Notes Lecture Intermediate Macroeconomics,
Output and Time
Tirza van der Vliet
November 2020
Contents
1 General information 3
2 Introductory lecture: refresher of prerequisite knowledge 3
2.1 Macroeconomics . . . . . . . . . . . . . . . . . . . . . . . . . . . 4
2.1.1 Output and Time . . . . . . . . . . . . . . . . . . . . . . 4
2.2 Chapter 2: Booms and recessions (I): the Keynesian cross . . . . 6
2.2.1 Goods market and aggregate demand . . . . . . . . . . . 6
2.2.2 Circular flow model . . . . . . . . . . . . . . . . . . . . . 7
2.2.3 Fiscal policy . . . . . . . . . . . . . . . . . . . . . . . . . 9
2.3 Chapter 3: Money, interest rates and the global economy . . . . 11
2.3.1 Money market (demand) and interest rate . . . . . . . . . 12
2.3.2 Money market (supply) and interest rate . . . . . . . . . 13
2.3.3 IS-LM model: The Global Economy . . . . . . . . . . . . 13
2.4 Monetary and Fiscal Policy: a first examination . . . . . . . . . . 16
3 Week 1: Chapter 4: Exchange Rates and the Balance of Pay-
ments; Chapter 5: Booms and Recessions (II): The National
Economy. 18
3.1 Globalisation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18
3.1.1 Analysis effected by R . . . . . . . . . . . . . . . . . . . . 19
3.2 IS-LM model extended . . . . . . . . . . . . . . . . . . . . . . . . 21
3.2.1 Equilibrium on the foreign exchange market . . . . . . . . 24
3.3 Mundell-Fleming model . . . . . . . . . . . . . . . . . . . . . . . 25
3.3.1 Mundell-Fleming: National economy model . . . . . . . . 27
3.4 Effectiveness of policy making by the government . . . . . . . . . 27
3.5 Effectiveness of policy making by the Central Bank . . . . . . . . 30
3.6 The effect of iwor ld . . . . . . . . . . . . . . . . . . . . . . . . . . 32
3.7 Risk assessment . . . . . . . . . . . . . . . . . . . . . . . . . . . . 34
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,4 Week 2: Chapter 6: Enter Aggregate Supply 37
4.1 Introducing supply . . . . . . . . . . . . . . . . . . . . . . . . . . 37
4.2 Mundell-Fleming and price changes . . . . . . . . . . . . . . . . . 38
4.2.1 Potential income Y* . . . . . . . . . . . . . . . . . . . . . 40
4.3 Supply in economy: labour market . . . . . . . . . . . . . . . . . 41
4.3.1 Labour supply . . . . . . . . . . . . . . . . . . . . . . . . 44
4.3.2 Classical labour market . . . . . . . . . . . . . . . . . . . 45
4.4 Indicators of unemployment . . . . . . . . . . . . . . . . . . . . . 46
4.4.1 Unemployment in equilibrium . . . . . . . . . . . . . . . . 47
4.4.2 Wage rigidities, potential and actual output . . . . . . . . 48
4.5 The new Keynesian theory of aggregate supply . . . . . . . . . . 50
5 Week 3: Chapter 7: Booms and Recessions (III): Aggregate
Supply and Demand 53
5.1 Prices and output . . . . . . . . . . . . . . . . . . . . . . . . . . . 54
5.2 Aggregate supply and aggregate demand in price-income space . 54
5.2.1 Deriving the aggregate demand curve . . . . . . . . . . . 56
5.2.2 Deriving the AD-curve with a flexible exchange rate . . . 57
5.2.3 Deriving the AD-curve with a fixed exchange rate . . . . 61
5.3 AD-AS model . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 65
5.3.1 Effects from fiscal policy . . . . . . . . . . . . . . . . . . . 67
5.3.2 Effects from monetary policy . . . . . . . . . . . . . . . . 71
5.3.3 Effects from a change in iwor ld . . . . . . . . . . . . . . . 72
5.3.4 Dynamic analysis of the short- and long-run effects . . . . 75
6 Week 4: Chapter 8: Booms and Recessions (IV): Dynamic
Aggregate Demand and Supply 76
6.1 Deriving the SAS and DAD curves . . . . . . . . . . . . . . . . . 76
6.1.1 Long-run equilibrium in an economy with SAS-DAD model 79
6.1.2 Analyzing the SAS-DAD model . . . . . . . . . . . . . . . 80
6.2 Different types of expectations . . . . . . . . . . . . . . . . . . . 81
6.2.1 Examples with different expectations . . . . . . . . . . . . 82
6.3 Effects from a shock or policy . . . . . . . . . . . . . . . . . . . . 96
7 Week 5: Chapter 12: The European Monetary System and the
Eurozone at work 96
7.1 European Monetary System (EMS) and the Exchange rate Mech-
anism (ERM) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 96
7.1.1 The national economy versus the rest of the world . . . . 97
7.1.2 The principal of the nth currency . . . . . . . . . . . . . . 98
7.2 The EMS crisis (1): unification West and East Germany . . . . . 99
7.3 Exchange rate target zones . . . . . . . . . . . . . . . . . . . . . 104
7.4 The EMS crisis (2): Speculative attacks . . . . . . . . . . . . . . 105
7.4.1 Preliminaries . . . . . . . . . . . . . . . . . . . . . . . . . 105
7.5 Monetary and fiscal policy in Eurozone . . . . . . . . . . . . . . . 112
7.6 Restrictions on fiscal policy . . . . . . . . . . . . . . . . . . . . . 116
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, 7.6.1 Stability and Growth Pact . . . . . . . . . . . . . . . . . . 116
7.6.2 No-bailout clause . . . . . . . . . . . . . . . . . . . . . . . 117
7.6.3 2007 crisis: fiscal union? . . . . . . . . . . . . . . . . . . . 119
8 Week 6: Chapter 14: Budget Deficits and Public Debt 120
8.1 Government budget . . . . . . . . . . . . . . . . . . . . . . . . . 120
8.1.1 Government expenditure . . . . . . . . . . . . . . . . . . . 121
8.1.2 Government revenue . . . . . . . . . . . . . . . . . . . . . 121
8.2 Budget deficits and public debt . . . . . . . . . . . . . . . . . . . 122
8.2.1 Scenario A: a primary deficit and high growth . . . . . . . 123
8.2.2 Scenario B: a primary surplus and high growth . . . . . . 124
8.2.3 Scenario C: a primary deficit and low growth . . . . . . . 125
8.2.4 Scenario D: a primary surplus and low growth . . . . . . 126
8.2.5 Phase diagrams . . . . . . . . . . . . . . . . . . . . . . . . 126
8.2.6 Adding the deficit ratio line . . . . . . . . . . . . . . . . . 130
8.3 Case study: Ireland . . . . . . . . . . . . . . . . . . . . . . . . . . 130
8.4 Monetary union and budget rules . . . . . . . . . . . . . . . . . . 134
8.5 Government debt and financial markets . . . . . . . . . . . . . . 135
8.5.1 Effect of increase of deficit on the R-line . . . . . . . . . . 139
8.5.2 Problems in government bond markets . . . . . . . . . . . 141
8.5.3 Criticism on credit rating agencies . . . . . . . . . . . . . 142
1 General information
Course material: Manfred Gärtner (2016) Macroeconomics; 5th edition.
Course format: on Wednesdays: recorded lectures and lecture slides. On
Fridays: live tutorials on selection of assignments.
Course assessments: mid-term exam 40 percent, end-term exam 60 percent
(both open questions via Remindo).
Main learning objectives: think in terms of abstract models when discussing
questions about the international economy (simplification of reality), describe
and explain the interactions between goods, money, and foreign exchange mar-
kets, describe the functioning of the economy in the short, medium, and long
run (time-frame), describe and explain the macroeconomic implications of an
open economy (countries that can be affected by the developments in the in-
ternational economy) and take a well-reasoned stance on key macroeconomic
problems and the fiscal and monetary policy measures to address them.
2 Introductory lecture: refresher of prerequisite
knowledge
Macroeconomics is trying to understand the big picture of e.g. national economies
and relationships between countries better. Try to understand what happens
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,to (parts of) entire economies. We look at big variables such as growth, na-
tional income, unemployment, inflation etc. and the relationship between these
variables e.g. how is income related to unemployment or what is the effect of
inflation on economic growth.
In addition to looking at the economy as a whole, macroeconomics also
accounts for various issues such as globalisation (international trading of goods
and services, international flows of capital and migration), the effect of economic
shocks, government policies and importance of institutions (institution can be
many things: e.g. European Union, type of exchange rate regime a country
follows or the way a country organises the labour markets).
2.1 Macroeconomics
One thing to look at when looking at the bigger picture of countries, is the
changing levels of output over long periods of time. When looking at Gross
Domestic Product (total level of output in economies) over the last years, in the
long run, we see a steady increase in total output volume of various countries.
We also see differences in the growth of GDP between these countries.
The total GDP is quite a rough indicator. We can also look at the Gross
Domestic Product per Capita. This is the GDP per individual in a specific
country (calculated by: total GDP / total number of people living in a certain
country). Again, we see that in the long run there is a steady increase in GDP
per Capita. One could argue that GDP per Capita is an indicator of welfare, and
that it (to some extent) represents productivity. However, it does not capture
inequality or happiness.
When zooming in on shorter times frames, the story is different. An example
is the situation in the 1930’s in Western-Europe and the USA. During this
time, there was a huge crisis in the world economy. We can see there is a big
decrease, or negative growth, during and just after the crisis. Relatively quickly,
you can see that economies recuperate and get back to an increasing trend-line.
When changing the time frame, we discover there are different things visible and
recognize that perhaps we need to focus on different factors in order to explain
these effects that might be different than when looking at the long run.
In short: when zooming in on shorter-term periods you can see e.g. effects
of negative economics shocks, if you would only look at the long-run, then these
things become much less visible.
2.1.1 Output and Time
”The most important goal of macroeconomics is to develop an understanding
of what makes income differ between countries and what makes them grow or
fluctuate over time” (Gärtner, p. 36). In order to be able to research these
topics, there are various things we need to do:
1. Analysing equilibrium. In equilibrium, what does a country look like?
What are the markets that are important for creating an equilibrium in
an economic system?
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, 2. Comparing equilibrium. What can we learn from comparing equilibrium?
If we have an equilibrium before and after a certain event (i.e. a cer-
tain change in variable), can we explain why a country is now in a new
equilibrium? How is that compared to the old equilibrium?
3. How do countries move between equilibrium’s? Can we explain how coun-
tries move from one equilibrium to the next one?
4. Different time frames. Analysis and explanation depends on time frame.
Different processes. Time frame might have implications for the type
of process we look at.
Different variables. Time frame might have implications for the vari-
ables we want to focus on.
Different policies. Time frame might have implications for the type
and effectiveness of policy making (for central bank or government). Chang-
ing your time frame might mean that you need to apply different policies
or the content of policy might have to be adjusted to the difference in time
frame.
Perhaps the best way to understand the difference in time frame, is by com-
paring short run and long run (medium run is always debatable where it actually
is). Especially in Macroeconomics by Gärtner, a key issue when thinking about
time frames is: what do we assume about prices?
If you think of an economic system, a very basic equation that you can think
of is the quantity equation: M (quantity of money) × V (velocity of money,
how many times does money change hands in an economy) = P (price level in
an economy) × Y (total output).
If we assume that the velocity of money is fixed:
– In the long run the total output (Y) is determined by production factors.
In the long run, you can only produce at maximum with the input that you
have. If this is true, then Y is fixed, and a change in the quantity of money only
leads to a change in price level: ∆M = ∆P. Here, the aggregate supply is thus a
vertical line at a fixed output level. If the aggregate demand increases, the only
thing that changes is the price level that goes up. However, if the productivity
in a country goes up, in the long run the level of output shifts to the right. This
is the classical macroeconomics analysis.
– In the short run, you can deviate from your long run supply. This is
because in the short run, you can play around with the level of output. In
the short run we assume price level (P) is fixed. Then, the total output (Y)
is determined by the quantity of money (M): ∆M = ∆Y. Here, the aggregate
supply (output) is thus a horizontal line at a fixed price level. If the aggregate
demand increases, the only thing that changes is the output level that goes up.
This is the Keynesian macroeconomics analysis.
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