Macroeconomics Tutorials Answers

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					                    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 2007 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 2007 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, John Vickers and David Williams have 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 held sway amongst
economists during 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 produc-
tion 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 invest-
ment (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 en-
sures 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 competition.
    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 –do not worry if you cannot complete all of them.
   Additional readings
   See the articles referenced by John Vickers on the course webpage. The Blinder, Akerlof
and Lucas articles are de…nitely worth reading, although they provide perspectives on some of
the great debates in twentieth century macroeconomics, 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)

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’?
   2. Why did the classical economists believe that in the long-run all unemployment would be
voluntary rather than involuntary? Illustrate your answer by showing what will happen in the
goods market and the labour market following a reduction in aggregate demand caused by a fall
in the money supply, i.e. show that a fall in the money supply will …rst decrease prices, raise
real wages and increase involuntary unemployment, but that later nominal and real wages will
fall in order to eliminate involuntary unemployment.
   3. How is the in‡ation rate determined in the classical model? What are the potential
problems with this theory?
   4. How is the allocation of spending between consumption and savings determined in the
classical model? How is the allocation of income between labour and capital determined?
   5. Do you think that the classical economists advocated government intervention in the
economy, to in‡uence GDP and unemployment?
   6. Using the classical model of the economy, analyse the implications of the following shocks:
   i) a halving of the capital stock caused by a war;
   ii) a one o¤ increase in the labour force through increased immigration;
   iii) an increase in government spending …nanced through additional borrowing.

3    Consumption and Investment

The …rst tutorial topic looked at how macroeconomic equilibrium is determined 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 as …lling in the details as to exactly what is meant by ‘                   .
                                                                    lifetime resources’ The early
inter-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 re-
sources 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 re-
sources and therefore consumption. Another idea often referred to in expositions of Modigliani’s
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
preference for smoothness on the part of consumers and access to perfect capital markets. As
such, 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 due to a good harvest, 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 a strong demand for 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. The Modigliani paper cited on the course webpage under the week 4 topic.
   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. The
question is overlooked by Mankiw and Taylor, but 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 receives an unexpected bonus payment that raises his current income.
How would you expect his 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 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 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. 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 does this help explain the introduction of
schemes that provide tax breaks on interest income, for example ISAs?
   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), explain how the changes described may a¤ect heterogeneous
e¤ects on di¤erent section of the population.
   5. In response to the macroeconomic downturn the government has cut the rate of sales tax
(VAT) for a …xed period 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) 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?
   (iii) Some economists have argued that the government should have adopted an alternative
…scal strategy that concentrated on income tax cuts for those on low incomes and tax breaks
for pensioners on the interest income earned on their savings. Why do advocates of such policy
changes argue that they would elicit a larger increase in consumer spending than the policy the
government has implemented?
   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, interest rates 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.
   6.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?
   7.. 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. 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
    3. 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:

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 multiplier in determining the total money supply.
   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. During the last 12 months 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.
   (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’attitude 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) Given that interest rate cuts currently seem ine¤ective in boosting lending and the money
supply, the Conservative Party has advocated a National Loan Guarantee Scheme that would
protect banks from losses in the events that borrowers defaulted. What is the rationale for
this scheme? How is it expected to revive bank lending and money creation? 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?
   For the above question you may …nd it useful to think through the case study in the Mankiw
and Taylor book of the US banking crisis that preceded the Great Depression in the 1920s. Also
see the following entry on Mankiw’ blog:
   For a description of the current problem in reverse (the government tried to curb lending
and money growth via interest rate rises in order to …ght in‡                        s
                                                             ation) look up Thatcher’ Medium
Term Financial Strategy on the web.
   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.
   8. 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?
   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.)
   9. 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?

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 rather strong and do not …t with the
macroeconomic experiences of most countries. Keynesian Economics emerged as the opposite
school of thought. Keynesian approaches make some rather ad hoc assumptions, but are able to
explain periods of prolonged expansion and contraction. The …rst model that we look at may
be familiar from A-level Economics. It assumes that money wages, the aggregate price level
and the rate of interest cannot vary, and then solves for GDP 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 model. 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. Svensson, Lars (2003). Escaping from a Liquidity Trap and De‡ation: The Foolproof
Way and Others, Journal of Economic Perspectives, 17(4), 145-166.
    3. See the other readings listed for the week 6 topic on the course webpage.

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 are assumed
    iii) Show that at the equilibrium level of income, total injections to the circular ‡ of income
are equal to total leakages from the circular ‡ of income.
    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. 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?
   3. 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?
   4. 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.
   5. 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?
   6. 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:

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.
   Brie‡ how will these accounts respond to (i) an appreciation of the exchange rate caused
by overseas factors; (ii) a cut in domestic income tax that raises disposable incomes?
   2. Does the current account have to balance in i) the medium-term; ii) the long-term?
   During the 1970s in particular, it was often argued that macroeconomic management in
Britain was characterised by ‘stop-go’policies, induced by the need to ensure current account
balance. What do you think is meant by this? Why is the problem less relevant nowadays?
   3. 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.
   4. i. Explain the Uncovered Interest Parity (UIP) hypothesis. What assumptions are

necessary in order for this to hold?
   ii. ‘When the UIP hypothesis holds, 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.’ Explain.
   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 large domestic current account de…cit caused a sudden drying-up of domestic oil …elds;
   iv) a doubling of the domestic money supply.
   Suppose that the nominal exchange rate is …xed. Will the real exchange rate e¤ects in (i) to
(iv) still occur?
   6. ‘ 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.

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.
    In the …nal part of the tutorial we will consider a completely di¤erent approach to explain-
ing short-run macroeconomic ‡uctuations, Real Business Cycle (RBC) theory. As we will see,
RBC theory was in part a response to the fact that accounts of the short-run correlation be-
tween output, unemployment and in‡ation imply a strong negative correlation between the real
wage and the level of GDP relative to trend, something that is at odds with the data (this is
the ‘Tarshis-Dunlop’ puzzle). The RBC approach assumes instantaneous price ‡exibility and
rational expectations so that there is no role for monetary shocks in driving macroeconomics
variables. Instead, random changes to the productivity of capital and labour induce an inter-
temporal substitution of resources that causes the long-run aggregate supply curve to shift in
a way that traces out the business ‡uctuations seen in the data. According to this view the
short-run correlation between the real wage and GDP relative to trend will be positive, solving
the problem associated with theories predicated on sticky prices and wages. However, we will
see that there are many objections to the RBC approach.

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, and
is more commonly used in the second year macro course. However, it is worth reading at this
stage because it goes much further than 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.
   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 Explain the di¤erences between the Keynesian, Friedmanite (adaptive expecta-
tions) 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 Using the long-run aggregate demand-aggregate supply model show the e¤ect on output
and the price level of:
   (i) a one-o¤ increase in the money supply;
   (ii) an increase in the money supply growth rate;
   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 commu-

nication with the private sector likely to be important in this case? Does the nature of the
expectations process matter for macroeconomic adjustment following a supply-side intervention
such as an improvement in technology or the imposition of a minimum wage?
   OR (i) Why might there be a short-run aggregate supply relationship between output and
prices of the form:

                                     Y = Y + (P        P e)

   where Y is output, P the price level and e denotes an expectation? How plausible do you
consider these theories to be?
   (ii) Using the AS-AD model, describe the short-run and long-run e¤ects of a debt-…nanced
increase in government spending, on output, employment and prices.
   (iii) How might investment be a¤ected, in the short run and the long run, by the …scal
   NOTE: In outlining di¤erent theories associated with (i), be as precise as you can about
what element of the theoretical model it is that causes price surprises to in‡uence output. It
may help to ask yourself the question ‘why would the above relationship become less important
if I took away the element of the model that I am talking about?’.

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
   4. i. How does the RBC approach to macroeconomic ‡uctuations extend the New Classical
approach introduced by Lucas?
   ii. What is the impulse mechanism in the RBC view of business cycle ‡uctuations? What is
the mechanism through which such shocks are propagated to other macroeconomic variables?
   iii. Why have the impulse and propagation mechanisms associated with RBC models been
   iv. How would an RBC economist interpret the long-run one-for-one correlation between the
money supply and the price level?
   v. It is often argued that the predictions of RBC models relating to the labour market are
especially problematic. Why is this the case?

8    Vacation Essay: 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.

8.1   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 listed
in the ‘key concepts’section at the end of each chapter of the Mankiw textbook.
   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. HM Treasury. Pre-Budget Report, November 2009.

   9. See additional readings for week 8 on the course webpage.

8.2   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 concerns were an important part
of Milton Friedman’ opposition to discretionary policy interventions).
   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?
   For this essay, see references 1, 6, 7 and 8 above. 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).


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