Instructor’s Manual Macroeconomics Fourth edition
Olivier Blanchard Alessia Amighini Francesco Giavazzi
Contents 1: A Tour of the World
01
2: A Tour of the Book
07
3: The Goods Market
12
4: Financial Markets: I
17
5: Goods and Financial Markets: The IS-LM Model
23
6: Financial Markets II: The Extended IS-LM Model
28
7: The Labor Market
34
8: The Phillips Curve, the Natural Rate of Unemployment, and Inflation
40
9: From the Short to the Medium Run: The IS-LM-PC Model
45
10: The Covid Economic Crisis
49
11: The Facts of Growth
51
12: Saving, Capital Accumulation, and Output
54
13: Technological Progress and Growth
60
14: The Challenges of Growth
64
15: Financial Markets and Expectations
67
16: Expectations, Consumption, and Investment
71
17: Expectations, Output, and Policy
76
18: Openness in Goods and Financial Markets
79
19: The Goods Market in an Open Economy
84
20: Output, the Interest Rate, and the Exchange Rate
89
21: Exchange Rate Regimes
94
22: Should Policymakers be Restrained?
99
23: Fiscal Policy: A Summing Up
103
24: Monetary Policy: A Summing Up
107
25: Epilogue: The Story of Macroeconomics
111
Answers to End-of-Chapter Problems
115
iii .
CHAPTER 1. A TOUR OF THE WORLD I.
MOTIVATING QUESTION
What is macroeconomics? The chapter does not provide an explicit or formal answer. Instead, it takes you on an economic tour of the world. At the beginning of 2020, the world population was hit by a serious pandemic caused by COVID-19, a new coronavirus that forced entire countries into quarantine and stopped production in many sectors. The world economy had just been hit by a disastrous economic crisis in 2008, the deepest since the Great Depression in 1929. World output growth, which typically runs at 4–5% a year, was negative in 2009. Since then, growth has turned positive, and the world economy has largely recovered. But the crisis, now known as the Great Financial Crisis, has left several scars, and some worries remain. Today, however, the pandemic will cause an even deeper recession. The chapter also provides an overview of the three main economic powers of the world: the United States, the Euro area, and China. The chapter concludes with a list of other regions of the world and macroeconomic issues of growing importance. A working definition of macroeconomics at this point is the study of output, unemployment, and inflation, terms that will be defined precisely in Chapter 2.
II.
WHY THE ANSWER MATTERS
This chapter attempts to provide students an incentive to master the theoretical material that follows in the remainder of the text. The implicit promise is that the theoretical model developed in the text will allow students to make sense of the various macroeconomic issues that continue to impact countries around the world.
III. KEY TOOLS, CONCEPTS, AND ASSUMPTIONS 1.
Tools and Concepts
Chapter 1 does not provide any analytical tools. However, it does force students to confront some basic data and introduces data sources for various regions of the world. In addition, the chapter introduces and defines the concepts of output, growth, the unemployment rate, and the inflation rate. A more precise definition of these terms follows in Chapter 2. Chapter 1 mentions in passing the terms standard of living, productivity, and purchasing power parity. All of these terms and concepts will be explored in later chapters in the text.
2.
Assumptions
Implicit in the Tour of the World is the assumption that the same basic macroeconomic tools can be used to analyze economies throughout the world. It might be worth making this point explicitly. The macroeconomic framework developed in the text would be neither terribly useful, nor compelling as a theory, if it applied only to the United States, and not to the other market economies.
IV. SUMMARY OF THE MATERIAL 1.
The Pandemic of 2020
A serious recession begun in the world in 2020, with few precedents in history. In just four months, the pandemic caused by the COVID-19 virus spread from the Chinese city of Wuhan throughout the world. This is an event that will mark this century, as last century was marked by the 1-1 .
‘Spanish’ flu of 1918, a virus that caused more deaths than the First World War. Recessions caused by a pandemic are different. They are not produced by any imbalance in the economy, but rather by an exogenous and unexpected shock, the diffusion of a virus. This shock affects the economy in three ways. First, by breaking the production chains. Second, to slow the spread of the virus, most countries have chosen to limit the mobility of people and many – all those who cannot work remotely – have stopped working, as vividly shown in Figure 1.2. Intermediate goods and workers, as we shall see in the next chapters, are essential factors of production, without which companies cannot produce. Their disappearance has therefore represented a ‘supply shock’, i.e. a shock that has limited production (more on this in Chapter 9). There is a third factor: the closure of factories and shops, and the associated fall in family incomes – since not all workers receive unemployment benefits – has caused a sudden slowdown in consumption. The “supply shock’ has therefore been accompanied by a ‘demand shock’, that is a fall in consumption.
2.
The Crisis
Included in the 8th edition of the textbook is a discussion around the major macroeconomic crisis that occurred in 2008. Figure 1-7 outlines the output growth rates for the world economy, the advanced economics and for the other countries separately since 2000. From 2000 to 2007 the world economy had a sustained expansion. Annual average world output growth was 4.5%, with advanced economies growing at 2.7% per year, and emerging and developing economies growing at an even faster 6.6% per year. By 2008, the world, advanced and emerging economy output growth rate began to decline marking the beginning of the macroeconomic crisis. In 2010, growth in advanced economies turned positive and has remained positive as of 2019. Highlights of the Macroeconomic Crisis: • • • •
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U.S. housing prices, which had doubled since 2000, started to decline in 2007. A number of mortgage loans originated during the earlier expansion were to high-risk borrowers which were increasingly unable to make mortgage payments. Declining housing prices caused the mortgages to exceed the market value of the homes thus creating an incentive to default. Banks that originated the loans often bundled, packaged and repackaged the loans into new securities and then sold them to other banks and investors. The holdings of securities, instead of mortgages by banks, added complexity that made it impossible to appraise the value of these derivative financial obligations. The complexity of the value of the securities and the quality of the assets made banks reluctant to lend to each other. September 15, 2008, a major bank, Lehman Brothers, went bankrupt creating borrowing issues and asset valuation problems for other banks. Within weeks the whole financial system was in jeopardy. Figure 1-2 shows how the financial crisis became an economic crisis with the collapse of stock prices indicated in the three stock price indexes (for the United States, Euro area and emerging economies). By the end of 2008, stocks had lost half or more of their value from the previous peak. The decline in housing prices and the collapse in stock prices lead to a decline in consumption of goods and services. Businesses’ concerns over sales and continuous decline in housing prices caused a sharp reduction in investment along with a decline in the building of new homes.
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3.
Despite strong actions by the Fed, including a cut in interest rates, and the U.S. government which cut taxes and increased government spending, both demand and output continued to decline in the U.S. A decline in the U.S. imports along with U.S. banks needing to repatriate funds from other countries moved a U.S. crisis into a world crisis. By 2009, average growth in advanced economies was −3.4%, by far the lowest annual growth rate since the Great Depression. Growth in emerging and developing economies remained positive but was 3.5 percentage points lower than the 2000–2007 average. Table 1-1, shows by 2018, economic growth in the U.S. was positive but still not at pre-crisis levels. Tables 1-1 and 1-2 show consistently high unemployment rates for the United States and Euro area since the beginning of the crisis. However, U.S. unemployment rates improved dramatically and are down to 3.7% as of 2018.
The United States
The recovery from the financial crisis started in the United States in June 2009. Since then, output growth had been positive until the COVID-19 pandemic broke and growth abruptly turned negative. In the United States, the 1990–2007 average rate of growth of the economy was 3.0%. In contrast the rate of growth during the crisis (2008–2009) was −1.3%. However, by 2018 the U.S. economy was growing at an annual rate of 2.9%. Beginning in June 2009, the U.S. economy continued to expand and is currently in the longest expansion on record. U.S. unemployment rates increased from a pre-crisis average of 5.4% to an average of 6.8% over the period 2010–2017. However, by 2018 the U.S. unemployment rate was down to 3.7% as firms began to add employees. One of the primary economic issues facing the U.S. is the current Federal Reserve policy of extremely low interest rates which have been necessary to propel growth. Figure 1-10 shows the federal funds rates from 2000–2019 which highlights this policy. Until the end of 2015, the Fed remained near the zero interest rate bound and it was not possible to lower rates much to stimulate growth if deemed necessary. However, by early 2019, the rate was up to 2.4%. This rate is still low by historical standards and continues to limit the Fed’s ability to respond to another recession. The low rates also push investors to take excessive risks in search of higher returns. Another macroeconomic issue is the low productivity in the U.S. Table 1-2 shows that productivity growth is significantly lower in all sectors of the economy relative to the 1990s. Slow productivity growth can decrease the real earnings power of workers and lead to an increase in income inequality. Since 2000, the real earnings of workers with a high school education or less have decreased. Policy makers need to change this trend and one mechanism to accomplish this goal is higher productivity growth.
4.
The Euro Area
Figure 1-12 displays a map the EU17 that uses the Euro as a common currency along with the 2018 output of the Euro area’s output for the countries of France, Germany, Italy and Spain. Table 1-3 shows that over the 1990–2007 time period right before the crisis, the Euro Area together experienced positive but relatively low growth. The Euro Area also experienced low inflation and continued high unemployment. The crisis caused growth to decline to negative 2.0% over the 2008–2009 period while the unemployment rate averaged 10.6% over the 2010–2017 time period. Some Euro Area countries, such as Greece and Spain, continue to struggle with unemployment rates exceeding 15%, even in 2018.
1-3 .