Macroeconomics - A European perspective
O. Blanchard, A Amighini & F. G iavazzi
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,Contents
1 A tour around the world .................................................................................................... 6
1.1 The crisis........................................................................................................................ 6
1.2 The United States........................................................................................................... 6
1.2.1 Low interest rates and the zero lower bound................................................................................................. 7
1.2.2 How worrisome is low productivity growth? .................................................................................................. 7
1.3 The euro area................................................................................................................. 7
1.3.1 Can European unemployment be reduced? ................................................................................................... 7
1.3.2 What has the euro done for its members....................................................................................................... 8
1.4 China ............................................................................................................................. 8
2 A tour of the book .................................................................Error! Bookmark not defined.
2.1 THe short run, the medium run and the long run...................Error! Bookmark not defined.
3 The goods market ............................................................................................................... 9
3.1 The composition of GDP ................................................................................................. 9
3.2 The demand for goods .................................................................................................... 9
3.2.1 (C) Consumption............................................................................................................................................ 10
3.2.2 (I) Investments............................................................................................................................................... 11
3.2.3 (G) Government expenditures ...................................................................................................................... 11
3.3 The determination of equilibrium output........................................................................11
3.3.1 The algebra of the equilibrium...................................................................................................................... 11
3.3.2 Using a graph................................................................................................................................................. 12
3.3.3 How long does it take for output to adjust ................................................................................................... 12
3.4 I=S > An alternative way of thinking about the goods-market equilibrium.........................13
3.4.1 Option one: deri vation from the simple equilibrium model......................................................................... 13
3.4.2 Option two: derivation from the private savings condition ......................................................................... 13
3.5 Is the government omnipotent? A warning .....................................................................14
4 Financial markets part 1................................................................................................... 14
4.1.1 The demand for money ................................................................................................................................. 14
4.1.2 Deriving demand for money ......................................................................................................................... 14
4.2 Determining the interest rate I .......................................................................................15
4.2.1 Money demand and supply equilibrium ....................................................................................................... 15
4.2.2 Monetary policy and open market operations ............................................................................................. 15
4.2.2.1 The balance sheet of the central bank ............................................................................................................ 16
4.2.2.2 Bond prices and yields .................................................................................................................................. 16
4.2.2.3 Back to open market operations.................................................................................................................... 16
4.2.2.4 Choosing money or choosing interest rate ...................................................................................................... 16
4.3 Determining the interest rate II ......................................................................................16
4.3.1 What banks do............................................................................................................................................... 16
4.3.2 The demand and supply for central bank money ......................................................................................... 17
4.3.2.1 The demand for central bank money.............................................................................................................. 17
4.3.2.2 Equilibrium in the market for central bank money ........................................................................................... 18
4.4 The liquidity trap ...........................................................................................................18
5 Financial Markets: the IS-LM model ................................................................................ 19
5.1 The goods market and the IS relations............................................................................19
5.1.1 Investment, sales and interest rate............................................................................................................... 19
5.1.2 Determining output....................................................................................................................................... 19
5.1.3 Deriving the IS curve...................................................................................................................................... 20
5.1.4 Shifts in the IS curve ...................................................................................................................................... 20
5.2 Financial markets and the LM relation ............................................................................20
5.2.1 Real money, real income and the interest rate ............................................................................................ 20
5.3 Putting the IS and the LM relations together...................................................................20
How policy changes the IS-LM relation ......................................................................................21
5.3.1 Fiscal policy.................................................................................................................................................... 21
5.3.1.1 Does it shift the IS curve and/or the LM curve and if so, how?........................................................................... 21
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, 5.3.1.2 What characterizes the effects of these shifts in equilibrium? ........................................................................... 21
5.3.1.3 How is this described in words?..................................................................................................................... 21
5.3.2 Monetary policy ............................................................................................................................................ 21
5.3.2.1 Does it shift the IS curve and/or the LM curve and if so, how?........................................................................... 21
5.3.2.2 What characterizes the effects of these shifts in equilibrium? ........................................................................... 21
5.3.2.3 How is this described in words?..................................................................................................................... 21
5.4 Using a policy mix..........................................................................................................22
5.5 How does the IS-LM model fit with the real world ...........................................................22
6 Financial markets II........................................................................................................... 22
6.1 Nominal versus real interest rates ..................................................................................22
6.1.1 Nominal and real interest rates: the zero lower bound and deflation ......................................................... 23
6.2 Risk and risk premiums ..................................................................................................24
6.2.1 The risk of default.......................................................................................................................................... 25
6.2.2 Risk aversion.................................................................................................................................................. 25
6.3 The role of financial intermediaries ................................................................................25
6.3.1 The choice of leverage................................................................................................................................... 25
6.3.2 Liquidity ......................................................................................................................................................... 26
6.4 Extending the IS-LM model ............................................................................................27
6.4.1 Financial shocks and policies......................................................................................................................... 28
7 The labour market ............................................................................................................ 28
7.1 A tour of the labour market ...........................................................................................28
7.1.1 The large flows of workers ............................................................................................................................ 29
7.2 Movements in unemployment .......................................................................................30
7.3 Wage determination .....................................................................................................30
7.3.1 Bargaining...................................................................................................................................................... 31
7.3.2 Efficiency wages ............................................................................................................................................ 31
7.3.3 Wages, prices and unemployment................................................................................................................ 31
7.3.3.1 The expected price level (𝑷𝒆) ........................................................................................................................ 31
7.3.3.2 The unemployment rate (u)........................................................................................................................... 31
7.3.3.3 The other factors (z) ..................................................................................................................................... 31
7.4 Price determination.......................................................................................................32
7.5 The natural rate of unemployment.................................................................................32
7.5.1 The wage-setting relation ............................................................................................................................. 32
7.5.2 The price-setting relation .............................................................................................................................. 33
7.5.3 How this stuff translates into a graph........................................................................................................... 33
7.5.4 Equilibrium in real wages and unemployment ............................................................................................. 33
8 The Philips curve, natural rate of unemployment & inflation........................................ 34
8.1 Inflation, expected inflation and unemployment .............................................................34
8.2 The Philips curve and its mutations ................................................................................35
8.2.1 The original Philips curve .............................................................................................................................. 35
8.2.2 The apparent problem with the Philips curve............................................................................................... 35
8.2.3 Reasoning about the Philips curve and weighing ......................................................................................... 35
A brief overview of the different curves and their according weightings ........................................................................ 36
8.2.4 Fitting the Philips curve with a regression line ............................................................................................. 36
8.3 The Phillips curve and the natural rate of unemployment ................................................36
8.4 Summary and many warning..........................................................................................37
8.4.1 Variation in the natural rate across countries .............................................................................................. 37
8.4.2 Variation in the natural rate over time ......................................................................................................... 38
8.4.3 High inflation and the Philips curve relation................................................................................................. 38
8.4.4 Deflation and the Philips curve relation........................................................................................................ 38
9 All markets together: From the short to the medium run.............................................. 38
9.1 Developing the IS-LM-PC model .....................................................................................38
9.2 Dynamics and the medium-run equilibrium ....................................................................39
9.2.1 Revisiting the expected inflation................................................................................................................... 40
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, 9.2.2 The zero lower bound and debt spirals......................................................................................................... 40
9.3 Fiscal consolidation revisited..........................................................................................40
9.4 The effects of an increase in the price of oil ....................................................................41
9.5 The effects of an increase in taxes..................................................................................41
17 Openness in goods and financial markets ....................................................................... 41
17.1 Openness in goods markets ...........................................................................................41
17.1.1 Exports and imports ...................................................................................................................................... 42
17.1.2 The choice between domestic goods and foreign goods.............................................................................. 42
17.1.3 Nominal exchange rates................................................................................................................................ 42
17.1.4 From nominal to real exchange rates ........................................................................................................... 42
17.1.5 From bilateral to multilateral exchange rates............................................................................................... 43
17.2 Openness in financial markets........................................................................................43
17.2.1 The balance of payments .............................................................................................................................. 44
17.2.1.1 The current account ..................................................................................................................................... 44
17.2.1.2 The capital account ...................................................................................................................................... 44
17.2.1.3 GNP and GDP .............................................................................................................................................. 44
17.2.2 The choice between domestic and foreign assets ........................................................................................ 45
17.2.3 Interest rates and exchange rates................................................................................................................. 45
18 The goods market in an open economy .......................................................................... 46
18.1 The IS relation in the open economy ..............................................................................46
18.1.1 The determinants of the demand function................................................................................................... 46
18.1.1.1 The determinants of C, I and G ...................................................................................................................... 46
18.1.1.2 The determinants of imports......................................................................................................................... 46
18.1.1.3 The determinants of export........................................................................................................................... 47
18.1.2 Putting the components together................................................................................................................. 47
18.2 Equilibrium output and the trade balance .......................................................................48
18.3 Increase in demand – to domestic or to foreign?.............................................................48
18.3.1 Increases in domestic demand...................................................................................................................... 48
18.3.2 Increases in foreign demand ......................................................................................................................... 48
18.3.3 Fiscal policy revisited..................................................................................................................................... 49
18.4 Depreciation, the trade balance and output....................................................................49
18.4.1 Depreciation and the trade balance: the Marshall-Lerner condition ........................................................... 49
18.4.2 Combining the exchange rate and fiscal policies .......................................................................................... 50
18.5 Looking at dynamics: the J-curve ....................................................................................50
18.6 Saving, investment and the current account balance .......................................................51
19 Output, the interest rate and the exchange rate............................................................ 52
19.1 Equilibrium in the goods market.....................................................................................52
19.2 Equilibrium in the financial markets................................................................................52
19.3 Putting goods and financial markets together .................................................................54
19.4 The effects of policy in an open economy .......................................................................54
19.4.1 The effects of monetary policy in an open economy.................................................................................... 54
19.4.2 The effects of fiscal policy in an open economy ........................................................................................... 54
19.5 Fixed exchange rates .....................................................................................................55
19.5.1 Policy with a fixed exchange rate.................................................................................................................. 55
20 Exchange rate regimes ..................................................................................................... 56
20.1 The medium run............................................................................................................56
20.1.1 The IS relation under fixed exchange rates................................................................................................... 56
20.1.2 Equilibrium in the short and medium run..................................................................................................... 56
20.1.2.1 The short run............................................................................................................................................... 56
20.1.2.2 The medium run .......................................................................................................................................... 56
20.2 Exchange rate crises under fixed exchange rates .............................................................57
20.3 Exchange rate movements under flexible exchange rates ................................................57
20.3.1 Exchange rates and the current account ...................................................................................................... 58
20.3.2 Exchange rate and current and future interest rates ................................................................................... 58
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, 20.3.3 Exchange rate volatility ................................................................................................................................. 58
20.4 Choosing between exchange rate regimes ......................................................................58
20.4.1 Common currency areas ............................................................................................................................... 58
20.5 Hard pegs, currency boards and dollarization..................................................................59
Article I: A decade after the global financial crisis: are we safer? ......................................... 59
20.1 Global financial stability assessment...............................................................................59
20.1.1 Intro ............................................................................................................................................................... 59
20.2 Fragilities in Emerging and Frontier Markets ...................................................................60
20.3 Banks – Stronger, but not yet out of the woods...............................................................60
20.4 Policies to safeguard Financial Stability ...........................................................................60
21 Article 2: The Euro crisis (Vercelli) ................................................................................... 61
21.1 The origins of the eurocrisis ...........................................................................................61
21.2 The Propagation of the Crisis in the Eurozone .................................................................61
21.3 The conventional explanation ........................................................................................61
21.4 The alternative explanation ...........................................................................................62
21.4.1 Not honouring the OCA conditions from Mundell ........................................................................................ 62
21.4.2 The short-term bias of the euro .................................................................................................................... 62
21.4.3 Other issues ................................................................................................................................................... 62
21.5 Policy recommendations................................................................................................62
21.6 Concluding....................................................................................................................62
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,1 A TOUR AROUND THE WORLD
1.1 T HE CRISIS
The crisis of 2008 is an interesting happening to look at to get a basic understanding of how
macroeconomic functions work and how we can approach is. Pessimist in America believed that
lowering interest rates, increasing demand, would be a good way to avoid a recession. This was in 2007
however even too optimistic. Due to citizens of America taking on mortgages which they could not pay
back in any way, the origins of the recession were rooted way deeper than these pessimists believed.
Complex constructions of mortgages which were used to pay securities which held the security of a
mortgage being paid back, made it hardly possible to value any security anymore. Banks held these
securities without knowing its full composition.
When house prices started declining, people could not pay back their mortgages. The securities held
by banks lost their values big time. In turn, banks held a lot less cash which and were unable to borrow
money due to their inability to pay it back. All of it resulted in the financial system standing on the
brink of collapsing. The financial crisis quickly turned in an economic crisis, driving stock prices down
and housing prices went down with it.
What even posed the bigger issue, was with all this stress in the financial market people started to cut
heavily on their spending. Firms worried about that decrease in spending, so they cut on their
investment in other projects. All of this led to a vicious circle, which had an enlarging effect in the crisis.
These problems occurred in America, but quickly spread across the world. This has two main reasons:
1. Trade: American spent less on their products which also meant that they needed less import
from other countries. To those countries which America imported from, this thus meant that
their export would lower leading to less cashflows.
2. Finance: Banks in America had borrowed money from banks in other countries as well. They
could not pay back their loans as well, leading to financial problems as well in other countries.
After the crisis, countries learned, and international agreements made sure a crisis of this magnitude
and with such complex origins would hardly be possible. Recovery was however uneven for a lot of
different areas. America has recovered back to levels that were before the crisis. Europe, more
precisely the eurozone, has not yet recovered well. The unemployment in this zone is still relatively
high and growth is still meagrely positive.
1.2 T HE UNITED STATES
When macroeconomists look at a country, they ask themselves two questions:
1. How big is the country from an economic point of view?
2. What is its standard of living?
To answer those questions, you look at the following statistics respectively:
1. Output of the country as a whole
2. Output per person
When you want to take a look at the health of a country, you want to look at:
1. The Output growth: How much output has changed
2. The unemployment rate: Rate of how much people are unemployed in a country
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, 3. The inflation rate: How much average prices have increased in the country
If you look at all these different subjects, America is doing quite good actually. The growth rate for the
USA has been steadily increasing, making economists feel optimistic about the USA. The Fed has
however stimulated the demand in the US by keeping the interest very low. Next to that, the
productivity growth in the USA has also been diminishing in growth rate.
1.2.1 Low interest rates and the zero lower bound
When the crisis hit, the fed lowered the interest rate to near zero. This was done to increase spen ding
as the cost of borrowing money goes down with it. Interest was however kept above zero, because a
negative interest would create a weird situation in which nobody would want to hold any bond as it
would cost them interest instead of deliver interest.
There are two other problems arising from approaching such a lower bound
- The fed cannot lower the interest again, which implies that they are also less able to respond
properly to future shocks
- People that do not hold a bond (because the return is too low) start investing in other risky
assets that could eventually trigger a crisis again
1.2.2 How worrisome is low productivity growth?
The main driver for long-term growth is productivity. If that does not grow, there cannot be a
sustainable increasing income for people. Some say it just fluctuates, so some low productivity years
are not that bad. Others believe that it is hard to measure and could be underestimated.
A significant problem with low productivity growth is that with it inequality grows. If productivity
growth is high, everybody benefits from it by a raise in their standard of living. Nowadays, the
inequality in the US is however growing.
1.3 T HE EURO AREA
The EU, European Union, is a special alliance of nations. Together, they decided to use the same
common currency which we all know as the euro. Some countries decided not to go along with it to
guard their own monetary union (like the UK). That’s why there is a different EU and a euro area. We
will keep a clear line in between the both. The EU is too different within to be one economic aggregate
whilst the euro area is an aggregate system.
The euro area responded the same as the US to the recession. An interesting difference is however
found after the recession because the euro area experienced another dip. This second dip is referred
to as the euro crisis and has to do with the issues around Greece. There was a lot of uncertainty about
whether the euro would survive all the debt issues. This crisis was resolved but left some permanent
scars in the euro area.
1.3.1 Can European unemployment be reduced?
Unemployment in the European Union varies a lot. Where Italy and Greece experience an rate of over
20%, Germany only sees that rate at about 5%. Bringing back unemployment is thus something that
must be done for each country differently. We first must look at the origins of this unemployment to
understand how to bring it back:
- Much of the current unemployment is due to the 2008 crisis. We can only hope that that effect
will fade away over time.
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, - How low can unemployment actually get? Some countries have had relatively high
unemployment forever. It tells us that this higher unemployment could originate from
something else as well and that it is that which we should be looking into.
One of the reasons for this constant high unemployment is to be found, according to some economists,
in the job-protection by European countries. This protection has the negative side ef fect that
companies are scared away from hiring people. Next to that, unemployment in the European countries
isn’t that bad. You are financially sponsored which takes away part of your incentive to find a new job
and un-unemploy yourself. The solution to this is to let market do its work and take away all these
protections or market rigidities.
1.3.2 What has the euro done for its members
To many, the euro is a strong symbol of unity. Political in the sense that it ends an era of war and
economically in the sense that it ends complicated exchanges and foreign currencies. It has brought
over 18 nations together politically and economically.
Other however worry that it is that symbolism that has a high cost. The high cost is found in the
monetary policy that tackles all countries: the interest. This interest is the same at all countries but this
creates a problem: it is too high for one and too low for the other. If a country, such as Greece, is in a
recession the interest rate drops to save that specific country. Other countries however suffer the
consequences of such a low interest rate as well, limiting their growth. Since that issue with Greece
this problem has become less abstract. Some believe nations have to leave the euro area so they have
more control over their currency and are better able to adapt to financial shocks which on the other
hand would cost them the huge benefits of being in such a strong monetary union.
The Brexit is a good indicator that there is something wrong with the European Union (at least in the
eyes of the brits). The benefits of being in this union did not outweigh the benefits anymore.
1.4 C HINA
If you look at china purely use its macroeconomic figures, you would not suppose China to be one of
the bigger economic powers in the world. Yet, somehow we hear new about that nation daily. Why?
It has mostly to do with the fact that China has been growing for three decades very rapidly. An
interesting number illustrating that is for example the very high output growth of 10%. Next to that
the Chinese economy is very closed off from the rest of the world, leaving it invulnerable to financial
shocks in the world.
Some say that China overestimates these numbers on purpose. If you however look at it from an
economic perspective, you find that China is really doing well. They first encouraged the investments
in companies (50% in China vs. 20% in US). Second, Chinese companies have collaborated a lot with
companies around the world. This allowed them to learn from the best, increasing their productivity.
This good economic situation mainly has to do with how it came to be. The fact that there is a very
stable (even though communist) political system has helped big time.
Recently, the growth has however diminished. Economist and the Chinese government as well have
said that this is a good thing. Instead of encouraging people to save money, people are now
encouraged to start consuming. This transition from saving to consuming is now the big issue lying in
front of the Chinese government.
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