Macroeconomic Analysis Rob Hart

A critical introduction to Macroeconomic Analysis Rob Hart c Draft date March 22, 2016 Contents Introduction 1 Chapter 1. An economy without money 3 1.1. Production in an economy without money 3 1.2. Increasing production: Economic growth 3 1.3. Unemployment 6 1.4. Stability and the business cycle 7 1.5. Summary 8 Exercises 8 Chapter 2. The circular flow, money, and interest 11 2.1. Coconut island and five types of agent 11 2.2. Investment and capital 17 2.3. Relevance to real economies 18 Exercises 21 Chapter 3. Economic growth 1: Empirical observations 23 3.1. Mathematical prologue 23 3.2. Pre-industrial growth 23 3.3. Patterns in growth across time and countries 24 3.4. Structural change 26 3.5. Measurement of GDP, and growth 26 Exercises 27 Chapter 4. Economic growth 2: Capital accumulation and technology adoption 29 4.1. Capital accumulation on Coconut Island 29 4.2. A model of growth through investment in new technology 31 4.3. Relevance to real economies 34 Exercises 35 Chapter 5. Economic growth 3: Endogenous growth 37 5.1. Growth through adoption of new technology 37 5.2. Growth through development of new technology 39 5.3. Research policy 40 5.4. Relevance to real economies: Case studies 42 Exercises 42 Chapter 6. The business cycle 1: Empirical observations 45 6.1. Fluctuations in GDP 45 6.2. Fluctuations in consumption, investment, and unemployment 45 Exercises 47 Chapter 7. The business cycle 2: A very simple Keynesian model 49 7.1. A model without saving and borrowing 49 7.2. Saving 51 7.3. The role of the government: Fiscal policy 53 7.4. The role of the central bank: Monetary Policy 55 7.5. Relevance to real economies 56 Exercises 60 Chapter 8. The business cycle 3: A model of the medium term with inflation 63 8.1. Keynes and the quantity theory 63 8.2. The AD–AS model 63 iii iv CONTENTS 8.3. The model with expectations, or why the government can’t outrun the market 68 8.4. Optimal stabilization policy 70 8.5. Relevance to real economies 72 Exercises 76 Chapter 9. Unemployment: Definitions and Data 79 9.1. The definition of unemployment 79 9.2. Different types of unemployment 80 9.3. Data on unemploymentrates 80 9.4. Data on unemployment, vacancies, and labour-market dynamics 82 Exercises 84 Chapter 10. Unemployment: Explanations and Policy 85 10.1. The riddle of unemployment 85 10.2. Inflation, the central bank, and the reserve army of labour 87 10.3. Determinants of the NAI rate of unemployment 89 10.4. Predictions and policy implications 93 10.5. Relevance to real economies 94 10.6. Appendix 96 Exercises 99 Chapter 11. Open economies 101 11.1. The circular flow and national accounts 101 11.2. Short-term and long-term stability in open economies 104 11.3. Unemployment and growth in open economies 107 11.4. Optimal currency areas: What currency system fits best? 109 11.5. Relevance to real economies 110 Exercises 113 Bibliography 117 Introduction Macroeconomics and macroeconomic policies In macroeconomics we study economic activity within the system in its entirety; phenomena such as growth, inflation and unemployment are analysed, and how the existing institutions (e.g. the country’s government and central bank) can influence these phenomena through policy measures or changes to the rules of the game. Generally you might suppose that enlightened economic policy (as with all other policies) should aim to achieve the best possible outcome for the country’s inhabitants, and potentially others (such as future generations or inhabitants of other countries). However, to make the policy problem manageable, we need to have morespecific targets which apply in different areas (health, education, the economy, etc.). With regard to managementof the economy we focus on three key measures of success: (i) a high level of production of goods and services (i.e. GDP), both today and in the future; (ii) a high degree of inclusivity in the economy, and thus low unemployment and low inequality; and (iii) a high degree of predictability and stability in the macroeconomic environment, and thus security for economic operators. In short, high growth, low unemployment, and stability. In the final chapter (forthcoming!) we also consider the goal of high environmental quality and long-run sustainability. To some extent the goals overlap, in the sense that if policy makers focus on one of the targets, the others may also be met as a spin-off. For example, a stable economy provides a good basis for growth, and having a lot of people who are unemployed is obviously not conducive to high GDP, other things being equal. But the goals do not always go hand in hand. For example, achieving stability and low unemployment is relatively easy in a planned economy, but at the expense of the dynamism in the economy which leads to economic growth and thus high GDP in the future. Studying macroeconomics provides a glimpse into the world of economic policy and politics. Why is there unemployment,and why do the different political parties disagree on how it should be addressed? Why do we have an independent central bank? Every citizen should understand basic macroeconomics! Furthermore, it’s incredibly fun and interesting. This book In macroeconomics, as in all science, we build models to try to understand a complex reality. These models can be precisely specified in the form of mathematical equations, or they can be more loosely defined verbally. In economics there is a strong preference for mathematical models because they allow for an unambiguous derivation of the results from the assumptions, meaning that shoddy or downright incorrect verbal reasoning can be avoided. Therefore I try to use exactly (mathematically) specified models as much as possible in this book. There is an obvious problem with this approach: how do you make the models sufficiently easy to understand while highlighting the key issues in macroeconomics, i.e. growth, unemployment, and the business cycle? My goal is to present only very simple models—in which concrete and precise assumptions lead to concrete and precise results—and then I discuss what we can learn from the model that is relevant for understanding the real (complex) economy. Often the reasoning is so simple that it need not even be derived mathematically, but sometimes you need a little simple mathematics. Another thing that sets this book apart from the crowd is that we put the money at the centre of the analysis. Without money, we have either no trade at all, or barter. Nor do we have financial assets or liabilities. (This is true by definition, since a promissory note is a form of money.) Without money there is no inflation, no interest, and no business cycle. Furthermore, there are no currencies or currency exchange rates. In short, money is the key to a modern economy in which agents specialize in different activities as well as working in groupsfor firms. In order to trace the path of money through the economy, we use the the circular flow, an image in which the main characters (or agents) are households, firms, the government, and the banks. Everything is ultimately owned by the households, but all of the agents are involved in economic transactions. The circular flow shows the movements of money associated with such transactions. 1 2 INTRODUCTION Note that money can be coins and bills, but can also be other things: if I have money at the bank it does not mean that the bank has a stack of gold coins—or even paper banknotes—in a safebox with my name on it. Rather, it means that the bank’s computerized accounts show that it (the bank) owes me money. Furthermore, it means that I have the power, at short notice, to purchase goods and services from other agents by transferring that ‘money’ to them. Outline of the book We start with the simplest possible economy and build gradually on the complexity of the analysis. • An economy without money. We begin by considering an economy without money. In the simplest case we assume a village on an isolated island in which all decisions about resource allocation are made together. How does such an economy work? How can we characterize the production process, is saving and investment possible, and can production in the economy grow in the very long run? Is there unemployment in such an economy? How does the economy respond to external shocks? The purpose of this analysis is to provide a benchmark against which to compare the market economy which is the main subject of the book. We find that the market facilitates growth of productivity in a modern economy, and thereby also facilitates growth in GDP. However, the market system also creates the business cycle and contributes to the existence of unemployment when compared to the economy without money. • The circular flow, money, and interest. In this chapter we focus on learning concepts and understanding how the economy as a whole works. We do this primarily through tracing the path of money and goods through the economy. We do not tackle our overall goals for the book, which are to understand, explain and predict economic growth, unemployment, and the business cycle. However, we building a solid foundation to be able to do so in future chapters. We introduce the key players in our story, known in economics as agents: these are households, firms producing goods consumption and investment goods, firms in the financial sector, the government, and the central bank.

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