module: macroeconomics1 economic matters in a closed economy 1.2 market prices market demand i the...

International Universityfor Cooperative Education

Module: Macroeconomics

PD Dr. Hagen Bobzin

International Universityfor Cooperative Education

Niedersachsen

February 2014

Version: February 6, 2014

iUCE, February 2014 PD Dr. Hagen Bobzin, Macroeconomics 1/116

Bibliography

Baumol, W. J., Blinder, A. S., Macroeconomics – Principles & Policy,

Mason, OH : South Western, 11. ed., 2009.

Davis, M. A., Macroeconomics for MBAs and Master of Finance,

Cambridge : Cambridge University, 2009.

Gwartney, J. D., Stroup, R. L., Sobel, R. S., MacPherson, D. A.,

Macroeconomics – Private and Public Choice, Mason, OH :

South-Western, 13. ed., 2008.

Hall, R. E., Lieberman, M., Macroeconomics – Principles & Applications,

Mason OH : South Western, 6. ed., 2008.

Mankiw, N. G., Macroeconomics, New York, NY : Worth, 7. ed., 2010.

le Mond diplomatique (ed.), Atlas der Globalisierung, taz-Verlag, 2006.

Sachs, J. D., Larrain, F., Macroeconomics in the Global Economy, New

York : Harvester Wheatsheaf, 1993.

Samuelson, P. A., Nordhaus, W. D., Economics, 19. ed., Boston :

McGraw-Hill, 2009.


Abbreviations

BOP balance of paymentsECB European Central Bank

ECU European Currency UnitEMS European Monetary SystemEMU Economic and Monetary Union

ERM Exchange Rate MechanismESA 95 European System of National and

Regional Accounts

ESCB European System of Central BanksEU European UnionFDI Foreign Direct InvestmentGATT General Agreement on Tariffs and

TradeGATS General Agreement on Trade in

Services

GDP Gross Domestic ProductGNI Gross National Income

HICP Harmonized Index of ConsumerPrices

ILO International Labour OrganizationIMF International Monetary FundOECD Organisation for Economic

Co-operation and DevelopmentPPP Purchasing Power ParityROW Rest of the World

SDR Special Drawing RightTEU Treaty on the European UnionTFEU Treaty on the Functioning of the EUTRIP Trade Related Aspects of Intellectual

Property RightsWTO World Trade Organisation


Symbols

B money base

C consumption

G government expenditure

i interest rate

I investment

K capital stock

L liquidity preference

M money stock

N labor

p commodity price

P price level

r rental rate of physical capital

S saving

T tax revenue

V velocity of money

w wage rate

x quantity of a good

Y national income

π inflation rate

open economy

e exchange rate

Ex export value

Im import value

NK net capital imports

KEx capital export

KIm capital import

TB trade balance

Z balance


Table of Contents

1 Economic Matters in a Closed Economy

2 Basic Concepts in Macroeconomics

3 Macroeconomic Policy (Global Steering)

4 Prospects of Macroeconomics




1.1 Preliminaries

1.2 Market Prices

1.3 Government Activities

1.4 National Accounting

1.5 Macroeconomic Goals





1 Economic Matters in a Closed Economy1.1 Preliminaries

I microeconomics – macroeconomicsI households, firms, prices of factors of production and goods

(→ Module: Microeconomics)I aggregates (e.g., consumption, investment, GDP, price level)

I closed – open economyI internal equilibrium: full employment, price stabilityI external equilibrium: adjusted balance of payments

(→ Module: International Economic Relations)

policy mix (Tinbergen’s rule, see p. 68)I fiscal policy→ full employmentI monetary policy→ price stabilityI economic growthI currency policy→ adjusted BOP

(→ Module: International Economic Relations)I value of money

I internal: price index/level (P, HICP), inflationI external: exchange rate (price of a foreign currency), terms of

trade(→ Module: International Economic Relations)


1 Economic Matters in a Closed Economy1.2 Market Prices

Overview:

I Market demandI Market supplyI Market equilibrium and price mechanismI Comparative statics



Market Demand

I The law of demand states by plausibility that the demand xD for a

good declines if the corresponding price p increases.I Aggregation denotes the summation of individual quantities

demanded to the market demand.I The market (or aggregate) demand has similar properties as

individual demand and holds true the law of demand.

x

p

xD



Market Supply

I The law of supply states by plausibility that the supply xS of a good

rises if the corresponding price p increases.I Aggregation denotes the summation of individual quantities

supplied to the market supply.I The market (aggregate) supply has similar properties as individual

supply and holds true the law of supply.

x

p

xS



Market Equilibrium

A market equilibrium denotes a price at which demand and supply

match each other. Consequently, a market equilibrium has two

components: an equilibrium price p∗ and an equilibrium quantity x∗.

In graphs, equilibria are determined by intersection points of demand

and supply curves.

x

p

xSxD

p∗

x∗



Price Mechanism

The price mechanism describes how markets may find an equilibrium

price when starting at a disequilibrium. The easiest way to think of

price mechanism is some sort of a trial and error process:

x

p

xSxD

p∗

x∗

xS > xD denotes an excess supply, p ↓

xD > xS indicates an excess demand, p ↑



The same reasoning holds good for

I commodity or service markets (goods prices)I labor or capital markets (wage rate, rental rate), see Sec. 2.3I foreign exchange markets (exchange rate)

(→Module: International Economic Relations)



Comparative statics

I variables internal to the market: price p and quantity x

→ movements along the curvesI external shocks, variations of parameters

→ shifts of demand or supply curves

comparison of equilibria

We learn: there are alternative equilibria.


1 Economic Matters in a Closed Economy1.3 Government Activities

I constitutional stateI market economy, competition, price mechanismI efficiency, performance justice, economic growth

I regulating and correcting stateI social market economy, market power, unaccepted market resultsI equity, fairness, other forms of justice

I the state as agent in marketsI household (collective needs)I firm (public sectors, market power, missing supply)

I public choiceI voting mechanisms (democracy)I the way that governments make decisionsI market failure→ government failure (see Sec. 4.2)


1 Economic Matters in a Closed Economy1.4 National Accounting

Overview:

I Flows of incomeI Closed economy without government activitiesI Closed economy with government activitiesI Open economy (outlook only)



Flows of Income (General Principles)

I two poles: housholds (consuming units) vs. firms (producing units)I factor markets and goods markets (exchange of services)I here: commodity flowsI principle: For each pole inflow must be equal to outflow.

households firms

factor services (labor, capital)

consumer goods and services



Flows of Income (General Principles)

I Control the principle that inflow must be equal to outflow for

each pole by monetary terms.I Drop commodity flows and use (reverse) monetary flows instead.

households firms

consumption C revenue C

factor income Y factor cost wN + rK

I Y = factor income = national incomeI C = consumption expenditure = value of sold productsI wN + rK = labor cost (wages) + capital cost



National Accounting

double entry bookkeeping system (detailed rules in ESA95):

a first extremely simple example

debit credit

Y = Cproduction account:

C = wN + rKuse of income account (households):

wN + rK = Ygeneration of income account (firms):

C= Yincome account (private sector):

Caveat: Summarizing accounts induces a loss of information.

Cf. income account of the private sector: missing statement about

wN + rK (→ functional income distribution, Sec. 4.1)



Flows of Income Including a Private Banking Sector

households firms

banks



savi

ng

S

investment I

I S = saving = anything of the income Y the household do not

consume (residual)I S = future consumptionI I = investment (form the capital stock for future production)I The banking sectors collects all recources not consumed, i.e. S,

and makes them available for investment I, see Sec. 2.1.



National Accounting

double entry bookkeeping system

Y = GDPproduction account:

GDP = C + Igoods and service account:

Y = C + I

C + S = wN + rKuse of income account (households):

wN + rK = Ygeneration of income account (firms):

C + S= Yincome account (private sector):

I = Sfinance account (banking sector):

The statement in the finance account is called ex post identity:

I = S



Flows of Income with Government Activities

government

households firms

banks

tax revenue T

public expenditure G public expenditure G

tax revenue T



savi

ng

S

investment I

budget constraint of the state: G = T (See also Sec. 2.1.)



National Accounting

Allowing for a government with regard to a closed economy:

Y = C + CSt + I + IStproduction account:

C + S + T = Yincome account (priv’ sector):

CSt + SSt = Tincome account (publ’ sector):

C + CSt + S + SSt = Yincome account (total):

I + ISt = S + SStfinance account (ex post identity):

by definition: government expenditure G = CSt + ISt

using the public sector income account: G = (T − SSt)+ ISt

substitution: I + (ISt − SSt) = S ⇐⇒ I + (G− T ) = S

alternative ex post identity for a closed economy

I + G = S + T



Flows of Income Regarding an Open Economy (Outlook)

government

households firms

banks rest of the world

tax revenue T

public expenditure G public expenditure G

tax revenue T



savi

ng

S

investment I

capital export KEx

capital import KIm

exp

ort

Ex

imp

ort

Im



Expenditure Components of GDP

Source: Eurostat Pocketbooks, Key Figures on Europe, 2010, p. 24


1 Economic Matters in a Closed Economy1.5 Macroeconomic Goals

Overview:

I Business cycleI Full employment vs. unemployment (→ internal equilibrium)I Price stability vs. inflation (→ internal equilibrium)I Economic growthI Ignored here:

Adjusted balance of payments (→ external equilibrium)




Business Cycle

A business cycle is identified as a

sequence of 4 phases:

1. Expansion or recovery (a

speedup in the pace ofeconomic activity)

2. Peak (the upper turning of abusiness cycle)

3. Contraction (a slowdown inthe pace of economic activity)

4. Trough (the lower turning

point of a business cycle,where a contraction turns intoan expansion)

A recession occurs if a contractionis severe enough . . .

A deep trough is called a slump ora depression.

timere

alG

DP

business cyclegrowth trend

cyclewithout trend

potentialGDP

trough peak

expansion contraction

recovery prosperity



Business Cycle

Further elements in the graph

I The business activity level is measured by real GDP.I The output Y r (= real GDP) depends on employment N (→

labor market) and the capital stock K (→ investment):

Y r = f (N, K )

I The potential GDP denotes the output at the capacity limit

including full employment.I The growth trend refers to economic growth in the long run.I The business cycle is depicted twice without growth trend

(dashed red curve) and including the growth trend (red curve).I On top of the business cycle there are seasonal ups and downs

not shown in the graph.



Business Cycle

Caveat: At one time, business cycles were thought to be extremely

regular, with predictable durations. But today business cycles are

widely known to be irregular – varying in frequency, magnitude and

duration.

Since WW II

I average duration of business cycles: three to five yearsI average duration of an expansion: 44.8 monthsI average duration of a recession: 11 months

Great Depression (1929–1933): 43 months from peak to trough

The Business Cycle Dating Committee of the Centre for Economic Policy

Research has identified the following recessions since 1970 for the euro

area: (peak/trough) (1974q3/1975q1) (1980q1/1982q3)

(1992q1/1993q3)



Business Cycle

Inherent problems of business cycles

I unemployment and deflation especially in the troughI inflation especially at the peakI insufficient provision of the economy with goods below the

capacity limit

Some causes (arguments follow expectations, risks, (mis-)trust, and

sentiments)

I Planned activities (saving, investment) cannot be realized.I Supply of money and demand for money do not match.

(e.g., credit crunch during the financial crisis)I Sentiments can change expectations on the future.

In order to prevent problems of business cycles it would be useful to

predict corresponding phases.



Economic Indicators

major attributes of economic indicators

I Relation to the business cycle / economy

I Procyclic: moves in the same direction as the economy, e.g. GDP,income tax revenue.

I Countercyclic: . . . opposite direction . . . , e.g. unemployment rate.I Acyclic: has no relation to the economy (is generally of little use).

I Timing

I Leading: change before the economy changes, e.g., stock marketsor business climate indicator. Leading economic indicators are themost important type for investors as they help predict what theeconomy will be like in the future.

I Lagged: . . . a few quarters after . . . , e.g. the unemployment rate.I Coincident: moves at the same time the economy does, e.g. GDP.

I Frequency of the data: In most countries GDP figures are releasedquarterly while the unemployment rate is released monthly. Someeconomic indicators, such as the Dow Jones Index, are availableimmediately and change every minute.



Unemployment

Definitions of the International Labor Organisation Germany, 2013

I focus on economically active population only population 81 m

(not children, retired persons, invalids or voluntary unemployed)I employees = total number of insured persons covered by the

unemployment insurance schemesI employed = self-employed + employees 42 mI unemployed = all persons 2.8 m

I between 15 and 65 years of ageI without work, i.e. not in paid employment or self-employment,I currently available for workI seeking work

= number of recipients of insurance benefitsI labor force = employed + unemployedI unemployment rate = ratio of unemployed to employed (ILO,

destatis) or ratio of unemployed to labor force (OECD) 6.5 %

More details follow in Sec. 2.3 (Labor Market). map of Germany



Unemployment

Kinds of unemployment

I frictional: movement of people, e.g., between regions or jobs (it

takes time to find a new job)I cyclical: the overall demand for labor is low due to a low level of

economic activity (business cycle or seasonal effects)I structural: mismatch between supply of and demand for labor

I structural changes where some sectors grow while others decline(one of the most important problems for new member states)

I In the EU high real wages, welfare benefits, subsidies, taxes, and soon have created high levels of structural employment.

High or even full employment is probably the most important

economic and political goal. (target value: unemployment rate ≤ 5%)

Hidden unemployment is a problem in the political context.

NAIRU (Non-Accelerating Inflation Rate of Unemployment) refers to a

level of unempl’ below which inflation rises via increasing wage rates.



Inflation

Inflation denotes a persistent increase in the general price level P of

commodities and services over some period of time.

I Inflation suggest an average increase in all prices of commodities

and services.I Inflation is an ongoing process not just a singular effect.I The inflation rate is measures on an annual basis (see below).I Inflation indicates that the value of money diminishes.

One needs more money to buy the same basket of goods.I The price level refers to a basket of goods consumed on average

by any household.I The ECB uses a basket of consumer goods consisting of 15.2%

food, 4.4% alcohol and tobacco, 7.1% clothing and footwear,

14.5% housing, 14.9% transport, 1.1% education etc.



Inflation

I Yn = nominal GDP in prices of the current year (e.g., 2014)

Yn = p2014

1x1 + p2014

2x2

I Y r = real GDP measured in prices of a base year (e.g., 2000)

Y r = p2000

1x1 + p2000

2x2

I P = price level

P2014 =Yn

Y r=

p2014

1x1 + p2014

2x2

p2000

1x1 + p2000

2x2

I Yn = PY r

I inflation rate π =Pt−1 − Pt

Pt−1

(deflation if π < 0)

I The ECB refers to price stability if π ≤ 2%.



Economic Growth

annual growth of business activity (most frequently used indicator:

GDP) in the long run (ignoring seasonal aspects or business cycle)

I quantities of factors of production

(labor, land incl. environment, capital)I qualities of factors of production

(education, pollution of the environment, technical progress)I organizational aspects

(constitutional state, administration, infrastructure)

measurement of growth:

I absolute growth Yt − Yt−1

I growth rateYt − Yt−1

Yt−1

I GDP per head more relevant than GDP





2.1 Commodity Market

2.2 Money Market

2.3 Labor Market

2.4 Total Equilibrium




2 Basic Concepts in Macroeconomics2.1 Commodity Market

Commodity Market (Overview):

I Consumption and savingI Investment and savingI (Demand sided) equilibria in the commodity marketI Government sector

I Government expenditureI Tax income (government finance)I Budget deficit

I Effects of a fiscal expansion

Remark: Y = C+ I + G refers to the demand side of an economy. The

supply side will be described by the labor market in Sec. 2.3.



Consumption and Saving

I Income Y = resources households can consume C.I Disposable income allows for taxes reducing the income (Y − T )

I Saving S = anything of the income Y the households do not

consume (residual, S = Y − C)I Saving = future consumptionI Saving = resources needed for investment

(Today you can either consume a cow (slaughter) or spare it. If you

spare the cow it can be used for future consumption (→ saving) and

meanwhile for breeding (→ investment).)



Consumption and Saving

Consumption C follows some simplified rules by plausibility:

I The higher the (disposable) income the more we spend on

consumption.I An extra unit of income (e.g., 1 euro) leads to an extra amount of

consumption (e.g., 66 cent).I There is a minimum amount Cmin the consumption does not fall

below (subsistence level)

Y

C(Y )

Cmin



Investment and Saving

I investment I – saving S (cf. ex post identity (I = S))I investment I – capital stock K, Kt+1 − Kt = In

t

I depreciation D – consumed part of the capital stockI gross investment vs. net investment: Ig = In + D

I by plausibility: investment I depends on the interest rate i.

i ↑ =⇒ I ↓

I

i



Equilibria in the Commodity Market

I Any equilibrium requires Y = C + I (equilibrium condition).I Suppose a given interest rate i, so that I = I(i) is determined.I Two cases may happen

I Increase in inventories if total output Y exceeds desiredconsumption C(Y ) and planned investment I.consequence: Y ↓ and C(Y ) ↓

I Decrease in inventories if total output Y falls short of desiredconsumption C(Y ) and planned investment I.consequence: Y ↑ and C(Y ) ↑

An equilibrium in the commodity market appears if planned output

equals desired consumption and planned investment. Only if unplanned

changes in inventories disappear, there is no need to adjust Y , C or I.



Equilibria in the Commodity Market

Y

C + I Y = C + I

C(Y )

C(Y )+ I

Y∗

increase in inventories

Y1←

decrease in inventories

Y2 →

45◦



IS-Curve

I additional: planned investment I depends on the interest rate i.I start: Y = C(Y )+ I(i) or, alternatively, Y − C(Y ) = S(Y ) = I(i)

I i ↑ =⇒ I ↓ =⇒ Y ↓I The IS-curve denotes all (Y, i) combinations that determine

equilibria in the commodity market.

Y

i



Government Sector

I Government expenditure G = CSt + ISt

I Balanced budget G = T or budget deficit 1 = G− T > 0

I expost identity I + (G− T ) = S. Not all of the private resources

S are available for private investments I having a budget deficit.I Art. 115 Grundgesetz (German constitution):

The budget deficit 1 must not exceed public investment ISt, i.e.

1 ≤ ISt.

Otherwise: 1 = G− T = CSt + ISt − T > ISt =⇒ CSt > T

Golden rule of public finance: Cover ongoing expenditures by

ongoing revenues or: do not finance public consumption by credits!I EU treaties, Protocol No 13, Art. 2 plus Art. 126 TFEU:

The budget deficit 1 must not exceed 3.0% of GDP (=Y).

EU: deficits by states



Government Sector

Financing a budget deficit 1 = G− T > 0 by

(a) increasing the money stock ("print money")

→ forbidden, see Sec. 2.2.

(b) issuing bonds (credit of the private sector to the government)

(c) using foreign exchange reserves (requires an open economy)


Caveat: In a closed economony (c) is excluded by assumption and (a) is

excluded by law, so (b) remains. The government either finds a

creditor (banks, firms, households) or it goes bancrupt ("does not pay

for parts of G").



Effects of a Fiscal Expansion

Y

C + I + G Y = C + I + G

C(Y − T )+ I

C(Y − T )+ I + G

Y∗∗Y∗ →

45◦



Fiscal Expansion

I Choose some interest rate i and hold it constant.I before: Y = C(Y )+ I(i)→ IS-curve as beforeI after: Y = C(Y − T )+ I(i)+ G→ new IS-curve (IS’)

Y

i

IS → IS’

i

Y∗→ Y∗∗


2 Basic Concepts in Macroeconomics2.2 Money Market

Money Market (Overview):

I Money supplyI Money demandI Quantity theory of moneyI Equilibria in the money marketI Effects of a monetary expansion

Remark: Money supply is controlled by the central bank. On monetary

policy see Sec. 3.2.



I Supply of money M (monetary aggregates)I narrow money M1 = coins + paper money + checking depositsI broad money M2 = M1 + saving accounts

Money supply M is different from monetary base B = coins + paper money +

reserves. The central bank controls directly B and indirectly M. More details

follow in Sec. 3.3.I Demand for money L (= liquidity preference)

I transactions demand for moneyI asset demand (financial economics)

I interest rate = price of moneyI You must pay for the opportunity to borrow money.I You receive money if you lend money to others.



Quantity Theory of Money

The monetarist approach

I Yn = P Y r = volume of transactions performed in the economyI V = velocity of money (speed at which money circulates)I M = money supply

Fisher’s identity (money as a medium of exchange)

M V = P Y r

quantity theory of money:

I assumptions: V = const., Y r = potential output (full employment)I result: M ↑ =⇒ P ↑



Quantity Theory of Money

Inflation is always and any-

where a monetary phenomenon

Milton Friedman



Hyperinflation

Hyperinflation: Most economists agree that a situation where the

monthly inflation rate exceeds 50% can be described as hyperinflation.

1922 Germany 5 000%

1985 Bolivia more than 10 000%

1989 Argentina 3 100%

1990 Peru 7 500%

1993 Brazil 2 100%

1993 Ukraine 5 000%

People lose their savings, which leads to a substantial loss in wealth for

broad segments of the population.

Over time money completely loses its role as a store of value, unit of

account and medium of exchange.



Asset Demand

I up until now: transactions demand for money (money as a

medium of exchange)I now in addition: asset demand (money as a store of value)

Idea: You can hold two types of assets (→ portfolio)

I money in cash without interest paymentsI interest bearing assets (e.g., bonds)

Plausibility: The higher the interest rate i

I the more you invest in bonds andI the lower is your demand for cash L.

Remark: For a fixed transactions volume Y r the transactions demand

for money L = 1

VY r can only be reduced if V increases

(i ↑ =⇒ V ↑).



Equilibria in the Money Market

I M = (nominal) supply of moneyI M/P = real supply of moneyI L = transactions demand for moneyI i∗ = equilibrium interest rate

L

i

L

M/P

i∗



Equilibria in the Money Market

I i∗ = const, Y ↑ (Y∗→ Y∗∗) =⇒ L ↑ (shift of L∗→ L∗∗)I i ↑ (movement along L∗∗)I new equilibrium at i∗∗

I LM-curve: all (Y, i)-pairs corresponding to an equilibrium in the

money market.

L

i

L∗ L∗∗

M/P

i∗

i∗∗

Y

i

i∗

i∗∗

Y∗ Y∗∗

LM-curve



Monetary Expansion

Increasing the stock of money M → M ′ shifts the LM-curve

L

i

L∗ L∗∗

M/P M ′/P

i∗

i∗∗

Y

i

i∗

i∗∗

Y∗ Y∗∗

LM-curve

LM-curve


2 Basic Concepts in Macroeconomics2.3 Labor Market

Labor Market (Overview):

I The labor market conforms the same rules as any other market:I labor supply (workers)I labor demand (firms)I (real) wage rate (price of a labor unit)

I Unemployment (see Sec. 1.5 on the definition)

Remark: On fiscal policy as an instrument to reduce unemployment

see Sec. 3.2.



Labor Market Equilibrium

Labor market equilibrium

I Everybody seeking work finds a job (full employment N).I Equilibrium at w (wage rate), N (number of employed persons)I Nmax = maximum number of persons that can work in principle.I Voluntary unemployment (Nmax − N S): people not willing to

work at the given wage rate; inactive on the labor market.

N

w

N SN D

w

N Nmax



Minimum Wage Rate

The effect of a minimum wage rate (wmin > w∗) on a perfect labor

market is unemployment.

Different statement for an imperfect market.

N

w

N SN D

w

N

wmin

N∗

N S > N D

Nmax

Nmax − N S

I N∗: realized employment (N∗ ≤ N)I N S − N D: (involuntary) unemploymentI Nmax − N S: voluntary unemployment



Minimum Wage Rate

Minimum wage rates follow from

I collective agreements between labor unions and employer groups,I governmental orders.I Administrative orders of employment protection can have the

same effect.



Supply Side of the Economy

Supply side of the economy:

I The total output Y of an economy depends on the realized

employment N and the capital stock K: Y = f (N, K )

Output Y increases with realized employment N .I All we produce is offered at the markets: Y S = f (N, K )

I Potential output Y S refers to production at the capacity limit

including full employment: Y S = f (N, K )

Two reasons for unemployment:

(a) minimum wage rates (see above)

(b) lack of demand (Y D < Y S), then potential output Y S will be

reduced and N falls below full employment N (see below).


2 Basic Concepts in Macroeconomics2.4 Total Equilibrium

Overview:

I IS-LM approachI total equilibrium including the labor marketI outlook: dynamic aspects (growing capital stocks)



A total equilibrium of the economy requires simultaneous equilibria on

the commodity market (IS) and the money market (LM).

Y

i

IS

LM

i∗

Y D

Y D = C + I + G refers to the demand side of an economy.



I The equilibrium (Y D, i∗) above refers to the of an economy.I The labor market equilibrium (N, w) represents the supply side;

all workers produce a total output Y S that is to be sold.

Y S = potential output at full employmentI Problem: For a lack of demand Y D < Y S, produced output will

be reduced to Y D = Y S which results in unemployment.

Graphical presentation on the next page.



Y

i

IS

LM

i∗

Y D Y S

The following section deals with the question as to how this problem

can be solved.






3.1 Theory of Economic Policy

3.2 Keynesian Approach

3.3 Instruments of Macroeconomic Policy



3 Macroeconomic Policy (Global Steering)3.1 Theory of Economic Policy

Overview:

I Jan TinbergenI Policy assignmentI Stability and Growth Pact (EU)



Tinbergen

Probably most important rationale of the theory of economic policy.

Jan Tinbergen

Regarding an interdependent economic system, each economic objective

requires at least one independent instrument.

→ Use instruments adequately to causes of problems.



Policy Assignment

In our closed economy the internal equilibrium is based on two goals:

I full employmentI price stability

Two independent instruments are available:

I fiscal policy (public expenditure G) by the governmentI monetary policy (money stock M) by the central bank

Policy assignment:

I fiscal policy (G)→ full employmentI monetary policy (M)→ price stability

Caveat: The two goals are interrelated, so both instruments must be

coordinated in order not to contradict each other.



Stability and Growth Pact (EU)

The policy assignment in the European Union (EU) has a special

problem of coordination.

I The monetary policy for those Member States adopting the euro

is performed by the European Central Bank (ECB). Eurozone

I Fiscal policies are executed by national governments.

The Stability and Growth Pact is an attempt to coordinate national fiscal

policies in order not to jeopardize the European monetary policy.



Further goals:

I economic growthI adjusted balance of payments (external equilibrium)

Economic growth is pursued by

I competition policy (passive role of a constitutional state)I industrial policy, business cycle policy (active role of the

government, much mor attractive for politicians)

Pursuing an adjusted balance of payments in an open economy depends

on the system of exchange rates (flexible or fixed exchange rates)

(→Module: International Economic Relations)


3 Macroeconomic Policy (Global Steering)3.2 Keynesian Approach

Overview:

I Lack of aggregate demandI Fiscal policyI Monetary policy

I Involuntary unemploymentI Sticky wage ratesI Stability Act (Germany)



Fiscal Policy (Fiscal Expansion)

I Start at (Y D1

, i1) with Y D1

< Y S (unemployment)I Fiscal expansion G ↑ =⇒ right shift of the IS-curveI New IS-LM equilibrium (Y D

2, i2) with i ↑ and Y ↑

I Unemployment reduced (Y ↑), but not eliminated (Y D2

< Y S)

Y

i

IS IS’

LM

i1

i2

Y D1

Y D2 Y S



Fiscal Policy

Fiscal policy might be used as follows (idea):

I Rule of thumb: The higher the national output Y S the more

workers are needed.

Potential output Y S corresponds to full employment (Y S ≤ Y S).

Problem if Y S > Y S = Y D = C + I + G (lack of demand).I Aggregate demand of the private sector C + I too small.

Hence, labor demand is small and this leads to unemployment.I Supplement private demand with public demand G = CSt + ISt

(Y D = Y S) ↑ and Y S converges to Y S

Additional output generates additional jobs and reduces

unemployment.



Fiscal Policy

Caveat:

I Public demand is to be financed by private resources.

An income tax T has similar effects as a tax on labor.I Withdrawing resources from the private sector reduces private

demand. This leads to a loss of jobs.I Possibly, jobs are merely shifted from the private to the public

sector (crowding out effect).



Monetary Policy (Monetary Expansion)

I Start at (Y D1

, i1) with Y D1

< Y S (unemployment)I Monetary expansion MS ↑ =⇒ right shift of the LM-curveI New IS-LM equilibrium (Y D

2, i2) with i ↓ and Y ↑

I Unemployment reduced (Y ↑), but not eliminated (Y D2

< Y S)

Y

i

IS

LM LM’

i1

i2

Y D1

Y D2 Y S



Benefit cost analysis of a monetary expansion

I Benefit: MS ↑ =⇒ Y ↑ (closer to full employment)I Cost: MS ↑ =⇒ P ↑ (inflation)

Statement of a former German chancelor (head of government):

"I prefer 5% of inflation to 5% of unemployment."


3 Macroeconomic Policy (Global Steering)3.3 Instruments of Macroeconomic Policy

Overview:

I Instruments of fiscal policyI Instruments of monetary policy



Instruments of Fiscal Policy

The major objective of fiscal policy is to reduce unemployment.

Instruments of fiscal policy

I increasing private demand C + I

I stimulation of C by reducing income or consumption taxesI promotion of I by reducing investment cost (e.g., public credits at

low interest rates, other investment incentives)

I increasing public demand G = CSt + ISt

I public investment programsI funds to accommodate the business cycle (incl. ERP fund)→ Accumulate surplus funds for problems in the future.

I finance G by credits with the hope of a higher tax income in thefuture (deficit spending)

Legal basis in Germany: Act on the Promotion of Economic Stability

and Growth (1967)



Instruments of Monetary Policy

The major objective of monetary policy is to promote price stability.

Instruments of monetary policy (eurozone, ECB, ESCB-Statute)

I open market operations, discount window, foreign exchange

operationsI minimum reserves,I overnight interest facilities

(Secondary) Targets

I steering of money supply M

I steering of liquidity of the private banking sectorI steering of interest rate i

Results: (indirect) effects on real terms (Y, C, I) only in the short run;

in the long run monetary policy affects almost only P.

The Fed (USA) puts more emphasis on indirect effects than the ECB (EU).




Basic ideas how instruments work:

(1) Open market operations, discount window, foreign-exchange

operations → monetary base

(2) Minimum reserves → money creation by private banks

(3) Standing facilities → steering of interest rates





operationsIdea: The central bank controls the volume of bank reserves bybuying and selling financial assets.

I main refinancing operations (maturity: 1 week)I longer-term refinancing operations (maturity: 1 month)I fine-tuning operations (maturity not standardized)

The ECB is «in principle» not allowed to buy government bonds.

(2) Minimum reserves

(3) Standing facilities





operations

Idea: The central bank lends money to the private sector (usually

private banks only) at an interest rate called discount rate.






(1) Open market operations, discount window, foreign exchange

operations

Idea: The central bank buys or sells assets dominated in foreign

currencies. Example: The ECB buys US dollars.








operations


Idea: Retard the process of money creation by loans of the private

banking sector. money creation






operations


(3) Standing facilities ECB data

Purpose to provide and absorb overnight liquidity, bound overnightmarket interest rates

I marginal lending facility to obtain overnight liquidity (marginallending rate)→ ceiling for the overnight market interest rate

I deposit facility to make overnight deposits (deposit rate)→ floor for the overnight market interest rate







4.1 Social Policy

4.2 Government Finance (+ Public Choice)


4 Prospects of Macroeconomics4.1 Social Policy

Overview:

I PovertyI Welfare state and social insuranceI Redistribution of income (functional income distribution)



Poverty (The World Bank)

I Poverty is a state of people not having enough (recources or

money) today in some dimension of well-being.I Absolute poverty refers to the deprivation of basic human needs

(food, water, sanitation, clothing, shelter, health care and

education).

Food-energy intake method: poverty line = consumption

expenditures at local prices just sufficient to meet some food

energy requirement (e.g., $ 1 a day = 1500 calories per day).I Relative poverty refers to economic inequality in the society in

which people live (e.g., less than 50 percent of a country’s mean

income or consumption).

Global absurdity: a cow in the developed world receives subsidies that amount

to almost twice the annual income of an average Third World farmer.



Welfare State and Social Insurance

The welfare state is a concept of a mixed economy arising in Europe in

the late 19th century.

I Idea:I Markets direct the detailed activities of daily economic life

(→ individual economic plans).I Governments regulate social conditions and provide pensions,

health care, and other aspects of a social safety net.

I (One) Instrument: social insurance (see next page)I Example: Germany is referred to as a «social» market economy.



Welfare State and Social Insurance

Social insurance is a mandatory insurance provided by the state in

order to improve social welfare.

I insurance: covers risks of accidential damagesI mandatory: all individuals have the right and the obligation to

participate (no selection)I social welfare: individual prosperity and social peace depend on

each other (cf., e.g., high unemployment rates)I examples: unemployment, health, or pension insuranceI realization differs between countries

Problem with business cycles: During a boom the revenues from an unemployment

insurance are high but unemployment is low. In a recession unemployment

benefits are paid out at low levels of revenues.



Functional Income Distribution

Functional income distribution describes the partitioning of GDP into

factor incomes.

I national accounting: Y = wN + rK

I labor share wN/Y

I capital share rK/Y

Problem addressed by Karl Marx: What party – workers or capital

owners – has more power to take influence on the distribution of

income (→ collective bargaining on wage rates).

Indirect problem: such a «distribution battle» may lead to a decrease in

GDP (→ minimum wage rates, strikes organized by labor unions).


4 Prospects of Macroeconomics4.2 Government Finance (+ Public Choice)

Overview:

I Sources of revenueI Classification of taxesI Public firmsI Privatization

I Selected classes of expenditureI Social policyI Education and health policyI Regional and urban development

I Government failureI Equity versus efficiencyI Public sector efficiencyI Reallocation of ressources



Sources of Revenue

Classification of taxes by OECD OECD figures

1. taxes on income, profits and capital gains, Germany: solidarity duty

(individuals, corporate) (→ income of households and firms, flows)

2. social security contributions

3. taxes on property (immovable property, net wealth, estate,

inheritance, financial transaction, etc.)

(→ wealth of households and firms, stocks)4. taxes on goods and services (→ business activities)

I taxes on production, sales, rendering services (value added tax)I taxes on specific goods and services (excises, customs, etc.)I taxes on use of goods or on permission to perform activities

Classification by ESA95: (1) taxes on production and imports, (2) taxes on

income, wealth, . . . , (3) capital taxes, (4) social contributions



Sources of Revenue (Public Firms)

Public firms (→ social ownership) are based on two aspects:

(→ Module: Microeconomics)

I the private sector is not willing or not able to provide certain

commodities or services at an adequate level (e.g., television).I the provision of such goods entails risks of market power which is

expected to be abused (e.g., local electricity or water services).

Publicly owned firms may solve these problems. They sell their services

at low profits (revenue ≈ cost), profits accrue to society, or these firms

are subsidized by the government (i.e. by consumers or tax-payers).

In essence, public firms finance their activities by corresponding revenues.



Sources of Revenue (Privatization)

Reasons for privatization of public firms

I The conditions for a public firm are no longer valid so that private

solutions are preferred (cf. telecommunications services).I Public firms tend to be inefficient due to missing competition (e.g.,

former Deutsche Telekom, Deutsche Bahn, Deutsche Post).I The government needs exceptional revenues to finance public

debt (e.g., Greece sells harbors and airports).



Selected Classes of Expenditure (Overview)

Source: Eurostat yearbook 2010, p. 116



Selected Classes of Expenditure

Social Policy




Education and health policy

I Expression of a provisional state (→ one aspect of a welfare state)I The government finds individuals not to assess the advantages of

education or health risks properly.I Basic decisions and responsibilities are shifted from

«incompetent» individuals to the government.I Government expenditure is necessary to meet these

responsibilities (→ financed by tax revenues).

Problem: where are the limits? Range from elementary schools to private and

public universities.




Regional and urban development

I Problem: regions and towns differ in their economic vitality.I Passive strategy («workers to the joby»): markets direct

resources into prosperous regions or urban areas (→ rural

exodus). Areas lagging behind suffer from unemployment and

unemployed are expected to move towards prosperous places

(→ problem of migration from periphery to agglomeration areas)I Active strategy («jobs to the workers»): a reallocation of

recources shall help poor regions to catch up with properous

areas (e.g., infrastructure investments). Example: EU



Government Failure

Equity versus efficiency

I «Perfect» markets yield outcomes where resources are used

efficiently (→ efficiency). (→ Module: Microeconomics)

I Market failure refers to market imperfections that hamper

efficiency.I Not all market results – although efficient – are accepted by

societies, e.g., unequal personal income distribution (→ equity).I If governments intervene in order to regulate or to correct market

results, they run at the risk to fail also (→ government failure).

Example: If a government redistributes personal income under reasons

of equity it destroys the incentives to participate in competition. The

effect might then be a shrinking GDP.



Government Failure

Public sector efficiency

If the public sector

I substitutes (water provision, railway services)I complements (institutional, material, personal infrastructure), orI competes with (television, universities, transport modes)

the private sector, the question arises as to what solution provides

preferable outcomes.

Empirical findings: publicly provided solutions tend to be more

inefficient than private solutions especially over a longer period of time.

Reasons:

I lack of private property / lack of responsibility for resourcesI missing competition / missing incentives to find better solutionsI investments do not follow rentability criteria



Government Failure

Reallocation of resources

I Factor allocations primarily result from factor markets. Factor

prices direct resources to purposes where they are needed most

urgently. (→ Module: Microeconomics)

I Regional reallocation of resources is a development strategy by

the state helping poor regions to catch up with more prosperous

areas (see above).

Problem: a reallocation requires to withdraw resources from

prosperous areas (→ slow down) and to distribute them among

regions with a less effective usage of resources (→ speed up).

It is hard to prove that this strategy has positive effects in total. The

European development program seems to lack almost any

advantageous effects.


5 Appendix

Table of Contents


1.1 Preliminaries

1.2 Market Prices

1.3 Government Activities

1.4 National Accounting

1.5 Macroeconomic Goals


2.1 Commodity Market

2.2 Money Market

2.3 Labor Market

2.4 Total Equilibrium


5 Appendix

Table of Contents


3.1 Theory of Economic Policy

3.2 Keynesian Approach

3.3 Instruments of Macroeconomic Policy


4.1 Social Policy

4.2 Government Finance (+ Public Choice)


5 Appendix

Index

aggregationdemand . . . . . . . . . . . . . . . . . . . . . . . . . . 9supply . . . . . . . . . . . . . . . . . . . . . . . . . . . 10

asset demand . . . . . . . . . . . . . . . . . . . . . . . . 54benefit cost analysis . . . . . . . . . . . . . . . . . . 78budget

deficit . . . . . . . . . . . . . . . . . . . . . . 45, 114business cycle . . . . . . . . . . . . . . . . . . . . . . . .27circular flow of income . . . . . . . . . . . . 22, 24COFOG . . . . . . . . . . . . . . . . . . . . . . . . . 25, 98depression . . . . . . . . . . . . . . . . . . . . . . . . . . 27equilibrium

external macroeconomic . . . . . . . . . . . 7internal macroeconomic . . . . . . . . . . . 7

eurozone . . . . . . . . . . . . . . . . . . . . . . . . . . 110ex post identity . . . . . . . . . . . . . . . . . . . . . . 21fiscal policy . . . . . . . . . . . . . . . . . . . . . . . . . . 74

instruments . . . . . . . . . . . . . . . . . . . . . . 80GDP

potential . . . . . . . . . . . . . . . . . . . . . . . . 27government failure . . . . . . . . . . . . . . . . . . 102hyperinflation . . . . . . . . . . . . . . . . . . . . . . . . 53income distribution, functional . . . . . . . . .93inflation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 35

rate . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 35law of demand . . . . . . . . . . . . . . . . . . . . . . . . 9law of supply . . . . . . . . . . . . . . . . . . . . . . . . 10

marketdemand . . . . . . . . . . . . . . . . . . . . . . . . . . 9equilibrium . . . . . . . . . . . . . . . . . . . . . . 11failure . . . . . . . . . . . . . . . . . . . . . . . . . . 102supply . . . . . . . . . . . . . . . . . . . . . . . . . . . 10

monetary base . . . . . . . . . . . . . . . . . . . . . . . 50monetary policy . . . . . . . . . . . . . . . . . . . . . .77

instruments . . . . . . . . . . . . . . . . . . . . . . 81money

demand . . . . . . . . . . . . . . . . . . . . . . . . . 50supply . . . . . . . . . . . . . . . . . . . . . . . . . . . 50

policyassignment . . . . . . . . . . . . . . . . . . . . . . 70fiscal . . . . . . . . . . . . . . . . . . . . . . . . . . . . 74monetary . . . . . . . . . . . . . . . . . . . . . . . . 77

poverty . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 90price level . . . . . . . . . . . . . . . . . . . . . . . . . . . 35price mechanism . . . . . . . . . . . . . . . . . . . . . 12quantity theory of money . . . . . . . . . . . . . 51recession . . . . . . . . . . . . . . . . . . . . . . . . . . . . 27social insurance . . . . . . . . . . . . . . . . . . . . . . 92Stability and Growth Pact . . . . . . . . . . . . . 71tax

classification . . . . . . . . . . . . . . . . . . . . . 95structure . . . . . . . . . . . . . . . . . . . . . . . 113

Tinbergen’s rule . . . . . . . . . . . . . . . . . . . 7, 69unemployment . . . . . . . . . . . . . . . . . . . . . . 33welfare state. . . . . . . . . . . . . . . . . . . . . . . . .91


5 Appendix

Regional Unemployment in Germany (Oct. 2013)

Regional unemployment

in the Federal States and

Districts of Germany

(Oct. 2013)

Germany 6.5 %

Western G. 5.8 %

Eastern G. 9.5 %

Federal Agency for Labor

Unemployment rates in

percentages of the total civil

labor force

go back


5 Appendix

Regional Unemployment in the EU (2007)

Regional unemployment

in the European Union

and Turkey

focus on Eastern

enlargement and

periphery

Unemployment rates in

percentages of the total civil

labor force

go back


5 Appendix

Eurozone (2014)

EU: 28 Member States

Eurozone (18 members)

1.1.2014: + Latvia

internally fixed rates

(single currency)

Rest of the European

Union

States adopting the euro

unilaterally

go back


5 Appendix

Money Creation Process

Minimum (required) reserves (money creation process) go back

round 1B 1CU 1D 1R 1Loan 1M1

= 0.21M1 = 0.81M1 = µ1D = 1D −1R = 1CU +1D

0. 100.0 – – – 100.0 –

1. – 20.0 80.0 8.0 72.0 100.0

2. – 14.4 57.6 5.8 51.8 72.0

3. – 10.4 41.4 4.1 37.3 51.8... –

......

......

...

accumulated

at 10. round – 68.0 274.7 27.5 347.1 343.5

after∞ rounds – 71.4 285.7 28.6 357.1 357.1

I monetary base (high powered money) B = CU + R

I money supply M1 = CU + D

I R = µD, reserve ratio µ = 10%

I Consequence: µ ↑ =⇒ R ↑ =⇒ Loan ↓ =⇒ M1 ↓


5 Appendix

ECB Interest Rates

go back


5 Appendix

Sources of Revenue (Tax Structure)

Source: OECD in Figures 2008, pp. 56–57 go back


5 Appendix

General Government Deficit

Source of data: Eurostat (code: tsieb080) go back


5 Appendix

General Government Debt

Source of data: Eurostat (code: tsieb090) go back


5 Appendix

Regional Reallocation of Recources

Example: The EU supportsregions lagging in theirdevelopment (75% of theEU-average income perhead) with resources fromthe European Fund ofRegional Development.

2007–2013: EUR 347 billion

≈ one third of the EU’s

budget

go back


module: macroeconomics1 economic matters in a closed economy 1.2 market prices market demand i the...

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