MACROECONOMICS Jagdish Handa McGill University, Canada World Scientific NEW JERSEY • LONDON • SINGAPORE • BEIJING • SHANGHAI • HONG KONG • TA I P E I • CHENNAI 2 Published by World Scientific Publishing Co. Pte. Ltd. 5 Toh Tuck Link, Singapore 596224 USA office: 27 Warren Street, Suite 401-402, Hackensack, NJ 07601 UK office: 57 Shelton Street, Covent Garden, London WC2H 9HE British Library Cataloguing-in-Publication Data A catalogue record for this book is available from the British Library. MACROECONOMICS Copyright © 2011 by World Scientific Publishing Co. Pte. Ltd. All rights reserved. This book, or parts thereof, may not be reproduced in any form or by any means, electronic or mechanical, including photocopying, recording or any information storage and retrieval system now known or to be invented, without written permission from the Publisher. For photocopying of material in this volume, please pay a copying fee through the Copyright Clearance Center, Inc., 222 Rosewood Drive, Danvers, MA 01923, USA. In this case permission to photocopy is not required from the publisher. ISBN-13 978-981-4289-44-3 ISBN-10 981-4289-44-2 3 Typeset by Stallion Press Email: [email protected] 4 To Sushma, And our sons: Sunny and Rish, And our delightful grandchildren: Riley, Aerin and Devyn 5 Contents Dedication Preface About the Author Glossary of Symbols Useful Mathematical Symbols and Formulae for Economics Part I Introduction to Macroeconomics 1 Output, Unemployment, and the Basic Concepts 1.1 Introduction to Macroeconomics 1.1.1 The nature of macroeconomic analysis The classification of goods in macroeconomics Closed economy versus open economy analysis Short-run macroeconomic theories, growth theories and business cycle theories 1.2 The Classification of Economic Agents and Markets in Short-Run Macroeconomic Models Box 1.1: The Analytical Devices of the Short-Run Versus Long-Run Analysis Real Time Concepts: The Short Term and the Long Term 1.3 Introduction to AD-AS Analysis 1.3.1 The supply of commodities The long-run (equilibrium) aggregate supply of commodities The short-run aggregate supply of commodities 1.3.2 The components of aggregate demand 1.3.3 The diagrammatic AD-AS analysis The possibility of disequilibrium in the economy The actual aggregate supply of commodities The impact of an increase in aggregate demand The impact of an increase in the long-run productive capacity of the economy The stability of equilibrium 1.4 The Relationship between Output, Employment, and Unemployment in the Economy The labor force Unemployment 1.5 Measures of National Output and Expenditures 6 1.5.1 Gross domestic product (GDP) Fact Sheet 1.1: Global Trends in GDP Per Capita, 1950–2003 1.5.2 Gross national product (GNP) 1.5.3 Net domestic product (NDP) and net national product (NNP) Fact Sheet 1.2: Comparing GDP and GNP, 1965–2004 1.5.4 Measuring GDP Box 1.2: GDP per capita as a Measure of the Standard of Living GDP as a Measure of Welfare 1.6 Measuring the Price Level and the Rate of Inflation 1.6.1 Measures of the price level 1.6.2 The inflation rate Fact Sheet 1.3: Inflation in Canada, 1915–2007 1.6.3 Core inflation Mathematical Box 1.1: Calculation of the Price Index and Growth Rates The construction of a price index: an illustration Differences between Laspeyres and Paasche indices Separating the rate of growth of nominal income into the real growth rate and the inflation rate 1.6.4 Deriving the rate of inflation from a price index Box 1.3: Mathematical Formulae to Learn Fact Sheet 1.4: Measures of Inflation for the USA, 1960–2007 1.6.5 Disinflation versus deflation 1.7 Nominal Versus Real Output 1.8 The Economic Relationship between Real Output and Inflation 1.9 The Nature of Economic Relationships Box 1.4: Definition of Equilibrium Equilibrium conditions versus identities Equilibrium versus disequilibrium Stable versus unstable equilibrium 1.10 Exogenous and Endogenous Variables and the Concept of Shocks in Macroeconomics 1.10.1 An illustration 1.10.2 Shocks 1.10.3 Multipliers 1.11 Growth Theory 1.11.1 Growth of the standard of living 1.12 Business Cycle Theories Fact Sheet 1.5: Booms and Recessions in the USA Since 1960 Box 1.5: The Fundamental Role of Economics as a Science Theories/models in economics Economics as the ‘premier social science’ 1.13 Paradigms in Macroeconomics 7 1.14 Economic and Political Systems: Organization of the Macroeconomy 1.14.1 Capitalism 1.14.2 Marxism and communism 1.14.3 Socialism 1.15 Conclusions Key Concepts Critical Conclusions Review and Discussion Questions Advanced and Technical Questions 2 Money, Prices, Interest Rates, and Fiscal Deficits 2.1 What Is Money and What Does It Do? 2.1.1 The functions of money 2.1.2 The practical definitions of money 2.2 Money Supply and Money Stock 2.3 The Nominal Versus the Real Value of the Money Supply 2.4 Bonds and Stocks in Macroeconomics 2.5 The Definition of the Money Market in Macroeconomics 2.6 A Brief History of the Definition of Money 2.7 The Current Definitions of Money and Related Concepts Extended Analysis Box 2.1: Current Meanings of the Symbols for the Monetary Aggregates in Selected Countries The monetary aggregates for USA The monetary aggregates for the Canada The monetary aggregates for the UK Fact Sheet 2.1: Monetary Aggregates of the USA 2.8 The Monetary Base and Bank Reserves 2.8.1 The relationship between the monetary base and the money supply 2.9 The Quantity Equation 2.9.1 The quantity equation in growth rates 2.9.2 The implications of the quantity equation for a persistently high inflation rate Fact Sheet 2.2: Money Growth and Inflation in the USA, 1960–2008 2.10 The Quantity Theory Extended Analysis Box 2.2: The Difference between the Quantity Theory and the Quantity Equation 2.10.1 The transactions approach to the quantity theory The adjustment period relevant to the quantity theory Is velocity constant over time ? Fact Sheet 2.3: Velocity of Money in the USA, 1960–2008 2.11 The Definitions of Monetary and Fiscal Policies 2.12 The Central Bank and Monetary Policy 2.13 The Economic Aspects of the Government and Fiscal Policy 2.13.1 The financing of fiscal deficits/surpluses and changes in the money supply 8 The implications of the independence of the central bank from the government for financing deficits 2.13.2 The public debt 2.13.3 The selective nature of government expenditures, taxes, and subsidies 2.14 Interest Rates in the Economy 2.14.1 The Fisher equation on interest rates Fact Sheet 2.4: Nominal and Real Interest Rates in the USA, 1982–2008 2.14.2 The concept of present discounted value (PDV) of a bond 2.14.3 Bubbles in asset prices The importance of asset bubbles for output and business cycles Box 2.1: The Determination of Stock Prices Bubbles in house and land prices A bubble in tulip bulb prices! Conclusions Key Concepts Summary of Critical Conclusions Review and Discussion Questions Advanced and Technical Questions 3 Introduction to the Open Economy: Exchange Rates and the Balance of Payments 3.1 Exchange Rates 3.1.1 Three concepts of exchange rates The (nominal) exchange rate The real exchange rate The effective exchange rate 3.2 Fixed, Flexible, and Managed Exchanged Rates 3.3 Purchasing Power Parity (PPP) as a Theory of the Exchange Rate 3.3.1 PPP at the level of a single commodity Absolute PPP among countries Extended Analysis Box 3.1: Does PPP Apply in the Real World? An Illustration 3.4 Relative PPP and Shifts in the Relative Efficiency of Economies 3.4.1 Long-run changes in relative PPP 3.4.2 Short-run changes in relative PPP 3.4.3 Implications of short-run PPP for exchange rates and inflation rates Box 3.1: International Comparisons of Standards of Living in Terms of PPP 3.5 Interest Rate Parity (IRP) and the Determination of the Exchange Rate 3.5.1 The benchmark IRP theory 3.5.2 The benchmark IRP as a determinant of the domestic interest rate 3.5.3 The benchmark IRP as a theory of the exchange rate under flexible exchange rates 3.5.4 The role of speculative returns to stocks in capital flows and IRP 3.5.5 Extending IRP to incorporate risk factors and risk aversion Fact Sheet 3.1: Interest Rate Differentials Between Countries 9 3.5.6 The relative importance of PPP and IRP in determining exchange rates 3.6 The Balance of Payments 3.6.1 The components of the balance of payments Fact Sheet 3.2: United States Balance of Payments, 1976–2008 3.6.2 Equilibrium in the balance of payments 3.6.3 The change in foreign exchange reserves Fact Sheet 3.3: US Foreign Exchange Reserves and Balance of Payments, 2005–2008 Equilibrium in the balance of payments Foreign exchange reserves and short-term bonds 3.7 The Balance of Payments in an Accounting Sense 3.8 The Market for Foreign Exchange and the Changes in Foreign Exchange Reserves 3.8.1 The demand and supply of foreign exchange 3.8.2 Equilibrium in the foreign exchange market Extended Analysis Box 3.2: The Demand and Supply of Foreign Exchange Stated in Foreign Currencies 3.9 The Market Determination of the Nominal Exchange Rate Fact Sheet 3.4: Exchange Rates against the US Dollar, 1980–2008 3.9.1 Hot money Box 3.2: National Policies on the Balance of Payments and Accumulation of Foreign Exchange Reserves 3.10 The Persistence of Balance of Payments Deficits and Surpluses Conclusions Key Concepts Summary of Critical Conclusions Extended Analysis Box 3.1.A: Comparison of the Actual and PPP Costs of the Big Mac Review and Discussion Questions Advanced and Technical Questions Part II Short-run Macroeconomics 4 Determinants of Aggregate Demand: The Commodity Market of the Closed Economy 4.1 Symbols Used 4.2 The Commodity Sector of the Closed Economy 4.2.1 Uses of national income 4.2.2 Sources of national expenditures 4.2.3 Equilibrium in the commodity market 4.2.4 National saving 4.2.5 The relationship between saving and investment 4.2.6 The (physical) capital stock Box 4.1: An Unjustified Oversimplification for a Modern Economy 4.3 The Two Uses of Private Saving and the Drag of Deficits on Investment 10