Ebook Macroeconomics Manfred gartner (3rd edition) Part 1

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macroeconomics

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

manfred gärtner

What’s new

•

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

•

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

•

Glossary and notes on Nobel laureates – A comprehensive Glossary of all relevant technical
terms has been added to the book, as has a new appendix titled Economics Nobel prize winners

and earlier giants, introducing students to the names and work of the greatest minds that have
contributed to the concepts and models that form the backbone of this textbook.

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

Third Edition

macroeconomics

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

manfred gärtner

•

Third
Edition

Macroeconomics is aimed at courses in intermediate macroeconomics,
applied macroeconomics, and on the European economy.
Manfred Gärtner is Professor of Economics at the University of
St. Gallen, Switzerland.

an imprint of

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Macroeconomics
Visit the Macroeconomics, third edition, Companion Website at
www.pearsoned.co.uk/gartner to find valuable student learning
material including:
●

Macroeconomic tutorials with interactive models, guided exercises and animations, plus an interactive road map connecting
key concepts and models.

●

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

●

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

●

Self-assessment questions to check your understanding, with
instant grading.

●

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


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We work with leading authors to develop the strongest
educational materials in economics, bringing cutting-edge

thinking and best learning practice to a global market.
Under a range of well-known imprints, including Financial
Times Prentice Hall we craft high quality print and electronic
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content, whether studying or at work.
To find out more about the complete range of our publishing,
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Macroeconomics
THIRD EDITION

Manfred Gärtner
University of St Gallen, Switzerland


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Pearson Education Limited
Edinburgh Gate
Harlow
Essex CM20 2JE
England
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 1997
Revised edition published as Macroeconomics 2003
Second edition Macroeconomics published 2006
Third edition Macroeconomics published 2009
© Prentice Hall Europe 1997
© Manfred Gärtner 2003, 2006, 2009
The right of Manfred Gärtner to be identified as author of this work has been asserted
by him in accordance with the Copyright, Designs and Patents Act 1988.
All rights reserved. No part of this publication may be reproduced, stored in a 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
a licence permitting restricted copying in the United Kingdom issued by the Copyright
Licensing Agency Ltd, Saffron House, 6–10 Kirby Street, London EC1N 8TS.
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 ownership
rights in such trademarks, nor does the use of such trademarks imply any affiliation with
or endorsement of this book by such owners.
ISBN: 978-0-273-71790-4
British Library Cataloguing-in-Publication Data
A catalogue record for this book is available from the British Library
Library of Congress Cataloging-in-Publication Data
Gärtner, Manfred.
Macroeconomics / Manfred Gärtner. —3rd ed.
p. cm.
ISBN 978-0-273-71790-4
1. Macroeconomics. I. Title.
HB172.5.G365 2009
339—dc22
2009007017
10 9 8 7 6 5 4 3 2 1
12 11 10 09
Typeset in Sabon 10/12 by 73
Printed by Ashford Colour Press Ltd, Gosport
The publisher’s policy is to use paper manufactured from sustainable forests.


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FOR DAVID, CHRIS, KAI,
DENNIS AND LOU


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BRIEF CONTENTS

Guided tour of the book

List of case studies and boxes
Preface
Publisher’s acknowledgements

1 Macroeconomic essentials

xiv
xvi
xix
xxiii
1

2 Booms and recessions (I): the Keynesian cross

34

3 Money, interest rates and the global economy

64

4 Exchange rates and the balance of payments

99

5 Booms and recessions (II): the national economy

124

6 Enter aggregate supply

150

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

181

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

209

9 Economic growth (I): basics

240

10 Economic growth (II): advanced issues

272

11 Endogenous economic policy

306

12 The European Monetary System and Euroland at work 330
13 Inflation and central bank independence

361

14 Budget deficits and public debt

392

15 Unemployment and growth

421

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

453

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

476

Appendix A: A primer in econometrics

504

Appendix B: Glossary

521

Appendix C: Economics Nobel prize winners
and earlier giants

535

Index

537


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CONTENTS

Guided tour of the book
List of case studies and boxes

Preface
Publisher’s acknowledgements

1 Macroeconomic essentials
1.1 The issues of macroeconomics
1.2 Essentials of macroeconomic accounting
1.3 Beyond accounting
Chapter summary
Exercises
Recommended reading
Appendix: Logarithms, growth rates and logarithmic scales

2 Booms and recessions (I): the Keynesian cross
2.1 The circular flow model revisited: terminology and overview
2.2 Income determination: a first look
2.3 Income determination: a second look
2.4 An intertemporal view of consumption and investment
Chapter summary
Exercises
Recommended reading
Applied problems

3 Money, interest rates and the global economy
3.1
3.2

The money market, the interest rate and the LM curve
Aggregate expenditure, the interest rate and the
exchange rate: the IS curve
3.3 The IS-LM or the global-economy model

Chapter summary
Exercises
Recommended reading
Applied problems

xiv
xvi
xix
xxiii

1
1
7
21
26
27
29
30

34
39
44
49
52
59
60
62
62

64

65
77
83
93
94
96
96

4 Exchange rates and the balance of payments

99

4.1 Globalization
4.2 The exchange rate and the balance of payments
4.3 Back to IS-LM: enter the FE curve
4.4 Equilibrium in all three markets
Chapter summary
Exercises

100
102
106
114
119
119


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x

Contents

Recommended reading
Applied problems

5 Booms and recessions (II): the national economy
5.1
5.2
5.3

Fiscal policy in the Mundell–Fleming model
Monetary policy in the Mundell–Fleming model
The algebra of monetary and fiscal policy in the
Mundell–Fleming model
5.4 Comparative statics versus adjustment dynamics
5.5 Adjustment dynamics with expected depreciation
5.6 When prices move
5.7 Today’s exchange rate and the future
Chapter summary
Exercises
Recommended reading

Applied problems

6 Enter aggregate supply
6.1 Potential income and the labour market
6.2 Why is there unemployment in equilibrium?
6.3 Why may actual output deviate from potential output?
Chapter summary
Exercises
Recommended reading
Applied problems

7 Booms and recessions (III): aggregate supply
and demand
7.1 The short-run aggregate supply curve
7.2 The aggregate demand curve
7.3 The AD-AS model: basics
7.4 Policy and shocks in the AD-AS model
Chapter summary
Exercises
Recommended reading
Appendix: The algebra of the AD curve

8 Booms and recessions (IV): dynamic aggregate
supply and demand
8.1 The aggregate supply curve in an inflation–income diagram
8.2 Equilibrium income and inflation: the DAD curve
8.3 The DAD-SAS model
8.4 Inflation expectations
8.5 The DAD-SAS model at work
Chapter summary

Exercises
Recommended reading
Appendix: The algebra of the DAD curve

121
121

124
125
128
133
134
136
139
142
144
145
146
147

150
151
159
173
176
177
178
179

181

182
183
191
195
204
205
206
206

209
210
211
212
215
218
232
233
234
234


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Contents

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

9 Economic growth (I): basics
9.1 Stylized facts of income and growth
9.2 The production function and growth accounting
9.3 Growth theory: the Solow model
9.4 Why incomes may differ
9.5 What about consumption?
9.6 Population growth and technological progress
9.7 Empirical merits and deficiencies of the Solow model
Chapter summary
Exercises
Recommended reading
Applied problems

10 Economic growth (II): advanced issues
10.1 The government in the Solow model
10.2 Economic growth and capital markets
10.3 Extending the Solow model and moving beyond
10.4 Poverty traps in the Solow model
10.5 Human capital
10.6 Endogenous growth
Chapter summary
Exercises
Recommended reading
Appendix: A synthesis of the DAD-SAS and the Solow model
Applied problems

11 Endogenous economic policy
11.1 What do politicians want?
11.2 Political business cycles
11.3 Rational expectations
11.4 Policy games
11.5 Ways out of the time inconsistency trap
Chapter summary
Exercises
Recommended reading
Applied problems

12 The European Monetary System and Euroland at work
12.1 Preliminaries
12.2 The 1992 EMS crisis
12.3 Exchange rate target zones
12.4 Speculative attacks
12.5 Monetary and fiscal policy in the euro area
Chapter summary
Exercises
Recommended reading

xi

235
237

240
240
242

249
251
254
259
264
267
268
269
270

272
273
276
284
286
290
294
299
300
301
302
302

306
306
310
314
316
321
326

327
328
328

330
331
334
340
345
348
354
355
356


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xii

Contents

Appendix: The two-country Mundell–Fleming model

Applied problems

13 Inflation and central bank independence
13.1 Inflation, central bank independence and the EMS
13.2 Supply shocks and central bank independence
13.3 Disinflations and the sacrifice ratio
13.4 Lessons for European Monetary Union
Chapter summary
Exercises
Recommended reading
Applied problems

14 Budget deficits and public debt
14.1 The government budget
14.2 The dynamics of budget deficits and the public debt
14.3 Maastricht, the budget and the central bank
14.4 What is wrong with having deficits and debt?
14.5 Does monetary union need budget rules?
Chapter summary
Exercises
Recommended reading
Applied problems

15 Unemployment and growth
15.1 Linking unemployment and growth
15.2 European unemployment
15.3 Persistence in the DAD-SAS model
15.4 Lessons, remedies and prospects
Chapter summary
Exercises

Recommended reading
Applied problems

16 Sticky prices and sticky information: new perspectives
on booms and recessions (I)
16.1 Reality checks: business cycle patterns and the
DAD-SAS model
16.2 New Keynesian responses
16.3 The Phillips curves and monetary policy rules
of current research
16.4 Supply shocks in the DAD-SAS model
Chapter summary
Exercises
Recommended reading

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

356
359

361
362
370
377
385
387
388
389

390

392
393
394
408
411
412
416
417
418
419

421
421
424
439
443
448
449
450
450

453
454
458
463
471
473
474

475

476
477


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xiii

Contents

17.2 A real business cycle model
17.3 A graphical real business cycle
Chapter summary
Exercises
Recommended reading

478
492
501
502

503

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

504
505
507
509
519
520
520

Appendix B: Glossary

521

Appendix C: Economics Nobel prize winners and earlier giants

535

Index

537

Supporting resources
Visit www.pearsoned.co.uk/gartner to find valuable online resources.
Companion Website for students
●

Macroeconomic tutorials with interactive models, guided exercises
and animations, plus an interactive road map connecting key concepts
and models.

●

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

●

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

●

Self-assessment questions to check your understanding, with instant
grading.

●

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

For instructors
●

Downloadable Instructor’s Manual including the solutions to chapter
exercises and questions.

●

Downloadable PowerPoint slides of all figures and tables from the
book.

For more information please contact your local Pearson Education sales
representative 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
Case studies
Every chapter contains one or more case studies that apply
core concepts to recent experiences in Europe and in other
parts of the world.
Macroeconomic essentials

CASE STUDY 1.1

CHAPTER

6

Enter aggregate supply

What to expect
Bullet points at the
start of each chapter
show what the reader
can expect to learn,
and highlight the core
coverage.

Key terms
Key terms and concepts
in each chapter are
highlighted in colour,
with definitions in the
margin.

What to expect

After working through this chapter, you will understand:
1 In more detail the meaning of potential income or output.
2 How wages and employment are determined in the labour market.
3 How regulations, trade unions, and other labour market characteristics, or demographic features, may give rise to involuntary unemployment which persists in the long run.
4 Why aggregate output produced by firms may temporarily exceed or

fall short of the level of potential output produced in equilibrium (or
the long run).

By now we have a good understanding of aggregate demand: that is, of what
happens on the economy’s demand side. This contrasts with our understanding of aggregate supply, the treatment of which so far has been, well, rather
simplistic. The only time we have explicitly touched upon the issue of firms’
level of output was when we discussed money in the circular flow model in
The aggregate supply curve Chapter 1. There we considered two extreme cases of the aggregate supply
shows the total quantity of
(AS) curve, the line that indicates how much output firms produce at differgoods and services supplied by
ent price levels. For easy reference, Figure 6.1 replicates these two versions.
all firms in the economy at
The horizontal aggregate supply curve shown in panel (a) is the one we emdifferent price levels.
ployed in Chapters 2–5 in the context of the Keynesian cross, the IS-LM
model and the Mundell–Fleming model. It is usually referred to as the
extreme Keynesian aggregate supply curve. It assumes there is slack and the
The extreme Keynesian
aggregate supply curve is
presence of one or more production factors in abundance. Then how much
horizontal, stating that, at the
firms produce depends only on demand. At the given price level, firms supply
current price, firms are ready
any level of output that is demanded. But then the price level never changes!
to produce any output that
is demanded. A refined
How does this correspond with the real world where continuous price
Keynesian aggregate supply
changes in the form of inflation are the rule rather than an exception? Quite
curve will be introduced later.
obviously, a horizontal aggregate supply curve cannot be the whole story.

Panel (b) in Figure 6.1 shows a vertical aggregate supply curve. Firms supply potential output Y* no matter what the price level is. This curve is generThe classical aggregate
ally referred to as the classical aggregate supply curve, for reasons that will
supply curve is vertical,
become evident in a moment. The drawback here is that, unless we assume
stating that firms produce only
that the AS curve shifts backwards and forwards all the time, only prices
one output Y*, no matter how
change, but never income. This is clearly at odds with real-world observations
high prices are.
of business cycles, evidence of which was presented in Chapter 2. Again, a
vertical aggregate supply curve cannot be the whole story either.

Measuring income: gross domestic income vs gross
domestic product

Income is a key variable in any economy, both as
proposed in our theoretical models, and as measured in reality. In our models we simply call it aggregate income, or output, and stick the label Y
onto it. In reality, it can be measured in a number
of ways. The two most important and most frequently used definitions are gross domestic product (GDP) and gross national product (GNP). Gross
domestic product sums up what is being produced
within the geographical borders of a country. Gross
national product is the term for all income received
by the inhabitants of a country, no matter whether
it results from production at home or abroad. This
is why it is often called gross national income (GNI)
these days.
Which of these two measures of income is the
proper one in a specific context depends on
whether we are modeling economic activity in a
geographic region or the material well-being of a

group of people. In most models introduced in this
book, the geographic region, say the UK, France,
Europe or China, takes centre stage. Then the
appropriate measure of income is GDP. In a few
instances, though, such as when we talk about the
effects and the motives behind globalization, we
need to look at how people rather than regions
are affected, and thus cast an eye on GNP.
In the real world, the distinction between GDP
and GNP is not seriously relevant for most countries, as Figure 1.8 shows. In Europe, there is less
than a handful of countries for which the difference between GDP and GNP is much larger than
what may be attributed to measurement error. At
one end, Ireland stands out, in addition to Luxembourg, with a GNP that falls short of GDP by a
whopping 15%. The reason is well known. By lowering taxes aggressively in competition with other
European countries for foreign capital since the
1980s, Ireland succeeded in attracting foreign firms
and capital investment from abroad at a breathtaking pace. As a consequence, a substantial part of
the Irish capital stock – machines, buildings, computers, laboratories and more – belongs to foreigners, or has been bought with foreign capital. The
earnings generated with this capital go to residents of foreign countries, and are thus included in
Ireland’s GDP, but not in its GNP.
The opposite applies to Switzerland. Here GNP
exceeds GDP by 8%. This is because a substantial

10
GNP–GDP (%)

5
0
–5
–10

–15
–20
IRL P

A NL E

I

D GER DK GR USA F

N

S

B

JP UK CH

Gap GNP–GDP, in % of GDP, 2004
Figure 1.8

Per capita income in 1,000 US dollars

12

50
GDP
GNP

40

30
20
10
0
IRL P

A NL E

I

D GER DK GR USA F

N

S

B

JP UK CH

GDP and GNP, 2004
Figure 1.9

part of Switzerland’s savings has been invested
abroad, in countries such as Ireland. The capital income generated by these investments – interest
earnings, dividends, rents or profits – adds to
Switzerland’s GNP, but is not included in its GDP.
Figure 1.9 compares the absolute levels of GDP
and GNP for the selected group of countries. The
message is that for most countries the difference is

barely visible, and we may not make a serious mistake by using one of the measures instead of the
other: say, if the other is not available. Even for
Switzerland and Ireland, the difference between
the two income aggregates appears less dramatic
in Figure 1.9 than it did in Figure 1.8.

Margin notes
Helpful tips and guidance appear in the margins, giving maths
reminders, examples, rules, empirical notes and reality checks.

Working with graphs (part II)

I do not recommend learning the slopes of equilibrium curves like LM by heart. Neither do I advise
memorizing which factor shifts the graph which
way. As long as the economic reasoning behind
some market equilibrium is understood, slopes and
shifts of curves can, in most cases, be worked out
by simple thought experiments. Algebra or calculus is not necessary.
For example, take the LM curve to demonstrate
the nature of the thought process. Suppose you
forgot how the graph slopes in the i/Y diagram
and how it shifts when the money supply increases.
Here is a way out.

The slope of a curve

Interest rate i

1 Pick an arbitrary point A in the i/Y plane. Assume that A is an equilibrium, i.e. a point on LM.
(You may safely do that as, without any further

information, you are free to position the LM
curve anywhere in the diagram.) See Figure 3.9.
2 Move horizontally from A to B. With i being the
same at A and B, but Y being larger at B, the demand for money at B is obviously higher than at
A. Thus, as we are holding the money supply
constant, B features an excess demand for
money. In other words, B is not on LM!
3 Starting from B, work out in which direction i
has to move in order to restore equilibrium. As
demand is too high in B, i must change so as to

LM curve
Supply = demand

Supply = demand

C

A

Raising the interest
rate re-establishes
equilibrium

B Supply < demand
Raising income
creates excess
demand

reduce money demand via higher opportunity

costs, i.e. it must rise. At some point such as C it
will have risen just enough to re-establish equilibrium.
4 Now that we have two points A and C on the LM
curve, we have identified the curve’s slope. In
fact, we may draw the curve right through A
and C.

How does the curve shift?
1 As before, pick an arbitrary point A in the i/Y
plane. Assume that it is an equilibrium point,
i.e. it lies on LM. See Figure 3.10.
2 Assume that the money supply has been increased. Since the old money supply equalled
demand at A, A must now feature an excess supply of money.
3 Holding i constant, work out whether Y has to
rise or to fall in order to raise money demand
and thus re-establish equilibrium. Here the answer is, obviously, that Y has to rise. So the
new equilibrium point is found east of A – say,
at B.
4 As we could have started from any other point
on the old LM curve and obtained the same
qualitative result, we may now conclude that
the entire LM curve has shifted to the right into
the position of the new LM curve.

Maths note. One euro
invested at home grows
to (1 + i ) euro after one
period. If invested
abroad it grows to
(1 + i World)(1 + (E e+1 Ϫ E)>E).

Setting this equal to (1 + i )
and subtracting 1 from both
sides gives interest parity as
i = i World +

E e+ 1 - E
E
E e+ 1 - E

+ i World
E
Equation (4.4) simplifies this
by ignoring the involved
exchange rate gain on the
interest payment, which is
small under normal
circumstances.

Old LM curve

The current account tracks net exports of goods and services. These we
already know from the above analysis of the goods market.
CA K NX = EX - IM = x1YWorld + x2R - m1Y + m2R

Y =

x2 + m2
x1 World
Y
+

R
m1
m1

Supply = demand
supply creates
excess supply at
former equilibrium
point A

A

Here the current account
is balanced (CA = 0)

B Supply = demand
Raising income raises
money demand;
establishes new
equilibrium at point B

Current account equilibrium

(4.3)

All points that balance the current account lie on a vertical line in the i– Y
plane, as shown in Figure 4.4, panel (b). As indicated in the graph, this
CA = 0 line shifts as its positioning parameters change. For example, if the
real exchange rate goes up, meaning that the home currency depreciates, exports rise and imports fall. At the initial level of income, i.e. on the old
CA = 0 line, where there was EX = IM by definition, we now face the disequilibrium situation EX 7 IM. Imports, which are too small at this new real

exchange rate and the initial level of income, can only rise up to the now
higher exports if domestic income increases. So what we need is a movement
to the right to find a new current account equilibrium: after a real depreciation a new equilibrium with CA = EX - IM = 0 can only be found to the
right of the initial CA = 0 line. Therefore, a real depreciation moves the
CA = 0 line to the right. By analogous arguments we find that an increase in
world income moves CA = 0 to the right as well. The text in the white boxes
summarizes these results.

equilibrium

2 Raising the money

(4.2)

Figure 4.4, panel (a), shows the current account as a function of income
and the interest rate. While the interest rate has no impact on the current
account (i is missing from equation (4.2)), CA deteriorates with a factor m1
as income rises.
For given world income and real exchange rate, only one income level exists
which balances the current account. An algebraic expression for this is obtained by letting CA = 0 in equation (4.2) and solving for Y. This yields

Current account CA

New LM curve

1 A is initially an

CA = 0
Current
account

surplus

Current
account
deficit

0
Interest
rate i

Supply > demand

Income Y

Income Y
(a)

Figure 3.9

Exchange rates and the balance of payments

Note. Economists rarely
work with 3D graphs. They
are used here and below to
show where the 2D graphs
on the right of Figure 4.4
come from. If you have no
problem understanding the
2D graph you can ignore the
3D version.

Interest rate i

108

Money, interest rates and the global economy

BOX 3.2

Interest rate i

78

Boxes
Boxes in each chapter
present useful guidance
to the reader and illustrate the concepts.

Line
↑ shifts left as
R
↑
Y world

Current
account
plane
Income Y

(b)

Line shifts right as
R↑
Y world↑

Income Y

Figure 3.10
Figure 4.4 The current account worsens as rising income raises imports. The interest rate does not affect CA. The current account equilibrium line, therefore, projects as a vertical line onto the i–Y plane. An exchange rate depreciation
or a rise in world income moves the CA plane up, shifting the CA ϭ 0 line to the right.


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Guided tour of the book

Chapter summary

59

CHAPTER SUMMARY
■

■

■

■

■

■

■

■

■

Key terms and concepts
A list at the end of each
chapter of all the key
terms and concepts, for
quick reference.

A country’s income at a given point in time is determined by the steadystate level of income, the deviation of potential income from steady-state
income, and the deviation of income from potential income. The latter is
called the business cycle.
In the circular flow model there exists one equilibrium level of income at
which actual spending is exactly as planned. What sets this level of income

apart from all other feasible income levels is that firms will try to set production to this very level to avoid having to invest or disinvest involuntarily.
An increase in autonomous expenditure, such as government purchases,
generates an income increase that may vastly exceed the original stimulus.
This multiplier effect occurs because the exogenous spending increase raises
income and thus induces consumers to spend more and raise income even
higher.
When the multiplier is large, small changes in government expenditure or
other autonomous injections or leakages may cause sizeable booms or
recessions.
Factors that reduce the size of the multiplier are high marginal income tax
rates and a high marginal propensity to import.
Consumption does not depend on current income only, but, more importantly, on expected future income.
Multiplier effects apply fully only if consumers consider observed income
changes to be permanent.
The multiplier becomes much smaller if observed income changes are considered transitory.
Investment rises when expected future income rises and/or when the interest
rate falls.

Exercises
Exercises at the end of each chapter are
geared towards the chapter’s central ideas
and consolidate the acquired knowledge.
60

Booms and recessions (I)

EXERCISES
Two US economists, Arthur F. Burns and Wesley
C. Mitchell, claimed half a century ago that the
typical business cycle lasts between six and thirtytwo quarters.

(c) Does this agree with your findings?

2.1 Consider French real output between 1900 and
1991 as given in Figure 2.19.
Add your guess of the paths of steady-state
income and potential income to the graph.
Real GDP

Chapter summary
Each chapter ends with a bullet-point
summary which highlights the material
covered in the chapter and can be used as
a quick reminder of the main issues.

France

2.3 Consider an economy with the following data
(note that I is planned investment, which may
not coincide with actual investment):

6,000
4,000

C = 750

I = 500

T = 0

G = 250

NX = 250 Y = 1,000

2,000

(a) Is this economy’s circular flow in equilibrium
in the sense that firms do not have to
change inventories involuntarily?
(b) Translate the above data into a diagram with
demand on the vertical axis and income on
the horizontal axis.
Add the assumption C = 0.75Y.
(c) Draw the aggregate-expenditure and
the actual-expenditure lines. Identify
demand-determined income in equilibrium
in your graph and analytically.
(d) What happens to equilibrium income if
government expenditure increases by 500
units? Show your result in a graph and verify
that it is supported by the multiplier formula
of equation (2.9).
(e) Using a graph, show what happens if net
exports fall from 250 to 100.

1900 1910 1920 1930 1940 1950 1960 1970 1980 1990

Figure 2.19

2.2 Figure 2.20 displays the evolution of real GDP
between 1978 and 2002 for the United States

and France.
(a) Try to identify business cycles, marking peaks
and troughs on the graphs.
(b) Identify the US position in 1991 in a diagram
with prices on the vertical axis and income on
the horizontal axis. Mark potential income,
steady-state income and actual income.

Key terms and concepts
United States
10,000

10,000

9,000

9,000

Real GDP (billions of FF)

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

transitory income 58

Real GDP (billions of US$)

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

8,000
7,000
6,000
5,000
4,000

France

8,000
7,000
6,000
5,000
4,000

1980

1984

1988

1992

1996

1980

2000

1984

1988

1992

1996

2000

Figure 2.20

Recommended reading
Each chapter is supported
by an annotated recommended reading section,
directing the reader to additional printed and electronic sources in order to

gain an alternative perspective, or to pursue a
topic in more depth.

328

Applied problems

Endogenous economic policy

63

Table 2.4

Recommended reading
Models of political business cycles are surveyed in
Manfred Gärtner (1994) ‘Democracy, elections, and
macroeconomic policy: Two decades of progress’,
European Journal of Political Economy 10: 85–109.
The empirical evidence is reviewed in Bruno S. Frey
and Friedrich Schneider (1988) ‘Politico-economic
models of macroeconomic policy: A review of the empirical evidence’, in Thomas D. Willett (ed.) Political

Business Cycles: The Political Economy of Money,
Inflation, and Unemployment, Durham and London:
Duke University Press, pp. 239–75.
Applications to US presidential elections are discussed in Ray C. Fair (1996) ‘Econometrics and
presidential elections’, Journal of Economic Perspectives 10(3): 89–102.

APPLIED PROBLEMS
RECENT RESEARCH

The economy and US presidential elections
Ray C. Fair (1996, ‘Econometrics and presidential
elections’, Journal of Economic Perspectives 10(3):
89–102) offers a non-technical update of earlier

efforts to explain the Democratic Party’s share by
economic variables and what he calls incumbency
variables. His new equation reads as follows:

Endogenous variables:
V Democratic Party’s share of the two-party vote
Exogenous variables:
Variable
Coefficient
cnst.
0.468
I
-0.034
I*d
0.047
g3 * I
0.0065
p15 * I * (1 - d) -0.0083
n * I * (1 - d)
0.0099
DPER
0.052
DUR

-0.024

t-value
(90.62)
(1.26)
(2.09)
(8.03)
(3.40)
(4.46)
(4.58)
(2.23)

Explanation
constant
Democrats are in White House (I = 1); Republicans are in White House (I = -1)
d = 1 if world war went on during last 15 quarters; else d = 0
income growth during last 3 quarters (g3)
inflation during last 15 quarters (p15)
number of last 15 quarters with good news (meaning g 7 2.9).
Democratic President is running (DPER = 1);
Republican President is running (DPER = -1)
number of consecutive terms in office by incumbent party (negative for
Republicans)

R2 = 0.96; 20 presidential elections 1916–92

The economic variables highlighted in the equation
all have a significant influence on the incumbent’s
re-election prospects: if income growth speeds
up by 1 percentage point, his vote share rises by
0.65 percentage points. If inflation moves up by

1 percentage point, his vote share falls by
0.83 percentage points. There is an added bonus to
high income growth. For each quarter in which it
exceeds 2.9%, which represents good news, the vote
share rises by 0.99 percentage points. The equation
explains 96% of the variation in the Democratic
Party’s vote share. It predicts the winner in 17 out of
the 20 presidential elections since 1916 correctly. The

use of the I dummy variable serves to turn effects on
the Democratic vote share around when a Republican
holds the presidency. The d dummy variable serves to
sever the link between inflation and good news, and
the vote during the world wars.

Year

C

Y - T

Year

C

Y - T

Year

C

Y - T

1960
1961
1962
1963
1964
1965
1966
1967
1968
1969
1970

14,561
15,919
17,967
21,017
22,784
24,366
26,873
29,767
31,762
34,838
39,992

22,520
25,151
28,215

32,109
34,988
37,708
40,973
45,192
49,082
54,302
60,652

1971
1972
1973
1974
1975
1976
1977
1978
1979
1980
1981

43,660
47,951
58,484
73,637
85,972
106,383
129,209
150,848
185,051

236,603
284,030

65,960
72,136
86,914
108,296
120,875
153,198
187,982
222,825
275,473
344,912
406,106

1982
1983
1984
1985
1986
1987
1988
1989
1990
1991

335,448
387,170
443,268
498,048

551,868
606,889
670,883
740,267
806,593
881,171

475,205
553,129
634,682
706,280
782,365
858,348
953,439
1,037,647
1,137,230
1,231,558

consumption almost perfectly. The marginal propensity to consume is found to be 0.71. The t-statistic of
486.5 renders this coefficient highly significant.
It can be argued that parts of consumption spending cannot be adjusted to changing income immediately: your summer vacation that has been booked
since the previous autumn; high car maintenance
costs that can only be reduced by selling the car at a
loss; your second daughter who insists on taking
ballet lessons just like her older sister, and so on. To
allow for such adjustment lags we may suppose that
only desired consumption C* is related to income,
that is C* = c0 + c1(Y - T). If desired consumption
drifts away from actual consumption, the response
of actual consumption only closes a fraction a of this

gap. Formally we may write C - C-1 = a(C* - C-1).
Substituting the above explanation of desired consumption for C* in the partial adjustment equation
yields C = ac0 + (1 - a)C-1 + ac1(Y - T ). Estimating
this equation yields
C = -1,830.6 + 0.22C - 1 + 0.57(Y - T )
(3.07)
(6.31)
(25.10)
R 2 = 0.999

Annual data 1961– 91

The autoregressive coefficient (the one in front of
C-1) 0.22 = 1 - a carries a t-statistic of 6.31, rendering it highly significant. The coefficient of disposable
income is also significant, but smaller than in our first
estimate above. Note, however, that it represents the
product ac1. Since a is estimated at 0.78, we may
compute c1 = 0.57>0.78 = 0.73, which barely differs
from the previous estimate. So while the long-run

marginal propensity to consume is the same as
estimated above, the short-run effect is smaller. If
disposable income increases by 100,000L, consumption immediately goes up by 57,000L. This is not the
end, however. One period later, consumption goes up
by another 0.22 * 57,000 = 12,540L, one period later
by another 0.22 * 0.22 * 57,000 = 2,758.8L, and so
on. So while the partial adjustment version of the
consumption function estimates the same overall
response of consumption as the simple version, it suggests that the response is spread over a longer span
of time.

YOUR TURN
Consumption function in first differences
One thing to note in the above study of Italian consumption functions is that both consumption and disposable income show a clear upward trend during
the thirty-one years considered here. This can be a
problem. Regressing two heavily trended variables
on each other may give a statistically significant result, although the two have nothing to do with each
other (a classic example is the negative correlation
between the number of telephones and the number
of storks during the first half of the 20th century).
In an attempt to alleviate this problem we may
compute first differences on both sides of the consumption function to obtain ¢C = c1 ¢(Y - T ). Please
check whether this formulation is supported by the
data.

WORKED PROBLEM
Who wanted the euro? (part I)
Journalists and politicians closely monitored public
attitudes towards the single European currency.
Table 11.3 gives the result of one such opinion poll

Applied problems
These optional problems show students how
intermediate statistical skills may be applied
to the study of macroeconomics, and encourage them to try for themselves.

To explore this chapter’s key messages further you are encouraged to use the
interactive online module found at
www.pearsoned.co.uk/gartner

Companion website references
A web reference is given at the end of each
chapter, guiding the student to useful and
relevant interactive resources on the companion
website to support their learning.


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L I S T O F C A S E S T U D I E S A N D B OX E S
Case studies
1.1
1.2
2.1
2.2
3.1
4.1
5.1
6.1
7.1
7.2
8.1

8.2
9.1
9.2
9.3
10.1
11.1
11.2
12.1
13.1
14.1
14.2
14.3
15.1
16.1
17.1

Measuring income: gross domestic income vs gross
domestic product
Central banks and the beginning subprime mortgage
crisis of 2007–08
Income vs leisure time in France and the USA
How to pay for the war: Great Britain in 1940
Policy options during the financial crisis of 2008
Italy’s current account before and after the 1992 EMS crisis
The 1998 Asia crisis
Ford’s focus: an experiment in efficiency wages
International evidence on the quantity equation and the
AD curve
AD-AS in crises
Deflation: inflation’s ugly sister

Quantity equation, Fisher equation and purchasing power
parity: international evidence
Growth accounting in Thailand
Income in Eastern Europe during transition
Income and leisure choices in the OECD countries
National incomes during the Second World War, east and
west of the Atlantic
Elections and the economy
Who wanted the euro? The role of past inflations
German unification as a tug of war
New Zealand’s Reserve Bank Act: a case from down under
The rise and fall of Ireland’s public debt
Who wanted the euro? The role of government debt
Lessons from the Belgium–Luxembourg monetary union
US vs European job growth: cutting the ‘miracle’ to size
The Canadian business cycle
Technology change in Malaysia: the return of the Solow residual

12
16
43
51
90
109
131
170
198
203
223
230

248
253
262
277
309
325
336
364
404
410
415
444
457
496

Boxes
1.1
1.2
2.1
2.2
3.1
3.2
3.3

GDP as a measure of total output or income
Working with graphs (part I)
Actual income, potential income and steady-state income:
Great Britain in 1933
Big stock market crashes
Money and monetary policy

Working with graphs (part II)
Exchange rates

6
24
38
55
70
78
81


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List of case studies and boxes

3.4
4.1
4.2
4.3
4.4
4.5
5.1

8.1
9.1
10.1
10.2
11.1
11.2
12.1
12.2
14.1
16.1
17.1
A.1

Money supply vs interest control in a changing world
Traditional vs new balance of payments terminology
Forecasting the US dollar in 2004: an exercise in
predicting exchange rates
Interest rates, default risk and the risk premium
The IS-LM-FE model in a different dress
Endogenous and exogenous variables
The Mundell–Fleming model under capital controls
How to solve rational expectations models
The mathematics of the Cobb–Douglas production function
An illustration of the income and distribution effects
of globalization
Labour efficiency vs human capital: an example
Political business cycle mathematics
From the political business cycle to the inflation bias
Convergence criteria in the Maastricht Treaty
The Stability and Growth Pact

Seignorage vs inflation tax revenue
The mathematics of the New Keynesian Phillips curve
A pocket guide to the history of macroeconomic thought
The coefficient of determination: R2

xvii
87
105
112
114
117
117
128
225
247
282
294
313
320
340
352
407
465
498
513


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P R E FA C E

What makes this book unique?
This text reverses the usual priorities in intermediate macroeconomics instruction. Here, the ultimate goal is not to simply to teach general macroeconomic
theories, models and concepts, with real-world applications thrown in for
motivation and excitement; rather, students work through this book towards
an understanding of the macroeconomic issues and challenges facing the
global economy and individual countries. Macroeconomic concepts are taught
only as they serve this end.

What is new in the third edition?
Whenever possible, graphs, tables and information in general were updated.

Countless explanations have been improved, case studies brought up to date
or replaced, and new exercises added. Beyond that, major innovations in this
new edition are:
■

■

The macroeconomics of the global economic crisis The third edition was
being prepared while this millennium’s first global economic crisis, indisputably the harshest in generations, unfolded and gained momentum. In the
Spring of 2009, the jury is still out on how far incomes will plummet and
how long the downturn may last. But as experts in many trades are trying
to come to grips with what has happened, and what is yet to come, it is
becoming increasingly clear that current events will have a lasting impact on
how we teach macroeconomics. Curriculums will not have to be scrapped.
Textbooks will not have to be rewritten. But the startling speed at which
demand and employment are receding, and the sheer magnitude of change,
has gravely tarnished belief in the self-healing power of the markets. This
calls for a revitalized interest in what can go wrong in financial and goods
markets, and when and how the government should step in to augment private demand when it is lacking. Acknowledging this, the text’s business cycle
chapters use the events of 2008–2009 very much as a running theme that
features in several Case Studies and Boxes. Key concepts that are given new
emphasis – concepts that had drifted to the edge of, or even off the radar of,
intermediate macroeconomics curriculums in recent decades – are liquidity
traps, market psychology and risk premiums in various guises. A related concept that must be taken seriously, and makes an appearance, is deflation,
with all the negative repercussions it may generate for the real economy.
Monetary policy rules While the text retains its full treatment of money
markets, where supply and demand interact in an explicit fashion and
match on the LM curve, it now acknowledges that recent years have seen
many central banks adopt monetary policy rules. Chapter 3 has been thoroughly rewritten to lay out in detail how the two approaches are related,

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Preface

■

■

thus offering instructors the option to emphasize one or the other in later
chapters.
An extended bridge towards graduate macroeconomics Oftentimes, students
struggle with the gap between what they learned in intermediate macroeconomics and the models that graduate macroeconomics rely upon. The text’s
concluding chapters try to bridge this gap, with Chapter 16 offering a serious introduction to the New Keynesian and Sticky Information Phillips
Curves, and Chapter 17 introducing the real business cycle approach. Here
also, empirical facts taken from current research are evaluated to explain
these concepts. Nevertheless, these chapters do stray from the book’s guiding philosophy, in that they focus on theory more than on issues. And since
they include the book’s most demanding sections, they may certainly be
skipped in courses where a majority of students do not plan to proceed to
graduate school.

Glossary and notes on Nobel laureates In order to spare students the effort
of searching for explanations in the main text, a comprehensive Glossary of
all relevant technical terms has been appended to the book. Another new
Appendix, ‘Economics Nobel prize winners and earlier giants’, introduces
students to the names and work of the greatest minds that have contributed
to the concepts and models that form the backbone of this textbook.

Content
The text’s main body comprises 17 chapters. Chapters 1–9 are fairly conventional in content, amounting to a streamlined, no-frills introduction to the
macroeconomic concepts that are useful for discussion of contemporary
macroeconomic issues in the world economies. Essential macroeconomic concepts are introduced in the context of the circular-flow-of-income model. Students are then led via the Keynesian cross, the IS-LM, the Mundell–Fleming
model and the aggregate demand-aggregate supply model to a fully dynamic
aggregate demand-aggregate supply framework for analysing short- and
medium-term macroeconomic issues. Chapters on the supply-side topics of
unemployment and growth round out this predictable set of tools.
Chapters 10 and 11 extend the toolbox into areas that most intermediate
macroeconomics textbooks barely mention in passing. The first refines and
extends the Solow growth model (introduced in Chapter 9) for a discussion
of human capital and poverty traps, and concludes with a first glimpse at
endogenous growth. Under the heading ‘Endogenous economic policy’, Chapter 11 then shows that politicians may steer the economy along courses not
considered desirable from society’s point of view, and discusses how institutions should be structured to reduce this risk.
Chapters 12–15 explore issues at the heart of European and global monetary and economic integration. All major topics are addressed in these chapters: inflation, monetary unions, budget deficits and the public debt, and
unemployment.
Chapters 16 and 17, thoroughly expanded for the third edition, offer a
sneak preview of what students might expect in macroeconomics courses at
the Masters level. They also make a serious effort to motivate students and
explain why current macroeconomic research has moved beyond the workhorse models of intermediate macroeconomics to study the potential of


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Preface

xxi

macroeconomics models with explicit microfoundations – of the realbusiness-cycle mould, or with sticky prices and information. To this end, students learn about the co-movement of macroeconomic variables, and why
sticky prices or sticky information may perform better than sticky wages in
explaining empirically observed patterns. They also grasp the intuition behind
real-business-cycle dynamics, without the elaborate formal apparatus that
usually comes with it.

Learning features
The book has a user-friendly design, featuring margin notes and definitions
that emphasize important concepts. Exercises geared towards each chapter’s
central ideas consolidate the acquired knowledge. An extensive and innovative use of graphs facilitates access and enhances learning success. Every chapter contains one or more Case Studies that apply core concepts to recent
experiences in Europe and in other parts of the world. And all chapters feature
links to our elaborate online material that includes interactive graphical versions of the book’s key models, guided exercises, online tests, macroeconomic
data, and much more.

What courses does the book accommodate?
The organization of the book gives instructors various options:
■

■

■

■

Primarily, the text is designed for courses in undergraduate or intermediate
macroeconomics that on the one hand insist on providing a sound theoretical foundation, but on the other also want to make a point of emphasizing
applications in the form of Case Studies or even, if so desired, elementary
statistical work.
The book’s first half can also be used for a self-contained short course in
macroeconomic theory whenever time does not permit working through a
voluminous 600–900-page macroeconomics text which has become the
standard.
Also, the book readily accommodates courses in Economic policy and
Applied macroeconomics. Such courses may be organized around an appropriate selection from the several dozen Case Studies and empirical applications. Conveniently, as deemed necessary, students can be referred to the
required theoretical tools in the same textbook.
Finally, the book accommodates European studies courses that can be organized around the applied topics discussed in Chapters 12–15. Here also,
should it be necessary to freshen up or expand previously acquired theoretical knowledge, such material is readily available in the same textbook.

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


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Preface

I am quite confident, though, that the book can also be adopted and used
successfully if a principles course is missing and algebraic manipulations are
avoided altogether. Dozens of Case Studies, some brief, some rather elaborate,
provide ample ammunition for keeping up motivation, and the big payoff
waits in the later chapters of the book.
Finally, and though it may sound frivolous: I believe that the book is even
suited for self-study. The acquired knowledge will definitely be more fragile
and lack depth compared with what can be achieved under the guidance of an
experienced instructor. But it should provide an up-to-date first foundation
for informed discussion of today’s national and global macroeconomic issues.

Acknowledgements
This brings me to the people I want to thank for their contributions to whatever 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.
It has been a joy to work with the professionals at Pearson Education, to
whom I owe a big ‘thank you’. They helped and guided me, with unmatched
skill and great patience, in preparing this thoroughly extended third edition,

and brought the book into its final shape: Georgina Clark-Mazo (senior editor),
Linda Dhondy (proofreader), Pauline Gillett (editorial administrator), Robin
Lupton (editorial assistant), Ellen Morgan (acquisitions editor) and Chris
Bessant (copy editor).
More than any other book of mine, this one would not even be close to what
it is without the talents and the enthusiasm of the people working with me at the
University of St. Gallen’s Institute of Economics. This new edition owes more
than I can express to Susanne Burri. She updated numerous graphs and tables,
often with data for more than a dozen countries, scrutinized Exercises and Case
Studies, prepared most of the new Glossary, and, playing the devil’s advocate,
challenging me on virtually everything I say between the front and the back cover.
In the course of joint teaching ventures based on this textbook, Florian Jung offered criticism and many constructive suggestions that improved this edition. He
also accepted the responsibility for proofreading along with Pascal Bischof,
Hanna Köpper, Björn Griesbach, Andreas Kleiner and Thomas Seiler. Frode Brevik performed the simulations reported in Chapter 17. And the interactive online
material that augments the textbook continued to grow and shine thanks to the
programming magic of Christian Busch and the maths skills of Frode Brevik. I
am deeply indebted to all of them; and to Gudrun Forster, for unparalleled administrative support and her eye for the big and the little things that contribute to
a work atmosphere which helps us all deliver our very best.
I have also benefitted from the reviews commissioned by Pearson Education. Both those that offered applause and encouragement, and those that
were more reserved, helped shape the book into a better teaching tool.
The mere writing of a textbook may mostly happen at the desk. But the
enthusiasm, the creativity and the discipline that are essential for such a project
come from beyond office doors. In this respect I owe much more to my wife
Louise and to our sons Dennis, Kai, Chris and David than they can possibly
know.


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PUBLISHER’S ACKNOWLEDGEMENTS
We are grateful to the following for permission to reproduce copyright material:
Figure 9.2 from Penn World Tables, Figure 6.2; Figure 9.6 and Figure 12.1 from
Economics, 1st edn, Prentice Hall Europe (K Case, R. Fair, M. Gärtner and
K. Heather 1999) Pearson Education Ltd; Figure 15.9 from Trade Unions in
Western Europe since 1945, 1st edn, Macmillan: New York (Ebbinghaus and
Vissner 2000) Macmillan; Figure 15.12 from />oilprice1869.gif.
In some instances we have been unable to trace the owners of copyright material, and we would appreciate any information that would enable us to do so.


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