summarizesthe observed changes: the current account deficit(- CA IM - EX) rose from -4% to +1%. Onepercentage point of this reflects the change ingovernment spending behaviour, that is, theincrease of the budget deficit from 2% to 3% ofGDP. The remaining 4 percentage points (that is,the remaining 80%) of the change in the currentaccount reflect the change in net private savings,which dropped from 6% to 2% of GDP.

Table 1 Injections and leakages before and afterGerman unification. Rounded averages for indicatedsubperiods as % of GDP

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

198690 6% + 2% + -4% = 0199195 2% + 3% + 1% = 0

Figure 2

086 87 88 89 90 91 92 93 94 95

YearKey

10

20

% o

f G

DP

Investment Savings



Table 1.2 The circular flow identity in numbers (2002, as % of GDP). The data decomposethe circular flow identity for a set of industrial countries. To permit comparability, aggre-gates are given in percentages of GDP. The data report similarities and differencesbetween countries. Consider Germany and the US. Both countries run virtually the samegoverment budget deficit. In Germany this is easily financed by private domestic savings(first column). What sets the two cases apart is that the German government runs intodebt against its own citizens, but the US runs into debt against the rest of the world.

S - I in % T - G in % EX - IM (or NX = CA) in %

Belgium 4.54 0.10 4.64Denmark 0.95 1.70 2.65France 4.05 -3.20 0.85Germany 5.45 -3.50 1.95Greece -4.59 -1.40 -5.99Ireland -0.06 -0.20 -0.26Italy 1.85 -2.30 -0.45Netherlands 3.95 -1.90 2.05Poland 1.10 -3.60 -2.50Portugal -1.87 -2.70 -4.57Spain -1.20 0.00 -1.20United Kingdom 0.07 -1.60 -1.53United States -1.13 -3.40 -4.53China 5.88 -3.03 2.85Japan 9.84 -7.10 2.74Source: Eurostat, IMF, International Financial Statistics.

only provides a glimpse at some key structural properties of a countryseconomy.

Actual numbers for the components of the leakages and injections com-bined in equation (1.1) and other related variables are assembled in thenational income accounts of a country. Table 1.2 presents the sums involved,expressed as percentages of GDP. While country experiences differ, there aresome common threads in the data:

Most countries still run sizeable budget deficits. Governments spend morethan they receive.

In the majority of countries private savings exceed private investment. Thisis one way of financing the government budget deficit (or syphoning offthe net injections coming from the government sector). Instead of savingsbeing passed on to firms for investment spending, they go to the govern-ment for financing the deficit.

About half of the countries shown here export less than they import. Inthose countries the net injection from the private and government sectors(the excess of I + G over S + T) is neutralized by a net leakage of spendingto other countries. Other countries may appear to refrain from buying ourexport goods with all the money they receive for our imports from them,but instead lend part of that money to our government and/or firms tofinance the national deficit.

Discussion of the twin deficits that were haunting the US economy in the1980s and 1990s and returned with a vengeance in recent years offers amplereal-world examples of uninformed use of the circular flow identity, which

National income accountsreport data for GDP and itscomponents.



Figure 1.8 Looking at the inner circle first,we assume that firms use 24,000 hours oflabour to produce 6 cars. If e30,000 circulates12 times a year, annual income and annualspending must be e360,000. Hence the wagerate must be e15 per hour and the price of a car is e60,000. Thus, given all the other factors, the supply of money determinesgoods prices and nominal wages.

Firms Households

Labour: 24,000 work-hours

Income: =C 360,000

Goods: 6 cars

Spending: =C 360,000

Price of =C 60,000 connects lower branches

Wage rate of =C 15 connects upper branches

the above stylized example attempted to discredit. To some, the US budgetdeficit causes the current account deficit, and therefore it has to be removed(based on EX - IM = S - I + T - G). To others, Chinese, Japanese and EUimport restrictions cause the current account deficit, which in turn forces theUS government budget into deficit (based on T - G = - S + I + EX - IM). Athird view is that neither is true. Rather, insufficient private savings in theUnited States drive the current account into deficit (based on (EX - IM) =(S - I) + (T - G)). Again, while there may be a grain of truth in all threeexplanations, no judgement is possible before we understand how the peoplewho make up the economy make choices.

Money in the circular flow

Figure 1.5 featured a counter-clockwise flow of real factors such as labourand goods, and a compensating clockwise nominal flow of money income(evaluated at todays wages) and spending (evaluated at todays prices). Weknow that each flow is simply a mirror image of the other. It seems plausiblethat how labour is linked to income depends on the wage rate, and howgoods relate to spending depends on prices. To sharpen our understanding ofthis we need to introduce money into the circular flow model. How doesmoney fit in?

Consider the example given in Figure 1.8. Firms only employ one factor ofproduction labour to produce one good cars. Assume this economy pro-duces 6 cars annually, using 24,000 work-hours. Assume 30,000 euros floataround in this economy, in notes and coins. To keep the argument simple, letthere be no other money (such as bank accounts). Now if those e30,000 arebeing turned over (meaning that they flow from firms to households andback) 12 times a year, the firms cash registers add up a total of e360,000.Since this sum represents the payments for 6 cars, the price of a car is obvi-ously e60,000. On the other hand, over the course of a year e360,000 alsoarrive in the pockets of households as wage incomes, as compensation for

Money is anything that sellersgenerally accept as paymentfor goods and services.



6

Aggregatesupply

Cars

Pric

e

66,000

60,000

6

Aggregatesupply

(b)(a)Cars

Pric

e

6.6

60,000

Figure 1.9 Two extreme versions of an aggregate supply curve. In panel (a), firms want to supply one specificamount of output only, no matter what the price level does. In panel (b), firms are ready to supply any amount ofgoods that the market demands at the given price level.

24,000 work-hours. So the hourly wage rate must be e15 per hour. Nominalincome and spending equals e360,000, while real income and spendingequals 6 cars.

Next, consider the following thought experiment devised by an econo-mist who later won the Nobel prize. Let a helicopter fly all over our imagi-nary country, and, little by little, scatter e3,000 in small notes. What are theconsequences? If by now e33,000 continue to circulate at the speed of 12turnovers a year, cash registers will count e396,000, as will wage earners. Asregards prices, we consider two extreme cases.

One possibility is that the number of work-hours used in the productionprocess remains at 24,000 hours. This could be because we are operating atthe capacity limit, and this leaves output at 6 cars. Then e396,000 of incomeand spending must be compensation for 24,000 work-hours and payment for6 cars. So the price of a car must have risen to e66,000, and the hourly wagerate to e16.50. Workers have to work 4,000 hours to earn enough money tobuy a car, just as much as before the helicopter mission. Putting this differ-ently, nominal income, income in terms of currency, grew by 10% frome360,000 to e396,000. Real income, income in terms of what it can buy, isunchanged at 6 cars.

As a second possibility, the increase of nominal spending to e396,000 mayinduce firms to increase output instead of raising prices. At the original pricelevel, 6.6 cars can be sold. This requires 26,400 work-hours, which, at thegoing wage rate of e15, produces e396,000 of income. Workers still have towork 4,000 hours to make enough money to buy a car. This leaves the realwage rate, the purchasing power of one hours work, unchanged at 0.00025cars. Economy-wide real income has increased by 10% to 6.6 cars.

Macroeconomists call a graphical picture of how much total or aggregateoutput is produced at different price levels an aggregate supply curve. Thefirst case discussed above is tantamount to postulating a vertical aggregatesupply curve (see Figure 1.9, panel (a)). Both at a price of e60,000 and at aprice of e66,000, 6 cars are being produced. In the second case, producers

The aggregate supply curveindicates how much outputfirms are willing to produce atvarious price levels.

The numerical examplediscussed here motivates theclassical quantity equationM * V = P * Y. It states thatthe money supply M timesthe velocity of moneycirculation V equals nominalincome PY (where P is theprice level and Y denotes realincome). In the example, Mincreases from e30,000 toe33,000, while we presumeV constant at 12. In the firstcase, this raises P frome60,000 to e66,000, leavingY unchanged. In the secondcase, Y rises from 6 to 6.6 atan unchanged price level. Itshould be obvious that bothP and Y may rise, as long asPY = e396,000.



are ready to produce different numbers of cars at one and the same pricelevel. This is tantamount to postulating a horizontal aggregate supply curve(Figure 1.9, panel (b)). We will be looking at aggregate supply curves, theireconomic underpinning and slope, in some detail in later chapters. For nowthe simple but important lesson to be learned from this stylized example isthat with our extreme second case being an exception the amount ofmoney circulating in the economy directly bears on the price level. So if thesupply of money changes, the price level changes. If this continues, we haveinflation. Equipped with this tentative understanding we now turn to a brieflook at the government budget and the balance of payments.

The government budget and the balance of payments

In addition to the national income accounts, which measure the circularflows with leakages and injections, there are two other accounts that macro-economists need in their elementary tool-box. These are the governmentbudget and the balance of payments. As Figure 1.7 shows, these twoaccounts simply trace the interactions between the domestic private sectorand the government sector (characterized by the left-hand rectangle) on theone hand, and with other countries (characterized by the rectangle on theright) on the other hand. While the basic data on leakages from and injec-tions into these sectors are already being supplied in the national incomeaccounts, the government budget and the balance of payments break downthese numbers in more detail. More importantly, though, they show howbudget deficits in the first case, and trade imbalances in the second case, arebeing paid for.

The government budget has two main purposes: to break up the catch-allvariables G and T into more detailed subcategories, and to show how a givenbudget deficit is being financed. Similarly, the balance of payments addsdetail to the general notion of exports and imports. But, again, it also traceshow a given imbalance between exports and imports is being financed.

Let us start with a look at how governments can finance budget deficits.As is the case for you and me, governments can only spend more than theycollect by running up debt (or running down wealth). Unlike private individ-uals, however, governments have the second option of running into debt withanother public or government institution called the central bank. So if wedenote government debt owed to the private sector by DPS and governmentdebt owed to the central bank (or, actually, to itself) by DCB, a budget deficitmust change either or both debt categories:

(1.3)

A government budget deficit changes government bonds holdings either byprivate citizens or by the central bank.

The balance of payments records a countrys international transactions.Usually these require the purchase or the sale of foreign currency (or foreignmoney). An exception to this rule is of course the Euro area, where cross-border transactions are done in one currency. The balance of payments issubdivided into three major accounts: the current account CA, the capitalaccount CP and the official reserve account OR. The official reserve account

G - T = DPS + DCB

The government budget isprimarily a planninginstrument. In hindsight itbreaks down governmentreceipts and expenditures, andshows how deficits are beingfinanced.

The central bank is agovernment agency primarilyresponsible for supplying theeconomy with the rightamount of money.

The balance of paymentsrecords a countrys trade ingoods, services and financialassets with other countries.

Here and in the remainder ofthe book the Greek letter denotes the change of theattached variable over thepreceding period.



is sometimes displayed as a sub-category of a more broadly defined capitalaccount. We list the two separately, however, because this enables us to keepprivate activities in the foreign exchange market, recorded in CP, apart fromgovernment intervention, recorded in OR. This distinction will prove usefulwhen we talk about the virtues of different exchange rate systems in laterchapters.

If we take the balance of payments of the euro area as an example, anytransaction that involves the purchase of euros is recorded as a positive entryin one of the balance of payments accounts. Any transaction resulting in thesale of euros is entered as a negative number. Since any purchase of euros byone person requires the sale of euros by somebody else, any positive entry inone account gives rise to a negative entry of the same magnitude in the sameor some other account. All entries must thus add up to zero. In other words,since purchases of currency must equal sales, the three accounts that make upthe balance of payments must add up to zero:

+ + = 0 (1.4)

Current account Capital account Official reserve account

The current account records the flow of goods and services across bordersthat was represented as leakages from and injections into the rest of theworld box in Figure 1.7. More generally, it measures the net demand fordomestic currency which results from the net sales of domestically producedgoods and services to the world, plus cross-border income flows and transferpayments. For most of the book we will ignore income flows and transfers toobtain the convenient approximation CA = EX - IM. Now, if an Americanbuys a Ferrari with a e180,000 price tag, this Italian export invokes the pur-chase of the appropriate amount of euros by the American customer inexchange for her dollars. It is recorded with a positive sign, as a credit item.

The capital account records all purchases and sales of foreign assets, that isof such things as bonds, stocks or securities, that do not involve the centralbank. It registers the net demand for the domestic currency which resultsfrom the net sales of domestic bonds and other assets to foreigners. If net for-eign assets (defined as domestic holdings of foreign assets minus foreignholdings of domestic assets) are denoted by F, then the capital account meas-ures the net fall in F that occurred during a given period, that is CP = -F.Let a Dutchman invest e50,000 in US government securities (Dutch F rises).Just as if he had bought an American car, he needs to purchase US dollars byselling euros in order to complete the transaction. Because euros are beingsold, this transaction is being recorded with a negative sign, as a debit item.

The official reserve account tracks the involvement of the central bank inthe foreign exchange market. It measures the net demand for domestic cur-rency which the purchase or sale of currency reserves held by the centralbank constitutes. If RES denotes central bank foreign currency reserves, thenOR measures the fall in RES, that is OR = -RES. If the European CentralBank sells $1 million that it held in its vaults in exchange for euros, reservesfall by $1 million, and a $1 million net demand for domestic currency results.The equivalent amount of euros purchased is being recorded with a positivesign, as a credit item.

OR()*

CP()*

CA()*

The current account recordsgoods, services and transfersinto and out of the country.

The capital account recordsthe flow of financial assets intoand out of the country.

The official reserve accountrecords the purchases andsales of foreign currency by thecentral bank.



Table 1.3 The balance of payments accounts. (2002, in millions of US dollars). Note thatwhile in theory CA + CP + OR = 0, this does not hold in reality due to errors and omissionsduring data compilation.

CA CP OR

Austria 4 -6,673 1,723Belgium* 9,418 -6,536 -1,442Denmark 5,092 -8,140 -5,615Finland 10,237 -8,716 113France 13,600 -27,810 3,970Germany 43,210 -70,420 1,980Greece -8,883 13,437 -1,863Ireland -350 -474 292Italy -6,005 14,361 -3,169Japan 109,130 123,770 -187,150Netherlands 9,571 -12,682 132Portugal -6,201 8,360 -1,017Spain -8,735 21,173 -3,690Sweden 10,545 -8,886 -661United Kingdom -25,740 14,090 630United States -475,200 577,600 -3,690*Numbers for Belgium include Luxe

economics - macroeconomics, 2nd edition - (manfred gartner) pearson prentice hall 2006

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