Macroeconomics Tutorials Department of Economics by alicejenny


									                    Macroeconomics Tutorials
   The Prelims Economics course concentrates on Macroeconomics during the …nal six weeks
of Hilary term. The tutorial topics to be covered are as follows:

         Week                             Topic                            Assignment

            3                     The Classical Model                     Short answers

            4                 Consumption and Investment                  Short answers

            5                     Monetary Economics                      Short answers

            6           Keynesian Theory of Aggregate Demand              Short answers

            7               Open Economy Macroeconomics                   Short answers

            8     Aggregate Supply, Phillips Curves, Business Cycles           Essay

   Additionally, there will be a vacation essay on macroeconomic policy (described at the end
of this document), which will be reviewed in a class at the start of Trinity term.
   The lectures start in week 3 and take place on Mondays and Wednesdays at 11am in the
Exam Schools on High Street. The lectures follow roughly the same structure as the tutorials in
terms of topics to be covered, but it is vital that you attend the lectures –the reason is that the
lecturer gets to set the exam questions, so by attending the lectures and observing the aspects
of a topic emphasised in lectures you will get some insight into the questions likely to come up
on the exam.
   The textbook for this course is now Macroeconomics - European Edition by N.G. Mankiw
and M. Taylor (2008). This is a variation on Macroeconomics by N. Gregory Mankiw (2006)
that was used in previous years. The material in the two books is essentially the same except
that (i) the European edition contains data plots and real world examples drawn mainly from
Europe as opposed to the U.S.; (ii) there is an extra chapter in the European edition (chapter 16)
that deals with currency unions, a topic that is obviously relevant to Europe (chapters 16-19 in
the 2006 version then become 17-20 in the 2008 version). In the readings below I have updated
the references so that the new European version of the book is cited, but the old version is a

close substitute in terms of the theory and so it is …ne to use that, noting the slight change to
the ordering of later chapters. If you purchase a textbook for the course then the more recent
European edition is the one to choose. In the library you will …nd 5 copies of the new European
edition of the book, plus many copies of the 2006 version of Mankiw and even more copies of
earlier editions of the Mankiw book –these are very similar to the 2006 version (the 6th edition)
but if you end up using one of them you will have to check the chapter headings to make sure
that you are reading the right material (send me an email if you are unsure about what to read,
but it should be the case that you always have access to the 2008 or 2006 editions of the book).
   Note that it is intended that you should read the textbook chapters and the articles be-
fore attending the lectures with John Vickers on Mondays and Wednesdays, so it would be
good to plan to work on Macro readings and written work during the weekend preceding each
lecture/tutorial combination.
   The department takes the view that the course should be based on just one textbook –that
by Mankiw, or now Mankiw and Taylor. I think that these books do a good job in presenting
the key elements of macro models, but in the case of some topics the analysis stops a little too
soon. In order to address this issue I have added references to a slightly more advanced textbook
in some cases –Macroeconomics and the Wage Bargain by Wendy Carlin and David Soskice. If
you would like more detail concerning a particular topic, this is the book to look at, but when
you see this book on the reading lists below, you should treat it as optional because it is beyond
the scope of the core course. On the reading lists you will see reference to some original articles,
all of which are quite accessible and which you should read.
   Other Resources
   The departmental webpage for the ‘Introduction to Macroeconomics’is a vital resource that
you should consult regularly. In particular, the course lecturer has provided supplementary
readings to support the lecture topic for each week. These should be read in conjunction with
the chapters from the Mankiw and Taylor textbook.
   A set of online materials is available to support the use of the 6th edition of the Mankiw
textbook. The materials include sample questions and answers, check lists for concepts in each
chapter, data plots to illustrate ideas and so on. The material can be found at:

   A useful complement to the textbooks and articles is online coverage of current macroeco-
nomic trends and their links to macroeconomic theory. I have added links to many relevant
news websites and blogs on my teaching webpage; browse some of them when you have time. I
have also added links to some major central banks. In the case of the Bank of England website
it is worth looking through the speeches made by Monetary Policy Committee members, the
In‡ation Reports that the Bank’ sta¤ produce on a quarterly basis and many of the other
documents that the Bank has put together outlining aspects of macroeconomic management in
the UK. The link to the relevant webpage is here:
   Finally, Richard Povey, an Economics tutor at Wadham College, has written up a set of
notes on micro and macro and made them available online. I have only skimmed the macro
notes but they appear very thorough and a useful complement to the core lectures notes and
course textbook, see
   It is important to have a good understanding of the main features of macroeconomic data
for the UK and other OECD countries during the last 40 years. This is especially important
in understanding the context in which di¤erent macroeconomic theories were developed during
the post-war period. A good source for cross-country macroeconomic data is the Penn World
Tables, available online at:
   Speci…c series for the UK can be obtained at the following site:

1     An Introduction to Macroeconomics

Macroeconomics is concerned with the determination of aggregate variables such as national
income, the exchange rate and the general level of prices. The subject draws on a number
of principles studied in the microeconomics course, for example maximising behaviour, market
clearing and resource allocation through relative prices, but is di¤erent to microeconomics in
that there is far less agreement concerning the appropriate set of assumptions on which to base
analysis. As a result of this, macroeconomists tend to divide up into several schools of thought
in relation to a number of key issues, each one providing a very di¤erent perspective on questions
such as: Why has the Chinese economy grown much faster than the European economy during
the last 30 years? Why has German in‡ation been half the level of Italian in‡ation for much
of the last 30 years? Why do households in Japan save a much larger fraction of their income
than do households in the United States? Why did so many countries go into recession during
the 1970s? What are the appropriate policy responses to the current credit market turmoil and
macroeconomic downturn?
    Over the course of the term we will look at some of the models used to address these questions,
and those of you who go on to study Economics next year will analyse these questions in some
detail, at both a theoretical and an empirical level. Before looking at such material, however,
it is important to get some perspective on the way in which macroeconomists build models, the
concepts that are important to understanding those models, and also some of the macroeconomic
history underpinning their development. To this end, please take some time during week one or
week two to read through the following material and make any notes that you consider helpful.

1.1   Readings

1. Mankiw and Taylor, chapters 1 and 2. Note: When reading the chapters you should take
notes that will serve as revision material. The notes should at least refer to each term listed in
the ‘key concepts’section at the end of each chapter of the Mankiw textbook.
    2. For a general discussion of macroeconomic trends in the UK economy during the post-war
period, see The British Economy Since 1945 by N. Crafts and N. Woodward.
    3. Browse some of the websites linked to the following page:

   4. The following article provides a critical review of the evolution of macroeconomic thinking
since the early part of the twentieth century:
   Krugman, Paul (2009). ‘                                    ,
                          How did Economists get it so wrong?’ New York Times Magazine,
2 Sept. Available at:
   A response from John Cochrane can be found here:

2    The Classical Model

In this tutorial we consider a model of macroeconomic ‡uctuations that was accepted by most
economists through until at least the early part of the twentieth century. The classical model
assumes perfect competition in the markets for labour, goods and services and loanable funds,
and full ‡exibility of all prices, including goods prices, wages and interest rates. The time
horizon considered in the model is that over which the stock of physical capital and the level
of technology can be considered …xed. This means that the only variable input to a standard
Cobb-Douglas production function is the quantity of labour, and the labour market therefore
plays a central role in determining the short-run position of the economy. As markets are
perfectly competitive, the derivative of the production function with respect to labour gives
the aggregate labour demand curve, and along with the aggregate labour supply curve, derived
through aggregating individual labour/leisure choices, this can be used to solve for labour market
equilibrium. The equilibrium quantity of labour can then be used to determine total output via
the production function, and this determines the location of the aggregate supply curve (AS),
an important concept in thinking about short-run macroeconomic adjustment. The other half
of the goods market is the aggregate demand curve (AD), which represents total spending
on consumption and investment (international trade is omitted at this stage, and government
purchases take the form of either consumption or investment). As we will see, the assumption
of a ‡exible interest rate ensures that the total level of aggregate demand is invariant to factors
such as business con…dence and consumer sentiment, and therefore the position of the aggregate
demand curve is dependent only on the quantity of money in circulation. The AS and AD curves
establish the equilibrium price level in the classical model. Finally, the allocation of spending
between consumption and investment is determined in the market for loanable funds, and
the division of the national income between returns to labour and returns to capital is entirely
dependent upon the relative productivity of those two factors, given the assumption of perfect
    Although the classical model is based upon quite strong assumptions, it conveys an important
message in macroeconomics, namely that aggregate ‡uctuations must be thought of as part of
a process of adjustment towards a general equilibrium, and that conclusions drawn based

upon comparative static exercises in just one market are unlikely to yield robust results. During
the process of adjustment towards equilibrium, the markets for labour, goods and lending will
interact in order to determine the response of the economy to interventions such as a change in
the money supply, or government spending. One of the main results to arise from this analysis is
that all ‘real’variables in the economy (essentially, those variables that describe a quantity, for
example output, employment, in‡ation adjusted wages etc.) can be solved for independently of
‘nominal’variables (those that ‡uctuate simply because of more money going round the system,
e.g. the average level of prices, or the average level of nominal wages). Further, it turns out
that in equilibrium the level of GDP is consistent with full employment of labour, a result
that greatly reduces the need to use macroeconomic policy in dealing with the consequences of
macroeconomic shocks.

2.1   Readings

1. Mankiw and Taylor, chapters 1, 2 and 3. Note: When reading the Mankiw and Taylor
chapter you should take notes that will serve as revision material. The notes should refer to
each term listed in the ‘key concepts’section at the end of each chapter of the textbook.
   2. Chapter 1 in Macroeconomics and the Wage Bargain by Wendy Carlin and David Soskice
(1996 edition). This book is at a more advanced level than the Mankiw textbook, and used to
be used in the second year macro course. I said above that the book is optional at all points,
but for this week only try to take a look at the chapter referenced because it takes things a lot
further than does Mankiw. Note that the book referenced here should not be confused with a
recent book by the same authors (published in 2006) that has a slightly di¤erent name. If you
do not like the Carlin and Soskice treatment, look at the chapter on the classical model in The
Macroeconomic Debate by Brian Hillier. The questions below require a bit more than what is
contained in Mankiw and Taylor.
   Additional readings
   See the articles referenced on the course webpage. They are de…nitely worth reading, al-
though they provide perspectives on some of the great debates in twentieth century macroeco-
nomics, and so you will probably get more from them by reading them for a second time at the

end of the course.

2.2   Questions (requiring short answers)

Note: Many of the questions below are intended to help you create a set of notes on a topic, so
you will be able to …nd answers to them in one of the textbook readings. However, some of the
questions ask you to apply principles in the textbook to problems/examples not directly covered
in the textbook. Feel free to email Chris Bowdler if you are uncertain about what is required
for any of the questions.
   1. i. Explain how macroeconomic equilibrium is determined within the classical model of
the economy. Your answer should follow the description of the classical model provided at the
start of this section and should refer to (i) the production function; (ii) the labour market; (iii)
a goods market diagram featuring AS and AD curves; (iv) a loanable funds diagram in which
the equilibrium levels of saving and investment are determined.
   ii. In this context, what is meant by the ‘classical dichotomy’?
   iii. The full employment quantity of output (the level of output on the vertical aggregate sup-
ply curve) is also the equilibrium level of national income (Gross Domestic Product) given that
the market value of output produced must be paid either as wages to workers or pro…ts to …rms
(and …rms are ultimately owned by workers so that pro…ts are a source of household income).
An important requirement is that the equilibrium national income is spent in full, either in the
form of consumption or investment, since only then will there be su¢ cient demand/expenditure
in the economy to purchase the full employment quantity of output. Explain the role of the
market for loanable funds in ensuring that full employment national income always translates
into an identical amount of expenditure, so that there are never problems of de…cient demand
or excess saving in the classical model. Hint: You may …nd it useful to google on Say’ Law for
this question.
   2. Why did the classical economists believe that in the long-run all unemployment would be
voluntary rather than involuntary?
   3. In the classical model what determines the allocation of national output between payments
to labour and payments to capital?

      4. Consider a scenario in which uncertainty concerning future private sector incomes is high,
such that households and …rms choose to save a larger fraction of their current income as a
      i. Explain the impact of this behaviour on the market for loanable funds.
      ii. Summarise the macroeconomic e¤ects of the rise in the saving rate. Will there be an
output recession or a rise in unemployment?
      iii. In criticising the various stimulus packages launched by the Obama administration, John
Cochrane, a distinguished Chicago Professor, has written
      ‘Every dollar of increased government spending (…nanced by borrowing) must correspond to
one less dollar of private spending.’1

      Illustrate this view using the classical loanable funds diagram. What are the implications
for the use of counter-cyclical …scal policy to minimise economic ‡uctuations?
      iv. Can you think of any situations in which the Cochrane view fails even though all of the
assumptions of the classical model hold? Hint: Analyse the loanable funds market for very large
rises in saving rates and/or very large declines in investment demand.
      5. How is the in‡ation rate determined in the classical model? What are the potential
problems with this theory? Hint: Consider the assumptions needed for the classical theory of
in‡ation (the quantity theory of money), and the conditions under which they may not hold.
      6. OPTIONAL: Suppose that the monetary authorites reduce the quantity of money in the
economy. Show how in the short-term this can decrease prices, raise real wages and increase
involuntary unemployment, but that eventually nominal and real wages will fall in order to
eliminate involuntary unemployment.
      7. Using the classical model of the economy, analyse the implications of the following:
      i) a halving of the capital stock caused by a war;
      ii) a one o¤ increase in the labour force through increased immigration;
      iii) a decision to set a minimum real wage above the market clearing level.
      Do any of these cases lead to a persistent increase in involuntary unemployment?

      The clause in parentheses has been added to the original quotation.

3    Consumption and Investment

The …rst tutorial topic covered the determination of macroeconomic equilibrium in the classical
model. The second half of the course will return to the general question of what drives aggregate
‡uctuations, looking at the views of Keynes, Friedman and Lucas. This week the tutorial topic
focuses in detail on two important sectors of the economy - the consumer sector and the business
investment sector.
    Consumer expenditure makes up a major component of GDP in virtually all countries. In
the United Kingdom consumption represents roughly two thirds of total income, and this is why
one often sees newspaper and magazine articles that talk of how the prospects for GDP growth
depend on the likelihood of an upturn in consumer spending. It is therefore no surprise that
economists seek to understand the decision-making processes underpinning the determination
of consumer spending. The key debate in the literature is whether consumption depends on the
income currently available to consumers (the simple Keynesian approach), or instead depends on
lifetime resources, as would be possible if households could borrow and save freely at all points
in time (this approach is associated with the names of, inter alia, Modigliani and Friedman).
If the latter view is correct then we may observe consumption smoothing over time and a
weaker correlation between current income and current consumption than the Keynesian model
predicts - we would also have one explanation for the observation that consumption tends to be
less volatile than income over time. Also, using the lifetime approach, many more variables will
enter the picture in determining consumption in the current year, e.g. the real rate of interest,
asset values (for example house and equity prices) and income expectations.
    It is worth making the point that textbook treatments of the consumption topic often re-
fer to many di¤erent theories of consumption – the Keynesian Absolute Income Hypothesis,
       s                                        s                           s
Fisher’ inter-temporal choice model, Modigliani’ life-cycle model, Friedman’ permanent in-
come model and Hall’ random walk model. There is really only one distinction to be made here
–between consumption based on current resources and consumption based on lifetime resources,
as described above. The many theories identi…ed in the Mankiw textbook can be thought of
                                                        lifetime resources’ The early inter-
as …lling in the details as to exactly what is meant by ‘                  .
temporal approach associated with Fisher takes lifetime resources to mean current income plus

the discounted value of future income. Modigliani expands on this concept of lifetime resources
by noting that individuals often have access to assets, e.g. those left through bequests, which
should be factored into the lifetime resources calculation, along with the discounted value of
the income stream. A lot of the points made by Fisher regarding consumption smoothing given
convex preferences, the response of consumption/saving to an interest rate change etc., will go
through in the more general Modigliani model, although there are some caveats in the latter
case because the presence of non-zero net assets leads to direct ‘wealth e¤ects’ on resources
and therefore consumption. Another idea often referred to in expositions of Modigliani’ work
is that the trajectory for income over the lifecycle is hump-shaped (less income as a child and
when retired), but that the trajectory for consumption can be much more smooth given a pref-
erence for smoothness on the part of consumers and access to perfect capital markets. In this
case, speci…c predictions can be made concerning the patterns of saving and borrowing during
an individual’ lifetime. The Friedmanite permanent income hypothesis is essentially the same
as the Modigliani model, in particular the de…nition of lifetime resources, but it draws special
attention to the point that some components of income are transitory, e.g. higher wages for
farm workers during the harvest season, and are therefore worth less when translated into units
of permanent income, i.e. a transitory £ 10 gain only corresponds to a £ 1 increase in permanent
income if there are 10 periods remaining in the life-cycle. Hall’ random walk model is a special
case of the inter-temporal model that arises given speci…c assumptions regarding preferences,
income expectations and the discounting of future income and consumption.
   A …nal point to note in relation to the consumption topic is that consumption smoothing is
often mis-interpreted, in that it is referred to as an assumption in the inter-temporal approach
when actually it is an implication of that approach. The models that lead to consumption
smoothing make assumptions regarding the constraints faced by agents in making lifetime con-
sumption decisions, and about the form of the utility function that agents seek to maximise.
Consumption smoothing is not an assumption in the model. Consumption smoothing is a result
that arises when preferences are convex (period marginal utility decreases with period consump-
tion) and borrowing is feasible –it is an implication of a particular set of assumptions.
   Investment is the means by which individuals transfer existing resources to the future; a high

level of saving and investment re‡ects the capacity to generate future consumption. Obviously,
therefore, investment spending will tend to play a key role in determining a country’ growth
prospects. Additionally, the volatility of investment spending means that it is very important
in understanding short-run ‡uctuations in GDP. For example, although investment normally
only accounts for about 10% of GDP, it is responsible for half the shortfall in total expenditure
during a typical UK recession. The reason for the volatility of investment spending appears to
lie in its dependence on private expectations of future rates of return, which tend to vary quite
dramatically over short periods of time. Try to think about the way in which this relationship
is accommodated in each of the models covered in Mankiw and Taylor’ textbook (it is not
accommodated by all of them).

3.1   Readings

1. Mankiw and Taylor, chapters 17 and 18. Note: When reading the Mankiw and Taylor
chapter you should take notes that will serve as revision material. The notes should refer to
each term listed in the ‘ concepts’section at the end of each chapter of the Mankiw textbook.
   2. Modigliani, Franco (1986). ‘Life Cycle, Individual Thrift, and the Wealth of Nations’,
American Economic Review, 76, 297-313.
   3. For question (2iii) below a good perspective is provided in the book Macroeconomics:
Theory and Policy in the UK by Greenaway and Shaw. If you cannot track down this book
quickly, do not spend a long time looking it up. I will go through (2iii) in the tutorial – it is
worth thinking about because it represents one of the issues on which Friedman was able to
challenge the Keynesian view of consumption.

3.2   Questions (requiring short answers)

1. What are the main predictions of the Keynesian Absolute Income Hypothesis? In what sense
are these predictions at odds with macroeconomic evidence?
   2. i) Why did Friedman object to the Keynesian hypothesis as a theory of the determination
of consumer expenditure?
   ii) Under what conditions do the Fisher or Modigliani (Life-cycle) or Friedman (Perma-

nent Income Hypothesis) models predict consumption smoothing? How likely is it that these
conditions will hold in practice?
       iii) A regularity that arises from the data is that low income households tend to have a high
average propensity to consume (APC), whilst higher income households tend to have a lower
APC –so cross-sectionally the data support Keynes. However, as total GDP rises through time,
the macroeconomic APC does not decline –it stays about the same, contradicting Keynes. How
did Friedman use the Permanent Income Hypothesis to reconcile the cross-sectional microeco-
nomic evidence with the macroeconomic time series evidence?
       3. A consumer has well-behaved preferences for current and future consumption, c1 and c2 .
He has current income y1 and future income y2 and can borrow or save at the market rate of
interest r.
       (i) Explain carefully, with the aid of a diagram, how the consumer’ optimal plan for con-
sumption is determined. At the tangency equilibrium, what is the mathematical expression
linking marginal utilities in the two periods and the real interest rate? How would the expres-
sion have to be modi…ed if agents discounted future utility ‡ows at the rate ?
       (ii) Suppose that he/she receives an unexpected bonus payment that raises his/her current
income. How would you expect his/her consumption plan to change? How does the allocation
of income across c1 and c2 depend on whether real interest rates are high or low?
       (iii) Assume that he/she is a saver, and the market interest rate falls. Explain how current
consumption will change, paying attention to income and substitution e¤ects.
       (iv) Is it possible that he/she is better o¤ after the fall in the interest rate?
       (v) Suppose that the government announces that the real value of the state pension is to
be reduced for those currently at the start of the life-cycle, due to funding pressures, but that
those currently in retirement will continue to receive the pension they had been promised.2 How
could this be represented in the 2 period consumption model and what are the likely e¤ects on
the current saving rate (saving divided by current income). If the current saving rate were not
to respond to the change to the pension plan, what would happen to inequality in consumption
levels across di¤erent generations within the population? How might this help explain the
       Assume pensions are an inter-generational transfer e¤ected through taxing the young and making transfers
to the old.

introduction of schemes that provide tax breaks on interest income, for example ISAs, and tax
relief on contributions to private pension schemes?
   4. Using the Life-cycle Model/Permanent Income Hypothesis framework for understanding
consumption ‡uctuations, discuss how you would expect the average propensity to consume and
the average propensity to save to respond to the following:
   (i) a rise in the number of working age Eastern European workers migrating to the UK;
   (ii) an increase in the life expectancy of those of working age who are still entitled to retire
at age 65;
   (iii) a sharp fall in house prices;
   (iv) a credit crunch that restricts current consumption to be no more than the sum of current
income and past savings; what happens if the credit crunch occurs at the same time as an increase
in the probability of unemployment?
   In the case of (iii) and (iv), why might the e¤ects vary across di¤erent sections of the
   5. In response to the macroeconomic downturn the government cut the rate of sales tax
(VAT) for a …xed period (ending January 2010) and increased certain cash bene…ts paid via the
welfare state.
   (i) Why do you think the government targeted a reduction in sales tax rather than income
tax? Why did they target a 2:5% VAT reduction for 15 months rather than a 1% cut sustained
for a longer period?
   (ii) Why did the government increase payments to those in receipt of bene…ts rather than
use the same amount of money to reduce everyone’ income tax by some amount?
   (iii) From the perspective of the inter-temporal consumption model, what are the limitations
of the government’ …scal policy in terms of raising expenditure in the economy?
   6. A long-standing puzzle in the study of consumer spending is that consumption in each
period of a person’ lifetime is much more highly correlated with income in that period than the
baseline inter-temporal model with a consumption smoothing motive would predict –the young
do not borrow hard enough and those in retirement do not run down their stock of savings fast
enough, whilst those in the middle of the lifecycle consume more than expected. How could each

of the following explain some or all of these outcomes:
   (i) uncertainty regarding future income and life expectancy;
   (ii) agents that derive utility from the consumption of their children;
   (iii) consumption habits, i.e. utility from consumption depends not only on total consump-
tion but also on the composition in that agents desire goods they have consumed previously.
   7.What are the main components of private investment spending and why is it particularly
important for economists to be able to explain ‡uctuations in investment?
   8. Provide a brief exposition of each of the following models of total investment expenditure:
   i) the Marshallian Net Present Value (NPV) approach.
   ii) the Keynesian Accelerator model.
   iii) the Jorgenson model (the Neo-classical theory).
   iv) the q-theory of investment.
   In each case, indicate the principal determinants of investment and outline the main advan-
tages and disadvantages of the approach.

4     Foundations of Monetary Economics

The conduct of monetary policy and the consequences of monetary policy decisions constitute
an extremely active area of research in modern macroeconomics. The vacation essay topic
(macroeconomic policy) will provide an introduction to some of the relevant issues and you
will have the opportunity to study more of the models in this area if you choose to do the
Macroeconomics paper and the Money & Banking paper in your second and third years. For
this tutorial, the focus will be on concepts and de…nitions of money and the basic theory of
money supply (credit creation) and money demand.

4.1   Readings

1. Mankiw and Taylor, chapters 4 and 19. Note: When reading the Mankiw chapter you should
take notes that will serve as revision material. The notes should refer to each term listed in the
‘key concepts’section at the end of each chapter of the Mankiw textbook.
    2. In the Mankiw and Taylor book see the case study of the US banking crisis that preceded
the Great Depression in the 1920s. Also see the following entry on Mankiw’ blog:
    3. The following news story provides a nice comparison of the credit multiplier in the UK
with that in other countries, and also hints at why the UK economy may be more vulnerable to
the e¤ects of the current crisis than others around the world:,28124,24805118-30538,00.html
    4. See other readings on the course webpage under the week 5 topic, also browse stories
relating to the credit crunch from websites linked to the following page:
    5. For this week and next there is some very simple maths that makes use of geometric
series, so it may help to review chapter 3 from the maths workbook.

4.2   Questions (requiring short answers)

There are a lot of questions for this topic. Try to keep your answers to the following questions
clear and concise and get as far down the list as you can.

   1. Outline the main functions of money. What are the di¤erences between a commod-
ity money and a …at money? Why has …at money become established in modern monetary
economies, i.e. why do you think it is generally preferred to commodity money?
                                          narrow money’and ‘
   2. What do you understand by the terms ‘                 broad money’? Why is the
distinction important, and what concept of money do economists have in mind when they refer
to ‘ money supply’?
   3. Explain the role of the credit or money supply multiplier in determining the total money
   4. Explain how the central bank may vary the total money supply using (i) open market
operations that in‡uence the monetary base; (ii) reserve requirements; (iii) the interest rate at
which the central bank lends to commercial banks (the discount rate in the US, the minimum
lending rate in the UK).
   5. Recently the Bank of England has slashed the rate at which it is prepared to lend to
banks and has actively purchased bonds (and other less liquid assets) from the banks in return
for cash, yet bank lending to the private sector has fallen dramatically and the rate of money
supply growth has been lower than many economists predicted. At the same time, formal reserve
requirements have not changed. Instead, banks appear to be holding excess cash reserves in their
own accounts.
   (i) Explain how a positive excess reserve ratio might a¤ect the formula for the credit multi-
plier and hence the value of the …nal money supply (there is no need for any formal analysis).
   (ii) Why do you think that banks may choose to hold excess reserves? How might the
propensity to hold excess reserves depend on the banks’attitudes towards risk?
   (iii) Why might the excess reserve ratio increase at the time of a macroeconomic downturn?
Why might the excess reserve ratio increase following a collapse in the value of assets (property,
stocks and shares) that private borrowers can o¤er as collateral for loans? What is the likely
impact of the behaviour of the excess reserve ratio on the scale of the economic downturn and
asset price collapses that started the process?
   (iv) Can you think of any other explanations for the recent collapse of the money supply
or credit multiplier? Hint: What was happening to the consumer currency/reserve ratio at the

time of the run on the Northern Rock?
   (v) The policy of quantitative easing involves creating reserves electronically and then using
them to purchase assets from banks, such that the narrow money supply (cash plus reserves)
increases. In theory this should prompt banks to lend more in order to clear the resulting excess
reserves from their balance sheets, and such lending should boost the broad money supply and
the economy generally. How might a shift in excess reserve targets be used to account for the
failure of quantitative easing to stimulate the economy?
   (vi) Some have advocated a National Loan Guarantee Scheme that would (partly) protect
banks from losses in the events that borrowers defaulted (the policy of credit easing announced by
George Osborne in November 2011 is a version of this). How might this help to address unwanted
increases in the excess reserve ratios maintained by banks? What are the limitations of such
a scheme? Why do you think that the US Federal Reserve is lending directly to corporations
rather than o¤ering to guarantee bank loans?
   (vii) In the 1980s the Thatcher government attempted the opposite of the measures central
banks are currently following in order to boost the money supply, i.e. the government tried
to curb lending and money growth via interest rate rises in order to …ght in‡ation. For some
background, see the abstract and introduction to the following article
   What do the recent experience and that from the Thatcher era indicate about the feasibility
of monetarist strategies based on targeting the money supply as a means to achieving broader
macroeconomic objectives? NOTE: If you ever had to do an essay on the problems associated
with monetarist strategies, you could discuss the issues addressed here as well as the debate over
the quantity theory of money and in‡ation discussed in the context of the classical model.
   Aside: In the second half of the course we will look at a related problem for policy: Even
when central banks succeed in inducing banks to lend, consumers may not want to take on loans
and the result is persistent weak demand in the economy.
   6. i. What are the main predictions of the Classical (=Friedmanite=Monetarist) and Key-
nesian theories of money demand?
   ii. In Keynesian theory, how will the demand for money be a¤ected by a fall in expected

in‡ation? Does it make any di¤erence whether your answer is based on the demand for real
money balances or the demand for nominal money balances?
       iii. In Keynesian theory, what will happen to the interest rate if there is an exogenous
increase in real income? What will happen to the price of bonds?3
       iv. Why is the elasticity of money demand with respect to the interest rate an important
concept in macroeconomics? (This question will be discussed in more detail in the week 6 topic
on aggregate demand.)
       7. Consider the Baumol-Tobin model of the demand for money.
       (i) Show that the total cost of holding money in the course of a year is given by: T C =
i 2N + F N where i is the interest rate, Y is total spending, N is the number of trips to the bank,
and F is the cost of each trip.
       (ii) Find the optimal number of trips to the bank, and hence the average money holding.
       (iii) According to this model, what are the elasticities of money demand with respect to
income and the interest rate?
       (iv) Critically assess the assumptions of the Baumol-Tobin model. Does the model provide
an adequate theoretical basis for the macroeconomic money demand function?

       In the Keynesian framework bonds are assets that pay a …xed coupon C in each period, on a permanent
basis. So the current price P ‡uctuates to ensure that in any period the yield on bonds   P
                                                                                              equates to the current
interest rate. Hence interest rates and bond prices must move inversely.

5     The Keynesian Theory of Aggregate Demand

In week 3 we looked at the classical approach to macroeconomics. Although the approach
provides a very elegant analysis, the predictions are very strong and do not …t with the macro-
economic experiences of most countries. Keynesian Economics emerged as the opposite school of
thought. Keynesian approaches examine macroeconomic outcomes over the short- to medium-
term when prices and wages are unable to clear markets and return the economy to full employ-
ment on the vertical aggregate supply curve, e.g. due to the e¤ects of contracts, costs of price
adjustment and so on. Models featuring sticky prices are able to explain periods of prolonged
recession and relatively high unemployment. The …rst version of the Keynesian model that we
consider may be familiar if you have studied Economics before. It assumes that money wages,
the aggregate price level and the rate of interest cannot vary, and then solves for output as the
…xed point of an aggregate expenditure function. The second approach allows the interest rate
to vary with market forces and yields the ‘workhorse model’of short-run Keynesian economics,
the ISLM diagram. Finally, we will look at the implications for ISLM analysis of allowing …rst
the price level and then the money wage rate to vary.

5.1   Readings

1. Mankiw and Taylor, chapters 9, 10 and 11. Note: When reading the Mankiw chapter you
should take notes that will serve as revision material. The notes should refer to each term listed
in the ‘key concepts’section at the end of each chapter of the Mankiw textbook.
    2. The FT columnist Martin Wolf has written many excellent articles on recent macro policy
that draw on the principles of basic Keynesian analysis. Relevant articles can be browsed at
    3. The following entry on the paradox of thrift is useful
    4. See the other readings listed for the week 6 topic on the course webpage.
    5. The following notes provide some thoughts on …scal policy, the coverage is broader than
the topic for this week but some of the ideas overlap with the material we will cover…scal.pdf

5.2      Questions (requiring short answers)

1. i) Show how the level of national income is determined in the Keynesian 45 degree model.
      ii) What assumptions are necessary in order to ensure that national income is determined
at the point at which output equals spending, i.e. what macroeconomic variables have to be
assumed to be …xed in order to ensure that the only determinant of E = C + I + G + X            M is
current income Y ?
      iii) Show that at the equilibrium level of income, total injections to the circular ‡ of income
(I + G + X) are equal to total leakages (S + T + M ) from the circular ‡ of income. Hint:
Combine the equilibrium condition in the 45 degree model with the budget constraint saying
that income can be either taxed, consumer or saved, i.e. Y = C + S + T .
      iv) Is there any guarantee that the equilibrium level of income will be consistent with full
employment? Why did Keynes believe that involuntary unemployment is particularly likely at
the equilibrium?
      2. ‘The fundamental di¤erence between the classical approach and the Keynesian approach
is that in classical theory the real interest rate adjusts to ensure I + G + X = S + T + M
following a rise in the saving rate, whereas in Keynesian theory the level of income adjusts to
ensure I + G + X = S + T + M following a rise in the saving rate.’
      i. Very brie‡ explain this statement.
      ii. In the Keynesian framework, what is meant by the paradox of thrift?
      iii. ‘Current e¤orts by the UK government to reduce the budget de…cit through spending
cuts and tax rises will be self-defeating and will actually increase the overall de…cit as in the
paradox of thrift.’ Brie‡ explain and discuss that statement.
      iii. In the discussion of the classical model, we noted that Cochrane has o¤ered the following
critique of the Obama stimulus plan

      ‘Every dollar of increased government spending (…nanced by borrowing) must correspond to
one less dollar of private spending.’4

      Explain why this reasoning is wrong in Keynesian analysis.
      The clause in parentheses has been added to the original quotation.

   3. The condition that total injections equal total leakages in equilibrium can be re-written

                                 (G    T ) + (I   S) + (X    M) = 0

   i. Using this version of the equilibrium condition, brie‡ explain the following claim:
   ‘ Keynesian theory, government budget surpluses used to repay debt can only be achieved
without loss of national income (or output) if there is a boom in either net exports or private
company investment, or both.’
   ii. In a situation in which governments around the world are all running budget surpluses to
repay debt, is an export boom likely to occur? When private sector …rms observe the implications
of …scal austerity, is an investment boom likely to occur?
   iii. Absent an investment or export boom, how will equilibrium be restored following the
shift to …scal austerity?
   4. What is meant by the national income multiplier? Illustrate your answer using the
Keynesian 45 degree model. What factors determine the size of the national income multiplier?
   5. i. Suppose that investment expenditures (I ) are linked to the real interest rate (r )
according to the equation I = c       dr. Use the 45 degree model to evaluate the consequences of
a reduction in the rate of interest. What is the relationship between the rate of interest and the
equilibrium level of income? Hence derive the Keynesian/Hicksian IS curve.
   ii. Explain what the LM curve represents and show the LM curve can be derived within the
Keynesian framework.
   iii. Indicate how the ISLM model is used to …nd macroeconomic equilibrium. In what sense
is this a general equilibrium?
   6. Using the ISLM model, analyse the results of the following:
   i) An increase in government expenditures …nanced by higher borrowing. Is the national
income multiplier larger or smaller than in the case based on the 45 degree diagram? Explain.
   ii) An increase in government expenditures …nanced by an increase in the rate of income
tax. Is the national income multiplier larger or smaller than in the case based on the 45 degree
diagram? Explain. Would your answer change if a lump sum tax had been used instead of an
income tax?

   iii) An increase in government expenditures …nanced by printing money. Is the national
income multiplier larger or smaller than in the case based on the 45 degree diagram? Explain.
   iv) A halving of the rate of income tax. How does your answer depend on the initial level
of income and the interest rate elasticity of the money demand curve?
   v) A world recession.
   vi) A reduction in the quantity of money in circulation.
   vii) A programme of …nancial liberalisation that raises the interest rate elasticity of money
   viii) A rise in the transaction velocity of circulation of money.
   7. Consider the ISLM model:

                             Y = C(Y      T ) + I(r) + G        (IS)

                                      = L(Y; r)         (LM )
   where Y is total income, C is the consumption function, I is the investment function and L
is the demand for money function. Assume that T , G, M and P are exogenous.
   Suppose that C = 200 + 0:75(Y     T ), I = 200 25r, L = Y      100r, T = 200 and M=P = 500.
   (a) Find equilibrium income when G = 300.
   (b) What is the value of the government spending multiplier? Determine this by (i) …nding
Y for unknown G and di¤erentiating for   @G ;   (ii) Computing Y for G = 400 and comparing your
solution to (i) above. How would the value of this multiplier change in a more general setting
in which taxes were income sensitive and some consumption took the form of imports?
   (c) Illustrate the balanced budget multiplier result using this model. Can you see any
problems with the balanced budget multiplier result?
   8. i) What does the aggregate supply curve look like according to the ISLM view of the
   ii) How do the e¤ects of a rightward shift of either the IS or the LM curve change if the
price level is allowed to vary? In your answer make reference to total income, the interest rate,
consumption and investment.

   iii) How do the e¤ects of a rightward shift of either the IS or the LM curve change if the price
level and the wage rate are allowed to vary? In your answer make reference to total income, the
interest rate, consumption and investment.
   iv) ‘The Classical model of the economy is one in which prices are ‡exible whilst quantities
are …xed. The Keynesian model of the economy is one in which prices are …xed and quantities
adjust.’ Brie‡ explain the basis for this statement and illustrate it using an example.

6     Open Economy Macroeconomics

An important feature of all of the major economies is that they are open to international trade
in goods and services, and to ‡ows of …nancial capital. In the United Kingdom the share of
imported goods and services in GDP is around 35%, and even for the United States, the world’s
largest economy, the …gure is a non-negligible 15     20%. It is therefore no surprise that the
macroeconomic performance of individual countries is extremely sensitive to international eco-
nomic conditions, consider, for instance, the turbulence in the British economy during the period
in which it was locked into the European Exchange Rate Mechanism at the wrong exchange rate.
    For this tutorial we consider the meaning of key accounting concepts in an open economy
framework, the interpretation of the nominal and real exchange rates, and the determination
of the nominal exchange rate in currency markets. These concepts are then used to extend
ISLM analysis to an open economy setting. The IS curve becomes an ISXM curve, where
X denotes exports and M imports (exports are an additional injection to the circular ‡ of
income, whilst imports are an additional leakage). The main change on the monetary side of the
model is that interest rate returns in the Home country must not deviate from those overseas,
after controlling for any expected exchange rate movements. This is the Uncovered Interest
Parity (UIP) hypothesis, and has important implications for the LM curve. The Mundell-
Fleming model uses the open economy ISLM framework to analyse the transmission of …scal and
monetary policy to aggregate demand under …xed and ‡oating exchange rate regimes. (Note
that the Mankiw and Taylor book develops an open economy ISLM framework in which the
exchange rate rather than the interest rate appears on the vertical axis. I much prefer the latter
for reasons that I will explain, but we can go through both.)
    In the second year Macroeconomics course the discussion will be extended to include inter-
national interest parity conditions, advanced models of short-run currency ‡uctuations, and the
theory of optimal currency areas.

6.1   Readings

1. Mankiw and Taylor, chapters 5 and 12. Note: When reading the Mankiw chapter you should
take notes that will serve as revision material. The notes should refer to each term listed in the

‘key concepts’section at the end of each chapter of the Mankiw textbook.
   2. Taylor, Alan and Mark Taylor (2004). ‘The Purchasing power Parity Debate.’ Journal of
Economic Perspectives, 18(4), 135-158.
   3. The open economy lecture slides at the following website may be useful:
   4. The following notes are relevant to the material covered in this topic and may be of

6.2     Questions

1. Explain what is meant by each of the following:
   i. the balance of trade;
   ii. the current account;
   iii. the capital account;
   iv. the balance of payments.
   2. i. What is the real exchange rate and why is it an important concept in macroeconomics?
   ii. How is the real exchange rate determined?
   iii. If the law of one price holds in its strongest form, what is the value of the real exchange
   iv. ‘The only puzzle concerning the purchasing power parity puzzle is that it was ever
considered a puzzle in the …rst place.’ Do you agree?
   v. De…ne the nominal exchange rate and explain how it is related to the real exchange rate.
        In                                                        ect
   vi. ‘ the short-run, movements in the nominal exchange rate re‡ the factors that set
the real exchange rate, but this is not true in the long-run.’ Explain. Hint: Consider the degree
of price ‡exibility in the short-run and the long-run.
   3. For much of the early part of this decade, China was able to run a surplus on both the
current account and the capital account of the balance of payments, i.e. the rest of the world
was simultaneously a market for rising Chinese output and a source of funding for investment

in China.
   i. Why might this outcome be considered surprising?
   ii. In theory, what should be the adjustment of the exchange rate in this situation?
   iii. What policy did the People’ Bank of China follow in order to prevent exchange rate
adjustment and to preserve simultaneous current and capital account surpluses?
   iv. Why does the Chinese approach create problems for US policy-makers aiming to achieve
full employment output in the US?
   Hint: For iii and iv The following notes from the Povey site referenced above will be useful,
as will 4 in the readings above
   4. i. Does the current account have to balance in i) the medium-term; ii) the long-term?
   ii. During the 1960s and 1970s global capital markets were less developed than today, and
as a result it was more di¢ cult for countries to o¤set current account de…cits by borrowing
internationally in order to generate capital account surpluses. At the same time, exchange rates
between national currencies were pegged for much of the period. In such instances, what policies
did governments have to adopt in response to current account de…cits, and how was this thought
to contribute to the macroeconomic volatility experienced by many countries during the 1960s
and 1970s? Hint: An essay title in part B of the 2007 exam paper points to the possible policy
   5. Explain how the real exchange rate will be a¤ected by each of the following:
   i) a foreign …scal expansion;
   ii) a protectionist trade policy adopted by the home country;
   iii) a sudden loss in export demand due to a global economic slowdown;
   iv) an increase in domestic in‡ation relative to that of major trading partners;
   v) a domestic …scal contraction in response to bond market concerns regarding the level of
national debt.
   Suppose that the nominal exchange rate is …xed. Will the real exchange rate e¤ects in (iii)
to (v) still occur? How will the length of time needed to adjust to equilibrium be altered and
what will happen to domestic aggregate demand (C + I + G + X            M ) and output during

the adjustment to equilibrium? What lessons can be drawn concerning the risks of joining a
currency union? Why are southern European countries being forced to sign up to measures to
boost their competitiveness and restrict their future budget de…cits?
   6. i. Explain why a country can achieve only two out of three of the following outcomes: a)
full capital mobility; b) exchange rate stability; c) a domestic interest rate that is independent
of the world interest rate.’
   ii. ‘ the Mundell-Fleming model the relative e¢ cacy of …scal and monetary policy in
raising output and employment depends on the choice of exchange rate regime.’ Discuss this
statement. How robust are the predictions from the Mundell-Fleming model to relaxing the
model assumptions? Hint: See reading 3 above.

7     Models of Aggregate Supply, the Phillips Curve and the Busi-

      ness Cycle

In studying the classical model we considered a simple representation of aggregate supply. In
that model the long-run aggregate supply curve was vertical in (output, price) space. Following a
shift of the aggregate demand curve the economy at …rst adjusted along a positively sloped short-
run aggregate supply curve, experiencing rising output and falling unemployment, but a higher
rate of in‡ation. This short-run equilibrium cannot be sustained in the long-term, however,
because higher prices erode the real value of workers’ nominal wages, prompting higher wage
demands in order to maintain living standards. The higher wage demands simultaneously price
the newly employed workers out of jobs and eliminate the increase in aggregate demand through
pushing up prices and reducing the value of the real money supply. In this tutorial the aim is to
consider the short-run adjustment of output, unemployment and in‡ation in detail. We will pay
particular attention to the way in which private sector in‡ation expectations set the position of
the short-run aggregate supply curve and thereby de…ne the trade-o¤ between unemployment
and in‡ation.

7.1   Readings

1. Mankiw and Taylor, chapters 6, 13 and 20. Note: When reading the Mankiw chapter you
should take notes that will serve as revision material. The notes should refer to each term listed
in the ‘key concepts’section at the end of each chapter of the Mankiw textbook.
    2. Chapters 3 and 4 in Macroeconomics and the Wage Bargain by Wendy Carlin and David
Soskice (1996 edition). This book is at a more advanced level than the Mankiw textbook. It
should not be confused with a recent book by the same authors (published in 2006) that has a
slightly di¤erent name.
    3. Friedman, Milton (1968). ‘The Role of Monetary Policy.’ American Economic Review,
58, 1-17.
                                                    The NAIRU in Theory and Practice.’
    4. Ball, Laurence and N. Gregory Mankiw (2002). ‘
Journal of Economic Perspectives, 16(4), 115-36.

   5. See additional readings for week 7 on the course webpage.

7.2   Essay Question

Write an essay on one of the following, aiming for 4 to 6 sides hand-written or the equivalent
when typed.
   EITHER Show how a short-run Phillips curve and a long-run Phillips curve may be derived
from the aggregate supply curve. Explain the di¤erences between the Friedmanite (adaptive
expectations) and New Classical (rational expectations) views of the Phillips Curve. Include
in your answer a discussion of the assumptions made and policy implications of each approach.
Which approach do you consider to be most plausible and why?
   OR What trade-o¤s, if any, must policy authorities take into account if they want to reduce
the rate of in‡ation?
   OR Using the long-run aggregate demand-aggregate supply model show the e¤ect on output
and the price level of:
   (i) an improvement in technology;
   (ii) an increase in the money supply; and
   (iii) the imposition of a minimum wage.
   In your answer, carefully explain how the adjustment process di¤ers according to whether
agents form their expectations adaptively or rationally. In what way is central bank communi-
cation with the private sector likely to be important in this case?

7.3   Other Questions for Consideration

Whilst completing the reading and the essay for this topic, you may …nd it useful to
think through and perhaps draw up some sketch solutions to the following questions.
They are not compulsory for the tutorial this week, but it would be a good idea to
look through some of them.
   1. i) What do you understand by Okun’ Law?
   ii) If the Phillips curve for a particular economy is negatively sloped in unemployment-
in‡ation space, what must the aggregate supply curve for that economy look like?

   iii) How does the Phillips curve relationship change when the short-run aggregate supply
curve is set conditional upon in‡ation expectations?
   iii) Apart from money wage illusion due to workers setting in‡ation expectations adaptively,
what explanations are there for the short-run aggregate supply curve and the short-run Phillips
curve not being vertical?
   2.What is the natural rate of unemployment and what factors determine it? How is this
concept of unemployment di¤erent to the unemployment problem that Keynes hoped to address
when writing the General Theory?
   3. i) Carefully explain the policy ine¢ cacy proposition, highlighting the necessary supporting
   ii) ‘The New Classical Macroeconomics says that the Phillips Curve exists as a statistical
relationship, but not as a macroeconomic relationship that can be used to guide macroeconomic
management.’ Explain.
   iii) Why do proponents of the New Classical Macroeconomics support policies such as (a)
releasing central bank forecasts and other information concerning the future path of the economy;
(b) the removal of unemployment bene…ts, minimum wage laws and other impediments to market

8     Vacation Work

There are 3 things to do: (i) the ISLM problem at the end of this document; (ii) the macro policy
essay immediately below; (iii) revise for a collection that will include (a) 3 micro problems, of
which you have to do 1, (b) 5 macro problems, of which you have to do 2, (c) 4 macro essays,
of which you have to do 1.

8.1      Macroeconomic Policy

The vacation topic focuses on aspects of macroeconomic policy, broadly de…ned. The topic starts
with a consideration of exactly what should be the objectives of macroeconomic policy. This
involves thinking about the relative costs and bene…ts of in‡ation and unemployment. Once
policy-maker objectives have been formulated the obvious question is how to achieve them,
and in most countries some combination of monetary policy tools are used for macroeconomic
management (the great advantage of monetary policy instruments such as the short-term interest
rate is that they can be changed more frequently than the instruments of …scal policy, such as
taxes and spending). In the literature an important question is whether or not macroeconomic
objectives are best achieved through an active policy that responds to the current state of
unemployment and in‡ation, or a passive policy, for example aiming to achieve money supply
growth of x% in each period (as was the case in Britain as part of Thatcher’ Medium Term
Financial Strategy) or hit an exchange rate target (as was the case when Britain was part of the
European Exchange Rate Mechanism). Within the class of active policies, Mankiw introduces
a distinction between …xed rules, for example the interest rate is always set using a formula
such as 1:5 times in‡ation plus 0:5 times output relative to trend (a so called Taylor rule), and
discretionary policies in which there is no such rule. In practice, however, most active policies
involve some discretion – policy-makers set interest rates using multiple indicators concerning
the direction of the economy. As such, the choice to be made is between passive policies and
active policies that entail some discretion. This question is the focus of one of the essay titles
    The readings and essay titles below also consider the macroeconomic role of …scal policy. The
main debate in the theoretical literature is why …scal policy matters. According to the Ricardian

Equivalence Theorem, a budget de…cit from a tax cut today must be o¤set by a budget surplus
from higher taxes in the future, so that the only thing that changes is the pro…le of private
sector disposable income, i.e. lifetime or permanent income is left unchanged. Consequently
expansionary tex cuts will not boost consumption or GDP, a conclusion much more extreme
                              crowding out’ hypothesis considered earlier in the term (the
than that associated with the ‘
other dimension of …scal policy, government spending increases, can raise domestic output in
the current period, but at the expense of a loss of output in some future period). In practice
…scal policy does seem to play a role in driving macroeconomic ‡uctuations, and therefore the
task is to identify the assumptions behind the Ricardian Equivalence Theorem that do not apply
in practice.
       The …nal topic draws on material that has come back into fashion since policy interest
rates hit very low levels during the recent recession. Keynes envisaged that during very deep
recessions, investors would steer clear of risky assets such as equities and bonds, given their
aversion to losses on these assets in the event the economy further deteriorates. Instead, there
would be investor ‡ight to safety, such that ‘             .
                                              cash is king’ When all investors wish to shift
their portfolios into risk free cash,5 the demand curve for money becomes perfectly elastic at
some interest rate. At what interest rate does this happen? Keynes was not clear, and simply
argued for a very low interest rate that is close to zero. In recent discussion it has become
common to say that this interest rate is exactly zero, the lowest the nominal interest rate can
be set (nominal rates below zero are not feasible because then depositors would be taxed for
making deposits and would instead hold hard currency). One justi…cation for this is that during
the deep recessions in Japan and the US, the policy interest rate did hit exactly zero. In this
scenario, increases in the money supply will simply be absorbed into the in…nite demand for
money –there will not be the classic e¤ect of a declining interest rate to clear the market, with
a resulting increase in investment (the adjustment we saw in week 6). In order for a policy
such as quantitative easing to have any e¤ect (recall the week 5 discussion) it must be the case
that …rms borrow in markets other than that for money, for instance they may borrow through
selling equity on the stock market, or through selling corporate bonds on the money markets.
       Cash is risk-free in the sense that it pays a …xed nominal return. There is a risk that in‡ation spikes and
erodes that real return, but in deep demand driven recessions, large rises in in‡ation are especially unlikely.

The interest rate paid on funds generated from the stock market is approximately the dividend
paid on shares divided by the share price, whilst the interest rate on a corporate bond is the
coupon payment on the bond divided by the price of the bond. Quantitative easing can drive
down these interest rates as the money injected into the economy is used to purchase shares and
bonds. Another policy option in a liquidity trap is, of course, …scal policy. Due to the shape of
the LM curve in a liquidity trap, there will be no interest rate crowding out of investment, so
…scal policy is highly e¤ective, assuming no Ricardian Equivalence or any appreciation of the
currency that might crowd out net exports. In fact, support for …scal policy may be one of the
ways in which quantitative easing works, since the creation of electronic reserves can be used to
purchase government debt, which facilitates government borrowing at low cost and hence …scal

8.2   Readings

Roughly speaking, readings 1-5 apply to the …rst essay topic (but you can spend less time on
3-5), readings 1 and 6-8 cover the second essay topic and readings 1 and 9- relate to the third
essay topic (reading 1 does not cover the liquidity trap, but you should still do reading 1 even
if you do the liquidity trap essay, since knowledge of the reading 1 material is important). Also
see the course webpage for further relevant readings.
   1. Mankiw and Taylor, chapters 14, 15 and 16. Note: When reading the Mankiw chapter
you should take notes that will serve as revision material. The notes should refer to each term
              key concepts’section at the end of each chapter of the Mankiw textbook.
listed in the ‘
   2. A nice discussion of the costs and bene…ts of in‡ation is provided in ‘The Optimal Rate
of In‡ation: An Academic Perspective’ by Peter Sinclair, published in the Bank of England
Quarterly Bulletin, Autumn 2003, pages 343-351.
   3. Bernanke, Ben and Frederic Mishkin (1997). ‘ ation Targeting: A New Framework for
Monetary Policy?” Journal of Economic Perspectives 11(2), 97-116.
   4. A piece that relates to the early days of in‡ation targeting at the Bank of England is
‘ ation Targeting in Practice, the UK Experience’ by John Vickers in the Bank of England
Quarterly Bulletin, 1998. Note: The Bank of England website is an excellent resource when

gathering information on the monetary policy topic, take time to browse the In‡ation Reports,
speeches made by MPC members and other relevant links.
                                                                              UK Monetary
   5. A piece that looks at the conduct of UK monetary policy through time is ‘
Policy 1972-1997: A Guide Using Taylor Rules’Centre for Economic Policy Research Discussion
Paper No. 2931 (available online). Published in P. Mizen (ed.), ‘Central Banking, Monetary
Theory and Practice: Essays in Honour of Charles Goodhart’ Volume One, Cheltenham, UK:
Edward Elgar, 2003, pp. 195-216.
   6. Bernheim, Douglas (1989). ‘ Neo-Classical Perspective on Budget De…cits’Journal of
Economic Perspectives, 3(2), 97-116.
                                                   The Macroeconomic Role of Fiscal Policy.’
   7. Allsopp, Christopher and David Vines (2005). ‘
Oxford Review of Economic Policy 21(4), 485-508.
   8. See lectures 12 and 13 in the second year macro course. These relate to …scal policy and
debt and the treatment is non-technical. A link is here:
   It is also worth looking at relevant parts of chapter 6 in Macroeconomics: Imperfections,
Institutions and Policies by Wendy Carlin and David Soskice (OUP, 2006), though this is a
more advanced treatment.
   9. Mankiw chapter 11 in the FYI box provides a brief discussion of the liquidity trap and
quite a useful summary of the ways in which monetary policy can be e¤ective even when interest
rates cannot be reduced any further. Question: How are the increases in in‡ation expectations
and depreciation of the currency discussed by Mankiw to be achieved when interest rates cannot
fall any further? This comes back to the above discussion of channels through which quantitative
easing may take e¤ect.
   10. Section 2.3.1 in Macroeconomics and the Wage Bargain by Carlin and Soskice provides
a nice exposition of the liquidity trap, including diagrams for money demand, LM and AD
curves. The material occurs in the middle of an interesting but now forgotten debate between
Keynes and the Classics about whether a market economy with freely adjusting wages and prices
will ever stabilise at full employment. You do not need the full details of that debate for this
question, for which the focus is just monetary policy interventions and the liquidity trap.

   11. The Krugman article referenced in the Mankiw discussion is something that you may
wish to consult, but it is very long. The following online article is an alternative
   12. Svensson, Lars (2003). Escaping from a Liquidity Trap and De‡ation: The Foolproof
Way and Others, Journal of Economic Perspectives, 17(4), 145-166.

8.3   Essay titles

Write an essay on one the following topics, aiming for 4 to 6 sides hand-written or the equivalent
when typed.
   1. EITHER With reference to the experience of the UK or other countries, discuss whether
…xed (or passive) monetary policy rules are superior to contingent (or discretionary or active)
monetary policy rules.
      The optimal rate of in‡
   OR ‘                      ation is zero.’ Discuss.
   Note: An example of a …xed rule is a regime that stipulates a target for one of the instruments
or intermediate targets of monetary policy, e.g. the money supply targets introduced as part of
Thatcher’ Medium Term Financial Strategy, or the exchange rate targets that applied during
Britain’ membership of the European Exchange Rate Mechanism (ERM). A policy regime that
sets a target for a variable such as in‡ation is di¤erent in the sense that the target applies
to a …nal policy objective rather than an intermediate variable that is intended to secure a
particular objective. In practice in‡ation targets often specify some band in which in‡ation
may ‡uctuate during normal times, and therefore in‡ation targeting regimes often feature an
element of discretion. An example of an even more ‡exible regime is that currently in e¤ect
in the United States. The 1978 Humphrey-Hawkins Act says that the Federal Reserve should
deliver full employment and price stability, but there are no guidelines on the unemployment
and in‡ation rates that should actually be achieved and there is considerable freedom for the
Fed to set interest rates.
   Given these examples of policy regimes, an essay on the …rst title could focus on topics such
as the advantages and disadvantages of …xed and ‡oating exchange rate regimes (see the end of
Mankiw chapter 12) and the arguments for and against in‡ation targeting in the United States

(Bernanke is known to be in favour of this – search for Fed Watch articles on the Bloomberg
website referenced on my teaching webpage). For such an essay it is also important to set out the
potential advantages of discretionary policy, such as stabilization of the economy in the event
of a global recession, and the limitations of such stabilizing policies (Mankiw discusses possible
errors in the size and timing of interventions, and such con
   For the OR question the Sinclair article is good. Also, why might a rise in in‡ation be
bene…cial at a time when global GDP growth is declining and real interest rate reductions are
needed to boost demand? And why might higher in‡ation bene…t heavily indebted countries
whose politicians cannot agree on how to generate the surpluses needed to stabilise debt?
   2. EITHER ‘Right in theory but wrong in practice.’ Is this a fair description of the Ricardian
Equivalence Theorem?
      What implications does the Ricardian Equivalence Theorem have for the …scal stimulus
   OR ‘
packages implemented in response to the current macroeconomic downturn?
   OR Should governments be required to balance their budgets each year, in order to prevent
further increases in national debt? Hint: See the following notes for the essay titles in 2…scal.pdf
   3. Explain what is meant by a ‘              .
                                  liquidity trap’ What do the money demand, LM and AD
curves look like in a liquidity trap? Is it true that if there is a liquidity trap monetary policy is
totally ine¤ective? What happens to the e¤ectiveness of …scal policy in a liquidity trap?
   Hint: To see how quantitative easing might help when the central bank interest rate is at a
lower bound, consider question 5 from the 2011 prelims exam paper.

4.  Consider an economy characterized by the following behavioural functions:

                                   C   = 150+0.75(Y -T)
                                   J =150-6r
                                   T =200
                                   M S =300

                                   M IJ =2 y -300r

      where standard notation applies. C stands for consumption, Y for national income, f
      for taxes, J for investment, r for the real interest rate, G for public spending, M S for
      money supply, and M IJ for money demand.

      (a)    Represent the IS and LM functions of this economy in a diagram and solve for
             the equilibrium levels of output and the interest rate. [25%]

      (b)    Suppose now that bad times fall on this economy because both (i) households
             decide to reduce consumption by 50, at any level of income, compared with
             their previous behaviour and (ii) investors decide to reduce investment by 50,
             at any level of the interest rate, compared with their previous behaviour.
             Represent the new equilibrium of the economy in the same diagram that you
             used in part (a), and solve for the new equilibrium levels of output and the
             interest rate. [25%]

      The government considers alternative policy actions to reverse the contraction in
      output. In doing this, policymakers are aware that fiscal expansion may lead to a
      'budget problem' and that the stimulative effects of monetary policy are restrained by
      the fact that interest rates must remain non-negative.

      (c)    Compare the effects on the budget deficit of a policy which fully reverses the
             fall in output by a cut in taxes with the effects on the budget deficit of a policy
             which fully reverses the fall in output by means of an increase in government
             expenditure. [25%]

      (d)    Suppose, instead, that only monetary policy is used to control the economy.
             How much of the fall in output could be reversed by monetary policy whilst
             interest rates remain non-negative, and what increase in the money supply
             would be needed to bring this about? [25%]

CPPE 4265
DMMA 4265                                                                      TURN OVER

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