THE BASIC MACRO FRAMEWORK 'Macroeconomics: Imperfections ...
THE BASIC MACRO FRAMEWORK ‘Macroeconomics: Imperfections, institutions and policies’ Carlin & Soskice 2006 (Ch 1- 4) CHAPTER 1 • The 3-equation model (IS, PC and MR) o Assumptions Short run – output and employment can change but before prices and wages respond to the changes in output and employment • i.e. can assume that wages and prices are given in the short run Medium run – wages and prices respond to changes in output and employment and supply side of the economy adjusts to establish a medium run equilibrium in which inflation is constant • Continue to assume that capital stock and labour force are fixed • Medium run analysis therefore focused on the behaviour of wage and price setters. o Fluctuations in output and employment ‘one concern of macroeconomists is with the causes and consequences of short run fluctuations in economic activity.’ ‘booms with strong growth of output and recessions with sharp contractions are evident: the swing from peak to trough and back again is called the business cycle.’ If we assume prices and wages are given in the short run, so we can concentrate on how quantities (i.e. output and employment) adjust to changes in the demand for goods and services. o Unemployment International comparisons • Trend of rising u/e from the 1970s to the 1990s in Europe • Idea of a roughly constant equilibrium u/e rate looks more plausible for the US than for Europe – in the US, u/e fluctuates a lot but it appears to have fluctuated around a rate of about 6% since the 1960s • UK o Followed the same trend rise in u/e as much of Europe from the early 1970s to the early 1980s o Since then, there has been a downward trend that was interrupted but not halted by the recession of the early 1990s • Seems that changes in unemployment persist over time, and big differences across countries o ‘they motivate the notion of a medium run unemployment rate, in which changes over time and differences across countries are associated with variations in supply side structure.’ Modelling medium run unemployment • Only kind of u/e that exists in the competitive equilibrium is voluntary u/e – ‘competitive equilibrium rate of unemployment’ • Imperfect competition model o Can be involuntary u/e even at equilibrium o Introduce wage setters and price setters Firms can earn supernormal profits ‘The real wage for an individual will depend both on the outcome of wage setting and on the outcome of price setting across the economy.’ One level of employment and rate of u/e at which both wage and price setters accept the prevailing real wage – ‘imperfectly competitive equilibrium rate of unemployment’ o Inflation Economy initially at medium run equilibrium – therefore equilibrium rate of u/e (ERU), no pressure for WS or PS to adjust and inflation is therefore constant
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Increase in AD o Output and employment rise in the short run and u/e therefore <ERU Fewer u/e workers available – workers in a stronger bargaining position in the labour market and real wages must rise to achieve the necessary real wage But if wages go up, then price setters will not be in equilibrium, so firms tend to raise prices in order to maintain their profits (higher wages raise costs for firms) o Therefore increase in AD increases inflation Inflation and monetary policy • Figure 1.5
• • o o o
o
Increase in inflation – MP increases IR o Increase IR reduces AD as investment falls and therefore reduces output – u/e would increase and inflation would fall
Economic growth ‘small differences in growth rates produce large effects in terms of the standard of living when they persist for long periods of time.’ ‘there are signs that over time as some countries have become richer and others poorer, the world has become increasingly more clustered between rich and poor countries.’ The stylised facts of economic growth Large discrepancies between both levels and growth rates of per capita income persist across countries and across time In the long run economies exhibit a balanced growth path, that is output per capita and capital per capita grow at roughly constant positive growth rates over time The real rate of return to capital is approximately constant over the long run, while real wages grow at a rate close to that of output per head. From the above facts, it follows that the ratio of capital to output shows no trend over time and the shares of capital and labour in total income stay roughly constant. High investment rates in both physical capital and formal education are closely related to high living standards Low population growth is associated with high living standards Technological process associated with product market innovation is the main driving force behind the long run growth of living standards in the leader country Political, social, institutional and historical factors affect the long run economic performance of an economy and are associated with differences in growth rates across countries. Growth and diminishing returns to factor accumulation In short and medium run, assumed that capital was fixed. In the long run, would expect differences in levels of output per worker across countries to depend on the amount of capital equipment available (including human capital). Neoclassical theory of economic growth developed in 1956 by Solow and Swan. • Focused on systematizing the role of factor accumulation in growth
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Increase in AD o Output and employment rise in the short run and u/e therefore <ERU Fewer u/e workers available – workers in a stronger bargaining position in the labour market and real wages must rise to achieve the necessary real wage But if wages go up, then price setters will not be in equilibrium, so firms tend to raise prices in order to maintain their profits (higher wages raise costs for firms) o Therefore increase in AD increases inflation Inflation and monetary policy • Figure 1.5
• • o o o
o
Increase in inflation – MP increases IR o Increase IR reduces AD as investment falls and therefore reduces output – u/e would increase and inflation would fall
Economic growth ‘small differences in growth rates produce large effects in terms of the standard of living when they persist for long periods of time.’ ‘there are signs that over time as some countries have become richer and others poorer, the world has become increasingly more clustered between rich and poor countries.’ The stylised facts of economic growth Large discrepancies between both levels and growth rates of per capita income persist across countries and across time In the long run economies exhibit a balanced growth path, that is output per capita and capital per capita grow at roughly constant positive growth rates over time The real rate of return to capital is approximately constant over the long run, while real wages grow at a rate close to that of output per head. From the above facts, it follows that the ratio of capital to output shows no trend over time and the shares of capital and labour in total income stay roughly constant. High investment rates in both physical capital and formal education are closely related to high living standards Low population growth is associated with high living standards Technological process associated with product market innovation is the main driving force behind the long run growth of living standards in the leader country Political, social, institutional and historical factors affect the long run economic performance of an economy and are associated with differences in growth rates across countries. Growth and diminishing returns to factor accumulation In short and medium run, assumed that capital was fixed. In the long run, would expect differences in levels of output per worker across countries to depend on the amount of capital equipment available (including human capital). Neoclassical theory of economic growth developed in 1956 by Solow and Swan. • Focused on systematizing the role of factor accumulation in growth
